How much convergence to expect?

Many of my entries concern the current economic situation and they often discuss short run demand-side stabilization policies (or lack thereof) such as fiscal and monetary policy.

But in a way I am more interested in the long run and thus in the supply side of the economy: Economic growth and possible convergence in Latvian GDP per capita with that of the EU. More GDP provides opportunity for both more private spending (most would enjoy that, certainly) and more public spending (better infrastructure, better hospitals, better education etc), which we all would benefit from, too.

But Latvia is still quite far behind the EU average, being the 3rd poorest of the EU countries with a level of GDP per capita roughly at 50% of the EU average. Negative interpretation: Poor country. Positive spin: Lots of catch-up potential!

But will Latvia, eventually, catch up or even overtake the EU average? In a way it is simple: It is all about amassing labour, skills, physical capital, good institutions – but if this was easy to do it would have been done a long time ago and Latvia would not be so far behind.

Conclusion # 1: Catching up is difficult. (Yes, I am REALLY deep here… But there are people who think catching up is something that ‘just happens’ – and they are wrong).

Figure 1 displays GDP per capita as a share of the EU average for Latvia, Portugal and Greece.

Figure 1: GDP per capita, EU27 = 100

Source: Eurostat

Portugal is chosen for two reasons: It is the poorest of the old EU15 countries and it is a country that hasn’t seen any convergence for the past 15 years. Of course they know this in Portugal; most likely they are interested in changing this but it hasn’t happened.

Conclusion # 2: Convergence is not automatic – the idea that Latvia will ‘inevitably’ catch up may just not be true.

Greece is included because it has something in common with Latvia. Greece managed pretty fine convergence in the early parts of this decade and came close to the EU average. Sorry for my extreme prejudice but when one reads about the zillions of inefficiencies and idiosyncrasies in the Greek economy, such a high level of GDP just cannot be true?!? And it isn’t – it was built as part of a demand-driven credit boom, not as a healthy expansion of productive capacity. Greece is now, as the bills for excessive borrowing have to be paid, reverting to where it belongs, to a lower level of GDP. The credit boom in Latvia implied very high growth rates and provided remarkable convergence but not all of it ended up as an increase in the economy’s potential.

Conclusion # 3: The demand side can influence growth in the short run but it is the supply side – building capacity to produce – that matters for the long run.

The idea behind Figure 2 is to illustrate a very typical feature of GDP per capita: Persistence. Sweden is richer than the EU average now, so it was 10 years ago, 20 years ago, 30 years ago, 40 years ago…. Very few countries have seen dramatic changes in their GDP rankings even over very long periods, suggesting that there are other forces – ‘culture’ – at play. Ireland is the example of a country that grew from one of the poorest EU countries to one of the richer ones; Italy is a rare example of a country moving the other way.

Figure 2: GDP per capita, EU27 = 100

Source: Eurostat

Conclusion # 4: The role of persistence. Again, this warns against the ‘inevitability’ of catching up.

The past few years have all been about austerity to stabilize public finances, preceding that we had a long credit-driven demand boom. Although these periods are like night and day, they have in common a lack of focus on the supply side of the economy. OK, there have, over the years, been tonnes of ‘National Development Plans’ etc but haven’t they to a large extent ended up on dusty shelves, leaving Latvia with an ‘implementation deficit’?

I really hope for more focus on the supply side in the coming years not least a non-prejudiced and bold analysis of the factors that may hinder economic convergence.

Morten Hansen is Head of Economics Department, Stockholm School of Economics in Riga