The Baltics experiment: the broader implications for the European Central Bank.

• Author: Wood, Barry D.

At first glance, it is laughable to view the three small Baltic states in northeast Europe as systemically important. The combined 68 billion [euro] GDP of Estonia, Latvia, and Lithuania is not even 1 percent of the era-ozone total. Statistically, the entire Baltic region is equivalent to two or three medium-sized cities in western Europe.

And yet the financial and economic tsunami that has swept over the region and the seven million inhabitants of these former Soviet republics is likely to have effects reaching far beyond Baltic shores.

With astonishing speed, the Baltic states lurched from being the European Union's fastest growers to its biggest decliners. The reversal was sudden and dramatic. In the three years after joining the European Union in 2004, Estonia, Latvia, and Lithuania registered Europe's highest growth rates, 8 percent to 12 percent advances annually. Per capita incomes rose by 50 percent, an achievement unmatched anywhere in transforming Europe. But in the late 2007, in the wake of America's subprime debacle, the region's housing bubble burst. The boom was fueled by what is now seen as reckless lending by Swedish banks, which accounted for much of the 40 percent to 50 percent annual increases in private sector credit flows.

In just months, growth stalled and went into reverse. In early 2008, Estonia was the first EU nation to slip into recession. The 8.7 percent growth the Baltics recorded in 2007 became a 0.7 percent decline in 2008. This year, according to the International Monetary Fund's July update of its World Economic Outlook, the shrinkage in the Baltics will exceed 10 percent. With the downturn still deepening in the third quarter, the Latvian economy is now expected to decline by a stunning 18 percent in 2009, while Lithuania falls 15 percent. and Estonia over 10 percent. Even with a mild upturn forecast for next year, growth is still expected to be negative in 2010. In all three economies, unemployment has quadrupled in the past year to levels ranging from 13 percent to 18 percent.

How did things get so much worse in the Baltics than elsewhere in the European Union?

UNHEEDED WARNINGS

Some experts saw the approaching crisis. Among them was Lars Christensen, Baltics specialist at Danske Bank in Copenhagen. In February 2007, he prepared a paper entitled "A Warning Not to Be Ignored." In it, he says, "We screamed about the imbalances," and argued that Latvia's current account deficit, in excess of 22 percent of...