Recent manufacturing trends in Latvia – are there reasons to worry?

1. Swedbank Analysis December 13, 2010
High unemployment in Latvia –
is it here to stay?
• Improving labour market, but structural imbalances
continue to build up
• High structural unemployment would bring serious so-
cial costs and would not disappear by itself
• Current policy action is insufficient and lacks important
elements; the focus should shift to structural policy
“Recessions leave scars on the labour market; the Great Recession of 2007-
2009 has left gaping wounds.” Dao and Loungani (2010)
After double-digit economic growth in 2005-2007, Latvia was not only hit High unemployment
by the global financial and economic crisis, but also suffered from a negative caused by the reces-
domestic demand shock due to the real estate bust. With the cumulative GDP sion…
fall of about 25% during 2008-2009, it is thus not surprising that Latvia
continues to be one of the unemployment leaders among the European
countries. Recovery in economic activity (so far, GDP is up by about 3% from
the trough in the 4th quarter of 2009) contributed to the fall in the job-
seekers’ rate during the last two quarters, but it is still at a crippling 18%.
There is a high risk that the high cyclical unemployment due to recession will … risks to become en-
become entrenched as a structural phenomenon. Particularly so, given that
trenched.
this is largely a structural rather than a cyclical recession. Such unemploy-
ment does not disappear by itself even if the economy is growing. The costs
of unemployment increase with the duration of unemployment. Conse-
quently, one cannot employ a “wait-and-see” approach to reduce structural
unemployment, and policy action is necessary. Besides timing, uneven re-
gional and sectoral developments should be considered while designing such
policy measures.
In our opinion, the current policy action is insufficient and lacks important
elements to diminish the risks and costs of structural unemployment. Al-
though the government has announced job creation as one of its goals, pro-
posals for the 2011 budget do not effectively support this goal. This paper
thus aims to (i) analyse the current situation in the Latvian labour market
and the progress made so far to reduce unemployment and (ii) show the ar-
eas where policy action is required to lower unemployment, providing sug-
Economic Research Department. Swedbank AB (publ). www.swedbank.lv
Lija Strašuna +371 6744 5875, Mārtiņš Kazāks +371 6744 5859,
Legally responsible publisher: Cecilia Hermansson, Group Chief Economist, +46 8 5859 7720

2. gestions and/or raising questions that need to be answered in order to de-
sign appropriate policy measures.
Structural unemployment and its costs…
There are several types of unemployment: cyclical (involuntary, short term, Structural unemployment
due to business cycle fluctuations), seasonal (involuntary but regular), fric- is caused by, e.g., skills
tional (can be both voluntary and involuntary, but is temporary, while work- or geographical mis-
ers are switching jobs), and structural (involuntary, long term). The latter is match between labour
caused by a mismatch between supply and demand of labour as workers' supply and demand.
skills are not the same as the skills needed on the job. Skills mismatch can be
caused not only by difficulties for workers in moving across industries (e.g.,
from construction to manufacturing), but also by regional immobility (e.g.,
from small towns to regional hubs). In this paper, we focus on structural un-
employment.
There are many economic theories/models that explain the existence of
Long-run price and wage
structural unemployment. One of the most important factors in these models
rigidities are one of the
is long-run price and wage rigidity, which makes it impossible to eliminate all
explanatory factors
unemployment in the long run. Two of the most traditional and widely used
theories are efficiency wages and trade unions. Efficiency wage theory im-
plies that employers drive up wages to ensure an optimal level of productiv-
ity of the workers (i.e., labour productivity positively depends on wages) and
are not willing to hire all the workers who want jobs at those wages, thus
creating structural unemployment. Trade union theory also entails structural
unemployment, as it implies higher wages for the union members (due to the
market power of trade unions), and employers thus cannot hire all the unem-
ployed at those wages.
Blanchard and Summers (1986) have advocated the concept of unemploy-
ment hysteresis – the substantial persistence of unemployment and the pro-
tracted effects of shocks on unemployment. This justifies structural unem-
ployment as created not only by the supply side of the economy, but also by
the actual unemployment path driven by aggregate demand shocks. Re-
cently Ball (2009) has presented additional evidence on hysteresis and has
particularly emphasised one of the channels through which it can work. The
idea is that an initial rise in short-term unemployment turns to long-term
unemployment as workers become detached from the labour market because
they are not attractive to employers or do not try hard enough to find new
jobs.
Skills mismatch in the labour market implies that job seekers cannot find jobs Beveridge curve – one of
even despite available vacancies, as they do not possess the necessary skills. the indicators of struc-
The Beveridge curve examines the relationship between the unemployment tural problems in the la-
rate and the vacancy rate, reflecting the matching between people who bour market
want jobs and employers who offer jobs. Normally, there is a negative rela-
tionship – the fewer vacancies, the harder it is to get a job and, thus, the
higher unemployment is. The Beveridge curve is often perceived as one of
the indicators of structural problems in the labour market – the more it
moves out to the right, the more severe the problems are, as with the same
number of vacancies there is now higher unemployment, reflecting some
mismatch in the labour market.
Unemployment brings substantial individual and social costs, which increase Unemployment brings
with the duration of unemployment (see, e.g., Dao and Loungani, 2010). In- substantial costs both in-
dividual costs refer to income loss, loss of skills, adverse health outcomes, dividually and to the
etc. Social costs correspond to lost tax revenues due to smaller number of whole society…
employed (and increased fiscal costs due to, e.g., unemployment benefits), an
increase in income inequality and poverty, a deterioration of social cohesion
(e.g., less confidence in public institutions), and a loss of human capital.
2 Swedbank Analysis • December 13, 2010

