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Sunday, September 29, 2013

As Good As It Gets In Latvia?

For Maurice Pialat, champion of the marginal centre.
"This raises a final question, which, while not central to the issues of this paper, is nevertheless intriguing: How can a country with a low minimum wage, weak unions, limited unemployment insurance and employment protection, have such a high natural rate [of unemployment]?"

"To summarize, the actual unemployment rate is still probably higher than, but close to the natural rate of unemployment. Latvia may well want to take measures to reduce its natural rate, but the recovery from the slump is largely complete."
Boom, Bust, Recovery Forensics of the Latvia Crisis, Olivier Blanchard, Mark Griffiths and Bertrand Gruss

With these words three IMF economists (hereafter BGG) effectively signed off on their study of "what just happened on Latvia" and, they hoped, drew to a close a debate which has been going on now for some 6 years. In fact, far from closing the debate, what they may have done is effectively extend it into new terrain, since these apparently harmlesss words - "the recovery from the slump is largely complete" - have far reaching implications, as does the methodology they use for reaching it. These implications reach well beyond Latvia, and even far beyond the Baltics and the CEE in general, despite the conclusion that everyone seems to be reaching that Latvia was just a "one off". Possibly without intending to do so, they have drawn onto the clinical investigation table issues which have been mounting  up in the theoretical lumber rooms of neoclassical growth theory for some time now, issues which begin to assume a paramount practical importance in the context of our rapidly ageing societies. What, for example, do we understand by the term "convergence" these days? And if "steady state" growth can no longer be understood as implying a constant growth rate (trend growth in developed economies is now systematically falling) should we be considering the possibility that headline GDP growth will at some point turn negative, even if GDP per capita may continue to rise, due to the fact that populations are steadily starting to shrink. And if the answer to the former question is "yes", then what are the implications of this for the financial system, for the system of saving and borrowing, and for the sustainability of legacy debt? Not little questions these, but ones which will need to find answers and responses in countries like Latvia over the next couple of decades.

And again, returning to a question I raise about Ukraine (here), while Latvia's recovery may be complete and thoroughgoing, what satisfaction can we really take  from our knowledge of this when - according to the country's President Andris Berzins - the end state leaves the very survival of the country as an independent entity ten years from now as an open question? The problem - the country's population is falling, along with its workforce, and young educated Latvian's continue to leave looking for a brighter future elsewhere, even if they now do so at a slower rate than they did during the height of the crisis.

This is the first time I have written anything on Latvia in some time. In 2007 and 2008 I argued for Latvian devaluation, but refrained from continuing to do so in 2009 since the will of the Latvian people was so obviously against taking this path. I think policy has to work in the real world and not in the one we - like visitors to Andrei Tarkovsky's "room" - might wish we were in. But more than the going back over the debate  about whether or not it would have been better to devalue - we will never know the answer to this one, although although the viewpoint still seems to me a more defensible view than many imagine - what I would like to stress here are the reasons which lead me to arrive at the conclusion is was a good option, along with the factors which influenced me in getting there. These are set out in my June 2007 monster post: Is The Latvian Economy Running Out Of People?. The post is a long one, extraordinarily so as I say there, even by my standards. But going back over it, and with more than six years of hindsight to benefit from, I can't help feeling there is not a great deal I would change or even add. As I say in the introduction to that post:
"It is generally recognised by most external observers that this malaise has its origins in structural problems in the Latvian labour market, and it will be argued here that these structural problems have their roots in recent characteristics of Latvian demography (namely high out-migration and a sustained low birth rate). As such there is no easy solution. Even in the longer run the position will inevitably be difficult, since demography almost inevitably casts a long shadow. This does not mean, however, that we should be complacent. There are steps which can be taken to address the issues which Latvia faces in the short term, and it is important that such appropriate measures are enacted. These measures clearly include policies to reduce the dramatic overheating which is taking place, but they also should include policies to loosen the labour supply, not only by encouraging increased labour market participation and mobility, but also by actively encourage inward migration. Such policies may be seen as short term measures which are vital to move Latvia away from an unsustainable and towards a sustainable economic path."

Measuring Trend Growth

The facts of the crisis in Latvia are by now more or less well know. As BGG outline it the story runs as follows:
"The basic and striking facts to be explained are given in Figure 1 (see chart reproduced above - EH): An increase in GDP of almost 90 percent from 2000:1 to 2007:4, followed by a decrease of 25% from 2007:4 to 2009:3, and a recovery, as of 2013:1, of 18 percent. A mirror image in terms of unemployment, with a decrease in the unemployment rate from 14% in 2000:1 to 6% in 2007:4, followed by an increase to more than 21% in 2010:1, and a decrease since then, down to 11.4% in 2013:2."
For anyone seeking more background BGG gives an excellent and informative summary. What went on in Latvia was not a fiscal overspending issue (which is not to say the administration should not have been running a higher surplus during the latter part of the boom), but an accelerated credit-driven consumer demand and (housing) investment boom financed by external borrowing. This boom massively structurally distorted the economy, in the process taking output to levels well above those which were sustainable in the longer run. As BGG point out, "the ratio of private consumption to GDP (in constant prices) increased from 62% to 72%, [and] the ratio of investment to GDP (also in constant prices) from 22% to 36%." Now you don't have to be a mathematical genius to spot that 72 and 36 add up to 108, ie consumption and investment total more than 100% of GDP. How can that be, you may ask. The answer to the apparent inconsistency is that the difference is made up by imports (or the trade deficit), ie the Latvians were consuming all their own GDP and part of someone else's, with the difference being made up by external borrowing. BGG put it more elegantly:
"As a matter of arithmetic, the result of increasing consumption and investment ratios was a steady deterioration of the current account balance, with the ratio of the current account deficit to GDP increasing from 5% of GDP in 2000 to peak at a very large 25% in mid-2007."

So it is clear the Latvian economy was running above capacity, but how much above capacity? This is really what the present debate is about, since depending on the answer you give to that question the estimated current trend growth level of the country will be either higher or lower, as will the non-inflationary unemployment rate. Using various vintages of output gap estimates taken from real time EU Commission economic forecasts (12% positive  in 2007 as estimated in  2013) the authors derive a series of cyclically adjusted fiscal balances which show how, at least from the current vantage point, the size of the output gap, and hence the degree of laxity in the fiscal stance, was systematically underestimated. In 2007, for example, the EU Commission only thought the positive  gap (ie degree of overheating) was some 3%. Well its always easier to see things more clearly with hindsight might be the common sense response. Would that things were so simple!

An Interlude Concerning Production Function Metaphysics

What is involved here is a really important and hard to resolve methodological (and even, god help us, epistemological) issue (especially in countries which pass thorough a deep and protracted economic slump) - what is the special privilege of the present as a valid vantage point, when compared with the virtual infinity which time will eventually offer us?

