Inflation in the Baltics: a warning for the rest of Europe

When inflation reached an almost unthinkable 20 per cent this year in Lithuania, residents in the rural south of the Baltic country began to tighten their belts.

“People are buying less. It’s hard. Everybody is trying harder, wearing what they already have more, shopping less,” says Laima, a 58-year-old woman who sells socks and other clothes from the boot of her car.

Across the main road in Sangrūda, a sleepy village of 200 people close to the border with Poland, it is the same story at the Aibė grocery store. “When the war broke out, people’s purchasing power dropped and they started saving money,” says Gintarė, the 32-year-old cashier. “Fuel and heating became more expensive, electricity, taxes . . . And food was left as the last thing to think of. People take what is most important now, cheaper goods, discounted ones.”

Inflation has been on the rise across the west to levels last seen decades ago, but few places have experienced a rise in prices quite like Estonia, Latvia and Lithuania, where inflation rose above 20 per cent this summer and is still above 21 per cent in all three countries.

While there are local factors that explain some of the surge, policymakers in the Baltics warn that the region is providing an early indicator of how price pressures could develop across Europe over the next year, even if the headline rate of inflation peaks.

Mārtiņš Kazāks, Latvia’s central bank governor, says the Baltics are a “canary in the coal mine” for the wave of inflation hitting Europe.

It is a worrying message for other European countries, where inflationary pressure could remain high over the winter and spring as energy price rises feed through. “We have front-loaded most of the external shock already,” adds Kazāks. “In other countries, it is still being passed through.”

Economists in the Baltics report how experts from other European countries are amazed by the seeming acceptance with which the public have greeted such extreme inflation. “Colleagues from abroad ask me: why are there no protests?” says Greta Ilekytė, economist at Swedish lender Swedbank, the biggest bank in the Baltics.

The Baltic states have two big advantages that most other western countries do not, say policymakers. First, they have experienced relatively high inflation for several years amid strong wage growth as their economies catch up with the rest of Europe, meaning that the sudden jump came as less of a jolt. And second, memories of their forced occupation by the Soviet Union for decades means they are more accepting of the consequences of Moscow’s current brutality in Ukraine, even if there are some worries about the potential for populists to exploit the situation.

“This understanding is significantly stronger here than in other parts of the world,” says Ingrida Šimonytė, Lithuania’s prime minister. “It would be very hard to gain major support among the population here for the idea that, ‘It’s because stupid governments have imposed sanctions on Russia, this is why you’re paying high prices’.”

Recent experience

Inflation had already been picking up in the Baltic countries, well before Russia’s full-blown invasion of Ukraine in February. Estonia, Latvia and Lithuania all had inflation rates close to zero at the start of 2021 but by this January they were up to 7.5-12.3 per cent, well above the eurozone average.

Unlike much of Europe, the Baltic countries also have recent experience of high inflation, such as in 2008, when Latvian inflation hit 18 per cent, which means the latest price surge has had less of an impact on the national psyche.

“In 1992, when we had just regained our independence, inflation hit 950 per cent,” says Kazāks. “It is not like Germans who have not seen double-digit inflation for generations. We know it is nasty, but it is not like we have never seen it before.”

Gediminas Šimkus, head of Lithuania’s central bank, points out that people’s living standards have risen dramatically in recent years, making it easier to absorb the recent reversal in purchasing power, helping to explain why the Baltics have avoided much of the protests and strikes seen elsewhere in Europe.

Wages have doubled in Lithuania since it joined the euro in 2015, while consumer prices are up only 40 per cent in that time. “Living standards have been getting much higher,” says Šimkus. “So there is an economic explanation why you still don’t have riots.” Ilekytė points out that Lithuania is now richer — on a GDP per capita basis, adjusted for purchasing power — than Spain, Portugal or Greece and not far behind Italy.

The recent crisis has only increased public support for the euro despite criticism elsewhere on the continent of the European Central Bank’s slow response to surging inflation, according to Šimkus. “Being a member of the euro area is a support for our safety. It is not only about economics and convergence. It is also a certain guarantee for our independence. That is how it is perceived. It is an extra layer of protection,” he adds.

The central bankers say inflation rose faster in the Baltics due to a number of differences with the rest of Europe, including the greater use of spot energy prices rather than the longer-term, fixed contracts that companies have in much of Europe. “So we see this reaction coming much quicker. For other euro area countries, the full effects are still to come,” Kazāks says.

Šimkus says inflation is also higher in the Baltics because people there on average earn less than in much of Europe, meaning they spend a bigger proportion of their income on essentials like energy and food, for which prices have risen furthest.

“Expenses for heat energy are almost four-times higher as a share of income in Lithuania than in the euro area,” he says. “Expenses for solid fuels are almost three times higher.” Lithuania’s central bank calculated this difference made local inflation 2 percentage points higher than the rest of the eurozone.

There is still plenty of concern among the local population, especially over what will happen through the winter. “Inflation has done its job — what we use to grow flowers has become very expensive. For us, our costs have doubled compared with two years ago,” says Raimonda Skeberdienė, the 33-year-old owner of a small flower farm on a dirt track outside Sangrūda.

Vida, a neighbouring 63-year-old farmer, adds: “Everybody is feeling inflation. Not everyone earns a good salary, so it’s hard for people. We went to the shops today and there were not many people. They used to buy anything. But now they are choosing what to buy.”

