Monetary Lag - What a Drag!

I abhor lag. Having surmounted jetlag, I now have to deal with latitude lag up here at 57°N in Riga. Only five hours of true nighttime means little sleep for your correspondent, but plenty of time to think. Now, monetary lag is foremost in my mind. Let me explain.

When the Baltic nations of Estonia, Latvia, and Lithuania joined the European Union in 2004 (they joined NATO the same year), the countries had to agree to certain standards for monetary policy that would eventually lead to accession to the European common currency.

Today, Latvia and Estonia are experiencing inflation far in excess of the euro zone targets. Euro zone inflation guidelines are distorted, however, because they are based on the lowest inflation rates in the entire EU and not in the currency club.

In olden times, the Baltic Sea and its periphery was the dominion of the Hanseatic League, the alliance of trade guilds in over 100 northern European cities that constituted a monopoly on trade from locales as far-flung as London and Novgorod. The Hanseatic League, made up of the guilds called hansas, used silver as a common currency.

Hanseatic silver eventually succumbed to the growing influence of Italian credit, which was based on negotiable paper currency.

These days, the euro is the European tender trend.

When I talk about monetary lag, I am referring to the tendency for pegged currencies such as the Latvian lat to reflect an imbalance of economic growth and structural rigidity.

It is a quandary of emerging market stabilization: to peg or not to peg.

In the US political echelon these days, "peg" is a dirty word.

We have considered the term especially as regards China and its yuan. I was in China when the yuan was allowed to float freely against the dollar last July, but as you know from listening to the politicos and US Treasury officials, it has not floated far.

When I arrived in the Riga airport and exchanged my British pounds for Latvian lats, I was shocked to received 98 lats to my 100 pounds sterling. How could this be? Chalk it up to stabilization and its correlates.

Currency volatility is a real danger for emerging economies.

Consider the astounding rate of GDP growth for the three Baltic States.

Estonian real GDP is expected to grow by 7% year-on-year in 2006. In Latvia, 6.5% growth is forecast. And in Lithuania, the lowest number for all three states is a not-too-shabby 6.1% change.

In 2003, Lithuania saw a 10.5% real GDP increase!

Now consider what that means for the amount of money in circulation. Wages must move at pace with price increases that result from such phenomenal activity in order for prices to stay palatable. But unfortunately for consumers, essential items have to be bought no matter where prices are, and that is where inflation threatens prosperity in times of growth.

Lithuania has been successful at limiting inflation, even keeping it in negative numbers during the 2003 boom. Estonia and Latvia, on the other hand, have gone as high as 7.3 percent, leading to my exchange shock at the airport. The currency is overvalued, and this greatly affects these countries’ chances of accession to the euro zone.

Lithuania has a much lower inflation rate, but was still denied admission to the euro zone by the European Central Bank and European Commission. What does this spell for Estonia, which hopes to join the euro in 2007, and Latvia, which could join in early 2008 at the earliest?

Lithuania falls short by less than a decimal point of the euro inflation target — that inflation must be no more than 1.5% above the average of the three lowest rates in the EU (Sweden, Finland, Poland), which is 2.6%. But Poland and Sweden are not in the euro. The three lowest inflation rates in the euro zone average to more like 3%.

Take a look at the pegs for all three Baltic currencies:

1 euro = 15.6466 Estonian kroons (12.8 avg. to dollar)

1 Lithuanian litas = 3.4528 euros (avg. 2.73 USD)

1 Latvian lat = 1.42 euros (1.77 USD)

I will keep you up to date on where purchasing power and consumer activity take prices as these pegs pave the road to the euro for these Baltic tigers.

– Sam Hopkins