5% annual growth – realism or illusion?

The still new government plans to increase the growth rate of the economy to 5% annually. Not today, not tomorrow but within a few years. This would be great for all sorts of reasons: Standards of living, catching up with the EU level of income per person etc.

But is it realistic? I am not so sure.

It has certainly been a while since the economy reached 5% growth on an annual basis, see Figure 1. Actually, it hasn’t happened since the first quarter of 2012 and growth has recently been some 2-3% per year.

Figure 1: Growth rates of the Latvian economy, 2011-I – 2016-I, quarterly data 

Source: Central Statistical Bureau

Raising the growth rate from, say, 3% to 5% per year may at first not sound like much but it amounts to about 500,000,000 extra euro of output per year and from that about 150 million EUR extra tax revenue. Not bad.

But I shall argue that I find it hard to imagine that the Latvian economy can reach a sustained growth rate of 5% per year.

In Figure 2 I plot three related graphs. Since 1995 when transition was sort of over and the economy started to grow again, Latvian GDP has more than doubled with an average growth rate of 4.1% per year. GDP per capita has grown faster as the number of “capita” has declined due to poor demographics and migration and it has almost trebled in size; not bad at all – which translates into an annual average growth rate of 5.3%. And then there is growth of GDP per person employed – important since those are the ones creating GDP – which has developed by 4.5% on average per year.

Figure 2: Development of GDP (1995 = 100), GDP per capita (1995 = 100) and of GDP per employed person (1996 = 100) 

Source: Central Statistical Bureau and own calculations

So, the economy has been able to grow on average by 4.1% from 1995 to 2015. Why should 5% not be possible? I’ll provide at least two reasons. The first is simple: Growth is typically higher when the catch-up potential is bigger. Latvia has caught up quite nicely to 64% of the EU average in terms of income per person, up from some 30% 20 years ago but this makes the remaining 36% more difficult to achieve – Latvia is still behind the EU average but by far not as much as it used to be.

The second reason is the development of the labour force. As Figure 3 shows, a quite big share of the population is employed – not such a big share as during the big boom preceding the financial crisis but the biggest share in the past 20 years except for 2006 – 2008. Not bad – but not something that can, seemingly, be much improved upon – and which therefore cannot help add to further growth.

Figure 3: Persons aged 15 – 74 years old employed as a share of the population, 1996 – 2015 

Source: Central Statistical Bureau

But it gets worse if we take into account demographics. At the moment the labour force is quite a big as a share of the population but this ratio will go down relentlessly due to the small cohorts of children of the past more than 20 years. They are entering the labour market right now – small numbers enter, large numbers exit. Take Figure 4 – the 15-19 year olds constitute some 88,000 persons and they will enter the labour market in the next 5-10 years. But the numbers that will exit – look e.g. at the 55-59 year olds or the 60-64 year olds are much larger. True, not everybody in an age category works but there will be many more workers leaving than workers entering – the labour force will shrink and shrink as far into the future as we can see.

And it is from this ever-shrinking labour force that economic growth is supposed to accelerate to a sustained rate of 5%?!?

I just don’t see that happening!

Figure 4: Population breakdown in Latvia, 2015

Source: Central Statistical Bureau

Points of view presented here are not necessarily those of the Fiscal Discipline Council.

Morten Hansen is Head of Economics Department at Stockholm School of Economics in Riga and a member of the Fiscal Discipline Council of Latvia