In my thesis I look at the experiences of the Baltic countries (Estonia, Latvia and Lithuania) after the fall of communism and the collapse of the Soviet Union. The main weight is put on exploring the choices taken when the countries set up a new institutional system, to find if differences in these choices can explain differences in economic performance between the countries. The background for this thesis is the fact that there’s been a marked difference in the economic performance of the Baltic countries since their independence. In 1990 Estonia was the wealthiest of the Baltic countries, measured in GDP per inhabitant, a bit above Latvia in the middle and with Lithuania as the poorest. Now the difference between Estonia and the two others is much greater, real growth 1990-2006 has been respectively 76.7%, 20.6% and 24.6%. Most of this difference came in the early years following communism, 1991-1995, between 1995 and 2006, growth has been almost similar. Therefore, the early years of transition receive most of my attention.
My hypothesis is that qualitative differences in the countries’ institutions and the uncertainty around their development have lead to different rates of growth. I look at different theories about how different institutions are important to achieve growth, and then see how they fit with empirics from the three countries.
I find that Estonia’s better economic performance in the transition years can be explained by its success in building better institutions than Latvia and Lithuania, and by lower uncertainty over its future, due to more consistent policies leading towards a market economy. Fast and effective reforms such as opening of trade, strict fiscal policy, the implementation of a currency board and banking reform helped to facilitate the introduction of hard budget constraints in Estonia, and the inflow of FDI, large as the uncertainty was low, made restructuring easier and more effective. Thus Estonia was able to get out of the transition slump faster than the other two, and the advantages gotten then seem to have remained.
The thesis is organised as follows: In section 2, I look at the history of the Baltic countries, with focus on the inheritance left by the years of Soviet economic policy and the problems faced in the transition from plan economy to market economy. Section 3 explores several theories of why some countries are richer than others, mainly focusing on institutional explanations. I look at initial conditions, the level of corruption, price liberalisation, privatisation, competition policy and banking regulation in the three countries, and find that mostly, Estonia has followed a policy that, according to the theories I use, is better for economic growth than the policies followed by Latvia and Lithuania, or at least as good.
In section 4, I use a model, taken from Dani Rodrik’s article “Policy Uncertainty and Private Investment in Developing Countries”, to show how uncertainty about a country’s economic policy might affect investment and thus growth in the country, and look at the Baltic countries’ experiences within this framework. While uncertainty concerning foreign relations was probably higher in Estonia and Latvia than in Lithuania, I find that Estonia was the fastest and most consistent country in introducing reforms. This implies that the perceived chance of the emergence of a well functioning market economy most likely was seen to be higher in Estonia, leading to more investment and thus higher growth. Finally, in section 5, I draw conclusions and mention factors that could be explored further or that I might have overlooked.