* The author, Academician Raimund Hagelberg, is a member of the Board of Eesti Pank.


The Estonian economy looks better for the outsider than for ourselves. This difference derives from the fact that foreign analysts have a broader field of vision - they can use comparative data on all countries in transition. And besides, the state of the Estonian economy has no personal impact on them and their evaluations are thus free of emotions. It is perfectly understandable why we ourselves are dissatisfied with the economic development so far. Regardless of certain achievements - the standard of living has improved as a whole during the independence years, the inflation rate has slowed down, the debt burden is not too heavy, etc. - these do not correspond to the optimistic expectations, let alone the promises made by politicians. We are dissatisfied with the slowness of economic growth, the slow increase in real consumption, the rapid increase in trade deficit, problems with balancing the fiscal system, inequality in regional development, etc. All this cannot be justified just by the lack of real possibilities - there are also many things that have been left undone or done wrongly, and this has happened on all levels, beginning from the man on the street and ending with the country's top leadership.

This is our controversial reality which, however, is charged with potential and has to be seen for what it is, without attempting to beautify it. I am convinced that the main motive force for us is not blunt criticism or mutual accusations although, obviously, we cannot do without them at the moment. In order to get a better understanding and set clear-cut aims for the future we need to build up an unbiased and systematic idea of the conditions we have to function in. This would also help us to see more clearly in what direction and how these conditions should be changed and what could and should be done for this. By the above I mean the economic environment we are all functioning in. Without an idea of the system as a whole, our attempts to organize it yield little results.

The outlines of the economic environment have not been defined very clearly on the theoretical level, although the handbooks of economic theory do touch or at least mention them briefly in the context of production factors. The thing is that in the economy of developed countries the economic environment has evolved over the time and changes in it are self-regulatory. Yet, here too new problems arise in connection with the globalization of the economy and the emergence of regional economic unions. A typical example here is the European Union. The economic environment widens, relations become more complex, economic rules need to be specified and harmonized, a need arises for an international legal regulation, etc. But let us leave this aspect of the problem aside and confine ourselves to the level of one country. The countries with transition economies first and foremost need to get a comprehensive picture of the system and how it functions.


While describing the economic environment through its main outlines (see Figure), the following aspects deserve attention:

The economic environment covers all production factors, the respective infrastructure as well as property and other legal relations. The corner-stone of the economic environment is the property relations. These determine the legislation, the nature of the state regulation and the main tendencies of the legal system that guarantees and protects it. In a democratic parliamentarian country the balance of political forces plays an important role in shaping and applying the actual mechanisms. On a political landscape that is still developing this can lead to serious problems. The most dangerous of them is the economic policy that proceeds from some narrow interests and disregards all other spheres, market requirements and real possibilities.

In the present conditions of the globalization and internationalization of the economy, the infrastructure, the monetary, banking and fiscal system are gaining an ever more important role. International economic relations have a decisive role in the economic development of a small country like Estonia, particularly keeping in mind our geographical position, natural resources and other production factors. Therefore, we are inevitably less free in our choices than bigger countries. Joining some economic union is, under these circumstances, probably the best solution. Estonia does not have the natural resources of Norway, or the banking and financial potential of Switzerland.

In view of the above, we have to put special emphasis on the manoeuvrability of the economic environment, for which important are the following prerequisites:
- openness, which we have to be able to control, regulate and protect in order to avoid abuses;
- competitiveness proceeding from the criteria of the international market;
- flexibility in order to quickly adapt to changes on the world market.
In essence, this means the adaptability of the economic structure and its components, in particular entrepreneurial activities, capital and labour, and the ability to achieve high productivity without large additional investments.

The so-called target for the functioning of the economic environment is an adequate perception of the demand, and in the Estonian conditions, demand on the foreign markets particularly. Meeting the demand through the supply depends on the economic structure, making use of its potential and the necessary investments for creating additional potential. As a rule, the problem is the sources of investment, expediency and efficiency of their use.

All major mechanisms function through stimuli, every agent strives for the goals he has set himself and which can be summed up as increasing one's own well-being. Since the interests of different economic agents can be contradictory, it is necessary to use the rules based on legal norms (agreements, etc.). In the course of time there have also developed rules that are not fixed in legal acts and are considered to be good economic practice - good business practice, good banking practice, etc.

On the state level the effectiveness of the economic environment is characterised by economic growth - the growth of the GDP, GDP per capita and various modifications of these indices. Here, too, the goal is to increase one's well-being. Yet, in evaluating it we should not ignore the factors that have the opposite effect. The living standard can be quickly and temporarily boosted, for example, through increasing the exploitation of the natural environment. What I have in mind is the extensive use of natural resources, inadequate concern for pollution, etc. A temporary gain here means a great loss in the longer run.


