Why not?

The crisis of Hungary and the drama of the EU – for a brief period separate from each other and the former even resolved at least in the imagery of the prime minister, Viktor Orbán – suddenly got bound to each other very firmly. Not only was the complete dependence of Hungary's economy on and from the European declared, but the unfolding crisis of the eurozone absorbed Hungary's fate last week, at the meeting of the European Council. The issue of whether the prime minister blundered diplomatically or not in Friday morning is significant only in a strictly Hungarian context as a possible demonstration of the governments rapidly diminishing capacity to handle politics and governance, not the first sign in this sense and hardly the last one. But the whole French-German plan bears utmost significance for the country as well and poses some questions concerning the governments confused reaction too.

The interpretations of the council's declaration pointed out at least four important aspects that should be considered from a Hungarian (and more broadly from an East Central European perspective). The proposed new fiscal stability rules can be seen as the end of (or even the outlawing of) Keynsianist economic policies. Furthermore, some argue that a fiscal union following the German blueprint of re-balancing through austerity can bring (or just aggravate) the present state of economics close to depression and bring about a serious challenge to democracy. The latter means that crisis stricken countries, among them Hungary, certainly have to reconsider their place and chances given the restrictive economic environment. But the plan is far from being unproblematic from a pro-European perspective too, it proposes an incomplete transfer union without proper governing bodies and democratic representation, reviving (or even enhancing) the never eliminated complaint of democratic deficit in the EU.

But with all of these issues that certainly should not be neglected or treated in an off hand manner, the Hungarian reaction was very curious. While the government portrays itself (and is selling this idea to its European partners at every occasion) as the champion of far reaching reforms, fiscal prudence and stability, hails itself as the only country that will achieve a budget deficit within the limits prescribed in the Maastricht Tretay, it still failed to sign to a new treaty that will only enshrine these self-proclaimed objects of national pried. Even if its boldly announced aim is to transform the country to the most (or most recently, from today one of the most) competitive countries in Europe , and one that can compete with China. Quite in line with what the Germans are blamed for, trying to make everyone German as a panacea for the crisis.

So, why the restraint? There is an obvious explanation, sovereignty. It means power and as the new fiscla riles and most notably the way they would be enforced would curtail the sovereignty of the parties to the new treaty, the government is not quite willing to hand its power to a European body or accept trusteeship of Germans and French. Especially if it still believes in its vision of a West in decline and an East on the rise. However, even if such considerations certainly played a role in the decision not to accept the new treaty (a position later softened to consulting the parliament on this issue) there is one valid point hidden in all of the verbal camouflage: is it possible to create a fiscal union on the proposed line without hampering or tacitly eliminating democracy? It is not only about the way the Greek and Italian premiers were replaced – seen by many as a plot of mysterious capitalists and foreign politicians –, but about the German plan's content: constitutional fiscal rules that could – in case of a suitable interpretation – ban fiscal stimulus and enforce the further dissolution of welfare institutions. Not that it would be too far from the Hungarian government's aim. It is frequently declaring the end of the welfare state, a new era of work-based society instead of one based on social benefits. But according to its interpretation this process is the result of the rise of the East, an industrious, demographically growing world, whose success can be followed only with its own measures, hence the insistence of gaining competitiveness vis-a-vis China.

But if one considers the process of how the welfare systems were rolled back, it is hard not to see other factors, intra-EU developments behind it. Most notably the insistence on market based investments in ECE after 1989 as opposed to institutional based ones. It meant a competition for investment even into social systems and as in every case investment could be attracted with the fastest and safest return on capital and with the fattest profit. The subsequent necessity to cut welfare systems as there was no need and way to finance them resulted not from the competition from the East but from the competition among new member (and accession) states.

From the above diagnosis one can conclude that some EU-wide measures would be beneficial for the members states in the sense of reducing the pressure on their present welfare systems and societies. Such as a harmonized tax base (part of the German proposal), that would reduce (or probably eliminate) tax competition in order to attract investment. With envisioning more significant reforms of the EU's architecture – in the longer term – there is the possibility to harmonize and connect – and later merge – certain welfare systems, such as health care,, unemployment benefits or pensions. It would alleviate a huge burden from some crisis stricken countries, like in Hungary's case 1-2 billion EUR would certainly reduce the dissipation of medical personnel. And as such changes would require a larger and more flexible EU budget it would make it possible to enact fiscal stimuli even if the member states adhere to the strict fiscal rules proposed. But it needs new political structure, with real political representation and responsibility, an enhanced role of EU instiutions in governing, not (only) intergovernmental action.

But as if such a situation wouldn't be complex enough, internal developments in Hungary makes the country's position even more complicated. Authoritarian tendencies transforming a functioning democracy into an illiberal one at best; a „visionary” economic policy, a mixture of classic nineteenth century capitalism, catholic social thinking from the thirties, neo-liberal dogmas like tax competition and flat-tax, and nationalist protectionism results in an unpredictable and growth restraining voluntarism; an overestimated potential of the country coupled with the belief in national peculiarity, all of these manifested in utterly misguided action and failure to recognize real constraints for the country, ultimately leading to a return to the earlier decried IMF as the only potential source of financing for the next years.