3. In the case of Latvia, a very important negative consequence of structural … like increased emigra-
unemployment would be increased emigration (there is largely free move- tion and lower potential
ment of the labour within the EU). According to different estimates, since growth
2004 about 100,000 Latvian residents (or about 4% of the population) have
emigrated and emigration flows caused by the recession continue. While
emigration would lower the number of unemployed, it would also imply an
increased social burden for the remaining employed,1 thus endangering the
sustainability of social protection and the pension system – either cuts in so-
cial spending or tax increases would then be necessary to balance the gov-
ernment budget. This, in turn, might lead to increasing tax evasion, as the
motivation to pay taxes would diminish.
Another consequence of structural unemployment and/or emigration, par-
ticularly of high-skilled labour (or, the “ brain drain”) is lower potential eco-
nomic growth – employers might be willing to create new jobs and increase
production volumes, but they would be constrained by the labour they have
and not be able to hire new skilled workers.
… can be minimized by timely policy action
The costs that unemployment brings urge policymakers to act in order to di-
minish them. The policy action depends on the kind of unemployment. While Adequate policy action
cyclical unemployment can be dealt with by stabilisation policy, i.e., tradi- can minimize unemploy-
tional fiscal and monetary policy to boost aggregate demand, structural un- ment and its costs
employment can be affected by structural policy affecting the supply side of
the economy, like the tax and the educational system, policy measures that
have an impact on the price and wage flexibility of the economy.
So-called active labour market policies (ALMPs) are public interventions ex-
plicitly targeted at groups of persons experiencing difficulties in the labour
market: the unemployed, persons employed but at risk of involuntary job
loss, and inactive persons who would like to enter the labour market (Euro-
stat definition). In most cases, ALMPs are designed to support labour de-
mand. They include public employment services, different training schemes,
and employment subsidies.
ALMP measures typically aim to reduce cyclical unemployment, but they may
also reduce structural unemployment when they improve the human capital
of the unemployed (e.g., training). For instance, Forslund and Fredriksson
(2009) conclude that while in the long run labour supply is the main determi-
nant of employment, ALMPs, if properly designed and targeted, can also
make a difference.
Timing (i.e., the phase of a business cycle) is important when choosing an ap- Timing is crucial when
propriate ALMP measure (see, e.g., OECD, 2010b). For instance, in the down- choosing an appropriate
turn phase, labour hoarding might be considered, while in the recovery phase policy measure
the focus should shift to encouraging job creation.
On the surface, the Latvian labour market
situation is improving …
The job-seekers’ rate peaked in the first quarter of 2010 at 20.4%. The la- Rising employment dur-
bour market situation has improved quite rapidly during the past two quar- ing the second and third
ters. Employment has been increasing as the number of both job seekers and quarters of 2010…
inactive persons has been falling. It should be taken into consideration that,
according to the Labour Force Survey methodology, employment numbers
include people participating in the ALPMs (27.7 thousand in the third quar-
1
In 2008, there were 2 employed per 1 pensioner (all pensions, including, e.g., those for
disabled persons), while in 2009 this ratio declined to 1.75 and is expected to fall further
due to demographic trends.
Swedbank Analysis • December 13, 2010 3

