Tallinn, Estonia

The Economist waxes enthusiastic about Estonia qualifying for membership in the Euro:

Many thought that highly unlikely. Only two years ago a property bubble collapsed, rocking the banking system and sending GDP plunging by 14.1% in 2009 (see story). Doom-mongers said devaluation was inevitable. But they were wrong. Flexible wages and prices have helped the economy stabilise: unit labour costs fell by 7.5% in the final quarter of 2009. Exports were up by a sixth in the first quarter of 2010 and the central bank forecasts growth this year of 1%. Estonia easily meets the euro zone’s rules on public finances. Its gross debt in 2009 was only 7.2% of GDP, and the government deficit is 1.7%. The only real concern is whether inflation will stay low: in the past 12 months the average was negative, at -0.7% comfortably below the 1% target. But the ECB report called for “continued vigilance” on that.

But is any of this actually a good thing? Estonia has certainly proven that a country with a currency pegged to the Euro that faces a situation in which devaluation would be good policy can, in fact, choose not to devalue. But the consequences of that decision seem fairly disastrous. One percent growth in 2010 after a 14.1 percent decline in 2009 is going to leave output over 13 percent lower than it was in 2008. If Estonia follows up its projected 2010 growth with three percent annual growth going forward it will recover its 2008 output level in 2019. Nor am I certain that inflation of -0.7 percent should be described as “comfortably below” anything—you don’t want to go below zero.

And what’s the upside of this for Estonia? Like Ryan Avent I don’t quite see it:

The natural question is what Estonia hopes to get out of euro zone membership. Its euro peg should look as credible as ever, so why permanently give up the ability to devalue? Borrowing costs would likely be lower, but that’s what led southern European nations to go on a debt binge. Is Estonia happy to share a monetary policy with the Germans? Are Estonians prepared to accept the cost of future bail-outs of struggling members of the currency area?

The funny thing about the Euro is that it does address a real practical problem of 20th century economic life. Until recently, the need to switch currencies was a substantial impediment to traveling, and creating a single currency across Europe would have had huge convenience upside for tourists and business travelers. That’s especially true for residents of small countries like Estonia. But thanks to ATM machines and credit cards, there’s really no problem with just traveling around in the normal “not much cash in my wallet, but I could get some with my card” state.

Here’s Cato’s Daniel Mitchell writing in April 2007:

The International Herald Tribune reports that the new government in Estonia plans to lower the rate on the flat tax from 22 percent to 18 percent. Estonia already ranks as one of the world’s most laissez-faire economies. Reducing the flat tax rate – which was originally imposed at a rate of 26 percent – will further enhance Estonian competitiveness and increase the power of tax competition in Europe.

Ah, Estonia:

Estonian GDP Shrinks By An Annual 15.6% In The First Three Months Of 2009

Well, the best thing that can be said about this is that it wasn’t as bad as the 18% contraction recorded in Latvia.

Back to Daniel Mitchell, writing with his colleague Chris Edwards who observe that “Latvia became the third Baltic country to adopt a flat tax . . . Latvia has experience rapid economic growth in recent years . . . like in Estonia, Latvia has been able to cut the overall size of its government.”

Not, of course, that flat taxes breed spectacular economic meltdowns. But many of the “miracle” economies pointed to by the right as proving the virtues of tax cuts—Ireland, the Baltics, to a lesser extent other neoliberal regimes in Central Europe—in fact clearly seem to have powered their past several years worth of growth largely by tapping the credit bubble in even bigger ways than the United States did.

Meanwhile, recall that the shoe of Eastern European defaults hasn’t necessarily finished dropping yet. The impact would be felt primarily in European banks, but it still spells trouble for everyone.