Journal of Baltic Studies (forthcoming)

Baltic States in World Markets: Does Katzenstein’s Framework

Still Hold?

Vytautas Kuokštis, Institute of International Relations and Political Science, Vilnius

University

Abstract

Small states, argued Peter Katzenstein a quarter of a century ago, are different. Faced with

the fluctuations of world markets, they adopt democratic corporatism and domestic

compensation, thus ensuring political legitimacy and successful economic adjustment. The

Baltic countries are an interesting case study for this framework, because in many ways they

are ‘smaller’ than the seven countries analysed by Katzenstein. This article finds that, on a

broader level, Katzenstein’s framework is very helpful in highlighting the key developments

in the Baltic countries. On the other hand, the specific causal mechanism that can be drawn

from this framework running from smallness to democratic corporatism to political

legitimacy as well as domestic compensation has not developed in the Baltics.

Key words: Katzenstein, small states, Baltic countries, democratic corporatism, legitimacy,

domestic compensation

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Introduction

Small States in World Markets (SSWM) by Peter Katzenstein (1985) is a

major work. At the time of writing this article, SSWM yields 3493 citations on Google

Scholar. Since its publication, SSWM has inspired many lines of research and equipped

scholars with new ways of thinking about issues in comparative and international political

economy. In particular, Katzenstein managed to draw attention to small countries which had

been neglected by previous scholars (Ingebritsen 2010). In his review of contemporary study

of political economy, Mark Blyth (2009, p. 194) names SSWM as one of the three founding

texts of the field, along with Peter Gourevitch’s Politics in Hard times (1986) and Peter

Hall’s Governing the Economy (1986).

Question is: how well does the theoretical framework of SSWM travel? Does it

still apply a quarter of a century since its inception? In his own revisit of SSWM in 2003,

Katzenstein recognized that while he had carefully delimited his investigation to seven early

industrializers of the Western ‘core’ nations (Sweden, Norway, Denmark, the Netherlands,

Belgium, Austria, Switzerland), his conclusions could be potentially fruitfully applied and

tested in other contexts: ‘analysis could have pushed further by investigating, in addition, the

strategies of other small states situated differently in the world economy’ (Katzenstein 2003,

p. 13).

Subsequent literature generally confirms Katzenstein’s insights in different

temporal and geographical settings. According to Eric Jones (2008, p. 8), ‘Katzenstein’s

thesis about small states and world markets remains relatively unchallenged’. The Baltic

countries make a compelling case for testing the arguments of Katzenstein’s framework.

Firstly they are small - indeed, they are smaller than the seven ‘dwarfs’ of SSWM. Recently,

their smallness and vulnerability was painfully exposed by a very severe economic crisis in

2008-2010. Secondly, the Baltic countries seem to pose a challenge for Katzenstein’s 2

predictions – given that they are very small and vulnerable, it is puzzling why they have not

developed democratic corporatism and strong domestic compensation mechanisms. This

article therefore sets out to answer the question: does (and in what ways) the Baltic

empirical experience fit into Katzenstein’s framework?

The implications of Katzenstein’s book are quite diverse, which speaks of the

contribution that SSWM has had to the scholarly community. At the same time, this gives

rise to some confusion, as it is possible to derive different and sometimes even contradictory

insights from Katzenstein’s work (or at least its interpretations). In this article, I provide two

interpretations. One interpretation is a ‘narrow’ one that posits a specific causal connection

that runs from smallness to corporatism and domestic compensation to legitimate and

flexible economic adjustment. The other is a more general (‘broad’) interpretation providing

guidelines for analysis and variables to look into rather than speaking about a specific causal

chain. This ‘broad’ interpretation encourages scholars to seriously take into account history,

ideas, and size; it also suggests political legitimacy as a precondition for the success of

economic policy.

The article surveys the current stock of literature on Baltic economic policy by

framing it according to Katzenstein’s approach. It reveals that in certain ways the Baltic

countries do not fit into Katzenstein’s framework (interpreted in a narrow way). While they

are even smaller and thus more vulnerable than the seven countries of SSWM, of all the new

EU member countries they have been the least inclined towards corporatism and domestic

compensation policies. Furthermore, while Lithuania and Latvia show very low levels of

political legitimacy measured by the level of trust in political institutions (which is

compatible with the predictions of Katzenstein’s framework), Estonia, which in fact pursued

the most consistent (neo)liberal policies, is characterized by relatively high levels of political

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trust, and thus serves as a deviant case for Katzenstein’s theory formulated in a ‘narrow’

way.

Nevertheless, the article concludes that the broader interpretation of SSWM

illuminates the core themes of Baltic developments since regaining independence. This

article argues that the broader interpretation helps to shed light on the emergence, continuity,

and even on some aspects of the relative success of the Baltic politico-economic regimes (in

particular Estonia’s better performance). Based on the analysis, it is concluded that SSWM

continues to be of relevance to the study of politics and economics of small countries (and

beyond).

The first section describes Katzenstein’s original contribution and its two

interpretations. The second section discusses and measures Baltic ‘smallness’. In the third

section, the ‘narrow’ and ‘broad’ interpretations of SSWM are tested in the Baltic empirical

case.

