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24 July, 2013

Estonia’s Mini-Eurozone Long Before the Big One

The path from kroon to euro and decisions from 20 years back that make Estonia’s finance minister proud today

Estonian Minister of Finance Jürgen Ligi is known in his home country for his colourful rhetoric. Although his “zingers” can often seem arrogant or self-aggrandizing, they also contain a healthy amount of incisive truth.  

In this sense, Ligi’s appearance at the Berlin-hosted series of events introducing the countries of the euro area, was typical, as he suddenly announced during a public discussion with German counterpart Wolfgang Schäuble: “Estonia created its own mini-Eurozone long before the big one, when we pegged our currency to the German mark in 1992. We understood that the new currency required a strong anchor, but also a strong fiscal and economic policy – and we went far by doing so.”

To claim that Estonia understood the necessity of a strong fiscal and monetary policy back in 1992 does smack of wisdom in hindsight and is clearly an exaggeration, however. Back then, the leaders of Estonia, newly free of the Soviet occupation, did not know much of anything about the market economy and monetary policy. Even theoretical knowledge was extremely sparse and patchy, to say nothing of practical skills and experiences, which people living behind the Iron Curtain simply could not have.

So how could it have happened that in a small, newly independent, dirt-poor country, these young reformers who lacked financial knowledge could make decisions that Estonia’s finance minister could be proud of 20 years later in the heart of Europe, and rightfully so?

Even though everything seems perfectly logical in hindsight, the building of the Estonian state was more guided by intuition and dreams than people dare admit now. Back then, it was important for Estonians that they be the antithesis of everything that was Soviet. So they did everything they could to tear themselves free of the past as quickly as possible. Society flew at wild speed from one extreme to another.

READ ALSO: Estonia: Restoration Meant No to a Soviet Legacy

When discussion started in the early 1990s about what Estonia’s currency should be, the answer was largely framed by the country’s past in the rouble zone. Roubles were called “alder leaves” in the late occupation period, because they couldn’t be used to buy much of anything – the shelves were bare. Be it bread, milk, soap, socks, even matches – at the end of the rouble era, all the main staples were distributed out only on the basis of vouchers or sold for foreign currency.

This also determined what conditions Estonians set for their national currency. The Estonian kroon had to be the opposite of the rouble. They had to draw their own currency so that it would be backed by reserves and be fully convertible for any other currency. Because inflation had soared to 1,000% at the end of the rouble era, it was important that the kroon have a fixed exchange rate and constant value.

How to make these dreams come true, how to create such a currency? No one really knew in re-independent Estonia in 1991. As the fledgling country lacked any liquid assets, it was hard to even imagine what could be used to back up the kroon. In the absence of better options, the parliament even allocated a huge tract of state forest to the central bank to prop up the currency, but it was clear that this standing timber could not really be used as collateral.

Unexpectedly, gold from Estonia’s first era of independence came to the central bank’s rescue. By 1940, when Russia occupied Estonia, Eesti Pank had, as it turned out, deposited a total of over 11 tons of gold in three countries – England, Sweden and Switzerland. Now all three of these countries agreed to compensate the value of the gold deposited half a century prior.  

And so kroon had its first matching funds, but there was no clear vision of how to go about the monetary reform. Final clarity dawned only two months before the scheduled monetary reform, when Harvard University professor Jeffrey Sachs arrived in Estonia for a visit in April 1992, at the invitation of the youngest member of the monetary reform committee, Ardo Hansson. As the son of war refugees, Hansson had grown up and been educated abroad (he is currently Eesti Pank governor). After hearing what Estonia’s leaders wanted and the options they had, Sachs sketched out a very simple reform plan. It was an old-fashioned but foolproof monetary system known as a currency board arrangement.

It was presently set forth in legislation that the Bank of Estonia could release into circulation only as many kroons as were backed by its gold and currency reserves. The central bank was also forbidden from lending the government money to cover budget deficits, which meant that the budget had to always be in balance. The kroons was pegged to the German mark and the exchange rate (1 D-mark to 8 kroons) was also stipulated in legislation. This ruled out an unexpected devaluation, as Parliament could not amend legislation in secret overnight. Although the ecu, the forerunner of the euro, was already in existence by 1992, the German mark was picked as the anchor, as it was a more comprehensible and clearer compass for people.

READ ALSO: Estonia and Euro: Missed Party or Bright Future?

And so it was that with stringent rules and at the cost of extreme belt-tightening, Estonia indeed created this mini-Eurozone ten years before the euro was introduced in the European Union. Under the Maastricht criteria, the government sector budget deficit has to be under 3 percent of GDP and government debt under 60% of GDP, the foreign debt in Estonia has always been under 10% of GDP and state budget was in balance or ran a surplus for close to 20 years, until the last economic crisis.

The only condition that Estonia did not meet when it came to joining the euro area after EU accession was inflation. For years, Estonia’s economy grew many times faster than the European average, and it was just about inevitable that prices would rise at a higher than average rate.

Oddly enough, the global recession actually helped Estonia get out of this predicament. Paradoxically, Estonia proved completely euroworthy only after the country’s economy had fallen into a negative 14% tailspin. At that point, inflation also eased off, and Estonia finally met the only criterion that had kept it apart from the “big” Eurozone. The Estonian kroon, which sceptics predicted would face devaluation, lasted unfalteringly through the worst crisis, until on 1 January 2011 it was swapped out for the euro at the same exchange rate at which it had been introduced on 20 June 1992.    

READ ALSO: One Reason for Estonia’s Success Lies Across the Gulf


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