A useful way to look at Latvia’s growth experience – and growth future

 

If one wants a flattering picture of growth in Latvia then a) go far back in time for comparison so as to lessen the impact of the 2008 – 2010 recession and b) use GDP per capita growth instead of GDP growth since the number of “capita” has been falling. Then one can have a picture like figure 1 below with Latvia being the second-fastest growing EU economy since 2000.

But it is not sheer manipulation – Latvia has, like Lithuania and Estonia, made a lot of structural and institutional development that makes this development well-deserved. But what about the next 10 – 15 – 20 years? Here a little decomposition of the growth experience might be helpful.

Figure 1: Growth of GDP per capita, 2000 – 2012, EU28

Source: Eurostat and own calculations 

Note: 2000 – 2012 and not 2013 since not all EU countries have 2013 data ready yet.

This decomposition answers the question of where the GDP per capita increase came from. A bit of arithmetic is needed:

GDP per capita = GDP/Population = A x B x C x D, where: A = GDP/Employment; i.e. GDP per employed person, a measure of productivity; B = Employment/Labour force; i.e. the share of employed people in the labour force; C = Labour force/15-64 year olds; i.e. the share of the labour force in the group of 15 – 64 year old people; D = 15-64 year olds/Population; i.e. the share of the 15 – 64 year olds in the whole population.

The more math-savvy readers (if anyone is still reading this…) will see that the formula is a simple expansion of GDP per capita but it is smart in giving us four reasons for GDP per capita growth: Higher productivity, more employment, a bigger labour force and more persons in the group most likely to be at work (those of age 15 to 64).

How has Latvia fared in these sub-components, what can we learn from that and, crucially, what does this tell us about the future? In the following table I have the calculations for the whole period (2000 – 2013) and for three sub-periods (2000 – 2007 i.e. the ‘fat’ years, 2007 – 2010 i.e. the recession years, and 2010 – 2013 i.e. the recovery years).

Table 1: Cumulative growth of GDP per capita and its sub-components in Latvia

What we see is that for the whole period of 2000 – 2013 GDP per capita almost doubled by growing 93.9%. By far most of this increase is explained by productivity growth (A, 74.8%) but also a sizeable expansion of the share of the labour force among the 15 – 64 year olds (C, 10.1% of overall growth of GDP per capita) while a small positive impact came from a higher employment rate (B, 2.9%) and a small negative impact came from a smaller share of the 15 to 64 year olds in the population (D, -2.2%).

The boom saw productivity together with higher employment being important while, not surprisingly, most of the bust of 2007 – 2010 is explained by a massive drop in employment (i.e. in B).

The recovery is, roughly, shared 50-50 between productivity growth and employment growth.

But what about the future? Productivity growth should be the driving force, of course, since the country is in a catch-up phase with respect to European partners so A will undoubtedly grow. But B, C and D? The unemployment rate is already at quite low levels for this country so there is not much extra to squeeze out of B, the employment rate. It would be nice to see an even higher share of labour force among the 15 – 64 year old but as I have argued earlier this rate is not small by EU standards so there is not so much scope for growth of C either.

And it is of course the D-component we have to fear. Due to ageing, bad demographics and migration the D-component will shrink for many years to come – or put in a non-econ-jargon way – the share of pensioners in the total population will relentlessly increase for years and years to come.

Most are familiar with this upcoming demographic burden so perhaps there is not all that much new in this post but I nevertheless think that this decomposition is a useful way to illustrate the uphill struggle the Latvian economy faces in terms of managing economic convergence – to increase GDP per capita, the A-component must increase and will do so but at the same time decreases in the D-component will hold back GDP per capita convergence – another story of two steps forward, one step back.

And some more, simple but still important truths: Massive focus on whatever can increase productivity, increase the employment rate and increase the labour force is highly warranted.

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