Baltic states continue march towards markets despite rocky road

After revolutions swept across Eastern Europe three decades ago, communism was counting its final days in more than two dozen countries on the verge of leaving socialism behind and welcoming a market economy. The former socialist economies, which varied considerably in their development process and economic growth before the fall of the Iron Curtain, elected different paths out of the dim past—some moving swiftly to reform and liberalize economies, others only mustering slow transitional strides in the years and decades to come. The Baltic states of Estonia, Latvia and Lithuania unreservedly embraced economic freedom since the collapse of the Soviet Union.

As a quantitative assessment of the degree of market liberalism in the Economic Freedom of the World (EFW) index shows, the highest levels of economic freedom in Eastern Europe in 2017, the most recent year of available data, were in Estonia, Lithuania, the Czech Republic and Latvia, while the lowest levels of economic freedom were in Ukraine, Belarus and Moldova.

The Baltic states have made a significant leap on the EFW index with Estonia increasing its level of economic freedom from 6.38 (53rd rank) in 1995 to 7.89 (13th rank) in 2017, Latvia from 5.59 (77th rank) in 1995 to 7.73 (24th rank) in 2017and Lithuania from 5.49 (82nd rank) in 1995 to 7.88 (16th rank) in 2017. Notably, though all three countries visibly increased their economic freedom level before the early 2000s, Estonia by 2004 already ranked 13th on the EFW index. By contrast, Lithuania and Latvia waited until 2013 to address business and labour regulations that were not only stifling economic activity but also providing fertile ground for special interests to become interlocked with political processes.

Subsequently, we saw sizeable amounts of foreign investment (Latvia—8.0 per cent of GDP in 2007, Lithuania—6.8 per cent of GDP in 2007 and Estonia—15.4 per cent of GDP in 2007), the highest economic growth rate in Europe (Latvia—11.9 per cent in 2006, Lithuania—11.1 per cent in 2007 and Estonia—10.6 per cent in 2000) and a substantial decrease in unemployment rates (Latvia from 14.5 per cent in 2000 to 6.1 in 2007, Lithuania from 15.9 per cent in 2000 to 4.2 per cent in 2007, and Estonia from 10.4 per cent in 1997 to 4.6 per cent in 2007) for all three “Baltic Tigers.” These findings make sense, as extensive empirical literature reveals that economic freedom is positively associated with national income, economic growth, living standards, economic equality and a variety of other desirable social and economic outcomes.

Following the economic boom, the Baltic economies fell to their knees as the global financial and economic crisis struck in 2008, experiencing one of the deepest recessions not just in Europe but the world, before rapidly rebounding in 2011 to stage the quickest economic recoveries in the European Union.

Today, public policies and political institutions of the Baltic states support high levels of economic freedom through open and competitive markets, protection of people and their private property, and free trade. Consequently, all three Baltic states have a favourable business environment, robust economic activity, a resilient financial system and stable government finances. In fact, in the World Bank’s Doing Business 2020 index, Lithuania scores 81.6 out of 100 points (ranks 11th out of 190 countries), Estonia scores 80.6 (ranks 18th) and Latvia scores 80.3 (ranks 19th).

However, challenges remain, including declining population, skills shortages, the shadow economy and corruption. In many areas, the Baltic countries face the same challenges.

First, the population in these countries is shrinking. Since 1990, the population in Latvia has fallen by 29 per cent, in Lithuania by 26 per cent and in Estonia by 15 per cent. The main reason for the decline is high emigration. Net emigration in Latvia continues even though its pace has slowed recently. On a positive note, Estonia began observing net immigration in 2015 and Lithuania is projected to have done the same in 2019.

Second, the Baltic economies are rapidly catching up with the rest of the European Union, primarily due to robust private consumption and an increase in investment, which places the countries in good standing to address challenges and ensure long-term growth.

Third, the labour markets in Baltics are tightening fast with the unemployment rate in 2019 dropping in Lithuania to 6.3 per cent, in Latvia to 7.0 per cent and 5.0 per cent in Estonia. Nevertheless, job vacancies in these markets continue to grow as the population keeps declining. For example, Latvia experienced the deepest plunge in the working-age population (aged 15-64 years) in the 2000-2017 period among OECD countries, which is one of the reasons for the increasing shortages of skilled labour. Unfortunately, this trend is expected to continue to at least until 2030.

Fourth, skills shortages and underinvestment in research impose a cap on productivity gains for the economy. And skills shortages on the rise across the region. The education systems have limited capacity to respond to the demands of the labour market. Crucially, without labour productivity growth, which will catch up with wage growth, the region will not be able to maintain competitiveness.

Finally, while Estonia manages to control corruption better than any other emerging country in Europe, according to recent research from the World Bank, undocumented extra payments or bribes aimed at influencing government policies, laws or regulations are a major obstacle to business and citizen economic activity in Latvia and Lithuania. Recently, however, both countries have shown some progress in their fight against corruption. For example, in February 2019, 26 people—including eight top judges in Lithuania—were detained under suspicion of receiving bribes ranging from 1,000 euros to 100,000 euros. Furthermore, in October of the same year, five people were detailed in Kaunas, Lithuania's second-largest city, after police carried out an international investigation into police corruption related to international fraud, money laundering and smuggling.

Latvia also struggles with corruption, financial crime and integrity in the public sector, even after the liquidation of its third largest bank ABLV for money laundering.

On the positive side, the outgoing Latvian parliament, the Saeima, adopted a whistleblower protection law in October 2019 and the country’s anti-corruption authority KNAB has recently uncovered several high-profile corruption cases. For example, Latvia’s central bank governor Ilmārs Rimšēvičs is accused of accepting a 500,000-euro bribe, taking a paid holiday in Russia and money laundering. Thee public procurement process in Latvia is also perceived to be highly susceptible to corruption, and government decision-makers are perceived to be influenced by favouritism through bribery. It also doesn’t help that there are delays in the implementation of the anti-corruption strategy. Time will tell whether or not Lithuanian Prime Minister Saulius Skvernelis’s prediction that, “The times of untouchables are over,” will come true.

For greater improvement in the incomes and wellbeing of their citizens, the Baltic states should boost productivity, output growth and competitiveness. To achieve these goals, they must strengthen skills, reduce skill “mismatches,” decrease the share of state-owned enterprises (SOEs), tailor education to labour-market needs, encourage cooperation between businesses and researchers, simplify conditions for work permits of skilled workers, emphasize high-quality transportation infrastructure, keep enhancing automated customs data management systems and reduce the size of the shadow economy. Tigers do not just know what they want; they also never give up trying to obtain it.