Tuesday 25th September 2012 | 14:10

Centre for Policy Studies: Why cuts work - lessons from Estonia

Estonia provides a clear case-study of a country which has successfully
embraced austerity and seen a return to sustainable economic growth, writes
Ryan Bourne in Estonia: a case study on how and why Estonia embraced
austerity, published on Friday 28 September by the Centre for Policy Studies.

Jürgen Ligi, the current Estonia Finance Minister (equivalent to the
Chancellor of the Exchequer in the UK), writes in the Foreword:

"We had a period of illusory growth, based largely on spiralling private
sector debt. This was unsustainable… In order to keep our economic
foundations intact, the only viable way was a swift reduction in government
spending. The recession initially came at a high price. But in hindsight
this was a necessity to put us back on the path of long-term, sustainable
economic growth. Recovery was regained without sacrificing any of our core
principles. Estonia continues to be a stable and growing economy, with a
balanced budget and low debt, which are increasingly rare qualities in the
world we live in today."

In 2008, faced with an economic crisis and shrinking tax revenues, the IMF
forecast that Estonia would have a budget deficit of more than 10% of GDP in
2009 on unchanged policies. In response, Jürgen Ligi cut government spending
drastically, explaining that the surging revenue growth during the boom had
resulted in pro-cyclical expenditure based on somewhat illusory growth. In
all two-thirds of the consolidation was done on the expenditure side and
one-third on the revenue side. The scale of the Estonian cuts meant a
decline in total nominal spending between 2008 and 2010 of 10%.

This did, of course, weaken output in the short term. Combined with the
global downturn, unemployment peaked at around 20% in early 2010. But since
then, on several measures the Estonian programme appears relatively
successful:

* unemployment has fallen back to just over 10% today

* the government met its deficit target - it never exceeded 3% of GDP  - and was back in surplus by 2010

* the economy rebounded with 3.3% growth in 2010 and 8.3% growth in 2011.

The paper also questions the critique by Professor Krugman's analysis of the
relevance of the Estonian model. Krugman has criticised the Estonian model
on the grounds of the output trajectory since the peak of the boom: "So, a
terrible 'Depression-level' slump, followed by a significant but still
incomplete recovery. Better than no recovery at all, obviously but this is
what passes for economic triumph?". But this interpretation is dependent on
assuming that the height of the preceding boom should be the starting point
in assessing the rate of recovery. As Estonian President Toomas Hendrik
Ilves tweeted: "Let's write about something we know nothing about & be smug,
overbearing & patronizing" And: "Guess a Nobel in trade means you can
pontificate on fiscal matters & declare my country a "wasteland". Must be a
Princeton vs Columbia thing."