After all, in the "present" which was 2007 things did look very, very different. Perhaps our current evaluation of our own "present" is just as conditioned as earlier perceptions of earlier "presents" were. The problem is we are using our present appreciation of the way things are to reach conclusions about the past which may look very different in some other, future, present. Yes, you're right, there is an element of circularity in the kind of argument that is used by BGG. As the people in the trade put it, potential output is an unobservable latent variable, you know, a bit like the Higgs particle, something you can't see or measure, but which you have to assume to exist for everything else in your theory to make sense.

As one of the IMF authors, Bertrand Gruss, puts it in his paper on the topic, there are "many different methodologies" which can be used "each of them encompassing a different precise definition of potential output and entailing advantages and disadvantages". All of them have, however, one thing in common:  "potential output estimates are subject to substantial uncertainty." As he also notes, in the case of a country like Latvia, emerging from a substantial slump, the degree of uncertainty is especially large. So those who would use the arguments in BGG to argue something simplistic, be chastened, the room for error is large. But then "substantial uncertainty exists over the past and future" doesn't make for good headlines, and, perhaps more importantly, doesn't inspire confidence in the policymakers who admit this.

So does each historical moment have its own special "truth" as far as potential output goes? This point - present moment bias - is described by Paul Krugman like this: "These methods automatically interpret any sustained decline in actual output as a decline in potential, and they cause that re-estimate to propagate backward through time." This approach could be described as "present moment reductionism" in the sense that events in the past are viewed and evaluated from the standpoint of the present, in a way which makes them explicable and comprehensible only in terms of the present they give rise to. The German philosopher Liebniz once put it this way,  we live in "the best of all possible worlds", if not in the best of all imaginable ones (back to Tarkovsky's room).

Basically, it is difficult to avoid the bad performance generated during the slump  "contaminating" the data. What we really need is information on Latvia's future performance, then we could situate the present. We need a time series from the future, then we could see much more clearly what is happening now. Unfortunately for us we can't have access to one. The "set up" (or world) we live in has this characteristic.On some views this is precisely what makes it interesting.

At the same time recognising this reality doesn't make the problem simply go away. As macroeconomists we are constantly forced to make what come near to being ad hoc judgements, and we need to do so time and time again, as we go forward and on the fly. As the Spanish poet Antonio Machado put it, "el camino se hace andando" - we make the path we walk along as we walk. The difficulty is that we are in a bit of a "garden of forking paths" here, since the decisions taken in 2008 and 2009 are the reason we have reached reach the endpoint we are at now, and it is this (momentary) endpoint which conditions our judgement about the initial conditions we set out from. And this is the case even though, had we taken another path  at the outset we would surely have arrived at another "now" from whence the starting point would have been seen differently.

That master of neo-classical growth theory Robert Solow put it thus in his Nobel acceptance speech:  
Growth theory was invented to provide a systematic way to talk about and to compare equilibrium paths for the economy. In that task it succeeded reasonably well. In doing so, however, it failed to come to grips adequately with an equally important and interesting problem: the right way to deal with deviations from equilibrium growth........if one looks at substantial more-than-quarterly departures from equilibrium growth........... it is impossible to believe that the equilibrium growth path itself is unaffected by the short- to medium-run experience.......So a simultaneous analysis of trend and fluctuations really does involve an integration of long-run and short-run, or equilibrium and disequilibrium. 
As he says, it is impossible to believe that the longer term path of the economy is unaffected by the trajectory taken during the deviations from trend - whether upwards or downwards.

(Incidentally, I used the comparison with Liebniz above because it seemed appropriate, because it seemed to me that Liebniz's "rationalisation of the real" was exactly what is going on here. This attitude was famously satirised by Voltaire in his Candide. Curiously when I went back to the Solow speech to dig the above extract out what else did I find - a reference to Candide. Happy to be in good company).

Now in fairness our IMF authors are well aware of this issue, although I'm sure they'd like to put it all very differently. Indeed, while they cite the EU Commission output gap estimates, they also carry out their own calculations (at least one of them Bertrand Gruss (as mentioned above) does, with the results being published in the 2013 edition of IMF Latvia selected issues). As his says in his commentary on the study findings:
"Many different methodologies have been used to estimate potential output, each of them encompassing a different precise definition of potential output and entailing advantages and disadvantages. No specific approach can be taken to be “the” correct one and potential output estimates are subject to substantial uncertainty. This uncertainty is probably even larger for countries like Latvia, a transition economy still going through substantial structural changes and coming out of a severe crisis that has likely rendered obsolete a significant part of the economy’s productive capacity."

For technical reasons which we don't need to go into here, BGG decide to use a production function methodology broadly similar to the one in the diagram above (click on image for better viewing), which is in fact the one they use over at the European Commission (Roeger, 2006) where they got the 12% 2007 output gap result.  In fact the IMF variant isn't identical. Their result (at least as of last January when the study was reported):  "Output was probably about 5–10 percent above potential before the crisis, although the extent of overheating at the pre-crisis boom is particularly uncertain."

[For the wonks, the benchmark PF model they used suggested the output gap peaked at around 5 percent of potential output before the crisis - well below the 12% level suggested by the EU Commission. Then, since they were worried about possible cyclical contamination of the TFP input, they used an alternative potential TFP series (cleaned up by applying an HP filter) and this gave them a gap estimate of about 9.5% much nearer to the EU Commission figure, which ain't that surprising since it is Roeger's preferred technique (see right hand path in diagram).]

Just to give us a feel for the kind of range of certainty involved here, Bertrand Gruss concludes his results by stating the following, "While acknowledging the uncertainty of estimates, staff believes output was significantly above potential before the crisis, but probably in the 5–10 percent range rather than in the 15–20 percent range".

More important than the actual result in my opinion is how they achieved it. A quick inspection of the left hand path in the diagram will reveal that a very significant part of the calculation revolves around labour inputs which ultimately depend on demographic dynamics. Indeed Gruss justified his preference for the production function approach precisely for this reason: "The emphasis on a production function approach reflects both staff view that it represents an adequate framework for Latvia (where, for instance, population dynamics and structural unemployment play an important role in potential labor and potential output estimates)....".

Put simply the only real positive impetus to trend growth we can expect in the future from Latvia will be on the TFP side, since the labour input component will turn negative at some point (if it hasn't already done so). Bertrand Gruss in fact puts it quite bluntly: "Labor is not expected to contribute to potential growth in the coming years."

Demographic Destiny?

Now, quite coincidentally, the IMF is finally getting round to thinking about the demographic side of the European periphery problem (not sure why it took them so long since they've been using the kind of production function methodology described above  for years). Well, at least in the Latvian context it is. I say "finally" because for whatever reason there seems to be some sort of resistance among fund economists to thinking about demographic issues (including migration flows) as part of the core macro picture, yet as can easily be seen above it really is, and Robert Solow wouldn't doubt it for a moment.

