What if… Gorbachev had succeeded?

On 7 October 1989 Mikhail Gorbachev visited Berlin for the celebration of the GDR 40th-anniversary, and said: “History punishes those who come too late” (Childs 2000): the statement criticised Honecker but was best suited as his own epitaph. 

But let’s try and imagine what might have happened if Gorbachev’s perestroika had actually succeeded.  Five years ago I wrote a paper developing this theme and presented it at a Conference in Warsaw. The paper illustrated how Gorbachev might have succeeded in achieving the radical reform of the Soviet political and economic system, the construction of market socialism, the re-structuring and acceleration (uskoreniye) of the Soviet economy, and the possible though unlikely continued existence of the USSR.

I should stress that this was not, or at least was not meant to be, an exercise in 20/20 hindsight. Alternative courses can be formulated without the possession of perfect foresight of the state of the world in 1985-1991.  Nor is a change in Gorbachev’s initial conditions required, of the kind “If only he had come to power in 1974, at the height of the fourfold rise in the oil price ...”. This exercise was meant as a genuine counterfactual alternative. Its purpose is that of damning Gorbachev’s disastrous economic strategy and showing that he and his economic policies, more than anybody else’s doings, are ultimately responsible for the collapse of  socialism in the Soviet Union, for the failure of an alternative design of market socialism, and for the immense human cost of post-socialist Transition.  A similar exercise, considering counter-factual alternatives to the actual course of Transition in Cental-Eastern Europe, is only outlined to suggest that Transition might have been handled at a lesser human cost. 

In order to succeed, Gorbachev would have had to act swiftly, instead of practically wasting his first two years in power (1985-87), and lay down sound economic foundations for perestroika: eliminate repressed inflation, preferably through a confiscatory currency conversion; break state monopoly of foreign trade, introduce rouble convertibility on current account, liberalise trade, foster competition. By 1991 he would have also legalised private ownership and enterprise, given state managers bonuses geared to market performance, implemented small privatisation, commercialised state enterprises, begun some privatisation of large enterprises and banks. On Christmas Day 1991, instead of resigning as President of the Union, he could have celebrated the victory of economic perestroika.

What next? There would have been still thorny choices and therefore possible mistakes to be made, before completing Transition and after. Gorbachev would have needed continued vigilance and sound economic advice, for instance to avoid too rapid dis-inflation at inordinately high real interest rates, as happened in 1994-95, and the consequent recession; to avoid an unsustainable combination of overvalued exchange rate, high interest rate to support it, and a public debt increasing as a result of high debt service, as happened in 1998 under the IMF’s watch; to avoid the unnecessary cost to the budget of switching the pension system from PAYG to a funded system.

As a result of the good economic foundations of economic perestroika, and the avoidance of these kinds of subsequent pitfalls, income losses from the Transition recession would have been lower, and growth would have accelerated earlier and faster than it actually was and did. The welfare of Russians would have improved significantly and continuously as a result. The same reasoning applies to all other Transition economies that to a greater or lesser extent followed stabilisation and Transition paths out of sequence or to excess. It is impossible to have unanimity about whether the measure taken were or were not mistakes, and how serious, let alone quantify the gains. But pretending that there were no serious unnecessary mistakes in the Transition is neither reasonable nor respectable. 

The improved economic performance would have generates political consensus, but not necessarily to the point of providing permanent democratic support for a political regime associated with significantly large state ownership and associated political values (of equality, solidarity, participation, etc.). In some Transition countries post-communist parties were returned to power in democratic elections (e.g. Poland, Hungary, Slovakia) after being defeated,  but only intermittently, not permanently; some party alternation in power is an integral part of democracy. But non-persistent, intermittent market socialism cannot deliver its expected economic and social advantages. When democratic support for an ecomic system is lacking or is not permanent, then its maintenance over time requires necessarily forms of political repression. There is a high political price to pay for an economically successful and persistent market socialism – as confirmed by "market socialist" countries such as China, Vietnam, Belarus, Uzbekistan. 

