Inflation in the Baltic States and Other EU New Member States: Similarities, Differences and Adoption of the Euro

New SSE Riga/BICEPS occasional paper by Morten Hansen (SSE Riga) and Alf Vanags (BICEPS).

Abstract. This paper examines the inflation experience of the EU new member states (NMS) since 2000, with particular focus on the three Baltic countries – Estonia, Latvia and Lithuania. Apart from being a natural focus of interest for residents of these countries it appears that their recent inflation experience – accelerating inflation in all three, with Latvia and Estonia posting the two highest NMS inflation rates in 2005 – marks them out from the other NMS. Indeed Latvia is now the country with the highest inflation rate in all of the EU. At the same time the actual levels of inflation are different across the three Baltic countries. So the central questions addressed in the paper concern the reasons behind the acceleration of inflation in the Baltic states when such an acceleration has not been observed in the other NMS and how to reconcile the ‘common Baltic acceleration’ with the observation that levels of inflation in the three countries remain different.

For Baltic governments who are pondering policy actions to reduce inflation the message is clear – if there is a serious intention to reduce inflation, then domestic demand needs to be reduced and if monetary policy is not available because of the constraint of pegged exchange rates then fiscal instruments must be used i.e. higher taxes or lower public expenditure or both. It will be painful – growth will decline, unemployment will rise and perhaps the property boom will collapse – but it will work.

A second shorter part of the paper briefly discusses the EMU convergence criteria and argues that the inflation criterion, the one which each of the Baltic states fail to meet, is increasingly unlikely to be met, partly due to fiscal policy negligence and partly due to the criterion being increasingly meaningless and unfair and that euro adoption may have to be postponed for quite a long time.

The paper is intended to be part of the current, hot economic-political discussion on inflation and euro adoption in the Baltics and thus on purpose avoids too much detailed economic theory.