Anyway, their current thoughts on the Latvian demographic outlook can be found in the form of an appendix to their 2012 Latvia Article IV consultation report. Coincidentally this report was published at the same time as the second part of their program monitoring reflections, ie the signal being given would seen to be that while demography is important, it is an "issue pending" which can be safely passed over to the post program environment. This is in complete contrast with the methodology being advocated here which is that the program should in part have been designed with this central issue in mind. I have been advocating this since 2007 and I will continue to do so.

Be that as it may, as they inform us in their appendix, Latvia’s population is shrinking rapidly.  

During 2000–11, the population declined by about 14 percent (340 thousand people). Emigration was responsible for about two thirds of this decline while natural change due to low fertility accounted for the remainder: 

Emigration: an estimated 200–215 thousand people, mainly young people—roughly 9 percent of the population—have left Latvia during 2000-11 (Hazans, 20111; and Central Statistics Bureau); and 

Low fertility: the decline of the population for natural reasons was about 125–140 thousand people (5 percent of the population). The number of births has halved since the early 1990s—from around 40,000 annual births to around 20,000—falling below replacement levels.

In fact saying that fertility has fallen below replacement levels is putting it mildly, since the Latvian fertility rate is currently around 1.3 (one of the lowest in the EU) and has been effectively below replacement since the country came into existence. The number of births has been falling more rapidly since the onset of the crisis due in part to the harsh economic conditions but also aided and abetted by the fact that the majority of the women emigrating are of childbearing age.

So Latvia is facing a massive challenge. A combination of low fertility and emigration mean that the population is shrinking rapidly and at the same time ageing. The proportion of over 65s is set to surge between now and 2030 as it is all over Europe. Naturally with the hole in the pyramid left by the "missing births" and the working-age-population migration-loss the country is bound to be an example of one of the worst case scenarios, far worse than Japan, since Japan has only been resisting immigration, it has not lost population through emigration. Fortunately, the country has a possible solution - it belongs to the EU, is about to join the Euro, and the possibility exists that the Euro Area will become a transfer union over the next decade. At least that's the theory, I don't doubt the reality could well be different. But really the creation of this transfer union is Latvia's only hope now, and obviously it would be a substantial net beneficiary, since otherwise it is hard to see how the country will be able to offer its elderly population modern minimum standard welfare services like health and non-poverty-inducing pensions.  

Emigration and the IMF Program

Actually BGG do try and address some of these issues. They do so since, as they say, "an important part of the adjustment has taken the form of emigration". As they also point out Latvian emigration long predates the crisis. The average net emigration rate was 0.5% from 2000-2007. It increased to an average 1.3% from 2008 to 2011, but by 2012, was roughly back to its pre-crisis average. So emigration isn't a product of the crisis, it was simply made worse by it, but still, and going back to Solow  ( it is impossible to believe that the equilibrium growth path itself is unaffected by the short- to medium-run experience.) how far was Latvia's longer term future being put at risk by the form in which the adjustment occurred.

[Just as a side issue it is worth noting that exactly the same question arises in the context of the Greek adjustment. Had the IMF forced the EU to accept debt restructuring and an EFF rather than the initial SBA, the pace of the fiscal adjustment could have been slower, and the loss in output lower. Mein Gott, we might not now be talking about a current estimate of a Greek output gap of plus 10% in 2007 (if you follow the logic of the argument advanced earlier). See my "Second Battle of Thermopylae" post].

In fact BGG do attempt to address this issue:
"The question however is whether this emigration is, in some sense, a failure of the adjustment program. In the United States, migration rather than unemployment is the major margin of adjustment to state specific shocks ..... These adjustments are typically seen as good, indeed as the main reason why the United States functions well as a common currency area: If there are jobs in other states, and if moving costs are low, it is better for workers to move to those jobs than to remain unemployed."
This is an argument that it commonly advanced in the context of Euro Area issues (let's leave aside for the moment the fact that Latvia wasn't in the Euro) - in an optimal common currency area this sort of labour mobility is a good thing. In addition let's leave aside the question that Europe isn't the United States, that it is a continent made up of nations, and that these nations form part of our identity as Europeans in a way which is hard to quantify economically and in a way which can't simply be wished away by waving a magic wand (or paying another visit to Tarkovsky's room), the fact of the matter is that the Euro Area isn't an optimal common currency one. At least institutionally it isn't. To become one of those it would need to have a common treasury and a common unemployment benefit and pension system, etc.

Unfortunately, this is an issue which BGG, like so many before them, simply slide silently past - "the largely permanent departure of the younger and more educated workers may indeed be costly for those who stay" -  like a ship in the night looking for open water while at the same time carefully evading the enemy  minefield.
"Is the answer [to the above question:EH] different for a small country than for a US state? Some economic aspects are different: Some of the costs of running a country are fixed costs, and thus may not be easy to support with a smaller population. In the United States, many of those costs are picked up by the Federal government (although, as we have seen for Detroit, the remaining fixed costs per capita may become too large for a state or a city to function). This is not the case for a country, which must for example finance its defense budget alone."
The reference to Detroit is of course salutory (this is exactly the problem), although it is curious that the example they take for the fixed costs of having a separate state is defence, an area where Latvia obviously benefits from the existence of external institutions like NATO and the EU. Again, the extent would be hard to calculate, but one of the factors which must have influenced Latvian's in their decision not to offend their EU partners by devaluing the Lat must have been a consideration of just this issue.

Still, the question remains, from a demographic point of view could things have been done differently? It's very hard to give a conclusive answer. My argument in favor of devaluation was always based on the potential demographic dynamics  which it might induce. Obviously there would have been a large drop in output, but Latvia had one of those in any event. Would less people have migrated out? That is very doubtful, and indeed, as BGG point out, people were emigrating even at the height of the boom. But then again, would the post crisis potential growth rate have been higher? Would the country still have had to face a non inflationary unemployment rate of 10%, or would the additional international competitiveness achieved have meant it was much lower? Would immigrants be arriving to do some of the lower skilled work?

The thing about this last point is, more than just ending the emigration what Latvia really needs (like Japan, like South Korea) is immigration to shore up the population pyramid, to make the welfare system sustainable in the longer run, especially since although the country's future currently depends on the creation of an EU transfer union there is no guarantee there is actually going to be one.

It is unlikely that the emigration hemorrhage would have been avoided even with devaluation - large numbers of Argentinians, for example, arrived irregularly in Spain in 2002 and 2003 and the two countries weren't in any kind of bilateral Schengen arrangement. But would the natural rate of unemployment have been different following the adjustment? We will now never know.

However,  an argument from two of my Economonitor colleagues - Andris Strazds and Thomas Grennes - should give us some food for thought. According to these authors, when it comes to emigration dynamics "Unemployment Matters Much Less Than Relative Income Levels". Now despite the fact that one might have some reservations about the actual methodology they use (they seem, for example, to confound the migration component in population dynamics and the birthrate one where in fact these are quite distinct channels) they are certainly digging in the right area, as the following chart which comes from a pre crisis IMF report makes clear.

