It takes only a brief visit to the Bank of Estonia’s small basement museum to grasp what turbulent decades the Baltic states have endured. This corner of Europe’s “bloodlands” between Russia and Germany saw a bewildering succession of currencies: roubles (tsarist and Soviet), marks (imperial and Nazi) and, among these, a cherished era of Estonian money, from 1919 to 1940. After the break-up of the Soviet Union, the kroon was restored in 1992, a symbol of independence regained.
Now the kroon, too, is destined to become a museum piece, though this time its abolition is voluntary. On January 1st Estonia adopts the euro, with mixed emotions among the numismatists in the museum shop. Most Estonians accept the government’s view that giving up the kroon will strengthen Estonia economically and politically. Pegged from the outset to the D-mark and then the euro, the kroon has hardly been independent. Abandoning it, say ministers, will end speculation about devaluation, reduce transaction costs, lower interest rates and boost investment.
To many Estonians, the euro also means security. For this small country of just 1.3m people, the single currency is a further step towards “Europe” and away from Russia. With its membership of NATO, the EU, the Schengen free-movement zone and now the euro, Estonia thinks of itself as one of the most integrated countries in Europe. As for the euro zone, Estonia’s accession is a demonstration of faith in the single currency. Many doubt its future after a torrid year of sovereign-debt crises and bail-outs.
Beyond the symbolism, Estonia’s economic experience in the past decade offers some lessons for troubled euro-area countries. First, even a small, poor, post-Soviet state in demographic decline can survive, indeed thrive, in a de-facto currency union with mighty Germany. Second, bold austerity measures can restore public finances even after a deep recession. Having shrunk by nearly 14% in 2009, the economy has rebounded and is forecast to grow by 4.4% in 2011. The newest and poorest member of the euro zone will have its smallest public-debt ratio: 8% of GDP.
For Jürgen Ligi, Estonia’s finance minister, the essence of this success is discipline in maintaining balanced or surplus budgets in good times, and courage in making swift and deep cuts in bad. Estonia’s accumulated reserves, and its exports, cushioned the blow. Not everything is rosy. Inflation is rising. Unemployment, which this year averaged 17.5%, is high; analysts worry about a brain-drain. Even so, qualifying for the euro is a big achievement.
How did Estonia avoid strikes and riots? Perhaps, say many, austerity is too not hard to bear after the experience of communism and late Soviet-era inflation. “Nobody would take to the streets flying the red flag,” says Mr Ligi. Toomas Ilves, Estonia’s president, suggests another factor: “Maybe it’s our peasant mentality.” Noting the thick snow outside his window, he says northern peoples are thrifty by necessity; they must save food in the summer to survive the winter.
These are partial explanations at best. Estonia now sees itself as a solidly Nordic country, yet its snow-clad neighbour, Latvia, needed an IMF-led bail-out. Luck has played a part: Estonia has been pulled up by recovery in Germany and the Nordic countries. And unlike Latvia, it did not have to rescue failed banks; Estonia’s financial institutions are foreign-owned.
Estonia’s medicine may be harder for other euro-zone countries to take. With big public-sector debts (the euro-zone average is 84% of GDP), restoring fiscal health could take decades of austerity, especially if growth is sluggish. Recession and, worse, deflation, would exacerbate the debt ratio. Still, Mr Ligi is impatient with the timidity of reforms in southern Europe. “Recession is much less painful than bankruptcy,” he says bluntly.
Is Estonia joining a moribund currency? The vital signs are worrying. The euro has fallen in recent months against the dollar, and bond spreads between its strongest and weakest members are still wide. The EU has kept it alive, averting, for now, default by Greece and Ireland, and the risk of another round of bank failures. The emergency room should continue to operate beyond 2013: a recent European summit agreed the wording of a treaty change to make permanent the EU’s bail-out funds, worth some €500 billion ($660 billion). The European Commission, meanwhile, is pressing ahead with plans for close monitoring of members’ budgets and economies, with punishments for those that do not follow its therapy. This will help long-term prevention.
But such actions have yet to relieve the danger of contagion in enfeebled countries such as Portugal, Spain and Italy. The summit declined to adopt the most frequently proposed treatments: common euro bonds to pool part of the euro zone’s debt; bigger bail-out funds; or even their more flexible use, say, to extend short-term loans. So the outbreak is being fought mainly by the European Central Bank, which has been buying bonds and supplying liquidity to banks. In December it requested a near doubling of its capital, presumably to counterbalance its risky assets.
France and Germany say countries could co-ordinate their economies more closely, perhaps in social-welfare policies. But this remains vague talk. Some see hope in China’s promise to buy bonds and make “investments” in troubled European countries. Yet Chinese medicine is no more than a palliative. This year’s prognosis, then, is for a chronic condition punctuated by crises.
Such is the sickly currency that Estonia is joining. It says the euro’s demise is unthinkable. And it is right in saying that self-help—austerity and structural reform—offers the most lasting remedy. But what if the cure kills the patient? Then Estonia will hope to inherit a share in a successor currency, perhaps a “northern euro”. That makes the gamble worth taking.