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Central and Eastern Europe, Current Recovery, the Euro and the IMF

English Pages, 18. 10. 2010

Dear Friends and Colleagues,

Thank you for giving me the opportunity to address this exceptional gathering, exceptional above all because of the presence of my good old friend Jacob Frenkel. The title I chose for my presentation – “Central and Eastern Europe, Current Recovery, the Euro and the IMF” – reflects, I hope, the intentions of the organizers of this meeting or is at least close to them.  

The easier topics are the euro and the IMF, which motivates me to start with them. As regards the first one, my conviction is that the European single currency, the euro, will survive its current acute crisis. Its long-term crisis will, however, continue and we will pay a very high price for the continuation of this experiment. We, who live in Europe, together with our children and grandchildren, are condemned to live in an era of long-lasting sluggish economic growth, if not stagnation. The euro is not the only reason, but it is one of them.  

Introducing one currency and one exchange rate for 16 – in many respects different – economies was not a rational solution. I agree with the arguments of Martin Feldstein that “the shift to a single currency meant that the individual member countries lost the ability to control monetary policy and interest rates in order to respond to national [which I translate as differing – VK] economic conditions.”[1] I would add that this loss can be ignored or underestimated only by those who consider monetary policy more or less irrelevant, only by those who think that “money does not matter.” Martin Feldstein also reminds us of the evident truth that “the single currency weakens the market signals that would otherwise warn a country that its fiscal deficits were becoming excessive” (p. 11). As everyone sees now, some eurozone countries – due to the non-existence of their own currency – had not been sufficiently warned. The usual market signals were weakened and delayed.  

These are the two main points repeatedly raised by Martin Feldstein and many others. I could add my own reservations about the costs and benefits of a single currency in a non-optimal currency area, but this was the topic of last year’s Prague Twenty conference and I don’t want to spend my limited time here repeating some of the well-known arguments – arguments long time known to all those who want to take them into consideration. Let me just refer to my recent Wall Street Journal article and to many others devoted to this issue.[2] 

The IMF is a different topic. As someone who in January 1990 – as a newly appointed minister of finance – sent his very first letter abroad asking for the renewal of our IMF and World Bank membership and who was extremely honored to sign our accession treaty to both of these institutions in Washington, D.C. in September 1990, I hope I can afford to say something critical and politically incorrect. I consider the IMF a barbaric relic from the Keynesian and fixed-exchange rate era. I know it is a harsh verdict but Keynes himself repeatedly used similar strong statements about his colleagues which justifies my using such a terminology.  

I am convinced the IMF should be dismantled or radically restructured as soon as possible. To do the opposite, to increase its role as it happened as a result of the last year’s G20 decision in the middle of the panic connected with the then looming crisis or to speculate about creating similar institutions on individual continents (especially in Europe) is a wrong way to go. It is yet another manifestation of a mistaken and dangerous global governance mindset which – to my great regret – has been getting more and more support in the intellectual and political circles these days. To whom and how at all can the IMF be held responsible for its activities? And if its proposals or measures turn out to be mistaken (and this can happen very easily), who will face the consequences? Certainly not the IMF. 

Proper functioning of the economy asks for right economic (as well as non-economic) fundamentals. We, in this country, know that and have never needed to be forced by the IMF to become aware of this. It may be different in other countries. When I recently spoke with one of the widely renowned reformers of the early 1990s, former finance minister of Argentina Domingo Cavallo, he insisted that his country did need an external pressure. Perhaps he was right. The advice of the IMF to maintain and keep supporting the existing fixed exchange rate and to radically increase interest rates in this country in the spring of 1997 is still deeply rooted in the memory of many of us. The recent unstructured and very superficial criticism of the whole CEE region by the IMF provoked another wave of distrust in this institution here. But I don’t want to make this the main topic of my today’s message. 

We were asked to talk about Central and Eastern Europe. As a president of one of those countries, I don’t have the academic freedom to explicitly discuss our neighbors. All I can do is to speculate about problems or tendencies.  

