Bliss was it in that dawn to be alive
But to be young was very heaven!
– William Wordsworth on the French Revolution
I was not that young when New Europe’s transition began in 1989, but I was there: in Poland at the start of the 1990s and in Russia during its 1998 crisis and after, in both cases as the resident economist for the World Bank. This year is the 25th anniversary of New Europe’s transition and the sixth year of Old Europe’s growth-cum-sovereign debt crisis. Old Europe can learn from New Europe: first, about getting government debt dynamics under control if you want growth. Second, about implementing the policy trio of hard budgets, competition and competitive real exchange rates to keep debt dynamics under control and get growth. The contrasting experiences of Poland and Russia underline these lessons (Andrei Shleifer’s take on the transition lessons can be found here).
Poland started with a big bang in 1990, but ran into political roadblocks on the privatization of large state enterprises. It achieved single-digit inflation only in 1998. Between 1995 and 1998, Russia did the opposite. By early 1998, privatization was done and single-digit inflation achieved. But while Poland started growing in 1992 and has one of the most enviable growth records in Europe, Russia suffered a huge crisis in August 1998 after which it was forced to adopt the same policy agenda as Poland.
The first difference is that Poland quickly established fiscal discipline and capitalized on the debt reduction it received from the Paris and London Clubs to get government debt dynamics under control. Russia lost control over its government debt dynamics even as the central bank obsessively squeezed inflation out.
The second difference is that Poland instantly hardened budgets by slashing subsidies to state-owned enterprises (SOEs) and subsequently restricting bank lending to loss-making SOEs. It summarily increased competition by liberalizing imports, but was careful to avoid a large real appreciation by devaluing the zloty 17 months after the big bang, and then moving to a flexible exchange rate. The first two elements of this micropolicy trio, hard budgets and competition, forced SOEs to raise efficiency even before privatization. The third, competitive real exchange rates, gave them breathing space. Indeed, SOEs were in the forefront of the economic recovery which began in late 1992, ensuring that debt dynamics would remain sustainable. This does not mean privatization was irrelevant: SOE managers were anticipating it and expecting to benefit from it; but the immediate spur was definitely the micropolicy trio.
In contrast, Russia’s privatized manufacturing companies were coddled by budgetary subsidies and large subsidies implicit in the noncash settlements for taxes and energy payments that sprouted as real interest rates rose to astronomical levels. Persistent fiscal deficits and low credibility pushed nominal interest rates sky high even as the exchange rate was fixed in 1995 to bring inflation down. The resulting soft budgets, high real interest rates and real appreciation made asset stripping easier than restructuring enterprises, killing growth. Tax shortfalls became endemic, forcing increasingly expensive borrowing that placed government debt on an explosive trajectory and made the August 1998 devaluation, default and debt restructuring inevitable. But this shut the country out of the capital markets, at last hardening budgets. The real exchange rate depreciated massively, leading to a 5% rebound in real GDP in 1999 (against initial expectations of a huge contraction) as moribund firms became competitive and domestic demand switched from imports to domestic products. This policy mix was maintained after oil prices recovered in 2000, ensuring sustainable debt dynamics.
Old Europe, especially the periphery, can learn a lot from the above. Take Italy. By 2013, its real exchange rate had appreciated over 3% relative to 2007, while real GDP had contracted over 8%. The government’s debt-to-GDP ratio increased by 30 percentage points (and is projected to climb to 135% by the end of this year), while youth unemployment went from 20% to 40% over the same period! Italy has no control over the nominal exchange rate and lowering indebtedness through fiscal austerity will worsen already weak growth prospects. Indeed, Italy has slipped back into recession in spite of interest rates at multi-century lows and forbearance on fiscal austerity.
The counter argument is that indebtedness and competitiveness don’t look that bad for the Eurozone as a whole. However, this argument is vacuous without debt mutualisation, a fiscal union and a banking union with a common fiscal backstop, the latter to prevent individual sovereigns, such as Ireland and Spain, from having to shoulder the costs of fixing their troubled banks; the recent costly bailout of Banco Espirito Santo by Portugal is a timely reminder. Besides, Germany has to be willing to cross-subsidize the periphery. Even then, this would only be a start. As a recent IMF report warns, the Eurozone is at risk of stagnation from insufficient demand (linked to excessive debt), a weak and fragmented banking system and stalled structural reform required for increasing competition and raising productivity. Debtor countries are hamstrung by insufficient relative price adjustment (read “insufficient real depreciation”).
The corrective agenda for the Eurozone has much in common with the “debt restructuring-cum-micro policy trio” agenda emerging from the Polish and Russian transition experience. The question is whether the Eurozone can have meaningful growth prospects based on banking and structural reform without an upfront debt restructuring. The answer from New Europe’s experience is “No.” Debt restructuring will result in a temporary loss of confidence and possibly even a recession; but it will also lead to a large real depreciation and harden budgets, spurring governments to complete structural reform, thereby laying the foundation for a brighter future. The key is not the debt restructuring, but whether government behaviour changes credibly for the better following it. As the IMF report observes, progress “may be prone to reform fatigue” with the rally in financial markets. In other words, the all-time lows in interest rates set in train by ECB President Draghi’s July 2012 pledge to do whatever it takes to save the euro is fuelling procrastination even as indebtedness grows and growth prospects dim. Rising US interest rates as the recovery there takes hold and the growing geopolitical risk over Ukraine, which will hurt the Eurozone more than the US, only worsen the picture. The Eurozone has a stark choice: take the pain now or live with a stagnant future, meaning its youth have fewer jobs today and more debt to pay off tomorrow.
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