In this clip from a recent interview with Gunther Fehlinger, I explore the connection between two very important important economic concepts: Convergence and Wagner’s Law.
Before launching into further discussion, let’s nail down two very important definitions.
Convergence is the notion that poor countries should grow faster than rich countries and eventually attain a similar level of prosperity.
Wagner’s Law is the seemingly paradoxical observation that richer nations tend to have larger fiscal burdens than poorer nations.
These two concepts deserve elaboration because many people either fail to recognize the implications or they draw the wrong conclusions.
Moreover, Wagner’s Law shows that politicians figure out how to extract more money and fund bigger government once nations become rich, but some people reverse the causality and assert that big government somehow caused nations to become rich.
The key takeaway from these observations, as I explained in the interview, is that poor nations that want convergence need to copy the policies that rich nations had when they became rich (in the interview at about 0:56, I mistakenly said “were rich” rather than “became rich”).
Which gives me another excuse to re-issue my never-answered challenge: Please show me an example, from any point in world history, of a country became rich after adopting big government.
This is because such data, especially over decades, teaches us very important lessons about the policies that are most likely to generate prosperity.
I’m revisiting these issues today because John Cochrane, a Senior Fellow at the Hoover Institution and a former professor of economics at the University of Chicago, recently wrote a column that contains a must-see chart showing how some of the major European nations have been losing ground to the United States over the past several decades.
The main thing to understand is that European nations were catching up to the United States after World War II, which is what one would expect.
But that trend came to a halt about 40 years ago and now these nations are suffering divergence instead of enjoying convergence.
Here’s some of Cochrane’s analysis.
…the US is 54% better off than the UK.. France…50% less than US. …the US is 96% better off than Italy. …And it’s been getting steadily worse. France got almost to the US level in 1980. And then slowly slipped behind. The UK seems to be doing ok, but in fact has lost 5 percentage points since the early 2000s peak. And Italy… Once noticeably better off than the UK, and contending with France, Italy’s GDP per capita is now lower than it was in 2000. GDP per capita is income per capita. The average European is about a third or more worse off than the average American, and it’s getting worse.
What’s most remarkable, as I wrote about back in 2014, is that the gap between the United States and Europe is “getting worse.”
Cochrane wonders if this is evidence against the European Union’s free-trade rules.
This should be profoundly unsettling for economists. Everyone thinks free trade is a good thing. The European union, one big integrated market, was supposed to ignite growth. It did not. The grand failure of the world’s biggest free trade zone really is a striking fact to gnaw on. Sure, other things are not held constant. Perhaps what should have been the world’s biggest free trade zone became the world’s biggest regulatory-stagnation, high-tax, welfare-state disincentive zone. Still, “it would have been even worse” is a hard argument to make.
For what it’s worth, I don’t think it’s “a hard argument to make”. I’ve pointed out – over and over again – that Europe’s reasonably good policies in some areas are more than offset by really bad fiscal policy.
Think of the different types of economic policy as classes for a student. If a kid flunks one class, that’s going to produce a sub-par grade point average even if there was good marks in all the other classes.
Besides, I suspect some of the benefits of free trade inside the European Union are offset by the damage of the E.U.’s protectionist barriers against trade with the rest of the world.
P.S. Some people may wonder why Germany was not included in Cochrane’s chart. I assume that’s because the reunification of West Germany and East Germany about 30 years ago creates a massive discontinuity in the data. For those interested, Germany is slightly better off than France and the U.K., according to the Maddison data, but still lagging well behind the United States.
P.P.P.S. I don’t think it’s a coincidence that America started out-performing Europe after Reaganomics was implemented.
P.P.P.P.S One obvious takeaway from Cochrane’s data (though not obvious to President Biden) is that the United States should not be copying Europe. Unless, of course, one wants ordinary Americans to be much poorer.
My main conclusion is that nations need decent policy to prosper, and Johan Norberg shares a similar perspective in this video.
Let’s see what academic researchers have to say about this topic.
