(Corrects name of the first post-Soviet president of Estonia.)
In May 2009, months after the passage of a $787 billion stimulus package in the U.S., Estonia’s government took the opposite tack: the hard line. It did not dip into the country’s reserves or borrow money. Ministers say they never even considered devaluing what was then Estonia’s currency, the kroon, which would have derailed a 10-year plan to adopt the euro. To maintain the country’s balanced budget, a tradition it had honored since the end of the Soviet occupation, Estonia’s government froze pensions, lowered state salaries by about 10 percent, and raised the value-added tax by 2 percent. The gross domestic product dropped more than 14 percent that year.
At Estanc, which makes high-pressure steel containers at a plant outside of Tallinn, profits stagnated. The company postponed plans to double floor space at the factory. Unemployment in Estonia got as high as 16 percent, and many of the country’s welders took the ferry ride across the Gulf of Finland to Helsinki to look for work. Vaido Palmik, the plant’s managing director, had friends lose their jobs during the crash. “It was a very hard time,” he says.
The welders are back now. In 2010, Estonia’s GDP grew by 2.3 percent. At the end of that year, the country ran into a burning building and adopted the euro. Last year, GDP grew by 7.5 percent. Estanc has increased its head count by more than a third in 2012. Palmik sells to Finland and Sweden; he wants to break into the German market and has moved forward with plans for expansion. Estonia’s unemployment is down to 10.8 percent—not ideal, but less than half that of Spain, and enough to get both the country’s president and its ruling coalition reelected in 2011. Last November, the International Monetary Fund praised the country’s export-led recovery and “enviable fiscal position.”
Economists don’t get controlled experiments, so they have to take countries as they are. Right now, Estonia seems to show that monetary and fiscal restraint can, after pain, create growth. “If you look back, the crash is very good,” says Palmik.
Not surprisingly, Estonia, a country with 1.2 million people, has been offered as a model by advocates of austerity in Europe and elsewhere. On the far side of the Atlantic, however, Nobel prize-winning economist and New York Times columnist Paul Krugman has been arguing for years against this kind of restraint, saying it leads to pointless misery. The argument is central to the future of the U.S.—and most other countries, too.
On June 6, in a blog post titled “Estonian Rhapsody,” Krugman took on what he called “the poster child for austerity defenders.” In his post, he graphed real GDP from the height of the boom to the first quarter of this year to show that, even after a recovery, Estonia’s economy is still almost 10 percent below its peak in 2007. “This,” he wrote, “is what passes for economic triumph?”
“It was like an attack on Estonian people,” says Palmik, in an office above his plant, surrounded by blueprints for his new production line. “These times have been very difficult. People have kept together. And this Krugman took all these facts that he wanted.”
Over the course of a week’s visit to three cities in Estonia, I met only two people who didn’t know what Krugman wrote about their recovery. This is not because Estonia is a country of blog-obsessed amateur economists. It’s because Toomas Hendrik Ilves picked a fight.
Ilves is the president of Estonia. The night Krugman wrote his post, Ilves was in Riga, on a state visit to Latvia. He gave a talk to the city’s business community, offering what he calls “moral support” for Latvia’s own austerity policy. He went to a reception on a boat, then returned to his hotel and pulled out his iPhone. “I read somewhere ‘Krugman attacks Estonia,’ and I thought, well, let’s look at his blog,” says Ilves. “I said ‘What the f …’” Ilves does not complete the word.
Estonia’s president has little formal power. As in the U.K., the prime minister runs the government. Like the Queen of England, Ilves has only a bully pulpit. On June 6, standing in front of the Riga Radisson, he linked to Krugman’s post and wrote five tweets in 73 minutes.
8:57 p.m. Let’s write about something we know nothing about & be smug, overbearing & patronizing: after all, they’re just wogs
9:06 p.m. Guess a Nobel in trade means you can pontificate on fiscal matters & declare my country a “wasteland.” Must be a Princeton vs Columbia thing
9:15 p.m. But yes, what do we know? We’re just dumb & silly East Europeans. Unenlightened. Someday we too will understand. Nostra culpa.
9:32 p.m. Let’s sh*t on East Europeans: their English is bad, won’t respond & actually do what they’ve agreed to & reelect govts that are responsible.
10:10 p.m. Chill. Just because my country’s policy runs against the Received Wisdom & I object doesn’t mean y’all gotta follow me.
The tweets made the Estonian papers and the international press. The next morning Jürgen Ligi, the country’s finance minister since 2009, had to comment on them at a press conference. “Maybe the style can be argued,” he tells me. “For example, the reaction was really sensitive, blaming Krugman, but the general idea was right. Krugman was clearly wrong. He clearly doesn’t understand differences of choices between America and in a small economy. By a Nobelist, it was a shame.”