4. ter). When the labour market programmes are terminated, these persons will
automatically end their employment. Nevertheless, employment net of
ALMPs has been rising as well – by 37 thousand in total during the second
and third quarters – implying that new job creation is happening. Annual em-
ployment growth was observed in the third quarter (0.7%) for the first time
in the last two years.
Unemployment rate Employment
25% 25 70% 50
20% 20 50%
30% 25
15% 15
10%
0
10% 10 -10%
5% 5 -30% -25
-50%
0% 0
-70% -50
Jan.06 Jan.07 Jan.08 Jan.09 Jan.10
1Q 04 1Q 05 1Q 06 1Q 07 1Q 08 1Q 09 1Q 10
Newly registered unemployed, thsd people (rs) Change in ALMP participants (rs)*
Registered unemployment Change in employment, thsd people (rs)
Job-seekers' rate Employment rate
Source: SEA, Eurostat * Data available for 2010 only Source: CSBL
It can be seen that the number of newly registered unemployed per month is …but the pace of im-
still nearly twice as high as in 2006-2007. Data for the second and third provement is likely to
quarters are still influenced by seasonal jobs, which usually end in October- slow
November.2 Preliminary data from the State Employment Agency (SEA)
show that the fall in the registered unemployment rate stopped in Novem-
ber. Therefore, it is very likely that the pace of improvement in the labour
market will slow in the coming months. Particularly so, given that proposed
2011 government budget consolidation measures do not effectively support
and in some cases even hamper job creation by increasing labour costs – e.g.,
the increase in the minimum wage.3
… but underlying imbalances continue to mount
Despite recent improvements, there are several signs of mounting structural A large share of job loss
problems. By the first quarter of 2010, the total job loss since the fourth
in domestic demand sec-
quarter of 2007 (i.e., the peak in employment) had reached 231.3 thousand,
tors is likely to be per-
which is much higher than the 146.4 thousand jobs generated during the
boom years. Comparing job gain and loss across industries, it can be seen
manent
that the employment fall was the most sizable in such domestic demand in-
dustries as retail and wholesale trade and construction. Anticipating that
these sectors will recover much slower than exporting industries in the com-
ing years, they will not need as many employees as they employed in 2007.
This means that many job seekers will need to change their qualifications to
be able to find new jobs.
For instance, construction activity in the coming years will be much lower
(due to more cautionary investment activity from the business side and lend-
ing policies of the banks, weak demand in the residential real estate market,
the miring of many projects in insolvency procedures, etc.). Due to lack of
work and sizable wage differences, many construction workers are thus
moving to work in other European countries (thereby causing many of the
social problems outlined above).
2
Data are also influenced by emigration, which is not fully accounted in the statistics –
most likely, the number of economically active and of job seekers is overestimated.
3
See http://www.fm.gov.lv/preses_relizes/dok/konsolidacija.pdf for more details (avail-
able in Latvian).
4 Swedbank Analysis • December 13, 2010

5. Job gain and loss, 2004-2010 (thousand)
80 80
60 60
40 40
20 20
0 0
-20 -20
Industry
health, other
Fin. sector
Real est., other
Construction
wholesale trade
Hotels, transport,
Public administr.
communications
Education,
comm. serv.
serv.
Retail&
Job gain (1Q 04 to 4Q 07) Job loss (4Q 07 to 1Q 10) Source: Eurostat
Employment developments across industries and inflation dynamics also
suggest that the unemployment rate in 2006-2007 might have been lower
than the natural unemployment rate due to overemployment in booming in-
dustries. The current economic structure and labour market skills set will not
be able to ensure such a low unemployment rate unless there is a rapid rise
in inactivity rates and/or emigration. As with any crisis, there is a tendency
to overshoot, i.e., in this case there might have been excessive job destruc-
tion, and the current decline in the unemployment rate to large extent may
be a one-off rebound.
Another potential problem is the structure of unemployment. The most vul-
nerable groups traditionally are youngsters, long-term unemployed (more
than 12 months), and those with lower education. The particular problem for
young people is to get their first jobs and become involved in the labour mar-
ket, as employers prefer to hire people with work experience. The problem
for the long-term unemployed is that, the longer they stay out of employ-
ment, the harder for them it is to find a job as their knowledge and skills are
deteriorating. Quite plausibly, additional education (which is valued by po-
tential employers) helps them to find jobs, but this requires money and time.
Long-term unemployment* in selected EU Job seekers by duration, thsd persons
countries, % of total
250
60
50 200
40
150
30
100
20
10 50
0
0
1Q 06 1Q 07 1Q 08 1Q 09 1Q 10
1Q 05 1Q 06 1Q 07 1Q 08 1Q 09 1Q 10
EU27 Germany Sweden
Estonia Latvia Lithuania <6M 6-11M >12M
* 12 months or more Source: Eurostat Source: CSBL
It is typical that the share of long-term unemployed diminishes at the onset Increase in the share of
of a recession as layoffs increase the share of newly unemployed, but grows long-term unemployed
in the recovery if the economy fails to create enough new jobs (IMF, 2010a).
The share of long-term unemployed in Latvia in total unemployment is now
very similar to that in the EU27 (close to 40% in the second quarter of 2010),
but this share was substantially below the European average before the cri-
sis. This as well indirectly points to a labour shortage and, consequently, very
Swedbank Analysis • December 13, 2010 5

