If we are so smart why aren't we rich or how to overcome the curse of a small nation

Part I. The curse of a small nation

We all have probably heard the question: "If you're so smart why ain't you rich?". On a personal level, this question usually causes moderate discomfort making us reflect on our life goals, ask ourselves: "Yes, indeed, why am I not a millionaire despite my alleged smartness?" and possibly draw some unflattering conclusions. However, we are able to get rid of the feeling of discomfort claiming that we don't want to be rich and prefer an intelectually rich life rather than a prosperous one.

Nevertheless, on the national level one cannot so easily discard the question. Population's welfare is usually any government's primary objective. The twentieth anniversary since the adoption of the declaration of independence was marked in May 2010. Two decades is a sufficiently long period of time to look back and review whether we have managed to achieve the goals we set at that time or not. Today we can answer with certainty – no, we haven't. Following the collapse of the USSR, all East European countries fell into the same category of "transition economies". At that time already, many economists believed that  this group of countries would split and join either the group of developing or the group advanced countries, in line with their historical background. As we see now, it has happened, and countries like the Czech Republic, Slovakia and Slovenia (lately also Estonia) are usually included in the group of advanced economies. Latvia in turn falls into another group – we are referred to as "emerging markets" along with many South American and African countries. Using the cold war terminology, we have become part of the "the Third World".

The reasons why Latvia happens to be in this situation should be a matter for an in-depth public debate. Where have we gone wrong? Unfortunately, such a debate is not taking place. Instead, we are daily "bombarded" with news about insignificant pseudo-problems. This distorted worldview is also supported by the EU funding, which, although directed towards achieving noble goals, commands a  public coverage, which is disproportionally large compared with the importance of the problems they are trying to address. The EU priorities have also exerted a relatively negative impact on the selection of human resources: cohorts of scientists and officials dealing with gender equality or tolerance issues have emerged because of the EU financing.At the same time, other , possibly more important, issues like the quality of education, tax or legal system system have not been discussed or researched at all. International institutions like the IMF also look at the world from a specific point of view: the IMF mandate is limited to a certain range of issues related to the monetary side of economies  and balance of payments crises.

This purpose of this article is to highlight the most important factors hindering Latvia's development. As I fully  subscribe to the notion that any theory, which cannot be explained in simple words is most likely a lie, I will try to explain my views in as simle words  as possible. So if something is misunderstood or left unclear I take the blame on myself.

The fact that our nation is so small is the main cause of our poverty. The consequences of this "curse of a small nation" lie at the heart of many important problems (lagging behind in economic terms, corruption or even the current crisis).

Its size works to a small nation's disadvantage. Globalization and access to the EU markets is a poor substitute for domestic market, in particular, forsmall enterprises. The EU entry has not changed anything in this respect. As 15 years ago, it's almost as impossible for a Latvian enterprise to launch a new business starting from the Swedish market.

To compete with large countries we should be smarter than they

Small market implies that industries should be more export-oriented. If a country is not rich in natural resources, it is necessary to convince the people of other countries that our products are in some way better than theirs, or, to put it in other words, we should be smarter than the people of large countries.

But is it possible to be smarter than superpowers?  The answer is " In general, no". Large countries have more opportunities to select talent. China with its 1.3 billion inhabitants is sure to have more talented people than Latvia. Even if the share of top performers in population is the same, there is a slight chance that a talent will be used to the best of the person's ability due to lack of adequate infrastructure. As financing available to large countries by far exceeds that available to Latvia, big countries can develop scientific infrastructure in more areas. This, in turn, allows them to enter new sectors at an early stage of a new technological break through. The Finnish Nokia was probably an exception; however, the subsequent success of the superpowers' companies like Sony, Motorola and recently Apple was a rule. High quality higher education gives a possibility to attract scientists from all over the world, and this sets the preconditions for a fast launch of production in any new promissing area. In a small country like Latvia, a scientist mostly does not get any support at all, and, despite his/her talent, can only watch how the great profit opportunities slip away.

Here's an example to illustrate what I mean. Let's assume that somebody in Latvia has shown considerable talent for mathematics. First, the chances are that this person dies young as a result of flaws of Latvia's security and health systems. Second, it is also very likely that his/her parents emigrate to another country. Let's suppose that none of these things has happened. Given that the elementary and secondary education obtained in Latvia is relatively good, his talents are most probably discovered during the secondary school years. However, if he cares about money he most likely decides to become an economist or lawyer as these professions have better prospects in Latvia's context. Let's again assume that some accident has prevented him from making this decision. Again, considering the numerous opportunities to study abroad the incentives to emigrate  remain strong during the years of university studies . And the probability that a world level talent would take up his/her doctoral studies in Latvia is virtually zero. What is the outcome? Even if this scientist refuses to accept a series of enticing offers abroad and returns to Latvia in the name of patriotism, it would be difficult for him to do any scientific work here, since most likely he would be the only researcher specializing in his/her field in the whole Baltic region. And since no relevant industries exist, his skills are not demanded. As a result, his talent gives little value added to Latvian enterprises, the majority of which are involved in a less sophisticated production, and the scientist's wage is miserable. Emigration is practically inevitable.