At the Estanc plant, Palmik struggles to explain his president’s tone in the argument with Krugman. “Maybe he could have said it in a more …” He turns to a younger colleague, who turns to Google (GOOG) Translate, open on a laptop in front of them. “Retired,” says his colleague. “Yes,” says Palmik, “he could have been more retired.”
Ilves, at first, is mildly annoyed to talk about Krugman. “I can’t meet anyone who doesn’t bring it up,” he says. “People come up to me on the plane and say ‘Are you the guy that wrote the Twitter stuff?’” A tall man, Ilves has to fold himself into an easy chair in his office in the Kadriorg palace, which Peter the Great built in Tallinn for his wife, Catherine. He buys his bow ties at Brooks Brothers and his three-piece suits from a tailor in Tallinn. With his wife, Evelin, he graces the covers of Estonia’s lifestyle tabloids. “For 20 years, I’ve been writing about this bizarre East-West thing of, you know, Easterners are just sort of gray people living in gray apartments,” says Ilves. “It ain’t that way anymore.” He explains he chose the word “wogs” to point out how faintly racist condescension toward the East is still socially acceptable in Europe.
He speaks flawless, comfortable English, and not just because he has a degree in psychology from Columbia University. His parents met in exile, among the 100,000 Estonians who fled the country in 1944, when the Soviets took over. Ilves was born in 1953 in Sweden. He grew up in Fort Lee and Leonia, N.J., in his words as “Tom Ilves, the Estonian kid.” His parents spoke Estonian at home and made him eat with his fork in his left hand.
Some kids in Fort Lee were from Poland. Poland was on the map. Some kids had grandparents from Italy. Italy was on the map. Ilves would point to Estonia, but the map showed only the Soviet Union. “Oh,” kids would say, “so you’re Russian.” When he was seven, he asked his father why, if they spoke this other language, they had come to America. “The communists came,” his father answered. He asked his father what a communist was. “They’re the people who round you up in the middle of the night, stick you in a cattle car, and ship you off to Siberia,” his father replied.
After college, Ilves went to grad school for psychology until he read Thomas Pynchon’s Gravity’s Rainbow. He wasn’t sure what he wanted to do after finishing the book, but he knew he was done with grad school. Ilves started translating Estonian poetry. He taught a course on the Estonian language. In 1984 he was offered a job as a researcher for Radio Free Europe. He ran Radio Free Europe’s Estonian service from 1988 to 1993. Older Estonians remember his broadcasts well.
After the occupation, Lennart Meri, the first post-Soviet president of Estonia, challenged Ilves to roll up his sleeves. “You’ve gotta come here,” Ilves recalls Meri telling him. “Don’t tell us on Radio Free Europe post hoc what we’ve done wrong.” Ilves renounced his American citizenship, and with other émigrés joined Estonia’s foreign service. He served as Estonia’s ambassador to the U.S., then as foreign minister. He was elected to his first term as president in 2006. His mother still lives in New Jersey. She tried to return to Estonia, he says, but found it hard. “She spent 60 years abroad,” he says. “All the people she knew were there.”
At a market in Tartu, a university city in the south, I ask Rando Veberson, a farmer’s son, what he thinks of his president. “I like his clothes,” he says. “The tie. He always wears a suit.” Veberson’s father had told him about the fight with Krugman. “My father thought Toomas did a good job, said it straight.” He pauses. “My father thought he was a bit drunk.”
Since independence, Estonia has focused on becoming part of the West. It joined NATO, the Coalition of the Willing, and the European Union. Mart Laar, Estonia’s first post-Soviet prime minister, likes to say that when he was elected, he had read only one book on economics, Milton Friedman’s Free to Choose. The country is open, efficient, and wired. On the World Bank’s Ease of Doing Business Index, it ranks 24th out of 183. Estonia speaks a language close to Finnish, and its strongest trade ties are with Finland and Sweden. At the Kadriorg, Ilves produces a colored map ranking the most competitive economies in the European Union. Estonia sits in the second tier, behind the Nordic countries, grouped with Germany and the United Kingdom.
But Estonians suspect that foreigners can’t be bothered to understand them. Ministers complain that, for all their hard work, the country still gets placed in a catchall folder labeled “East” or even worse, “rim.” The crisis has left Estonians, once again, defensive about making sure they make it into the right folder.
Ilves divides Europe into countries that follow the rules and countries that don’t. And he has started worrying about a new kind of populism in Europe: people who play by the rules and are unwilling to help those who didn’t. Ilves points to Finland, where the True Finns party has won votes by rejecting bailouts, and to Slovakia, where the prime minister lost a confidence vote last year for her support of Europe’s bailout fund.