Would an economically successful Gorbachev have been able to hold together the Soviet Union? There would be economic advantages to be shared out, from holding it together.  A continued Union would maintain and promote intra-Union trade volumes thanks to the single currency, and sustain inter-republic imbalances through transfers within the All-Union budget and inter-republic credits.  An early initiative and widespread economic success, including internal and external convertibility of the rouble, would have lessened centrifugal forces. If some political and administrative autonomy was granted to the 15 republics as well, the chances of retaining the Union would have improved. But the Soviets had seldom solved ethnic conflicts, mostly they had only suppressed them (just as they had done with inflation). Independence aspirations would have made it difficult for Russia to retain close ties even with republics that economically had most to gain from continued integration, like Ukraine. The probability of holding together the Union would have been greater than zero, but not significantly greater. 

Would a successful market-socialist Russia have been able to hold together CMEA/Comecon? Arguments similar to those for holding together the Soviet Union would apply, but would be much weaker. The international socialist division of labour had a bad name, in spite of Soviet subsidisation of its Comecon partners since 1974, by supplying oil and raw materials at below world prices. Memories and accusations of earlier Soviet exploitation through trade were still deeply ingrained. In January 1990 Comecon partners de facto destroyed it by trading freely rather than continue the old trade arrangements, even at the cost of paying higher prices for oil and materials. By September 1991 Comecon was officially dissolved. Comecon Soviet trade partners were already negotiating European Association Agreements and aid programmes with the European Community (now the European Union).

Gorbachev's hypothetical successful perestroika would not have led to Comecon survival.  At most, perhaps, a couple of years earlier he might have been able to extract economic assistance from the West in exchange for his acquiescence to the re-unification of Germany – for which he got nothing at all – and for the Finlandisation of Eastern Europe – a prospect overtaken by events in 1989.   

What difference would Gorbachev’s hypothetical successful perestroika have made in Russia? Only an alleviation of the pains of Transition in the 1990s; there would have been not very much difference in the 2000s, considering that in his second presidential term Putin had already reversed enterprise ownership trends, re-acquiring greater state control in many sectors and a majority stake in energy (Hanson, 2008). By comparison with the sensitivity of Russian performance to the price of oil, probably Gorbachev’s success would have been equivalent to a ten-year-long rise of $10 on the price of a barrel. (According to the Bank of Finland Research Department a $10 permanent increase raises Russia’s growth rate by 1%). The recent implosion of the US and global financial system had a far greater effect on Russia’s prospects.

What difference would Gorbachev's hypothetical successful perestroika have made to modern geopolitics? An earlier economically stronger Russia would have probably contained USA bids for the "American Century", thus sparing them the humiliation of their century ending so soon after it had barely begun.  Certainly Georgia would not have responded to encouragement by George W. Bush and Dick Cheney to attack Russia. But the Twin Towers had nothing to do with Russia, and it is impossible to tell whether the major armed conflicts that followed their attack – in Afghanistan and Iraq – would have been prevented by an economically stronger Russia. Most probably not.

Gorbachev’s and the whole Transition’s economic débacle clearly reduced the demand for socialism on a world scale, but his success would have made no difference for European social-democracy, as it would not have prevented the disintegration of the Italian left or the degeneration of British Labour into New Labour, nor favoured Zapatero’s victory in Spain. Probably both the European Union and NATO would have been smaller than they are now.

A Russian economy made stronger by an efficient Transition would have been less vulnerable to the contagion of global financial turmoil, both in the South East Asian crisis of 1997 (that was an important factor in the Russian crisis of 1998), and today. But a stronger Russia would have neither prevented such global financial crises, nor contributed much to their resolution. 

We should leave the future to futurologists. In 1989 Fukuyama’s conjecture  about The End of History was falsified before the ink had dried. All we know for sure, whether Gorbachev had or had not been successful in implementing economic perestroika, is that – as prophesised by a wall graffiti in London in 1991: "The future is not what it used to be".    

