On thin ice?

Hungary's prime minister is in full gear. With declining popularity and approval ratings he is convinced that it is due to his government's inability to make people understand how well they are treated. Instead they believe in the lies of the opposition. As a result Viktor Orbán appears everywhere, gives interviews (even to reporters earlier exiled to remote corners of the public media) and engages the opposition in the parliament. (Contrary to the British custom there is no informal obligation of the premier to participate on Prime Minister's Questions every week.) Additionally he visits friendly societies, in order to clarify his program for faithful followers. 

Aside from the obvious ominous signs - what to expect from people supposedly belonging to the country's business elite who are listening to Orbán's contradictio in adiecto statements without objection, moreover, taking it with applause - the prime minister made yesterday an interesting comment in one of these circles. He referred to that although it is almost impossible to introduce fixed exchange rate it is worth to contemplate the possibility. 

Given the self-proclaimed and proudly borne "unorthodox" nature of the economic policy of the government, such a hint is not necessarily as meaningless as one would be inclined to take it. There is at least one recent example that a country managed to regain competitiveness and growth with a set of measures including capital - and implicitly exchange rate - controls. Paul Krugman gladly compares the example of Iceland as a country that took a more traditional devaluation focused IMF approach in the aftermath of its crisis to the European countries taking the internal devaluation path. Iceland is an example for a country's potential to convince the IMF  that act of its own design can serve the common aim of returning to growth just as well as the IMF's proposals. According to the latest IMF report on Iceland the government insisted on capital controls in order to make devaluation (and implicitly inflating away debt) easier with pre-empting capital flight.

In the light of Iceland's performance, much praised by the IMF, even the idea that Hungary's leaders are contemplating something similar cannot be written off easily. However, some caveats should be made here concerning the viability of a possible change of strategy. Firstly, Iceland started negotiations with the EU on its accession simultaneously with its IMF program. On the one hand it means a strong pledge that capital controls and exchange rate manipulation will remain temporary, on the other hand it was free from the EU rules, something not given for Hungary, part of a joined EU-IMF credit program. It is hard to see in Hungary’s case how EU law can be eliminated, even if it allows for reintroduction of capital controls in case of economic danger. Secondly, Hungary is still following the path of classic austerity – despite the government’s insistence on the opposite –, it is “on the Greek road”, as Orbán likes to formulate. Even if it is possible to change track, the austerity already has forced its citizens to deplete their reserves, it has not strengthened its banking system (as Iceland did), rather weakened it in the last year, and the typical neo-liberal reforms (for example on the labour market) proudly passed in Parliament yesterday do not suggest the government’s willingness to take an alternative route in order to share the burdens of the crisis more fairly. Thirdly, and this point is knit the former, Orbán has a distorted vision of Hungarian society, impeding him to realize policies strengthening equality. Yesterday he also announced that his policies are aimed at strengthening the middle class. However, the latest income statistic of the Statistical Office showed that people with a monthly per capita net income of 130000 HUF (400 EUR, equivalent of 200000 HUF gross wage) in 2010 belonged to the top income decile. Fidesz’s new flat-tax in 2011 meant a tax raise for everyone with a gross wage under 290000 HUF. One can safely guess that Orbán’s policy – however strongly he is convinced of the opposite – benefits only 4-5% of the population, and certainly not the middle class, only the elite. And last, but not least, a sudden change of track would not only need approval from Hungary’s creditors (something certainly not happening without clearly formulated and well founded strategy), but a bit more capacity to act than the government has shown until today.

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.

The taxation liquidity trap

It was clear for a while that the Hungarian government's secret weapon to curb economic growth is a low tax economy. (Well, with a supposedly strong and active state, something that would most probably result in a despotic state instead, but it is a sidetrack here.) The reason they gave why the government does not want to join the new competitiveness pact of the EU was nothing else that the country wants to keep its tax-independence.* They argue that Hungary needs to regain competitiveness with the "most competitive tax system", i.e. with very low tax rates. Apart from the narrow-mindedness of such attempts one have to admit that rational argumentation never really could deter ECE politicians from operating and manipulating with the tax rates in the hope they will attract investment, make black and grey economy visible and kick-start local companies. In case someone refers to the fallout in budget revenues the usual answer is that higher growth rate will generate even more tax revenues.

Opinions are divided whether it is true or not and how much impact lower tax rates on real and potential growth has. I will not argue here that the assumption of the government can be wrong, because another phenomenon raised my interest, what I baptized as the taxation liquidity trap. The liquidity trap is a well-known phenomenon of economics, it is a situation when monetary policy has no or minor influence on activity because people fail to invest even if interest rates are low. However, in some cases liquidity trap is simply identified with the so-called zero bound, a situation when the institution setting the policy rate of a country hasn't any room left because interest rates already attained zero. (Although, theoretically negative interest rates are also possible, but it is rarely exercised.) If one assumes a really competitive environment regarding taxation something similar is conceivable considering taxes.

Suppose there is already a tax competition, what is in fact the situation across ECE. Countries tried to attract investment with ever lower tax rates and flat tax and as as during the boom years before the crisis it seemed to work politicians are still faithful to this idea. One can find tax rates in the region like the 10% in Bulgaria or Macedonia, 16% in Romania and Hungary (where there is in fact a two bracket corporate tax with 10 and 19% rates) 19% in Slovakia etc. For a while, under the pressure of the terrible situation of the budgets politicians accepted the IMF's view and refrained from every kind of serious tax cut. However, after Hungary "reformed" its tax system and introduced a new nominally 16%, de facto 20% flat tax the tax competition was revived.** Bulgaria plans even lower taxes, Romania a 10% or 12% flat-tax and so on. (The reason is never a thorough investigation of the situation in one's country. Such plans usually appear after a media outlet runs a tabloid story on companies immediately leaving the country and settling in one of its low tax neighbours. It is also noteworthy that the UK government joined this competition recently.)

