2008 has quickly turned into a macroeconomic quagmire for the Baltic states. (If you deny it, then that probably means you're a politician.) Prices are galloping higher by the month in all three countries, and consumers are increasingly pinched. Food expenditures comprise an ever larger share of household incomes, even though incomes are also rising on net. Soon energy prices 's gas, heat and electricity 's will jump on the heels of new supply agreements signed with Russia's Gazprom, and then we'll experience a new round of price rises across the board.
Is there a light at the end of the tunnel? Analysts, both in ministries and banks, claim the inflationary woes will desist in the second half of the year. But don't hold your breath; we've heard the same talk before. Latvia's Finance Ministry said 2007 inflation would come in at around 6.5 percent. It ended up being 14.1 percent. When confronted with the hard truth, ministers blamed global trends, even though they knew full well that bank lending exploded 56 percent in 2006. Apparently a few ministers skipped the chapter on microeconomics in their textbooks.
There is some basis to believe that this year is different. In Estonia and Latvia, new car purchases have dropped year-on-year. In Latvia, mortgage lending has fallen dramatically (after skyrocketing 92 percent in 2006 and another 40 percent last year). Construction businesses, in fact, are sounding the warning bells, saying that the industry could see significant layoffs as new housing starts plummet to nearly nil. Another builder, however, shrugged off such fears, saying public demand will simply step in to fill the gap. Given the state's aim to build two new power plants and a national library (among others), he would appear to be right. How Latvia's government juggles these enormous infrastructure projects with the urgent need to tighten fiscal policy will have a profound impact on inflation in 2009 and beyond.
There is a risk, of course, that the government may tighten the screws a bit too much and thus dampen economic growth. But inflation should be the core battle, not pandering to construction companies. As long as inflation remains higher than 4 percent (which is still higher than the Maastricht criteria), pensions and savings will continue to erode, and the Baltics will not have healthy economies.
Also, more needs to be done to boost industrial output, which has been lackluster. In the first 10 months of last year output increased only 1 percent in Latvia. In Estonia, it ticked up 3.8 percent and in Lithuania 7 percent. At a time when the countries should be focusing on boosting industry and exports to balance the trade deficit, this is troubling. Here investment is sorely needed, but finding it for an economy with double-digit inflation and a chronic labor deficit will not be easy.
Finally, it is worth noting that there has been minimal or no political fallout from the economic hardship, and understandably so. Even though inflation in Latvia, for instance, is clicking along at 16 percent, wage increases are twice times that. The government of Aigars Kalvitis resigned not because of economic mismanagement but because of abuse of power, particularly with changing national security laws on the sly and firing a popular anti-corruption chief.
But this could soon change. If the inflation nightmare continues, Baltic voters will inevitably take out their frustration at the ballot box. Latvia appears ahead of this curve, as three parties 's two new and one old 's appear ready to enter the fray. Considering how awful the current four-party coalition has been, we wish them all luck.