Something is afoot in Latvia. According to the latest Eurostat data on annual wage costs, in the first quarter of 2007 wages in Latvia were up by an astonishing 32.7% when compared with the first quarter of 2006 (for a simple graph of the course of Latvian wages since 2001 try this) . Without knowing anything more about Latvia it is obvious that something important is happening here, and that the situation as it stands is clearly unsustainable.
And it isn’t only wages that seem to be spiraling out of control. Consumer price inflation has been steadily increasing, and now runs at an annual rate of around 9% (graph here), while the current account deficit (currently around 25% of GDP, chart here, graph here, also see the chart comparing Latvia with the other EU8 countries here) has also shot up, while domestic consumption is rocketing, fueled by an inward flow of bank funds and remittances (see table) and this rapid growth in domestic consumption is producing an upward spiral in house prices (see graph) – Latvia (Riga) was number one in the most recent Knight Frank global housing index at a staggering annual increase rate of 62.1% – and this spiral may well constitute a bubble.
Worse, there is some sort of consensus among experts and analysts that there may be no easy policy remedy available, that the problem may be structural, and guess what, despite all the protests from the Economist that demographic changes don’t have important visible economic impacts, the key to the Latvian problem is a demographic one: essentially they are running out of people. Running out of people that is if they wish to sustain their current high levels of economic growth and experience “catch up” growth to bring their living standards alongside those of their Western European EU neighbours. A simple example should suffice: during 2006 Latvian employment was increasing at an annual rate of around 70,000, but if we look for a moment at live births – see chart - we will see that since the early 1990s Latvia has been producing children at an annual rate of under 40,000 and that by 2006 this number is down to 21,000.
What follows below the fold are a series of observations and policy proposals which are based on a much more extensive economic analysis I carried out for Global Economy Matters, which can be found here.
Meantime Latvian Prime Minister Aigars Kalvitis seems to have come up with his own solution:
Prime Minister Aigars Kalvitis, speaking in a radio interview over the weekend, appealed to Latvians to do their part in bringing down inflation and stop spending so much money. Kalvitis asked Latvians to be more thoughtful about borrowing money to buy big-ticket items, warning them that the future generation may be forced to foot the bill.
Basically the Latvian conundrum revolves around the fact that a very favourable set of economic circumstances (exceptionally high levels of global GDP growth, strong risk appetite in the banking and investment sector, EU institutional guarantees, strong inward remittances flows, and significant potential for “catch up” growth) coupled with very unfavourable internal demographic dynamics, combine to present the Latvian authorities with a rather unique problem set. As the authors of a recent BICEPS report on Latvia observe:
“The recent surges in wage growth, PPI growth and CPI growth are also worrying in the sense that they seem to indicate a shift in the economy from simply overheated to potentially structurally imbalanced.”
Essentially Latvia has a capacity problem, but this is not a problem of funds for investment, it is a labour supply one. On this virtually all the external observers who are thinking about the situation are agreed (see this recent IMF statement, and this report – Inflation in Latvia: causes, prospects and consequences – from the BICEPS group of Baltic economic analysts): the labour supply problem is the key issue.
Latvia is not alone in having this problem, and indeed in the medium term, as this recent World Bank report – From Red To Grey - makes clear, this issue will affect virtually all of Eastern Europe and Central Asia (see this chart of changes in working age population between now and 2025). What is special about the Latvian case is the speed with which the problem has arrived.
Essentially the Latvian government seems strapped on the horns of a dilemma, and one which means they seem to be condemned to run, and keep running, in an ongoing chase to try and catch up with their own shadow (their demographic one that is). But just how big is their demographic problem?
Well the Latvian population is now falling, and at a significant rate (by 0.648% annually according to the 2007 edition of the CIA World Factbook). In addition the birth rate seems stuck at a very low level – 1.3 TFR in 2006 according to the Population Reference Bureau), and of course there is out-migration, which is hard to measure with any precision (a difficulty which 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).
At the same time the internal employment situation is becoming ever tighter, with unemployment levels falling and falling – in Q3 2006, for example, employment was increasing at a rate of 7.2% (y-o-y), while the unemployment rate was down to 6.2% (falling from 8.7% a year earlier). Put another way, an increase in employment of some 75,000 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.
An additional problem the Latvian authorities face is the level of the wage differential with say the UK or Ireland, and the problem of out-migration that this presents. This chart, which compares the Irish and the Latvian wage distributions may be helpful in seeing the problem in better perspective.