Even though it is almost self-evident, we should say loudly that the CEE countries neither caused the recent worldwide crisis nor made it bigger or deeper. From our perspective, the crisis was imported. It did, however, help to reveal some important built-in structural differences among the CEE countries which are worth discussing and worth paying attention to. I stress it because there is a fashionable tendency not to differentiate among them. I appreciate the words of the Chairman of the Board of Directors and CEO of the Czech part of the Austrian bank Die Erste, Gernot Mittendorfer, who recently said that: “Internationale Analysten haben bei Osteuropa nie differenziert. Man hat das schlechteste Land als Maßstab für alle anderen genommen.“ (“International analysts have never differentiated among the East European countries, the worst country being taken as a benchmark for all the others.”)[3] 

What are the main differences causing the very differing macroeconomic outcomes of the CEE countries? I will mention five of them. 

One important difference is the size of the country and the capacity of its internal market. It was much easier for a bigger country, such as Poland, to avoid the crisis (or to cope with it) than for a typical “small open economy” heavily dependent on exports. The share of exports on GDP is about 40 % in Poland, but 77 % in the Czech Republic (and 83 % in Slovakia). Thus it is not surprising that the Czech Republic was hit rather severely because it is more open (also its share of industrial production on GDP is the highest in the European Union).  

But “big is not always beautiful.” Big Ukraine has had bigger problems than most of the smaller countries and its GDP decreased by 15 % in 2009. The third biggest country in the region, Romania, had sufficiently big problems as well. Its GDP fell by 7 per cent last year. It only confirms that fundamentals are more important than size, but size in some cases helped to mitigate the imported crisis. 

The second important difference is trust in national currencies. People in countries which successfully avoided galloping inflations or hyperinflations in the past – like the Czech Republic – do believe in their own money. The traditionally low inflation and interest rates motivated them to borrow in domestic currencies, not in the foreign ones. In the Czech Republic, less than 2 % of all kinds of personal loans, including mortgages, are in foreign denominations. In Hungary it is 85 %, in Latvia and Estonia it is more than 90 %. When the exchange rates moved in the direction of the devaluation of domestic currency, it was clear to everyone that the higher the share of foreign currency loans, the more painful the depreciation of domestic currency. 

Some countries believed (and still believe) in exchange rate flexibility,[4] others tried to eliminate exchange rate fluctuations by all kinds of rigid exchange rate arrangements – ranging from introducing a currency board (the Baltic countries and Bulgaria) to entering the eurozone (Slovakia, Slovenia). In the era of overall economic stability in the first half of the last decade (and I agree with Richard Cooper[5] that the period 2002 – 2007 was probably the best period for the world economy ever), it worked well. In the crisis, however, rigid exchange rates created additional problems. The much needed exchange rate adjustment was impossible to make or it was made too late. The costs of adjustment by means of an “internal devaluation” reached a very high level. In the last two years, Latvia lost 25 % of its GDP and the unemployment rate moved above 20 %. I am convinced that the exchange rate regime played an important role in the CEE region as well. 

My fourth point is that the countries differed also in their budgetary discipline. It is a big problem for all the CEE (and not only CEE) countries now, but for some of them, e.g. for Hungary, it was a big problem already before the outbreak of the worldwide crisis. The crisis only made the problem bigger and more visible. In some CEE countries, there is a tradition of fiscal restraint. In some other countries, it is different. 