UPDATE

I have been asked where the paper referred to above was published and whether it is available on line. "A counter-factual alternative for Russia's post-socialist transition" was presented at an international conference on The Great Transformation, 1989-2029, TIGER at Kozminski University, Warsaw, 3-4 April 2009, published in Conference proceedings, as Grzegorz W. Kolodko and Jacek Tomkiewicz (Eds), 20 years of Transformation Achievements, Problems and Perspectives, Nova Science Publishers, New York, 2011, https://www.novapublishers.com/catalog/product_info.php?products_id=17656.  

The typescript can be downloaded here.

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Iron Lady: Rust In Peace

Margaret Hilda Thatcher (1925-2013) once famously said, in an interview to Woman’s Own of 31 October 1987, that "There is no such a thing as society. There are individual men and women, and there are families”. Naturally she was often reviled for such a proposition, including by me as I repeatedly quoted her and criticised her vigorously for it in lectures and seminars.

Taken literally such a proposition is patently false. Clearly the collection of individuals and their families are interconnected in a vast and thick mesh of relationships – through economic, political and social institutions – known as “the fabric of society”. The total is infinitely larger than the sum of its individual parts.

But what Thatcher actually meant is that society is all of us, and is not an external entity distinct from the collection of all individuals and their families, so much so that she went on to say: "And no government can do anything except through people, and people must look after themselves first.” A perfectly simple and innocent call for self-help, and for restraint in the reliance on government transfers from a budget to which in the end we all have to contribute. Sure, she was neglecting the fact that welfare transfers are not necessarily always a disincentive to create income and wealth, that they also represent a stimulation of demand and therefore may generate employment and income, and that a more equal and cohesive society may be worth attaining - at least up to a point - even if re-distribution had a net cost in terms of efficiency. But even these omissions and reservations are legitimate though possibly misguided opinions, for which Thatcher did not deserve to be reviled. Therefore belated but sincere apologies are due and are here unreservedly made.

Nevertheless, there are still many exceedingly serious reasons to revile her. The general principle, that one "not speak ill of the dead", does not apply to influential public figures (as we are reminded by Glenn Greenvald, Guardian 8 April): noblesse oblige. I lived in England throughout most of her political career, from 1962-1982, and intermittently until after her downfall in 1990, and disliked her passionately. Mrs Thatcher - for I could never bring myself to call her a Lady - to me was forever Thatcher-the-milk-snatcher (as in 1971, while Minister for Education in the Heath government, she abolished free milk for school children aged 7-11 years). Never mind the destruction of the British coalmining industry: coalmining is an attractive occupation and culture only in the morbid, romantic literary sickness à la D.H. Lawrence, and miners should have been retired gradually by Labour governments over the previous thirty years, instead of being kept employed artificially as a reserve army of Labour voters. But there was no reason to confront them as Thatcher did and unleash riot police on horseback assaulting them: she could have easily bribed them instead with the proceeds of North Sea Gas.

Nor was there any need to start a class war using a regressive and odious poll tax, or to deny Irish hunger strikers in the Maze prison their political status thus leading to their death. She lowered taxes and cut welfare expenditure and industrial subsidies, promoting de-industrialization and unemployment (that rose to a record of nearly 13 per cent under her watch); she privatized council houses without building new ones, and sold off all kinds of public assets, including public infrastructure (steel, airways, etc.) and utilities such as water, telecoms, gas and electricity, transferring massive public wealth to the private sector. She de-regulated economic activities, especially finance, and shrunk the size of the state. In doing this she somewhat revived competition - which she could have done if she had wanted to even without privatization - but did not promote economic growth in the UK, as she is widely credited to have done.

Thatcher never understood any macroeconomics - or she would not have written (in her Path To Power, 1995): "There is no better course for understanding free-market economics than life in a corner shop." With infinitely greater confidence than that applicable to her assertion about society, we could say that "There is no such a thing as a market system". For in order to substantiate the naïf, oversimplified market vision of her mentors (Milton Friedmann and Friederich von Hayek, Alan Walters and Keith Joseph and the whole of the Mount Pelerin Society) as a system of self regulating equilibria we would need a system of complete markets, i.e. of exclusive, spot and inter-temporal, instantaneous and non-sequential markets, for all dated and contingent goods and services. Instead of which we only have a relatively small number of spot markets, a handful of forward markets except for labour and mostly for homogeneous primary commodities as well as money, all sequential and rarely contingent on the states of the world. In the market system as we know it economic agents act on the basis of expectations as well as prices in a typical, incontrovertibly Keynesian world of inadequate and unstable effective demand and involuntary unemployment.  

