Above the NOISE: Estonia should be the future model of Europe

The debt crisis in Europe is still on and the overhang from our reckless spending in governments and households will haunt us for years, maybe even decades. The hangover will be worst for the most indebted countries, predominantly peripheral countries and French-speaking countries (France and Belgium). Our current situation is a cancer brought about by two main catalysts: dysfunctional labour market laws and a reckless spending culture fueled by disregard for savings and investment. Estonia has completely avoided this cancer and the country's model should be considered the future model of Europe.

Estonia is number one in government debt and budget discipline

The chart below shows the distribution of the Eurozone countries' government gross debt in percentage of GDP, with 2011 actual figures and 2017 forecast based on IMF figures. To no surprise Greece, Italy and Portugal are the most indebted countries and also the epicenter of the debt crisis. The reason why Spain is such a concern and also part of the epicenter these days is the debt trajectory. The chart clearly shows that Spain is expected to see an explosion in its government debt to GDP. The poster child in the Eurozone is Estonia which has virtually no government debt to speak of. It gets even better.

Estonia is also by far the poster child when it comes to government budgets. The chart below shows that Estonia is the only country in the Eurozone that had a budget surplus in 2011. Again peripheral Europe and Ireland rank as the recklessly overspending countries.

Estonia's success is built on long-term fiscal discipline

Now is it a coincidence that Estonia is so well run? No, the country's current fiscal and debt situation is a result of disciplined government policies since 1995, as you can be seen in the chart below. The government's gross debt to GDP has never been above 10 percent and the government has only briefly run deficits. Even during the Great Recession, Estonia only had two years of budget deficit before returning to a budget surplus in 2010. What a different situation from what we are observing in Spain, Italy, Portugal and Greece.

What makes the Estonian model work?

Well, as we have outlined, the first two pillars of a sound economy are balanced budgets and low government debt. Estonia excels in both. Next is the country's 18 percent flat-rate income tax system (down from 26% in 2004) that has reduced bureaucracy and increased incentives for the population to work. Estonia has been able to reduce its tax burden significantly since 2004 and even lowered the tax rate in 2010 when most Eurozone countries were in trouble. Think about that for a second. As a result economic growth (because lower tax burden is associated with higher growth) has been a median 5.9 percent year-over-year by far surpassing most countries in the world. No wonder, the World Bank has named Estonia the Baltic Tiger.

Now everything is not perfect in Estonia. It's score on the OECD Employment Protection Index - which measures the flexibility of employers to hire and fire - was on the high side, which means that existing workers' jobs are protected at the expense of labour market flexibility. It is still better than Italy, Germany, Norway and Spain but it is not good enough. The result is a sticky labour market. As a result the unemployment has only fallen from its peak of 18.8 percent in early 2010 to now 11.7 percent. However, it will probably continue to fall to around 4-6 percent as was the range before the Great Recession as the economy continues to expand.

Source: OECD Social, Employmen and Migration Working Papers, 2009

In nature the animals that cannot adapt die eventually. The same go for political and economic systems. Estonia is by far a superior system to old Europe, which should learn from their Eastern cousin. The biggest contribution to the developed world in modern times would be for Estonia to go on an export crusade to pursuade other countries to adopt their model.

Estonia shows that difficult times are no excuse

You could argue that Estonia has been able to transform their country as they had a clean slate following the collapse of the Soviet Union. Nothing could be further from the truth. According to IMF, Estonia's real output per capita saw an initial drop of 22 percent in the first two years of independence! Spain has only seen a 3.1 percent drop on the same metric during the Great Recession. Estonia's economy recovered quickly from the chaos as the country engaged in a wide range of reforms to transform the country into a market economy. They did it despite of the complete aftermath chaos stemming from a planned economy and lack of investment for decades. There is no excuse why Europe should not be able to reform itself even in the midst of a crisis.