Catch Up Growth and Demographics - Evidence from Eastern Europe

by Claus Vistesen: Copenhagen


Performing a simple series of adept Googling exercises around various sources on the internet you can easily discover that certain species of the lynx are able to travel at speeds of up to 50 kph (31 mph). Wikipedia informs us that the Eurasian lynx, on average, commands a hunting area of between 20-60 square kilometers in which the lynx is able to walk and run about 20 kilometers in one single night. All in all, a pretty rugged and constitutional little thing this lynx.

In this way, and perhaps because, at that particular point in time, the Eastern European Economies looked as if nothing could come in their way of economic prosperity and growth they were paired, by the Economist, with the region's sturdy feline coining the notion of 'Lynx Economies.' Thus, 'that particular point in time' was sometime back in the spring of 2006 where the Economist's (and my own) coverage of the CEE and Baltic economies came in hot on the heels of publications by the World Bank and and the Vienna Institute of Comparative Economic Studies speaking favorably of the future prospects of economic prosperity and thus 'catch-up' growth in the CEE and Baltic Economics.

Yet, merely 1 year and a tad later things seem to have changed quite significantly with respect to the discourse on the economic situation in Eastern Europe. Many of the contributors to this blog has been pitching on the change in discourse but also some of major institutional actors have been flagging the red banner. Not least the World Bank seems to have changed their attitude somewhat with most notably a recent report on the demographics of Eastern Europe entitled From Red to Gray - The Third Transition of Ageing Populations in Eastern Europe and the former Soviet Union as well as a recent writ with specific focus on the macroeconomic risks prevailing in the region. Yet, also the IMF in their latest World Economic Outlook devotes a chapter to the managing of large capital inflows where Eastern European economies also take center stage of the general tone of warning; in essence this note of warning concerning Eastern Europe seems to be the general talk of the day amongst economic analysts and journalists. As such, perhaps even the lynxes roaming the forests and planes of Eastern Europe are beginning to feel that the otherwise catchy notion conjured by journalists at the Economist is becoming something of a stretch according to the reality of the situation. Sure, things are moving fast now but it is what happens next which might finally serve to make the allegory rather unrealistic. In this entry I set out to explicitly investigate an issue which in fact has been treated several times on this blog and perhaps most often in the context of the CEE and Baltic Economies. Simply put and in the form of one simple question;

• How do changing demographics and more specifically the final and ongoing stages of the demographic transition affect the notion and principle of economic catch up growth and thus economic convergence as it is stipulated by (neo-classical) economic growth theory?

As I have hinted above in the introduction my main subject of analysis on which the general theoretical argument is based is the current and ongoing situation in the CEE and Baltic economies. A lot has been written about this recently not least from the hands of the contributors to this blog (see also above). As a one-stop overview of the concrete issues at hand this recent note by Edward over at Global.Economy.Matters should provide you with suitable ammunition to get you started. In particular, the following three point overview of the current economic situation in Eastern Europe should always be in the back of your mind as we move forward from this point ...

Basically the principal outstanding issues confronting the EU10 countries are threefold:

• Labour capacity constraints (which are normally a by product of long-term low fertility and large scale recent migration flows) are producing significant wage inflation and strong overheating.

• A structural dependence on external financing - which is in part a by-product of the effect of low levels of internal saving, and which is another factor which separates the EU 10 from those like India or China who are benefiting from a typical demographic dividend driven catch up, is leading to large current account deficits, and potentially high levels of financial instability.

• A loss of control over domestic monetary policy due to eurozone convergence processes which - with or without the presence of formal pegs - make gradual downward adjustment in currency values as a alternative to strong wage deflation virtually impossible. This issue is compounded by the likely private "balance sheet consequences" of any sustained downward movement in the domestic currency given the widespread use of mortgages which are not denominated in the local currency.

