TALLINN, Estonia — For nearly two decades, Estonia embraced capitalism with such gusto that it seemed to be channeling the laissez-faire philosophy of Milton Friedman. From its policies meant to attract foreign investors to its flat tax and freewheeling business culture, it stood out as the former Soviet republic most adept at turning post-Communist chaos into a thriving market economy.
And the country’s political and business leaders say the challenge will be weathering not just the downturn, but the transition from an economy based on the breathless consumption that left the streets of Tallinn clogged with Hummers to one founded on the hard work of selling goods and services to the world.
Many business executives say Estonia must emulate Switzerland and Luxembourg — two small countries that are more closely tied to the global economy than Estonia is. But that will require developing high-end, knowledge-intensive production and consumer-oriented design.
Whatever happens, government officials say there will be no betrayal of Friedman’s philosophy. “We will stay a laissez-faire economy,” said Juhan Parts, Estonia’s minister of the economy.
At the same, though, Estonia will see more state direction in the economy than they are used to, not as a matter of ideology, but as a matter of circumstance.
When it joined the European Union in 2004, Estonia became eligible for “cohesion funds,” money that rich countries give to poorer ones in the name of smoothing out economic development across the 27-nation bloc. From 2007 to 2013, Estonia will receive 3.4 billion euros ($4.6 billion) from this pot of cash.
As a result, the government is investing heavily in some things it would have eschewed in the 1990s, like financing for start-up companies, exports and technology development. Tarmo Kalvet, director of the innovation policy program at Praxis, a research organization in Tallinn, said these constituted a de facto industrial policy.
“We have had a ‘no policy’ policy,” Mr. Kalvet said. “Now we have a policy, sort of.”
Modern Estonia, like many countries in central and eastern Europe, has never lived through the downside of a normal business cycle. The population is accustomed to a steadily rising living standard based on cheap credit for boundless imports.
“I’m an optimist,” said Marje Josing, director of the Estonian Institute for Economic Research. “Fifteen years ago things looked bad, but they managed. A little real-life pressure won’t hurt.”
Indeed, so far the downturn has done little to discourage Estonia’s ambitious entrepreneurs. If anything, it has made them look more avidly elsewhere for growth.
“Estonia may be a small country,” Tarmo Prikk, chief executive of Thulema, an office furniture maker, said with a laugh. “But my ego is bigger.”
Annual growth exceeded 10 percent for three years before slowing sharply last year. Most forecasters expect the economy to be flat this year. A labor shortage has eased somewhat, leaving unemployment around 4 percent. Next year, though, the jobless rate is expected to rise a few percentage points.
Even so, the government of Prime Minister Andrus Ansip urged Estonians last summer to tighten their belts.
The government cut the state budget by 1 percent of gross domestic product to avoid running a deficit this year, even though Estonia has hefty fiscal reserves invested outside the country.
Fiscal stimulus and specified assistance, Estonian officials said, would only delay the inevitable.
In that, the Estonian response to economic distress contrasts sharply with the United States, where Washington is borrowing freely and desperately trying to prevent the housing bust from wreaking havoc across the economy.
“The economy needs to adjust,” said Märten Ross, deputy governor of the Bank of Estonia. “There is no sense in policies that try to keep construction workers in construction.”
Whatever the approach, both business executives and government officials agree that Estonia needs to become much more export-oriented — though right now being unburdened with foreign debt has saved it from being another Iceland. With 1.3 million people and a G.D.P. of $29.4 billion, only about 18 percent of the country’s companies export anything at all.
“So far we have been pretty good in sectors when it is business to business — subcontracting to Finns and Swedes,” said Siim Raie, director of the Estonian Chamber of Industry and Commerce. “What we are not as good at is getting in touch with trends and consumers.”
There are exceptions, however — several business that hint at Estonia’s economic potential.
Skype, the worldwide Internet phone service owned by eBay, still has its technical operations in Tallinn. Baltika, a garment producer and retailer, is expanding throughout eastern Europe.
Others are trying to follow a similar path.
Aquator, a small company that manufactures high-end Jacuzzis and bathtubs, watched its business fall off a cliff late last year, as the Estonian building boom came to an abrupt end. But Will Pogga, Aquator’s managing director, said the company has managed to absorb much of the blow because of new sales in Ukraine.
The next step is for Estonia to develop a global identity that would make it easier for its companies to succeed with affluent consumers outside the country.
“Italian design everyone understands,” Mr. Pogga said. “German quality too. But Estonian design? It’s very hard.”
In fact, Estonia was a center for industrial design even in the Soviet era because of the Estonian State Art Institute. The legacy lives on in the smooth lines that characterize Aquator’s products. But Mr. Pogga estimates that Aquator needs to increase exports by about 30 percent to finance the knowledge-intensive design and development of its products.