Manoeuvreing between political constraints abroad and a sense of omnipotency at home (given the governments 2/3 majority and its ability to change the constitution according to its will in days) was channeled into an attempt to completely rebuild the state. As a result next year Hungarians have to face not only the expected economic hardships (declining real wages, stagnating, probably even growing unemployment etc.), but the possible chaos brought about radical changes in the structure of the state. (Reducing local self-governments to a minimal role, building a centralized public instruction system, drastic reduction of higher education, centralization of pub,ic administration hitherto enacted by local self-governments etc.) The government during its eighteen months long tenure showed rather incapacity to carry out such sweeping changes, resulting in frequents delays compared to the previously announced deadlines, window dressing without real changes, frequent reversals of earlier measures (the most telling is the example of minor taxes, the government in an attempt to reduce red tape eliminated 10 of them, but in a year introduced another twelve). Nothing happened according to the plans outlined, everything was in a permanent delay and confusion and the deepest changes are still only in the phase of legislation. Not to speak of illusory ideas, like a restructuring of the disability pensions and benefits system, with a failed plan to reconsider the status of almost 400 000 people in six month. Meanwhile the lowest levels of state administration became highly politicized, party commissaries installed, essential systems are underfinanced (health care, education, administration) while the budget renounces significant potential revenues (progressive taxation, a progressive property tax etc.) But there is no EU-wide resolution of the problems on offer from Hungary, neither an attempt to fight for preserving what was left from social equality and cohesion. This fight is not for the greater good of the community – or only in a weird sense, for the greater good of a non-existing, imaginary organic nation –, but for the power of a government sliding into authoritarianism.

The irony of the situation is that the government – while deluding itself that so-called unorthodox measures (windfall taxes etc.) do not mean austerity – creates exactly the same self-generating and self-intensifying cycle of austerity that can be expected from the German plan too. Its followers – and its politicians – still think that it is just temporary, a kind of transition, with the rebuilding of the state finished amelioration of the situation is in sight from 2013. However, given its impact on economic growth and the proven inability of the government to provide effective governance the fight for sovereignty can easily end in a catastrophe. German style austerity carried out while the state simply dissolves. In the face of this prospect – and it is the irony – even a strict, closely monitored IMF-EU program can be favorable.  

Frustration, failure, voluntarism

Hungary is still only a secondary front-line of the renascent crisis, not among the headlines and for a superficial observer (i. e. for most of them) it could seem justified. Although the slippage in this years budget (and the obvious: the flat tax was not capable to stimulate growth) could warrant some worry, the government is imitating action at every negative sign, this time announcing 100 billion HUF correction measures. Hardly credible (enhancing tax collection makes 40% of this amount, and a freeze on government purcheses another 40%) and hardly structural, but it didn't really disturb analysts. Not even the news that the execution of the Széll Kálmán-plan (the bouquet of austerity and supposed reform measures planned to bring 550 billion HUF savings next year and about 900 billion until 2013) suffers from serious slippages, and exactly at those fields from where the government expects the highest savings could shake the belief in these guys. They can at last claim that the government is devoted to the deficit figure and ready to apply new measures if necessary. (I would really like to know how long would they bosses at their banks tolerate if they would announce that they had managed to failed to achieve the planned profit in the first eight months of the year, but they are very committed to the planned number and are ready to make corrective measures.) Anyway, it was hardly the sensation of the week, especially in the light of the government's even harder commitment to the flat tax.

But the end of the week brought back the memories of last year, when hardly a week passed without events and announcement testing everyone's heart and patience. It turned out that something was cooking (besides the books) in the witch's kitchen run by the government, a new plan to save the fx-loan holders.

Well, the malicious will certainly point out that as a complete program with this aim was already implemented and started two weeks ago it was even more short-lived than this year's budget, another object of pride of the government. But as one of the reasons the government came up with this new idea was the not qiite spectacular success of the original program (there was no opportunity to show long queues, praising the government in the TV) it is worth to be mentioned. The other reason behind the new plan – at least in my opinion – is the complete failure of the flat tax and the resulting frustration with the economic policy. I'm sure they attribute the lack of internal demand not to the fact that the new tax system was a tax hike for most of the population and it favored the segment with the least marginal propensity to consume, but to the spiking mortgage rates due to the CHF based loans. I fear it is telling regarding the mind-set of the government that facing the obvious collapse of the whole of their economic governance they decided to stimulate their original stimulus, instead of changing the pattern of redistribution. (Furthermore, they will cement in this tax system with a two-thirds majority law.)

What is the problem with the proposal? Firstly, it is its aim: to „release” the income of households in order to make them spend more on consumption. Secondly, the set-up of the plan and the parameters applied. Not only is there a few evidence that the weakness of the forint was the main reason of the weakness of domestic demand* but it fails to address the major problem caused by the fx-loans: the effective fixed excahnge rate of the HUF. As long as hundreds of thousands has fx-loans the country can not devalue because it will immediately harm, cause pain to millions. But external devaluation would improve export competitiveness faster and with less pain (mainly thorugh import generated inflation) than the internal devaluation (austerity) executed by Fidesz. However, the government only hopes to bring redemption to a quarter of the 1,2 million households with fx-loans with their plan to enforce a conversion of the loans at an exchange rate of 180 Huf (50 forints weaker than last Friday's close), signaling that they do not really want to get rid of the effective peg in order to curve out more room for manoeuvre for the economic policy, but to fend of the popular pressure.

