What made Latvia grow until now – and what will not make it grow in the future

 

In terms of income per person as measured by GDP per capita, Latvia is still behind most of its peers in the European Union, being at some 64% of the average EU level.

But GDP per capita has been growing a lot over the years – since 1996, i.e. for the past 20 years it has grown no less than 173.4% (all this data is from the Central Statistical Bureau of Latvia). But where did this growth come from, what can we interpret from that and, crucially, how may that help explain or predict growth in the future?

A useful way of addressing these questions is to look at the following decomposition of GDP per capita (written as GDP/population) into four parts.

GDP/employment – this component measures growth of GDP per employed person, i.e. what we would call productivity growth. This accounts for the by far biggest part of the total increase in GDP per capita, namely an increase of 129.8% – on average, an employee in Latvia is more than twice as productive now (and this is measured in constant prices, of course), i.e. he/she produces more than twice as much as in 1996.

Employment/labour force – this component speaks of how big a share of the labour force is employed (thus also how small or big the unemployment rate is). This grew from 79.3% to 90.1% (equivalent to an unemployment rate of 9.9% in 2015 which is a component increase of 13.6% from 1996 to 2015.

Labour force/15-74 year – this is the share of the labour force in the group of 15 – 74 year old persons; the group that contains virtually all employment since (hopefully) no one under 15 works and rather few over 74 do. Growth of this ratio means a higher activity ratio, meaning more potential labour for the economy. This grew modestly by 4.7% over the period.

15-74 year/population – the share of potential labour force in the population. The smaller this ratio is, the fewer persons are candidates for the labour force; fewer will be in the labour force and fewer will be employed, imposing a drag on the economy. This was virtually unchanged over the period with a tiny decline of 0.1%

Altogether the accounting then becomes (in case you ask) 2.734 = 2.298×1.136×1.047×0.999.

Growth of GDP per capita in Latvia in the past 20 years has thus come mostly by productivity increases but also from a higher share of employed persons and a bigger share of the labour force in the 15 – 74 year group.

But what about the future?

Growth is still supposed to be mostly coming from productivity advances – this is completely normal and uncontroversial – and with Latvia still behind the potential is there should be plenty of scope – but there will be precious little help from the other components and one of them will actually create more and more of a drag on growth.

See Figure 1. With labour force participation above 80% for the 20 – 54 year old, there is limited scope for higher participation (i.e. not much to gain in component three). Similarly with employment rates, component two (the difference between blue and red reflects unemployment) – the unemployment rate is, at under 10%, already low by Latvian standards.

One group where neither figure is acceptable is for the 60 – 64 year old. A labour force participation of below 50% (but with very many of those employed!) is clearly unacceptable in a modern economy and the increase in the retirement age is helping to remedy this. But there are no big gains in components two or three to be made.

The big trouble is, of course, with component four whose development will reflect the deteriorating demographics hitting the labour market. Figure 2 helps to explain this.

 

Small cohorts are entering the labour market in the years to come – 179,000 young persons aged 10 – 19 will be labour force material in the coming 10 or so years while, say, the 60 – 69 year old will mostly leave the labour market and they constitute 229,000 persons. Net loss of potential labour force: 40,000. And as can be seen from the graph (and I guess this is mostly common, if painful, knowledge) labour force losses will just increase later, see e.g. the many 50 – 59 year old).

Component four, 15 – 74 year old as a share of population is thus turning into negative growth and thereby creating an overall drag on growth of the economy, on growth of GDP per capita and on income convergence.

This will also make it even more difficult to reach the annual 5% per year growth rate of the economy that the government envisages and, frankly, I don’t see how such a growth rate can be achieved and sustained. But this little decomposition of growth components shows how important it is for the economy do anything possible to promote productivity growth – because no other component is going to be of significant help.

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