6. low unemployment rates in Latvia in 2006-2007.4 It should be noted that
labour market arrangements vary substantially across countries (e.g., due to
unemployment benefit schemes). A good case for the authorities to examine
would be that of the Nordic countries, where the long-term unemployment
share constantly has been under 20%.5
Job-seekers' rate by education, % Job-seekers' rate by age groups, %
40 40
30 30
20 20
10 10
0 0
1Q 05 1Q 06 1Q 07 1Q 08 1Q 09 1Q 10 1Q 05 1Q 06 1Q 07 1Q 08 1Q 09 1Q 10
Higher education Vocational education
15-24 25-34 35-44
Secondary education Primary education
Average 45-54 55-74 Average
Source: CSBL Source: CSBL
As a proportion, youth unemployment in Latvia is somewhat below that in
High youth unemploy-
Europe (1.8 times higher than the average job-seekers’ rate, versus a 2.2 ra-
tio in the EU27). However, the level is significantly higher – the job-seekers’
ment
rate among 15-24 years’ old is 35% in Latvia, which is one of the highest
among European countries (21% in the EU27). This makes the emigration
risk even more acute, as young people are typically more mobile.
While the Latvian unemployment structure is not extraordinary compared Similar problems as in
with the EU average, there are two reasons why this does not imply that the the EU, but more acute
situation is normal. First, Europe is experiencing similar labour market prob- because of higher unem-
lems after the global economic crisis that must be addressed, and, second, ployment level
the overall unemployment rate in Latvia is about twice as high as that in the
EU27.
Employment expectations*, % New unemployed and job vacancies, thousand
40 30
20 25
0
20
-20
15
-40
-60 10
-80 5
Jan.05 Jan.06 Jan.07 Jan.08 Jan.09 Jan.10
0
Services Manufacturing
Retail trade Construction Jan.04 Jan.05 Jan.06 Jan.07 Jan.08 Jan.09 Jan.10
Newly registered unemployed
* Net position of employers' expectations: (+) Source: DG Reg. job vacancies
reflects an increase and (-) a decrease ECFIN Source: SEA
Business confidence surveys show that employment expectations in the
main Latvian industries, except for construction, are still fluctuating around
zero (i.e., the number of companies that expect to hire new workers is nearly
4
Surveys showed that wages for new workers hired in 2006-2007 were often higher than
those of existing experienced employees, because otherwise it was impossible to fill the
vacancies.
5
Labour markets in these countries are flexible, but at the same time with good social
protection (e.g., the so-called flexicurity model in Denmark). However, the costs of such a
model are significant.
6 Swedbank Analysis • December 13, 2010

7. the same as those that are planning layoffs). From registered unemployment
data, it can be seen that available vacancies are still falling significantly be-
hind the number of newly registered unemployed,6 implying that recovery in
the labour market is still quite fragile and job creation slow. Job vacancies are
growing, more and more companies point to labour as one of the factors lim-
iting production (i.e., due to insufficient competence or labour supply).
The costs of prolonged unemployment are becoming increasingly evident. Costs of unemployment
The number of recipients of unemployment benefits is falling quickly7 – their
becoming evident
share fell to only 30% of total registered unemployed in the third quarter of
2010. Accordingly, poverty has been increasing – in September 2010 there
were more than 180 thousand persons, or about 8% of the population, char-
acterised as poor (up from about 100 thousand in January), and only 66
thousand of them were receiving guaranteed minimum incomes.8
Risk of high structural unemployment
The above-mentioned factors suggest that there is a high risk that cyclical
unemployment will become entrenched as a structural phenomenon. This
especially concerns long-term unemployment and youth unemployment,
which are commonly perceived as the most vulnerable groups (e.g., according
to IMF and OECD research). How acute is the problem in Latvia?
The Beveridge curve for Latvia was nearly vertical during the times of rapid
economic growth reflecting a labour shortage – the vacancy rate increased
much more rapidly than unemployment declined. At the beginning of the re-
cession, the number of vacancies evaporated quickly, but a rise in unem-
ployment followed with a lag, as companies were not anticipating such a
large fall in economic activity. In 2009 and early 2010, unemployment rose
sharply while vacancies remained at very low levels.
Beveridge curve, 2005-2010 Beveridge curve, 2005-2010
2.5 2.5
1Q 07
2.0 2.0
Registered vacancy rate, %
Jan.07
Vacancy rate, %
1.5 1.5
1Q 05 ? ?
1.0 1.0
Jan.05
? Sep.10
0.5 0.5
2Q 10 ?
0.0 0.0
0 5 10 15 20
0 5 10 15 20 25
Registered unemployment rate, %
Job-seekers' rate, %
Source: CSBL Source: SEA, CSBL, Sw edbank calculations
6
It should be taken into consideration that only some employers register their vacancies in
the SEA database (and, most likely, not too many of those who are seeking highly quali-
fied labour).
7
Currently, the registered unemployed are eligible for unemployment benefits for nine
months. Depending on the length of service, a large part of the unemployed received only
LVL 45 in benefits in the last three-five months. The average monthly net wage in the
third quarter of 2010 stood at about LVL 318. True incomes of unemployed may be a bit
higher due to tax evasion (i.e. employment and wages are underestimated).
8
LVL 40 for an adult, and LVL 45 for a child.
Swedbank Analysis • December 13, 2010 7