The problem, of course, isn't only relevant to Latvia. Despite the fact that Spain's unemployment rate is currently around 27% immigrants continue to arrive in the country (often risking their lives to do so), a fact which puzzled the Financial Times demography correspondent Norma Cohen when we spoke about this article. "Why on earth," she asked me "would people want to come to Spain with such a high rate of unemployment?" Because salaries are better than in their home countries would be the simple answer, and because they are willing to do work which many Spaniards are reluctant to do, at least at the salaries which are on offer. So economic migrants continue to arrive, an estimated 300,000 of them last year, even though the net migrant flow reversed since more left (both native Spaniards and immigrants) with Spain's population falling for the first time in modern history as a result.

The idea of "centre and periphery" seems like a useful analogy here, since more than simple emigration or immigration what we seem to have is a steady displacement of population with migrants of lower skill entering one side of a country while higher skilled natives exit across the other. In this sense one can truly speak about "population flows". Naturally the net human capital loss involved  is substantial. Italy had some three million immigrants during the first decade of this century, but the overall annual rate of growth was not much above zero.

Beyond implementing the maximalist programme of a completely federal Europe with population moving in one direction and transfers moving in the other  it is hard to see what the solution is here.


"Do these lessons extend beyond Latvia? The evidence from adjustment in Euro periphery countries suggests great caution." - BGG

"I’m not sure I believe this [BGG] story but if you do, what lessons does Latvia hold for other countries, and the euro in general? And the answer, in brief, is none. Latvia’s story as I’ve just told it looks nothing like anything we’ve seen in the past, and probably not like anything we’re likely to see in the future – including, by the way, Latvia’s future." Paul Krugman, Latvian Adventures

The general consensus seems to be that Latvia is an interesting case study, but one where the lessons learned have little application beyond the country's frontiers. I'm not sure I buy this. Let's start at the beginning.

We all know what happened in Latvia - the country's economy massively overheated - but are we so sure why it happened? The answer isn't as obvious as it seems. The quick synthesis explanation offered by BGG runs as follows:
In short, the anticipation of a large scope for catch up growth, together with cheap external financing, led to an initially healthy boom. As time passed, the boom turned unhealthy, with overheating leading to appreciation and large current account deficits, with lower credit quality, and with balance sheet risks associated with FX borrowing.
Yep, but why was there so much external financing available, and why did it continue even after it was obvious to all bar the Latvian government that the accumulating imbalances were putting the country at risk of disaster? Paul Krugman puts my question in a little more elegant fashion:
 First of all, on a conceptual level, how does an economy get to operate far above capacity? We understand operating below capacity: producers may fail to produce as much as they want to if there isn’t enough demand for their products. But how does excess demand induce producers to produce more than they want to?
I think part of the answer here is that we all generally thought that in an epoch of large scale globalisation with extensive migrant and fund flows "open" really did mean open, in the sense that to erect a well functioning economy all you needed was a large strip of land (of which Latvia has plenty), cheap tax rates and flexible labour laws, then the entrepreneurs, the capital and the labour would all flow in. The problem in Latvia's case was they didn't. The capital was there, so were the entrepreneurs, but one of the other factors was in short supply, and indeed instead of flowing in it was flowing out. Then bang!

That's over-simplifying a bit, but it is the bare bones of the situation, a situation which surely has lessons to be learnt for other CEE countries (or far flung places with similar underlying demographics like Vietnam). In particular the word "Ukraine" comes into my head.

But beyond this, why was all that capital flooding in to finance something which to the careful eye was evidently not working? My reply would be, and taking us back to the literature of the time, the operation of the Global Financial Accelerator, a term coined by the Danish economist Carsten Valgreen to describe what was happening in Ireland and Latvia before the crisis actually hit. Essentially, in an environment of ample global liquidity being generated by central banks in countries which don't have the capacity to absorb all the liquidity phenomena like Latvia and Iceland simply happen, as we have been seeing in recent months as the Fed tapering debate lead to a sudden stop in one Emerging Market after another. Fortunately on this occasion the liquidity was being withdrawn before the kind of massive imbalances we saw in both Latvia and Iceland had time to occur. I for one, at least, think it's worth considering what happened in Latvia, and what can be learned, in the context of the current EM debate.

Another issue worthy of note, as I say in the introduction to this post, concerns the issue of convergence. Historically it has been assumed that per capita incomes in countries forming part of the EU would tend to grow at faster rates than those in richer economies with the result that all member state economies should eventually converge to some common living standards band in terms of per capita income. This now seems unlikely to happen, especially given the demographic and growth outlook on the periphery, Latvia included. The economy is growing well right now, but as we can see it is labouring under severe structural problems (the unemployment rate) and the demographic outlook suggests that growth will now steadily weaken. What we have is as good as it gets.

Ironically GDP per capita has been performing well in relative terms since the bust, and in ways the textbooks never envisaged - through a drop in the population numbers. Despite the fact that output is still well below the pre crisis level, as BGG note, Eurostat estimates PPP GDP per capita to now be at 9% above its 2008 peak.

Finally there is the point about how the adjustment took place. As BGG explain, the majority of the internal devaluation took place not through wage and price reductions, but through productivity - the mysterious factor X. But is it that mysterious? What happened was that there was massive labour shedding, as unemployment shot up to 22%. Then, as growth resumed, employment didn't follow (mirroring a pattern which arguably we are seeing in a milder form elsewhere, in other countries which are recovering from sharp housing busts). So while output recovered employment didn't which simple arithmetic tells you results in a strong productivity boost. As BGG explain, there was a strong underlying improvement in TFP taking place due to the "catch up" effect, and this undoubtedly helped Latvia in ways we don't yet fully understand. More study would be useful, since again I do think there are things to be learnt.

As a last word I would say that if you are reading these lines you have probably struggled your way all through this inexcusable indulgence in  verbiage. In which case thank you. You may also have noticed I haven't referred to the issue of fiscal austerity once. Not even a teensy weensy bit. There is a simple explanation for this, the Latvia debate was all about whether or not to devalue, it never was a for or against austerity one. As Paul Krugman puts it: "if we were really looking at an economy with a double-digit inflationary output gap, even the most ultra-Keynesian Keynesian would call for fiscal austerity". For reasons I have outlined above, I don't fully grant the whole inflationary output gap estimate, but still I think the point holds, this was never about for or against fiscal austerity, since among other reasons it was never about public sector debt.


The paper published by Blanchard, Griffiths and Gruss relies heavily on the work of the Latvian demographer Mihail Hazans whose groundbreaking studies effectively forced the Latvian authorities to amend their population and migration estimates. I had the pleasure of meeting Mihail when I shared a platform with him in a colloquium organised in 2012 by the American Chamber of Commerce in Riga. The title of the gathering was, not surprisingly, Latvia's Demographic Future (you can find my presentation here).

Basically every country on the EU periphery needs its Mihail Hazans, since we have no accurate or systematic system for measuring these important migrant flows.