Below I will bring forth some observations on the status and functioning of the Estonian economic environment. The analysis of the current situation can be started from any point of the system (see figure), depending on what aspect is being studied. It is an elementary fact that supply depends on demand, that the possibilities of supply are determined by the economic structure, and its development (restructuring) depends on the targeting and effectiveness of investments; on those, in their turn, depend productivity, competitiveness of the products, that is, their marketability, price, quality, etc., etc. A foreign investor for example usually first looks at the country's business climate, legislation, technical infrastructure and then proceeds to evaluating the possibilities of investing into a concrete project. No matter where or why we begin there are always two key questions. First, there must be a demand, which creates the prerequisites for launching a respective project. Secondly, investments and the necessary sources without which it would be impossible to carry out the project.

In 1996, Estonia's export amounted to 24.6 billion kroons and import to 38.4 billion kroons. The 13.8 billion kroon trade deficit indicates that our economic structure has not been able to adapt enough to the requirements of international markets. For the same reason, we have not been able to replace imported products on the domestic market. The smallness of our domestic market and the present relatively low purchasing power do not allow large and medium-sized companies or even narrowly specialized small-size companies to orientate only on domestic demand. Therefore, in the course of restructuring the economic environment we have to find suitable outputs and market niches first. Our supply should not focus on traditional, market-saturating production which would mean entering a hard or even hopeless competition. I share the view that new paths are more easy to develop by medium-sized and small companies, making use of innovative solutions and modern technology. Here our research and development activity could render a helping hand too. Investments into small companies can also be made by Estonian capital, and in small companies it is easier to reorientate production in case of changes in demand. In any case, we should try to avoid the practice of foreign investors bringing out-dated technology to Estonia that has already being replaced in the home country of the investor.

The sphereand size of the investment is decided by the businessman who carries out the project. If all rules were to be followed, making a respective decision is a very vast and complicated process which cannot be described within the short space of this article. However, I would like to draw attention to one aspect which you will not find in the rulebook of investment strategy. If the investment depends on finding additional investment sources (foreign investor, bank loan, etc.) there may arise certain side effects which do not always coincide with the long-term goals of economic restructuring. In investments so far the main emphasis has been on spheres with quick capital turnover and shorter payback period. Such areas are, particularly, wholesale and retail trade, services, tourism, food industry. Take, for instance, Finland which has held the leading place among foreign investors in Estonia from the very beginning. According to a study by the Bank of Finland, it is quite typical of the countries in transition and can thus be used for making generalizations.** Thus, quickly circulating capital bringing back quick returns does not contribute enough to the creation of a bigger production and export potential in the future. However, from the point of the businessman such an approach is perfectly understandable and, besides, the majority of businesses based on the Estonian capital have chosen the same path during their starting period. So far, there have been no significant new production facilities set up for the utilization and more intensive processing of the forest, peat and other natural resources, or for facilitating transit trade and transport (not even for setting up free trade zones in Estonia), or for the alternative land use and other fields of activity that have great potential in the longer run.

**See Juhani Laurila, Inkeri Hirvensalo: Direct Investments from Finland to Eastern Europe. Review of Economies in Transition, 5/96. (Author's note).


Drawing a parallel with mathematics, we could say that what we have here is a system of equations with several unknowns which does not have only one solution. First of all, we have to build up this system. There are certain constant values in the system, some values that fluctuate within certain fixed limits and a big number of unknown factors. The structure of the system in its turn depends on what we need the system for - to find an answer for evaluating the current situation, or making a short-term, medium or long-term prognosis.

We should begin from the market equations where there are few constants and a large number of variables, including unknowns. As a rule, the solutions of the system as a whole begin here.

The second place, subordinated to market requirements, belongs to the equations of the market structure. However, here we have to take into account constants and variables that fluctuate within certain limits in the form of production factors in the actual reality. These also set certain limits to the possibilities of adjusting to the market requirements. However, we should not exclude the possibility of making extensive changes through importing production resources, as we can see from the example of Japan.

The bigger the desired changes in the economic structure, the bigger the role of investments. Proceeding from the possibilities of the transition economy itself, we are inevitably dealing with an inequality where foreign investments and loans serve as temporary balancing factors.

The main criteria for evaluating the strategy and tactics of the development of the whole system are productivity, supply, international competitiveness and economic growth.

Raimund Hagelberg