8. With the recovery in 2010, we see that the movement in the Beveridge Beveridge curve analysis
curve has reversed – the unemployment rate is diminishing and the vacancy implies that unemploy-
rate increasing. However, the question is, how will the curve move in the fu- ment has not yet become
ture? At such an early stage of economic recovery, it is premature to judge entrenched, but the risk
whether structural unemployment has become entrenched. However, there of it is high
is a high risk that, with the same vacancy rates as in 2007-2008, the unem-
ployment rates will be much higher in the coming years if adequate policy
action is not undertaken, especially considering the unemployment structure
and skills mismatch discussed above.
While the labour market in Latvia is considered to be quite flexible,9 there are
definitely wage and price downward rigidities, which were mentioned above
as one of the factors explaining structural unemployment. For instance, dur-
ing the recession the necessary labour cost cuts were primarily done through
layoffs and decreases in working hours rather than through reductions in
wages10 – in 2009, the total wage bill in the economy declined by 25%, of
which employment in full-time equivalents by 21% and wages by 4%. Thus,
wage cuts comprised only 16% of the wage bill decrease, compared with
nearly one-third in Estonia and Lithuania.
Current policy action is insufficient and lacks
important elements
Policy action has so far mainly focused on ALMPs. Expenditures on ALMPs So far main focus has
increased notably in 2009, partly financed by EU structural funds. Expendi- been on active labour
tures on the labour market programmes provided by SEA were over LVL 30 market policies
million (nearly 0.25% of GDP), and a similar amount is planned for 2010 (up
from about LVL 12 million in 2008). The number of participants also in-
creased. The main labour market programmes can be seen in the following
table.
The most important labour market programmes used by SEA11
Measures Number of partici- Expenditures in Brief description
pants in 2009 2009
Measures to raise About 39 thousand About LVL 0.3 E.g., networking and commu-
competitiveness (one person can million nication skills, psychological
participate several treatment, presenting skills,
times) Latvian language lessons, sell-
*
ing techniques, etc .
Career counselling About 55 thousand n/a E.g., career planning, profes-
*
(one person can sional suitability tests, etc .
participate several
times)
Measures to im- About 32 thousand About LVL 15 Different types of short training
prove or acquire million (vocational education, incl. at
qualifications employers’ and different edu-
*
cational institutions) . There is
a monthly scholarship of LVL
70 for the participants.
9
For instance, according to World Economic Forum (2010), Latvia ranks 49th out of 139
countries with regard to labour market flexibility.
10
See Swedbank Analysis “Competitiveness adjustment in Latvia – no pain, no gain?” (March
2010) for more details: http://www.swedbank.lv/eng/docs/materiali.php?nmid=0&naid=3
11
More detailed information in English is available in the report by the Ministry of Welfare;
see http://www.lm.gov.lv/text/1533
8 Swedbank Analysis • December 13, 2010

9. Temporary jobs About 20 thousand Nearly LVL 11 Include paid temporary public
million works like LVL 100 worth sti-
pends and work practice in
**
municipalities .
Sources: SEA and Ministry of Welfare
*
See <http://www.nva.lv/index.php?cid=3&mid=311#parkv> for more details (available in Latvian).
**
See <http://www.nva.lv/index.php?cid=3&mid=313#prakse> for more details (available in Latvian).
Measures to raise competitiveness and career counselling have the largest
number of participants and require relatively little expenditure; however, in
our opinion, they are of little help if there is insufficient job creation. Public
work programmes, meanwhile, may provide short-term relief but no long-
term solution (they aim to reduce cyclical unemployment only).
Training schemes are much more efficient as they improve the human capital Training schemes are the
of the unemployed (which might help to diminish structural unemployment), most credible among the
but they are also more costly. Another challenge is to provide quality training measures taken, but the
that is actually valued by employers. In addition to the short-term training number of participants is
schemes offered, a coupon (or voucher) system has been introduced to facili- low
tate competition (and thus better quality) among education providers and to
offer employees with reduced working hours or unemployed with unfinished
tertiary education an opportunity to upgrade their skills and knowledge at
their chosen institution of education. However, the number of participants in
this programme is very low – about 3,000 part-time employed participated in
2009 (this part of the programme was terminated in March 2010) and about
350 unemployed participants have been planned for 2010. In addition, Jong
and Vanags (2009) have warned that, without adequate monitoring and
quality assurance, vouchers by themselves may have only a limited effect.
Overall, while the use of ALMPs increased during the crisis and some of them Without structural
yield positive results also in the longer term, without structural changes they changes, available meas-
are, in our opinion, insufficient to minimize structural unemployment. The ures are insufficient
main structural policy measures actually taken so far have been related to
improvements in the business environment, e.g., easing start-ups of new
businesses, especially for small and medium-sized enterprises. However, it is
clearly insufficient
Uneven regional developments should be taken into
consideration
Regional factors should be taken into account when designing appropriate Lower activity rates and
policy measures. While the registered unemployment rate has always been deeper potential struc-
substantially lower in Riga than in other Latvian regions, job-seekers’ rates tural unemployment
are more similar (implying that less job-seekers register as unemployed in problems in the regions
Riga).12 It should be taken into consideration that participation rates in the
regions are notably lower (i.e., people are not looking for jobs). It may sug-
gest that in rural areas more people are detached from the labour market –
they have been unemployed for a while and do not see opportunities to find
a job thus they are not really searching. It points to larger structural prob-
lems in the regions.
Wages in the regions are notably lower than in Riga, which raises a question
whether the public work programmes are really efficient in the regions. For
12
For instance, the registered unemployment rate in Riga was 9.5% in 2009, versus 16.3%
in Latgale; the job-seekers’ rate amounted to 16.9% in Riga and 17.4% in Latgale. Latgale
region is the poorest and easternmost part of Latvia, bordering the Russian Federation,
Belarus, and Lithuania.
Swedbank Analysis • December 13, 2010 9