Policies based on such hyper-liberal (then labelled monetarist) approach, which she shared with Ronald Reagan who gained power in 1980, had massive adverse consequences over time and space. They contaminated and corrupted the New Labour approach of Tony Blair and Gordon Brown, they deeply affected the transition path of the Soviet Bloc from central planning to market economies and caused its immense unnecessary costs, and they paved the way for the global Great Recession of 2008 which is still causing our misery to date. 

Internationally, she strengthened her failing domestic support by declaring war on Argentina over Britain colonial possession of the Malvinas, instead of conducting political negotiations; her tears over the accompanying loss of lives, revealed by recently published War Cabinet papers, are only evidence of hypocrisy. She played a key role in bringing about the first Gulf War, and advocated the 2003 attack on Iraq. She denounced Nelson Mandela and the ANC as "terrorist", while she befriended dictators like Augusto Pinochet, Saddam Hussein and General Sukharto ("One of our very best and most valuable friends"). She opposed German re-unification and the euro but fortunately she was defeated by Germany and France trading one for the other.

For somebody so opposed to the state taking care of its citizens "from cradle to grave", it is ironical that she should be given a lavish “ceremonial funeral with military honours” yesterday in St. Paul’s Cathedral at an estimated cost of £10-12mn. It is only fair that Ken Loach should have suggested that her funeral should have been "privatized": "Put it out to competitive tender and accept the cheapest bid. It's what she would have wanted".

Transition economies: a worse nosedive than anticipated

“At the start of this year, the global economic crisis was hitting central and eastern Europe with unimaginable force. Any illusion that this region was somehow immune from the “western” credit crunch and the subsequent financial squeeze was definitively quashed. Output was declining at startling rates that would only become apparent much later in the Spring.”
“But the danger signs were everywhere. There was real risk of a genuine emerging market crisis – that financial systems in a number of countries would collapse entirely, that currencies would run out of control, that there could be sovereign defaults.” (Anthony Williams, EBRD Head of Media Relations, The road to a fragile recovery, 16 October 2009)

Now they tell us

I don’t remember the EBRD ever signaling any such danger. Slowdown, yes, in their forecasts for 2009 and 2010, that from optimistic growth expected in May 2008 got progressively worse to insignificant growth in January 2009 and an average 5.2% contraction for the 29 countries of EBRD operation in May 2009. I suppose it is part of the institutional duties of the EBRD not to encourage pessimistic expectations that may become self-fulfilling, but then we should note this for future reference and remember that, when the EBRD forecasts a significant slowdown, what they really mean is an impending disaster.

How was the disaster averted? “That this horror scenario didn’t happen – Anthony Williams continues – was a result partly of unprecedented international support, with the EU and organizations like the IMF providing huge macroeconomic packages that were flexible and tailored to specific country needs [to Latvia, as well as Hungary, Ukraine, Romania and other CEE]. Other IFIs, including the EBRD, stepped in to provide micro support to banking groups and corporates with little or no access to liquidity. Crucially western banks, a dominant force in financial sectors in many countries in central and eastern Europe, did not retrench as feared. The authorities in eastern Europe responded with policies aimed at dealing promptly and effectively with the crisis, even though those responses were in some cases immensely painful and politically unpopular.”

At least in Latvia, it is not at all clear that a systemic crisis has been averted. And evidence that western banks “did not retrench as feared” has not been provided by the EBRD; perhaps they will in due course, in their Transition Report 2009 due in November 2009 or elsewhere. Did western banks really not retrench at all, or on average? Did they retrench less than feared, and how much were they feared to retrench and by whom? Certainly not by the EBRD. And recently Swedbank, the largest Swedish lender in the Baltic region, “has threatened to scale back its presence in crisis-hit Latvia if the country goes ahead with controversial plans to limit the amount lenders can collect from mortgage-holders” (Stefan Wagstyl, 28 September 2009).