In an article for the Journal of Economic Literature, Paul Johnson and Chris Papageorgiou have a somewhat pessimistic assessment about the outlook for lower-income countries.
In its simplest form, convergence suggests that poor countries have the propensity to grow faster than the rich, so to eventually catch up to them. …there is a broad consensus of no evidence supporting absolute convergence in cross-country per capita incomes—that is poor countries do not seem to be unconditionally catching up to rich ones. …Our reading of the evidence…is that recent optimism in favor of rapid and sustainable convergence is unfounded. …with the exception of a few countries in Asia that exhibited transformational growth, most of the economic achievements in developing economies have been the result of removing inefficiencies, especially in governance and in political institutions. But as is now well known, these are merely one-off level effects.
Here’s a table from their study.
As you can see, high-income countries (HIC) generally grew faster last century, which is evidence for divergence.
But in the 2000s, there was better performance by middle-income countries (MIC) and low-income countries (LIC).
That seems to be evidence that the “Washington Consensus” for pro-market policies generated good results.
Indeed, maybe I’m just trying to be hopeful, but I like to think that the last several decades have provided a roadmap for convergence. Simply stated, nations have to shift toward capitalism.
For another point of view, Dev Patel, Justin Sandefur and Arvind Subramanian have a somewhat upbeat article published by the Center for Global Development.
…the basic facts about economic growth around the world turned completely upside down a quarter century ago—and the literature doesn’t seem to have noticed. …While unconditional convergence was singularly absent in the past, there has been unconditional convergence, beginning (weakly) around 1990 and emphatically for the last two decades. …Looking at the 43 countries the World Bank classified as “low income” in 1990, 65 percent have grown faster than the high-income average since 1990. The same is true for 82 percent of the 62 middle-income countries circa 1990. …It’s not “just” China and India, home to a third of the world’s population on their own: developing countries on average are outpacing the developed world.
Here’s a pair of graphs from the article. On the left, we see nations of all income levels grew at roughly the same rate between 1960 and today.
But if we look on the right at the data from 2000 until the present, low-income and middle-income countries are enjoying faster growth.
That article, however, doesn’t include much discussion of why there’s been some convergence.
So let’s cite one more study.
In a report for the European Central Bank, Juan Luis Diaz del Hoyo, Ettore Dorrucci, Frigyes Ferdinand Heinz, and Sona Muzikarova look for lessons from European Union nations.
…sound policymaking plays a key role in the attainment of real convergence, primarily via adequate measures and reforms at national level. …for a given euro area Member State to achieve economic convergence it needs to improve its institutional quality, i.e. that of those institutions and governance standards that facilitate growth… some euro area countries have not met expectations in terms of delivery of sustainable convergence… in the period 1999-2016 income convergence towards the EU average occurred and was significant in some of the late euro adopters (the Baltics and Slovakia), but not in the south of Europe. …Several low-income euro area members have, in fact, only just maintained (Slovenia and Spain) or even increased (Greece, Cyprus and Portugal) their income gaps in respect of the EU average.
Let’s close with two charts from the ECB study.
First, look at this chart tracking the relative performances of Italy, Spain, Portugal, Greece, and Ireland compared to the average of Western European nations.
What stands out is that Ireland went from being a relatively poor nation to a relatively rich nation.
Needless to say, I would argue that Ireland’s dramatic improvement is closely correlated with a shift toward free markets that began in the 1980s.
Indeed, Ireland currently has the 10th-highest level of economic freedom for all countries.
Next, here’s a chart reviewing how various European nations have performed since 1999.
Ireland grew the fastest, given where it started. But notice how Slovakia and the Baltic nations also have been star performers.
So the nations that have adopted free-market reforms have grown faster than one might expect based on convergence theory.
And you won’t be surprised to see that the nations that have lagged – Greece and Italy – are infamous for statist policies and an unwillingness to reform.
The bottom line – assuming you want to improve the lives of people in poor nation – is that the world needs more capitalism and less government.