Anyhow, it is clear that countries competing for investment and hoping to generate growth with lever lower taxes can easily outcompete each other for a while. But what happens when they arrive to the point of zero taxes? Well, in case the earlier tax cuts have proved themselves and delivered the envisaged result probably everything is right for a while. But what happens, if not? These countries simply will lose the means they see as the best way to curb growth, therefore they will be left without any hope for it. Furthermore, it is hard to expect a very long period of sustained growth, without minor or major recessions or periods of stagnation. If a country renounced taxes they hardly would have any means to counteract such slumps, especially as in this magnitude the abolition of taxes would mean a very low level of budget revenues. If and when a country reaches these levels of taxation it will arrive to a taxation liquidity trap and if earlier hopes for strong growth wouldn't materialize they will be stuck.

There is another effect of such policies on the state itself. The more revenue they eliminate the more constrained their budget will be the less chance they will have to regain the lost revenues even through stronger growth. A quick and rough back of the envelope calculation can prove it. If and when a country cuts its tax rate from 35 to 30 percent it can calculate a loss of 1/7 of revenues. With a 3% sustained growth - ceteris paribus - they can collect the same sum circa five years later. If higher growth through lower taxes would come true and they could achieve sustained 4% growth tax revenues will attain the earlier volume four years later. However, if and when a country cuts the same 5 percentage points from a 15% tax rate, they will practically never regain the lost amount of money. With the above mentioned pair of assumptions the revenues five years later would still not higher than 80% of the earlier revenues. At the end the government certainly have to cut budget expenditures and slowly dismantling the state as any tax hike would have an immediately negative effect on growth.***

* It is an horrific custom of theirs always to coin a new word they think of as an inventive way of communication. I fear it rather conveys stupidity.

** Normally it shouldn't have happened as the new Hungarian tax system is a huge tax raise for the 80% of the workforce and as the government insists that companies have to compensate their workers for their lost net revenue it is in fact a blow to cost competitiveness. However, not only Hungarian politicians are stupid, their regional peers also have no idea about what's going on around them and they bought it was a significant tax cut. Ironic, isn't it? Only the politicians in the neighbouring countries believe in this tax cut, no one else. :)

***There is a factor not taken into account here, the growth of revenues from indirect taxes in case higher sustained growth is achieved. It is not easy to simulate the across the economy effects of such tax cuts and the resulting higher growth. However, if empirical evidence could give any idea, ECE is momentarily experiencing a jobless recovery, exports soaring and internal demand flatlined. As a consequence relatively high growth rates are not accompanied with soaring revenues, because of the lower effective indirect tax rates on export, most notably the lack of VAT paid.

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. 

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?

An action plan of indecision? Updated

Hungary's new prime minister, Viktor Orbán announced yesterday his "action plan" a set of measures seen as the guidelines of the government's economic policy. The announcement followed days of insecurity caused by remarks of Fidesz and government officials on the budget deficit this year, frequently using phrases "like Greece", "default" etc. This debacle (retrospectively Fidesz politicians - speaking only from behind the defense line of anonimity - hinted to a conscious strategy, but the party has a tendency to reinterpret every failure afterwards into a plan of a mastermind, therefore it is less and less credible with time) signaled the abandonment of earlier ideas and the realignment of the possible policies.

Anyway, the prime minister delivered a very conscious speech conveying the will and energy to achieve his goals and announcing 29 measures. It had an immediate effect, it was certainly a good show of an illusionist, especially among Hungarian analysts, whose obsession with flat-tax is almost a medical case. Many of them hurried to hail the greatest structural change of the last two decades etc. And the impression in general was certainly favorable, on the surface the new policy seemed to be really well thought. Nevertheless, if scrutinized with a more critical eye - without allowing oneself to be deluded by the flat-tax - it is a surprisingly empty and astonishingly not elaborated package.

The starting point was that the government has to achieve a budget deficit as high as 3,8% of GDP this year, because the IMF and the EU (espacially the latter) would not let them to raise th target to 5-7%. However, Fidesz promised a "tax revolution" in the campaign (although it was clear that they couldn't decide whether to opt for flat-tax or a family-tax system, copying the French model) and tax cuts for enterprises. After they lost a lot of room for manoeuvre when they had to accept the lower deficit figures they still stuck to this idea and decided to find other sources of revenues to offset the income losses. The solution was imaginative but not quite convincing: the banks will pay a half of their profit to the budget in order to allow them to relax the tax burden on individuals and on other companies. Besides the 16% falt tax combined with the family tax the prime minister announced the reduction of the wage costs in the public sector, reduction of tax on companies' profit (at least for those who has a profit less than 500 million HUF) from 19% to 10%, complete freedom of distilling spirits for individuals (really!) a freeze of public services fees for the population, a ban on mortgage based fx-loans and some symbolic measures, for example reducing costs in the state sector and subventions to political parties.

However coherent it seems (and the underlying idea, even if its is horrific, is really coherent) it do not need a Nobel-prize winner to discover how scratchy it is nd how much it lacks the essence of political action: decision on some core issues and acceptance of confrontation. First of all it is still not a decision to fuse two tax systems based on very different principles, it is the opposite: an escape from decision. Considering this state of affairs it is not quite surprising that today none ion the government was capable to give information on details. There will be something with a 16% flat tax rate and with tax breaks and credits for families raising children, but to wich amount the latter will extend, what will happen with the so-called "szuperbruttó" in the present system ("super-gross calculation" an effective extension of the tax base, it taxes the ammount of the social contribution as if they would be part of the income itself) and the tax rebate. Even more serious issue is the problem of "lower wages". The present system - due to a very extended tax rebate - lays only 16% tax on a monthly income of 230000 Huf well over average and median wage in Hungary. The elimination of this part of the system was announced - in two years - which at first sight will effectively mean a tax hike for everyone with 230000 Huf or lower income. There were hints that the government will ensure that no one pay more, but there seem to be no other solution than to raise wages, but an effective 20% wage raise will not deliver one if the most sacred result of as flat tax system (at least in the eyes of its adherents): lower labour costs. (On the idea that it will create incentives to present previously untaxed incomes for the tax authority you can see my earlier post. The very theory used to support the flat tax contradicts to this idea. There is no evidence, ECE countries with flat tax are more infected with black and grey economic activity than Hungary, according to every estimate.)

