It all looked so good: Strict but prudent monetary policy brought Latvian inflation down to 1.4 percent in 2002, easily within the Maastricht requirement for adopting the euro. In 2003 it crept up to 3.3 percent, and the most recent data shows 6.7 percent on an annual basis.
What happened? And what should be done? No less important, who is to blame?
Contrary to common belief (prejudice?), higher inflation should not really be blamed on EU membership. There are essentially 6 reasons for higher inflation - three of which are transitory and therefore should not be seen as a cause of concern, one we should be happy for (sic), one the central bank can address and one where the government can intervene.
True, EU membership requires some harmonization - e.g. tariffs - and some other administered prices have been increased, but both are one-off effects. More importantly - but almost neglected - has been the impact from the exchange rate. Over the past two years the euro has appreciated strongly against the dollar, which, due to Latvia fixing its currency to the IMF basket currency, the Special Drawing Right, has caused the lat to appreciate against the dollar but depreciate vis-à-vis the euro. Imports into Latvia are huge - more than half of the value of GDP - and most of these imports are denominated in the euro, thus their prices in lat-terms have risen, thereby adding to inflation.
But by Jan. 1, 2005, Latvia will switch its fix to the euro and thus insulate itself against future fluctuations in the euro. (And let us not forget that Latvian exporters have had a field day due to a rising euro - they have increased their competitiveness substantially.) Alas, temporary effects and thus no concern.
Poorer countries generally have lower price levels than richer ones (just show me an expat who is seriously unhappy with the price level here). As they catch up, however, so do their price levels - this is known as the Balassa-Samuelson effect. Let us skip the lecture part, though, and suffice it to say that Latvian inflation will on average be higher than inflation in the "old EU" as long as the country is catching up, which is exactly what we want it to do. It is "good inflation," so to say; nothing to try to change.
Very low interest rates, greater willingness from the side of the banking system to lend and the possibility to borrow more on a long-term basis have all led to a credit boom. Latvians are fast becoming similar to West Europeans and Americans - fond of borrowing. Very fond, actually - the stock of money in circulation currently expands at a rate of 23 percent annually, much faster than in the euro area or in the U.S.A. All this borrowing takes place for one reason only, and that is to buy - be it houses, cars, TVs or whatever.
All this willingness to spend fuels economic growth as firms happily produce more to sell more but it also risks fueling inflation as firms, just as happily, raise prices when they can. The Bank of Latvia responded as it should by raising interest rates in the spring to make it more costly to borrow and thereby reduce overall borrowing - i.e. no blame should be doled out here either.
Lastly, there seems to be a general tendency toward overheating. The Latvian economy is roaring ahead. The Bank of Latvia recently increased its forecast of economic growth from 7 percent to 7.5 percent, a very high number indeed - we are almost talking China here. If sustainable it implies that the economy will double in just over nine years - quite staggering!
Several factors are behind this strong growth, but it can be pinned down on the private sector, where consumer spending expands merrily and where construction is booming (which everyone has seen and not least heard in the past few years). To provide all these goods and construction-services, people - i.e. labor - are needed, and the labor market has grown ever tighter; employment is at its highest level since the days of state owned enterprises and life-long employment. As usual, supply and demand determines the outcome: A shortage of qualified workers will lead to wage increases, which will only further fuel inflation.
In such a case, the government can play an important role by constraining public spending to reduce the economy's risk of overheating and the ensuing inflation. It is therefore surprising and quite dismal that the government is doing exactly the opposite by choosing to dole out another 50+ million lats (75.76 million euros) This can only add to the inflation problems; it does not help the budgetary situation, and it ignores recommendations from the Bank of Latvia and International Monetary Fund. Blame the government if inflation becomes entrenched - not the EU, not the Bank of Latvia. o
Morten Hansen is a Eurofaculty economics lecturer, at the University of Latvia and Stockholm School of Economics.