This Selected Issues paper on Trinidad and Tobago highlights that real GDP growth accelerated slightly from 2.4 percent in 1995 to 3.2 percent in 1996. In both years, growth was mainly driven by a good performance of the non-oil sector, which expanded by 3 percent and 3.6 percent, respectively. Construction, distribution, and tourism grew at an especially rapid pace. Manufacturing showed an uneven performance, growing in 1995, but stagnating in 1996, which was owing to the differential effects of trade liberalization on its various subsectors.

Abstract

This Selected Issues paper on Trinidad and Tobago highlights that real GDP growth accelerated slightly from 2.4 percent in 1995 to 3.2 percent in 1996. In both years, growth was mainly driven by a good performance of the non-oil sector, which expanded by 3 percent and 3.6 percent, respectively. Construction, distribution, and tourism grew at an especially rapid pace. Manufacturing showed an uneven performance, growing in 1995, but stagnating in 1996, which was owing to the differential effects of trade liberalization on its various subsectors.

II. Persistent Unemployment and the Shortage of Capital

40. Unemployment rose sharply in Trinidad and Tobago after the oil price decline in the early 1980s. The original increase in unemployment can be explained by excessive increases in real wages in the face of a weakening in the terms of trade. By the mid-1990s, however, real wages had declined by 60 percent, but unemployment continued to be very high. This section argues that at least part of the unexpected persistence of unemployment can be explained by a contraction of national savings, and an associated reduction of the capital stock.

A. Background

41. The economy of Trinidad and Tobago is very dependent on energy exports. Oil and oil-derived products on average made up 30 percent of GDP and over 90 percent of total exports over the last 20 years. Historically, fluctuations in the petroleum sector have always been the main driving force for fluctuations in the rest of the economy, including in the labor market. The overview of stylized facts, therefore, starts with a look at the evolution of the oil price and the terms of trade (Figure 1).

Figure 1.
Figure 1.

The terms of trade are largely determined by the oil price.

Citation: IMF Staff Country Reports 1997, 041; 10.5089/9781451837544.002.A002

42. Due to the oil price shocks of 1973 and 1979, the terms of trade more than doubled for Trinidad and Tobago, creating a period of unprecedented affluence and wealth. The country had large budget and current account surpluses, and real per capita GDP increased from US$4,200 to US$6,200 within just nine years from 1973 to 1982. However, the base for this prosperity was precarious and evaporated quickly as the oil price began to decline in the early 1980s. The terms of trade worsened, and the economy slid into a deep and long recession, which could not be overcome until 1994. Over this period, GDP per capita fell by 35 percent and the unemployment rate climbed from 10 to more than 22 percent (Figure 2).

Figure 2.
Figure 2.

Deep recession and sharply rising unemployment after the oil boom.

Citation: IMF Staff Country Reports 1997, 041; 10.5089/9781451837544.002.A002

43. In Trinidad and Tobago, like in many other Caribbean countries, unemployment has traditionally been high, averaging 10 percent even during the oil boom years. However, in the late 1980s, almost a quarter of the labor force was out of work. Certainly, some increase in unemployment had to be expected after the large terms of trade shock which Trinidad and Tobago suffered in the mid-1980s, but unemployment has remained high for more than a decade after this event and shows little sign of reverting back to former levels. The macroeconomic upturn that started in the recent years has so far failed to transmit strong impulses to the labor market. After several years of economic growth, the unemployment rate has decreased only to 16 percent in 1996.

44. The persistence of unemployment long after the terms of trade shock suggests that the equilibrium in the Trinidadian labor market has undergone a structural change. Figure 3 portrays an attempt to distinguish the cyclical and structural components of the unemployment rate. This distinction has important policy consequences, because expansionary demand policies would affect the cyclical but not the structural component of unemployment. The figure shows an empirical measure of structural unemployment, the NAIRU (Non-Accelerating Inflation Rate of Unemployment). It accounts for several supply side factors in the economy, i.e., factors that influence the labor market equilibrium.8 As can be seen, equilibrium unemployment has risen strongly during the recession of the 1980s and has remained high thereafter. The present unemployment level appears to be almost exclusively structural.

Figure 3.
Figure 3.

Actual and structural unemployment.

Citation: IMF Staff Country Reports 1997, 041; 10.5089/9781451837544.002.A002

45. These results suggest that the factors behind the equilibrium in the labor market deserve closer attention. A key variable in this context is the real wage. Figure 4 shows its historical evolution. A remarkable “wage bubble” can be observed during the 1980s, the time of the long recession. Real wages started to rise around 1980, shortly after the second hike in oil prices. The steep upward trend continued during the first years of the recession, reaching a peak in 1986. From then on, real wages subsided and fell back to roughly their 1978 level. The change in income experienced by a Trinidadian worker was very large: the purchasing power of wages increased by 60 percent between 1980 and 1986 and subsequently decreased by the same amount.

