V. Kraft. Economic policy options in a knowledge-based society


Vahur Kraft
Speech delivered on 27 September 2004 at the conference "Science and Knowledge-Based Society", which took place within the framework of the German-Estonian academic week 'Academica'.

A change of paradigm is clearly taking place in the world economy today - we can observe a powerful emergence of knowledge-based, innovation-based economy, which directly derives from creation, introduction, and application of knowledge (or innovation).

A majority of countries consider the growth of economic competitiveness extremely important, presuming that the increased ability to compete would result in creation of employment and economic welfare, which, in turn, would lead to general improvement of the economic environment. In a knowledge-based free market economy, competitiveness basically means the innovation ability, that is, the ability to discover and maintain one's original distinction and thereby achieve a high profitability enabling market position. The enterprises of tomorrow need to be more innovative, productive and lucrative, and more oriented towards creating added value, as otherwise they are not going to be sustainable in the growing competition and liberal economic conditions.

A knowledge-based society is something worth aspiring to. There is probably not a single person in Estonia today, who would throw doubt upon that nice slogan. But what should be done in order that Estonia could become 'knowledge-based and innovative'? I think the most honest answer would be that so far there is no good answer to that question in Estonia. At this point, a proper economic (scientific) analysis would come in handy.

To continue, I would briefly speak about WHY I think so.

(1) To start with, I would like to present a short overview of Estonian economic policy of the last 15 years. What are the factors the success we have had so far is based on?

Estonian GDP per capita, which considers the purchasing power parity, is currently 46% of the average level of the European Union's 25 Member States. Since the preliminary adaptation of the earlier centrally-planned economy to the sudden and large-scale changes caused by market economy, which culminated in a recession in 1995, the average annual growth of the GDP has been exceeding 5%. Today the Estonian GDP per capita is approximately two-thirds bigger than 10 years ago[1]. During the entire transition period, Estonian economic policy has unwaveringly relied on the following principles:

Liberal foreign trade policy and free movement of capital.
Prompt and decisive implementation of structural reforms and extensive privatization.
Fixed exchange rate and strong financial system.
Flexible labour market and strong budgetary discipline together with simple, understandable, and stable tax system.

In consequence, the factors behind our success have been openness, encouraging competition, flexibility, and budgetary discipline.

(2) What can our further success be based on?

By now, one stage of developing Estonian economy has been successfully completed. Our international economic contacts are mostly orientated towards the European Union. In addition, Estonia has become one of the Member States of the European Union. In 2003, the European Union received approximately 70% of Estonian main exports, in addition the goods imported from Europe to be processed and then re-exported. Around 85% of the inflow of direct investments came from the European Union in 2003.

The future economic success of the European Union as well as Estonia depends on whether the European economy will be able to be sufficiently flexible and competitive, whether the opportunities provided by the single currency will be made use of, whether there will be an environment, which maintains and even increases the inflow of investments into economy.

For Estonian economy, which is especially dependent on the continuous inflow of foreign investments, having a full share in the advantages brought along by the single currency is one of the short-term key issues. The Estonian public sector budget is in balance, but there exists a considerable deficit in the private sector financing. This deficit has to be covered on account of external funds. Foreign investors and rating agencies have, on evaluating the reliability of Estonian economy, taken into account that Estonia is striving to become member of the euro area as fast as possible. The interest margins required from us, as well as credit ratings are already at the level comparable with old Member States. This level must be maintained. At the same time, it is extremely important for Estonia that the large and powerful common market we just joined, the market, which encompasses approximately 65% of the foreign trade of the EU Member States, would function as efficiently as possible, and that Europe would favour innovative ideas.

The economic policy trends of the European Union today are summarised in the principles of the Lisbon Strategy. The economic policy priorities of Europe specified for the years 2003-2006 are fostering economic growth, creation of employment, and sustainability of public finances. Although the Lisbon process as a whole is extremely large-scale and touches upon almost all the fields of economic and social policy of the European Union, it can still be claimed - in a simplified manner - that its essence lies in market-based measures for fostering economic growth.

Due to the recent enlargement, the area of the European Union increased by a quarter and the population by a fifth. The enlargement did not considerably increase the GDP of the European Union, but it did add growth potential. Whether the potential growth will become a reality or not, depends on solving several rather complicated economic policy issues.

In recent years, the economic growth of the European Union has been lower than expected, especially compared to the USA. Experts claim[2] that European growth has been hindered by the considerably weak productivity gain, less intensive exploitation of labour resources compared to competitors, and decrease in labour resources due to the continuous aging of the population.

Starting from the mid-1990s, productivity gain in the USA has been permanently higher than in Europe. (In previous decades the situation was contrary, the European increase in productivity surpassed that of the USA). Whereas in the USA the productivity gain in mid-1990s accelerated, in the euro area the reverse happened - why?