As for the second problem the plan lays the whole of the burden and the losses on the banks. However, the balance sheet of these banks is already full of hidden losses due to the non performing loans and the loss of value of the real estates serving as collateral fro these fx-loans. As long as they can keep their debtors afloat they not necessarily can declare these losses and they can manage „only” with setting up appropriate reserves. So, they can hope – and in this sense their interest is common with their debtors' interests – that at the end these loans will be payed back according to schedule and they can release the reserves set up to cover projected but at the end avoided losses. However, as soon as they are forced to accept the conversion of these loans (or the repayment in one sum) at 180 HUF exchange rate they will realize huge losses on these loans that has to be covered. According to preliminary estimates it can be as high as 1100 billion HUF. It will effectively force them to recapitalize. Even if their owners (Western Banks mainly) will provide them with the necessary capital – that is far from being certain – they will certainly try to find as much foreign capital as they can for this purpose. One option is to freeze lending and use the capital to cover losses. And on the long run they will certainly pay close to zero rates on deposits, as they won't need to accumulate capital this was because they won't lend. (There is of course the secondary effect of losing confidence in Hungary. As this move would be most probably illegal, violation of existing contract by a third party without interest in these contract, violation of property right and that way unconstitutional and against EU law if the government implement it it will be equal with the declaration that no investment and no property – remember the private pension funds! - is safe here.) Anyway, it could bring the banks to the decision to withdraw – gradually or even abruptly – from Hungary. It will certainly cause further reduction in lending and tighten already very tight financial conditions. And such events are rarely beneficial to economic growth, something the government desperately wants to deliver.

As the plan is clearly not part of a coherent one on how to free the Hungarian economy from constraints from which it can be disentangled it is hard to see how it could lead to positive result. It is not aiming to the solution of the most important problem, just for short term political gains. (And it is the expression of frustration as the information on the discussion in Fidesz's caucus suggest. The most important supportive argument against the objections of the more restrained members was that the banks caused this whole mess they should bear the whole of the burden.) Not that there wouldn't be place for an orderly and well balanced solution to the problem. There were even plans proposed by bankers. And even if those were rejected with the cooperation and advice of the IMF and the EU (and with their loan) a kind of bad bank or special financial vehicle could be set up in order to clear the bank's balance sheets, convert the loans and that way achieve simultaneously the re-ignition of bank lending to the economy (that was already constrained by the huge implied losses and the subsequent frenzy to collect enough capital to cover these probable losses) and the lifting of the burden of households. But it would obviously end the economic war of liberation so proudly waged by the government.

*According to the data of the Office of Statistics retail sales grew in this year m-o-m and y-o-y as follows:

               m-o-m        y-o-y

January     0,9% and   0,9%

February -0,3% and   0,1%

March     -0,5% and -0,9%

April       -0,3% and -1,2%

May         0,5% and   0,7%

June        -0,5% and -0,5%

Meanwhile the CHF-HUF exchange rate fluctuated between 220 and 205 HUF in January, between 203 and 214 HUF in February, between 201 and 214 HUF in March, between 200 and 210 HUF in April, between 204 and 221 HUF in May and between 214 and 228 in June. Funnily, retail sales declined in the month when the CHF was weakest.

Hungary, even more path-dependent?

Hungary is again pushing forward on its path towards its demise with the so-called Széll Kálmán-plan and the Draft Constitution. It would be (or probably will be) entertaining to analyze the constitution in depth in the light of Fidesz's organic/integral nationalism, how it correpsonds to this idea.JUst as it would be important to give a more detailed coverage of the economic plicies of the government, sometimes seemingly sane, but considered in its entirety lunatic at all, again very much an expression of the above mentioned ideology. However, in this post I will only formulate some preliminary thoughts and conclusions on one of the most worrisome aspects of the new constitution.


1. The new constitution will implement a debt ceiling at 50% of the GDP (although the GDP they measure to will not necessarily be identical with the Eurostat/National Office of Statistics data, a separate law will define it). Legislation on taxes and social contribution, as well as on the pension system will be subject of laws passed by a qualified - 2/3 - majority. It seems an exteremely rigid framework for any meaningful economic policy, practically requiering consent of the government and the opposition even to minor changes.
2. The government promised to bring down the debt-to-GDP ratio to 50% until 2018. The nationalization of rpivate pension funds can kickstart it and the government predicts a ratio between 65-70% in 2014 but 15% is still a long way to go. (Between 1998 and 2001, during their tenure they are still very proud of, Fidesz reduced the debt level from 62% to 53%, or 9% of GDP, with tight budgets between 1998 and 2000 and GDP growth around 4%.) 15% (more realistically around 20%) in four years seems a daring promise.