Estonians, in their own eyes, have always followed the rules, and in 2009 took their lumps to do so. Ilves says Estonia’s average salary is 10 percent below the minimum salary in Greece. He says pensions are also much lower, and civil servants retire 15 years later. “You can imagine why there might be some frustration,” Ilves says.
The outburst at Krugman came from that frustration and from Ilves’s youth in America. He says he’s better able to hear Western condescension, the habit of treating all those little countries the same. “This is why I relish being good in English,” he says.
The night of our conversation, Ilves hosts a concert and a reception as part of a three-day meeting of Estonia’s Friends International, a group of expats and foreign investors. Estonia, like Israel and Ireland, is figuring out how to use its diaspora to draw foreign investment. Ilves comes upon me at the reception and tells me there’s something he forgot to say at the Kadriorg. “With those 840 characters,” he says, “I did more than with a lifetime of academic essays.” He’s off by a few characters, but it doesn’t matter.
Paul Krugman hadn’t known that Ilves grew up in New Jersey until I tell him on the phone. “That explains a lot,” he says. “Then my response to him would be ‘You got a problem with that?’” Krugman says he gets “hysterical reactions” to things he writes all the time. He hadn’t expected one from a head of state.
The question for a country like Estonia, he says, is how to get wages into a competitive position: how to pay workers less so that a country can sell more products abroad. There are two ways to do this. A country can devalue its currency, making its labor comparatively cheaper. Or it can undergo what economists call an internal devaluation: It can hold on to its currency’s value and force workers to accept lower wages.
Had he been making Estonia’s decisions in 2009, he would have devalued the kroon. It’s difficult to get people to accept a drop in pay, says Krugman, an insight that reaches back to John Maynard Keynes, who described wages as “sticky.” It’s easier to make labor comparatively less expensive through a devaluation than absolutely less expensive through an internal devaluation. Estonia chose the harder way. The country kept its kroon pegged to the euro, and then nailed those colors to the mast, adopting the euro in 2010. In conservative parlance, it took its medicine.
“It’s very difficult to understand for American people why some crazy Estonians decided to join the euro zone during the crisis,” says Andrus Ansip, Estonia’s prime minister. Ultimately it was Ansip’s decision. His office in Tallinn looks north, out over the Gulf of Finland. Swedish and Finnish entrepreneurs, he says, remember the early 1990s, when those two countries went through their own devaluations. For a small country with an open economy and little capital, foreign direct investment is everything. But after the crisis, Nordic investors “were not ready to invest in Estonia’s economy,” says Ansip. “They couldn’t so much trust those small national currencies.”
From 1992 until the country adopted the euro in 2010, a currency board controlled monetary policy in Estonia. The board was an independent entity that pegged the value of the kroon to the German mark and then the euro, and it was meant to remove any hint of currency risk for investors.
But in 2009 there were rumors of an Estonian devaluation anyway. Ansip’s government had to explain that its hands were tied on exchange rates even to finance ministers from Nordic countries, who asked when a devaluation would come. The kroon came under speculative pressure. “The only way out from all those rumors and doubts,” the prime minister says, “was to join the euro zone as soon as possible.” Large countries have the luxury of a discretionary currency policy. Small countries have a credibility problem no matter what they do. Krugman’s prescription doesn’t account for Estonia’s very real need to be taken seriously, as both a matter of pride and of function.
The need to join the euro also explains the country’s fiscal decisions. The Maastricht criteria—rules for joining the euro zone—demand that a country’s deficit be no greater than 3 percent of its GDP and that inflation remain low. The financial crisis had taken care of inflation. Estonia needed to avoid running a deficit. It had a six-month window to join the euro and get rid of the perception of currency risk. “We cut our dreams for 2009,” says Ansip, referring to the austerity measures. “If you will cut these dreams early, they are less painful.”
Krugman says he understands that a currency board can make it hard to devalue, but he does note that Argentina’s currency board, after a drawn-out debt crisis, abandoned that country’s peg to the dollar in 2002. And he concedes Ansip’s point on reputation, kind of. “It’s true,” he says, “pledges to fixed [exchange] rates are never perfectly credible. But the kind of money that comes in because you’re safe is probably not the kind of money that you want.” In being seen as a safe destination for foreign capital, he says, Estonia is asking for a chance to be just like Spain. What’s happened so far, however, is that Estonia is just like Estonia—the old Estonia, the one before the housing bubble, a country with cheap, skilled labor that attracted foreign direct investment and showed moderate, steady growth.
