The issue is labour supply and economic growth (what Claus and I call the "capacity problem"), and how a very tight labour supply in Latvia is producing an astronomical 33% annual increase in wages. The problem is basically how a society which has experienced strong out-migration and lowest-low fertility during an extended period can sustain strong economic "catch up" growth (which of course all the Eastern European societies need if they are to come anywhere near the per capita incomes of Western Europe) given the constraint that is produced on new labour market entrants.
Basically, economies can grow in one of two ways. They can either grow horizontally (by expanding economic activity in existing product categories) or the can grow vertically (by moving up the value chain). The problem is that it is a lot more difficult to achieve rapid vertical growth in a short period of time, since moving into new economic activities is, by its very nature, a comparatively slow process given that new human capital needs to be formed, experience needs to be gained, and learning-by-doing needs to take place. Thus bottlenecks inevitably arrive (Indian outsourcing growth would be one good current example of this issue). So during the initial periods of catch-up growth it is normal that horizontal growth plays an important part (this process is what economists tend to call the initial accumulation of inputs). This was clearly the experience, for example, in the classic case of the Asian tigers, were it is clear that strong productivity driven growth only took place at a later stage (China may now be about to become another example of this).
But the problem for countries like Latvia is they do not have the latent human resources to really get the benefits from this "inputs accumulation" process. At comparison of the Latvian projected population pyramid changes 2006-2025, and the Irish one 1986-2000 (which I have put up here) may help make this clearer.
What follows below is an edited version of the demographic component of my Global Economy Matters post. I think it is also important to note that - as Claus points out in this post - this tendency, which is now making its presence felt in Latvia will soon extend across Eastern Europe and Central Asia, (you can find a chart showing the labour force change projections for these countries between now and 2025 here). All of this takes on a certain importance when we think about the kinds of issues we were discussing in the Polish context (here), and if we look at the present rate of decrease in Polish unemployment. Poland's unemployment rate fell in May 2007 to 13 percent, and this was a decrease of 23% in one year (and Polands economy, remember is "only" growing by 6.5% a year). If this process continues, Poland will have an unemployment rate of 9% in May 2008, 7% in May 2009, 5% in May 2010, and 4% or below in 2011. So within 4 years Poland could hit a growth-constraint wall. This is all remarkably rapid indeed. Of course, growth may falter, but in which case it is hard to see how Poland can ever catch up with Western Europe. This is a race against time in some ways, before a window of opportunity closes.
Russia itself is already feeling the pinch, and out further East Azerbaijan's economy is growing at 35% a year. In the Russian case, John Litwack, the World Bank's chief economist in Moscow, estimates that Russia is going to need about a million migrants a year.
To compensate for this(the labour force decline, EH), Russia would need an annual inflow of 1 million immigrants, which is three times as the average official annual flowover the last 15 years, and five times the official flowin recent years.
Latvia, Fertility, Migration and the Labour Supply
So how big is Latvia's demographic problem? Well to try and get some sort of appreciation of the order of magnitude here we could think about the fact that during 2006 Latvian employment was increasing at an annual rate of around 70,000, while if we look at live births for a moment, we will see that since the early 1990s Latvia has been producing under 40,000 children annually (by 2006 this number is down to 21,000 (as the chart below makes clear).
Indeed ex-migrant flows, the Latvian population is now falling (by 0.648% annually according to the 2007 edition of the CIA World Factbook), and at a significant rate (the birth rate is at a very low level, 1.3TFR in 2006 according to the Population Reference Bureau). Taking into account uncertainties about out-migration (which is almost certainly greater then is reflected in the official statistics) in fact the rate of decline might be even greater.
At the same time the internal employment situation is becoming ever tighter, with unemployment levels becoming ever lower (see chart below, data 2005, and Q1 2005 through Q3 2006).
(please click over image for better viewing)
As can be seen in Q3 2006, employment was increasing at a rate of 7.2% (y-o-y), while the unemployment rate was down to 6.2%. Put another way, an increase in employment of some 75,000 had produced a reduction in the unemployment rate of 2.5% (or about 30% of the registered unemployed). It doesn't take sophisticated mathematics - or "robust" models - to see that this cannot last.
One solution is obviously to try and increase the level of labour market participation, but - and it is interesting that almost no-one here seems to be talking about the need for labour market reforms - it is hard to estimate just how much potential in reality there still is for this. According to the Latvia Statistical Agency Q2 2006 labour force report:
In Q2 2006 more than a half (63.8%) of residents in the age from 15 to 74 were economically active – this indicator was 68.9% amongst males, and 59.4% amongst females. in the 2nd quarter of 2006, the number of economically active population, in comparison with the corresponding period of 2005, increased by 2%.
These numbers, since they include everyone up to 74, and many under 20 - an age where education may still be taking place in many cases - are really very hard to interpret. But whichever way you look at it there is certainly a problem, since wage increases of this order would normally be considered to motivate more labour to come into the market, were it available. However, before going into this labour market structural bind in greater depth, let's take a look at some more of the details of the general economic dilemma.