Similarly vague is the idea of the reduction of costs of public services. It is even not clear whether this applies to the entire public sector, only to certain parts of it or to the state owned companies? While the prime minister mentioned 120 billion Huf as saving for this year and referred to it as 15% reduction of these costs, the only concrete measure was a 48 billion reduction at state owned companies. (But it is tricky as it is the 15% of the wage bill for the entire year while the cuts will come in the second half. The result: 25-30% for six months!) Whether public instiutions, ministries, authorities or schools, the health care sector etc. will bore the remaining 72 billion or just a part of it it is still not clear.

The freeze on public services prices was declared to be temporary, until the government negotiates something with the respective companies. However, price control will soon be reestablished. The bank tax announced without preliminary consultations. Even the method of "liberating" spirit distillation is not clear., it is at the moment not more then a wish list without calculations. And it is based on a very tight calculation, without any reserves and always counting on the most optimistic scenario. If the bank tax falls of or fails to deliver the necessary amount, if growth will remain sluggish the deficit will soar up and austerity will settle to other sectors. Moreover, even the real extent of tax cuts is not clear, because no one knows the amount of family tax breaks and rebate and the future of the present tax rebates. Therefore no realistic calculation of the effect of the package on the budget is possible. (And no structural reforms - some percentage points relaxation in an already almost flat-tax system is far from being one, across the board cuts in the public sector can also be seen hardly as such,Gyurcsány would have been ridiculed by the same "analysts" with a similar action plan who are now praising Orbán.) We have seen the sorcerer, the white rabbit was fat and juicy but it evaporated in a day....

However, the direction is clear: redistribution of wealth from the lower strata to the rich (the very rich) and from the poorest regions to the richest quarters of Budapest. It's negative effect on local economies is predictable as purchasing power will dissipate (while the positive effects of creating jobs is doubtful at best, the recovery could easily turn out to be fragile with the austerity programs of EU governments, the most far-sighted ideas of the Fidesz program were postponed - investment into energy efficiency, for example - or even thrown off etc.) and already huge differences in the country will grow. Well, the show was excellent, but the road is still covered by thick fog.

Update: So, we have a plan with the aim to keep under control the budget deficit and boost competitiveness through lower labour costs. But the secretary of state in the ministry of national economy responsible for tax issues announced today that the "szuperbruttó" will be eliminated and no one will be worse off in the new system (i.e. no one will have lower net income) than in the old one. No details, of course.

But even in this very basic and vague form the plan seems to be way off the announced aims. If the government will pressure companies to raise wages it will negatively affect labour costs without an equivalent raise in productivity. At the moment the average wage of 56500 physical workers in the agriculture is 109746 HUF. They would need a 12,2% higher wage in order to have the same level of net wage. But it would mean an additional 3,5% in higher social contributions as well. Similarly, the (non-existent) average industrial worker (441900 people) will need a 7% rise in wages what would mean an additional 2% in social contributions. The 195900 workers in the commercial sector will need a 10,7% higher salary, an additional 2,9% burden in social contribution. Moreover, the state employs hundreds of thousands of public sector workers and teachers, nurses etc. who also will have to enjoy the benefit of higher salaries in order to offset negative effects - if the secretary of state mentioned above told the truth. 3,5% raise for average employees in the health care sector (148300 people), 13% for physical workers in the same sector (90200 people), 10% for physical workers in the educational sector etc. Certainly more than 30 billion HUF just in order to compensate them real wages still declining. It is still not a well thought plan, just improvisation.

Random thoughts at the end of a long year

I have to admit I faced a much easier task at the beginning of the year, when the events of the crisis were dominant in the public sphere and easily bound to a coherent narrative. With the pressure - at least seemingly - lowering on a series of countries the picture became more distorted, while some states earlier seen as almost doomed now are considered as almost exempt from the consequences and new countries joined the group of economies in a concerning state. Most notably Greece and Spain. However, Hungary, Latvia, Romania are still considered as basket cases. And some surprises at the end of the year are worth to pay attention to.

