Madis Müller, Governor of Eesti Pank and member of the Governing Council of the European Central Bank

17 March 2021

I have promised to talk today about the state of the economy and the role of the central bank in exiting the crisis. Tomorrow will mark exactly one year since we decided at the European Central Bank to launch additional support measures because of the Covid-19 crisis. We had to intervene so that anxiety in financial markets did not make the crisis worse. And so we have been living with this crisis for a year now.

Looking back, we can say that the bleakest scenarios painted at that time did not come to pass. When the restrictions were lifted in the summer, the economy at first recovered quite quickly, but then came a new wave of the virus and we had to endure some very difficult times in Estonia. A very important difference from March last year is that there are now several vaccines that work, which at that time could only be hoped for somewhere in the future. Yes, there are still difficulties with supply and there have been setbacks that have postponed the lifting of the restrictions that were introduced to stop the spread of the virus, and the opening of the economy. But even if there is to be a delay in opening economies, there is reason to assume that we will be talking about a delay of one or two quarters and not more than that.

The industrial sector in the euro area is already recovering at a good rate, as foreign demand is picking up. The United States and Japan have approved large packages of assistance to reignite their economies and support measures are being launched in the European Union to help exit the crisis. This all means that the broader external environment is doing better than we even dared hope in the autumn.

We must understand though that a crisis as deep as the current one has rarely been experienced in history. No country in the world has escaped untouched by the coronavirus pandemic. Some countries may have succeeded in avoiding the worst of the healthcare crisis over the past year, but they have still felt the economic impact. The new year entered in the euro area with a new and rapidly spreading wave of Covid-19 that prevented restrictions on movement and activity being lifted. There remains in consequence a lot of uncertainty about the near future.

The euro area economy

The European Central Bank published its latest economic forecast last week, which showed that although growth in the first part of this year has been slower than was forecast in December, we still expect growth of 4% in the economy for the year overall. We will still not get back to where we were before the pandemic, as the economy in the euro area shrank by 6.6% over the past year.

Inflation has picked up in the euro area in recent months as the oil price has risen and several temporary factors like VAT cuts in Germany have had an impact. Various one-off factors make it probable that we will see inflation temporarily approach 2% in the second half of the year. For these reasons the European Central Bank also raised its inflation forecast for this year from 1% to 1.5%. Given the continuing weakness in the demand environment, the low growth in wages and the large amount of economic resources standing idle though, we do not yet see any consistent inflation pressures building up.

Inflation in the euro area has averaged 1.2% over the past decade. This is some way below the target of the European Central Bank of close to 2%, where it is far enough away from the danger of deflation but low enough to encourage growth in the economy. To get closer to the target, the European Central Bank has introduced several extraordinary monetary policy measures such as negative interest rates, longer-term targeted loans and asset purchases. Inflation will however remain below the target of the central bank throughout the forecast horizon up to 2023.

All the governments in the euro area have provided wage subsidies and loan guarantees during the crisis, and this was of great assistance in surviving the crisis. Such support measures are necessary for as long as there remain restrictions that prevent the economy from functioning normally.

The support packages have however increased the debt burdens of national governments, and pushed them very high in some countries. The sustainability of the debt is not currently a problem given the low interest rates, but it must be remembered that interest rates will rise in the longer term. To be able to pay off that debt in the future, it is very important to invest now in areas that will lay the foundations for new growth. It is good to note that there is a common understanding about setting the priorities for recovery financing from the European Union.

It is much more complicated though to actually implement these priorities effectively. We are facing not only the healthcare crisis and its aftermath, but also the structural problems that have for a long time caused low productivity growth in the whole of the euro area and in the Estonian economy. There are also many other questions to face such as whether different branches of the economy will recover at the same rate, how the crisis will have affected the labour market and whether it will have caused permanent damage there, and what will hold growth in euro area back in the longer term.

Monetary policy

As I mentioned earlier, the European Central Bank increased its purchases of bonds in March last year to ease the impact of the coronavirus crisis. This was done because interest rates in the bond markets had risen very sharply both for governments and businesses. Borrowing became suddenly much more expensive, and this would have made it harder for economic activities to recover. As it will take time for the economy to recover from the pandemic, the Governing Council of the European Central Bank has promised to focus particular attention on keeping the financing conditions favourable in the euro area for as long as the crisis lasts. The central bank is also continuing to provide longer-term loans to commercial banks on exceptionally good terms so that they could then keep the lending conditions for their clients as favourable as possible. The cost of borrowing is now by some measures actually lower than it was before the crisis erupted.