In response to what I perceive to be a major lack of knowledge and information I have established a dedicated Facebook page in a vain attempt to campaign for the EU to take the issue of  emigration from countries on Europe's periphery more seriously, in particular by trying to insist member states measure the problem more adequately and having Eurostat incorporate population migrations as an indicator in the Macroeconomic Imbalance Procedure Scoreboard in just the same way current account balances are.

If we don't have the necessary information then how can we hope to formulate the adequate policy responses. If you are willing to agree with me that this is a significant problem that needs to be given more importance then please take the time to click "like" on the page. I realize it is a tiny initiative in the face of what could become a huge problem, but sometimes great things from little seeds to grow.

Monday, May 23, 2011

BELLS In Hell That Don't Go Ting a Ling a Ling

After the BRICS, came the PIGS. Now a new acronym is being born, that of the BELLS. These particular "ding-dongs", however, are not a set of hollow cast-metal instruments suspended from the vertex and rung by the strokes of a clapper, they are countries, countries which may, like those unfortunate WWI British soldiers whose love of their country and sense of duty lured them into one of the most senseless conflicts of modern European history, be headed towards their own pretty unique form of modern purgatory.

The BELLS are a group of four countries (Bulgaria, Estonia, Latvia and Lithuania) who in their wisdom decided to adopt and then stick "come hell or high water" to a currency peg with to Euro. Thus was opened one of the more interesting and lively chapters in modern macroeconomic debate.

Now talk of some sort of ultimate inferno here may strike a pretty discordant note with many readers, since most of the economic chatter of recent days has centred on how the BELLS constitute a positive example, not to mention a most attractive alternative to all those dreadful sounding PIGS. According to GaveKal's François-Xavier Chauchat, for example, the BELLS should be seen as a ray of "Hope For EMU Peripherals", since just like the PIGS the BELLS have also had their own debt crisis, one which was so severe at the time that it put into question the very sustainability of their fixed exchange rate regimes. However, in these most fortunate of cases, the bad times are now well and truly behind us since a happy combination of IMF programmes and fiscal consolidation (coupled in Estonia's case with subsequent admission into the Euro group) eventually led them out of crisis, and without the need for any sort of sordid devaluation to boot. And then, as they say in Spanish "fueron felices y comieron perdices" (or to put it the English way, "they all lived happily ever after"). Or did they?

Well, on Chauchat's view, the BELL crisis was always more of a liquidity than a solvency one (see chart below) – and this despite the fact, which he notes, that Latvia was very often argued to be a modern equivalent of the Argentina of the late 1990s (an assertion which, he says, has ultimately proved to be wrong, although in fact on this particular solvency vs liquidity argument, the true test will be the ability of Latvia to pay back the 7.5 billion euro EU/IMF bailout loan, in full and on time, and especially the very onerous 2014/15 installments). From a macroeconomic perspective, however, the big issue was always one of just how the hell these countries were going to dig themselves out of the hole they had dug themselves into, and do so at the same time as staying on the peg.

A Profession That Is Losing Its Grip On Reality?

The view that the BELLS have somehow proved the monstrous regiment of professional macroeconomists totally wrong is now quite widespread (for a balanced and more nuanced version of the argument see this post by my fellow RGE Economonitor blogger Ed Dolan) , and indeed such sentiment may well form part of a much more general dispute between micro- and macroeconomists about how to find solutions to the present crisis. Only last week the Latvian Prime Minister Valdis Dombrovskis presented a book in Riga which he has co-authored with Anders Åslund of the Peterson Institute which has the rather assertive title: How Latvia Came through the Financial Crisis. The associated press release proudly states that a key lesson to be learnt from the resolution of Latvia’s financial crisis is that "devaluation is neither the panacea nor the necessity that many economists make it out to be".

Not content with this statement our authors go even further, striking what some might consider to be a rather too "close up and personal" tone:
"Finally, the international macroeconomic discussion was not useful but even harmful. Whenever a crisis erupts anywhere in the world, a choir of famous international economists proclaim that it is “exactly” like some other recent crisis—the worse the crisis, the more popular the parallel. Soon, prominent economists led by New York Times columnist Paul Krugman claimed that “Latvia is the new Argentina.” A fundamental problem is their reliance on a brief list of “stylized facts,” never bothering to find out the facts".

As a macroeconomist who has been deeply involved in the Latvian debate I have to say that if such statements weren't so foolish (and ill-befitting of the Prime Minister of any country) I would want to protest that they were extraordinarily condescending and even verging on being insulting. As someone who has spent hours and hours during this crisis perusing excel sheets and making charts trying to fathom what is going on in the BELLS (and in particular in Latvia) I have to say I certainly don't recognise myself in this paragraph, and if anyone could be bothered to take a look at that infamous Krugman piece they would find he was basing his argument not on some obscure set of stylised facts, but on my detailed analysis of the problem (right or wrong, but here it is - why the imf's decision to agree a Latvian bailout programme without devaluation is a mistake).

The funny thing is that, far from having learnt from the error of my ways, I still consider the original IMF decision to have been a mistake, although I would point out that I personally never suggested Latvia was like Argentina (another thing is to say that much of what is going on along Europe's periphery of late carries with it a distinct sense of Argentina deja vu), since I actually think that Argentina is an example of what not to do and that if you are looking for historical precedent for what should be going on in Latvia (read the BELLS) Turkey would be a much better role model. I also think that one of the conclusions we will eventually be able to draw from this whole sorry affair is that those who specialism is not macroeconomics would do better dedicating more of their precious time to trying to understand what we are saying rather than engaging in ill-informed ideological polemic. And I say this since I believe that the Latvians themselves deserve better. They may well not be able to avoid serving as guinea pigs, enabling macro- and microeconomists to see just who is right, but they surely don't merit being converted into yet another ideological football. Didn't we have enough of that during the Soviet years!

On the other hand, and before getting into the actual analysis, I want to stress that I personally am not advocating devaluation of the Lat at this point in time. Even though I still consider it a mistake not to have devalued, and an even bigger mistake on the part of the EU leadership not to have accepted the IMF proposal for immediate devaluation and Euro entry, I accept that the decision not to devalue represented the democratic will of the Latvian people (following the advice of the IMF given the EU response), and it was for precisely this reason that I declined to go to Latvian in August 2009 and speak at a meeting organised by the then governing People's Party, since I think I was only being asked to go there to cause trouble.

The difficult thing here is not to cause trouble (which is easy) but to find realistic solutions, which is why we need free and open debate.

Did Latvia's Internal Devaluation Cut Hard Enough And Deep Enough?

The point, I think, is this: if Latvia is not going to recover the competitiveness all agree it lost through a normal devaluation process (for whatever reason) then it needs to do so via the procedure which has become known as "internal devaluation" (a procedure which in an earlier era was known by the name of "wage and price deflation"), and indeed this is what the Latvians have attempted to do.