Traditionally a rigorous economic analysis in the light of the immediate events would focus a lot on point 2 and 3 but in this note we shall look specifically at number 1 and the issues of labour capacity, its constraints, and what it means of the economic growth of less to medium developed countries. Now, the most obvious caveat in this entry is that I really don't have the time at this point to really lay out the whole theoretical framework of economic growth theory and as such the precise slot in which my argument should be inserted within the wider theoretical framework. This will be the topic of a more rigorous article not suited for the blog format. However, I still need to attach some comments to set the scene where I should also immediately note that my previous note here at DM about catch up growth in Eastern Europe serves as a good state of the game post for what comes next.

Apart from my studies of selected pieces of the economic growth literature one of the best overviews of the concept of economic convergence as a function of the theoretical and practical assumptions vested in the growth models is to be found in an article by Norbert Fiess and Marco Fugazza on economic integration in Europe (PDF). As such it is important to note that convergence of GDP per capita levels is not a holy grail within the fields of economic growth theory. Rather, the process of convergence should be seen as an inbuilt consequence of the fact that as economies mature returns to production inputs decrease; that is to say that this discussion essentially revolves around the concept of increasing v. decreasing returns to scale in our economic model. If we think about decreasing returns to scale and introduce the concept of marginal productivity to production inputs we can then see that less developed countries are likely to exhibit higher rates of growth than their more mature counterparts in the sense that their marginal productivity is higher which then leads to a process of convergence. Now, this argument in its most strict sense is usually applied in the context of capital as a production input and coupled with the properties of an open economy and subsequent free flow of production factors this would lead to a rather rapid process of convergence or absolute convergence as the technical term. As regards to labour as a production input is has also been argued that the universal transition from an agricultural to manufacturing over to service (?) based economy produces a mechanism of convergence in the sense that this process implies a move up the value chain and thus that every unit of labour becomes more productive. Of course and even though we are talking about stylised facts here, this is also where the whole debacle begins in the context of my immediate argument because how certain is this process? Also, we need to take into account the distinction between stocks and flows (of labour) which is a crucial issue to consider when talking about ageing economies.

However and it does not take much of an economist to see that empirical facts do not support the idea of absolute convergence or at least it seems as if the process takes much longer to materialize than predicted by the theory. This has lead, among other factors, to a 'new' strand of economic growth models which allows for persistent growth divergence to exist between countries. The crucial aspect to understand here is the mechanism through which persistent divergences can occur. In this way, one of the widest contributions by economist to this thesis has dealt with the possibility that technological processes and thus accumulation of technological advances exhibits increasing returns to scale. The fundamental brilliancy of this notion is that it allows for a model where there is indeed decreasing returns to labour and capital but where different levels of technological effort leads to internal positive feedback mechanisms and thus explains persistent divergences in growth and 'prosperity' across countries.

Ok, I think that I have already said enough at this point and in order to get us back to track one crucial assumption and conceptual idea needs to be pinned down. As such and if we look at the rudimentary description of the economic growth process above it is not wholly unreasonable to argue that the growth process of an economy is somewhat directly related to the process of the demographic transition. Or as Robert Lucas puts it in a widely cited article ...

That is, the industrial revolution is invariably associated with the reduction in fertility known as the demographic transition.

As such, why don't we take a look at Eastern Europe where the economies have experienced, quite as expected by the conventional theory of economic growth, economic dynamics tantamount to catch-up or convergence. Especially the economic data since the expansion from EU15 to EU25/27 and, for some countries, the subsequent anchoring to the Euro has been very impressive indeed. Yet as Edward and I have been at pains (see link above) to explain again and again these countries are not your average emerging markets. This follows from the fact that their demographic structures have been fundamentally distorted due to a collapse of fertility in the beginning of the 1990s which has been aggravated by a persistent net outflow of migrants serving to further speed up the decline in the working and essentially also most productive cohorts. In order to capture this development and in order to frame the current situation the following point I made in a previous note is worthwhile to repeat.

In short, we are dealing with countries where the demographic transition by far, and indeed worryingly, has out paced the traditional economic process of economic convergence.

