Thursday, September 20, 2007

Inflation gap between the three Baltic states

Inflation is the top economic story in Latvian news these days. (Large current account deficits are harder to explain to general public.) The year-on-year inflation just topped 10% and, in a call-in poll of "Kas notiek Latvijā?" TV show, 97% answered that think the government should resign. (Call-in polls are not scientific and "Kas notiek Latvijā?" audience may skew significantly more to pro-opposition side than general Latvian population. Nevertheless, that sentiment is widespread, even if it's not 97% in general population.)

Inflation has been rising in both of other Baltic countries, but significantly less. It's now 5.5% in Lithuania and 6.4% in Estonia. Why Latvia?

There are a few factors that get mentioned all the time and one that gets overlooked. The currencies of the three countries had their exchange rate to Euro fixed at different times. Estonia fixed the exchange rate to German mark which became Euro. Latvia had a peg to a currency basket and switched to Euro peg in December 2004, in preparation for the switch to Euro (which is indefinitely postponed now). Lithuania fixed the rate to dollar and then switched to Euro in early 2002.

Latvia happened to switch at the time when Euro was very high compared to other currencies. Lithuania switched when Euro was around its lowest point ever.

It made quite a difference. Latvian exchange rate is 1Euro=0.70 lats. If Latvia had switched at the same time as Lithuania, it would have been 1Euro=0.55 lats. If Latvia had pursued the Estonian strategy of pegging to Euro from the beginning, it would have been around 1Euro=0.60 lats. By switching in 2004, Latvia unintentionally devaluated its currency, pushing both prices and salaries in euros down by 15-20% from what they would have otherwise been. As a result, the gap between Latvian and EU salaries became bigger than in the other two countries. With bigger gap, the rise in salaries and prices has been bigger.

I wish I could figure out how much of the inflation gap between Latvia and the other two Baltics is due to this effect and how much is due to other reasons...


Tanvir said...

This is an interesting article. Estonia is flourishing economically mostly because business are free from government restrictions. I just ran into a website about Estonia the other day - it is a Documentary about Estonia's Singing Revolution:

Edward Hugh said...

Interesting point about the impact of the currency valuation at the time of the peg. I am sure you are right, and that this is a factor. Just how big a factor I'm not sure. Probably this is a topic which is right up the street for Alf Vanags and the BICEPS boys.

To put things in perspective a bit, lot was made about the deflationary impact on German wages of the high value at which the German Deutschmark entered EMU, but as I have just shown in a post on Bonobo Land, there are also much bigger and longer term structural factors also at work in Germany.

Curiously, many have identified the union of the two Germanies as the moment the German economy went into historic decline, but this moment precisely coincided with the moment when the 25-49 age group touched it ceiling as a proportion of the entire population. Two birds on a wire coincidental statistical correlation, or interesting fact? Well, I guess you already know what I thing.

Tanvir seems more interested in music than in economics, since he left virtually the same comment on my blog. Maybe the Estonians are hoping they can sing their way out of trouble :).

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