The chance of using a great talent to his/her full potential in a small country is close to zero. In a globalized world, fighting against the centripetal forces, attracting the talent to big countries, is more like a mission impossible.

For small countries, advancing to the group of countries with a high level of welfare is the exception rather than the rule

In the context of economic development, the statement "small is beautiful" is nothing but a lie. History matters: if we look around, there are not too many examples of former colonies (this could also apply Latvia)  graduating to the group of advanced economies. Maybe our consolation could be that one such an example with a similar quasi-colonial history is quite close to us, both geographically and culturally. It is Finland. But , what can we do to lessen this "curse" of a small nation?

Part II. What should be done to lessen the "curse" of a small nation

First, small countries should be more specialization-oriented than the large ones

Small countries should support only those industries which have the potential for achieving results at the international level with as low costs as possible. Each industry has its own minimum level of financing, a kind of “fixed costs” of research activities, and infrastructure to be functional.

That is the main reason why for a country like Latvia it is necessary to  set clear priorities. Not because we could hit the jackpot and successfully pick the winnerbut because we simply do not have enough money for supporting all industries. It would be very good if the Latvian society could support research infrastructure of all industries at the first-class level. It would make us ready to quickly jump on the train of any industry experiencing a technological breakthrough. This is a strategy pursuedby the US or China. A small country, unfortunately, cannot afford it. Efforts to allocate the restricted funds in a thin layer across all sectors would simply result in money squandering.

The necessity for specialisation also means that international cooperation is our interest and it should be part of the national policy. We will never be able to pay for top-notch experts in civil service and expensive studies, assessing policy alternatives, in all sectors. Fortunately – these costs can be largely forwarded to other European countries through the single EU legislative framework. If the EU didn't exist, we would possibly have to copy some larger country's legislative framework. For the same reason we need to further cooperate with other countries in science. In many areas, it will be less costly to send our students abroad than to maintain high quality  education facilities in the relevant industry. Therefore, it is important to improve the cooperation between the higher educational establishments and civil service of the Baltic countries, as well as to extend the cooperation to the Northern countries.

Small countries should use their human resources more effectively than the large countries

It is more difficult for a small country to  retain their talent. And even if a country has success in doing so in some industry, it is difficult to expand the industry so that it would bring return. However, we are not the only small country in the world, and other countries have found ways how to lessen the impact of the "curse" of a small nation. One of the approaches we could adopt is the more effective use of human resources.

It's not a coincidence that it is the small and prosperous countries that are characterized by the most pronounced equality and the greatest opportunities to move up the social ladder. It's simply a matter of survival. Small countries cannot and may not afford to waste their human resources and give greater opportunities to someone only because he is the son or friend of some important person.

The world of sports is always a good reflection of society’s values: we can compare Denmark and Latvia. Why is the small Denmark able to compete in football that is the most popular sport in the world and often beat larger nations where football is almost a cult? Large nations are sure to have more God-given talents. The answer is effectiveness. While large countries, like Brazil, can afford to treat their talents carelessly, Denmark does not leave any potential talents undeveloped. Within the framework of the club system, in which practically all Danes are part of some sports club, the abilities of all children are screened. No restrictions (because of origin, financial restrictions) are placed on the further development of talents. What surprises us in Scandinavia is the huge number of quality football fields where children can freely play football whenever they want. And considering that football is a democratic and inexpensive kind of sports, it's not a miracle that the country can still compete with the football superpowers. Economies of all Scandinavian countries are based on a similar principle. A quality education system filters out the best students able to achieve the world class results. And it's not a whim or tradition – it's simply the only way how to survive.

How are things in Latvia? Our national kind of sports – hockey – tells much about our society. Hockey is for the elite since only offsprings of relatively well-off parents can go in for it. Many players of junior teams are sponsors' sons. What striking results can one expect from such a team of "well-off players and relatives"? In my opinion, close to none. The whole economy functions in the same inefficient way: the unsatisfactory quality of the higher educational system gives a vague idea about the real capabilities of students. Thus, even reasonable entrepreneurs are compelled to rely on recommendations, not to mention the fact that all this results in a system under which virtually any person  can easily qualify for any position in the public sector (everybody can get a diploma of some kind). The results are obvious – total lack of competitiveness in almost all areas.

Small countries should impose higher taxes on consumption than the large ones

Economy is simple. Latvia's basic problem is the following: how to ensure sufficiently high exports that would meet the import requirements necessary for our development. Exports and imports are interrelated – this is what we have finally learnt from the crisis (I hope).