This is exactly what we are talking about here and apart from going to the heart of the imminent issues in Eastern Europe it also strikes right smack into the concept of economic growth theory and how to deal with the fact that the demographic transition does not occur the way it was originally anticipated. Most emphatically, we can see in the context of the Eastern European countries that the final stages of the transition have arrived far before and quicker than the twists and turns of history allowed for these economies to really get on with business. Yet, the general argument can just as easily be expanded into a discussion of the ageing part of OECD where it is painfully clear at this point that conventional economic theories are wholly incapable of explaining what is likely to happen next. In fact, we could stretch it so far as to say that modern economic growth theory is not able to explain what happens when fertility drops to a level below replacement level and stays there!

In Summary

Even though that a lot words have been written in this entry I am afraid that only superficial contributions have been made to the final answer of the proposed question. This entry principally had one main task, namely to initiate a line of reasoning which ultimately and hopefully can lead to a better understanding of modern economic growth processes in a context of the current demographic profile of many developed and developing economies. Specifically, this entry revolved around the concept of catch-up growth/convergence where the countries in Eastern Europe were suggested as an example to demonstrate how demographics can fundamentally alter the principles by which the economic growth process is likely to conform. In this way, the message is not that modern economic growth theory and growth accounting methods are rendered obsolete in the face of changing demographics but rather that considerable adjustment needs to be made; especially in the context of catch up growth/convergence but also crucially in the context of the notion of a steady state of economic growth. Returning briefly to the real world before we sign off it could seem as if the branding of the lynx economies never was more than a quick and essentially expensive make-up which is set to quickly wear off as we venture on. Specifically, recent signs coming out of the ECB and the European commission suggest that expectations are aligning towards an outlook where the process of convergence effectively risks grinding to a halt. My advice would then be not to exchange the carrot too swiftly into a stick since this would only serve to kick those who are already on the ground.

Poland's Trade Balance

Employment in Poland

This post is essentially a research note on the current state of the Polish labour market. It forms part of a series of posts being prepared by Global Economy Matters to accompany the up and coming Polish elections, which are due to be held this weekend. Alongside this post you can find a general review of the electoral situation by Manuel Alvarez, and I will be writing additional notes on the Polsih trade balance and on migration and remittances in the Polsih context, while Claus Vistesen will be taking a look at indebtedness, capital flows and the current account balance situation. All in all a rather full analysis, which given the key role which Poland may play in any Eastern European emerging markets disarray is probably only fitting.

Now, at the end of September the Polish Statistical Office published its unemployment report for the second quarter of 2007, and very interesting reading it is.


Before going into the details of the report, perhaps a bit of background information would be useful. First of all, economic growth. GDP has been growing at a pretty nifty clip in Poland in recent quarters, not as fast as in the Baltics, but pretty fast, as we can see in the chart below. Over the last twelve month the rate has been hovering in the 6% to 7% region.




Now the question is, is this growth sustainable? Stripped to its bare minimum, an economy needs three things for growth - labour, capital and raw materials - pretty much in the same way as a cement mixer needs sand, cement and water, all in the right proportions, of course. The analogy, in the present context, is not completely devoid of significance, since construction activity, and hence the production of cement, is an important part of the recent Polish story in its own right.

So as I say: is this sustainable? Well, capital is at present in pretty plentiful supply, although the danger does exist - since this capital is to a large extent not the product of domestic Polish savings - that this supply could dry up, and even be sucked backwards, as Claus will explain in his post. Raw material are available, but not always at the most favourable price, as we are currently seeing in relation to food and energy.

But what about labour? What is the position with the labour supply situation in Poland? Well this brings us directly to the tricky topic of Polish unemployment, which we will now proceed to explore.

Long Term Unemployment Decline

Historically unemployment in Poland has been pretty high. Most recently it peaked in 2003, and has now been dropping for a number of years, as can be seen from the annual unemployment chart below.




If we come to look at the monthly unemployment data for the last twelve months then we can see that this decrease in unemployment has been accelerating steadily in recent times.





The decrease in the numbers of unemployed is in part, of course, a reflection of an increase in employment, and the volume of employment in Poland has, as can be seen below, been increasing steadily since the end of the contraction which took place between 1999 and 2004.