10. instance, LVL 100 worth stipend constitutes nearly half of the average net
wage in Latgale, thus there is a stronger motivation to register as an unem-
ployed and to participate in such programmes. There is a risk that an unem-
ployed in a region would choose to participate in such a programme instead
of searching for a permanent job and/or work full-time. This may cause dis-
tortions in the regional labour markets – one of the reasons why it is cur-
rently planned to transform LVL 100 stipends to LVL 80 stipends.
Job-seekers' rate by region, % Participation rate by region, %
20 75
70
16
65
12
60
8
55
4 50
2002 2003 2004 2005 2006 2007 2008 2009 2002 2003 2004 2005 2006 2007 2008 2009
Vidzeme Latgale Zemgale Vidzeme Latgale Zemgale
Kurzeme Rīga Kurzeme Rīga
Source: CSBL Source: CSBL
Net wage by region, LVL
400
300
200
100
2002 2003 2004 2005 2006 2007 2008 2009
Vidzeme Latgale Zemgale
Kurzeme Rīga
Source: CSBL
This underscores that the unemployment problem in regions should be per- Resource concentration
haps addressed in ways other than in the largest cities. But how? We see in the regional centres
two possible options. The first one is job-creation in the regions. This would should be considered
involve the necessary improvement of skills. Currently, despite low labour
costs, it is difficult to create new jobs in the regions due to the lower qualifi-
cation of the potential employees and their smaller activity in the labour
market. In most cases, production that asks for low-skilled labour is the only
sensible option. A second solution is the concentration of resources and
strengthening of incentives for labour to move to regional centres, where
the critical mass of employment is larger and it is perhaps easier to create
viable jobs. A decision should then be made as to whether and according to
what criteria investments in infrastructure in the regions with low popula-
tion density are credible.13
13
In many Latvian strategy documents (e.g., the National Development Plan), polycentric
development is mentioned but not clearly defined, i.e., is the focus on the largest towns or
also on rural municipalities?
10 Swedbank Analysis • December 13, 2010

11. Job creation should be promoted
As already outlined above, timing is one of the important factors in choosing Hiring subsidies is one
an appropriate policy measure – in the recovery phase, job creation should be possible measure for
encouraged. One of the measures to promote job creation and reduce the risk promoting job creation in
of structural unemployment is hiring subsidies for the employers, targeted at the recovery phase
the most vulnerable groups, see OECD (2010b), IMF (2010b), and Dao and
Loungani (2010). However, opponents to this approach (e.g., Marx, 2005)
say that the net employment effects are actually smaller than most theoreti-
cal models and simulations imply. Further research is required to determine
whether such a subsidy is worthwhile in Latvia, but, taking into account cur-
rent unemployment levels, it should at least be considered and publicly dis-
cussed.
One of the most common ways to implement a hiring subsidy is to allow for a
temporary reduction in an employer’s social contributions for hiring a long-
term unemployed or a young person seeking his/her first job. In such a way,
the most vulnerable groups are provided an opportunity to enter the labour
market and improve their human capital, while employers’ training costs are
partly compensated for.
In order to minimize possible distortions from a hiring subsidy, it is very im- Such a subsidy should be
portant that it be targeted and temporary. It is recommended that such a targeted, temporary, and
subsidy be introduced in the early recovery stage, so as to minimise costs re- aimed at increasing net
sulting from providing a subsidy to a person who would be hired anyway. employment
Another issue is to ensure that this subsidy increases net employment
growth (e.g., not allocated to a person who is replacing a previously resigned
or dismissed worker). This certainly increases the complexity of administer-
ing such a subsidy, but also makes it more cost-efficient.
Job creation can also be promoted by attracting new investments. Upgrading
the country ratings (among the international rating agencies, only Moody’s
has kept Latvia’s rating at investment grade) is one of the issues, but reduc-
ing uncertainty with respect to, e.g., tax policy at least several years ahead
is also very important.
Sectoral labour reallocation should be encouraged
Research by the IMF (2010a) emphasises the importance of differentiating Policies that facilitate
between permanent shocks (e.g., a real estate bust) and temporary shocks labour reallocation
(e.g., a fall in external demand) in choosing an appropriate labour market pol- across industries should
icy. For countries experiencing temporary shocks (like Germany in 2009) la- be supported
bour hoarding proved to be most effective. However, for countries facing
permanent shocks (like Latvia or Spain) policies facilitating sectoral labour
movements should be considered, as jobs in industries that have experienced
pre-crisis bubbles are not expected to return.
In order to support economic growth and, in the case of Latvia, to hasten
productivity convergence with the advanced European countries, labour Labour movement to
movement towards high-productivity sectors is considered to be efficiency
higher-productivity sec-
tors is considered to be
enhancing (see, e.g., OECD, 2010b). Taking into account structural adjust-
efficiency enhancing
ment in the economy during the recession and subsequent recovery, there is
thus a trade-off between supporting short-term employment (like offered
public works) in less productive sectors and the long-term objective of facili-
tating reallocation of workers and jobs towards more productive companies
and industries. A task for policymakers would be to find a sensible balance
between these two options.
Swedbank Analysis • December 13, 2010 11