The SSWM and its two interpretations

Katzentein wrote his book in order to solve an interesting puzzle about small

Western European countries (1985, p. 9). On the one hand, political scientists emphasized

their political stability generated by corporatism. On the other hand, economists focused on

their economic flexibility and successful performance. In SSWM, Katzenstein aimed to

resolve this conundrum by arguing that these two aspects were in fact related: ‘they are not

contradictory but mutually contingent’ (p. 9). He noted how other states could potentially

4

learn from their experience, as even ‘large industrial countries are beginning to experience

an increasing economic openness and vulnerability’ (p. 9).

Katzenstein chose to investigate the political economies of seven small

Western European countries. Although he did not explicitly state what ‘smallness’ meant, he

largely discussed such aspects as population and size of the economy. Importantly,

smallness was also related to and to some extent captured by economic openness. Overall,

Katzenstein noted that ‘small countries are more open and vulnerable than large ones,

economically, politically, and militarily’ (1985, p. 81). Smallness and openness generate

vulnerability stemming from changes in international economic conditions. Small countries

are more vulnerable to these changes because they need depend heavily on imports.

Furthermore, they tend to specialize in certain sectors and are thus less well diversified.

Finally, important parameters of economic performance, such as growth rates and inflation,

are heavily influenced by outside forces.

Overall, according to Katzenstein, all countries must find ways to respond to

global economic change. However, there are three basic responses. First, ‘liberal countries

such as the United States rely on macroeconomic policies and market solutions’ combined

with ‘limited, ad hoc protectionist policies’ (p. 23). Second, ‘statist countries such as Japan

are endowed with the means and the institutions to pre-empt the costs of change through

policies that pursue the structural transformation of their economies’ (p. 23). Small

countries, however, do not have the means to adopt either of these two approaches. Instead,

the elites in small European countries ‘live with change by compensating for it’ (p. 24).

They have ‘a preference for a reactive and flexible policy of industrial adjustment (…)

relying heavily on indirect policy instruments such as taxation rather than broad-gauged

political efforts to transform the structures of their economies’ (p. 27).

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What is this ‘domestic compensation’? It includes measures such as welfare

spending to compensate the losers from economic changes and reduce the uncertainty

stemming from market fluctuations. According to Katzenstein, ‘these policies are carried by

the conviction that it is important to counter some of the harmful effects of international

liberalization’ (1985, p. 47). This is what explains a faster growth of public economy in

smaller states than in large ones in Europe (Katzenstein 1985, p. 54). Besides, these small

countries ‘have tried to restrain their wages and, occasionally, prices through a government-

coordinated incomes policy (as in the Netherlands and Denmark), or through a centralized

system of collective bargaining (as in Sweden and Norway), or though some combination of

the two (as in Austria)’ (Katzenstein 1985, p. 56). Wage restraint is used to ensure

competitiveness and adjust to balance of payments problems.

In turn, the policies of domestic compensation allow for securing political

legitimacy: ‘through their policies, political leaders in the small European states have

maintained the legitimacy of the political arrangements governing their societies (…)

Political leaders retain a tight hold on mass participation, and electoral changes have been

very small’ (Katzenstein 1985, p. 28). In his follow-up article writing about the small

Western European industrialized countries, Katzenstein (2003, p. 19) notes that ‘since for

decades their policies offered generous social protection against international dislocations,

confidence levels are high and stable’. Katzenstein (1985, p. 28) acknowledges that

legitimacy is a ‘broad construct’ and difficult to measure. When writing about legitimacy, he

refers to such aspects as trust in politicians and political institutions, high levels of

participation, small electoral changes and lack of protests (Katzenstein 1985, p. 28).

Both domestic compensation policies and political legitimacy are created via

the institutions of ‘democratic corporatism’. Katzenstein distinguishes the ‘democratic

corporatism’ characteristic of small industrialized Western European states from 6

authoritarian corporatism (e.g. in fascist Italy) or ‘state capitalism’ (e.g. in Japan).

Democratic corporatism has the following characteristics (Katzenstein, 1985, p. 32): ‘an

ideology of social partnership expressed at the national level; a relatively centralized and

concentrated system of interest groups; and voluntary and informal coordination of

conflicting objectives through continuous political bargaining between interest groups, state

bureaucracies, and political parties’. Corporatist institutions ensure greater political stability

and consensual, rather than confrontational, policies. Eric Jones (2008, p. 9) stated this in the

following way: ‘small states are more consensual because they are more vulnerable to world

market forces (and because they are aware of that vulnerability)’.

All of these preconditions also ensure a successful adjustment to changing

economic conditions. Political legitimacy and consensual politics reduce tension within

society and form a basis for the search for flexible solutions and policy learning.

Furthermore, coordinated wage bargaining helps to avoid deteriorating competitiveness and

associated macroeconomic problems.

Narrow interpretation One possible way of reading SSWM is extracting a specific causal chain

running from smallness to vulnerability to corporatism and domestic compensation to

political legitimacy and finally to successful economic performance. Smallness

(vulnerability) increases the chances for (or leads to, if stated deterministically) democratic

corporatism and domestic compensation policies. Domestic compensation refers to the size

of the public sector, and especially welfare spending. In Hardiman’s words, ‘the

“compensation hypothesis” holds that increasing trade exposure gives rise to pressures for

an expansion in public spending, especially on welfare items’ (Hardiman, Murphy & Burke

2008, p. 599). Of course, Katzenstein has not been the only author to lay out this argument.