The quicker productivity gain of the USA is, above all, related to the faster growth of the so-called total factor productivity (TFP), which is considered to have been caused by higher productivity gain in branches producing information technology and computer technology compared to the euro area, and -which deserves in the context of today's event a special emphasis - in service sectors implementing information technology.

In addition to productivity gain, growth of employment has also been far better balanced in the USA than in the European Union, already since the 1980s. This is partly due to the faster increase in labour force in the USA, but the too high relative level of labour costs in Europe is obviously one of the reasons as well.

The outcome of such developments was to be expected. From the mid-1970s to the mid-1990s, the income per capita in the European Union constituted 75% of the USA level. From there on it has permanently decreased. Approximately a half of the differences in income can be ascribed to the shorter working time of Europeans. Europeans work around 1,500 hours a year, whereas Americans work approximately 1,800 hours.

On evaluating the European growth perspective and selecting the possible growth-fostering measures it is important to find the answer to the question who is right, whether the ones who claim the shorter working time of Europeans is an expression of conscious 'social choice', preferring spare time to bigger income; or the ones who think we are dealing with a peculiarity of a framework non-conducive to working and supportive of equal allocation of the existing work.

Analysis of productivity development in various sectors in the euro area indicates that if the proportion of more innovative and faster-developing sectors grew more quickly, it would considerably increase the productivity growth potential. But faster developing of the more innovative sectors necessitates bigger flexibility - reducing the barriers that hinder entering markets, price regulations, the stiff framework of wage negotiations, and some measures aimed at increasing employment. In conclusion, it must be admitted that by means of structural reforms it would be possible to favourably affect productivity and at the same time support the growth and creation of employment. It is important for Estonia that the structural reforms aimed at greater efficiency of the use of resources would continue in both the recently accessed countries, as well as the old Member States of the European Union.

Thus, the same openness, favouring competition, flexibility, and budgetary discipline should continue to be the basis of our further success.

(3) What is the current situation concerning structural reforms aimed at greater efficiency of the use of resources in Estonia? Lately, there has been a fallacy spreading among Estonians that for a long time already we have been extremely capable and prone to reform, that our economy is open, we are innovative, and there is no need to make any further efforts. But such self-admiration is not constructive, and there is plenty of room for development.

The results of several surveys, as well as current economic indicators reveal that notwithstanding of the similarity of the general macroeconomic framework, there exist profound differences between the competitiveness of the European Union Member States. The countries, which have better competitiveness, are thereat characterized by bigger openness of the economy. That is why continuous openness is extremely important for Estonia, a fresh Member State, as well.

According to the theory of the optimal currency area, the flexibility of markets, especially of the labour market, is one of the most significant preconditions for the efficiency of common monetary policy. Although the existence of some regulatory barriers cannot be denied, it is rather the cultural and linguistic differences that hinder the movement of workers between the Member States in today's Europe. Regardless of the fears of the 'old' Europe, extensive immigration of workforce from the new Member States is quite unlikely in the years to come, in the same way it is improbable that the movement of workers between the old Member States would considerably increase (according to estimates, the movement of workforce between the EU Member States is 6 times lower than between the US states[3], and it remains 3 times lower than in the USA even after the last enlargement). Therefore, the insufficient flexibility of trans-European labour market has to be counterbalanced by a very efficient internal market, high capital mobility, and, above all, as flexible national labour market as possible.

Estonian economy, for example, is hindered by the high level of unemployment, as well as the extensive lack of workforce. According to the Statistical Office, more than a half of the Estonian unemployed have been out of work for a year or even more. This is a sign that unemployment in Estonia is of structural character, that is, the skills of the unemployed do not comply with the requirements of the posts available. In reducing the structural unemployment, active labour market measures play an important role, and the most.

In Estonia there is currently taking place the creation of modern pension and health insurance system. This is a field, where in Estonia as well as in the 'old' Member States of the European Union, which are both characterised by aging population, one has to move towards attaching greater importance to individualised contributions and to guaranteeing a higher level of employment. How to do that? Especially in a situation, where it has to be taken into account that the tax burden of Estonian workforce has reached almost the same level as in the 'old' Member States of the European Union, whereas different from us, the tax burden in Europe is of declining character.

In the European context, the Estonian labour market has so far been relatively flexible, but the implementation of the unemployment insurance system, raising of the minimum wages, and increase in the tax burden on the workforce are going to change it more rigid. If we wish our economy to grow, we should guarantee preservation of a more free framework - among other things also due to the negative experience of several countries, where it has appeared that the political decisions that increase the reglementation of the labour.