Otherwise, is everything fine now in transition economies? It might be in the Czech economy, which has been taken off the list of EBRD countries of operation because it no longer needs its credit – the first to deserve this upgrade – and, most annoyingly, off EBRD statistics. Not fine at all in the 28 EBRD remaining client countries (including Turkey since last year), where the average nosedive now expected for 2009 turns out to be more pronounced than the Bank anticipated in May 2009: a contraction of 6.3% instead of 5.2%, with Estonia, Latvia, Lithuania, Armenia and Ukraine expected to decline by well over 10%.

“Signs of positive growth in the third quarter of 2009 suggest that the recession is now bottoming out in many countries of the EBRD region. However, any upturn in 2010 is likely to be fragile and patchy.” (EBRD press report, 15 October 2009) For 2010 the EBRD now forecasts an average growth for the region of about 2.5%, which is 1% higher than it forecast in May 2009, but since it starts from a level which is now 1.1% lower than it was expected then, the higher growth forecast for 2010 actually masks a lower absolute level of GDP than previously anticipated. And “There are likely to be significant cross-country differences in output growth in 2010”, with Latvia, Lithuania, Hungary and Bulgaria expected to continue to contract until 2011. “It is also clear that the social costs of the global economic crisis are only likely to be felt in earnest next year, when corporate bankruptcies and unemployment will continue to rise”, said EBRD Chief Economist Erik Berglof (Ibidem)
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The same factors that transmitted the global crisis to transition economies – the contraction in world trade and tight credit conditions – are now causing its continuation. “The Institute for International Finance, a bankers’ group, estimates that in 2007 $382bn – more than 40 per cent of the financial flows into all emerging markets – went into CEE. The IIF forecast in June that even with all the extra support the IMF, the EU and the EBRD are putting into the region, this year’s figure would be about zero” (Stefan Wagstyl, FT, 28 September 2009).

Heterogeneity

Transition countries with a fixed exchange rate regime – excluding euro-zone members but including Bulgaria, Latvia or Lithuania – are facing a slower and more painful adjustment, the burden of which falls on wages and prices and therefore ultimately demand and employment. Other factors explaining country heterogeneity are the differences in their fiscal positions, the weakness of banking systems, and dependence on commodity exports. The full set of the EBRD October forecasts is reproduced below, or can be downloaded from the EBRD website ).

“Russia’s economy is expected to shrink by 8.5 per cent on a year-on-year basis in 2009, followed by a rebound in late 2009 and growth of about 3 per cent in 2010 year-on-year. Kazakhstan will suffer a much milder output decline this year (of about 1.5 per cent) but the recovery is expected to be weak, in the order of +1.5 per cent.”

“Relatively faster 2010 growth, in the order of between about 2 and 5 per cent is expected in some internationally competitive countries with relatively sound pre-crisis banking systems, such as Albania, Poland, Slovakia, and Slovenia.”

“Some commodity rich countries including Azerbaijan, Mongolia, Turkmenistan, and Uzbekistan, whose financial systems were smaller and less affected by the crisis, and whose growth is mostly driven by commodities, are also expected to grow faster in 2010, in the order of 5 per cent or more.”

“In Hungary, which was hit particularly hard at the start of the crisis, the crisis has been contained thanks to strong international support as well as sound domestic policies. However, its growth is expected to remain slow in 2010 due to necessary fiscal adjustment and a continued credit crunch. It is expected to show slightly negative growth next year, driven by a weak economy in late 2009 and early 2010” (EBRD press report, 15 October 2009, cited above).

Divergence?