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Other authors provided theoretical and empirical support for the assertion that increased

economic openness leads to public sector growth (e.g. Rodrik 1998).

It is interesting that in his follow-up article, Katzenstein (2003, p. 22) makes a

specific prediction about the future development of Eastern European capitalist systems,

including those in the Baltic countries. After noticing what he saw as corporatist trends, he

outlines his expectations:

The emerging social market economies are unlikely to resemble statist or neoliberal variants

of capitalism. It is more likely that they will have greater resemblance with the institutions of

the German variant of capitalism, among the large industrial states the closest cousin of the

democratic corporatism of the small European states.

Focusing on the second part of the causal argument, democratic corporatism and domestic

compensation create condition for political legitimacy. This, in turn, helps to secure

successful economic performance. The prediction is that countries (at least small ones)

which have democratic corporatist institutions as well as strong domestic compensation will

be more successful economically and, even more importantly, politically, and as a result

more trust in political institutions. One should note here that this assertion also implies a

counterfactual: in the absence of democratic corporatist arrangements and domestic

compensation policies, wide economic fluctuations would preclude the build-up of political

legitimacy and trust or erode its existing stock. Overall, the expectation is that small open

countries lacking legitimacy due to lack of democratic corporatism and domestic

compensation will be less economically and politically successful.

8

Broad interpretation

However there is another way of interpreting SSWM. In contrast to the

‘narrow’ version, the ‘broader’ interpretation refers not to specific causal connections

outlined above, but rather to a more general way of approaching the study of political

economy in particular and politics in general. What I mean by ‘broad’ interpretation in this

article is the position to take into account size (smallness) as a variable, analyse ideas and

history, as well as recognize the importance of political legitimacy in affecting economic

performance. Note that only the first item focuses on differentiating small states from larger

ones. History, ideas and political legitimacy are important regardless of state size.

To begin with, one of the main lessons of SSWM is that size is important and

should be treated as a variable rather than a constant. In ‘Small States and Small States

Revisited’, Katzenstein (2003) briefly explains his motivation for writing SSWM. SSWM

was a follow-up on an earlier research project – Between Power and Plenty (Katzenstein

1977) – and an attempt to address some of the latter’s drawbacks. One of the chief ones was

inattention to size as an explanatory variable. Smallness and vulnerability – Katzenstein

maintains – have important and far-reaching consequences for the development and

functioning of small countries’ politico-economic regimes. Of course, the ‘narrow’

interpretation also focuses on the effects of smallness, but it formulates a specific prediction

on its role. By contrast, the ‘broad’ version simply states that size is significant, but the way

it affects any country’s political economy and politics is contingent.

The second implication of SSWM is the significance of history. Specifically,

‘in the small European states (…) a tradition of accomodative politics dating back beyond

the nineteenth century facilitated the political reorientation that took place in the 1930s and

1940s’ (Katzenstein 1985, p. 35). In SSWM, Katzenstein claims that history is important,

which means that there are powerful continuities to a given country’s economic and political 9

strategies as well as the related policy choices. He explains the emergence of and differences

in democratic corporatism historically. In other words, choices are not simply made in an

abstract vacuum, but rather are conditioned by historical context. In explaining the

emergence and continuities of the corporatist systems in small Western nations, Katzenstein

turns to their experience of vulnerability in the first half of the twentieth century. One of the

conditions for the formation of democratic corporatism, Katzenstein argues, was weak

political right. Notice that this argument is in some contradiction with the first causal link of

the ‘narrow’ interpretation, because vulnerability alone is no longer enough to produce

corporatism – rather, democratic corporatism is a product of two necessary but insufficient

conditions: (perception of) vulnerability and weak political right. In fact, adopting a

historically informed perspective it’s possible to argue that this corrected version of the

causal chain is still flawed in the sense that while vulnerability and weak right produced

corporatism in the specific temporal and spatial context (industrialized small western

countries), it might not occur in other contexts. In other words, causal processes are context-

specific and should be treated as such. Third, SSWM highlighted the significance of ideas.

In his revisit of SSWM, Katzenstein (2003, p. 11) writes this:

What really mattered politically was the perception of vulnerability, economic and

otherwise. Perceived vulnerability generated an ideology of social partnership that had

acted like a glue for the corporatist politics of the small European states. This was the first

and most important explanatory variable in Small States.

Katzenstein continues noting that this point was largely missed in the reception

and reviews that followed SSWM’s publication. He argues that the field of political

economy was not yet ready to include ideas as an important and researchable variable into

the analysis of political and economic reality. Consequently, Mark Blyth (1997, p. 201) sees

the seeds of constructivist political economy in Katzenstein’s work:10

This is why Small States is more than a synthesis of coalitional and institutional approaches.

It also opened the door to moving beyond them, to put ideas and social constructions front

and center in political economy explanations rather than treat them as a residual category

to mop up variance unexplained by these other approaches.

Finally, Katzenstein’s work attests to the importance of political legitimacy. As

Herman Schwartz (2010, p. 365) points out, it is exactly the issue of political legitimacy, and

not economic efficiency, that is at the core of SSWM: ‘Small States in World Markets is

about political efficacy and legitimation rather than scoring who is ahead in the economic

sweepstakes. Its case for democratic corporatism rests on norms, particularly stability, rather

than on narrow measures of economic efficiency’. In Katzenstein’s words, ‘economic

performance, then, is not a yardstick by which we can directly measure the successes and

failures of the small European states’ (Katzenstein 1985, p. 28). Still, even if economic

performance was not the key issue in SSWM, one can draw the implication that political

legitimacy does matter for economic performance.