Longer term yields of sovereign bonds have recently risen as some optimism about the outlook is returning globally. Even so, we can say that at current levels the interest rates will not be holding back the recovery from the crisis. We should not overestimate the role of long-term sovereign yields on the recovery of the economy or the decisions of the central bank, especially as cost of borrowing for companies and households remains very low. It is however one indicator among many that we follow at the Governing Council when assessing financing conditions and access to finance. It is clear though that low interest rates by themselves will not bring us out of this crisis. The favourable funding needs to find its way to new projects launched by businesses and the government should invest borrowed money in reforms and in laying the grounds for future growth.

The situation in Estonia

The Estonian economy lost around 3% during the crisis of the past year, which is less than half of the euro area average. We have been used to the Estonian economy being much more volatile than the bigger economies of Western Europe. We could cautiously suggest then that compared to other countries in Europe, we escaped last year with nothing but a fright. The year turned out much better than was at first feared because the spread of the virus did not get out of control and most sectors of the economy recovered their usual operating environments very quickly.

This year has been different though. The infection rates in Estonia last week were the highest in the world. Fighting the pandemic needs tighter restrictions, and it is clear that they will have a strong negative impact on the economy. This is where it is important that the government supports struggling people and businesses. Such support should above all be extended to those who have suffered directly because of the restrictions. After that it becomes harder to make choices. The benefit gained from each euro of subsidy can vary widely depending on who it is given to and under what conditions.

There are two perspectives that can be taken on this. The first is the short term, when the main focus is on national health and on supporting people and businesses. The second is the longer term, which needs the focus to be on the competitiveness of all aspects of the economy. Both these perspectives must be considered if the crisis is not to make us forget our long-term goals, as it is those goals that will start to define Estonia’s success as soon as the crisis has faded away.

Decisions taken within the country carry even greater weight now than they did over the past year. Estonia was threatened more last year by the performance of foreign markets, but this year it is the situation at home that matters. We are having to fight a serious epidemic at a time when global demand is improving even faster than was expected even just a few months ago. Last week the OECD raised its forecast for growth in the global economy this year sharply from 4.2% in earlier forecasts to 5.6%. The European Central Bank also adjusted its outlook for the euro area upwards last month, though by less. We must nevertheless again be cautious, as there remains great uncertainty around all forecasts at the moment.

The performance of the Estonian economy depends mainly on when businesses will be able to operate without restrictions. It is apparent now that the crisis will drag on longer than was predicted in the Eesti Pank December forecast, and the recovery will be delayed. We currently assume in our outlook for the economy that companies will be able to return to their usual rhythms of operation from May but unfortunately there is no guarantee of this. It is still too early to estimate the possible lasting damage caused by the crisis dragging on.

So far, three people in a hundred in Estonia have lost their jobs, which does not sound very many given the extent of the global crisis. However, relatively more people lost their job in Estonia than in the rest of the euro area or in neighbouring countries despite the wage support measures and other subsidies that were introduced last year. Companies reacted quickly when the virus crisis started last spring. As little was known about how the crisis may play out, decisions were taken that were aimed above all at letting companies survive. People were made redundant in order to cut costs and banks were asked to give payment holidays on loans, which in the end were serviced without problem.

Businesses have by now adapted to the new circumstances as much as is possible. There are still enough resources available to relaunch business activities and the economy more generally once the restrictions have been removed, as we saw last summer. It cannot be assumed though the reserves and savings will last forever in a depressed economy.

Household savings have increased at the same time, as there have been few opportunities to consume and wages have continued to rise surprisingly fast. Data from the Tax and Customs Board show that the growth in the average wage paid out at the start of this year was around 5%, as it was in the second half of last year. It is notable that wages rose at the start of this year even in those sectors where employment has fallen. This is a picture from the time when restrictions were looser, but the full impact of the restrictions that are now in place is only starting to be felt. This raises a question for our upcoming discussion of how to soften the blow to our labour market, which is one of the most flexible in Europe but is then also one of the least secure for employees in times of crisis.

The risks and uncertainty surrounding the future are extraordinarily large. The state of the Estonian economy may become harder to forecast. It is not impossible though that access to vaccines, the lifting of restrictions and the consequent growth in the economy will happen faster than expected.

We should not be satisfied with only monitoring events. The government and businesses can be decisive in taking the lead. The main motivation for today’s seminar was to bring together dynamic and informed thinkers and policy makers, whose discussions could produce ideas for how we can exit the crisis stronger, and maybe even find some benefits in it.

The government has just taken several decisions on how to support the economy, but there is no shortage of topics to discuss. How can those decisions now best be implemented? How can we give greater confidence to businesses? Will there be new solutions for the chronic problems in Estonia’s economy like the shortage of skilled labour? Where will we find the capital to launch projects that could fuel new growth?

We will have two discussion panels that are certain to be very interesting and thought-provoking. I hope they will also find some answers to the questions I have just thrown out and more besides.