Budgetary issues are a big problem in the European Union today, from the point of view of both long-term sustainability - due to the need to reform the pension and especially health care systems, as well as the budgetary position of the Member States, which worsened in 2003.

As far as Estonia is concerned, our so far conservative budgetary policy is a big competitive advantage for us. Estonian budgetary policy is and has been strict and balance-oriented. At the moment, the debt burden of the public sector of Estonia is approximately 5% regarding the GDP (the lowest among the EU candidate states); our public sector budgetary deficit exceeded the maximum level prescribed by the Maastricht criteria in 1999 only.

But in evaluating the importance of the budgetary balance requirement from the point of view of Estonian further competitiveness, we certainly have to consider that the mere meeting of the Maastricht budgetary criteria does not necessarily have to be the key to success. Under the conditions of the common monetary policy, budgetary policy becomes the main economic policy tool, by means of which a country is able to independently affect its economic development (for example by stimulating its economy in a slow growth period). But in order to be actually able to flexibly use the budgetary policy tools, the budget has to be balanced not just one year, but over the entire economic cycle - in surplus during the periods of fast economic growth, and not more than in a 3% deficit regarding the GDP during the periods of recession.

Is it really that simple?? That if we continue with the successful structural reforms, maintain the openness and flexibility, favour competition, and keep the budget balanced, then we will eventually reach the 'flourishing knowledge-based economy' period in any case. By and large it really is so. But that is not the whole truth. In addition to knowing what to do, one also has to know how to do it. By acting reasonably we achieve success considerably faster and with smaller factor cost. What do we need to know in order to act reasonably?

(4) One of the key issues of the further economic development of Estonia is productivity gain. When speaking about productivity gain, the first thing that usually comes to mind is industry. But perhaps there are other sectors, the productivity gain of which could contribute much more to Estonian economy as a whole? (Let us remember the significant role of the IT-based service sector in the general productivity gain in the USA.) Maybe it is too restricting to evaluate competitiveness by only concentrating on industry? Let us take into account that industry constitutes only 20% of the GDP of both Estonia and the EU states. It is possible to find numerous examples of countries with high productivity, where the role of industry is quite modest. So far, no good answer has been found to these questions in Estonia. At this point, a proper economic (scientific) analysis would come in handy.


Investments of Estonian enterprises in science and development have not been very large in recent years. Everybody agrees with this statement, which has become a sort of 'alert phrase' for many public figures, good to come out with in every situation.

It is true, Estonia today spends considerably less on research and development than the level prescribed by the Lisbon strategy for the year 2010. And only a third of it can be ascribed to Estonian enterprises. At the same time it should be pointed out that the current level of Estonian educational costs is rather progressive - we spend 6-7% of the GDP on education, which is more than in other transitional countries, and similar to the level of Finland and Sweden.

It should be asked how big the costs on science and development ought to be in the current developmental stage of our economy. How much would our economy benefit if these costs were larger? And what kind of development costs are the most rational from the point of view of our economic development - creation and elaboration of high-technological, unique products, or expenditure on the fast and efficient utilization of the best technology? So far, no good answer has been found to these questions in Estonia. At this point, a proper economic (scientific) analysis would come in handy.


To continue, if we presume that science and development are currently worth investing in, immediately the question WHERE to start arises. We need a good forecast or at least a vision: which fields in Estonia have enough potential to deserve systematic development.

Some analyses suggest Estonian government prepare and implement cluster programmes supporting the development of information, bio and material technology. At the same time, numerous countries with high or average income are already dealing with those fields. Should we not fear that due to the low level of development of Estonia, we would not be able to finance such programmes as efficiently as the more developed countries? So far, no good answer has been found to these questions in Estonia. At this point, a proper economic (scientific) analysis would come in handy.


Science and development are fields, where, besides the domestic economy and national perspective, we also have to consider the European context. Let us mention here the problems related to accounting reports of venture capital investments of cross-border companies...

It is quite unlikely that equally high contribution to science and knowledge-based activity in the entire European Union will ever be achieved. But is it really so important - if the effective investments in science and development of Europe as a whole were accompanied by an efficient common market at European Union level for products, services, and capital?

It is possible that Estonia has, due to its smallness, no potential at all for the development of high-technological industry, as the latter would need the formation of clusters. Even if we succeeded in creating our own high-technological industry, a sufficiently high-level know-how would still evolve only in a few spheres. This, of course, does not mean that we should develop only a few single spheres. Proceeding from the principle of risk spreading, supporting science and development should take place on a rather large scale.

I imagine as an ideal a regional co-operation in the sphere of science and knowledge-based developments between the Baltic Rim countries similar to the successfully launched collaboration in the financial sector. At this point, I would like to call for a more efficient utilization of the possibilities offered by the international co-operation programmes of the Nordic countries, which are already open for the Baltic States, such as NorFA, which specialises in training top-level scientists, and which annually allocates research grants worth around 40 million Norwegian krones (it must be admitted, though, that in 2004 NorFA had nothing to offer to economic researchers).