Figure 4.
Figure 4.

The real product wage.

Citation: IMF Staff Country Reports 1997, 041; 10.5089/9781451837544.002.A002

46. The public sector played a leading role in this episode of rising real wages. At the beginning of the 1980s, oil revenues had boosted government finances and created political pressure to redistribute the windfall gains. Large wage increases were granted to public sector workers. These increases spread to the rest of the economy owing to the action of militant labor unions.

47. Real wages kept their rising momentum during the first years of the downturn. It proved difficult to adjust back to more austere living standards as the terms of trade deteriorated. The perception was widespread that the recession would be temporary. Also, extensive COLA clauses had been added to wage contracts. Since these contracts usually covered a period of three years, any adjustment of real wages was a slow process.

48. The rapid increase in real wages could not be matched by an equally fast increase in productivity. Figure 5 shows that unit labor costs nearly doubled between 1980 and 1986. During some of these years, real wages outpaced productivity growth by as much as 20 percentage points. This evolution not only led to huge budget deficits (oil revenues began to dwindle as the wages increased), but also to an enormous cost pressure on domestic firms. The large budget deficits and lower profits both reduced drastically national savings. As can be seen in Figure 5, national savings fell by 75 percent in real terms between 1981 and 1988.

Figure 5.
Figure 5.

Rising unit labor costs led to a sharp reduction of savings.

Citation: IMF Staff Country Reports 1997, 041; 10.5089/9781451837544.002.A002

49. Figure 6 shows that the sharp drop in national savings led to a similar decline in the amount of investment. In real terms, investment decreased by 66 percent between 1981 and 1988.9 However, because the decline in savings preceded the decline in investment, large current account deficits appeared in the early 1980s.

Figure 6.
Figure 6.

The reduction in savings was mirrored by an equally sharp reduction in investment.

Citation: IMF Staff Country Reports 1997, 041; 10.5089/9781451837544.002.A002

50. The decline in investment had important feed-back effects on the labor market. As investment adds to the capital stock, it has an important capacity effect. It is probable that the reduction of investment to a mere one-third of its previous level meant that it no longer covered depreciation and thus the capital stock fell. A reduction of the capital stock reduces output, lowers the productivity of labor, and reduces labor demand.

51. In brief an excessive increase in real wages during the early 1980s reduced employment via two channels: first, it squeezed the budget and profits of firms, leading to cost pressure and immediate lay-offs; second, by lowering national savings and investment, it reduced the capital stock and further decreased demand for labor.

B. A Diagrammatic Model

52. A short theoretical analysis, conducted in terms of simple diagrams, can help to organize the observed stylized facts. The model presented below contains three main elements: labor supply, labor demand, and capital accumulation. Labor supply is derived from the utility maximization of households. Households have a utility function containing consumption C and leisure (the negative of labor, N) as arguments. An example is the following:

U=CN1+β1+β(1)

53. A household earns wage income WN, which it either consumes or saves. For the time being, let us simply assume that the household does not save and consumes its entire income:

PCC=WN(2)

where Pc is the consumer price index. To highlight the effects of openness, assume that the consumption basket consists entirely of imported goods, priced at world prices. The household maximizes utility (1) subject to the budget constraint (2). From the first order conditions, the following equation can be obtained:

W/P=PC/Nβ=ENβ(3)

where P is the price of domestic goods, W/P is the real product wage and Pc/P = E is the real exchange rate.10 If export and domestic goods are aggregated into a single commodity, E also represents the inverse of the terms of trade. Equation (3) relates labor supply to the real wage expressed in domestic prices (the real product price) and the real exchange rate. The properties of this labor supply function can be seen more clearly if it is expressed in logarithms (lowercase letters):

wp=e+βn(4)

54. The corresponding curve in a real wage-employment diagram has a positive slope and is shifted up by an increase in the real exchange rate (a real depreciation), or equivalently by a deterioration of the terms of trade (see Figure 7). A real depreciation or a deterioration of the terms of trade increase relative import prices. Higher import prices reduce the purchasing power of a given nominal wage. Workers will therefore demand a nominal wage increase for supplying the same amount of labor as before. However, the variable relevant to the labor market is not the real consumption wage W/Pc (deflated by consumer prices) but the real product wage W/P (deflated by producer prices). Since domestic prices in the model are not affected by the terms of trade deterioration, an increase in nominal wages is equivalent to an increase in the real production wage for the firms. A terms-of-trade deterioration drives a wedge between real consumption and the real product wage and shifts up the labor supply curve.

Figure 7.
Figure 7.