Political legitimacy here refers to the same concept as described above under

the ‘narrow’ interpretation. Furthermore, it does not contradict the causal chain posited

above about the positive influence of political legitimacy on economic performance.

However, the ‘broader’ version, in contrast to the ‘narrow’ interpretation, does not hold that

democratic corporatism and domestic compensation are necessary conditions for political

legitimacy. Furthermore, the ‘dividends’ of high legitimacy potentially encompass other

dimensions of economic performance not covered in SSWM. For instance, scholars argue

that trust in political institutions might be important in encouraging tax morale and therefore

fiscal performance (Torgler 2003).

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Baltic smallness

Before turning to the analysis and initial comparison of Baltic ‘smallness’ to

the ‘size’ of original countries analysed in SSWM, it is relevant to ask whether one is not

comparing apples and oranges in this case as the background conditions of the two countries

are very different. First of all, the primary goal of the article is not the comparison of these

two groups. Even so, while in some regards these two groups of countries greatly diverge,

one must also remember that neither the ‘narrow’ nor the ‘broad’ versions of the framework

speak against such a comparison or the extension of the framework to new cases. The

‘narrow’ version as formulated in the theoretical part does not limit itself to any particular

geographical or historical setting and in fact predicts a universal (although possibly

probabilistic rather than deterministic) relationship between smallness on the one hand and

domestic compensation, democratic corporatism and legitimacy on the other. In contrast, the

‘broad’ version is sensitive to a particular historical, social and ideational setting, but again

the way it is formulated (sensitivity to size, ideas, history and legitimacy) does not preclude

applying the approach elsewhere. Finally, as already mentioned, Katzenstein admitted the

desirability of applying the framework to new settings and even made predictions about the

emerging political economies in Eastern Europe.

Turning to the analytic part, in economic terms the Baltic countries are

‘smaller’ than the seven countries of SSWM, and thus make interesting cases for studying

how SSWM’s framework fits their experience. Table 1 below reveals that the Baltic

countries are generally indeed ‘smaller’ (more vulnerable) than the original ‘dwarfs’. This is

true both in terms of absolute GDP figures and population size. Furthermore, volatility of

economic conditions in the Baltic countries – as illustrated by standard deviation of annual

GDP growth – is way higher than the one experienced by the 7 ‘SSWM countries’. Behind

this statistic lies the story of a recent roller-coaster ride of the Baltic countries – after posting

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impressive growth numbers in the run-up to the crisis, all three Baltic States recorded double

digit contractions in 2009. A similar, although less dramatic, story occurred a decade ago

when the Baltic countries were hit by the Russian crisis in 1998-1999. As Aldis Austers

(2014, p. 9) puts it, ‘the crisis of 2008-2010 can be seen as just another episode in a drama

related to Latvian experience in a capitalistic world’. Only in terms of trade openness do the

‘7 dwarfs’ match the Baltic ‘smallness’.

Table 1 here

Smallness and vulnerability are not confined to the economic realm, but can

also be generated by political conditions. Baltic countries historically have been exposed to

larger threats with real possibilities of national extinction than the ‘7 dwarfs’. Due to their

unfavourable geopolitical location, they often found themselves at the crossroads of great

power politics. During the twentieth century alone they gained independence from Tsarist

Russia, only to be occupied by the Soviet Union and then by Nazi Germany and once again

by the Soviet Union. Finally independence was restored after fifty years of Communist rule

that involved not only the loss of independence but also massive deportations and a

complete changeover of the socio-economic system. As was put by Lamoreaux and

Galbreath (p. 1), ‘in 1940 and 1944, smallness meant forced incorporation into the Soviet

Union’. Problems with Russia continue till the present days. Even the entrance into the EU

(European Union) and NATO (North Atlantic Treaty Organisation) did not calm these

tensions: ‘five years after the double enlargement, the permafrost in Baltic-Russian relations

shows no signs of melting, but instead seems to thrive in the increasingly chilly climate of

the Russo-Western relationship’ (Berg & Ehin 2009, p. 1). Furthermore, in Lithuania’s case

13

one can observe re-emergence of problems with Poland that have been muted over much of

the recent independence period. In Estonia and Latvia, the sense of vulnerability is fostered

because of big ethnic Russian minorities. Recent Russian actions in Ukraine involving

annexation of Crimea on the grounds of protecting local Russians have added to the Baltic

sense of vulnerability. In response to these events, all three Baltic countries requested

stronger signs of commitment and security guarantees from their NATO partners.

In the words of Maria Mälksoo (2006, p. 277), ‘The quest of the Baltic states

for membership in the EU and NATO has been the politics of survival par excellence, aimed

at securing Western security guarantees against historically aggressive and unstable

neighbouring Russia’. Mälksoo (2006, p. 277) concludes that ‘despite certain relief in their

immediate security concerns after the dual enlargement, the shift by the Baltic states from

existential politics to normal politics is far from being accomplished’.

