In its latest March 2023 macroeconomic forecasts drawn up amid persistently high uncertainty, Latvijas Banka has revised the inflation forecast downwards for the entire projection horizon: to 10.0% for 2023, to 2.7% for 2024 and to 2.6% for 2025. Is this based on solid ground or just a hopeful attempt to deny a harsh truth?

The GDP forecast for 2023 has been revised upwards to 0.5%, which in turn reduces growth in the coming years: to 3.7% for 2024 and to 3.3% for 2025 (3.5%).

Inflation in the euro area remained significantly above the central bank target (2% in the medium term). And it is expected to stay above the target for too long. Therefore, the ECB is raising interest rates.

Lower energy and food prices and assumptions about their developments allow a downward revision of the inflation forecast. Despite that, inflation in Latvia remains high – it was the highest among the euro area countries in February. The most optimistic assumptions see inflation gradually subside over the course of 2023 and could fall below 3% at the end of the year. Hence, average annual inflation will still be high in 2023 (10.0%); however, it could already end up below 3% in 2024–2025.

Although the impact of the wage increase on core inflation has so far been assessed as minor, a stable rise in wages and subsequent pressure on core inflation are projected in the context of a labour shortage.

Amid the high inflation, the government has kept spending support, especially in covering energy costs. Savings accumulated during the pandemic also let part of the population keep their consumer behaviour unchanged.

With businesses facing weakening demand and climbing costs, labour demand declined and the number of job vacancies decreased. However, the projected short-lived recession and the expected labour shortage resulting from the rebound in activity make businesses retain their employees, and so far there is no significant change in the unemployment rate.

However, the investment growth prospects have not improved, taking into account the absorption of EU funds as well as the elevated uncertainty and rising interest rates weakening the slow lending. With the absorption of EU funds becoming more active and input prices normalising, 2024–2025 is expected to witness economic growth above 3% (3.7% and 3.3% respectively).

The most significant risks to Latvia’s economic growth involve the persistently low investment level and deteriorating competitiveness. Due to the accumulated input costs, exports could lag behind foreign demand. In the long term, investment is a precondition for a competitive economy. The general government deficit (4% of GDP this year) could decrease in the future. However, that won’t be enough: efforts related to facilitating economic transformation are necessary.

Governments do not generate wealth, as public spending uses resources taken from economic agents who generate wealth. Wealth producers exchange their products with each other, a voluntary activity. The key point is that trade must be free and reflect the individual’s priorities. Hence, government taxes are coercive, forcing producers to part with their wealth.

The more non-market-related projects the government undertakes, the more real wealth is transferred from wealth producers. Government-employed individuals are just able to exchange the tax money for consumer goods, and not to provide innovation. This, in turn, undermines the wealth-generating process of the economy. A framework to enhance free market competitiveness is then a priority to boost production and innovation, not merely support consumption (and, in turn, inflation).

On the other hand, if lowering taxes is not matched by a reduction in government spending, this will encourage a misallocation of savings. The emerging budget deficit will be funded either by borrowing money or by creating new money.

“The treasury may hoard a considerable part of the lavish revenue from taxes which flows into the public exchequer as a result of the boom. As far and as long as it withholds these funds from circulation, its policy is really deflationary and contra-cyclical and may to this extent weaken the boom created by credit expansion. But when these funds are spent again, they alter the money relation and create a cash-induced tendency toward a drop in the monetary unit’s purchasing power. By no means can these funds provide the capital goods required for the execution of the shelved public works.” (Ludwig von Mises)