The Fall and Rise and Fall Again of the Baltic States

The incident dented Latvia's reputation hugely. The country's institutions had so far done an impressive job in seeming to insulate the running of the country from the political shenanigans of the elite. Now they had failed glaringly to supervise the country's best-known financial business, with near-catastrophic consequences. Latvia's financial weakness suddenly revealed the hollowness of past success.

The crisis has not spared Estonia and Lithuania either. A vivid illustration of that is the loss of air links with the outside world. Flying direct to Tallinn or Vilnius from main European destinations has become difficult or outright impossible. Estonia's national carrier, Estonian Air, has cut back its routes sharply. Lithuania's FlyLAL went bust amid an acrimonious dispute with the owner of the Vilnius airport, endangering the country's role as the intellectual and diplomatic hub of the Baltic. Also at risk is Lithuania's cherished prize—its yearlong celebration of the selection of Vilnius as the "European Capital of Culture" for 2009. Faced with a time-consuming and costly stopover in Copenhagen, Helsinki, or Frankfurt, many potential visitors may simply decide to stay away. Once again, the Baltic states feel they are fading from the map.

The three countries face this round of economic hardship with many important policy levers out of reach. The obvious step would be to devalue their currencies, but because they are guarded by the banks, that move would shake each country to its foundations while also bankrupting the many households and firms that have loans in euros and Swiss francs. The Baltic states have no room to relax monetary policy. Nor can they use fiscal policy to ease the pain—borrowing money to boost state spending—because all three countries are trying to meet the euro area's 3 percent budget deficit criterion.

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