TCS Daily

Don't Harmonize, Liberalize

By Marian Tupy - June 16, 2006 12:00 AM

Estonia is a poster child for the success of economic transformation in post-communist Europe. Liberalizing measures undertaken by successive Estonian governments have given the country high growth rate and brought the Estonian standard of living closer to that in the West. But globalization makes the benefits of economic integration available to all countries that are willing to embrace liberal economic reforms. As more of them choose to do so, Estonians need to recognize that economic liberalization is an ongoing process. They'll need to address those aspects of their economic organization that compromise the competitiveness of Estonian firms. They'll also need to think about their future in the European Union, for the benefits of the EU membership are fast diminishing.

According to the Economic Freedom of the World: 2005 Annual Report, which is published by the Fraser Institute in Canada, Estonia ranked as the ninth economically freest country in the world. It also ranked as the freest country in the former communist bloc. The rating of Estonia, which is measured on a scale from 0 to 10, where 10 represents the highest measured level of freedom and 0 represents the lowest measured level of freedom, has also been improving. While Estonia's rating was only 7.1 in 2000, by 2003 it rose to 7.8.

But improvement in the individual components of Estonia's economic freedom has been uneven. Government consumption as a percentage of GDP remains high, giving Estonia a mere 4.4 out of 10. The combined measure of the top marginal income and payroll tax rate has actually worsened from 4.0 in 2000 to 3.0 in 2003. At 6.5, the impartiality of the legal system needs improvement as does the protection of intellectual property (6.2). Worryingly, administrative obstacles to the creation of new businesses have worsened from 7.6 in 2000 to 5.5 in 2003. There is no time for complacency.

Moreover, it would be a huge mistake to think that EU membership guarantees Estonia's future prosperity. In fact, the EU could have a deleterious effect on Estonia's growth. To be sure, the ideas behind the creation of the European common market were very sound. Trade protectionism that followed World War I worsened the world-wide economic recession and contributed to the rise of authoritarian regimes. It was, therefore, highly desirable to return to the pre-war days of free commerce, and to eliminate barriers to the movement of people, goods, services and capital. As such, the signing of the Treaty of Rome in 1957 and the establishment of the European Economic Community were steps in the right direction.

Unfortunately, the benefits of the EEC were partly offset by its costs. The creation of the Common Agricultural Policy, for example, was staggeringly costly in terms of money and economic efficiency. Moreover, over the succeeding years, the costs of the EU membership began to rise. The initial "liberalizing" phase of European integration, which focused on the removal of barriers to cross-border trade, gave way to centralization, regulation and harmonization. Harmonization of rules and regulations throughout the EU should be of particular concern to Estonia. For example, lobbying by special interest groups in Western Europe can result in harmonization of production standards at Western levels, thus increasing production costs in Estonia.

Similarly, Estonians should be aware of the limits of free trade in the EU. The process of economic liberalization has been uneven. Though the trade in goods is largely free, the movement of labor and capital remains restricted. The same goes for the free movement of services. Today, 70 percent of the EU's GDP is generated by the service industry. Yet, European countries cannot agree on full liberalization. For example, the so-called "country of origin" principle, which would have made it easier for companies in the new member states, including Estonia, to outcompete their Western rivals and benefit consumers by driving down prices, was left out of the recently agreed services directive.

In a recent speech, President Vaclav Klaus of the Czech Republic argued that economic liberalization functions according to the law of diminishing returns. As such, decades old liberalization of the movement of goods and partial freeing of the capital and labor markets can no longer provide satisfactory stimulus to the EU economy. The numbers seem to support his view. The average annual economic growth in the EU was 4.9 percent in the 1960s, 3 percent in the 1970s, 2.4 percent in the 1980s, 1.9 percent in the 1990s and 0.9 percent between 2000 and 2005. If Klaus is right, then Estonia, which has entered the EU in its "harmonizing" phase, will be increasingly subjected to the rising costs and diminishing benefits of the EU membership.

The above arguments do not necessarily mean that Estonia has to withdraw from the EU at the earliest convenience. Clearly, other factors, including increased sense of security from undue Russian influence that emanates from Estonia's closer association with the rest of Europe, are of considerable importance. But, a sense of realism about the EU and recognition of its shortcomings are important as well. The Estonian government should make a supreme effort to work with other reformist member states who are trying to move the EU away from "harmonization" and bring it closer to the original "liberalizing" phase. There are those, who believe that such drive is doomed to encounter insuperable obstacles in some Western European countries, including, most prominently, France. But, Estonians ought to give it a try.

Marian L. Tupy is assistant director of the Project on Global Economic Liberty at the Cato Institute.


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