Thorvaldur Gylfason Eduard Hochreiter

 Since collapse of Soviet Union in 1991  Three Baltic states, now EU members, have fared significantly better than other FSU states  Aim is to apply standard growth economics to a comparison of Estonia and Georgia  Extensive vs. intensive growth  Similarities  Small, poorly endowed with natural resources  Prosperous in past golden age  Annexed by Russia in 1721 (Estonia), 1801 (Georgia)  Independent (Estonia), (Georgia)  Difference  Estonia embarked on ambitious reforms  Georgia did not, was torn by civil war

 Estonia’s per capita GDP sank from rough parity with Finland in 1940 to a third of Finland’s in 1991 …  … then rose to half of Finland’s per capita GDP in 2005

 Georgia’s per capita GDP fell from almost half of Estonia’s in 1991 to one-fifth in 2005 …  … and also declined relative to Russia, from 38% to 32%

 Georgia took a deeper and longer lasting plunge: its per capita GDP contracted by almost 80%  Estonia’s per capita GDP contracted by 33%

 Same story on logarithmic scale  Puzzle: with such a low level of initial income, why did Georgia not grow more rapidly than Estonia thereafter?  Sources of growth

 Per capita output depends on  Efficiency, A Trade  Human capital per person, H/L Education  Capital/labor ratio, K/L Investment  Natural capital per person, N/L We assume c = 0

Suppose a = b = 1/3, c = 0 Assume v = 0.1 u = years of schooling Assume v = 0.1 u = years of schooling By definition; K/Y is proportional to I/Y

 Real capital  Investment in machinery and equipment  Human capital  Education, on-the- job training, and health care  Foreign capital  Trade and investment Growth Investment Education Trade

 Estonia invested 29% of GDP in machinery and equipment on average compared with 20% in Georgia Real capital

 Nearly all Estonian youngsters attend secondary schools compared with 80% of Georgians  Nearly two thirds of young Estonians go to college compared with 42% in Georgia  Expenditure on education amounts to about 6% of GDP in Estonia compared with 2% in Georgia Human capital

 In Estonia, 483 personal computers per 1,000 inhabitants compared with 42 in Georgia  In Estonia, 513 internet users per 1,000 inhabitants, 39 in Georgia Human capital

 Life expectancy at birth took a deep dive in Estonia before 1990, did not recover until a decade later, and then sailed past that of Georgia in the late 1990s Human capital

 In 2001, Estonia had 6.7 hospital beds per 1,000 inhabitants compared with 4.3 in Georgia  All child births in Estonia are attended by skilled medical staff compared with 92% in Georgia Human capital

 Population of both countries continues to decline …  … but that is also true of most of the rest of Europe and the OECD region Human capital

 Net inflows of FDI in Estonia: 7% of GDP on average compared with 4% in Georgia  With more domestic and foreign investment and more students at school, small wonder that Estonia grew faster than Georgia Foreign capital

 Exports from Estonia equaled 73% of GDP on average compared with 33% in Georgia  Export figures include re-exports Foreign capital

 Estonia has abolished all tariffs, while Georgia continues to depend on import restrictions for about 10% of its tax revenues  It takes 1.7 days for importers in Estonia to clear customs compared with 3.4 days in Georgia Foreign capital

Growth Liquidity Honesty Democracy Equality  Financial capital  Liquidity greases the wheels of production and exchange  Social capital adds to cohesion  Honesty  Democracy  Equality

 Georgia initially had higher inflation than Estonia, but managed after 2000 to bring it down to single- digit figures  In Georgia, severe initial monetary overhang Financial capital

 Not surprising that process of monetization of economic transactions was slower in Georgia than in Estonia Financial capital

 In 2005, interest spread was 3% in Estonia compared with 14% in Georgia, suggesting continued inefficiency and lack of competition in Georgian banking system, or high credit risks Financial capital

 Yet, progress also in Georgia where interest spread used to be 20%-24%  Almost all bank assets are now foreign-owned in Estonia compared with two thirds in Georgia Financial capital

 Agriculture’s share of GDP in Estonia has decreased to 4% compared with 18% in Georgia  Reflects Estonia’s stronger emphasis on economic modernization Economic structure

 In 2005, electrical power was interrupted for one day in Estonia compared with 39 days in Georgia  In 2007, it took 7 days to start a business in Estonia against 11 days in Georgia Economic structure

 Manufacturing accounted for almost 75% of Estonia’s exports compared with 33% in Georgia  World Bank’s Ease of Doing Business Index now puts Estonia in 17 th place and Georgia in 18 th, up from 112 th place in 2003 Economic structure

 In 2005, tax rates were cited as a major business constraint by 3% of managers surveyed in Estonia compared with 36% of managers in Georgia Economic structure

 Both countries have liberalized on many fronts at once according to the Economic Freedom Index  Source: Heritage Foundation Social capital

 Democratization as investment in social capital  Infrastructural glue that holds society together and keeps it working smoothly and harmoniously  Until 2004, Estonia scored 1-2 points higher than Georgia Social capital

 In Estonia, 2% of managers surveyed described their lack of confidence in the courts as a major business constraint compared with 12% in Georgia Social capital

 In Estonia, 2% of the managers surveyed described crime as a major business constraint compared with 24% in Georgia Social capital

 On a scale from 1 to 10, there is a persistent 3 to 4 point difference between corruption perceptions indices in Estonia and Georgia  Source: Transparency International Social capital

 In Georgia, 20% of managers surveyed described graft as a major constraint on their business operations against 4% in Estonia  In 2003, Gini index of income inequality was 36 in Estonia and 40 in Georgia Social capital

Suppose a = b = 1/3, c = 0 Assume v = 0.1 u = years of schooling Assume v = 0.1 u = years of schooling By definition; K/Y is proportional to I/Y

Assume v, g, and  are the same in Estonia and Georgia Assume v, g, and  are the same in Estonia and Georgia

 Decomposition of 2005 per capita income differential of 4.73  Investment rates are 0.29 and 0.20  Would by itself account for a 20% difference in per capita incomes  Years of schooling are 14.5 and 13.1  Would by itself account for a 100% difference in per capita incomes  Leaves a 95% difference to be explained by differences in efficiency, including governance  Intensive growth  Intensive growth counts, not extensive growth

 Estonia invested more relative to GDP than Georgia, and also attracted more FDI  Estonia sends more young people to secondary schools as well as to colleges and universities than Georgia  Estonia has done more than Georgia to increase economic efficiency  Liberalize  Liberalize trade  Stabilize  Stabilize prices, stem corruption  Privatize  Privatize its banks and other state enterprises  Estonia has moved farther and faster in a growth-friendly direction Fini