Here is the annualy % change in the volume of employment:




And here are the numbers of employed on a quarterly basis since the begining of 2004:




The number of people registered with the Polish labour offices as unemployed at the end of June 2007 was 1,895,100 (of which 1,107,700 were women). This constituted a reduction of 337,400 on the number of unemployed in March (the end of Q1). Compared with June 2006 unemployment was down by 592,500 (or by 23.8%). Thus, viewed on a quarterly basis, the decline has been very dramatic, as can be seen below.




Perhaps also worthy of note is the fact that the decline in the numbers of unemployed has been more rapid among men - 322,800 (or 29.1% of the total unemployed) - than among women 269,800 (or 19.6%).

When compared to June 2006 unemployment decreased in all the Polsish voivods, and the declines have been quite dramatic. The most significant declines took place in in Dolnośląskie (30.2%), Wielkopolskie (29.8%), Pomorskie (27.5%), Opolskie and Śląskie (26.8%).

(Please click over image for better viewing)




The unemployment percentage rate at the end of June 2007 was 12.4% of the economically active civilian population, and was thus 2.0 points lower than in Q1 2007, and 3.5 % points lower than in June 2006.

There is still considerable territorial difference in the levels of unemployment in Poland. The highest unemployment rate is to be found in the voivods of Warmińsko-Mazurskie (19.6%), Zachodniopomorskie (17.9%), Kujawsko- Pomorskie (16.2%) and Lubuskie (by 15.8%), while the lowest unemployment rate exists in the voivods of Wielkopolskie (9.3%), Małopolskie (9.5%), and Mazowieckie (10.2%).

(Please click over image for better viewing)




Looking at the two maps taken together, it is very clear that the area where labour tightening is most dramatic at the present moment is Wielkopolskie, since the unemployment rate is already comparatively low, and the pace of reduction in the unemployment rate is also pretty rapid. Wielkopolska Province is second in area and third in population among the sixteen Polish voivods, with a land area of 29,826 km² and a population of 3.4 million. The province's principal cities are Poznań, Leszno, Kalisz and Gniezno. It also hosts part of the Kostrzyn-Slubice Special Economic Zone.


In general terms what we can see is that as the Polish economy has been expanding, it has been consuming labour, and rapidly so. One interesting calculation here is to make an estimate of how much labour is needed to produce 1% of GDP growth with the current proportions of sand, cement and water which are being shoveled into the economic mixer (ie at today's rate of productivity increase). A rough and ready, rule of thumb type, calculation would tell us that to get 6% annual growth the unemployment roll is coming down by about 600,000 peopple per annum, that is that each annual percentage point of economic growth reduces the numbers of available unemployed by 100,000. (This is a rough and ready calculation, but it is a more sophistocated one than first meets the eye, since it does, in approximate way, implicitly incorporate the ageing and withdrawal from the labour force dimension).

What this means quite simply is that, given the relatively low size of the younger cohorts about to enter the labour force, a 6% growth rate just is not sustainable for that much longer. If we imagine that unemployment could only with great difficulty fall below 500,000 without producing spiralling hyper-inflation, then we have an outer limit of 2 years at the present growth rate I think.

After that, what is the sustainable - capacity - growth rate? This is very hard to say without a much fuller econometric analysis, since it depends among other things on the direction and intensity of both migratory and capital flows. Many people, and especially those with a relatively poor understanding of how economic processses actually operate, tend to raise the objection at this point that such a calculation may not be accounting for productivity growth. This would be a mistake, and an elementary one, since the present rate of unemployment attrition already incorporates a certain level of productivity improvement.

So what such an argument normally wants to claim is that some sort of rapid improvment in the rate of productivity growth is on the horizon - rather like Alan Greenspan argued in the late 90s based on the arrival of the internet. A continuing increase in Polish productivity is, of course, to be expected, but it is not clear why people are expecting a dramatic acceleration in the rate of productivity growth. If this expectation is to become more than a simple vain hope it does need some sort of analytical justification. In the meantime we might do well to bear in mind that such improvements are a by product of stocks and flow movements in human capital formation, which is why the age structure of the existing population, and their education level, is such an important topic.

So, if we said that between 2010 - 2012 Polish capacity economic growth might be something in the region of 2 to 3%, then we probably would not be that far from the mark. Post 2012 it is much harder to estimate things, especially since, among other issues, the ageing population component will begin to have an ever greater impact.