The Constitutional Court in Latvia ruled that a core element of the austerity measures of the government trying to meet the demands of the EU and IMF, the cut in the existing pensions is void. Moreover, it has to be repaid until 2015. Although politicians reacted with disappointment, the prime minister even stating that the country would simply go bankrupt if the authorities obey every legal provision, the issues goes in a sense to the heart of every so-called economic and social reform from the last few years. The Western model of state is based - at least nominally - on the rule of law, providing the society with a stability of rights and obligations. The CC in Riga simply decided that pension expectations - anchored by law - are such obligations of the state that can reasonably be expected to be fulfilled by the state. The rule of law idea has been chosen as a pillar of democratic society with a good reason and historically its neglectment led to very severe consequences. This time the government will also try to comply, but there is an inherent contradiction between the preconditions of the agreed loan and the constitutionality of these measures. The economic policy implied by the agreement is thought to be the optimal way to deal with the crisis, but the legal provisions - and sometimes the lack of political support and will - are an objection on this road. However, after mass-scale experiences with a system in which every aspect of life was submitted to the perceived needs of the economy and at the same time economy was considered as the area of society that determines everything else it is hard not to feel reservations. And now, after the collapse of the above mentioned system, we are in an era where exactly the same is happening, this time invoking democracy. (OK, socialist systems also perceived themselves as democratic ones.) The earlier experiences didn't really confirm that submitting the society to economy is a good idea, without reservations.
It is clear that rule of law, especially in times of rapid changes not necessarily equals sustainability of a society and the rules sometimes have to be accomodated to the changing environment. But the ruling could remind everyone that so-called reforms, however bright those ideas seem, need democratic legitimacy and popular support, otherwise, only acting in the name of some kind of rationality they can led to surprising consequences. (Not to speak of how irritating can be the view of technocrats praising measures that diminish the standard of living of everyone but them.)
Otherwise the ruling could raise another important - and for the time being clearly neglected issue, the distribution of the burdens of the crisis and the coming period of adjustment. Especially as two quite contradictory views confront in this regard. The dominant perspective - at least in ECE - sees elderly, inactive people only as burden on the shoulders of the active members of the society and this way justifies the confinement of their social benefits to a minimal level. But the crisis was mainly caused by the excess borrowing and consumption of the active groups of the societies, they were the front runners of consuming beyond possibilities. (At least I presume that more active people got FX loans than pensioners.) And the cut in social benefits - especially with a determination to save those loans from effective default - is nothing else then putting a burden on those who were less responsible for what happened and who would have a chance to regain some of their losses during their remaining active life, while pensioners can not really hope for recovering their losses. One can argue that governments has a very limited room for maneuver and it is true as a general assumption. But especially in cases of low redistribution systems the pose - taken by governments - of the guardians of the (would-be) middle class interests is rather a defence of the interests of the very wealthy, whose income and property is untouchable, at least it taxation is an anathema with the reasoning that it would reduce entrepreneurial incentives. It is maybe the case, but even in this case some moral principles could be taken into consideration. But as long as we have very few data on the disposition of the wealth of those at the upper end of the income scale it is a mistake to presume unconditionally that they invest every additional cent and every piece of their existing property in productive enterprises. Why? Didn't they invested in real estate funds, hedge funds, specific financial products linked to exotic financial indices and derivatives etc.? Would it be more reasonable to think that instead the wealthy - who were always proud how sophisticatedly they manage their wealth compared to the ordinary (“kádárist) people- the pensioners fueled those financial enterprises?

It would be easy to think - and one must admit it is also quite popular - that this greed of some individuals was the structural reason behind the crisis, but scrutinizing the situation more closely one should conclude that unfortunately we are all behind this situation and not only because taking loans irresponsibly was a widespread phenomenon. Moreover, this issue is also connected to the problem that in this crisis companies are less ready to absorb losses with reduction of profit. In an ideal and traditional world of capitalism, characterized by family enterprises of many generations the company is the property of a few people who occasionally can decide to take losses for a certain period and reduce profit. It doesn't necessarily mean that they would do it, but they certainly has a choice, at least as far as they can fulfill their financial obligations to lenders and to the state. From a different angle it means that even though profit is still the main driver of enterprise it is easier to resist immediate action for preserving profitability in times of hardship. But this world of the Buddenbrocks or Morels is in principo less biased towards immediate layoffs than the present, where very an ever growing number of companies has more and more nominal proprietors as shareholders while in fact the management make decisions, the only expectation is to provide shareholders with higher and higher profit. Moreover, the personal income of managers is bound to profit rates, but profit is more and more the result of the rising price of the company's share instead of production. Anyway, it is a logical decision to concentrate on keeping profitability high even in times of crisis and the only means is to cut back production costs as much as they could be aiming at a relatively high profit ratio.
It would be easy to assume that this is still a game that is advantageous only for a small minority of a society, but as social security and services (most notably pension systems and health care) became gradually - and sometimes only partially - privatized the high profit rates are in the interest of everyone who has social insurance as well. As soon as company profitability collapse more people would be hit than one would initially assume, just because pension funds invest in financial products either directly into company shares, or indirectly. In this system social redistribution rate is lower, instead of taxation long term profit yields personal security and stable living environment. But it makes people increasingly dependent on the success of financial companies, maybe exactly because only high profit rates that can only be achieved on these markets can compete with effective redistribution - at least as long as demography do not intervene.
Beyond these considerations there is the problem of financing companies' production. Once again in the traditional and ideal world it is based on direct credit links to banks (many of them also private companies, properties of a limited number of individuals), while modern finance brought about a huge change. Direct financing from the market - issuance of shares, bonds etc. - became more popular. However, this reorientation not only meant an easier access to savings, but a profound change of the traditional way of financing the economy. (Once again in an ideal world.) Savings placed on accounts at banks, borrowed by companies thoroughly scrutinized by those financial institutions and re-payed with a modest return on capital, resulting an equally modest percentage of income on for the initial savers. The increasing importance of the direct financing from the market offered higher profit for individual investors, while production itself lagged behind returns of investment in financial assets. Savings were distracted towards financial markets in a growing proportion, quite logically.

This issue also leads to the problem of sovereign debt and sovereign default, because the privatized systems - although with certain restrictions - channels the savings from the state bonds to other financial products in order to gain more profit, compared to the low return on government bonds. Nowadays sovereign default is considered as a horrific perspective - one of the bigest issues of 2010 - although there were more complete or partial one in the histroy than one would except and the consequences - if it happened in a regulated way - were not always catastrophic. Just to mention a recent example from ECE: Poland defaulted on its external debt and it lasted fro years to achieve an agreement with its creditors but at the end it didn't hampered its development after the change of regime, Romania instead payed back almost literally every cent in the '80s with serious social consequences, Hungary tried to manage its debt for almost three decades with more or less success, but today one of the most important limitations on its economy is the sovereign debt. (And yes, even the US defaulted in fact on some of its debt during the Great Crisis, but as it was well managed it was not a very spectacular event.) However, sovereign default, if it is not well prepared and managed, a very unpleasant event, therefore governments were moe inclined to use inflation for effectively reduce outstanding debt in the past. It also gave a chance o place some of the burdens on the lenders, as inflation hurted them as well. However, with the strengthened independence of central banks and the limitations on direct issuance of money it is more complicated today, even if a country is capable to borrow in its own currency. Markets are too alert to inflation risks and as soon as they suspect it the price of issuing government bonds can easily rise.
But one of the causes of the crisis is the existence of excess liquidity in the world and up to this moment central banks, financial authorities and governments were only successful in replacing it but not effectively reducing it. As long as this excess liquidity remains it is hard to imagine a really stable and sustainable financial system. One way to reduce it is nothing else then write off even in the form of sovereign default. Or more precisely regulated write-off is the alternative of sudden and unexpected sovereign default.