So the question now is has this worked? Or put another way, has the internal devaluation gone far enough and deep enough? The conventional wisdom has it that it has, but I, for one, am not convinced, and looking at the latest round of Latvian data serious questions arise as to whether the recovery is strong enough or sustainable in the longer term.

Growth started to return to these economies in the second half of 2010, but with capital inflows now well below pre-crisis levels they have now entered a lengthy and difficult adjustment process. With domestic demand well below earlier highs and still struggling, exports have now become the prime mover of economic growth. Since the recovery in external demand has produced a rapid return to earlier export peaks the impression of a return to earlier economic dynamism has been created. I think this interpretation of the recent strong export growth is misleading, since it is one thing to recover lost ground, and quite another to attract the FDI needed to seriously expand capacity and keep increasing exports beyond their pre crisis peak. Strong year-on-year increases in exports have moved headline GDP numbers forward, but as 2011 continues annual export growth rates will drop substantially, and may even get stuck at a snail’s pace, meaning that the respective economies will be struggling to find growth, create jobs, and maintain the servicing of their external debt.

The most worrying piece of evidence I have found is the failure of capital investment to rebound alongside exports. In part this is understandable, since a lot of the earlier capital investment was in property, but this offers only part of the explanation, since for these economies to really take off as export driven strong new investment growth in plant and equipment will be needed. In order for these economies to attract investment in sufficient volume they will need to recover a large part of the competitiveness lost between 2005 and 2008, when wage growth far outpaced productivity gains. However, given the difficulties faced in lowering the exchange rate, they can only realistically try to recover lost ground through sustained productivity improvements, a lengthy and slow process, and in the meantime the debt and population ageing problems keep ticking away

In my opinion, and despite some early encouraging signs, it is far from self-evident that the so called “BELLS” (Bulgaria, Estonia, Latvia and Lithuania) are going to be able to export their way out of trouble in the way they need to (given the collapse of internal demand) with the current relative price structure. It is my considered opinion that the “internal devaluation” process may have been underambitious and allowed to come to a halt far too soon. And indeed, if we get to the point, this is why so much of the conventional macroeconomic wisdom and advice leans towards open devaluation, simply because it is hard to maintain the political consensus for long enough to carry out a deep and painful deflation adjustment, and indeed this is the lesson drawn from the 1930s that I was brought up on.

Export Dependency and An Ageing Workforce

In addition two major unresolved issues may leave a legacy, one which could weigh down any recovery and lead to more serious problems when the next recession eventually arrives. Many observers seem to forget that it is one thing navigating a leaky ship when you have the wind behind you, and quite another one going face-forward into a tempest.

In particular there are two things which preoccupy me about the present situation:

a) The existence of a substantial debt overhang the credit crunch which exists as a result
b) The demographic challenges the country faces, and in particular the impact of a rapidly ageing and declining population.

But before getting into this, let's take a serious look at the current state of play in the Latvian game.

Worrying Signs In Latvia

The first thing I notice when I start to go through the Latvian data is that despite a substantial improvement in exports:

GDP growth is currently slowing.

Latvian GDP expanded by a quarterly 1.5% in Q3 2010, by 0.9% in Q4 and by 0.2% in Q1 2011. Thus Latvian GDP has been steadily slowing, and this despite the fact that the export environment in the first three months of this year was exceptionally positive, and Latvian exports were booming. Latvian GDP fell by around 25% during the crisis, and has subsequently rebounded by 5% (over 5 quarters). We are far from a "V" shaped recovery, and pardon me if I mention it, but it is precisely the sort of thing most macroeconomists were imagining would happen.

Essentially the problem is that consumer demand has failed to recover, and if my analysis (about ageing and the debt overhang) is right then it will continue to fail to recover (all of this, incidentally, is what I argued would happen after the crisis broke out).

Industrial output languishes (partly because the non-tradeable sector is contracting as fast as the tradeable one is expanding).

While capital investment fails to recover:

Obviously a large part of the investment slump is due to the decline in consumption activity, but there is little sign of a serious pick-up in ex-construction investment, and anyway, outside of construction there was comparatively little investment going on in the period before the bust, and very little FDI.

So Where Is The Problem?

Basically the Latvian economy faces three main problems

i) a debt overhang
ii) a declining and ageing population
iii) a high level of unemployment, low rate of job creation, and a substantial wage differential with Western Europe which encourages young people to emigrate and drift west.

The first two problems put a serious brake on economic growth, and it is this that exacerbates the third problem, which then in its turn feeds back and aggravates the first two.

Cheap interest rates, supported by the peg and the prospect of Euro membership meant that Latvian households and corporates were able to get themselves heavily into debt. And debt in Euros (which is why the devaluation difficulty exists) - over 85% of Latvian mortgages are Euro denominated.

Now the Latvian economy is experiencing a sharp credit crunch, private sector credit which was increasing in 2007 at a rate of around 65% is now falling at a rate of 9% per annum.

Has The "Internal Devaluation" Been Called To A Halt Too Soon?

Claims that Latvia's internal devaluation has been deep and effective are widespread.The following claim from Commerzbank's Barbara Nestor is typical:
"The competitiveness adjustment has been substantial; labour costs fell 25% from the peak. The gap that opened up between productivity growth and labour costs in the boom years has already been closed. Exports responded sharply. Resources have not been switched among sectors, but production has been redirected from domestic use to exports".

The IMF itself is also pretty congratulatory. In this months press release announcing completition of the fourth review of the standby arrangement they state:
"Strong policy actions under the SBA have helped restore confidence, contributed to economic recovery, and enabled significant progress toward Latvia’s goal of euro adoption. The government has continued to achieve substantial fiscal savings while also protecting the poorest through social safety net spending and a temporary public works jobs program, and is strengthening its active labor market policy efforts. Looking ahead, the government has committed to meet the Maastricht criteria for euro adoption and strengthen the financial sector, which should further enhance confidence and support a rebound in growth".

Or again in the joint IMF/EC Statement on Latvia on the Review Mission:
The Latvian economy is now showing clear signs of recovery, with economic growth of 3.3 percent expected this year, reflecting the Latvian authorities’ continued implementation of their economic program. Their policy agenda for 2011 sets the stage for meeting the conditions for euro adoption in January 2014, and for sustaining the economic recovery

But is the Latvian economy showing clear and unequivocal signs of recovery? This is exactly the question I am asking here. Part of the issue is whether the competitiveness correction has so far been deep enough to ensure a higher level of competitiveness in the non-tradeable sectorer and a shift of resources from non-tradeable to tradeable. Certainly when the IMF programme was being contemplated, the extent of the correction needed and the difficult challenge which implementing it would involve was not doubted by anyone. Here's what the IMF had to say at the time of the staff report on the standby facility request (IMF emphasis):
In addition to maintaining the existing fixed (narrow-band) exchange rate, staff considered a number of alternative exchange rate options. These included, inter alia: (i) widening the current exchange rate bands to the full 15 percent range permitted under ERM2; and (ii) accelerated euro adoption at a depreciated exchange rate.

