Monday, May 12, 2008

Baltics Head Into Stagflation

The Baltic states for long enjoyed the highest growth rate in the EU and was therefore held up by many free market advocates, including me, as a good example of the positive effects of low tax and low spending policies. However, unlike most others, I also warned already back in 2005 that the Baltic boom had an unsound element in the form of excessive monetary expansion. After I wrote that, these excesses became worse and worse, so my general assessment of the Baltic economies and particularly Latvia became more and more bearish.

In recent month, the state of the Baltic economies has deteriorated quite significantly. First of all, consumer price inflation have gotten worse and worse, with Estonia seeing an inflation rate of 11.4%, Lithuania an inflation rate of 11.7% and Latvia an inflation rate of 17.5%.

And while Claus Vistesen is not yet willing to call the Baltic downturn a recession, I am (at least with regard to Estonia and Latvia). While there are no official confirmation of that yet in the form of quarterly changes in GDP (or for that matter, NBER-style coincident indicator index), there are yearly changes available. And we saw in Latvia
how year over year growth nose dived, from 8.0% to just 3.6%.
A decline in 4.4%: points between two quarters almost certainly imply negative quarterly growth. In Lithuania on the other hand, quarterly growth could be on the plus side, if only slightly, as the decline in year over year growth was just from 8.0% to 6.4%. For Estonia, no preliminary GDP figures are available, but sharp declines in retail sales and industrial production on even year over year terms clearly indicate that Estonia is in a recession.

Given the fixed exchange rate policy, this economic downturn will likely result in a significant downturn in inflation. And given the strong microeconomic fundamentals, the Baltic economies should eventually recover and again see rapid economic growth. But hadn't they copied the ECB's inflationary policies this boom-bust cycle wouldn't have happened and would have passed faster than it now will.

UPDATE:As Claus Vistesen points out and as I also see in the latest Eurostat release on EU GDP, Lithuania did in fact see a falling quarterly GDP in Q1 2008.


Anonymous Jüri Saar said...

"But hadn't they copied the ECB's inflationary policies this boom-bust cycle wouldn't have happened and would have passed faster than it now will."

I must confess I have a hard time figuring out which specific policies you are refering to. It seemed to be that the money supply increase came through Scandinavian banks and their agressive loan policies that took advantage of low ECB interest rates.

7:20 PM  
Blogger stefankarlsson said...

Jüri, aren't you aware of the fact that Estonia has a fixed exchange rate policy versus the euro? A fixed exchange rate policy means that interest rates must be set to stabilize the exchange rate, meaning in turn it must be adjusted to the currency of the country it is pegged to.

You are however right that certain Scandinavian banks aggravated the problem greatly through reckless lending policies. These banks will now be punished by suffering significant credit losses.

9:22 PM  
Anonymous Anonymous said...

The article you linked to saying you warned about this, does not contain any warning. At least nothing I can read out.

11:56 AM  
Blogger stefankarlsson said...

In the third sentence in the third paragraph I pointed out there were some inflationary excesses.

1:16 PM  
Anonymous Jüri Saar said...

Stefan, thanks for the clarification. As any other Estonian I'm well aware of the fixed exchange rate to the euro. I understand the theory in your comment, but unfortunately fail to grasp the specific reality in this case.

To my knowledge, no interest rate is set by the Bank of Estonia independent of the ECB. So for me the question comes down to: what interest rate are you refering to?

Thanks for your patients.

3:50 PM  

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