I tend to conclude the political intention and the legal framework will create a peculiar situation. Firstly, it will certainly put Hungary in the straitjacket of almost another decade of strong austerity, after 5 years from this experience. Moody's had some calculation on the possible scenarios of debt reduction and they concluded the 50% level is attainable only with an extraordinarily benevolent international environment and not quite realistically high growth rates. I would characterize it as voluntarism, and an extremely dangerous form of it.
Furthermore, there is a risk that the package - or more precisely the declaration of intention - announced last week - is simply not calculated properly. For example the Ministry of National Economy wants to spend the revenue from the electronic toll system entirely on debt reduction, while the Ministry of National Development counts on it as a source for the maintenance of public roads. Or, the government is propelling forward with a legislative package on public instruction, with an estimated annual extra cost between 300-500 billion HUF while the entire ammount of budget savings is estimated around 900 billion per year. And there is the danger, that they simply misinterpreted Hungary's economic woes. It seems they believe in the magic mixture of flat-tax (actually a significant tax-hike on labour in case of about 85% of the employed workeforce) and super-flexible labor market (i.e. very low level of social aid and unemployment benefits) just like Bajnai or earlier the Reform Alliance.
Meanwhile important elements of command economy appeared, especially the central regulation of prices for public services and utilities. But after it turned out that the new flat-tax is in fact a tax-hike they put pressure on employers to raise wages, now they threaten with legislation on this issue. And they couldn't find a solution for the problem of the fx-denominated loans, for the indebtedness of local authorities - the majority of which was controlled by Fidesz since 2006 and deliberately taking the path of making debts - and the PPP projects. The flat tax, due to the above mentioned reasons probably will not bring a significant rise in internal demand and households are still struggling with their debt and with rising public utility costs. I'm not really optimistic, although I can imagine the markets temporarily buying the package and waking up to an even worse situation after austerity bites but fails to bring meaningful growth.


P.S. It is again worth to look at Romania with its totally incompetent government, After narrowly escaping colapse and pushing thorugh a hard austerity package, still far from reducing budget deficit significantly enough, they are in a hurry to implement tax cuts. Although tehre is still no convincing proof that it could bring growth alone and Romanian is sliding down to large scale poverty with last years measures. Moreover, it will create a whole in the budget eytremely hard to patch, just look at Hungary, what is happening there. The government had to accept austerity after it carried out tax cuts around 500 billion HUF. Now, they have to cut public expenses, unemployment benefits, social aid etc. in order to save the money they handed out nicely, as a gift for the very rich and a narrow upper-upper middle class. 

Pride over not being prejudiced

Ok, it was a safe guess. Nothing specific and new in Orbán's speech. Even though I have to admit, even my guess was too optimistic: Orbán didn't even announced anything specific regarding unemployment benefits. Anyway, I'm proud as clearly I was among the few expecting what really happened.

Playing Cassandra, resolving cognitive dissonance and on the importance of not investing too much emotional and intellectual capital in expectations

As I try to take a distance from politics in a stricter sense it could mean that in less troubled times I remain silent. My intention is not to comment on everything happening in Hungary or in ECE, especially not when someone else is perofrming it with more expertise and in line with my opinion, rather to give my ideas when I feel I can express thoughts and ideas less prevalent in the public discussion. (Even if this blog is clearly not part of any kind of public discussion, just a variety of a diary or a notebook.) Furtherome, many occurences in the politics are connected to the crisis only indirectly. Although the electoral success of Fidesz in Hungary, their two-thirds majority enabling them to pass a new constitution and change the basic laws of Hungary according to their will, was not independent from the economic crisis and the populations distaste for and discontent with the Socialists and asuterity, the concept according to they are acting is their very own, rooted in their nationalist ideology what is not a reaction to the crisis. Therefore, although I can offer some thoughts on this problem it is only tangentially part of this blog. Nonetheless, the "war of economic independence" or "economic war of independence" as Fidesz labelled its economic policy in the summer that is part of this broder effort of reshaping the country, reached its next phase this Feburary, after the quasi-nationalization the compulsory private pension funds. The Fidesz now has its own budget, not one they can pretend to have no responsibility for and they acquired enough room for manoeuvre with the partial default and forced natioinalization to come up with their own and original ideas.

Some of the important constraints remained, from the EU with the deficit target under 3%, and from the broader environment as the crisis still looms over Europe. (During the Irish crisis Hungary was significantly affected.) But the government now tries to pre-empt negative reaction and contributed to the growing expecatations regarding a fresh refrom package due in February, at aboput 600-660 billion HUF. The story offers an interesting experience of human behavior and psychology, its failings in a supposedly rational and competitive environment. Especially as it is not the first occasion we can observe an almost identical chain of action and reaction. The sequence is always built on communication according to the taste, expectations and desire of the so-called analysts (or in its impersonal form the markets), a sudden eruption of enthusiatsic love for the government, even more communication and more active emanations of this strengthening love and... Well, in the earlier cases the end was always disappointment but it is clearly not a hindrance of the renewed passionate realtionship. Anyway, and this is where I dare to take Cassandra's role and robes, I would be surprised to see a different outcome this time, as the facts and the stark inner contradictions of what the government suggests and the analysts accept as a new, profound reform agenda are pointing to the opposite what the markets are expecting and waiting for. But this revived love-story is telling in itself.