Narrow interpretation and Baltic experience

1. Smallness democratic corporatism and domestic compensation

I will start with the narrower interpretation. Turning to the first link in the causal chain,

things immediately get complicated for the theory. Given that the Baltic countries are small

and very open, based on the ‘narrow’ version one would have expected them, first, to

develop democratic corporatism and, second, to have strong policies of domestic

compensation. Neither of these happened.

First, the Baltic countries are actually some of the least corporatist in the EU. According

to Thorhallsson and Kattel (2012, p. 2), Estonia is ‘an ideal test case of the advantages and

disadvantages of small European states that have not followed the corporatist trend’. Trade

unions in the Baltic countries are weak, with little capacity to influence public policy. Baltic

14

trade unions have one of the lowest density rates in the EU and among the new member

states (see Table 2). Furthermore, density rates have been declining fast. From 2003 to 2008

total trade union membership declined by 16 percent in Latvia, 18 percent in Estonia and 34

percent in Lithuania (Carley 2009). The Baltic countries were among the six EU members

were these figures fell most significantly in that period. Employers in the Baltics are not

organized either (Norkus 2008, p. 632). There are no formal or informal nation-wide wage

bargaining processes in the Baltic countries. According to Bohle and Greskovits (2007, p.

447), Baltic countries are characterized by ‘low union density, decentralized, uncoordinated

wage bargaining and low coverage rates of collective agreements’. Several scholars

(Feldmann 2006; Norkus 2008) have compared two small new EU member states, Estonia

and Slovenia, and concluded that they approximate two opposite models of capitalist

systems that emerged after transition. In contrast to Estonia (one could also argue Lithuania

and Latvia), Slovenia is an example of ‘democratic corporatism’ with institutionalized

practices of interest (both employers’ and employees’) representation. Slovenia most closely

approximates the small country model analysed in the SSWM.

Interestingly, during the last crisis of 2008-2010 the weak rudiments of democratic

corporatism were neglected even further (Gonser 2010) and thus the existing institutional

structure reinforced. Economic adjustment packages – which were based on very high levels

of fiscal consolidation involving a mixture of spending cuts and tax increases – were crafted

very quickly, after little consultation with social groups. According to Kallaste and

Woolfson (2013, p. 253), in the Baltics ‘a negotiated response was either not sought at all by

governments or was of minor importance at all levels of interaction between the social

partners. If anything, national-level social dialogue deteriorated, remaining at a low level

even after the crisis had peaked’.

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As for domestic compensation, the Baltic countries have one of the smallest public

sectors in the EU (see Figure 1). Table 2 provides several more specific indicators of the

extent of domestic compensation, such as welfare state (social) expenditure, state support for

businesses as well as labour market policy expenditure. Baltic countries emerge generally as

less compensating than other new member states and substantially less than the EU average.

As Bohle and Greskovits (2007) describe, the Baltic countries feature a low level of

‘protection’ for society and domestic businesses from fluctuations in economic conditions.

Figure 1 here

In other words, contrary to the narrow interpretation of SSWM (and Katzenstein’s

predictions in 2003), smallness and vulnerability in the Baltic countries, reinforced by severe

economic crises, did not lead to democratic corporatism and substantial domestic

compensation.

Table 2 here.

2. Lack of democratic corporatism and domestic compensation low political

legitimacy

Next, given that the Baltic countries opted for non-corporatist regimes, one should

follow the counterfactual derived in the theoretical section: one should see lower and/or

eroding levels of trust in political institutions that are measures for the broader concept of

political legitimacy. Does empirical evidence support this prediction? Latvia’s and 16

Lithuania’s situation is indeed compatible with this interpretation: political trust (i.e. trust in

political institutions) in these countries is very low (see Table 3 below). The absence of

domestic compensation policies can at least be advanced as a strong candidate explanation

for these facts, although the usual caveat about correlation versus causation holds. One fact

undermining this explanation is that during the ‘fat years’ before the crisis with very rapid

wage and public expenditure growth did not bring higher levels of trust. In 2007, only 24

percent of Lithuanians and 19 percent of Latvians and as many as 62 percent of Estonians

said they tended to trust their national parliament (European Commission 2008, p. 56).

Table 3 here

Nevertheless, Estonia’s situation is incompatible with the second link of the

‘narrow’ interpretation of Katzenstein’s theory (see Table 2). Estonia has actually pursued

even more (neo)liberal policies (for instance, it liberalized trade policies most radically and

the earliest of the three Baltic nations, and was the first to adopt a very strict monetary

arrangement, the Currency board), but it has also managed to build up a solid trust base.

Furthermore, electoral volatility in Estonia has been lower than in Latvia and Lithuania

(Powell & Tucker 2013, p. 9). The latest elections in 2011 after the economic crisis

confirmed this trend – in fact, the incumbent Reform Party increased its number of seats

even after implementing austerity measures during a very painful economic crisis.

Writing on the continuing political legitimacy of small Western corporatist

countries, Katzenstein in 2003 (p. 19) noted that ‘an indirect reflection of the learning

capacity and performance of the small European states is the relatively constant and high

levels of confidence in political institutions that their citizens express, in sharp contrast to 17

declining and relatively low levels in the large industrial states’. By that measure, Estonia

has held up well. According to Standard Eurobarometer, in the spring of 2010, just after a

double-digit contraction of GDP in 2009 and a spike in unemployment, Estonians were

among the most optimistic in the EU regarding the direction of their country. The percentage

of people who supported the ‘direction where the country was going’ was 47 percent, only

surpassed by Sweden (61 percent) (European Commission 2010, p. 111). In other words,

Estonia is a deviant case for the ‘narrow’ interpretation of Katzenstein’s theory: high level of

legitimacy exists despite the posited necessary condition – corporatist arrangements and

strong domestic compensation (see section ‘Discussion and conclusions’ below for a

possible explanation of why this might be the case).

