This European country sailed through the credit crunch, yet it’s still cheap
Matthew Partridge Jul 23, 2012
It’s not exactly the 'fight of the century'. But the latest spat involving Nobel prize winner Paul Krugman has economists hot under the collar.
His opponent? Estonian President Toomas Hendrik Ilves.
It all began when Krugman wrote an article in the New York Times on Estonia. He complained the eurozone nation was being unfairly held up as a successful example to support the arguments of the austerity school. He argued that its “incomplete recovery” could not be used to prove that austerity – and hanging on to the euro – had worked.
Ilves hit back hard. Krugman was “smug, overbearing and patronising”, he said. He also accused him of racism. The tiny Baltic state might have been hit hard, but its recent strong growth suggests that cutting spending and hanging onto the euro might not be such a bad idea. He also claimed that Krugman cherry-picked data, ignoring the wider context.
Now, this might seem an obscure debate. However, as Krugman himself points out, even small economies can provide insight into which policies work. Given that we’ve previously used the cases of Argentina and Iceland to argue against fixed currencies, and for devaluation, it’s only fair that we have a look at the other side of the coin.
So who – if anyone – has got it right? And what does it suggest for your investments?
Estonia’s biggest mistake
Estonia’s defenders say that you can’t measure recovery on the basis of how rapidly a country returns to peak pre-crash GDP levels.
They point out that growth in the last few years of a boom is driven by cheap credit. This falsely boosts the economy, creating an economic mirage. So it would have been impossible to quickly return to these levels, or to prevent a fall.
So you should instead look at growth over a longer period. And using an earlier starting date makes Estonia’s performance look better.
Indeed, the Council for Foreign Relations notes that Estonia, Latvia and Lithuania, which all pursued austerity and fixed their currencies, have grown by more than the Icelandic economy (which pursued devaluation and default instead) since 2005. Use 2000 as the base, and the gap gets wider.
Estonia’s supporters have a point. But they go too far in the opposite direction to Krugman. Here’s why.
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Like other Baltic states, Estonia has been very successful in creating policies that improve productivity. Indeed, the Index of Economic Freedom ranks Estonia as 16th out of 179 ranked countries. Even the World Economic Forum puts it 33rd (only 3 places behind Iceland).
Given this, and the fact that its income is still one of the lowest in the EU, Estonia should benefit from strong catch-up growth. So under normal conditions, it should grow much faster than a mature country like Iceland.
So the fact that its GDP is still nearly 10% below its 2007 peak suggests that its policies have indeed hit growth. In other words, while Estonia has recovered somewhat, if it had pursued different policies, it would probably be better off than it is now.
However, this doesn’t mean that Krugman has the right solution. Not all of Estonia’s government policies were bad. At a time when Francois Hollande in France is introducing punitive rates of tax, and some Greek civil servants can still retire at 55, it is heartening to see Estonia tackling public-sector pensions.
Estonia’s biggest mistake wasn’t austerity, it was the decision to surrender control of the national currency. Fixing the Estonian kroon (EEK) to the euro from 2002 (joining it nine years later) caused a credit boom. Estonia then found itself unable to use devaluation to cushion the impact of the bust.
A more successful Eastern European country
If you want to see a European country that really has had a ‘successful crisis’, look no further than Poland.
Poland kept its own currency, the zloty. This acted as a drag on growth during the boom years. However, it also reduced the scale of the credit bubble, and meant the Polish central bank had the freedom to act far more quickly during the crisis, cutting rates by 250 basis points within a few months.
In less than a year, the zloty fell by nearly 35% against the euro, from a peak of €0.312 to €0.2049. Although it bounced back, it is still substantially lower than it was four years ago. This has been good news for Polish firms exporting abroad.
Meanwhile, Poland was also able to take advantage of its sound government finances to grow public spending. All these factors meant that Poland has kept growing throughout the crisis.
Why you should invest in Poland
And the country still looks worth investing in. While Poland hasn’t reformed as much as Estonia, its still has a strong pro-business environment. Indeed, the World Economic Forum ranked it ahead of Italy in its last survey.
And like Estonia, its ex-communist legacy means that it can be expected to keep liberalising. Growth is projected at 2.5% and 2.9% this year and next.
Kasia Zatorska of Lombard Street Research is upbeat: “Poland is well placed to withstand the upcoming global slowdown. Domestic demand should remain solid while the economy is also less vulnerable to the euro crisis than other CEE [Central and Eastern European] countries.”
It also looks attractive on a valuation basis. The iShares MSCI Poland Investable Market Index (NYSE: EPOL) is trading at nine times trailing earnings. It also has a relatively high yield of 5.4%. The firms in the portfolio also trade below the value of their net assets. This provides a 'margin of error' against a sudden downturn in the Polish economy.
If you do decide to buy the exchange-traded fund, do bear in mind that there is a currency risk. The only other downside is that it has a relatively high exposure to financial services. However, this isn’t as much of a problem as you might think. Indeed, as well as providing a sound economic model to follow, it seems the Poles could teach us something about banking as well.
Polish banks are run on 'narrow banking' lines. This means that they focus on low-risk lending financed with deposits, rather than speculation in the property and bond markets. This makes them much more secure than their Western counterparts.
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