12. Among the employed ALMPs in Latvia, different training schemes (measures
to improve or acquire qualifications, including a coupon system) seem to be
the most important element to promote labour reallocation across industries.
However, taking into account lack of job creation and low planned number of
participants, these measures are likely to be insufficient to solve the struc-
tural unemployment problem. Wider changes in the economic structure and
motivation are necessary, i.e., structural policy should be employed.
Focus on structural policy
While ALMPs can be quite efficient in supporting employment in the short
It is more efficient to
term, maintaining them in the longer term might lead to distortions (e.g., re-
solve structural problems
call the case of the LVL 100 stipends in Latgale). Structural policy is much
with structural policy
more efficient in solving structural problems. While some progress has been
made in improving the business environment, there are many areas that still
need to be improved in order to reduce structural unemployment. Let us
mention here just four of them that we see as particularly important and ur-
gent. The aim is not to provide a detailed description of necessary reforms,
but outline, in our opinion, the main areas and encourage discussion, hope-
fully, accelerating the implementation of reforms.
(i) Tertiary and vocational education
This is crucial to allow those unemployed to improve/change their skills to
find jobs in other industries. So far, any reforms made in this area have been
scarce or nonexistent, and the education quality in many cases is poor and
outdated. To improve the situation, vocational education must be brought
closer to business, the number of tertiary education institutions must be
sharply reduced, and the academic staff’s remuneration and career path must
be made to depend significantly upon the track record of their publications in
internationally renowned journals.14
(ii) Research and development
Taking into account problems with skills mismatch and uneven regional de-
velopments, boosting cooperation among educational institutions, busi-
nesses, and government/municipalities is of the utmost importance. This
would help to develop innovations in areas that can actually be used by busi-
ness afterwards. Currently any spillovers from research into business are
very limited. The share of enterprises with innovation activities in Latvia is
significantly below the EU average (16% for the former and 40% for the lat-
ter in 2006). Boosting innovations would support exports and, thus, eco-
nomic growth, which would also help to create new jobs, especially in higher
productivity sectors. For instance, Dombrovsky (2010) suggests that avail-
able EU funds be used to fund R&D projects aimed at developing new prod-
ucts or adapting new technologies to specific industries or firms run by the
public agency with councils from academic, business and government.
(iii) Competition policy
The economic literature points to the importance of competition in product
markets in reducing unemployment. The less competitive are the product
markets, the more depressing is the effect on labour reallocation (OECD,
2010a). According to World Economic Forum (2010) the intensity of local
competition in Latvia has worsened, and the extent of market dominance in-
14
An extensive list of suggested reforms can be found in, e.g., Commission of Strategic
Analysis (2010), “Tertiary education in Latvia: facts, problems and opportunities” (avail-
able in Latvian)
12 Swedbank Analysis • December 13, 2010

13. creased, while the effectiveness of anti-monopoly policy has deteriorated in
comparison with other countries. Consequently, despite improvements in the
entrepreneurial environment (e.g., starting new businesses), the level of do-
mestic competition has decreased (partly due to increased tax evasion) –
Latvia now ranks 74th out of 139 countries (57th last year) in domestic
competition. A reduction of the “grey” economy and improved competitive
product market regulations would help to ease labour market pressures.
(iv) Tax policy
The 2011 government budget plans imply that the tax burden on labour in-
comes will, albeit marginally, increase.15 A widening of the labour tax wedge
may create additional barriers to job creation. We think that the opposite pol-
icy must be undertaken – the tax burden on labour must be significantly and
sharply eased to support job creation, and the tax burden should be shifted
to real estate and consumption.16 It is particularly important given a large
share of low-skilled labour – an increase in labour costs thus significantly in-
fluences ability of business to create new jobs.
What next for structural unemployment?
Structural unemployment will rise, and policymakers should deal with it pro-
actively. What are the likely take-away points that should be addressed
when designing policy measures? Let us recall just a few:
• Resource concentration. What do policymakers mean by “polycentric
development”? How many centres is polycentric enough… a few
largest towns or over 100 existing rural municipalities? Should
cross-regional labour reallocation be promoted? To what extent and
according to what criteria should infrastructure investments be
spread across the regions?
• Productivity convergence. Should, and, if yes, then how sectoral la-
bour relocation to higher-productivity sectors to be encouraged?
How to promote innovations? How to improve quality and effec-
tiveness of tertiary and vocational education? How to improve do-
mestic competition?
• Tax policy. How should it look like to promote job creation? Should
hiring subsidies to employers be introduced?
• Labour market model. How do Nordic countries deal with unem-
ployment? Should Latvia follow suit, and, if yes, then how to intro-
duce, e.g., the flexicurity model of Denmark?
Lija Strašuna
Mārtiņš Kazāks
15
For instance, it is planned to increase employees’ social contributions from 9% to 11%
and to reduce the personal income tax from 26% to 25%. Tax payments will increase for
employees receiving a gross wage more than LVL 500 and decrease for those receiving
less than LVL 500. An increase in minimum wage is planned from LVL 180 till LVL 200.
See <http://www.fm.gov.lv/preses_relizes/dok/konsolidacija.pdf> for more details (avail-
able in Latvian).
16
See Swedbank Analysis “The Fiscal stance in Latvia: how to return to a sustainable
path?” (October 2009) http://www.swedbank.lv/eng/docs/materiali.php?nmid=0&naid=3
and Swedbank Monthly Newsletter on the Latvian economy, October 2010
http://www.swedbank.lv/eng/docs/materiali.php?nmid=0&naid=6 for more details.
Swedbank Analysis • December 13, 2010 13

