“Concerns about economic growth outweighed concerns about high inflation and strong wage pressure,” said Maja Goettig, the chief economist at Bank BPH in Warsaw. “The decision opened up a cycle of loosening monetary policy in Poland.”

This is exactly the main issue. The discourse has changed since Spring/Summer and we are now seeing the obvious policy consequences. However, for Eastern European economies it was never going to be an easy process in either direction since, some way or the other, the economies are saddled with economic (as well as structural) imbalances which need to unwind. In this way, the current process crucially need to be a managed one less we really want to see what a crisis looks like.

One example where this is blatantly clear is in the Baltics where we are moving towards the end of the line for the pegs. Edward asked the obvious question a couple of days back of whether a Baltic devaluation is now in the works. I think this is pretty much given at this point. Whatever kind of road the Baltics need to take to get out of the current mess a look at the Euro peg simply needs to be included. What kind of arrangement we will see is debatable. A recent commenter suggested to me that Scandinavia is using the Baltics as a spearhead to help prevent Russian influence. This was undoubtedly true back in the heaty days where the Baltics first claimed independence and the Scandinavian countries were among the first to recognise their independence. Whether today's situation is reminiscent, I really do not know. One thing which will be interesting in that respect will be what e.g the Riksbank does in the context of Swedbank (Hansabank) if and when the pegs are loosening. Remember in this respect that the Baltics themselves really do not have their own banking system which means that if the foreign subsidiaries draw back, a new system needs to be built up from the ground. In this light, whatever scenario will unfold it will be messy and filled with compromises, but one thing is certain. The peg will loosen, it has to. The only thing that would prevent this would be a Euro pushed to substantially lower levels against a weighted global basket. 

This may of course still happen and we should also take note of the reverse effect as some economies (e.g. my own home country) seem to be scrambling for a quick entry into the Eurozone. Yet I cannot put it strongly enough how detrimental this would be. The Eurozone has enough on its plate as it is and if suddenly half of Eastern Europe, Denmark (and Iceland?) are considered for a potential rushed membership the edifice will crack, I have no doubt. I am a strong fan of Europe as a common idea, but the Eurozone has some deep structural issues to deal with and admitting 5+ new members in the face of financial crisis is not one of the solutions.

How to go From A to B then?

This notes has been primarily concerned with emerging economies in Eastern Europe, but the argument can be applied more widely I think. To the extent that emerging economies on a large will now embark on a collective easing of monetary policy it raises some important questions. Firstly and as I noted above, some economies will have an easier time lowering interest without suffering a real rout on the currency and capital market. In this sense I would expect some emerging economies to use the devaluation tool as an alternative to a gradual nominal depreciation, the point being that in some cases this downward nominal adjustment will be anything but gradual if markets have their way.

However, there is a flip side to this. What about the emerging economies who will start growing again in mid 2009 and onwards (and trust me, some of them will). In particular, I am speaking about those economies such as India, Brazil, Chile, etc whose trend growth alone (based on domestic momentum) should help the ward off the most significant impact even though the current climate is dangerous for everybody. Clearly, these economies (no matter who this will turn out to be) are face with an equally big dilemma. As such, how do they maintain an interest rate to reflect domestic capacity and momentum conditions in a world where the Fed, the ECB, and the BOJ all are headed for some kind of quasi zirp/QE scheme. It does not take much of an economic literate to see that the potential carry gains flows here are enormous and even though any kind of revival of carry would mean a significant change in risk sentiment, it would happen in a world where more economies (than before!) have very low interest rates relative to those brave souls who dare (or are able to) keep interest at "normal" levels. Thus the screw turns yet again for the global economy and the asymmetry of capital flows. In fact, before we get to a reasonable understanding of why this is, and why some economies are inadvertently driven towards a specific growth path directed by crisis, fundamentals or both, we are still, as it were, sailing without a compass.

(1) - See in particular my article entitled Currency Dilemmas in Eastern Europe" for a detailed argument.