I’m more interested, however, in why convergence often doesn’t happen, or only partially happens.
And I’m extremely interested in why we often see divergence, which occurs when two countries are at a similar level of development, but then one grows much faster than the other.
Let’s consider the example of Brazil vs, South Korea. Otaviano Canuto has an interesting article, published by the Center for Macroeconomics and Development, that looks at how the two countries have diverged over the past 50 years.
Here’s the chart that depicts the dramatic difference.
The author analyzes many of the reasons that South Korea has enjoyed faster growth.
It’s especially worth noting that Brazil’s protectionism has been self-defeating.
The “middle-income trap” has captured many developing countries: they succeeded in evolving from low per capita income levels, but then appeared to stall, losing momentum along the route toward the higher income levels… Such a trap may well characterize the experience of Brazil and most of Latin America since the 1980s. Conversely, South Korea maintained its pace of evolution, reaching a high-income status… The path from low- to middle- and then to high-income per capita corresponds to increasing the shares of population moved from subsistence activities to simple modern tasks and then to sophisticated ones. …South Korea relied extensively on international trade to accelerate their labor transfer by inserting themselves into the labor-intensive segments of global value chains… with the “helping winners and saving losers” of Brazil’s industrial policies…, the temptation to use surpluses to accumulate wealth in ways to maximize frontiers of interaction with the public sector prevails… Brazil’s long-standing high levels of trade protection and closure also favored such an option… The Brazilian economy pays a price in terms of productivity foregone because of its lack of trade openness.
If you compare the scores the two countries get from the most-recent edition of Economic Freedom of the World, you’ll find that South Korea scores better on trade.
But you’ll also notice that there are much bigger gaps when looking at scores for size of government, legal system and property rights, and regulation (and the gaps for the latter two indices have existed for decades).
The bottom line is that there are many policy reasons why Brazil lags behind South Korea.
International development experts often write about a “middle-income trap.”
According to this theory, it’s not that challenging for nations to climb out of poverty, but it’s difficult for them to take the next step and become rich countries.
The theory makes sense to many people because it describes much of what we see in the real world.
We even see the trap at higher levels of income. European nations were catching up with the United States after World War II, but then the convergence process stalled.
But I don’t think there’s actually a “middle-income trap.” Instead, nations don’t enjoy full convergence because they are hamstrung by bad policy.
And Hong Kong and Singapore are the best evidence for my hypothesis. These two jurisdictions have routinely ranked #1 and #2 for economic freedom.
And their solid track record of free markets and small government has paid big dividends. Here a chart, for Our World in Data, which shows how they have fully converged with the United States after starting way behind.
The performance of Hong Kong and Singapore is particularly impressive because the United States historically has been a top-10 nation for economic liberty (notwithstanding all my grousing about bad policy in America, we’ve been fairly good compared to the rest of the world).
So it takes extraordinarily good performance to catch up.
P.S. By the way, one thing I noticed in the above chart is that Singapore has surpassed Hong Kong in the past couple of decades. This could just be a statistical blip, though I wonder if this is a result of the transfer of Hong Kong from British control to Chinese control. Yes, China has wisely chosen not to interfere with Hong Kong’s domestic policy, but perhaps investors and entrepreneurs don’t fully trust that this economic autonomy will continue.
P.P.S. Don’t forget that comparatively rich nations can de-converge if they adopt bad policy.
The theory of “economic convergence” is based on the notion that poor nations should grow faster than rich nations and eventually achieve the same level of development.
Today, let’s look at convergence between Western Europe and Eastern Europe.
Here are some excerpts from a new study published by the European Central Bank.
This paper analyses real income convergence in central, eastern and south-eastern Europe (CESEE) to the most advanced EU economies between 2000 and 2016. …The paper establishes stylised facts of convergence, analyses the drivers of economic growth and identifies factors that might explain the differences between fast- and slow-converging economies in the region. The results show that the most successful CESEE economies in terms of the pace of convergence share common characteristics such as, inter alia, a strong improvement in institutional quality and human capital, more outward-oriented economic policies, favourable demographic developments and the quick reallocation of labour from agriculture into other sectors. Looking ahead, accelerating and sustaining convergence in the region will require further efforts to enhance institutional quality and innovation, reinvigorate investment, and address the adverse impact of population ageing.
