Rise And Fall Of The Baltic Boom
In the beginning, the boom was mostly sound, being based on reduced tax rates, reduced government spending and exchange rate stability. But during 2005 and 2006 the sound foundation began to erode while the unsound elements gained pace.
As I pointed out in this post, there is a strong empirical relationship between economic growth and change in the share of GDP going to government spending. Indeed, it held true for all countries except for Latvia and Ireland (and as later revised numbers would indicate also Estonia). Not coincidentally, Latvia, Estonia and Ireland have seen their booms turn into a bust.
The argument against assuming that the economic growth is caused by the spending reduction would be that the causal relationship can go the other way: namely that an economic boom in the private sector will cause the share going to government to decline. It is true that this opposite causal relationship also exist, but there are still two reasons for believing that reduced government spending will boost economic growth. First (and most importantly), based on economic theory as lower spending will enable either lower taxes which improve incentives, or lower deficits which reduce the crowding out effect on private investments. Secondly, because we have some examples of governments using booms to boost government spending even more than private sector activity. That is exactly what we saw in Estonia and Latvia which saw government spending relative to GDP rise from 34% and 35.6% respectively in 2005 to 35.5% and 37.7% respectively in 2007. At the time, the other factor driving these economies were strong enough to ensure that growth continued, but as the sound basis were eroded, that made these economies more vulnerable to a downturn.
The unsound element of the boom was the massive monetary boom that took place. For Latvia, money supply statistics is only available from 2003, meaning that annual growth rates are only available from 2004. M1 growth in Latvia rose from 22% in 2004 to 43% in early 2006 and remained at 40% in early 2007. By 2008, nominal money supply growth had turned negative, which given the price inflation rate of more than 15% meant that real money supply growth at the time had turned significantly negative. Now money supply is shrinking at a 12% rate, which combined with a 10% price inflation rate means that real money supply is contracting at a 20% rate.
Estonia's monetary boom and bust story is somewhat less dramatic, but only slightly so. Money supply growth rose from 14% in July 2004 to 40% in January 2006, fell back to 26% in January 2007 and 3% in January 2008. Money supply is now contracting at a 9% rate. Because previous monetary inflation was somewhat less dramatic in Estonia than Latvia (cumulative money supply growth from July 2003 to July 2007 was 128% in Estonia, compared to 188% in Latvia), Estonia's price inflation rate has plummeted much faster, to 4% in January 2009. But that still implies a 12.5% real money supply contraction-a sharp contrast to the over 30% real money supply growth in early 2006 and nearly 20% rate as late as 2007.
Estonia and Latvia are thus clear examples of the Austrian Business Cycle Theory in practice-with massive monetary inflation fueling an unsustainable boom followed by significant monetary deflation that reveals all of the malinvestments made during the boom (and perhaps also knocks out some sounder businesses as well). This inflation was in part a result of Estonia and Latvia pegging their currencies to the euro and therefore also the inflationist policies of the ECB and also the result of irresponsible lending practices by certain Swedish banks. Add to this the fact that the boom apparently made the Estonian and Latvian government so complacent that they thought it would be OK to significantly increase government spending during the boom.