Labor Supply.

Citation: IMF Staff Country Reports 1997, 041; 10.5089/9781451837544.002.A002

55. The preceding argument was based on the utility maximization of an individual household. However, in the case of Trinidad and Tobago the role of labor unions has to be taken into account as well. In practice, it is not the individual workers but some 195 unions that bargain over most wages. Labor unions provide workers with a real wage premium due to their market power in the labor market. In this respect, they resemble monopolistic firms in a concentrated goods market. The stronger and more militant the labor unions, the higher is the real wage premium for any level of employment. An increase in union market power can be depicted as an upward shift of the labor supply curve:

wp=z+e+βn(5)

where z proxies for union bargaining strength.11

56. Labor demand is derived from the production function of firms. As an example, consider the Cobb-Douglas production function

Y=KαN1α(6)

where Y is output, K is capital, and N is employment. Under perfect competition, the real wage paid by firms equals the marginal product of labor. Written in logs, this translates into the following labor demand function:

wp=const.+α(kn)(7)

57. Labor demand is a linearly declining function of employment, n. In a wage/employment diagram, its slope is -α. The intercept is determined by a unimportant constant (the log of labor’s share in income) and the capital stock k. A lower capital stock means a lower intercept and translates into a downward shift of the labor demand function (Figure 8).

Figure 8:
Figure 8:

Labor Demand

Citation: IMF Staff Country Reports 1997, 041; 10.5089/9781451837544.002.A002

58. The real wage equals the marginal product of labor only under perfect competition. In this case, price equals marginal costs. Under imperfect competition, however, the firms pay a real wage below the marginal product, since prices exceed marginal costs. With a linearly-homogenous production function, marginal costs can always be expressed as a multiple of nominal wages W. Since the ratio P/W is higher under imperfect competition due to markup pricing, the real wage W/P is lower than under perfect competition. Assuming that the markup is independent of the level of employment, equation (7) can be complemented in a simple way to allow for imperfect competition:

wp=const.μ+α(kn)(8)

where μ is the log of the markup ratio. This parameter takes the value of zero under perfect competition and increases with the degree of market power in the goods market, thus shifting down the labor demand function.

59. The last element of the model is capital accumulation, or the behavior of savings and investment. As noted earlier, we shall assume zero capital mobility across countries. Therefore, national savings equals national investment.12 Investment adds to the capital stock within one period. Thus, the amount of savings determines the pattern of capital accumulation and the dynamics of this model economy.

60. National savings originate from three sources: (1) labor income; (2) profit income, and (3) budget surpluses. For purpose of illustration, we shall abstract from this distinction and simply assume that savings are a constant fraction of output Y:

S=sY(9)

61. Figure 9 shows the production function of the economy. In the short run, capital is fixed and output is a function of labor input only. Due to the law of diminishing returns, the short-run production function has a concave shape. Figure 9 illustrates the effects of an upward shift in labor supply. The real wage rises, but employment is reduced. Therefore, output decreases and savings decrease also.

Figure 9.
Figure 9.

Excessive wage demands reduce savings.

Citation: IMF Staff Country Reports 1997, 041; 10.5089/9781451837544.002.A002

C. An Application to Trinidad and Tobago

62. The model can now be used to interpret the unemployment experience in Trinidad and Tobago over the last two decades (Figure 10).

Figure 10.
Figure 10.

Lower savings lead to a lower capital stock and lower labor demand.

Citation: IMF Staff Country Reports 1997, 041; 10.5089/9781451837544.002.A002

63. At the end of the oil boom, the power of unions had reached a maximum. Their demands for a redistribution of the oil windfall met little resistance from the government, which granted large wage increases to its employees. The public wage bill increased by 95 percent in real terms in the year 1982 alone. Also, public transfers and subsidies to other sectors increased by 65 percent in real terms between 1980 and 1983.13 In terms of the model, the union’s militance pushed up the labor supply curve during the early 1980s.

64. As oil prices began to fall after 1982, unemployment quickly increased. This prompted unions to moderate their demands for further real wage increases. Their strategy now was to defend the achieved level of purchasing power. However, rapidly deteriorating terms of trade would have called for an even more fundamental redressing of wage policy: the weakening economy needed not just a temporary freeze, but a significant reduction of real wages. In fact, holding worker’s purchasing power at its boom level amounted to a second cost shock to the economy.

65. The deterioration of the terms of trade led to an increase in the relative price of imports. As discussed above, such a situation drives a wedge between real consumption and real product wages. In Trinidad, extensive COLA clauses in wage contracts protected the purchasing power of wages institutionally, increasing nominal wages in line with the prices of imported goods. However, for firms the real product wage increased, leading them to reduce employment sharply. In fact, real product wages continued to climb until 1986, the fourth year of the recession (see Figure 3). In terms of Figure 9, the labor supply function was pushed up. The economy moved from point 1 in the late 1970s to a situation such as point 2 in the early 1980s.

