Saturday, October 20, 2007

The Economist Wrong On Baltic Story

The Economist generally has the highest quality of all mayor news magazines, often expressing semi-Austrian points of views. Sometimes however they too get the story wrong and express points of views which are Keynesian or otherwise misleading. So is the case in their story on the problems of the Baltic economies, and the Latvian economy in particular, which looks dangerously overheated.

In the story, devaluation is presented as the solution to Latvia's problems with 11.4% consumer price inflation and a current account deficit of 23% of GDP. But while a substantial devaluation could reduce the current account deficit, at least in the short term, it would certainly not solve the problem of excess inflation. Quite to the contrary, it would in fact aggravate that problem by putting upward pressure on import prices too.

While I certainly agree that the Latvia and the other Baltic economies should drop their peg to the euro, the point of that is not to lower the value of the currency. The point is, or should be, to tighten monetary policy and raise interest rates dramatically in order to rein in money supply growth and price inflation. By reducing domestic demand that would both reduce price inflation and the current account deficit. While that might cause a recession, in the long run it would be healthier to deal with the excesses now rather than allowing things to get worse,

If on the other hand the point of dropping the peg is to devalue, the result would only be more inflation and aggravate the problems of the Baltic economies.


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