Catching Up?

One of the most fundamental assumptions on economic growth in the long-run is idea of convergence or catch-up growth. This is a process by which developing economies countries grow faster than their developed counterparts. The nature of this convergence process which should be seen in the context of neo-classical economics (new growth theory) depends on the overall assumptions of scale economies built into the models. This entry will not go into this in much detail but rather home-in on the case of the Eastern European transition economies, often also referred to as the lynx economies alluding to their comparison with the Asian tigers.

The main point of departure is the May monthly bulletin from the European Central Bank (ECB) which includes an article on the determinants of growth in Central and Eastern Europe. In many ways the analysis is a plain vanilla application of the Neo-classical growth model with the inbuilt assumption that institutions matter and as such that growth perhaps should be seen as endogenous instead of exogenous as it was originally proposed by Solow. However, the authors' main thrust raises some very interesting points. Apart from the standard (and also important mind you) recommendations to ensure credible fiscal and monetary policy, increased spending on R&D, elimination of red tape to improve the attractiveness of the business environment the authors also note the crucial importance of investing in human capital as well as the need to address the structural labour market mismatch.

Now all of this in the East European context needs to be understood in the light of two mechanisms which are currently at work. One of these is the catch-up process itself, and this process entails a steady move up the value chain and of course if the country's human capital endowment does not move to match this development it will create bottlenecks. However, a more crucial point is this ...

The existing skill mismatches may be affected by the increased migration of labour from the CEE countries to some of the other EU countries following the opening of their labour markets. Given that young and qualified workers typically show the highest propensity to migrate, increased east-west migration within the EU, while generally beneficial and desirable in economic terms, may temporarily aggravate existing labour market bottlenecks in some sectors in the CEE countries. At the same time, the skills that these workers acquire abroad may support productivity growth in the long run, provided that the large share of current migration is temporary in character.

The first thing to notice is that this impact of migration flows and their subsequent affect on the labour market, and indeed abililty to move swiftly up the value chain, was exactly the critique I levied recently towards the large World Bank report on migration in Eastern Europe, the CIS, and Asia. Secondly there is of course the last part of the extract which talks about how net emigration in the long run might support productivity growth as the skilled labour returns to their home country to offer their highly productive labour. This is a bold assumption and far from certain I think. More generally, and despite the authors' ardent efforts, they are, I think, bumping against the frontier in terms of the explanatory power of neo-classical growth theory here. As such, the suggested remedies of increasing labour market reforms and investment in human capital seem to me to be missing the main point at issue. In short, we are dealing with countries where the demographic transition by far, and indeed worryingly, has outpaced the traditional economic process of economic convergence.

At some point these two processes will intersect (they are perhaps doing so already?) and the reality will be that these countries will have serious problems in nudging up the value chain. An interesting data point here is that the labour market for the tertiary (i.e. services/high value added) sector is already extremely tight in the all of Eastern and Central Europe. The average unemployment rate in these sectors is at a staggering 3.27% - with lows in Lithuania, the Czech Republic, and Latvia at 2.4%, 2.5% and 2.6% respectively. Combined with very high unemployment levels in the primary sector this does of course suggest that there is plenty of room for targeted investment to exert a pressure which transfers general capacity up through the value chain, but with the sustained process of ageing which these countries face (and the difficulties that this poses in terms of altering their skill profile) this looks as very difficult task indeed.

Regarding the low unemployment rate in the tertiary sector, conventional wisdom would of course envision that this would keep those engineer graduates at home or perhaps persuade those who have left to come back. Yet, what if the extremely low unemployment rates is a function of something else and more structural? What if in fact the low unemployment rates is a reflection for a general scarcity of highly skilled labour? This would then suggest a more structural capacity issue rather than the traditional notion of a labour market mismatch. In this case it is of course not exclusively one or the other but since the structural capacity issue is only very rarely mentioned I think it is important to emphasize this, and especially in connection with the trend of net-emigration of skilled labour. A concrete example of this capacity constraint and labour market mismatch can be found in Poland as I noted over at Alpha.Sources some time ago:

(from the FT)
Poland’s rapid leap in productivity is taking place in spite of the drag caused by the 20 per cent of the Polish workforce that is employed in agriculture – producing only 3 per cent of GDP. The country also has the highest level of unemployment in the European Union, at 17.8 per cent, and the lowest level of labour participation in the OECD, the world’s most industrialised countries.

Many of those out of work are unemployable in a modern economy and some Polish companies are experiencing difficulty in finding qualified workers. A recent study by Poland’s central bank found that 42 per cent of firms had trouble finding qualified workers.

The reason why many of these unemployed workers might be considered "unemployable in a modern economy" is of course their comparatively low level of education and their comparatively old age, and it is the combination of these two which presents the problem.

This effect is of coursed primarily and in the short run driven by sectoral labour market mismatches but more structurally it is exacerbated by outward migration and a structural decline in the labour force as a result of ageing. And despite the increasingly tighter labour markets it is exactly this potential vicious circle which should lead us to be rather cautious about assuming a great reversal in migration flows.

In Summary

So, there you have it; another dose of demographic fundamentalism. Well, after all this is the 'demography.matters' blog so it should not come as much of a surprise. Having said that I am not fundamentally at odds with the traditional economic analysis fielded in the ECB article noted above. Without a doubt there is much pertinence in their general analysis. However, I do think that it fails to adequately factor-in the demographic component of long term growth and in this case the ability of these economies to sustain the convergence process by continuously moving up the value chain. However it should be noted that all the signs still point to a continuation in the convergence process, at least for now. Consequently, if you look at growth rates in, for example, the Baltic countries these are still very healthy. The question really, of course, is just how long this can be sustained and whether in fact these economies can decidedly shift their economic activities in the effort towards a long run steady state (or process of continuous endogenously driven growth)?

Post scriptum ...

In terms of general sources on this topic I recommend the following ...

This publication from the UN (PDF!) which describes the process of very rapid fertility decline in the Eastern and Central European transition countries from 1982-1997.

This publication from the European Bank of Reconstructuring and Development (PDF!) which attempts to give an overview of the impact from ageing on pension systems and public finances in the transition countries.

And finally I can hardly take on this subject without also noting Edward Lucas who is the Eastern and Central European correspondent for the Economist. Over at his blog, he posts relentlessly on the region's economy, politics, and society. As a one stop source for information on the topic at hand you would be hard pressed to find anything more informative than Edward Lucas' writings.