The crisis spells – at least temporarily – a reversal in the convergence process that had accompanied EU enlargement. In 1999-2008 income per head in the EU (15) grew at an average yearly rate of 1.41%, and in the Euro-zone at 1.47%, while in the new member states it grew at 2.00% (Poland) or more (from 2.29% in Hungary to 4.17 in Romania). “Growth over the medium term in the EBRD region is also likely to be below the trend experienced over the last decade” (Erik Berglof, quoted). The crisis is reinforcing the heterogeneity of national performances among transition economies and within the EU.

It is true that some of the factors making for vulnerability to external shocks – such as trade openness, economic and financial integration – are also factors that will reinforce recovery trends in an upturn. But there are other vulnerability factors – such as weak banking systems, fiscal over-stretching, or high private and public indebtedness made worse by mismatching of assets and liabilities – that need tackling before the global upturn can be expected to pull national economies out of recession or stagnation. And membership of a single currency area can make countries more resilient to a downturn but cannot be a cure after the event: a rush to a precipitous euro-zone enlargement today – necessarily preceded by a devaluation – apart from being against the Maastricht rules would not make any sense.

EBRD capital increase

Before the crisis the EBRD was confronted with demands from the US, its largest shareholder, to reduce the scale of its activities in transition economies. Now, as anticipated last May, the Bank is seeking a 50 per cent capital increase, an extra €10bn, from its shareholders – some 60 governments, including European Union members, the US and Japan – to compensate for the decline and reversal of capital inflows into the area. Thomas Mirow, the EBRD president, in a letter to shareholders warns that working with its current €20bn capital, the Bank would have to limit its annual lending to about €8bn in 2009-10 and reduce it to €6bn thereafter. “Activity would shrink while the recovery is still precarious,” while “raising the capital by €10bn to allow the bank [would] commit €9bn-€10bn annually, or €20bn in total extra funding in 2010-15. By mobilizing extra capital from private investors, the total additional funds raised could reach €60bn” (Stefan Wagstyl, FT, 28 September 2009). A final decision will be taken at the EBRD’s next annual meeting in Zagreb, in May 2010.

Mr Mirow states that “The region will need to change its growth model – away from reliance on easy finance and commodities, and towards the development of domestic financial markets, strong institutions and a diversified production base.” If conditions improve “further and faster than is currently expected”, the extra capital might not be needed and could be returned after a review in 2015. Not a chance, regardless.

Markets can be expensive

In Central Eastern Europe and the Former Soviet Union the transition to an open market economy was accompanied by the rise and persistence of unemployment, the rise of inequality and of poverty. These phenomena were particularly serious because they meant a drastic reversal of earlier conditions of full employment, greater equality and low poverty incidence. Moreover higher inequality could not be justified as the reward for efficiency, as in normal market economies, but – particularly in Russia – was mostly the result of unrestrained pillage by privileged operators.

Before the Fall

The traditional, pre-Transition, Soviet-type system was characterized by full employment of labour, indeed by over-full employment: excess demand for labour at the prevailing wage rate. While full employment was obviously desirable, it was not the result of a specific policy but the by-product of persistent repressed inflation, i.e. excess demand for commodities at artificially low prices below equilibrium, which translated into excess demand for labour. Of course there was nothing positive about over-full employment, which was only a cause of high labour turnover and inflationary wage drift, which in turn contributed to the perpetuation of a state of excess demand for goods.

Wealth was almost entirely in public hands (in Albania even private ownership of cars was forbidden); the little that remained private was a source of direct satisfaction rather than income. By itself, this made distribution of income among the population more equal than in a market economy where income is derived also from private wealth (which is always more unequally distributed than labour incomes). There were also factors making for greater equality across Soviet republics and countries within the bloc: the emphasis on industrial development in every country, regardless of efficiency considerations; the socialization of enterprise profits and their re-distribution via the state budget; large scale subsidies via the All-Union Soviet budget, and via the under-pricing of raw materials and oil within the USSR and Comecon.