3. Lack of corporatism and domestic compensation low political legitimacy

lower success in economic adjustment

The final causal link relates to political legitimacy's influence on the success of

economic adjustment. Regarding this last link, no easy verdict can be passed on SSWM

framework in the Baltic case. First, SSWM spoke about political legitimacy produced by

corporatist arrangements and domestic compensation. Since Estonian legitimacy has been

caused by other factors, one could argue that the analysis of legitimacy’s influence on

economic performance is invalid with reference to SSWM framework. Second, SSWM

spoke about legitimacy giving rise to the necessary flexibility in adjustment related to

industrial policy. What the Baltic countries did during the last crisis (and before) was not

engage in increased domestic compensation or flexible industrial adaptation but to opt for

orthodox macro-management with the aim to ensure macroeconomic and financial stability.

In other words, they sought to solve the crisis in the same familiar way, with little flexibility

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or rethinking of their approach (although with a very high level of flexibility in terms of

labour market adjustment (i.e. fall in wages), which is a completely different matter).

Whether this continuity is a good thing from a normative perspective is an open question At

least in terms of response to the last economic crisis, the answer depends on whether the

results were ‘successful’. On the one hand, the Baltic countries managed to preserve the

fixed exchange rate and return to fiscal sustainability. At the same time, they suffered very

big economic contractions, saw increased emigration and there are indicators in Latvia and

Lithuania to suggest that populations were largely dissatisfied with the approach to the crisis

(Kuokštis and Vilpišauskas 2010).

Despite very similar background conditions, including external economic and political

challenges (vulnerability), the fact that Baltic countries score so differently on political trust

makes them an interesting case to see whether Estonia’s higher score helped the country in

terms of their specific chosen adjustment. Still, such an interpretation goes significantly

beyond the ‘narrow’ causal chain posited above and will be covered in the following section

under ‘broad’ interpretation.

Broad interpretation and Baltic experienceTo clarify, the four broad implications of Katzenstein’s framework emphasize

four different aspects. Three of them (the importance of history, ideas, and size) point to a

broad ‘politico-economic regime’ or economic policy package. By themselves, they are

normatively neutral (history can affect economic policies in all sorts of ways, as can ideas or

perception of vulnerability). In contrast, the fourth implication – political legitimacy’s

influence on economic results – has clear normative connotations: the hypothesis is that high

level of political legitimacy helps to adjust successfully in economic terms (although not

necessarily using corporatist institutions and domestic compensation).

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The Baltic experience since transition demonstrates the limits of purely

materialist/rationalist accounts Dorothee Bohle and Bela Greskovits (2007) as well as Rawi

Abdelal (2001) on different grounds have argued convincingly for the importance of

ideational dimension in accounting for the formation of Baltic capitalist systems in the

1990s. Abdelal contrasts the experience of Lithuania, Belarus and Ukraine after the collapse

of the Soviet Union and concludes that identity was the crucial explanatory factor for

radically different foreign economic policy orientations chosen by the three countries (West-

oriented, East-oriented, and ambiguous respectively). Bohle and Greskovits aim to describe

and explain the types of capitalism that emerged in the new EU member states. In their

words, ‘the decisions concerning the new regimes have been motivated both by the legacies

of the past and their perception as either threats or assets from the viewpoint of national

sovereignty and economic independence’ (Bohle & Greskovits 2007, p. 444). Their

argument is bolstered by the fact that objective structural conditions cannot account for the

divergence in development of the Baltic countries on the one hand and the Visegrad group

as well as Slovenia on the other. For instance, industrial structure measured in terms of

product sophistication in the early 1990s was similar, and only diverged later (Bohle &

Greskovits 2007, p. 459). Ideas could also explain why trade unions played and continue to

play such a small role in the Baltics. As Gonser put it, trade unions in the Baltics are

‘associated with the past and, therefore, objected in many cases’ (Gonser 2010, p. 2). In

general, leftist economic and social policy ideas in the Baltics suffered greatly during the

transition, in contrast to, for instance, Slovenia. According to Norkus, ex-communists in the

Baltics essentially implemented neoliberal economic policies (2008, p. 623). The Baltic

experience is very much compatible with Katzenstein’s assertion that ‘in the rationalist

world of political economy actor identities are assumed to be fixed and unproblematic, an

intellectually untenable position in the case of the small European states, and perhaps more

20

generally’ (Katzenstein 2003, p. 11). Moreover, the choices made during the transition

period, as has already been mentioned, were closely related to the (perception of)

vulnerability stemming from ‘smallness’, just as would be indicated by the ‘broad’ version

of Katzenstein’s framework. It was the perception of this threat that moved the Baltic

countries to pursue very liberal economic policy. As Bohle and Greskovits write, ‘these

countries could neither take their nation nor their state institutions for granted, and inherited

the least favourable legacies in terms of economic institutions from state socialism’ (Bohle

& Greskovits 2007, p. 444). Elsewhere Greskovits writing about Estonia notes that ‘stability

culture and trust in its guardians, the currency board, a balanced budget, and central bankers,

could become a cornerstone of national identity, especially as measures to foster national

independence and transformation have been introduced as part and parcel of the same policy

package’ (Greskovits 2009, p. 211). This sense of geopolitical threat could also be one of the

explanations why the Baltic countries are among the ones most eager to join the Eurozone

(Estonia did this in 2011, Latvia in 2014 and Lithuania is expected to join from 2015).

