As Spain and Greece Burn, Estonia Offers a Lesson

Over the past few days, new strikes and riots have convulsed Greece and Spain. Conventional wisdom (including from economist Paul Krugman) suggests that cuts in government spending—often described as “austerity”—are a primary cause of the economic downturn in these nations and across much of Europe.

This “demand deficiency” hypothesis leads to the conclusion that the European Central Bank and the troubled European states should undertake hugely expansionary monetary and fiscal policies, an approach embraced by the protestors on the streets of Athens and Madrid.

Usefully, the eurozone crisis has provided a natural experiment in how to deal with a severe downturn. The results of that experiment have not favored the unsophisticated Keynesian view that more borrowing is the answer. The highly indebted southern European states decided to run big fiscal deficits in the aftermath of the crisis, and now they face suffocating debt burdens and still-uncompetitive labor markets.

On the other side of the spectrum, the Baltic nations (especially Estonia and Latvia) cut government spending and liberalized their economies. While the short-term effects were painful, these two countries grew last year by 8.3 percent and 5.5 percent, respectively—remarkable when you consider that Greece, Spain, and Italy are in recession.

In Estonia, total government spending fell by 10 percent in just two years. The Estonian people displayed admirable fortitude, while the Estonian government recognized that the spiralling private-sector debt of the previous decade had produced unsustainable, illusory growth and that the financial crisis of 2008 had exposed structural flaws in their economy.

Remarkably, their swift action—which, in line with best practices, made significant supply-side reforms alongside the spending cuts—enabled them to keep their highly competitive 21 percent flat tax. They even got rewarded for their efforts with re-election.

It remains to be seen whether this approach is politically feasible in southern Europe. Those nations are much more highly indebted than Estonia was, and poor policy over the past decade may mean the competitiveness gap cannot be closed without severe political and economic repercussions.

But as the Estonian experience illustrates, the problems in southern European are structural. Excessive borrowing, large welfare states, high debts, illiberal labor markets, and dysfunctional banking sectors—and, decisively, the euro as it was adopted in 1999—are the real underlying causes of today’s crisis. Remedying it will require addressing those problems, not pumping more borrowed money into the system.

Ryan Bourne is head of economic research for the U.K.-based Centre for Policy Studies.