Why Did Estonia Choose Fiscal Retrenchment after the 2008 Crisis?

Abstract

The budgetary response of Estonia to the 2008 global financial crisis poses a puzzle. While many other countries increased public expenditure and ran high deficits in 2009, the Estonian government was different: it undertook fiscal retrenchment, combining expenditure cuts and tax increases, despite a large drop in economic output. This article explains why the Estonian government opted for fiscal consolidation during the crisis. The ideological position of the governing parties and their desire the join the euro-zone played an important role in driving fiscal discipline. It also argues that the key to understanding Estonia's fiscal decisions in 2009 is what happened in the 1990s: fiscal policy choices became path-dependent as a result of positive feedback loops from previous periods of fiscal consolidation. Path-dependency was further reinforced by institutional capabilities (or lack thereof) created by initial macroeconomic policy choices.

Administrative Structure in Times of Changes: The Development of Estonian Ministries and Government Agencies 1990–2010

“…Khan University] at 01:06 08 October 2014 818 SARAPUU visible during the first decade of transition and the global economic crisis at the end of the 2000s (see also Raudla, 2011;Raudla & Kattel, 2011). This has pushed reformers toward de-agencification and the formation of larger multifunctional structures.…”

From the ruble zone to the euro zone: the political economy of Estonian macroeconomic policy

“…This may have contributed to "path dependence" in policy-making, as key government ministries had been prioritizing the currency board and fiscal prudence since the early 1990s (Raudla and Kattel 2011). However, another important element of the institutional context was the centrality of Swedish banks in the Estonian financial sector and their behavior during the crisis.…”

The Baltic Republics and the Crisis of 2008–2011

“…Importantly, nominal exchange rate adjustment would have precluded joining the eurozone as an exit strategy from the crisis. Furthermore, given that a large proportion of loans in these countries had been denominated in euros, 8 external devaluation would have imposed large costs on significant parts of the population and reduced private sector net worth (and potentially led to a surge in loan defaults, with contagion effects to the rest of the economy) (see also Purfield and Rosenberg 2010;Raudla and Kattel 2011a). Kuokstis and Vilpisauskas (2010) note that among the local policy-makers and experts, the prevalent causal belief was that devaluation of the currency would have been "clearly wrong and potentially disastrous".…”

“…9 It was felt that by devaluing the currencies, the governments would lose an important focal point for action. In addition, none of the Baltic countries had had experience with alternative exchange rate regimes and hence no existing competencies to manage "non-automatic" systems (see Raudla and Kattel 2011a). Internal devaluation as an adjustment strategy was also supported by the European Union, who was afraid that devaluation of the Baltic currencies would cause havoc in the financial markets and, potentially, lead to spillovers to other Central and Eastern European countries, inducing capital flight from this region (Kuokstis and Vilpisauskas 2010;Åslund 2010).…”