The study is filled with fascinating data (at least if you’re a policy wonk).
This chart, for example, shows how many nations are converging (the dots above the diagonal line) and how many nations are falling behind (the dots below the diagonal line).
The yellow dots are Eastern European nations, so it’s good news that all of them are experiencing some degree of convergence.
But the above graphic doesn’t provide any details.
So let’s look at another chart from the study. The blue bar shows per-capita GDP in selected Eastern European nations as a share of the EU average. The yellow dot shows where the countries were in 2008 and the orange dot shows where they were in 2000.
The good news, at least relatively speaking, is that all nations are catching up to Western Europe.
But the report notes that some are catching up faster than others.
The developments were…heterogeneous within CESEE countries that are EU Member States. Some of them (the Baltic States, Bulgaria, Poland, Romania and Slovakia) experienced particularly fast convergence in the period analysed. At the same time, other CESEE EU Member States found it hard to converge… In fact, GDP per capita in Croatia and Slovenia diverged from the EU average after 2008… Given these heterogeneous developments, it appears that while in some CESEE countries the middle-income trap hypothesis could be dismissed (at least given their experience so far), in others the signs of a slowdown in convergence after reaching a certain level of economic development are visible.
My one gripe with the ECB study is that there’s a missing piece of analysis.
The report does a great job of documenting relative levels of prosperity over time. And it also has a thorough discussion of the characteristics that are found in fast-converging countries.
But there’s not nearly enough attention paid to the policies that promote and enable convergence. Why, for instance, has there been so much convergence in Estonia and so little convergence in Slovenia?
Lo and behold, a quick glance shows that higher-ranked nations (blue numbers indicate a nation is in the “most free” category) have enjoyed the greatest degree of convergence.
Here are some specific observations.
The Baltic nations are the biggest success stories of the post-communist world. Thanks to pro-market reforms, they have enjoyed the most convergence.
Romania and Slovakia also experienced big income gains. Romania is in the “most free” group of nations and Slovakia was in the “most free” group until a few years ago.
Poland has enjoyed the most convergence since 2008. Not coincidentally, that’s a period during which Poland’s economic freedom score climbed from 7.00 to 7.27.
Bulgaria also merits a positive mention for a big improvement, doubtlessly driven by a huge improvement (from 5.55 to 7.41) in economic freedom since 2000.
Sadly, Slovenia and Croatia have not experienced much convergence, which presumably is caused in part by their comparatively low rankings for economic liberty.
To be sure, there’s not an ironclad relationship between a nation’s annual score and yearly growth rates.
But, over time, poor nations that want convergence almost certainly won’t get the necessary levels of sustained strong growth without high scores for economic liberty.
A key insight of international economics is that there should be “convergence” between rich countries and poor countries, which is just another way of saying that low-income nations – all other things being equal – should grow faster than high-income nations and eventually attain the same level of prosperity.
The theory is sound, but it’s very important to focus on the caveat about “all other things being equal.” As I explain in this interview from my last trip to Australia, countries with bad policy will grow slower than nations that follow the right policies.
When I discuss convergence, I often share the data on Hong Kong and Singapore because those jurisdictions have caught up to the United States. But I make sure to explain that the convergence was only possible because of good policy.
I also share the data showing that Europe was catching up to the United States after World War II, just as predicted by the theory, but then convergence ground to a halt once those nations imposed some bad policy – such as costly welfare states.
In other words, convergence is a choice, not destiny.
Countries with small government and laissez-faire markets are the ones that grow and converge. The nations with statist policy languish and suffer. Or even de-converge (with Argentina and Venezuela being depressing examples).
Let’s see what academics have to say about this issue.