Another thing worth patterning upon and maybe even following is the work done under the aegis of the Nordic Innovation Centre, which deals with very specific spheres of business (for example, high-technological textiles, resource-saving production of high-quality welds), but also the Nordic collaboration programme on industrial development policy, which will be completed in 2005, is aimed at increasing the competitiveness of enterprises in the key areas and improving the availability of strategic resources, and is characterised by the key words competency, capital, progressive technology, access to information, and the most efficient utilization of resources located in the vicinity of enterprises. The vision of the above-mentioned programme is summarised as participation in 'creating a Nordic business environment which will ensure that our increasingly internationally oriented children and grandchildren both can and will choose to live, work and be creative in the Nordic region'.

Estonia should definitely set up a similar goal. Let us take into account that in 2030, a hundred thousand less people will be engaged with work than today. From the point of view of retaining the competitiveness of the country, it is of extreme significance whether we are able to provide our young educated adults with sufficiently interesting and well-paid work or not. The question, to which extent we will need to import brains in the future, must be considered already today. Which could be the optimal choices and frameworks for Estonia, The Baltic States, and the Baltic Rim region? So far, no good answer has been found to these questions in Estonia. At this point, a proper economic (scientific) analysis would come in handy.


If we decide to adopt the experience of other countries in developing a knowledge-based society, WHOSE experience should we adopt? For example, the fact that Finland is a small country like us, and above all, our neighbour, does not necessarily mean that their experience is suitable for us to follow. We also need to consider the starting level in one or another country...We could, for example, compare the number of presented patent application on each side[4].

One of the important questions that should be answered by an analysis of science and development activity, is to evaluate the role of innovation as a factor of economic growth in the different development stages of economy. Could we, for example, presume that the role is the bigger the higher is productivity of the country?

Which could be the role of science and development activity in Estonia, where the majority of companies are small and their income level is much lower than in the EU and in the USA? If this question should remain unanswered, one might claim that considering out low income level, other factors are much more important (for example, investments in fixed sock, education, strengthening the legal order, etc.), and although the role of science and development activity as a factor of economic growth is continuously increasing, it is still of secondary importance. So far, no good answer has been found to these questions in Estonia. At this point, a proper economic (scientific) analysis would come in handy.


(5) As we can see, a lot of unanswered questions are related to the transition to a knowledge-based economy. But the answers must be found, and they have to be correct ones, suitable to Estonia. Estonians have no other way to achieve success than to exploit their knowledge and skills. As we all know, there are no oilfields in Estonia to help us gain prosperity. Therefore, what is left for us to do is to be innovative and willing to develop.

Lately there has been a lot of talk about knowledge-based economy in Estonia. Thereat a widely spread and somewhat true opinion has formed - that knowledge-based does not mean exactly the same as fundamental studies and academic education. Without wishing in any way contradict those, who emphasise the importance of applied research and private investments made to support the development of industrial production, I would still like, considering the peculiarity of today's forum, to say a few words in defence of academic education.

All the economic policy questions I have pointed out in the course of this presentation, expect answers on the level of a top professional, a top analyst. Such level is usually certified by a doctor's degree. In recent years the demand for economic specialists with a degree has increased in both the public and private sector in Estonia. It is highly likely that this tendency will also continue in the future. I want to emphasise that post-graduate studies in the field of economy are necessary not only for maintaining academic continuity, but also for the preparation of top specialists.

In Estonia the number of universities providing post-graduate studies in economics is not very big, and in each of them there are not that many post-graduate students. It is obvious that we need a closer internal co-operation in organising post-graduate studies in economics - just as it is working in Finland, Denmark, and also Stockholm, where Stockholm School of Economics and University of Stockholm are organising joint courses. Finland has found it efficient to gather together all the post-graduate students from 11 Finnish universities and give them lectures together. I am happy to admit that the economics post-graduate studies related co-operation between Tartu University and Tallinn Technical University, which Eesti Pank has also promised to support, has had a good start. I suggest other fields of study follow that example!

[1] It is 4.5 times bigger than 10 years ago in current prices and 1.8 times - in constant prices.
[2] See for example IMF, ECB
[3] CEC
[4] According to the Estonian Patent Office, in Estonia the number of issuance of patents to protect products unique in the world per 100,000 residents is approximately 50 times smaller than in other Member States of the EU - in Finland, 40-50 patent applications are submitted per 100,000 residents, in Ireland 30, in Estonia below 1.

V. Kraft. Economic policy options in a knowledge-based society