Uneven Inflation Spike Redraws Euro Zone’s East-West Divide

(Bloomberg) — Surging inflation in smaller euro-zone nations are redrawing the economic divide between the continent’s east and west.

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In the Baltic region, where inflation is the bloc’s quickest and has topped 25%, Estonia has seen the cost of goods and services leapfrog Italy and Spain since last year, making it the most expensive country in central and eastern Europe. Slovakia and Slovenia are also gaining ground and now aren’t far behind.

The hope was always for the continent’s formerly communist economies to converge over time with their richer neighbors, raising living standards along the way. But the nature of the price shock means wages are lagging behind, with salary disparities having driven one of the biggest waves of worker emigration to Europe’s richer west in recent years.

The situation is due in part to the euro zone’s common monetary policy, with Baltic officials only belatedly helping persuade the European Central Bank to hike ultra-low interest rates. A higher exposure to market prices for energy heightens the pain.

“We’ve caught up to the European Union average price level very quickly,” Estonian central bank Governor Madis Muller said. But “our incomes still aren’t quite at the European average.”

The result is dwindling purchasing power that’s unlikely to recapture last year’s level until 2024, according to research by the Bank of Estonia. That will weigh on economic output, which was roaring post-pandemic but is now in retreat.

Households are under intense pressure and companies that can’t transfer rising costs to customers risk going out of business, Swedbank Estonia Chief Executive Officer Olavi Lepp said. That could test Estonia’s traditional role as low-cost exporter.

“Looking at Scandinavia and central Europe, the question arises whether Estonia is an attractive place to buy goods and services from,” he told Baltic news service Delfi.

While firms face short-term disruption, the shift should bring benefits down the line, according to Lenno Uuskula, chief economist at Luminor in Tallinn.

“One after another, companies that can’t afford to pay the average salary need to shut down,” Uuskula said. “Then new employers will emerge that can afford to pay higher salaries. It implies higher value-add jobs in Estonia.”

The country of 1.3 million people has already been nurturing a tech industry that helped spawn Skype and 10 startups valued at more than $1 billion, though part of the allure for budding entrepreneurs had been the lower cost of living.

“We’re still cheap compared with western Europe,” Uuskula said. “But Warsaw is certainly cheaper at this point.”

In Lithuania, another Baltic euro-zone member, central bank chief Gediminas Simkus also underscores the transition to higher value-added production and attributes faster inflation in part to being an economy rushing to reach the level of its wealthier neighbors.

Simkus brushes off the recent spike in prices, preferring to focus on a longer horizon. He also highlights boosts to salaries that have risen beyond those in Italy when adjusted for spending power, and will benefit further in 2023 from a jump in minimum pay.

“We have a higher level of inflation but we also had higher growth of wages over the last 10 years,” he said. “Wages grew about 2.5 times” but “prices didn’t double in the last decade, so the real purchasing power has definitely increased.”

Zooming out from the steep price gains of recent months, Estonia may too look back eventually on a period that jolted it closer to the ranks of Europe’s richer west.

But in the nearer term, the journey will remain bumpy: Economists polled by Bloomberg see inflation remaining close to double digits next year — more than the central bank predicts.