The Baltic governments have responded like most in Europe by offering support schemes to damp the effect of the price increases, especially in energy. “You need to see where the balance is between what you can pass on to consumers and what you can compensate with excess borrowing by the state. Nobody is happy,” says Šimonytė.

So far, there has also been relative political unity, with most parties not wanting to give Russia a propaganda victory by protesting too much. “We can’t play around and use anything we get as a weapon to beat our opponent,” says Gintautas Paluckas, parliamentary leader of the opposition Social Democrats in Lithuania. “It’s a matter of a common threat we are facing and on important issues we stand together. Our political system is still in its infancy and will not allow foreign agents to bring in a fight.”

But there are worries about more extreme forces brewing. In Estonia, the far-right party Ekre has cemented its position as the second-biggest political force in the country behind the Reform party of prime minister Kaja Kallas ahead of parliamentary elections in March. Pollsters attribute much of Ekre’s recent gains to angst about the rapid rise of inflation.

Margarita Šešelgytė, director of the Institute of International Relations and Political Science at Vilnius University, says that in Lithuania one of the most popular politicians in recent polls is Ignas Vėgėlė, a lawyer who has attracted attention for his anti-vaxxer comments on Covid-19. “It will have political consequences. We have some radical forces that are on the rise,” she adds.

Still, the war in Ukraine offers a powerful antidote to protests in these countries on the frontline between the west and Nato on one side and Russia on the other, three decades after they regained their independence from the Soviet Union.

“There is this realisation: let’s not complain too much, at least we don’t have war. The realisation we could have war here is much higher than in countries further away from Russia. Here it’s very vivid,” says Šešelgytė. Ilekytė, adding: “Our memories of the Soviet Union are still alive. If you are going to protest, then what are you protesting against? Ukraine probably.”

Signs of economic stress

There are already signs that these price pressures are taking their toll on the Baltic economies. Estonia and Latvia have been the weakest performers out of the 19 euro area members so far this year, after their economies contracted 2.3 per cent and 0.4 per cent respectively in the third quarter from a year earlier.

The slowdown has been particularly acute in the industrial sector, where production fell 5.8 per cent in the year to October in Estonia and 2.7 per cent in Latvia. While Lithuania’s economy has held up better, its 2.5 per cent growth in industrial output in the same period was below 3.5 per cent growth in the overall eurozone.

One of the biggest political issues is the price of heating over winter as each government faces questions over how much financial support to offer. “I burn mulch. Of course, I feel the price increase. The price of materials has also gone up,” says Algis, a 78-year-old who works in Sangrūda’s modest thermal power station that heats the local school, foster home, and other municipal buildings.

Some politicians in the region believe that the potential problems from higher inflation are easier to manage than they would be in many other parts of Europe.

“It is easier here. In other countries, where I see double-digit inflation in the old eurozone countries, where you know the labour market is rather stable and the wage growth is rather different from what we have in this part of Europe, it is probably much more pressing,” says Šimonytė.

She adds that Lithuania is still protected by dint of it still catching up with the European average in economic terms: “We’re in a more comfortable position as a converging country. But you still need to be vigilant because it is easy to blow the public finances.”

The high wage growth of the Baltic region sets it apart from much of the rest of Europe over the past decade and boosts its ability to cope with the current period of unusually high inflation, according to economists.

In Lithuania, wages have almost trebled in the past decade, while they have risen about 95 per cent in Latvia and 85 per cent in Estonia, according to Eurostat, the European Commission’s statistics agency. But in the same period, EU wages are up only 26 per cent.

“Here in Sweden, we are lucky to have 1 or 2 per cent real wage growth in a good year,” says Jens Magnusson, chief economist at Swedish bank SEB. “But in the Baltics they’ve had 6 or 7 per cent real wage growth for several years and that provides a cushion to make it easier to cope with such high inflation now.”

In countries like Germany, which until this year had not experienced double-digit inflation since 1951, such rapid price rises are more of a psychological shock than in the Baltics, where such inflationary bursts are a more frequent occurrence.

“Inflation of 10 per cent in the rest of Europe is at least as impactful and difficult as 20 per cent inflation in the Baltics,” Magnusson says, pointing out that their relatively low levels of government debt gave Baltic countries more fiscal leeway to provide support to those hit hardest by high energy and food prices.

There was widespread relief among central bankers after eurozone inflation fell from its record high of 10.6 per cent in October to 10.1 per cent in November — its first decline for 17 months. “When I look at the inflationary pressures in the euro area it resembles what we experienced in Lithuania six months ago,” Šimkus says, adding that the “peak of headline inflation in the euro is probably just around the corner”. Ilekytė says she still forecasts inflation will be 8-9 per cent in 2023.

But Lithuania’s central bank governor adds that even if wholesale European energy prices do not return to their recent record highs, the cost of many goods and services will keep rising at well above the ECB’s 2 per cent target for an uncomfortably long period. “I think the pass-through of these energy impulses into final goods and services is still to be seen,” he says. “That is exactly what worries me.”

Officials in both the Baltics and the rest of Europe worry that the surge in inflation will leave behind traces for years to come. “This is not a passing shock,” says Latvia’s central bank governor, Kazāks. “This is a permanent shift, which requires structural solutions.”

He says the EU needs to come up with a coherent and ambitious energy strategy: “If we are unable to ensure that our economies get access to affordable energy, we will start losing companies that are energy intensive and they will relocate and that will have consequences in terms of unemployment and lower growth.”

Additional reporting by Urtė Alksninytė in Sangrūda