Estonia had the smallest government debt in the EU 2007. You’ll Never Guess What Happened Next.

In 2007, Estonia had the smallest amount of government debt in relation to GDP, among all the EU countries. Latvia and Lithuania were also among those with the smallest debts. Shortly thereafter all the three Baltic countries (hereinafter ELL) were hit by major financial crises, causing the public debt to increase. In Latvia and Lithuania, the increase were substantial. To the extent that government debt did changed in the years before the crises, it was slightly decreasing.

This is not only curiosities. Many seem to think that the crisis that started around 2008, which is still largely going on in many countries, arose because of large Government debts. Many seems to find it difficulty to imagine that private debt might be a central mechanism behind these problems. This also affects how we look at economic policy in general.

s2007e bal_s2e

Data from AMECO

1. Low unemployment before the crisis

Like most crisis-affected countries, ELL experienced strong economic growth during the years prior to the crisis, as the unemployment rate fell to around 5 percent – a record compared to the 10 previous years. As the crisis hit, unemployment rose sharply in all three countries. Since then, unemployment has fallen again but six years later it still hasn’t returned down to the previous low levels, although Estonia is near.



Data from Eurostat


2. Low taxes and deregulation

Years before the crisis total tax revenue were around 36 percent of GDP in Estonia and just under 34 per cent in Latvia and Lithuania (according to Eurostat). Compared in this way with other countries, ELL seems neither to have had extremely high or low taxes, when the crises hit.

The Baltic countries were previously part of the Soviet dictatorship. But after the Eastern Block fell, many goods and services markets have been deregulated. According to the OECD regulation index, Estonia doesn’t seems to be that much regulated, compared with other OECD countries. The graph shows the OECD index of regulation in 2008. Higher value = more political regulations. Some of the worst affected countries in crisis highlighted in blue.

Greece stands out as relatively tightly regulated. USA, which also went into a similar severe financial crisis, about the same time as Greece, stands out as one of the least regulated. Values ​​are not available for Latvia and Lithuania but similar index from 2013 do not indicate that any of those was extremely regulated – nor extremely unregulated. Therefor, overall regulations doesn’t seems to explain the crisis.


Data from the OECD Product Market Regulations .

3. Private debt major cause behind the crisis

What instead appears to be the single most important explanation for the start of the crisis in these three countries is private debt. Thus, the same mechanism as seems to have been a central factor behind the troubles in Greece, Spain, Ireland, the USA and many other countries around the same time.

Before the crisis, banks borrowed in ELL (both Baltic and foreign-owned banks) large sums to individuals and businesses so that they could buy things they acctually could not afford in the longer term. Among other things, this seems to have driven up the price of housing. Between the year 2000 and 2007 house prices on average increased by 450 per cent in Lithuania – which is simply insane.

The total amount of outstanding private loans and debt increased during the 2000s in all three countries. From the equivalent of 10-15 percent of GDP in the mid-1990s, to about 105 percent of GDP in 2009 in Estonia and Latvia and 70 percent in Lithuania. In all three countries, the growth rate of private loans were high during the years just before the crisis – over 40 per cent increase in the total stock of loans per year, adjusted for inflation.

The loans’ growth rate begins to decline around 2007 and started decreasing in 2009. In connection with this, all three countries went into crisis. As in many other countries, it is only after the private stock of loans starts to decline, that government debt begins to increase. In Estonia, the increase in government debt is modest compared to many other countries, but the increase that does take place, happens after the amount of private loans begins to decrease.

One way to illustrate the above is these three graphs: bars (left axis) = annual change in the total amount of private loans, the change divided by GDP. Bar above the zero line = the total amount of private loans increased that year. The red line shows public debt as percent of GDP (right axis).

Lithuania-d2 Latvia-d2

Estonia d2

When the private sector reduces its debt, this creates a risk that the demand for goods and services will decreaseThis is because if a sufficiently large share of the private sector wants to reduce its debts, the money that goes to the banks as the public pays back their loans, does not generate enough new loans. Instead, it might be described as that money disappears – money that would otherwise have been used for consumption. A fall in aggregate demand (or a more slowly increase than before), results in a decreasing demand for labor. This causes unemployment to rise, at least in the short term (and maybe even in the longer).

When total demand is weak, it can also lead to problems for borrowers. Households and firms may not be able to pay back their loans. It might also lead to falling prices, such as for housing. 

4. The impact of the crisis and the phenomenon

Several things about this deserves more attention, than what I feel it’s been given so far.

After the crisis began and unemployment surged, it has in recent years declined in all three countries, but mostly in Estonia. Among the countries that were hit the hardest in the 2008 crisis, this is unusual. Although unemployment been falling in all three countries,  Latvia and Lithuania still have an unemployment rate around 10 percent, which is pretty high.

In the early/mid 1990s Estonia and Lithuania introduced currency board for their monetary policy (unusual today, but a common tool in the past). Currency boards, an independent authority whose purpose is to keep the exchange rate fixed and inflation low, is often motivated to stabilize the monetary policy from political pressures in a clearer way than, for example, independent central banks could guarantee. It is interesting to note, that this does not seems to have had a dampening effect on the private debt growth – although this does not seem to have been an object of this policy. All three countries kept a fixed exchange rate against the euro for several years before the crisis and has subsequently adopted the euro completely.


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