But not only reduction of liquidity would be necessary to really stabilize - and not only repeat the earlier cycle - the world economy, we need stable state finances as well. Sovereign default s looming over our head because state finances proved to be very fragile and facing the crisis almost none of the important economies had reserves to spend. Instead government debt amount and ratio to GDP soared. The usual recipe for this state of affairs is cuts in budget spendings and tax cuts in order to reignite growth. However, exactly the story of the last one or two decades shows that the usual mixture of tax cuts - spending cuts and reforms were not capable to ensure fiscal stability, they even became a factor in the instability after the unheard fiscal stimuli. Just look at Germany, where politicians try to keep electoral promises in forms of huge tax cuts, but sovereign debt is predicted to skyrocket in the next few years. The usual mixture is never really aimed to build up reserves, but to keep the state finances on the edge of managebility, due to popular and business pressure for more and more tax cuts. Maybe it would be more reasonable to modify this approach, as the last few years, with a series of significant tax cuts in Europe riding with the tide of the credit bubble created growth hardly can prove that lower taxes will necessarily result in an upswing of revenues later. Especially as consumption is far from recovering and the environment is hardly promising for investing in production.

The ideas and reasoning above is clearly not all-encompassing and it is only designed to deal with such aspects of the problems that are usually not in the forefront of the discussions. It is not claiming to be universal and sole solution, it's aim is only to highlight that these problems are interconnected with other issues, equally significant for a society. However, one conclusion is clear: democratic societies shall take into consideration these aspects as well and democratic decisions, upkeeping individual and collective freedom can only be made with regards to these besides the sole economic factors. Nevertheless, in a crisis it is hardly the task to distribute surpluses and gains, it is all about distributing the pain. In a righteous way.

Prudent politician vs. Hungarian madness

One of the most typical accusation to the adress of the Hungarian politicains from the business elite that the political elite simply bargains long term advantages fro short term political ones. (The most recent one comes from the prime minister, Gordon Bajnai, who is not really a politician, but one of the experts - with current finance mininster, Péter Oszkó, who arrived with great plans into politics and administration and clearly had to realize that in the public administration best practices from business can be even outright failure...) This statment is usually supported by an argumentation, pointing out that other ECE political elites could have managed their countries better and were more focused on the long term. Well, after a deputy whip of the largest Polish government party told in an interview to Bloomber that his party is not ready to commit political suicide and make budget cuts until the elections in 2011 I think this refine construct could be forgotten. Ukraine is a complet mess, because politicians are not willing to committ the same suicie, Romania similarly, in Serbia - another recent candidate for overtaking Hungary in the self-flagellant and nationalist discourse - the number of pensioners is estimated to be higher at the end of the year as those working (a fact advertised by the largest and most professional Hungarian economic website, www.portfolio.hu as the only case in the region, even though it was already the case in Romania two or three years ago, although to admit it would have meant an abandonment of the idea of the Romanian miracle due to flat tax), and this series could be much longer. It is again a small but clear sign how self-focusing and how detached from realities can this supposedly expert thinking be...

(Oh, and it is not excluded that at the end Germany will experience something similar to Hungary's fate in the 2000s. The liberals in the new coalition are very insistent on their promised tax cuts - the justification is the same: lower taxes mean more employees and more income - while their partner(s) in this "natural" alliance are fighting against their ideas - not only against their proposed tax cuts and the realization of it, but privatization in the health insurance system etc. The conflict is clear and at least superficially not dissimilar to the internal conflict of the Gyurcsány-government in Hungary. Moreover, the tax cuts are a textbook example of redistribution from down to the middle and upper income categories. In the lower segment of income it will be offset by growing costs of public services - litter transportation, contribution to the costs of health care etc. That makes it an illusion or at least a dubious attempt - especially in ECE with relatively low income levels - that tax cuts will bring more purchase power, more demand for local services, consumption goods etc. As long as it had to be offset by spending cuts it will automatically lead to higher cost of public services and in case of low income levels this raise of expenditures will suck up the additional income. While those with a really high income won't really spend more on hair cuts as their hair won't grow faster due to more money....)

Why do statistical offices exist?

My preferred Romanian politician, Mr. Băsescu swung into action today again. At a conference entitled "The Future of Social Change: 1989-2009: Visions and Perspectives after 20 Years of Transition" he vigorously attaced the lazy and populist Romanian politicians as - according to him - Romania is in danger to become a country of peoples depending on social assistance. Mr. Băsescu - who recently began to play safe on economic issues, he even contradicted the optimistic forecasts of the Chair of the National Bank and predicted a lasting contraction of the economy - interpreted the facts quite peculiarly. It is probably true (I havn't checked it, I only rely on other data) that a half of the country's nominal population receive regular social assistance in the form of some payments. (It is actually more than half of the real population, as millions are working abroad.) But the alleged reasons for it - populist politicians, except Mr. Băsescu himself, of course, buying votes with social transfers - is a gross oversimplification of the social processes of the transition period.

According to official data the number of employed people in Romania, a country with a nominal population of 22 million, and a real one somewhere between 19 and 21 million, is at around 4,6 - 4,8 million. (Just a slight comparison: in Hungary, a country of 10 million, where the official rate of employment is not higher than 55-56% the sheer number is 3,7-3,8 million.) Moreover the ratio of active people and those who receive pensions - either regular or so-called agricultural ones* - is below 1, at around 0,98. That means: less than one working Romanian bears the burden of providing one inactive with some kind of benefits. It is usually not considered to be a healthy and sustainable situation. (It is true that the financial transfers of guest workers make this picture less disastrous, but as it is unofficial the state can not lift its responsibilities using it as a pretext, nor enjoy some decent income from it.)