Small countries need more imports. Let's give a theoretical example. Let's assume that there are 100 goods which are vital for a country's development (for example, computer programmes, cranes, production technologies, books, subscriptions to science magazines etc.). A large country like the US possibly domestically produces 95 of 100 goods. The rest of goods should be imported in order to balance imports with exports, so the need for exports equals the price of the remaining five goods respectively. Thus, only a small part of society has to be internationally competitive. In a small country, only five of these 100 goods are domestically produced, so the volume of exports to purchase these goods is much higher. In fact it means that the majority of people must be able to convince foreigners that they can outdo them in some area.

But what can we  do if we  simply are not able to produce export goods in a sufficient amount to meet our import requirements? The answer is: to balance exports with imports, we need to tax the unnecessary consumption (with VAT, excise tax and other duties) , therefore, reducing imports of these goods.

Is it a coincidence that taxes on transport vehicles are very high in those Northern countries which do not manufacture cars? Is it a coincidence that the VAT rates in the Scandinavian counties ares one of the highest in the world? In Denmark,  population drives older cars than in Latvia, while the export/import balance has almost always been positive.

Imposing taxes on optional consumer goods, while applying tax benefits to the sectors important for the development enables a country to achieve the external balance. Thus, for Danes income in terms of euro is relatively high; however, in terms of new cars or any other unnecessary "luxuries" it is actually low. At the same time, Danish students can buy the most recent books costing 60 lats or more, or acquire the latest computer software. Reasonable tax benefits and taxes on the “unnecessary” part of consumption ensure easier access to knowledge and technologies in the areas where it is vitally important for a country's development.

Imposing taxes on consumption has another positive effect: it facilitates  orientation toward exports. Because of consumption taxes, export-related needs start to get higher on the list of businesses' priorities. We could observe this processduring the crisis in Latvia: one of the positive consequences of this crisis was that enterprises finally started to take interest in exports (because of the domestic market contraction). During the “bubble”, one could observe an opposite trend: the domestic market grew more rapidly than exports; hence more resources were devoted to  domestic expansion.

Before the crisis is over, increasing any taxes would be unwelcome. However, once the VAT is raised, reversing the rise when the crisis is over would be a mistake.

Small countries should accumulate larger savings

When joining the EU, Latvia committed to introduce the euro, which by its nature is a strictly fixed exchange rate. Under a fixed exchange rate regime there is only one possibility to reduce the impact of economic crises: to use savings. The main reason why Estonia got through the crisis less affected than Latvia was that Estonia had savings. The same explains why it was easier for Asian countries to overcome this crisis: they had attended the “class of 1997" (the Asian crisis started in 1997). Small countries cannot hope to overcome the crisis successfully without national savings.

And the smaller the country the relatively higher the ratio (to GDP) of the savings required. Large countries are less dependent on the external markets; therefore, they overcome crisis easier, while the consequences of the crisis for small countries dependent on exports are usually more problematic. In Latvia's case, the level of savings should amount to at least 20 % of GDP. Given that we will step out of this crisis with a debt amounting to approximately 50 % of GDP, responsible policy-making would mean a surplus in the general government budget for many subsequent years. Yes, it is hard, but is there any other alternative? Living without savings means that we put our economy in the hands of irresponsible financial speculators who at any moment can generate a new story as to which countries they find safe and which not. Latvia has already experienced this. We did attend the “class of 2008". Do we want to go through it once again?

Small countries should remember how it is to be modest

20 years ago we believed that Latvia is a good place for investment and has a "relatively skilled labour force".  Unfortunately, it is no longer true! And it's not that we have become  less skilled, it's the world, which is moving forward at a rapid pace. At the end of the 19^th century, inhabitants of Vidzeme and Kurzeme with their close-to-zero illiteracy ratesand elite that knew the German language better than the Latvian formed an extremely competitive society.

Even now, we can be proud of all this; however, we should realize that we do not look so well globally anymore. General education is no longer something exclusive, while the quality of the higher education in Latvia already lags behind that of many emerging countries, God knows why, we sometimes look down upon. Even if our attitude towards various ratings is skeptic, the University of Latvia usually ranks not only below the best universities of the East European countries but also those of Costa Rica, Malaysia and Chile, not to mention larger countries like India, Brazil, Argentina and Thailand, whose universities can compete with the best Western higher educational establishments. The leaders of many "emerging economies" nowadays havedoctor's degrees from the US Ivy League universities and posess  broad international experience. Latvian scientific elite largely is highly proficient in the Russian language only. These language skills are undeniably useful; however, the effect of these skils on the social and technological development is certainly  less positive than that of German at the beginning of the 19^th and 20^th century. The 19^th century is behind us already for 100 years, and we have to look in the mirror and start to wriggle our way uphill again with modesty and eagerness to learn, once so typical to Latvians.

The article was published on the website of Delfi on 21 December 2010.