1. 1 Hardo Pajula Estonian economy: Autumn 2007

2. 2 Analytical framework Output and income growth Labour market Inflation Competitiveness Balance of payments Money supply and credit Interest rates and asset prices Capital account David Hume All water. wherever it communicates. remains always at a level. Ask naturalists the reason; they tell you. that. were it to be raised in any one place. the superior gravity of that part not being balanced. must depress it. Exchange rate

3. 3 The watershed In the second half of this Feb- ruary rumours about an immi- nent devaluation of Latvian currency drove interbank rates from 4.5 to 9 percent and pushed the lat to touch its upper boundary. In the following two weeks the share prices of Swedbank and SEB fell by 12 and 9 percent respectively, reflecting the worries about their exposure to Baltic credit boom.

4. 4 “Bronze night” takes toll on confidence The images of shattering shop-windows which under other circumstances might have shaken off as a minor disturbance seem to have had in this phase of the cycle a more damaging impact. Its impact on transit and inbound tourist flow has been equally distructive.

5. 5 “Fear index” on the rise Sharply increased risk- aversion will make it harder for parents to raise money. The boom was predicated on the transfer of cheap funds from the core to perihery. Historically, the problems at the core tend to be amplified in the peripheries.

6. 6 Key factor: Animal spirits “Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations … Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits – a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.” John Maynard Keynes on long-term expectations Entrepreneur from Africa

7. 7 Growth and economic sentiment

8. 8 Aggregate demand and its components

9. 9 Industrial output and confidence

10. 10 Exports and order books

11. 11 Construction output and confidence

12. 12 Retail sales and consumer confidence

13. 13 Labour market

14. 14 Prices and wages

15. 15 Balance of payments

16. 16 Credit growth

17. 17 Interest rates and asset prices

18. 18 Main findings Current statistics tells the story of a strong growth which in reality has already passed. The leftover growth we do see is skewed heavily towards domestic demand which is particularly susceptible to abrupt changes in the expectations of residents – the animal spirits argument. As the persistent flow of bad news makes expectations to shift, domestic demand will fall (possibly rapidly) in the second half of this year. To the extent it does, we are going to see a process of unwinding of accumulated imbalaces with inflation and wage growth coming down and external balance narrowing. In this different environment the expectations formation becomes once again a key issue. Deeply ingrained inflationary expectations could set fixed exchange rate under intense pressure.