Economic crisis in the Baltics: It is time to break the piggy bank

It is probably well-known to readers of this blog that the Baltic countries are in a deep economic crisis. When the USA and the countries in Western Europe sneezed, the Baltic countries caught a cold. And a bad cold, that is. GDP fell in 2008 in both Estonia and Latvia, and in 2009 GDP is expected to fall by 10 percent or more in all three countries. Meanwhile, unemployment is increasing rapidly, many workers experience falling nominal wages and personal and corporate bankruptcies are on an upward trend. Latvia recently had to turn to the IMF for emergency funding as a domestically owned bank, Parex, went belly up and had to be rescued by the government. The capitals of Latvia and Lithuania have seen street protests against their governments’ crisis management.

The bleak outlook is aggravated by the apparent lack of remedies, which can help pull the countries out of the crisis. The labour markets are admirably flexible; the local news media report on numerous businesses lowering their nominal wages and it shows up in the statistics in the form of rapidly decreasing wage growth. Still, the main trading partners (Sweden, Finland, Germany and Russia) are also in recession, and lower export prices are unlikely to provide relief in the short term. It follows that increased demand must come from domestic sources. The standard recipe in the USA, Japan and Western Europe is to increase public demand, i.e. to pursue expansionary fiscal policies. This option, however, is largely unavailable to the Baltic countries. In spite of small fiscal deficits and public gross debt below 20% of GDP, it has become increasingly difficult for the governments to borrow in financial markets. The bond markets have dried up and syndicated loans are becoming expensive (even when sourced in euro or dollar). It is clear that the needed demand injection cannot come from the government budgets.

The Baltic countries have introduced funded pension systems during the last decade. The model adopted in all three countries is the three-pillar model advocated by the World Bank. The first pillar is a traditional Pay-As-You-Go system, where pensions are paid out of current contributions. The second pillar is a compulsory saving scheme where a part of the wage-bill is excepted taxation and instead transferred to privately run pension funds. The third pillar comprises private pension savings with preferential tax treatment. Currently, most individuals participate in the second pillar scheme, while fewer (mainly high-income) individuals contribute to the third pillar. The contribution to the second pillar comprises 6 percent of the wage bill in Estonia, 8 percent in Latvia and 5.5 percent in Lithuania. The savings are administered by private pension funds and to a large extent invested in bonds and stocks in high-income countries.

And here comes the irony: while the Baltic economies were collapsing in 2008 and an increasing number of individuals encountered problems servicing and/or refinancing their debt, the same individuals kept on contributing to their second pillar funded pension. The result is that some individuals see their homes and cars reprocessed at depressed prices, while they continue to save for their retirement perhaps 30 or 40 years ahead in time!

As crisis measures, the Baltic governments have already lowered or plan to lower the second pillar payments transferred to private savings funds. The Estonian government plans to suspend the current second pillar payments with the effect that 4 percent of the wage bill will be transferred to the budget while the remaining 2 percentage points will be paid out. In Latvia the second pillar contribution has been lowered from 8 to 2 percent of the wage-bill with the remaining 6 percent being transferred to the budget. In Lithuania the transfer to private saving funds has been reduced to 3 percent of the wage and the balance is being transferred to the government-run pension fund.

I believe that it would be advantageous if the governments in Latvia and Lithuania suspend the remaining second-pillar contributions to private pension funds altogether (i.e. 2 percent of the wage-bill in Latvia and 3 percent in Lithuania). The money could be paid out to the income earners in order to put a little extra cash in their hands in a time of crisis.

The question is, however, whether the Baltic countries should go one step further and allow individuals to take out their entire accumulated second-pillar saving. It seems most appropriate to make the withdrawal voluntary and to tax the withdrawn sum relatively lightly. The legislation in many countries already gives the individual contributing to a funded pension some access to his or her account. This applies for instance to the USA where individuals can borrow from their 401(k) pension accounts in case of economic hardship.

I see three major benefits of allowing withdrawal of accumulated second pillar (and third pillar) funds. First, it might be able to reduce the number of households facing personal bankruptcy. The reduced pension saving meant for a distant future seems a small cost when compared to the cost of personal bankruptcy, distressed sale of property etc. Second, it might inject badly needed demand into the Baltic economies. Individuals will partly spend the withdrawn savings on domestically produced goods and services and thus help stimulate the economy and preserve jobs. Third, the extra tax revenue will be a welcome revenue source for governments with limited borrowing possibilities.

The main drawback of allowing individuals to withdraw their second-pillar saving is that the banks and other financial institutions offering the pension funds will loose business. The funded pensions have been very profitable to those running the funds, but the question is whether the well-being of bankers is very high on the current political agency. If withdrawals from the second pillar become widespread, then the funded pension systems in the Baltic countries might be up in the air. However, the current three-pillar systems are anyway ripe for a revamp.

I will return in a later block with a more detailed discussion of the pros and cons of the World Bank three-pillar model. At this stage it suffices to raise the question whether the three-pillar pension model is so fantastic. Looking at a map it becomes clear that mainly middle-income countries in Latin America and Eastern Europe have introduced the model. Most countries in Western Europe have a rapidly aging population and weak public finances, but have by-and-large not taken steps to introduce the three-pillar system. If the three-pillar system is really so good against a variety of ailments, then it is a bit puzzling that so few of the countries with long-term problems have taken the medicine. It is time to break the piggy bank in the Baltics.