66. The overall impact of wage pressure and rising unit labor costs on savings has been shown in Figure 4. Employment was reduced, output was reduced, and so were savings, if the assumption of a constant savings rate is approximately true empirically.14 The sharp increase in unit labor costs squeezed profits of private and public firms, and government finances deteriorated drastically (the budget deficit reached 13 percent in 1984).

67. The ensuing contraction of gross investment was sharp enough to make net investment negative, ie., investment became too low to cover depreciation. The capital stock began to decline, lowering the productivity of employed workers. This reduced demand for labor, and the labor demand curve started to shift downward (see Figure 10).

68. There are no direct observations of the capital stock of Trinidad and Tobago. However, a capital stock series can be estimated using the perpetual-inventory method.15 Figure 11 presents the result of a benchmark scenario with an assumed depreciation rate of the capital stock of 7.5 percent per year. As can be seen, capital accumulation was especially fast during the first and second oil prices hikes in the 1970s and early 1980s. The decline in oil prices and the ensuing savings crisis suddenly stopped the buildup of capital in the mid-1980s. As net investment turned negative after 1986, the capital stock contracted. Net investment has remained negative until the present day, and Trinidad and Tobago has lost about 20 percent of its productive capital.

Figure 11.
Figure 11.

Estimation of the capital stock of Trinidad and Tobago.

Citation: IMF Staff Country Reports 1997, 041; 10.5089/9781451837544.002.A002

69. The pattern of rising unemployment and falling real wages predicted by the model could actually be observed in Trinidad during the late 1980s (compare Figures 2 and 3). As the capital stock contracted after 1986, real wages declined sharply, but unemployment continued to increase until it reached a peak in 1989. The NAIRU climbed until 1988 and has remained at a high level ever since. Thus, after the wage pressure episode, the labor market has entered a regime of capital shortage. This has reduced the real wage to the level before the oil boom, and limits the prospects of a rapid reduction of unemployment in Trinidad and Tobago.

References

  • Auty, R. Gelb, A. (1986): “Oil Windfalls in a Small Parliamentary Democracy: Their Impact on Trinidad and Tobago.World Development, 14, 11611175.

    • Search Google Scholar
    • Export Citation
  • Barro, R. Sala-i-Martin, X. (1995): Economic Growth, Cambridge: Harvard UP.

  • Carlin, W., Soskice, R (1991): Macroeconomics and the Wage Bargain. Oxford: Oxford UP.

  • Fallon, R., Verry, P. (1988): Unemployment and the Labor Market. Cambridge: MIT Press.

  • Obstfeld, M, Rogoff, K. (1996): Foundations of International Macroeconomics. Cambridge: MIT Press.

Data sources

International Finance Statistics (IFS): Figures 1, 2.

Central Statistical Office (Trinidad and Tobago): Figures 2, 4, 5, 6.

Fund staff estimates: Figures 3, 5, 11.

8

The NAIRU was estimated following the method of Fallon and Verry (1988). Their approach consists of regressing the unemployment rate on the change in wage inflation and a vector of structural variables, and then calculating an unemployment rate consistent with no change in inflation. In our example, the structural vector includes the terms of trade, the capital stock, real investment, the ratio of tax revenues to GDP, and a strike variable accounting for union militancy.

9

The observation that national savings and investment are highly correlated is pervasive and commonly referred to as the “Teldstein-Horioka Puzzle”. It is sometimes taken as evidence for an incomplete integration of international capital markets (for a discussion see e.g. Obstfeld and Rogoff, 1996). To build this observation into the following model in a simple way, we will take the extreme assumption that capital is not mobile internationally.

10

In this notation, which has become the standard in international macroeconomics, an increase in E means a real depreciation of the exchange rate.

11

For a more formal deduction of this result see Carlin and Soskice (1991), chapter 16.

12

This assumption is mainly made to mimic the observed close correlation of savings and investment in Trinidad (see figure 6), as explained in footnote 9. A more complete overlapping-generations model can reproduce this effect without assuming zero capital mobility (Obstfeld and Rogoff, 1996).

13

For a thorough description of the economic and political redistribution during the Trinidadian oil boom see Auty and Gelb (1986).

14

The savings rate actually declined, reinforcing the effect described above. This could be attributed to the fact that profits were hit harder than worker’s incomes, and the propensity to save out of profits is higher.

15

A recent description of this method can be found in Barro and Sala-i-Martin (1995), p. 384.

Trinidad and Tobago: Selected Issues
Author: International Monetary Fund