It began already in December, when - even before the budget was passed - the government announced they will prepare and introduce a reform package in Februay. Common sense would have warned everyone as the least normal course of events is to make a budget with huge efforts, bring it to the parliament, proceed with it with energy and determination only to abandon it after one and a half month. Is this the way governments work? - could have asked everyone. But, instead, it caused jubilation and was taken as a sign that the Fidesz was brought back to its senses and at last they admitted the necessity to come up with structural changes bringing budget spending under control in the mid- and long term. Soon the opening moves of this subtle chess play were made, firstly György Matolcsy and later Viktor Orbán himself - in an interview with Wall Street Journal - told that his government will ensure the state pension fund will not spend more than it recives in the form of social contributions (although the ministry made it clear already in November that it means transfering disability pensions to a separate fund financed from the budget), and announce cuts concerning subvention of medicines, the social services for unemployed and the public transportation system. They even mentioned the sum of 100-100 billion HUF in case of the former two and 50 billion in the case of the latter. As these are the pet targets of every analyst who are reluctant to admit that the structural problems in Hungary can not be solved by simply cutting budget spending in some sectors it was well received and generated a wide-spread belief in the coming of a substantial reform package in mid-February. Neither an easy reality check - asking whether it is possible to cut 100 billion from these funds, both not higher than 340 billion per year while unemployment is well over 10% - nor Fidesz politician's instistence on not doing harm to the population and tampering with their benefits could have deterred analysts from their firm conviction that soon something important will happen. Optimism prevailed even after the first reports on the process of the preparation surfaced, showing that the government is still in the phase of brainstoriming in early Februray. (At that moment the different ministries still collected their ideas independently from each other and they had to put them forward to Matolcsy and Orbán, who are entitled to the final choice.) Optimism was not shaken by the emergence of other details - later admitted by Matolcsy - , suggesting that the plan is not to cut 600 billion in 2011 - an earlier assumption of the markets - but making a cosmetic surgery in this year and delivering some more substantial budget correction in 2012 and 2013. (A few days later the plan turned out to be to begin savings in 2013!) Furthermore, as the process of the planning was in delay the announcement was postponed. Originally the promise was a package published in mid-February. In January it was modified, mid-February became the date when the government could discuss it in first readingand the date of the announcement was established at 28 Februray. In early February the new informations suggested even more delay.

Nevertheless, analysts were very excited at the beginning of this month and expected Viktor Orbán to share important elements of the package with the public in his so-called "state of the country" speech, due on 7 February. As Orbán held a very banal speech, composed of proverbs and self-styled popular sayings analysts, the markets did not show dispair or at least some surprise, they predicted that Orbán will make the whole package public on 14 February, in the parliament, and expetced the Fidesz caucus to discuss it between 9 and 11 February. The latter obviously did not happen, but expectations remained.

However, as there seem to exist no coherent package in the moment, the ideas during the long barainstorming more and more turned towards raising new revenues instead of planning the reforms eagerly awaited it would be astonishing to hear something really significant, different from Orbáns 29 points and the economic plan implemented in October - with the quasi-nationalization of the pension funds. Something certainly will be announced, probably pointing out some directions vaguely, packed in the banal terms of the renwal of the country and it is also probable that cutting unemplyment benefits will be one of the few explicit measures. But it will fall short of any kind of reform and will be very far from the expectations driving the markets to extasy in the last few weeks. There are at least three reasons to expect this outcome. Firstly, Fidesz is aiming at a renewal and reorganization of the nation in its own, nationalist terms. What they try to realize is not some cost-effective restructuring of sub-systems based on thorough consideration of existing models and good practices, but the only model that would express the substance and spirit of the Hungarian nation. It is quite different in the sense that the plans are based on a set of speculative assumptions, but they assume that no constraints of costs may impede its realization. (Exemplified by Orbán, who told the Fidesz caucus, that even if people are right that the governments plans for the public instruction system will cost more than at present, it is the responsibility of the economic minister to find the necessary resources, and not the secretary of state for education to adjust plans to budget constraints as the plans are pointing to the right direction.) Such approach also means that fields analysts consider important in the reforms could be of secondary importance for the government, leading to their neglectment, while other sub-systems - like education - won't be restructured according to the criteria analysts are expecting to direct the changes. Secondly, Fidesz clearly wants to avoid confronting any significant electoral group and as long as they can implement measures that at least seemingly do not affect the people - like the so-called crisis-taxes - they will opt for thes. It is hard to expect major changes in the funding of the public transportation system if it would mean rising costs for the population - for example elimination or curtailing of existing benefits for students, children under 6 or people over 65. The whole brainstorming approach and the continous delay of the announcment is exactly because of this reluctance. According to the information leaked, the apparatus was always very effective in bringing new ideas of new revenues and not quite successful in outlining cost-cutting measures. Thirdly, the present structure of the government and its personal composition with a lot of inexperienced and not quite bright party hacks occupying key positions in ministries consisting concurring departments without a minimum of internal coordination and with a minister responsible for economics ad budget who only trusts in a very limited number of people is an obstacle in the way of preparing a coherent plan, assessing every proposed measure in the context of the state as a public institution and an instrument to deliver public good the most effective way - apart from its assessment in the light of Fidesz's nationalist ideology.

I do not realy want to contemplate the question why analysts again swallowed the bait. Probably they invested too much emotional and intellectual capital in their belief of Fidesz's rationality and willingness to go down the way they expected and at the end they could not disengage. However, it is of some use, at least at a personal level. For a while I had to feel guilt as I was crying with the pack of analysts whom I had criticized earlier. Now it is a chance to detach myself and again point out their failings. Vanity and arrogance as it may be, but reassuring because it restores a part of my identity. :) It resolves this particular form of cognitive dissonance.

