Small States and Financial Fragility Rainer Kattel Institute of Public Administration Tallinn University of Technology, Estonia Rainer Kattel Institute of Public Administration Tallinn University of Technology, Estonia

Concepts Small states are weak links in diverse international linkages Financial fragility: Minsky/Kregel: companies and countries can have following financing positions: hedge, speculative, Ponzi Techno-economic paradigms: from mass production to modularity

Financial fragility, origins Financial fragility has essentially one origin and two additional factors enforcing/alleviating it: Origins: all business models are speculative financing positions Minsky: permanent stability is impossible as successful business models (innovations) engender systemic lowering of margins of safety

two factors First, businesses innovate in the hope to become hedge financing position (securitization, product eg iphone, business model eg skype, marketing to sell mortgages, assembly production) Second, public policies and regulations (exchange rates, labour laws, banking regulations) intend to finance sustainable growth (undervalued exchange rate, low inflation, flexible labour markets) Financial stability or fragility results from the interplay of these both factors and international context and country’s level of development: they determine how and in what companies innovate

How can small countries avoid fragility? Small states are by definition prone to fragility as cushions of safety low Two ideal typical strategies: Type A is Nordic economy in post WWII Type B is Baltic economy in 1990s-2000s

Type A Resource based exports, diversification into industry (scale economies in mass production) Exchange rate / capital controls; devaluations / wage negotiations welfare state, active labour market, regional labour markets, NMT hedging long-term development and innovation in increasing returns industries with strong linkages to local economy, getting the paradigm right

Type B Macro-economic stability, currency peg and FDI Modularity in production (outsourcing, lack of increasing returns+learning), regional uneven integration Weak labour and social partners Inputs for exports and private borrowing in foreign currency, huge current account deficits Hedging short-term consumption and real-estate booms Crisis inevitable because Type B is a Ponzi scheme

Conclusion Type A fit perfectly TEP Type B fully misunderstood TEP Lessons for small states: flexibility to respond to speculative positions; regulations, procurement to create lead markets; industry associations to socialize risks of development projects; regional trade etc agreements, technical know-how creation; macro+fiscal policy help to socialize long-term R&D risks