Migration As A Solution?
Well given that a strategy of relying exclusively on fiscal tightening and strong deflation (as is being recommended to the Latvian government by a variety of sources) is fraught with risk, another possibility which should be seriously considered would be to apply a determined policy mix of both decreasing the rate of economic expansion and increasing capacity by loosening labour market constraints somewhat via an open-the-doors policy towards inward migration and with the active promotion and encouragement of an inward flow of migrants from elsewhere in Eastern Europe (or further afield). This would seem sensible, and even viable given the fact that Latvia is a pretty small country. However, as Claus Vistesen notes here, this can only be thought of as an interim measure, since, as the World Bank has recently argued, all the countries in Eastern Europe and Central Asia are effectively condemned to face growing difficulties with labour supply between now and 2020 (so in this sense what is now happening in Latvia may be an extreme harbinger of the shape of things to come). But given this proviso it is clear that a short-term inward migration policy may help Latvia escape from the short-term vice it seems to be in the grip of. This short term advantage may be important, since longer term solutions like increasing the human capital component in the economy and moving up to higher value activity need much more time, and what is at issue here is transiting a fairly small economy from an unsustainable path to a sustainable one.
However Latvia certainly faces difficulties in introducing a pro-migrant policy. One of these is that such a process may ultimately put downward pressure on unskilled Latvian workers wages in a way which only sends even more of the scarce potential labour Latvia has out to Ireland or the UK. A recent report by the US Council of Economic Advisers made some of the issues involved relatively clear. The report cited research showing immigrants in the US on average have a “slightly positive” impact on economic growth and government finances, but at the same time conceded that unskilled immigrants might put downward pressure on the position of unskilled native workers. Now in the US cases these US workers are unlikely to emigrate, but in Latvia they may do.
A further difficulty is the lack of availability of accurate data on the actual scale of either inward or outward migration in Latvia (this difficulty is noted by both the IMF staff team and the Economist Intelligence Unit). On the latest estimate from the Bank of Latvia some 70,000 Latvians, or around 6% of the labour force, are currently working abroad - mostly in the UK and Ireland - but the true number is very likely considerably higher (IMF Selected Issues Latvia 2006, for example, puts the figure at nearer 100,000).
Several recent surveys also suggest that the potential for outward migration remains substantial. For example, a survey conducted by SKDS (Public Opinion on Manpower Migration: Opinion Poll of Latvia’s Population) in January 2006 revealed that about 22 percent of Latvian residents see themselves as being either “very likely” or “somewhat likely” to go to another country for work “in the next two years”. Based on the current estimated population, this translates into between 350 and 450 thousand residents (between 15 and 20 percent of the 2005 population). The survey also indicated that these respondents were significantly skewed toward the relatively young (15-35), which would significantly reduce the working-age population and labor force in the near future. These respondents were also slightly more likely to be male, less educated, low-income, employed in the private sector, or non-Latvian.
But there is a second issue which immediately arises in the context of projected in-migration into Latvia, and that is the situation vis-a-vis the presence of large numbers of Russophone Latvian residents who are non-citizens. The issue can be seen in the table below.
(please click over image for better viewing)
Essentially out of a total population of 2,280,000, only 1,850,000 are citizens. Of the remainder the majority (some 280,000) are Russians. And these Russians are not recent arrivals, but they are a part of a historic Russophone population which build up inside Latvia during the period that the country formed part of the Soviet Union.
In fact, if we look at the chart below, we will see that during 2003 the rate of out migration from Latvia seems to have dropped substantially, and given what we know about the post 2004 out migration boom, this, on the surface, seems strange.
(please click over image for better viewing)
The answer to this puzzle is to do with the Russophone population who are not Latvian citizens (and therefore logically at this point not EU citizens either). The majority of the pre 2004 out-migration was actually towards the CIS, and it is reasonable to assume that many of these migrants came from the Russian speaking population. And this process is not over as this recent article from Itar-Tass about a joint project to settle Russian speaking Latvian residents in Kaliningrad makes clear.
So clearly the fact that the Latvian authorities may still be actively considering encouraging the resettlement of Russian speaking Latvian citizens elsewhere gives an indication of just how unprepared the collective mindset in Latvia is for all that is now about to come upon them.
Yet one more time the difference with Estonia couldn't be clearer. According to the Baltic Times this week, Estonian Economy Minister Juhan Parts is busy working on a set of proposals - which before Parliament by November - which will attempt to address Estonia’s growing shortage of skilled workers. The quota of foreign workers will be doubled to about 1,300 and the bureaucratic paperwork slashed . Now it is true that Parts is still to bite the bullet of accepting the need for unskilled workers too, but in the present situation a start is a start, and it is one that Latvia has yet to make.
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