Hungary and sovereign default

It's almost official: the government's ingenious plan is to nationalize compulsory private pension savings and spend it on current budget expenses (pensions) and debt reduction. They hope it will enable them to survive without major restructuring and action until the tax cuts will bring 7% GDP growth. (Actually many expressed doubts, how realistic this expectation could be. Some calculate that 8-10% growth would only fill the holes of the budget from 2013.) Anyhow, the government expects 90% of the mambers of such private pension schemes will return to the state run, pay-as-you-go system, eventrually transferring their portfolio to the state. The delicacy of the issue: it is nothing else than default on a part of the debt and restructuring.

Private pensions savings, although compulsory, are private property. They hold about 2800 billion HUF savings in sovereign bonds (circa 1300 billion) and other assets, mainly stocks and investment funds. It means at around 5% of the GDP is in the hands of these private as government issued bonds. As soon as they transfer it to the government they will be rewarded with a promise of a state pension and their portfolio transformed into state property. Obviously the state will never be obliged to redeem them, it will reduce the debt. It is not a straightforward way of default and debt restructuring, but in its essence it is nothing else. Government liabilities at private debtors are declared void and exchanged to another type of government liablity. At the moment it is - nominally - voluntary. However, the pirme minsiter expressed his firm conviction that as much as 90% ot the members of private pensions schemes will choose the satte run system in two months time. As this number is highly unrealistic on a voluntary basis one could expect legislation making it compulsory, transforming the process in a confiscation. Especially in the light of Fidesz's willingness to reduce the jurisdiction and competenc eof the Constitutional Court, barring it from judging the constitutionality of economic legislation.

Hungary in fact defaulted today...

White mice - Updated

After months of permanent "revolution" the prime minister, Viktor Orbán announced new measures this Wednesday aimed to bring the budget deficit under the ceiling aggreed with the EU, supposedly without austerity. It would be easy to mock him how he defines austerity (as next years budget is planned with a nominal cut in budget expenditures, obviously affecting a lot of people) but I presume it will be a popular activity in the coming weeks. It is more interesting whether this new action plan (complemeted with a modified tax system due to be announced next Monday, but a series of ideas already known) signals a dicision at last concerning the economic policy. Especially as the 29 point from June were the sign of indecision. (See my post here.)

It would be easy to dismiss yesterday's plans as the postponement of this state of agony, as it is not easy to see any coherent direction of action in the rather patchy series of new - intentionally only temporary - levies. However, considering the nature and content of the earlier internal conflict and the resulting political dilemma for Orbán, this time one should assume the decision has been made and what one can see is the backbone of the new economic strategy of Hungary's government. For years economists around and inside Fidesz fought a pitched battle whether the state has to be reduced with drastic cuts in order to make room for tax cuts in a corresponding extent or taxes should be reduced without any offsetting measures. Funnily and ironically proponents of both directions pointed out the same examples, most notably Slovakia, but in the last few years Romania and Bulgaria as well. The representatives of the former line - many of whom participated in the activity of the Reform Alliance in 2008 and 2009 - argued that the size of the state was and is too large and its extent of income redistribution - especailly with its ratio of social expenditures - is crowding out private investment and depresses initiatives. A much smaller state would enable the private sector to invest more leading to higher production and with time higher income. However, according to this line of thought, the balanced budget is a precondition of higher grwoth, because the budget deficit is just as harmful as the high redistribution ratio. If the state runs deficit it needs financing and the sivereign bonds issued attract the capital easier than investment. Those holding an opposite view in Fidesz do not deny the necessity of a smaller state. Nevertheless, their recipe is quite different, as their diagonisis focuses on the reasons of the weakness of economic growth eslwhere, finding it in the lack of sufficient internal demand. Therefore they propose a kind of shock, government measures in order to raise personal income levels creating the preconditions of rapid growth.* They presume this boost of internal demand would lead to such a growth rate that would allow a larger state expenditure in nominal and real terms and simultaneously reduce the redistribution rate as a ratio of GDP.

It is clear the latter "soultion" needs either a very benevolent attitude form those financing the diefict or a permission of the EU, the guradian of the Stability and Growth Pact, because it is usually seen as a way leading to immediate worsening of the situation of the budget. Even if faster growth would bring higher revenues with time as the proponents of this solution claim (far from being certain, but a very popular argument) someone has to finance this transitional period. The idea of a higher deficit for this year, so ferociously defended (portrayed as inevitable) during the run up to the election and afterwards served exactly this purpose. After the EU Commission reppoached Orbán and made it clear they wouldn't accept any deviation from the plans outlined by the outgoing government the circle looking for this way needed to find another soultion. For a while it seemed the former group prevailed and next years' budget will be constructed very cautiously, but meanwhile there were signs of attepmts signaling the almost desperate will for implementing the second version of economic policy. Despite these signs "analysts" and "economists" were deluded by the readily repeated promises of government officials that Hungary will stick to the deficit target both this and next year. They convinced themselves it logically means bugdet cuts, asuterity, reforms.**

Yesterday it turned out we won't see the first alternative being realized, instead Orbán Viktor opted for raising internal demand without lasting measures to offset losses. It doesn't mean the budget won't be extremely tight, but every inch of room for maneuvre will serve the purpose of a huge tax cut. (The one I sketchily characterized in my previous post.) However, the whole action has a transitory nature as the government expects a new wave of additional revenues from higher growth. New windfall taxes on telecommunication companies, on the energy sector and on retail cahins will be imposed (already due this year!) and contributions to private pesnions schemes (obligatory for at about 3 million people in Hungary) will be withhold in the budget. Whether it is the first step towards complete nationalization (a very contorversial issue under EU law) or just a necessary step to cover losses temporarily (the minister hinted to an eventual compensation, although without specifying its nature) is not clear. Anyway,for many observers it seems the government bought itself enough time to bring about its tax cut without destroying the budget and placing the country at the mercy of external financers. Doubts are only raised regarding durability of the reduction of the budget deficit when these measures expire without significant reforms.