I would like to mention one additional difference, which is the quality of governance. It is not a traditional economic variable but a socio-economic constant with only very slow movements in time:

- it is influenced by historical traditions, by the coherence of a country and in the CEE region by the success of its recent political, economic and social transformation from communism to a free society and market economy. The situation in countries like the Czech Republic, Poland, Hungary and Slovakia is in this respect better than in countries like Ukraine and Moldova;

- in smaller and more homogeneous countries (Slovenia, Estonia) it is easier to practice the much needed governance than in countries like Ukraine, Romania and various ex-Yugoslav countries;

- it is also fair to say that democracy is a difficult form of government because it is slow and costly. But compared to all other variants, it is no doubt a better system. For most of us, it is the highest, almost sacred goal because it constrains the power of the state. However, the degree of democracy is, paradoxically, relevant for the rapidity and resoluteness of governance in an inverse relationship. It is easier to make decisions in a country with a traditionally strong government and a limited position of parliament, in a country with a lesser role of media and civil society organizations than in a full-fledged democracy. A lower degree of institutionalized democracy also helps to make unpopular decisions. I will not dare to suggest candidates that should be included in one category or another but the apparent silence after the introduction of the very painful restrictive measures or after the radical changes of health care or pension systems in some countries indicates what I have in mind. 

What can be expected in this region in the near future? Will this region follow the developments of the rest of Europe, better to say of the EU, or will it have its own specific path of development? I doubt it. Most of the CEE countries have already implemented – some with joy, some reluctantly – the European economic and social model. They have done so partly because they themselves wanted to do it and partly because it was a precondition for the EU membership (already realized, or intended).  

This model is not growth-friendly. It is more redistributive than productive, more stationary than dynamic, more risk-averse than risk-taking, more stability-oriented than creatively destructive.[6] The acceptance of all kinds of European standards and entitlements made the CEE countries premature welfare states (the countries of Western Europe – although not all of them! – can be perhaps called mature welfare states).  

This systemic handicap suggests that the economic recovery in the CEE countries will not be much different from the countries of Western Europe. On the other hand, these countries are still in the process of catching up, they want to move ahead, their citizens’ propensity to work has not yet fully disappeared, the people there are eager to achieve something. Because these factors are more important than standard factors of production and their interplay in well-known models of production functions, I expect the economic recovery here to be faster than in the rest of the EU – on condition that their public finance problems will be overcome in a rational way.

There is some reason for hope.

Václav Klaus, speech at the conference “Central and Eastern Europe after the Crisis,” Prague Twenty, Malostranský palace, Prague, October 18, 2010.


[1] Martin Feldstein, “The Euro’s Fundamental Flaws,” The International Economy, Spring 2010.

[2] V. Klaus, “The Euro as a Non-Optimum Currency Area,” Wall Street Journal online, June 1, 2010; http://www.klaus.cz/clanky/2616; the original Czech version of the article was published under the title “Kdy zkrachuje eurozóna,” Ekonom, April 22, 2010; http://ekonom.ihned.cz/c1-42783570-kdy-zkrachuje-eurozona.

I used very similar arguments years ago in my lecture “The Future of Euro: A View of A Concerned Outsider” (CATO Institute, Washington D.C., November 20, 2003; http://www.klaus.cz/clanky/439); published also in Czech in Ekonomie a ekonomika (Euromedia Group, Prague, 2006). See also my much earlier speech: “European Monetary Union and Its Systemic and Fiscal Consequences,” New Atlantic Initiative Luncheon Address, The American Enterprise Institute, Washington D.C., September 30, 1996; http://www.klaus.cz/clanky/2096.

Three weeks ago, the Center for Economics and Politics published a book devoted to this topic under the title “Autoři CEPu o euru” (The Authors of CEP about the Euro), CEP, Prague, 2010.

[3] G. Mittendorfer, “Die dramatischen Erkenntnisse waren alle falsch,” Die Presse, August 5, 2010; http://diepresse.com/home/wirtschaft/eastconomist/585848/index.do.

[4] The Czech Republic has had floating exchange rate for 13 years now. Before, it had a fixed exchange rate regime.

[5] Point made at the “Roundtable Conference on Global Money“, Santa Colomba, Italy, July 10, 2010.

[6] See my speech “Reflections on Potential Global Power Shifts: Notes for Lago Maggiore,” Ditchley IIF Conference, Stresa, Italy, July 1, 2010; http://www.klaus.cz/clanky/2637. Its Czech version was published in Hospodářské noviny, July 2, 2010; http://www.klaus.cz/clanky/2638.

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