We’ll start by looking at some research at VoxEU by Professor Linda Yueh. She wants to understand the characteristics that determine national prosperity.
It’s a long-standing economic question as to why more countries are not prosperous. …The World Bank estimates that of the 101 middle-income economies in 1960, just a dozen or so had become prosperous by 2008… But, hundreds of millions of people have joined the middle classes. …How has this been achieved? Possessing good institutions is what economists have come to focus on and the spread of such institutions seems to have been key…the father of New Institutional Economics…Douglass North…stressed that there was no reason why countries could not learn from more successful economies to better their own institutions. That finally happened in the 1990s.
I’m a fan of Douglass North since he – along with many other winners of the Nobel Prize – has endorsed tax competition.
In his case, the goal was for nations to face pressure to adopt good institutions.
And Professor Yueh explains that this means rule of law and free markets.
China, India, and Eastern Europe changed course. China and India re-oriented their economies outward to integrate with the world economy, while Eastern Europe shed the old communist institutions and adopted market economies. In other words, having tried central planning (in China and the former Soviet Union) and import substitution industrialisation (in India), these economies abandoned their old approaches and adopted as well as adapted the economic policies of more successful economies. For instance, China, which has accounted for the bulk of poverty reduction since 1990, undertook an ‘open door’ policy that sought to integrate into global production chains which increased competition into its economy that had been dominated by state-owned enterprises. India likewise abandoned its previous protectionist policies…in Central and Eastern Europe. Communism gave way to capitalism, with these nations adopting entirely new institutions that re-geared their economies toward the market.
All of this is good news, but not great news. Simply stated, partial liberalization can lift people out of poverty.
But it takes comprehensive liberalization for a nation to become genuinely rich.
As many of these economies, especially China, have become middle-income countries, their economic growth is slowing down. And they may slow down so far that they never become rich. But, their collective growth has lifted a billion people of out of extreme poverty.
Let’s now see what other scholars say about convergence.
Some new research from the St. Louis Federal Reserve examines this topic. Here’s the mystery they want to address.
Over the past half-century, world income disparities have widened. The gap in real gross domestic product (GDP) per capita relative to the United States between advanced and poor countries has increased. For example, the ratio of average real GDP per capita among the top 10 percent of countries to the bottom 10 percent has increased from less than 20 in 1960 to more than 40 in 1990, and to more than 50 since the turn of the new millennium… The main point to be addressed in this article is why the income disparities between fast-growing economies and development laggards have widened.
In other words, they want to understand why some nations converge and some don’t.
We select a set of 10 fast-growing economies. This set includes Asian countries and African economies that are perceived as better performing. In contrast, we select a set of 10 development laggards. Beyond the typical candidates of countries mired in the poverty trap, this set includes countries with similar or even better initial states than some of the fast-growing countries, but with divergent paths of development leading to worse macroeconomic outcomes. That is, among development laggards, we choose two subgroups, one consisting of trapped economies and another of lag-behind countries. …Using cross-country analysis, we find that a key factor for fast-growing countries to grow faster than the United States and for trapped economies to grow slower than the United States is the relative TFP… Overall, we find that institutional barriers have played the most important role, accounting for more than half the economic growth in fast-growing and trapped economies and for more than 100 percent of the economic growth in the lag-behind countries.
Here are their case studies, showing income relative to the United States (a 1.0 means the same degree of prosperity as America).
As you can see, some nations catch up and some fall further behind, while others have periods of convergence and de-convergence.
And what causes these changes?
The degree to which nations have good policy.
…we identify that unnecessary protectionism, government misallocation, corruption, and financial instability have been key institutional barriers causing countries to either fall into the poverty trap or lag behind without a sustainable growth engine. Such barriers have created frictions or distortions to capital markets, trade, and industrialization, subsequently preventing these countries from advancing. …By reviewing the previous country-specific details, one can see that the 10 fast-growing countries have all adopted an open policy… Their governments have undertaken serious reforms, particularly in both labor and financial markets. …Thus, the establishment of correct institutions and individual incentives for better access to capital markets, international trade, and industrialization can be viewed as crucial for a country to advance with sustained economic growth
Here’s a table from the report showing the policies that help and the policies that hurt. Needless to say, it would be good if the White House understood that protectionism is one of the factors that undermine growth.