This situation – namely one wherein a period of restrained wage growth may produce yet more out-migration which in turn makes the domestic wage pressure even greater (another kind of ‘vicious loop’) – is by no means easy to address and as the October 2006 IMF staff report authors note:
Some analysts called for expanding inward migration to alleviate shortages and dampen wage pressures. However, policymakers generally considered that this would have the effect of replacing domestic low-cost workers with imported ones, thereby holding down wages and promoting further emigration.
That is, one solution to the wage increase problem might be to open the frontiers to some extent to migrant labour, but policymakers worry that any resulting flow – being possibly mainly of unskilled workers – might only serve to push down unskilled wage rates and push more Latvian nationals over towards the UK and Ireland. Certainly the Economist Intelligence Unit in its most recent report also noted this issue (January 2007):
The government argues that rapid wage convergence with western Europe is needed to check emigration. On the latest estimate from the Bank of Latvia (BoL, the central bank), some 70,000 Latvians, or around 6% of the labour force, are currently working abroad, mostly in the UK and Ireland.
Of course there is no single clear remedy here, but I think we need to say strongly that this attempt to stem the migrant out-flow by being lax on the wage inflation front is to invite disaster, serious disaster.
Now it is important to be clear that one of the implications of the structural diagnosis that is being generally offered (both here, and at the IMF, and by the BICEPS authors) is that implementing the kind of anti-inflation plan which is being proposed will not allow Latvia to simultaneously achieve acceptable inflation, acceptable growth and a positive external balance. It would appear that Latvia has become strapped on the horns of a what is called in the literature a Tinbergen policy dilemma, simply put, and with or without the existing peg to the euro, it simply has too few instruments available with which to achieve all its policy targets. (A classic explanation of the Tinbergen dilemma from none other than euro-intellectual father Robert A Mundell – I don’t know whether to laugh or to cry at this point – can be found here, while another, and now rather outdated, version of the underlying idea – and one which became pretty fashionable in economic circles in the 1990s – is Krugman’s eternal triangle. Obviously in the light of recent developments in the global financial and migration systems this whole literature is now badly in need of an update).
So we do not live in a perfect world, indeed in the Latvian case we are living in a far from perfect one.
Migration As A Solution?
Well given that a strategy of relying exclusively on fiscal tightening and strong deflation 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 via an open-the-doors policy towards inward migration, 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 has already been mentioned: that such an approach may ultimately put downward pressure on unskilled 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 â€œslightly positiveâ€ 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.
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 Latviaâ€™s Population) in January 2006 revealed that about 22 percent of Latvian residents see themselves as being either â€œvery likelyâ€ or â€œsomewhat likelyâ€ to go to another country for work â€œin the next two yearsâ€. 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 here.
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.
The protracted way in which this problem has been resolved raises in and of itself important issues. A recent article from the Itar-Tass news agency (a Russian source I know, but still) about a joint project to settle Russian speaking Latvian residents in Kaliningrad gives some indication of how deep this problem may still be. If there is any real basis for such reports and for the idea that the Latvian authorities are still be actively considering encouraging the resettlement of Russian speaking Latvian citizens elsewhere then it may give us gives some 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 Estoniaâ€™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 (Claus Vistesen has a post on this here).
Of course debating the niceties of the policies we would like to see is one thing, and addressing the economic realities of the policies we have is another. If domestic demand does not abate steadily now, a hard landing could well result. Under this kind of scenario, one or two more years of GDP growth in excess of an annual 10% rate would probably lead to such pressure on the labour market (remember the unemployment rate was dropping in 2006 by about 2.5% a year) and thus to such an acceleration in inflation that the impact on competitiveness and external liabilities would become unbearable. Under these circumstances attracting the necessary external financing would become increasingly difficult, and a sharp slowdown would probably result as the underlying accumulated output gap was corrected in an unduly short space of time. The most worrying point about such a scenario is that we really don’t know the long term consequences it might induce. Latvia – like many East European and Central Asian societies – is about to experience a severe demographic challenge, and it would be better to face that challenge with the wind behind you rather than the wind in your face, and certainly better to try and chart your own course than head off in the direction of “destination unknown”.
Incidentally, just to show how seriously I take all of this, Iand for any of you who read this and want to follow the course of events in Latvia, I have now established a Latvia Economy Watch blog, to accompany my Hungary Economy Watch one.