Hungarian economic growth – a factor model-based interpretation

Economic growth is a top indicator that analysts enjoy to look into in different ways. I prepared a short assessment on the growth outlook of the Visegrad countries based on the two-factor model, which simply condenses production volumes and production factor prices to the level of capital and labor.

First, let’s split the GDP of the Visegrad countries into two components: capital intensive and labor intensive industries. Capital intensive industries include those industries that operate with costly infrastructure (manufacturing, telecommunications, etc.). Labor intensive industries are predominantly services, employing higher skilled workforce.

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We can see that the Hungarian GDP is made of less capital intensive industries than the neighboring countries. Does this limit competitiveness? Well, that depends on how fast these industries can grow. By assuming, that investing more capital in the capital-intensive industries and investing into labor in case of labor-intensive ones are directly boosting growth, the driver in our case seems to lie in the cost of the two factors.

According to the factor model, goods can be produced by different combinations of capital and labor, but there are optimal combinations for each good, that are defined by the unit costs of the two factors.

Now, if we take a look on how the prices of these factors evolved in the post-crisis years, there are two things that pop up. The cost of capital has gone down basically to zero, as a result of all the QEs, liquidity boosts, money printing, forward guidance and other sophisticated monetary policy tools aimed to keep interest rates low for long. I have selected the 1M money market interest rates as a proxy for the short term expectations and thus an appropriate measure for the financial market sentiment. As all the selected countries, in a global context, act as small open economies, large scale interventions on the financial markets are considered exogenous. Therefore, as the dominant players of the global money markets (US, Japan, ECB) intent to keep the yield curve flat and low for longer periods, we can assume cheap sources of capital in the future.

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forrás: Statisztikai Hivatalok

The measure for the cost of labor is the unit cost of labor, which can be split into real wages and labor productivity. Region wide, real wages have been relatively stable in the past years, whereas productivity has slightly increased, but still keeping the unit labor cost on a rising path. All in all, what we see in that the relative price on capital to that of labor has shown a severe decrease.

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This means, that those companies employing large shares of human labor, are facing difficult times. The two options they have are either to lay off people and try to increase productivity of the remaining employees or to lay off people and replace them with capital. The first option is what most of the companies already did – unemployment rates skyrocketed to above 10%. In addition, productivity cannot be increased to infinity and pushing it beyond the limits requires additional resources (e.g. controlling function).  The second option might sound odd, but if we take a look back in the late 18th, early 19th century, this kicked off the industrial revolution – obviously, the problem of the past years is not at the same level of magnitude as it was back then.

Future expectations for the unit labor costs are slight and stable growth, as productivity cannot be increased any further for free and no shakeup is expected in terms of the real wages either.

We can conclude that in such an environment, where the price of labor and that of capital tend to move in opposite directions, the structure of GDP will have a significant effect on growth. The relatively low share of capital-intensive industries in Hungary is a structural barrier that limits its competitiveness among the Visegrad countries.