How to move Estonia forward?

10.12.2012, 15:57

There has been a lot of heated discussion in the media about the need to find new strategic direction for Estonian economic policy. As an entrepreneur who has spent the last 15 years running a successful business in Estonia, I would like to share my thoughts on this subject, writes Max Rivshin, CEO of Top Connect OÜ.

If we look back over the past 20 years, Estonian achievements are admirable, they can be summarized as follows: establishing modern institutions and legal framework, including a predictable and simple tax code, running a successful privatization program and in the process dramatically decreasing the role of state in the economy, establishing a somewhat competitive and relatively diversified economy based on a decent infrastructure, integrating into global markets and introducing the EURO.

While success of the past 20 years is admirable, the current sate of affairs is bleak. What are the major problems that Estonia faces now and how does government plan to tackle them?  Its low income and high unemployment and underemployment, income inequality, non existent social safety net systems, poor government services, specially in the medical field, extremely high rate of emigration and social ills such as crime and depression.

The economy is stuck in an adverse self reinforcing cycle, where low income leads to decline in government revenues, which in turn creates a need for cut backs in government expenditure, in turn deteriorating quality of government services and generating unemployment in the process, leading to social problems and emigration that further depress government revenue base and create a need for further cut backs and so on. 

The policymakers probably recognize their predicament, but budget deficit does not allow any room to maneuver.  In the current situation, it would be imprudent to stimulate growth through government expenditure; financial markets are not kind to deficit spending states.  Increasing revenue base through new taxation, when income is already low and declining, is close to impossible.  Therefore, unless the economy starts to expand, it is close to impossible to introduce fundamental changes in either taxation or spending by the state.

Tools that worked so well in the past are exhausted. Estonian economy is already open and there are no artificial barriers for firms to invest and create jobs.  Estonian policymakers place their hopes with export markets, creating various programs to promote export growth. Unfortunately, due to poor global economic conditions, international demand does not expand at a fast enough pace to compensate for the lack of domestic demand.

In my opinion, the most important ingredient that is missing from Estonian economy is a strong domestic demand. Depressed demand is the real reason for under investment, social problems, emigration, substandard government services and so on.  Businesses will not create jobs while there is no underlying demand for their goods and services.  Competitive tax rates and decent infrastructure are useless if demand is not there. Remove oxygen from the room and the athlete will not be able to compete, not matter how much he trained.

The state is ignoring this key relationship between demand and growth and worse still the state is responsible for some of the negative growth, through its wage policy for state employees, for example.

One of the important misconceptions present in official Estonian economic thinking is a deep belief in the ability of free market, with minimal state interference to fix present economic ills. The success of leizess faire policy in the first 20 years of independence lead to an almost religious trust in free markets as the only way of moving economy forward.  The fact that most successful economies including our Northern neighbors have roughly 50% of economic activity generated by the state is ignored.  It is not a coincidence that developed countries are also the ones with high level of state participation and correspondingly high and complex taxation systems.

Since I live in Canada, I would like to use as an example one of the more effective economic tools used by Canadian policymakers and leave it as an alternative solution for Estonian policymakers to consider. The demand and income levels are directly related to the loan growth and corresponding growth in money supply. I believe that one of the main goals of policymakers in Estonia should be pursuit of strong consistent growth in money supply and corresponding growth in domestic demand and income.
 
One of the key methods of pushing up demand is attracting financing towards real estate. Real estate absorbs significant loans and creates local employment. In Canada an institution called Canada Mortgage and Housing Corporation was set up by Federal Government in 1946 to ensure there is adequate supply of low priced mortgages for homebuyers. CMHC provides to banks an insurance against default on mortgages as long as certain criteria are met (loan to market value, income of applicants and so on).  Canadian Banks offer their clients a choice, if the creditor is highly secure, then mortgage is offered without CMHC insurance, if bank is unwilling to extend the loan, then bank may ask the client to pay a CMHC insurance premium.  In Estonia, I would suggest setting up insurance for first time buyers with a 5% minimum down payment, this would attract new funds to the market and at the same time serve as an important social policy tool.  All of a sudden a new source of demand for housing would be created from client base that was previously neglected by financial institutions.  Banks become highly motivated to increase portfolio of real estate loans, this drives up demand for housing, increasing income and employment in this key sector.  New demand leads to a steady rise in real estate values and improves liquidity in the market; therefore collateral to loan value on existing loan portfolio improves over time. Through multiplier effect, other sectors of the economy benefit from increase in money supply.  Unlike other government schemes, Estonian equivalent of CMHC can pay for itself, by charging insurance premium for guarantee against default.  Such institution can be set up as a separate entity, or as part of an existing entity such as Kredex or EAS. Furthermore, the state can effectively manage money supply and real estate values by changing its terms on its mortgage insurance and if necessary by expanding into other programs such as equity loans.

Once real estate starts to grow and market recovers, I propose a next step should be considered which is diversifying and increasing the revenue base and corresponding government expenditure. The state should use real estate expansion to improve its revenue base, through a steady increase in property taxes, real estate transfer taxes and increasing fees related to building permits.  New forms of taxation of financial institutions may be considered as well. Improvement in the revenue base should be consumed immediately on alleviating the most pressing social ills, increasing wages for state employees, improving social safety net systems and so on.