Labour Quality


One of the main issues on which we are focusing in this analysis is the rate of reduction of the unemployment level in Poland and the evolution of the future labour supply. It is important to be aware that this future evolution is in great part conditioned by two factors:

1) The very low numbers of live births (in historical terms) which there have been in Poland since the late 1980's and;

2) The relatively high levels of out migration which Poland has expecienced in the last three or four years, which mean certain key groups of workers in the main productive age ranges will not be available to Poland to fuel growth as we move forward.

I have a much fuller (examination of the Polish fertility vackground in this post , but the following graph should make the underlying position pretty clear:



Basically live births dropped from a level of around 700,000 per year in the mid 1980's to around 400,000 per annum in the mid 1990s. That is a net loss of 300,000 potential labour market entrants per year (or a reduction of around 40% in the labour flow, I can hear that cement mixer starting to crunch as I write), a loss which will increasingly make its presence felt between now and 2015.

With these points in mind it is interesting to note that in Q2 2007 the number of people who left the unemployment rolls was 873,000. The largest group who went off the unemployment rolls in Q2 2007 did so as a result of finding a job. In fact 364,000 people left the rolls to take up work in Q2 2007 (or 41.7% of the total leaving) as compared with 425,300 (or 46.8%) in Q2 2006.


It is also inetersting to note that during Q2 2007 264,900 people who were previously registered as unemployed did not confirm their readiness to take a job. This seems to suggest that the Polish authorities are busily cleaning up their unemployment registers - the reduction for "non-availability" constituted some 30.3% of the total reduction in the number of people on the unemployment rolls during the quarter (in Q2 2006 the figures were respectively 259,500 and 28.6%) - and many of the people removed were more than likely already working, whether the work in question was inside or outside of Poland.

So one part of the apparent Polish "reserve army" may in reality simply not exist. Another part may - speaking in plain English terms - be far from serviceable for modern economic growth purposes.

In this context it is interesting to note that the long-term unemployed constituted 65.7% of the Q2 2007 total (1,245,000), and many of these people may turn out to be very hard to "recycle" into the modern world. In terms of the relative age structure of the remaining unemployed, under 25 year olds constituted 18.9% of the total (358,600), while persons aged over 50 were 21.0% (398,1oo thous).

At the end of Q2 2007, 1,639,300 people on the rolls did not possess the right to unemployment benefit, and this group represented 86.5% of the total number of registered unemployed, (in the previous quarter it was respectively 1,930,700 and 86.5%). Among this group 43.4% were people living in rural areas.

There were also more female than male unemployed. At the end of Q2 2007 58.5% of the total unemployed were female, and this was up by 3.1 % points on Q2 2006. The highest percentage share of women in the total number of the unemployed is to be found in the Wielkopolskie (65.6%), Pomorskie (64.0%), Kujawsko-pomorskie (62.3%) and Małopolskie (61.5%)vovoids.

One of the key difficulties in evaluating the remaining unemployed labour force in Poland is getting a precise reading on the quality of the labour which remains available. It is hard to get a clear picture here, but one indication which is not without importance can be found in the fact that the majority of the unemployed registered in the labour offices were persons with relatively low levels of education. The share of registered unemployed who did not have any occupational qualification whatsoever was 30.7% of the total registered unemployed (582,000).

In addition the two largest groups among the unemployed were persons having only basic vocational orlower secondary education (30.1% of the total), or persons with only primary or even incomplete-primary education (32.5% of the total number of the unemployed registered at the end of June 2007). Combined these groups constitute 62.6% of the total number of the unemployed.

On the other hand some 22.3% of the total had the certificate of completion of post-secondary and vocational secondary schools, while 9% had completed secondary education and 6.1% were graduates from tertiary schools.

So, in conclusion, and to reiterate. Poland is facing a potentially very acute and imminent trade off between economic growth and inflationary cost push. Some indication of this can already be found in the producer price index, which has been coming under increasing pressure since early 2006:



The earlier interest rate tightening from the central bank seems to have had some sort of short term impact during the March to July period, but, as we can see, the thing now seems to be taking off again. This position is only even more strongly confirmed if we look at the construction producer cost index.