If the informations regarding the harsh cuts in the budget (affecting sectors like health care, already drained by years of austerity) turn out to be correct one should conclude the situation is more serious than one would have thought earlier. In this case it will be clear the country is the scene of a mass experiment of supply side economics and the government is playing a gamble. Not that some of the problems they conceive would not be real. Further austerity - albeit propsed by the EU and requested and expected by the markets - could easily push Hungary to the Greek, Irish or Portuguese road. Austerity depresses growth and fails to reduce debt to GDP ratio lastingly making a new wave of cuts necessary and further depressing growth. The vicious circle is not easy to escape (I tend to think it is impossible without coordinated efforts of the EU) and the governments plans to brake it can be seen as legitimate. Although some of the doubts echoed are equally legitimate, the real problem with the proposed solution lies elsewhere. The government relies on the assumption that the only hindrance for growth in the country is the depressed internal demand and a sufficiently strong boost will give the necessary impulse to the economy, bringing new orders to local SMEs etc. In order to achieve this they will introduce a Slovak-type tax system (they even copied the abolishment of the inheritance tax) accompanied by Slovak-type social assistance system, but contrary to the Slovak model they won't prefer market-oriented reforms of systems like the health care, child benefits or pensions. A very strange version of neoliberalism (provincial and protectionist) but still supply sider neoliberalism.

This is exactly the Achiles heel of the whole plan, it focuses on one single factor and assumes a large enough change will generate substantial changes in the whole economy and society. Ironically, it would need a completely and perfectly funcitiong economy, something doesn't exist in the country to the extent the plan would presume (and the existence of which would make the whole idea obsolete). But beyond rather insignificant general observations the whole plan suffers from many important deficiencies. Firstly, there is no sign of the rowth generating effect of stronger internal demand among the present circumstances. Real wages and incomes have grwon in Hungary in this year due to not insignificant tax cuts for middle income categories. On some income levels it was almost 10% raise of net income and on an aggregate level in the first half of the year real income was 5% higher than a year earlier. (This is now fading due to base effects.) Nevertheless, retal sale were continously decreasing, an omnious sign for every attempt to use internal demand as a means of stimulus.***

An even more important factor giving way to doubts is the very uneven distribution of benefits from the proposed tax cuts either in terms of social status or georgraphy. According to preliminary calculations based on the leaked informations on the new tax system a very sognificant part of the working populatioin will not be better off or only with an insignificant ammount, probably meaning a loss of real income. It won't be offset by the child allowance fr these social groups. Moreover, even families with low income but three or more children will not benefit from the generous child allowance. The only group that will certainly enjoy a significant advance in financial terms will be the one of families with high income and three or more children, while the more people earn at the present the more positive the effects of the tax cut will be. Although it is hard to assess the distribution of the tax cuts precisely, it is safe to assume it will make better the position of those with a lower marginal propensity to consume except families with children. Moreover, while the tax cuts can serve as a stimulus via internal demand, the cuts of budget expenditure will have a negative effect on public invesment and public consumption, a factor of GDP dragging down growth already for years. Once again, I have no clue to the ratio of these conflicting effects, but it is hard to accept the planned 500-600 billion HUf tax cuts will raise grwoth with the envisaged 2%.

Of course one can say at least the demographic effect will be positive and I wouldn't be surprised to learn of a temporary positive change in the birth rate in next year. Given the number of live births just under 100000 per year 10000 additional newborn would be a very significant development. However, as I mentioned the child allowance will only mean a significant help for thosew with extremely high income (by Hungarian standards) and with three or more children. People with high income could opt for a third child, but it still won't change the picture fundamentally. Meanwhile the sate will renounce on the social infrastructure of child upbringing (kindergartens, play-scholls etc.) as it won't have the necessary funds to rebuild the instiutions lost in the last two decades. The well-to-do large families will be able to afford private kindergarten (the monthly fee of which is equal to the ammount of the entire child allowance planned!) and will be able to finance one of the parents remaining at home, while those with less children and/or lower income will still struggle to reconcile work (substantial to secure an accepatble family income) and child care. The whole complex is aggravated by the fact that in the backward regions of the country where unemployment - longterm, structural - is concentrated and where the above mentioned larger family type with low income (somteimes living on social assitance) is widespread people's burden won't really be lifted by this new tay system. The result: higher inequalities in the country, less opportunity for people in these reagions and less social mobility. The latter is especially important as under the planned tay system lasting positive developments in demography would need very strong social mobility, because the real positive effect on birth steps in at higher income levels. As long as one can not break away from poverty or the trap of mediocre income one could not really enjoy generous child allowance. (The difference is huge. The child allowance is worth 10000 HUF for the first two children each, and 33000 for each children after the third one is born!)