The main advantage of widening the bands is that it should eventually deliver a faster economic recovery. Although growth would be depressed in the short run by balance sheet effects, the economy might then bounce back more sharply, and a Vshaped recovery would likely start in 2010. This reflects a faster improvement in competitiveness since high pass-through (reflecting Latvia’s openness to trade and liberalized movement of labor within the European Union) would be dampened by the negative output gap. Enhanced competitiveness would also reduce the current account deficit more quickly. This would come mainly from import compression, with a relatively slow response of Latvia’s underdeveloped export sector, especially as the external environment is not as supportive as in previous devaluation-induced recoveries as Argentina, Russia or East Asia.

So at the time a 15% exchange rate adjustment was being contemplated. Did we get that? Well I personally don't think so. If we look at the CPI, the drop (from peak to trough) is only something like 3%.

In fact the producer price index fell a little further, maybe by about 12%.

But as can be seen, in both the CPI and the PPI case, since these indexes bottomed prices are now rising again. And indeed they are rising faster than is the case in those countries with which the Latvian currency is pegged (the Eurozone 17).

So in fact, and especially if we take as a point of reference the start of 2007, we can see that the actual price correction has been comparatively small, and indeed the position is once more deteriorating, even though output in the Latvian economy is over 20% below its pre-crisis peak. Is that really such a flexible situation?

A similar pattern emerges if we look at wage costs and productivity.

As we can see, despite having a relatively high standard of living Germany has managed to maintain unit labour costs relatively stationary over the last decade, due to rising productivity. Latvia evidently has not. This has nothing to do with being rich or poor, as can be seen from the years 2000 to 2004 Latvian living standards were rising, but they were rising in line with productivity, which is of course perfectly sustainable, and basically the pattern you want to see. Then from 2005 onwards the link was broken, and Latvian wages exploded in a way which was totally unsustainable. During 2008 and 2009 unit labour costs started to improve (in part because a lot of very unproductive workers in construction lost their jobs, the pattern in Spain is similar) but from the start of 2010 onwards the process has been in reverse gear again, and once more it is interesting to note that German labour costs (even though the economy is booming) are not following suit.

A lot of ink has been spilt writing about the large drop in wages in the public sector (possibly over 20%) but unfortunately public sector workers normally don't export, and if we come to look at private sector wages, and especially hourly wage rates, then we again find that the correction has not exactly been massive, and of course, inter-annual wage rates are once more starting to rise.

The rough and ready measure most macroeconomists like to use when it comes to competitiveness changes if the Real Effective Exchange Rate, and as we can see from the chart below, the loss of competitiveness (when compared in this case with Finland) since 2005 has been substantial. But then when we use REERs most people who really aren't that convinced that exchange rates matter tend to be not very impressed.

So let's try and put the argument another way. The real proof of the pudding is in the eating, and the real test of Latvian competitiveness is whether, now that it is totally export dependent, the Latvian economy will be able to produce sufficient economic growth and employment such that the weight of the debt can be steadily burnt down. And let us remember here the currency pegger's (or euro member's) catch 22: growth in nominal GDP is what matters when it comes to reducing debt, and nominal GDP is composed of real growth and inflation, so in a way inflation could be beneficial, but any inflation you have which is over the level of your countries of reference (the Euro Area 17) will lose you competitiveness in a way which reduces real growth, so you are up against a limit on both sides (deflation, which makes you more competitive, only compounds the debt problem) and possible the most appropriate characterisation of the situation would be "trapped".

The real problem now is that the credit-bust economies are totally export dependent for growth. What does this mean. Well let's take this simple and rough-and-ready expression:

GDP = Domestic Consumption + Investment + Government Spending + Net Trade

(Growth in Net Trade = Growth In Exports – Growth in Imports)

Which means growth in GDP = Growth in the sum of the above factors. Now we know that domestic consumption is in decline, and that investment in plant and equipment will only return in statistically interesting volumes to meet the needs of export growth. We also know that government spending is being reduced (that is what the IMF programme is centered on), so all we are left with for a real growth driver is exports.

But when we come to look at the SIZE of the Latvian export sector, we will see it is way to small for the job. The chart below comes from national accounts published by the Latvian statistics office, it shows GDP and value added in manufacturing industry. I think it is obvious that the proportion here is horribly small (only slightly over 10%), since even though Baltic economies generally are fairly open, many of the exports are in fact imports that have been reprocessed so actual proportion of their value produced in the country is not large. Germany by comparison (which is a modern economy, with reasonable living standards) has over 40% of GDP originating in value added in manufacturing. Yet this tiny part of the Latvian economy is now about to do the heavy lifting? It just doesn't make sense. Nor does it make sense that the IMF focus so much attention on reducing the fiscal deficit and virtually none on this issue, yet it is on resolving this issue that Latvia's economic future belongs.

There is another piece of evidence that Latvia's internal devaluation has eased up far to soon, and this comes from the current account. A great deal of praise was lauded on Latvia for the rapidity with which the current account went into surplus. In part this was the "ouch" effect, as financing dried up, people lost their jobs, and imports fell sharply. Exports, as we have seen, also improved, and this certainly helped. But there was another factor which we should also take into account, and that was what happened to the income account. This is composed of interest payments and returned profits and dividends. Now Latvia has a net external debt of not far short of 100% of GDP, and this involves a lot of interest payment. As is well known, most of this debt is denominated in Euros, and attached to Euribor interest rates, so of course, as the ECB brought rates down, interest payments came down in like fashion. At the same time, as the economy was contracting by 25% firms were producing a lot less in the way of profits, and there were far fewer dividends.

Now things are improving again, and as we can see in the chart below, the current account is once more moving back towards deficit. This is not a good sign.

So there we are, these are my causes of concern, and I think it is now over to those who already feel that the devaluation debate has been shown to be irrelevant to suggest what they think should be done next to put Latvia back on the "internal devaluation" track again. When I suggested at the start of this post that Latvia might be stuck in a peculiar kind of hell, possibly limbo would be a better term. Latvia's current situation is hardly comfortable. Unemployment is still very high, and new employment is only arriving in a trickle. Meantime the debts are still there, and the problems people are having paying them haven't gone away. In this sense a "restructuring bomb" is still ticking away under Latvia, and rather than continually crying victory maybe it would be better if more people (Prime Ministers included) dedicated a little more of their energy to trying to defuse it.

This post first appeared on my Roubini Global Econmonitor Blog "Don't Shoot The Messenger".

Tuesday, July 20, 2010

The Social Impacts of the Economic Slowdown: The Latvian experience

Guest Post by Eliana Marino

The economic and financial crisis that started in 2008 seems to be on its way to being overcome by many EU member states, but the population in some of the most touched countries is still labouring under the ongoing effects of the slowdown. Latvia, which underwent an annualised decline of 18% of GDP in the first quarter of 2009 and still has the highest unemployment rate in the EU, is experiencing a veritable revolution in its population structure and is preparing to face serious demographic challenges.