Interestingly, Latvia started showing more determination to join the Eurozone after the Great

Recession than Lithuania, although there were no significant changes in structural-economic

conditions. A plausible candidate to explain this difference is the fact that Latvia went

through a bigger crisis than Lithuania. Latvia was the only country that experienced a

collapse of a major domestic bank during the crisis and was forced to turn to international

financial assistance. In turn, this could have produced a higher sense of ‘smallness’ and

‘vulnerability’.

In the theoretical part, it was also argued that Katzenstein’s framework

interpreted broadly can be seen to argue for the importance of ‘history’. History means that

policy choices are prone to inertia – i.e. the more some course of action and policies had

been applied in the past, the likelier it is that they will be continued. The experience of the

21

Baltic countries indeed reflects this. A good example can be the very high level of support

for fixed exchange rates specifically and currency board systems more generally. Kuokštis

and Vilpišauskas (2010) analyse how the decision to preserve the fixed exchange rates rather

than seek currency devaluation during the last crisis did not stem from international pressure

or simple material interests. Instead, fixed exchange rate systems which had been created in

early 1990s became stronger over time, as they anchored macroeconomic stability and also

increased the number of interest groups incentivized to support them. Furthermore, writing

about fiscal policy choices during the crisis, Raudla and Kattel (2011, p. 163) argue that

these ‘became path-dependent as a result of positive feedback loops from previous periods

of fiscal consolidation’. Interestingly, most outside observers predicted the collapse of fixed

exchange rate regimes in the Baltic countries, but this did not happen (Kuokštis and

Vilpišauskas 2010). Sensitivity to the specific historical context of the Baltic countries as

suggested by the ‘broad’ interpretation of SSWM would likely have precluded such a-

contextual, excessively bold predictions. Furthermore, it is exactly this sensitivity to context

and history that allows us to answer why smallness failed to foster democratic corporatism

and extensive domestic compensation in the Baltics, as would have been predicted by the

‘narrow’ interpretation. While smallness found its way into democratic corporatist

arrangements in the states analysed in SSWM, under specific Baltic conditions existing in

the early transition a high degree of vulnerability was channelled into a different set of

institutions. As Katzenstein (1985, p. 136) put it, ‘small size is thus not treated as master

variable that somehow forces a particular political solution – the relationship between small

size and democratic corporatism is historically contingent rather than logically necessary’.

Finally, one should deal with the importance of political legitimacy, and

specifically its effect on economic performance. As has been mentioned, during the last

crisis for the Baltic countries the major challenges arose and most important actions were

22

taken in the domain of fiscal policy. While all three Baltic countries chose to pursue very

similar adjustment policies in the form of macroeconomic austerity, Estonia’s attempts were

clearly more successful. The northern-most of the three Baltic countries had prepared better

for the crisis by accumulating fiscal reserves, reacted faster when the crisis started, and was

also able to reduce budget deficit much more successfully, enabling it to join the Eurozone

from 2011. Compared to 2008, in 2009 public deficit as percentage of GDP expanded by 5.6

percentage points in Latvia, 6.1 percentage points in Lithuania and it actually decreased by

0.9 percentage points in Estonia, although all three countries were experiencing double-digit

contractions in real economic activity (author’s calculations based on Eurostat data).

Economic-structural conditions cannot account for this difference, as broad

economic developments as well as tax and spending policies were very similar in the Baltic

countries (Kuokštis 2012). One convincing explanation is that these factors – crisis-

readiness, faster reaction and more successful results of tax policies – can be explained by a

gap in political trust among the three Baltic countries mentioned earlier. Correlation is not

causation, of course, but given the large empirically grounded literature on the relationship

between trust and tax compliance and very similar economic trends, there seems to be a

strong case for linking Estonia’s better performance to its larger stock of political trust

(Kuokštis 2012). So while the specific causal link was different from the one posited under

the ‘narrow’ interpretation, the Baltic experience demonstrates the role of political

legitimacy in ensuring the success of economic policies.

Discussion and conclusionsHow does Katzenstein’s theory hold when faced with the empirical case of the

Baltic countries? The answer to this question depends on which interpretation (narrow or

23

broad) of the SSWM is applied. In terms of the narrow interpretation, the empirical Baltic

case, especially Estonia, presents serious challenges to the framework. At the same time, the

broad version is useful in highlighting the main developments in the Baltics since regaining

independence.

Regarding the ‘narrow’ interpretation, the Baltic countries do present

important problems for Katzenstein’s framework. First, vulnerability stemming from high

degree of economic openness as well as a special geopolitical situation did not lead to high

level of domestic compensation and corporatist practices. Quite to the contrary – the Baltic

countries are some of the least corporatist and ‘compensating’ countries among the EU

member states. It has to be noted that Bohle and Greskovits provide an interpretation which

is more compatible with Katzenstein’s account – namely that loans from Western banks

served as compensation mechanisms substituting for real welfare policies (Bohle &

Greskovits 2009). Even so, this interpretation only refers to the compensation side and

leaves out corporatism, and in this regard still fails to corroborate the causal chain of

SSWM. Second, it is doubtful whether credit booms were a result of a conscious effort by

politicians to provide compensation policies, rather than an outcome of the specific

construction of Baltic macroeconomic regimes (in other words, credit booms in the Baltics

seems to have been due to an error of omission rather than commission).