“What Krugman has not mentioned at all,” says Urmas Varblane, “is that when economic crisis entered Estonia in 2008, then we had already our own crisis.” For Varblane, who teaches economics at the University of Tartu, the real crisis was what came before the downturn: unsustainable, debt-driven growth that distorted the economy.
In the 1990s, Estonia’s labor costs were low, and the workforce was skilled and educated, so the Finns moved south and started businesses. In a way, Estonia was Finland’s East Germany—close, cheap, and culturally familiar. Around 2004, Swedish and Finnish banks began to compete aggressively to sell mortgages in Estonia, and Estonians began to build new houses. Varblane lists what he calls the “dreadful developments” of the boom years. Private debt increased from 10 percent to 100 percent of GDP. As debt flowed into the country, workers left manufacturing for more lucrative jobs in construction. Wages grew rapidly, and productivity growth flattened out. Manufacturing became more expensive. Domestic debt began to crowd out foreign investment.
The crash was necessary, says Finance Minister Ligi, “to correct our understanding about growth potential.”
Ligi tells the story of a prominent Estonian businessman who asked in 2007 why he should export when Estonians were becoming richer and it was possible to make money at home. “Now he’s more or less bankrupt,” says Ligi. Politicians choose their own stories, and one broke, unnamed businessman does not prove an economic policy. But Ligi, like Varblane, says there were two crashes in Estonia. One came from the global slowdown. One came because Estonians got ahead of themselves and thought themselves richer than they were.
In his blog post, Krugman started his graph—and his logic—when Estonia’s GDP had reached its peak, in 2007. Wages were high, and unemployment was low. Good for most citizens, and for most citizens now things are still worse than they were then. But if you move Krugman’s graph all the way back to 2000, you see slow, steady growth in GDP, then a short boom, then a hard crash, and now growth leveling back off to where it would have been without the boom. In the boom years, says Varblane, “GDP growth was not real. It was artificial,” fueled by cheap debt from abroad. The peak, Krugman’s point of comparison, was not “real,” he says. That Estonia has not reached it again is a good thing, Varblane and Ligi say. It never should have been there in the first place.
Krugman was right about one thing: Wages were sticky. But they weren’t glued. They declined slightly in 2009 and 2010. They have grown since, but the larger wage trend since 2007 is flat. Anecdotally, some industries reported wage cuts of as much as 30 percent. Productivity, in the meantime, recovered. And both look roughly where they’d be now had there been no housing boom. As hoped, Estonia’s growth in 2010 and 2011 came from exports. The government points proudly to Ericsson’s (ERIC) recent decision to build a plant near Tallinn. Estonia’s politicians seem relieved that the country has resumed its rightful place in the world: manufacturing, exports, and sobriety.
Krugman doesn’t deny that there are good things happening in Estonia. “I have no particular dog in the fight over Estonian policy per se,” he says. “My interest is in this broader debate over whether internal devaluation is a viable strategy.” Estonia, according to Krugman, is just another “hero of austerity” promoted by advocates now that Ireland is stubbornly failing to grow. If the post came off as condescending, he says, it was meant to condescend to the people he calls “austerians,” in particular Jens Weidmann, president of the German central bank.
On the eighth floor of Estonia’s Finance Ministry, which is housed in a Soviet-era tower, I tell Ligi that a boy in a market suggested that Ilves might have been drunk when he tweeted. Ligi laughs, considers his words, then smiles. “I can suspect that Krugman was drunk,” he says.
Estonia’s housing boom left a lot of work undone. Close to the park around the Kadriorg, clusters of prewar wooden houses haven’t seen a coat of paint in 20 years. Behind the windows hang lace curtains, an old custom in Nordic countries. A few houses have scaffolding, and where a restoration has taken place, the lace is gone. Two new glass towers are visible in the center of Tallinn.
Virgo Veld walks out of a four-story concrete apartment house, carrying a duffel bag and a saxophone case. He is a musician, waiting for a ride to a sound check at Tallinn’s summer beer festival. Asked what he thinks of Ilves, Veld says, “I like him.” Ilves projects the right kind of image, mostly. “He got into this argument,” Veld says. He searches for a word. “Krugman?” I offer. “Yes, Krugman.” Veld snaps his fingers. “This is stupid. The president of the country should be bigger than these kinds of blogs.”
By now his ride has arrived, a rusted Peugeot driven by a friend. I ask whether the recession was hard on musicians, and both look at me the way people look at you when you have asked a question that is both stupid and offensive. “Yes,” says Veld, “it was very hard. People don’t pay for parties.” Should the government have borrowed money to keep unemployment low? “No,” he says. “We don’t want to be like Greece.”