14. Abbreviations
ALMPs – Active labour market programmes
CSBL – Central Statistical Bureau of Latvia
EU – European Union
IMF – International Monetary Fund
OECD – Organization of Economic Cooperation and Development
SEA – State Employment Agency
References
Ball, Laurence M. (2009), “Hysteresis in unemployment: old and new evi-
dence,” NBER Working paper 14818, March 2009
Blanchard, Olivier J., Lawrence H. Summers (1986), “Hysteresis and the Euro-
pean unemployment problem,” NBER Macroeconomics Annual 1986, Volume 1
Dao, Mai, Prakash Loungani (2010), “The human cost of recessions: assessing
it, reducing it,” IMF Staff Position note SPN/10/17, November 11, 2010
Dombrovsky, Vyacheslav (2010), “Does Latvia Need an Industrial Policy?”
Discussion paper, Stockholm School of Economics in Riga and Baltic Interna-
tional Centre for Economic Policy Studies
Forslund, Anders, Peter Frederiksson (2009), “Income support systems, la-
bour supply incentives and employment – some cross-country evidence,” The
Institute for Labour Market Policy Evaluation (IFAU), Working paper 2009:32
IMF (2010a), “Cross-cutting themes in employment experiences during the
crisis,” October 8, 2010
IMF (2010b), “Unemployment Dynamics during Recessions and Recoveries:
Okun’s Law and Beyond,” Chapter 3 in World Economic Outlook April 2010
Jong, Philip de, Alf Vanags (2009), “Assessment of training measures by the
Latvian State Employment Agency”, European Employment Observatory
Thematic report
Marx, Ive (2005), “Job subsidies and cuts in employers’ social security contri-
butions: the verdict of empirical evaluation studies,” Centre for social policy,
University of Antwerp
OECD (2010a), “Moving beyond the jobs crisis,” OECD Employment Outlook
2010, Chapter 3: Institutional and policy determinants of labour market
flows
OECD (2010b), “Supporting labour demand,” Position paper, July 2010
World Economic Forum (2010), “Global competitiveness report 2010-2011”,
http://www.weforum.org/en/initiatives/gcp/Global%20Competitiveness%2
0Report/index.htm
14 Swedbank Analysis • December 13, 2010

15. Economic Research Department
Sweden
Cecilia Hermansson +46 8 5859 7720 cecilia.hermansson@swedbank.se
Group Chief Economist
Chief Economist, Sweden
Magnus Alvesson +46 8 5859 3341 magnus.alvesson@swedbank.se
Senior Economist
Jörgen Kennemar +46 8 5859 7730 jorgen.kennemar@swedbank.se
Senior Economist
Marie-Anne Larsson +46 8 5859 7740 marie-anne.larsson@swedbank.se
Assistent
Estonia
Maris Lauri +372 6 131 202 maris.lauri@swedbank.ee
Chief Economist, Estonia
Elina Allikalt +372 6 131 989 elina.allikalt@swedbank.ee
Senior Economist
Annika Paabut +372 6 135 440 annika.paabut@swedbank.ee
Senior Economist
Latvia
Mārtiņš Kazāks +371 67 445 859 martins.kazaks@swedbank.lv
Deputy Group Chief Economist
Chief Economist, Latvia
Dainis Stikuts +371 67 445 844 dainis.stikuts@swedbank.lv
Senior Economist
Lija Strašuna +371 67 445 875 lija.strasuna@swedbank.lv
Senior Economist
Lithuania
Nerijus Mačiulis +370 5 258 2237 nerijus.maciulis@swedbank.lt
Chief Economist, Lithuania
Lina Vrubliauskienė +370 5 258 2275 lina.vrubliauskiene@swedbank.lt
Senior Economist
Ieva Vyšniauskaitė +370 5 258 2156 ieva.vysniauskaite@swedbank.lt
Senior Economist
Swedbank Analysis • December 13, 2010 15

16. Disclaimer
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16 Swedbank Analysis • December 13, 2010