Still, Latvian and Lithuanian empirical record is compatible with the second

link in the SSWM causal chain – given the absence of corporatist and significant welfare

policies, the observation of very low levels of trust within Latvian and Lithuanian societies

is in line with the ‘narrow’ version of Katzenstein’s framework. The caveat here is that a

comprehensive test of causal rather than correlational association of these two variables has

been outside the scope of the article.

24

The Estonian case is a different story, though. Its relatively high level of

political legitimacy and anti-corporatist policies is a significant challenge toward

Katzenstein’s framework when interpreted in a narrow sense. What can explain this? To the

best of my knowledge, no attempt has been made in the literature to tackle this puzzle.

Examination of this question is beyond the confines of this article, but it is possible to

formulate a suggestion for future research. The hypothesis is that Estonians trust their

government more despite the fact that their government's performance is well below that of,

say, Scandinavian countries, but because it is relatively better than that in its ‘reference’

group – which can in turn be hypothesized to be the two other Baltic countries, Latvia and

Lithuania. These two serve as natural reference points for Estonians, because all three Baltic

countries started at almost identical positions in early 1990s in terms of economic

development and political situation, yet Estonia emerged fairly quickly as the leader of the

pack, and its governments have been able to exploit this relative lead vis-à-vis the other

Baltic States both in terms of relative indicators of performance (e.g. GDP growth or

corruption indices) as well as specific landmarks of achievement (e.g. being invited to

negotiate with the European Union first and more recently – the first of the three to enter the

Eurozone).

The broader interpretation of SSWM does reveal crucial elements of recent

Baltic economic and political history. Size matters, and so does history, ideas, and political

legitimacy. However, ‘smallness’ effects are context-dependent – while smallness and

vulnerability matter, the specific way that they matter can be very different. This is where

‘history’ and ‘ideas’ enter the scene – the specific Baltic situation at the beginning of

transition meant that the perception of vulnerability was channelled to (neo)liberal policies

reflecting the desire to abandon the previous socio-economic system, consolidate nationhood

and integrate into the Western political and economic structures.

25

26

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Table 1. Smallness and openness indicators for the three Baltic countries and the seven

countries analysed in Katzenstein's SSWM

Table 1. Smalness and openness indicators for the three Baltic countries and the seven countries analysed in Katzenstein’s SSWM

GDP, in

billions of

euro (2012)

Exports/GDP,

in percentage

(2012)

Population, in

thousands

(2012)

Volatility of

growth,

standard

deviation of

real GDP

growth from

2002-2012

Estonia 17 91 1325 7.27

Latvia 22 62 2045 8.47

Lithuania 33 84 3004 6.95

Austria 307 57 8408 2.05

Belgium 376 86 11095 1.71

Denmark 245 55 5581 2.42

Netherland

s

600 88 16730 2.14

Norway 389 41 4986 1.56

Sweden 408 49 9483 3.03

Switzerland 491 52 7955 1.76

Sources: Eurostat 2013; author’s calculations.

31

Table 2. Selected indicators of domestic compensation and democratic corporatism for the

Baltic countries, Visegrad countries and EU average

Expenditure on

social protection,

in percentage of

GDP (2011)

Non crisis state

aid to industry

and services, in

percentage of

GDP (2009-2011)

Labour market

policy expenditure,

in percentage of

GDP (2011)

Union density rate

(net union

membership as a

proportion of wage

and salary earners

in employment)

(2009)

Estonia 16.1 0.11 0.73 7.1

Latvia 15.1 0.27 0.69 14.8

Lithuani

a

17.0 0.37 0.56 8.5

Poland 19.2 0.73 0.72 15.1

Czech

Republic

20.4 0.64 0.56 17.4

Slovakia 18.2 0.33 0.79 17.2

Hungary 23.0 1.33 1.01 16.8

Slovenia 25.0 0.89 1.24 26.6

EU

average

29.1 0.48 1.95 NA

32

Sources: Columns 1, 2 and 3: Eurostat; Column 4: Visser.

Table 3. Trust in political institutions in the Baltic countries.

Parliament Government Political

parties

Regional/local

authorities

Justice system

Estonia 49 58 21 59 76

Latvia 11 15 4 40 48

Lithuania 8 15 6 24 48

All countries in

Eurobarometer

(average)

38 36 20 50 66

Percentage of people who tend to trust in a given institution in 2010 (for parliament and government) and 2011 (political parties, regional/local authorities and justice system). Sources: Masso, Espenberg, Masso, Mierina, Philips 2012, p. 92, based on Eurobarometer surveys.

Bulgaria

Latvia

Slova

kia

Poland

Malta

Luxembourg

German

y

Croati

a

Icelan

d

United Kingd

om

Hungary Ita

ly

Swed

en

Belgium

Finlan

d0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

Figure 1. EU member states and selected other countries in terms of expenditure as

percentage of GDP in 2012. Source: Eurostat.

33

34