The phenomenon was a result of the transition itself, when - not only in Romania, but in many other ECE countries - the suddenly rising unemployment was "cured" by allowing people to escape into the pension systems, momentarily relieving the states from the discontent of its citizens, but in the long run causing ever growing demands on the social systems. But even retrospectively it is not clear whether this treatment was a complete failure or more logical than it seems. In many cases (Hungary, Poland, Romania, Slovakia) the respective economies never really regained the lost workplaces (in Hungary the volumen is 1 million!) and even though outmigration was a factor rapidly depleting the reservoir of unemployed people in some cases (Romania, Poland, Slovakia) the rate of unemployment remained high. (Romania was seemingly an exception, but with the huge number of pensioners it is only a statistical trick.) The FDI focused policies were not capable to ensure a low level of unemployment in two decades and with the crisis hitting ECE and undermining the former economic model it is not clear whether the nearest future will bring further opportunities.

The situation is aggravated by the fact, that Romania experienced a long period of sustained high inflation and the wages remained relatively low in order to achieve competivity. The former led to a rapid loss of real value of social payments, the latter led to the necessity to rein in state income - due to lower taxes - to give a bit more to the "ordinary people". (It was also a core element of a perceived competivity advantage, although personally I consider this argumentation dubious.) Nevertheless, state income remained low not allowing to raise social spendings, but at the same time personal income was not growing rapidly as well (except in the last two years, but it was a result of overheated economic growth, tightening labor market, therefore unsustainable, and even with this rapid rise average wages remained the lowest in ECE, except Bulgaria, somewhere around 250-300 euros a month. Therefore it is not surprising that not only pensioners but other social groups need state assistance for various reasons. (For example some subsidy or support to the natural gas consumption, that can amount in winter months higher than the monthly income of a family.)

But, not denying the role of populist politics, in Romania and in other ECE countries, the main factor behind the extended social provisions - and their limited effectivity as well - is the process of transformation itself. There is no better example for it than Romania, with its large poverty stricken social sectors, shabby infrastructure (a source of balanced budgets in recent years was the lack of investment in those areas) lifting costs of social services and low wages in order to ensure competivity. From this perspective, Mr. Băsescu was not right, rather he completely missed the point: it is not a a shame but a necessity to be a nation of socially assisted people and the only option to alter the situation is to get rid of every kind of social responsibility of the state. (Even minimal ones, as for example average pensions are not higher than 100-150 euros per month, not a huge amount for decent living, but a real burden on a state household determined to lift every tax from enterprises.) But even in this case there would be a half of the population left without the necessary means for a subsistance.

* In Romania two pension systems exist, the regular one and the so-called agricultural. The latter is composed by people earlier working in agriculture during the communist era and paying contributions into a separate system.

Never say reform again? - Despised words and obvious bias

The release of the GDP data gave an opportunity to quickly assess the situation in ECE and Reuters did it with an article yesterday. Although the piece is not unbalanced, it has some peculiarties in it, showing incoherence in the picture and the argumentation. (Although it is rather a report then a text expressing opinion, the concluding remarks disguised as a citation from Katinka Barzych, clearly shows the preferences of the authors, more reform is needed in ECE.) Especially the part about the two types of ECE economies is lacking any real factual basis and can only be interpreted as a sign of an effort of those analysts who visibly failed as experts, to uphold their views and their personal legitimacy. After yesterday's data it is really questionable to make a significant difference between so called reform countries - Poland, Czech Republic and Slovakia - and "reform laggards" like Hungary or Bulgaria (!). Especially in the case of the latter, where not only a budget surplus was achieved - that means having had more restricted public finances as in any of the above mentioned reformers, but that was also praised as a booming and investment and business friendly country. Other telling fact is the lack of Romania from the classification, wich was again pointed out as a model for the reform laggard(s)... Maybe it would have been too much even for our experts to qualify Romania as having brighter outlook after the country registerd the largest contraction outside the Baltics?

Even more contradictory is the classification of the Baltics. For years those countries were considered to be among the most reform oriented, most business friendly ones with flat-tax systems and budget surpluses, low redistribution rates and social expenditures,* while Hungary as reform laggard - implicitly even in the above mentioned article - was criticized because of its "high" social spending. The fate of the Baltics, simply dosn't fit into the framework of reform countries having a good chance to emerge early from the crisis, and I'm convinced that it completely undermines the whole argumentation. Moreover the "experts" expressed their views that countries relying on strong export oriented industrial sectors will have an earlier recovery, due to growing demands in their export markets as the recession fades. But the reform laggard Hungary has one of the strongest export oriented industrial sector that in itself performed quite well even under the strains of the restrictive fiscal policy of the recent years, with huge growth rates in production and export as well. Why do these so-called economists think that Hungary's export oriented companies wouldn't be able to use the growing demand in order to expand their production, especially as the country's public finances are in a significantly better shape then two years ago? And why do they think that the Slovak industry relying heavily not on a differentiated range of products but on three car producing companies will experience a growth similar to the one seen in the last years? Can they ensure that the demand for cars will remain the same? Can they predict that consumers will have the same amount of money to spend and will look after the same goods at the same amount? I would call it voodoo economics rather than expertise... Or, even worth the complete incapability to pose the right questions.

The similar effects of the crisis in ECE and the contraction far worse then expected in countries earlier expected to fare better than "reform laggards" can be a sign - besides showing those experts in their completely miserable condition - that the very model of growth implemented in these countries after the change of regime reached its limits, especially as the integration of the financial markets deprived the fiscal policy from its means to controll and influence the outside flow of capital.

