Western Europe in the 1950s. Though the relative merits of different institutional frameworks in supporting economic development remain subject to debate, empirical studies have shown that the systems in East Asia have been less effective in promoting efficiency and innovation.

Thus, the main lesson from the international evidence is that TFP, rather than mobilization of factor inputs, has the greatest potential to spur growth in Latvia in the medium and long term.

# **Box 2: Growth Accounting in CEEC**

Boldrin and Canova (2003) attempt to quantify the extent to which the next wave of EU accession countries (CEEC) are economically behind the EU15. They review trends in GDP per capita and labor productivity, savings and investment patterns, and carry out an ambitious growth accounting exercise. They find that despite the fact that the quest for convergence with the EU began to bear fruit in the mid-1990s, “the average CEEC is still where it was ten years ago relative to the average EU15 country.” They document that, with the current investment rates in physical capital, it will take a considerable amount of time for CEECs to reach the capital-output ratio existing in the EU. The key drive for faster results will be the dynamics of technological acquisition in these countries.

From the viewpoint of a simple growth accounting exercise, productivity gains, as measured by the growth rate of total factor productivity (TFP), seem to be the main determinant of long-term growth. Sources of TFP include foreign direct investment, shrinkage of the public sector or the agricultural sector, and institutional change. In the case of Latvia, it appears that the TFP contribution accounted for over 80 percent of output growth during the period 1991-2002, while labor contribution was negative.

||**Time Period**|Δy/y|Δk/k|Δn/n|ΔTFP|ΔFDI/FDI|
|---|---|---|---|---|---|---|
|Bulgaria|1991-2001|-0.04|0.006|-0.04|-0.006|0.001|
|Czech|1993-2000|0.02|0.02|-0.002|0.002|0.003|
|Estonia|1992-2001|0.02|0.015|-0.015|0.02|0.004|
|Hungary|1992-2001|0.023|0.014|-0.004|0.013|0.003|
|**Latvia**|**1991-2000**|**0.077**|**0.008**|**-0.013**|**0.082**|**0.002**|
|Lithuania|1991-2000|0.049|0.018|-0.014|0.044|0.002|
|Poland|1991-2001|0.032|0.012|-0.006|0.04|0.001|
|Romania|1991-2001|-0.004|0.01|0|-0.015|0.001|
|Slovak|1993-2000|0.03|0.022|-0.01|0.017|0.003|
|Slovenia|1992-2000|0.05|0.017|-0.01|0.042|0.001|
|CEEC|average|0.025|0.014|-0.011|0.022|0.002|

_Notes:_ Δy/y = output growth; Δk/k = capital growth; Δn/n = employment growth; ΔTFP = TFP change; ΔFDI/FDI = FDI growth; AGR Δn/n = _contribution of agricultural employment. The increments in capital stock are computed summing up investment over the period and subtracting yearly depreciation. Data for depreciation is available only for the three Baltic States: the depreciation rate is estimated to be around 40-50percent of the investment rate. We apply a value of 45percent to the other seven countries. The increments on the labor input are computed using bodies and not hours which are not available in many countries. Data for Hungary indicate that the difference is small. The domestic increment in the capital stock is calculated as residual. The same depreciation rate is applied to domestic capital and FDI, therefore biasing downward the contribution of FDI to growth. The contribution of agriculture to growth is calculated multiplying δn/n by the decrement in the population employed in agriculture_ . Source: Boldrin and Canova (2003).

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