Still 3rd from the bottom

Reasons why Latvia does not perform better than Russia

Corrupt, non-transparent, run by oligarchs, authoritarian or semi-fascist – Russia usually does not prevail all that well in economic-political beauty contests but by some measures it is now richer than Latvia , this is in terms of GDP per capita adjusted for price differences.

That’s pathetic, isn’t it? OK, Russia has its vast natural resources some will say but we know that resource-endowed countries are seldom rich since these resources often lead to massive corruption plus a crowding-out of other economic activity (Dutch Disease). Latvia, being a market economy and benefiting from membership of the EU should do better, shouldn’t it? But it doesn’t so where are the reasons?

We know that GDP is a function of the accumulation of factors of production:
Physical capital
Labour
Labour’s skills (human capital)
Land
Natural resources
and the efficiency by which these factors ‘work together’ (Total Factor Productivity).

Since Latvia’s GDP (per capita) is low in an EU context some of these factors of production are lacking here when compared with the richer countries of the EU. Obviously, currently the input of labour is down (reflects high unemployment) but what else?

When Latvia entered the new millennium it was the third poorest country of what is now EU27 (only ahead of Romania and Bulgaria). Today, one decade later, Latvia’s position is, ahem, still 3rd from the bottom. OK, by definition someone always has to be 3rd from the bottom and some convergence has taken place but although everybody talks of future growth and development etc I have never understood why so little focus has been on this issue. If the country was more interested in addressing why it is behind countries like Lithuania, Slovakia and now even Russia, perhaps it would be easier to see where development should take place? Or, in other words, what is it that so severely constrains the supply side of the Latvian economy?

But at first the numbers:
GDP per capita at PPS (comparable prices), 2009, Baltic Sea countries, EU27 = 100

Source: Eurostat and own calculations.

Allow me just one example of where I think constraints on the supply side are poorly understood (but I could make many more). From ''Vienotība'' (Unity) we get, if I have understood it correctly, that the level of education should rise above the European average over the next four years.

Hmmm…. I think it is reasonable to say that changing the level of education is a slow-moving process so to really achieve this goal Latvia today should not be that far from the average. But then a conundrum arises: If Latvians are almost as well-educated as the EU average how come they produce so little (just 49% of the EU27 average)? The production function above would then suggest that there should be a lack of physical capital but the open borders of the EU allow technology transfers and the free mobility of capital to places with smart people who can use it so this can’t be the explanation. Or it should be an ultra-inefficient use of resources i.e. lots of bureaucracy, red tape and corruption, implying smart people constantly being harassed by the system. While it is always tempting to cave in to this explanation and while it may have some merit here and there it is just not the full explanation. Latvia is significantly below the EU average in terms of GDP per capita partly because its level of education is also significantly below the EU level – and thus not close to the EU level and thus in no way will supersede the EU level in the next four years.

The policy goal of improving education is highly laudable but – if I am right – is built on a wrong assumption that the country is not that far behind today. But it is – again if I am right – and thus much, much more needs to be done before Latvia can move away from the position as 3rd from the bottom. And if this is not done due to falsely believing that everything is (almost) well, then start looking out in the rear view mirror for Bulgaria and Romania.
Morten Hansen is Head of Economics department, Stockholm School of Economics in Riga.