Interestingly, the study from the St. Louis Federal Reserve includes some country-specific analysis.
Here’s what it said about India, which suffered during an era of statism but has enjoyed decent growth more recently thanks to partial liberalization.
During 1950-90, India’s per capita income grew at an average annual rate of only about 2 percent, a result due to the Indian government’s implementation of restrictive trade, financial, and industrial policies. The Indian state took control of major heavy industries, by including additional licensing requirements, capacity restrictions, and limits on the regulatory framework. …In the late 1970s, the Indian government opened the economy by liberalizing both international trade and the capital market, leading to rapid growth in the early 1990s. As argued by Rodrik and Subramanian (2005), the trigger for India’s economic growth was an attitudinal shift on the part of the national government in 1980 in favor of private businesses. …The final trigger of the major economic reform of Manmohan Singh in the 1990s was due to the well-known 1991 balance-of-payment crisis….This reform ended the protectionist policies followed by previous Indian governments and started the liberalization of the economy toward a free-market system. This event led to an average annual growth rate that exceeded 6 percent in per capita terms during 1990-2005.
We also have some discussion regarding Argentina, which is mostly a sad story of ever-expanding government.
Argentina is the third-largest economy in Latin America and was one of the richest countries in the world in the early twentieth century. However, after the Great Depression, import substitution generated a cost-push effect of high wages on inflation. During 1975-90, growing government spending, large wage increases, and inefficient production created chronic inflation that increased until the 1980s, and real per capita income fell by more than 20 percent. …In 1991, the government attempted to control inflation by pegging the peso to the U.S. dollar. In addition, it began to privatize state-run enterprises on a broader basis and stop the run of government debt. Unfortunately, lacking a full commitment, the economy continued to crumble slowly and eventually collapsed in 2001 when the Argentine government defaulted on its debt. Its GDP declined by nearly 20 percent in four years, unemployment reached 25 percent, and the peso depreciated by 70 percent after being devalued and floated.
But if we go to the other side of the Andes Mountains, we find some good news in Chile.
From the Second World War to 1970, real GDP per capita of Chile increased at an average annual rate of 1.6 percent, and its economic performance was behind those of Latin America’s large and medium-sized countries. Chile pursued an import-substitution strategy, which resulted in an acute overvaluation of its currency that intensified inflation. …Although most Latin American countries have practiced strong government intervention in the markets since the mid-1970s, Chile pursued free market reform. …The outcomes are as follows: Exports grew rapidly, per capita income took off, inflation declined to single digits, wages increased substantially, and the incidence of poverty plummeted (compare with Edwards and Edwards, 1991). Since the democratic administration of Patricio Aylwin in 1990, the economic reform has been accelerated and Chile has become one of the healthiest economies in Latin America.
Not only has Chile become the richest nation in Latin America, it also has enjoyed significant convergence with the United States. About 40 years ago, according to the Maddison database, per-capita GDP in Chile was only about 20 percent of U.S. levels. Now it is 40 percent.
I’ll close with a chart, based on the Maddison numbers, showing how Hong Kong, Singapore, and Switzerland have converged with the United States. These are the only nations that have ranked in the top-10 for economic freedom ever since the rankings began. As you can see, their reward is prosperity.
I’m a fan of the Baltic nations in part because they were among the first to adopt flat tax systems after the collapse of the Soviet empire. But tax reform was just the beginning. Estonia, Latvia, and Lithuania have liberalized across the board as part of their efforts to become prosperous.
Economic Freedom of the World is always the first place to check when you want to understand whether countries have good policy. And the dataset for the Baltic nations does show that all three nations are in the top quartile, with Lithuania and Estonia cracking the top 20.