(Some additional thoughts.) The last - but not the slightest of problems - of the new line of action is that ironically it makes Hungary even more dependent on external factors than earlier. While the government claims to have realized economic independence with getting rid of the IMF, its plan is based on the positive development of a series of external factors. Even if one assumes a turnaround in the reatil sales (a signal of grwoing internal demand) public consumption and investment will affect GDP negatively. Therefore, Hungary will need significant export growth to make its very ambitious plans a reality and collect the revenues envisioned. However, the tax cuts has almost no effect on competitiveness and there are some ominous signs. In the first half of this year the extraordinary growth in germany did not generate enough export oriented economic activity to have offset the decrease elsewhere. If the world ecopnomy will slow down Hungary can find itself trapped again. Beyond this worrying possibility one should take into account the ongoing sovereign debt crisis in the eurozone. If in March, when Ireland will return to the financial markets its yields will still be too high to lend credibility to its claim of beginning to reduce debt as a ratio of GDP the whole edifice can collapse, bringing down Hungary as well. Meanwhile the world economy is inchoing towrads "currency war", a series of competitive devaluation, a dangerous development to the export capabilities of the EU.

As it seems although Hungary freed itself from the the IMF (but not from rules of the EU, that are much less flexible) it did not gain a larger influence on these exterenal factors. While countries had a chance to really negotiate measures with the IMF, and that way implement an economic policy - at least partially - of their own making and enjoying the safety of having the support of this institution, now the Hungarian government acts in the hope that every single external factor it can not influence will at the end contribute positively to its economic plicy. In this sense Hungary is less and not more independent at the moment, its future hinges exclusively on the positive developments in the world.

I do not want to presage an inevitable failure of this new policy, although I have not much confidence in it. But even if I try to make this generous gesture of fair play I could not escape feeling myself as a white mouse looking out of a cage juts before entering a labyrinth in a new laboratory experiment.

* Please note, the owner of this blog doesn't concur with any of these opinions, considering them very simplistic if applied to Hungary's present state of affairs and in general as well.

** One should pay respect to the few exceptions, most notably among the Peter Attard Montaldo at Nomura, who echoed suspicion from the beginning.

*** There could be many reasons for this surprising development. One of them is certainly the process of deleveraging, especially as the fx-based loans were hit by the rapid deterioration of the exchange rate of the HUF against CHF and EUR. People probably pay higher mortgage rates from their higher income, something that could easily last for years.

The Great Economic Experiment

For a while I was convinced that Fidesz's action plan is just the result of confusion and lack of time, that's the reason behind its incoherence. However, probably it is a more refined action to achieve the elbow room they wanted. As one of their basic slogans in the campaign was the end of "traditional economics" they decided to prove how problematic its basic assumptions are. This is an experiment, an empirical test of the Ricardian equvivalence, or at least one of its underlying basic assumptions, that rational actors always presuppose later developments and act accordingly. (In its basic form if the government finances today's debt with borrowing taxpayers will expect tax hikes later and therefore they begin to save instead of spending. However, in a generalized form it suggests that rational actors act not only according immediate advantages and benefits but they consider costs occurring on a longer time-horizon.)

What did the Hungarian government in the last few days? They announced an incoherent package of measures with the aim to keep deficit at 3,8% of GDP and simultaneously boost growth through competitiveness. One that probably won't help to keep deficit under control with measures (see my previous post) and contains measures controversial in itself, like the introduction of flat-tax with countermeasures defending lower income categories from losing form their net income due to higher effective tax rates. One very definite countermeasure was the announcement of higher minimal wages. (According to rough calculations the necessary raise would be around 23% plus at about 4% in higher social contributions after the new gross wage.)

What happened after the government made this plan public? The package as a whole was praised by analysts in Hungary while received with more doubt outside the country. (It is worth to note that one cannot easily imagine more rational actors in economics than financial analysts.) The former category can expect a significant material advantage from the new tax system as they certainly belong to higher income categories, the latter are not affected as they are paid under a different tax regime. Up to this moment no financial analyst exposed the controversial nature of the tax "reform", especially regarding its effects on competitiveness. Neither was doubt raised regarding financiability of the tax cuts, even though the offsetting measures are vague and in their present form unrealistic. Nothing was heard from the associations of entrepreneurs, whose companies will be subjected to these changes. (And entrepreneurs should be rational actors, by virtue of being entrepreneurs.)

However, what we are looking at is contradicting to Ricardian equivalence and its basic underlying assumptions. Although it is probable that competitiveness will be suppressed by the higher wages leading to a result contrary to the will of everyone (and certainly affecting companies' profits), the hole in the budget will be filled with tax hikes affecting income later, people for whom the new tax system will bring immediate benefits support it, despite the prospect of negative measures later. They are not acting according to the Ricardian equivalence.

I think the whole action plan is an empirical test of economics. If the government can expose analysts and entrepreneurs neglecting the basics of rational expectations they can claim that the "traditional" economics really failed and ask for their well deserved higher deficit target. Why bother with the reaction of "rational markets" when they are proven to be irrational?