Despite the possible objections and the important questions looming over ECE even if "experts" do not dare to ask after them, they sole advice is to continue reforms. Although the crisis and the events in the Baltics even before, revealed that the economic model so wholeheartedly advocated was not capabale to fulfil any of its promises - sustained and fast growth, growing incomes at the individual level, fast real convergence to Europe - they are sticking to these ideas. Peculiar. And not only peculiar. Sometimes it is complete blindness. Nigel Sharing expressed his opinion that: "“The Baltics have proven that they are flexible enough to carry out these reforms and wage cuts. The only danger is that public pressure could grow due to the rounds of budget cuts.” But it s a contradictio in adjecto. If the Baltics already prooved its flexibility then no danger of the abovementioned kind should exist. If such danger exists then the Baltics has not proven anything of its flexibility. Moreover, the political developments - recently the Estonian coalition practically collapsed, the rightist parties look after new possible combinatitons, excluding social democrats - shows that the pressure is growing. Why not, one should ask? It is not only the course of events to be expected in an economic crisis, but at the same time reveals another important part of the problem. The much advocated model ensured fast growth - at least seemingly and certainly only temporarily - but at the cost of social cohesion, with growing inequalities. Why shouldn't societies opt for a moderate growth - especally as the sustainabilty of the 6-7-8-9% rates in the medium term are highly questionable, at least after the recent crisis' experiences - instead of a faster one menaing only real convergence to Europe only for the highest 10% or 20% of the respective societies. Sometimes there is a reason behind the development that the phrase reform is more and more despised in some ECE countries...

Oh, and the Slovak press was once again true to its traditions. The SME summarized the Reuters article with the following title
"Reuters: Slovaks made refomrs, Hungarians didn't. We can see the result" Yes, we can see. Slovakia is falling from a higher cliff into a deeper canyon?

*A recent rankings of competitivity of individual economies, based on the data from 2008 (!) provided by the IMD Business School ranked the Baltics still higher than the other ECE countries, despite a huge loss of position compared to the previous year....

Doomsday or the truth revealed? - Q1 GDP data released...

It is almost official - Slovakia is always keen on overtaking Hungary either towards heaven or hell. The official (although preliminary) data on the economic growth in the countries of Hungary, Slovakia, Czech Republic and Romania is out. Every one of them was much better then the landlside experienced in the Baltics ranging from a 12,/% to a 18% year-on-year, but neither was very rosy. The Hungarian one 5,8% seasonally adjusted is slightly better then it was expected especially as the range of predictions/forcasts (or rather guesses, sometimes even bets) was between 5,5% and 10%(!). The other three publications were equally surpirsing, Slovakia with 5,4%,* Czech Republic 3,8% and Romania 6,4%. In these cases the data was far worse than it was expected, the contraction being twice or three times faster than predictions/forecasts (or rather guesses, sometimes even bets).

The conclusions? The situation is not rosy (ok, it is dire) but ECE is more homogenous than the "analyts' and "economists" were ready to admit. The predicted differences are less pronounced in terms of GDP contraction and if one compares the decline of the GDP with the year on year datas from the 4th quarter of 2008, then it is quite clear that Hungary, the economy of which fared worse in 2008, performed relatively better, not that it has any real significance among the present circumstances. The important issue is that those countries that were presumed to be more resilient either because being in the Eurozone and/or having a supposedly better tax system making them more competitive in the eyes of so-called analysts and economists underperfomed their forecasts. Those factors that were considered to influence the economic processes were seemingly not really importante in determining the economic contraction's pace. One can even dare to assume that they played no role in it. The broader framework of the world economy determines the fate of ECE not individual country's responses.

Moreover it is another question mark regarding the expertise of the analysts, who have a great influence on the image on the individual countries - conferring and/or conveying the opinion and judgment of the "markets" about those economies, and that way sometimes even deciding whether those will be financed or not - sticked to ideas clearly not really having roots in the present reality, namely that every country is an individual case and the main reason behind the depth of the crisis is the respective economic policy.

Otherwise the competiton is not finished. Slovakia is on the heels of Hungary and Romania is already leading the pack. Beware Hungarians...!!!

*Update: according to figures at the website of the Slovak Statistical Office the seasonally adjusted data for Slovakia was in fact 6% decline, that means even higher than the respective Hungarian one.

A week later - today's world as seen from Bratislava

Things are changing with an aunexpected pace in Slovakia as weel. Only a week after the serious lecturing delivered at the adress of Hungary the SME begin to relize that the problems looming over Slovakia are in fact larger than expected. Today they published an article with the title "The budget in state of an heart attack". The tone of the piece is substantially different from earlier one and it prophesizes that without major modifications (that means cuts on expenses) the deficit can reach a level the dubble of the forecasted. The resons: the collapse of VAT incomes, the loss of revenue from corporate taxes, the relatively high sums paid out for "stimulus pacakges". The danger: with a higher deficit Slovakia won't be recieve financing and investment from abroad, as the example of Hungary shows. The conbclusion: Slovakia need to adjust its udget to the circumstances and cease with the practice to give for everybody who raies his hands.

But the SME was not deviating too far from its earlier opinion. Although one could think that it is a profound change, there are signs contrary. The perceptible intention is to attack Fico, who is fra from being beloved by the liberal newspaper and as we can see the usual "Hungary-complex" remained, only to be reversed, this time put forward as a threatening example of collapse. But as things are going forward we can expect further changes as well.

Today's world seen from Bratislava

The liberal daily from Bratislava, SME, published today an article on the political situation in Hungary.(Unfortunately it is not a longer piece, as its author, Peter Morvay is a colorful personality, for example he was for a while probably the last Czechoslovak citizen, more than a decade after the dissolutuon of that country.) Otherwise the article is a short one, outlining the possibilities and arguing that the decision of one of the candidates for being designated prime minister to reject the offer was reasonable, given the limitations of his role. Later Morvay poses the question whether the leader of the Hungarian opposition, almost certainly prime minister after the next elections, will be able to implement reforms, even if these will be contrary to his campaign promises, replicating the situation that destroyed Gyurcsány's credibility.