So are these market-oriented policies paying dividends? Has the shift in the direction of free markets and limited government resulted in more prosperity?
The short answer is yes. The European Central Bank has released some very interesting analysis on the economic performance of these countries.
The Baltic States have been able to maintain an impressive rate of convergence towards the average EU per capita income over the past 20 years. …these three countries have each pursued a strongly free-market and pro-business economic agenda… The three countries are different in many ways, but share a number of key features: very high levels of trade and financial openness and very high labour mobility; high economic flexibility with wage bargaining mainly at firm level; relatively good institutional framework conditions; and low levels of public debt.
And this has translated into strong growth, which has resulted in higher incomes.
The Baltic States are among the few euro area countries (along with Slovakia) in which real GDP per capita in purchasing power standard (PPS) terms has shown substantial convergence towards the EU average over the last 20 years. While in 1995 their average per capita income (in PPS) stood at only around 28% of the EU15 average, in 2015 it reached 66.5% (see Chart A).
Here’s the chart showing how quickly the Baltic countries are catching up to Western Europe.
The ECB report also measured how fast the Baltic nations have grown compared to theory.
The long-term convergence performance of the Baltic States has exceeded what would have been expected based on their initial income level.
And here’s the chart showing how they have over-performed.
The ECB study says that the Baltic countries have been especially good about replacing cronyism with the rule of law.
One of the possible reasons for the fairly strong convergence performance of the Baltic States is the strong improvement in institutional quality in these countries… The Worldwide Governance Indicators of the World Bank, which is a composite indicator of institutional quality, suggests that institutional quality has improved markedly in the Baltic States – especially in Estonia – over the recent decades.
I agree. Indeed, I’ve written that Estonia is a good role model, having reduced corruption by limiting the power of politicians and bureaucrats.
The report also credits the three countries with rapid rebounds from the financial crisis, which is a point I made back in 2011.
While the crisis hit the Baltic States hard, the adjustment of imbalances was very fast. The rapid adjustment in fiscal balances and private sector balance sheets implied that the Baltic States could avoid the accumulation of a large debt overhang. In addition, the fast reduction in unemployment helped to decrease the risk of hysteresis, thus avoiding lasting consequences for potential growth. …The external adjustment of the Baltic States was facilitated by painful but effective internal devaluation. …This relatively fast adjustment in the Baltic States was facilitated in part by a strong initial rebound in employment growth, supported by an adjustment in labour costs.
Though the report does warn that there are not guarantees that the Baltic countries will fully converge with Western Europe.
International experience suggests that countries that reach a middle income level, like the Baltic States, tend to find it difficult to converge further and achieve a high income level. A World Bank study suggests that out of 101 middle-income economies in 1960, only 13 had become high-income economies by 2008.
Unfortunately, this is one area where the Baltic nations are weak. Yes, the burden of government spending may be modest compared to other EU countries, but the public sector nonetheless consumes more than 35 percent of GDP. And even though these nations have flat taxes, they also have stifling payroll taxes and government-fueling value-added taxes.
Another problem (not just in the Baltic region, but all through Eastern Europe) is that the demographic outlook is unfriendly, which means that the welfare state automatically will become a bigger burden over time.
If the Baltic countries want genuine convergence (or if they want to surpass Western Europe), that will require additional reform, particularly efforts to reduce the burden of government spending to the levels found in Hong Kong and Singapore.
Unfortunately, it’s more likely that policy will move in the other direction. There are constant efforts to repeal the flat tax systems in the Baltic countries. And efforts by the European Commission to harmonize business taxation ultimately may undermine the pro-growth approach to business taxation in the region as well.
P.S. For those who want an in-depth look at a Baltic nation, I recommend this video about Estonia. And if you want some amusement, check out how Paul Krugman wanted people to believe that Estonia’s 2008 recession was caused by 2009 spending cuts.
(in the interview at about 0:56, I mistakenly said “were rich” rather than “became rich”).