The strong recession experienced in the last few years has sadly confirmed the high propensity of Latvian people to migrate for economic reasons and generated a real “exodus” of working age population.

Before 1999, a peak of emigration was registered due to the endogenous migration potential of the collapsed Soviet Union, but, from 1999 to 2002 the outflows seemed to stabilize and to show a slowing trend. This trend changed with the accession to the European Union and the immediate application of the free movement of labour by UK, Ireland and Sweden, which decided to open their borders to New Member States immigrants without any transitional restrictions. These conditions created an increase in the number of emigrants in 2006 and the “old” member states definitely replaced the Russian Federation and the ex Soviet Republics as main countries of destination.

The decline of the outflow in 2007 is linked to Latvian extraordinary economic growth which appeared to guarantee an increase in the wellbeing of the population. This situation started to deteriorate in the second half of 2008, generating a new rise in emigration decisions and increasing more and more in the following year.
Net migration has always been negative and, combined with a Total Fertility Rate among the lowest in EU, it strongly contributed to a progressive and continuous decline of the total population.

Official data, as analyzed above, cannot provide a real portrait of migration dynamics in Latvia. While the registration of immigrants is enough reliable due to the strict controls at the external borders of the EU, emigration statistics are completely unreliable because the large majority of emigrants did not declare its departure and no alternative method is adopted to catch up their real number. The gap between registered and factual data is showed by the comparison with statistics provided by the destination countries, as showed in the graph below:

More recent data were collected through the EU funded project The Geographic Mobility of the Labour Force , consisting of a survey conducted in 2007. The study arrived at the conclusion that a bit more than 40˙000 people emigrated between 2004 and 2005 (87% more than registered data). The authors forecasted that intensive emigration was expected to continue and that, looking at the number of respondents who said that they wonted to leave and at those who already did something in pursuit of this dream, by 2010 between 10˙000 and 16˙000 people were supposed to leave Latvia, thus totaling 50˙000 to 80˙000 emigrants from 2004 to 2010.

These estimates were presented in 2007 when Latvia was going through a period of sustained economic growth and no one could even imagine the economic collapse which the country is undergoing in this moment.

The survey, which I personally conducted in Riga from September to December 2009 and which involved some of the major Latvian experts on migration issues, showed that around 30,000 people are supposed to have left Latvia in 2009 and the same number is forecasted also for 2010.

These massive emigration flows from Latvia can strongly affect the future demographic and economic structure of the country, creating serious problems of labour shortage, unsustanability of the pension system and huge population decline.

Since the years of great economic growth, Latvia experienced a huge problem of labour shortage due not only to the lack of high skilled professionals but also to the general discrepancy between demand and offer of labour. In 2006-2007 this situation was one of the main topics of political and public debate and, under the pressures of the enterprises, the government approved a more liberal immigration policy in order to select labour force from abroad.

The downturn of 2008 caused an inversion of the trend: enterprises were obliged to reduce the labour force and the employment rate decreased together with the level of wages. These elements represented the main push factors for emigration and they are currently generating a real “exodus” of the labour force, creating dangerous structural problem in Latvian economy. Actually, lack of labour and especially of high skilled professionals will be a veritable challenge for the economic recovery of the country and nowadays it is one of the main reasons of concern for Latvian politicians and intellectuals.

From the demographic point of view, the impact of emigration can be considered under two different aspects:

- emigration of working age population makes the demographic burden increase: the number of inactive people (children and retired people) exceeds the number of active people, creating serious challenges for the sustainability of the welfare system;

- the most part of the outflows consists of working age population (from 15 to 65 years old) that includes people in reproductive age (from 15 to 49 years old). A huge number of emigrants in this particular age group means a further reduction of the natural increase of the population. In fact, they will probably have their children abroad or the migration decision itself will discourage the creation of numerous families.

This situation has to be combined with the low levels of Total Fertility Rate which characterize the country since more than 20 years ago. In Latvia, the first demographic transition to a rational regime of reproduction began at the end of XIX Century and the total fertility rate was lower than the replacement level already in the second half of the Century, due to repressions and harsh living conditions during the wars and the Soviet occupation. The replacement level was met only in the 80s after the introduction of partially paid child birth leave. Since then, the birth rate has decreased to unprecedented level and has represented an issue of serious concern for Latvian government. In particular, the decline of total fertility rate accelerated during the economic and political transition, since the Soviet centralized welfare collapsed and the national government opted for a shock therapy instead of a gradual and progressive transition to the market economy.

However, Latvian government recognised the need to ensure reproduction of the population as a prerequisite for the nation’s existence and started to evaluate adequate tools for family support. The adoption of successful family policies made the birth rate level stabilize since 1999 and start to increase at the beginning of the XXI Century. Anyway, the total fertility rate never reached the replacement level and it is still among the lowest in the EU (average 1.4 children per woman in the period 2005-2010 ).

As a consequence of these indicators, Latvian population dropped from 2.5 to 2.2 million people in 15 years and the negative growth rate is expected to accelerate in the next years.

The experts interviewed in the last months of 2009 proposed different solutions to both economic and demographic challenges but they agreed on the fact that a more liberal immigration policy might be really helpful to solve problems of labour shortage and pension sustainability as well as to contribute to the inversion of the negative demographic trends. However, this proposal, which is one of the main topic of public debate since the economic boom, is in direct conflict with the hostility of national population toward immigrants. Latvian critical historical experience with integration of different ethnicities is the clearest explanation of this hostility and probably some years are still needed to overcome these cultural barriers.

In definitive, the results of the survey allow to conclude that Latvia needs some important structural reforms (concerning an efficient social policy, a comprehensive population policy, a strong action against corruption and a reduction of the bureaucratic burden) to be implemented by the national government in order to prepare the country to play its role at the European and international level and to take the best advantages from the opportunities provided by the integration and globalization process. The first step to achieve this objective is the promotion of a cultural change whose main goal is to dump the “dependency from the past” and to open mental and factual borders to modernity.


1/ Latvija Statistika (Central Statistical Bureau of Latvia), www.csb.gov.lv, accessed on April 17th 2010

2/ Herm A. et Al, THESIM-Toward Harmonised European Statistics on International Migration, Country Report Latvia, Sixth Framework Programme, priority 8.1: Policy Oriented Research, Integrating and Strengthening the European Research Area, December 2004

3/ Krišjāne Z. et Al., The Geographic Mobility of the Labour Force, National Programme of European Structural Funds “Labour Market Research”, project “Welfare Ministry Research”, University of Latvia, co-financed by the European Union, 2007

4/ Eglīte P., National Policy for Increasing the Birth Rate in Latvia, in Humanities and Social Sciences Latvia, University of Latvia, Institute of Economics-Latvian Academy of Sciences, 2008

5/ UNdata, www.data.un.org accessed on January 30th 2010