The "Latvia-should-produce-more-high-value-added-goods" fallacy

All the years I have been here I have heard the argument that Latvia should produce more high value-added goods, seemingly supposed to mean something more high-tech and certainly less low-tech. So why does the country not do that? Because the argument contains some inherent fallacies. It is thus a largely meaningless discussion but it seems to go on, year after year….

From a macroeconomic perspective the argument is trivial. As value added is just another word for GDP it is the same as saying that the country should create more GDP i.e. be richer and I guess nobody is really against that. Latvia is currently, by GDP per capita, the most often used measure for income per person, in 24th position in the EU27, just ahead of Poland, Romania and Bulgaria. In an EU context Latvia is thus poor and of course we would like to see that change.

It is more interesting to analyze the more-high-value-added-goods idea from a microeconomic point of view. Allow me an example with a very simple production process, the digging of holes and a very simple "product", holes dug (!) Let a man dig holes with his hands and he will not dig that many. Give him a shovel and he will dig more but give him a Bobcat and he can dig very many! In microeconomics we would say that the better equipped labour is with physical capital (factories, equipment etc.) the more productive it is i.e. the more holes it can dig and thus the more GDP it can create. Argument: Latvia might be relatively poor because of a lack of physical capital. But one fallacy also appears. Even holes dug with the help of a Bobcat are not really high-tech, right? Paul Krugman once, famously, had an example of one of the most value-adding production processes per person employed in America: The making of potato chips… I guess it is one man pressing a button and then machines do the rest.

But our hole-digging man has more issues to address – some of his working time is spent not digging holes but doing accounting to report his earnings to the State Revenue Service. The more details he has to report, the fewer holes he can dig thus the less GDP he creates – red tape makes people less productive. Argument: The more bureaucratic the public sector is the lower is GDP.

But why is our man digging holes – which, as mentioned, I would associate with low-tech production – in the first place and not producing fancy software or whatever so-called high-tech product one might think of? Because he does not have the skills to do so, he lacks education. A more than 200 years old principle still applies but is so often misinterpreted: Countries produce what they are relatively good at – they produce according to their comparative advantage. If Latvia does not produce enough high-tech software, biotech goods etc it is because it is just not good at it – the relevant inputs, here mainly highly skilled labour just do not prevail. And one cannot "order" more production of such goods – that would be a sort of planned economy way of thinking – "ordering" more of such production – and this is the second fallacy to believe that this can "just" be done – would fail as the lack of proper skills would result in such goods either not being appropriately made or being made at way too high costs and thus being uncompetitive.

Yes, yes – there are many smart people in Latvia and there is also fancy production here and there and all that – but this simple analysis explains why the country is still poor in an EU sense: It is on average poorly equipped with skills, possibly poorly equipped with physical capital and most likely equipped with a burdensome public sector – and that’s why it deals with scrap metal and not wind turbines.

Increase the level of skills, make the country more attractive for investment and production and its comparative advantages will shift – but believing that one can dictate shifts in production is futile.