What is interesting in this piece is the perspective and the implcit lecturing Hungary on the lack of reforms, similar to the achievements of the Dzurinda governments. Hungary is portrayed as very sick country with an almost dead economy, while its neighbors are realtively safe from the effects of the crisis. Even though both statements are exaggerated (Romania's budget are in a worse shape, and its economyc funamntals are maybe even worse - the driving force of growth was a housing bubble, instead ofr exports as in Hungary or Slovakia, Slovakia's budget, although clearly unnoticed for Morvay, is in the process of collapse because of the tax system's faults, the exchange rate for the koruna by the introduction of the euro disadvantaged the Slovak industry very much and paradoxically this is perhaps only veiled by the crisis (!)*, not to speak of Ukraine, and recession is hardly evitable in every country in the region) my aim is not to make an argument. On the one hand, because the criticisim is not completely unfounded, on the other hand because the stance of the SME is more important for this blog. It shows how easy it is in ECE to accept the role of leader of the pack, that of the model country's and how easy it is to present one country as superior to the others, using achievements and the sufferings leading to them as proofs of this. Today's world seen from Bratislava is a very assimetrical one, instead of the crisis, and Slovakia is its rigid schoolmaster.

(Ok, let me provide some proofs: the economic sentiment index hit in March an all time low in Slovakia, construction, services, retail sales confidence in almost free fall and industry and consumer confidence showing deep depression and no increase even though the Slovak car making plants were positively affected by the German "Umweltpraemie".)

Our Hero, the bycicle repairman?

The Romanian premier proudly announced yesterday that during the negotiations with the IMF the government was capable to defend both the flat tax system and its level, because, as he put it: the loan has a preventiv character and therefore the Fund set no conditions for it. (???) The latter statement is a bit confusing as according to the prime minister 2/3 of the loan will raise the reserves of the national bank while 1/3 will be used for recapitalizing banks and restart the flow of credit in the economy. This seems very similar to the case of Hungary where a part of the loan was directed to the reserves of the cantral bank (optically it raised the rate of debt/GDP ratio although at the end it is not the necessary outcome, if it will be used for replacing outgoing debt or not used up just returned to the IMF, but market "analysts" are hardly aware of this fact, only some real economists were capable to do this simple accounting task) and the IMF set conditions for the Hungarian government as well, although not specific, rather general ones. MMoreover, the IMF seems to be very "flexible" these days regarding the individual measures, for example in the Baltics they presented their proposals for Latvia, but yielded to the Latvians pressure and accepted that the country is not ready to give up the currency peg. I suppose this was the case here as well, the IMF delegation presented an overview of the situation prepared by their staff (according to the Cotidianul the IMF forecasted 4% contraction and 4,7% budget deficit) and suggested some measures. The Romanian governemnt defended the pride of the Romanian economy, the flat tax system and the low tax rates - at least in public - vehemently and prevailed.

It is quite probable that the IMF was not sticking to their own ideas as they accepted proposals of governments in other countries as well and even they are forced to accept the rapidly changing realities in ECE, making the reaching of the goals of the IMF sometimes illusory. Romania simply repeated the tactics of some Baltic states, its politicians fought for something easy to achieve to make the bitter pill a bit sweeter, and preserve national pride. We don't know of course how proud ordinary Romanians are of their tax system, but politicians are clearly obbsessed with the idea that: a, they are, b, this tax system is the primary source of the growth of the recent years.

Maybe they are right, although I would be a bit suspicious. But the real question is what kind of measures were offered and accepted by the Romanian government to comply with the conditions of the IMF, if they are not ready to raise budget revenues even if the income of the state houshold is collapsing in the recent months? (The chairman of the social democrats, the coalitional partner of Emil Boc's PDL attacked yesterday the IMF agreement and offered instead a relaxation of the budget deficit from 2% of the GDP, implicitly suggesting that the governemnt accepted keeping this rate as a goal of the agreement, leaving not much room for easing. But once again a caveat is in order. As Boc can present a success to the public it is possible that Geoana simply wants to have his own one and fights for a larger budget deficit after it was already agreed by the IMF.) The logical solution is budget cuts, but it is a problematic issue, as we could have seen in the case of Latvia as well. Unions are preparing for demonstrations even because of the cuts in the present budget that became obsolete in one month (it was accepted in February) and with further painful measures they will be even more eager to act. The coalition is not united regarding the necessity of the loan and it is another political risk. As for the economic problems, in Romania the export oriented sectors has much lower share in the GDP than in Hungary, Slovakia or in the Czech Republic and the country's growth was driven by a real estate bubble based on credit fuelled by transfers from abroad. (According to different estimates 1,5 -4 million Romanians are working abroad, mainly in country seriously affected by the crisis, like Spain, Italy.) It was similar to the Baltic case and signs of overheating were clear, therefore the task would be not only to manage the crisis but to direct the economy on another track. The government at the moment tries to launch great construction projects based on the better absorbtion of EU funds (the plans are 10bn euros for this year!) and to relaunch stalled housing projects. The proposal is simple, but doubious: local self-governments will buy those stalled projects and finish them.

It is not sure that another path, the raising of revenues would be succesfull as well. It clearly won't be benefitial for demand, although it hardly would be the main reason for the real estate market to be frozen. As the workers abroad will be affected by the crisis it will dissipate the basis of credits and consumption and it is hard to imagine the government pump enough money to the economy to substitute 7-9bn euros a year. But the real danger could be the financing of the deficit. Romanias credit ratings are in the "speculative range" and the main reason the country was not affected by this fact earlier was the massive transfer of income from abroad and the optimism about the countries future. But it is hardly a way to follow in the coming years and the government in an effort to defend higher income form higher taxation can deprive itself from budget revenues even after the crisis is over.