In search of new growth

Ardo Hansson
Ardo Hansson
Governor of Eesti Pank and Member of the Governing Council of the European Central Bank

After the Eesti Pank economic forecast was published in the middle of June, the main focus of attention fell on the slowdown this year in the growth of the Estonian economy. Although growth will accelerate again next year, the question remains as to whether the Estonian economy still has the strength to catch up with the wealthiest countries in Europe. It is clear that the growth that lies ahead will be more moderate than that seen in the years before Lehman Brothers collapsed. The cause of this is not the wearing effect of the crisis, but rather the opposite; the Estonian economy has learned a lesson and has reorganised significantly from where it was earlier. The slowing of growth is down to the simple fact that Estonian income per capita adjusted for purchasing power has almost doubled in relation to the European Union average since the mid-1990s, and this means that the rate of growth that the economy can manage has fallen. The speed at which the Estonian economy will develop in future depends on many factors, most important among which are the availability and qualifications of the labour force, and what is produced and how.

A new normality for economic growth

Recently there has been much discussion of a “new normal”, or the expectations for the post-crisis economic growth facing the global economy, including the economies of the EU member states. Earlier experience of crises and the build up of economic problems over the years in many countries around Estonia have left their mark on the future development of those countries. This will continue to exert some influence over the outlook for growth even if the planned structural reforms are successfully carried out, as the elimination of imbalances is a lengthy process. The integration of economies means that what happens beyond the border has an impact on the Estonian economy too, although this does not mean that the importance of domestic factors should be underestimated.

Generally speaking the speed of economic growth is set by the growth of the resources needed for production and by how efficiently they are used. A distinction is traditionally drawn between three types of resources needed for production, which are capital, labour, and what economists call total factor productivity. Total factor productivity essentially reflects the ability of the workforce to create for consumers more attractive and more expensive products, which have higher added value and can earn more income. It is also closely connected to increases in productive capital as buildings and facilities and new and modern machinery and equipment are brought into service. Although Estonia has invested a much greater share of GDP since regaining independence than other EU member states have, there is still a long way to go in making the economy more capital intensive. Across the water in Finland, more than three times as much production capital is used per worker as is the case in Estonia, which means that the average worker in Finland is three times as productive as one in Estonia and so there is also a similar-sized difference in income levels.

It is often asked whether it is because a bus driver moving from Estonia to Finland suddenly becomes much more productive on the other side of the sea that he earns a wage many times higher than at home. After all, he is driving the same sort of bus and doing so just as well as in Estonia. The answer is no, the difference in wages stems from the economic structure. The productivity and income levels of the exporting sector are transmitted to the whole economy in a process that resembles the principle of communicating vessels, so that the income earned and the income levels of economic segments that are open to foreign competition and are usually more productive are passed into closed sectors such as domestic transport or other services. This means that to ensure growth in the future in Estonia, it is particularly important to develop the sector that is open to foreign competition, as the rest of the economy will follow behind. Development will be aided by a constant improvement in the amount of production capital allotted to workers and a simultaneous elimination of the technological gap to more developed countries.

Fortunately the next few years will be favourable for making investments as interest rates on loans will remain very low and there are no major barriers to access to finance. The economies of Estonia's neighbours have started a new cycle of growth and domestic demand in Estonia is becoming more active, meaning that now is a good time to move forward with carefully considered projects. However, we should guard against any reliance on overly optimistic assumptions, as the low interest rates are a consequence of the economic cycle and it must be remembered that interest rates may rise for long-term investments.

The need for qualified workers

Even quite recently as the economic crisis was worsening, the main problem facing the labour market was identified as rapidly increasing unemployment and underutilisation of those who were employed. A large share of labour resources were going unused, although the existence of a reserve of idle labour allowed rapid economic growth to be achieved after the crisis through increases in employment and hours worked. The unemployment rate has fallen sharply in recent years and it has been below the European Union average for some time now. However, employment growth slowed down considerably in the last two years. Unfavourable demographic trends are starting to have an ever greater impact through both natural population change and emigration. In the short term, we should remember that regardless of any falls in unemployment, the number of workers in the country will decline. First indications from the population census suggest that this trend is growing. For business this means that increases in production will come more from higher capital intensity than from any increase in the number of workers employed.

The decline in the working age population has been offset in previous years by increased labour participation rates, and getting people who are not active in the labour market to participate more and flexibly will be vital in the future. It must also be remembered that these demographic changes will lead to a bigger burden on each worker supporting the social insurance system. To keep the burden as small as possible, the social protection and tax systems need to favour the active involvement of large parts of the population in the labour market. This means that parental benefits, work incapacity pension or unemployment benefit must not be allowed to discourage people from working. It should be attractive for benefit recipients to work part-time if they can't work full-time and in this way the older part of the population or those who are inactive for other reasons could become active. At present, a much smaller proportion of the employed population in Estonia is working part-time than is the case in most other European Union countries. Could it be that the reason for this lies in the different benefit schemes and minimum rates for social taxes? To answer this we should look at the experience of other EU members.

Technological changes are happening rapidly all around us and an increasing proportion of added value is being created at the knowledge-intensive start of the production chain in the design and product development stage. The same is also true at the end of the production chain in the marketing and service stage. This means that economic growth is highly dependent on the activities that go into the different stages of the production chain. A good example is the assembly of an iPod, which creates an estimated four dollars of added value for China for a product that retails for 299 dollars.  Carrying out projects that create high added value in Estonia will require a qualified workforce. Estonia’s education indicators, such as the proportion of people with higher education, are close to the averages for the European Union but continuing training and retraining need to be convenient and accessible not only for young people. Vocational schools and institutions of higher education need to work more closely with business so that study programmes are up to date and reflect the needs of the labour market.

It is clear that the key factors for economic development in the years ahead will be the enterprise, knowledge and skills of individual people. If the outflow from Estonia of people looking for work is not to increase, Estonia has to be able to offer a similar quality of life to that found in the countries where these people mostly go. Beyond patriotism and their mother tongue, what will persuade young people to make their lives in Estonia is robust economic development and a positive outlook for future income growth. Therefore the responsibility for creating a successful and decent society lies with all of us, whether we are economic leaders, business owners or salaried employees.

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