It is also very clear that the steady tightening of labour market conditions is having an impact of Polish wages and salaries.



The annual rates of increase have been steadily picking up speed, and while they are still below those to be found elswhere in Eastern Europe (like the Baltics, Romania, Ukraine) the early warning signs of the "Baltic Syndrome" are there, which is hardly surprising since the underlying causes are essentially the same.

Information for this report comes, by and large from the Polish Statistical Office and Eurostat. In particular the recently publishedunemployment report for the second quarter of 2007 was evry useful, while additional information was taken from the Q2 2007 Labour Report (archive).

Poland House Price Index September 2007

Here's the relevant part of the monthly annual rate of change on the house price index that goes accompanies the EU monthly harmonised CPI. The rate of increase is brisk, but it is hardly inordinately high.

Polish Construction Output 2007

Well, I think this graph pretty much speaks for itself. Polish construction has seen some pretty large increases in output during 2007.




Since there are some silght differences between the two, here is the version of the index which is published by Eurostat. Since the time series I am using is also slightly longer, we can see that construction activity really seems to have taken off last autumn, reached a peak - in terms of monthly rates of increase - this spring, and is now slowin slightly, although, as I say, the rates of increase are still pretty substantial.

Inflation in Poland September 2007

Well with all that inflation going on all round the EU 10, I guess Poland wouldn't want to be left out, now would it? So just to prove a point, Polish inflation accelerated in September for the first time in three months. As elsewhere the increases were led by food costs, but there was also a sneaky little detail of housing maintenance costs. We wouldn't be short of a Polish plummer here and there would we?

In fact the inflation rate rose to 2.3 percent, after falling to 1.5 percent in August. Consumer prices gained a monthly 0.8 percent after dropping 0.4 percent in August.

Anyway, here is the chart for monthly inflation this year.



Actually, compared with what is happening eslewhere this rate of inflation almost seems saintly. Nonetheless it looks very probable that the central bank will raise interest rates again. In fact the Polish central bank has been very successful in bringing down inflation in recent years, as can be seen in the following chart for annual inflation.



The Polish central bank is more likely to raise its benchmark 4.75 percent repurchase rate This would be the fourth time this year that the bank has raised the rate - which is currently at 4.75% - to try to keep price growth under control as inflation threatens to breach the bank's inflation target for a second time.

The Monetary Policy Council of the Polish central bank lifted borrowing costs in March for the first time since May 2005 after the annual inflation rate reached the bank's target of 2.5 percent. The inflation rate fell to 1.5 percent in August from 2.6 percent in June.

Food prices rose 2.4 percent in September from August and 5.1 percent from September 2006. House maintenance costs gained 0.3 percent from August and were up 3.5 percent from a year ago.

The zloty also advanced following a pattern we are seeing in other countries as people react to the idea that interest rates might rise by finding the currency more attractive without reflecting on the long term dimension of where all this is leading.

Typical of the sort of response we are seeing is this one quoted in Bloomberg:

``The data should show the need for further monetary tightening in Poland and is likely to push the euro/zloty to new five-year lows below 3.72 today and toward 3.70 this week,'' a team of analysts led by Gavin Friend at Commerzbank AG in London wrote in a research note.

But the real underlying problem is not food prices by growing labour shortages and wages, as was made clear in separate report which showed that average annual wages climbed by 9.5% in September, down very slightly from the from 10.5 percent a year rate regsitered in August. Again, we are not yet at Baltic levels, or even at Bulgarian or Romanian ones by the curve is ascending and the clock on all those labour shortgaes is ticking away inexorably.





Of course, with delicate situations developing all over the EU10 the last thing Poland needs right now is an election, but that is what we are having this Friday. The latest news on this front is that support for the Citizens' Platform - the largest opposition party - rose to a record 46 percent according to a poll carried out by TNS OBOP and published by the Dziennik daily., This would be enough to create a majority government, but matters are far from clearcut, and rolling survey by PBS DGA published in Gazeta Wyborcza daily showed backing for the Platform at 38 percent and for Law & Justice at 37 percent.