Analytics, Economics, EU – Baltic States, Financial Services, Real Estate

Cost per square meter has dropped from 1,611 euro to 669 euros since April 2007, according to Ober-Haus Real Estate Advisors. Swedbank says up to 30% of its mortgages in Estonia are in negative equity. Recent loans are in euros – not the local kroon.

Professor Ulo Ennuste from Tallinn University says the private net wealth of Estonia's people has fallen below zero. I know of no other country in the world where this has occurred, though Latvia may be deeper in hock. Estonia's foreign debt is 116% of GDP, second highest in Eastern Europe.

It is not a good moment for the poster-child of the flat-tax revolution, but those crowing the end of "Margaret Thatcher's Baltic Model" neglect half the story.

Estonia's euro peg is anything but free-market. It makes Tallinn dance, awkwardly, to Frankfurt's distant tune. It stoked the boom by enticing people to borrow cheap at eurozone rates: it is now prolonging the bust.

The economy will contract by 14.5% this year, twice as bad as Iceland (OECD forecasts). Industrial production has fallen 28%. The unemployed receive half their former pay for a few months, then benefits fall to 12 pounds a week. The shock awaits this winter.

Most governments would try to cushion the blow. Estonia is instead pushing through yet another austerity package to keep the budget deficit below the EMU ceiling of three% of GDP. Such is the totemic appeal of euro entry in 2011.

"This is an absolutely mad policy," Ennuste told an Open Europe Forum. "We're in a vicious circle where thousands more lose their jobs and don't pay taxes, so there have to be more cuts. We need fiscal relief packages at once. This makes nobody happy but the Kremlin."

The government could spend more. The national debt is just 5% of GDP. It chooses not to do so. Such ultra-orthodoxy shows admirable discipline. Estonians will be a shining example to all if they pull it off – and hold their society together.

"Estonia's credit rating (A-) is going to rise against other countries next year," said economy minister Johan Parts. "The next phase of the global crisis is how states are going to manage their huge deficits."

Dag Kirsebom, the author of Hard Landing: a Fairy Tale of the Rise and Fall of the Estonian economy, said the elite had lost the plot. "They are complacent, and they shouldn't be. We're in a downward spiral but all they are focused on is joining euro. The free-market model worked great for 15 years and then they ruined it with crazy lending. Did Margaret Thatcher say you should borrow money from Swedish banks to buy German cars? I don't think so. They screwed up, and now it is too late. They need to let the currency fall to reflect the damage already done."

The euro is more than a currency ambition for Estonia. Like joining Nato, it is part of a national strategy of locking into every part of Europe's security system as quickly as possible to keep Russia at bay.

Officialdom seems to think it enough that they have managed to defend their peg without recourse to the IMF, and that their neighbour has collapsed even faster.

"The situation in Latvia is a tragedy," said Mr Parts. "Nobody will lend them any money except the IMF, and it has the same menu whether you are Latvia or Zimbabwe. The big difference between us and the rest of the Baltics is that we had a buffer of reserves, and we didn't run budget deficits in the good times."

Parts quoted Aristotle to defend Estonia's currency peg: "Give me a single fixed point and I can move the globe". But is the euro the right "fixed point" when the currencies of Sweden, Russia, Poland, Ukraine have plunged around you? The official view is that exports are not sensitive to the exchange rate. This overlooks the suffocating effect of deflation in a post-bubble economy saddled by debts and wage levels that raced ahead of productivity. The country faces an "internal devaluation" within the EMU bloc to right the ship again. Such cures are painfully slow, and very damaging to democratic solidarity.

Edward Hugh from Baltic Watch advises the four fixed-peggers – Estonia, Latvia, Lithuania, and Bulgaria – to bite the bullet and negotiate a joint devaluation against the euro rather than suffer the political agonies of deflation.