By World Bank standards of poverty – equivalent to $2.15 per head per day at 1996 Purchasing Power – in the socialist countries of Europe and Central Asia in 1988 on average fewer than 4% of the population lived in such absolute poverty.[1]

Unemployment

The initial prolonged recession of the early 1990s was naturally accompanied by shrinking employment and the rapid emergence of labour unemployment, converging to similar average values and dispersion typical of European Union countries. The many queues for goods typical of the old, typical shortage economy were replaced by a single but much longer queue for jobs. In the CIS, however, there were lower rates of job loss and limited job creation, leading to an increase in under-employment and reductions in real wages.[2]

Table 1 provides data for unemployment rates and employment ratios for 1998–2006. While unemployment remained high in Central and Eastern Europe, it tended to decrease in the rest of the area. Employment ratios did not have a clear trend, with several countries remaining under 60% and only a few being close to the Lisbon target of 70% for the EU member states. Employment rates tended to be higher in the CIS countries than in CEE countries, but this partly reflect higher under-employment and lower unemployment benefits.
The global economic crisis of 2008–2009 has already raised unemployment and reduced demand for migrant labour.

Table 1. Unemployment rates and employment ratios in CEE/CIS


Source: UNICEF (2006), TransMONEE data bank, updated 2009, Florence.
Note: Results from national Labour Force Surveys, except for Albania, Belarus, Armenia, Azerbaijan, Kazakhstan (2004 and 2005), Kyrgyzstan, Tajikistan and Uzbekistan, which are official data. The different sources may use different criteria, for example for registering unemployment, working activities in the informal sectors, temporary jobs.

Inequality


Egalitarian ideals associated with socialist ideology should not be exaggerated. First, there was significant residual real inequality due not so much to monetary income differentials but to privileged access to goods for the Party nomenklatura: this was no small matter, as it affected access to housing, motorcars, holiday facilities, health and education, foreign travel, imported and luxury goods as well as simple items of daily consumption which were in scarce supply for the ordinary citizen. Second, in 1931 Josef Stalin in person had condemned the “leftist leveling of wages” (uravnilovka), and urged the introduction of sharp wages differentials between skilled and unskilled and between difficult and easy jobs. And there were prizes for managers for plan-fulfilment and over-fulfilment, discretionary prizes for workers, money to be made by mediators (tolkach) in the informal semi-legal exchange of materials among enterprises, in the black and grey markets among consumers, the reliance on "pull" (blat’) through "acquaintances" (znakomstvo) to obtain scarce goods and services; a few legal markets, such as kolkhozian food markets and flea markets (barakholki). Bribes and large gifts (prinoshenie) were also common. All these factors distorted the significance of the degree of inequality as measured through official monetary incomes.



Subject to these qualifications, pre-transition measures of inequality, such as the Gini coefficient (=0 for absolute equality; 1 for absolute inequality, a situation in which one subject takes all) were impressively low in the Soviet Union and Central Eastern Europe, about 0.25-0.30. From 1989 to 2004 Gini coefficients increased significantly nearly everywhere in the transition, to around 0.35-0.40. Indeed, in many countries especially in the CIS they soon surpassed the degree of income inequality normally found in western market economies. The exceptions are the Czech Republic, where the Gini coefficient was and still is lower, though rising from 0.198 to 0.235; Belarus, with a similar trend; and Slovenia where it fell slightly from 0.265 to 0.243 between 1991 and 2004 (see UNICEF 2006).

“In recent years inequality has either increased at a much slower rate, or – in some cases – even declined. For example, in those CIS countries, where levels shot up in the mid-to-late 1990s, there have been signs of reductions; while in the Central European countries, where levels increased less dramatically in the 1990s, rates of increase have continued to be slow but steady. However, in most of the region, levels of inequality have remained high in the period of economic recovery, suggesting that growth has not always been inclusive in nature” (UNICEF, 2009).


An apparently similar degree of income inequality – Russia in 2007 had a Gini coefficient of 42%, i.e. a more equal income distribution than China’s 47% – can conceal a profound diversity. In China, and in “normal” capitalism, income inequality depends mostly on entrepreneurial success and is the price to be paid for efficiency; in Russia it depends primarily on the pillage of national resources during the transition and therefore it is a form of inefficient inequality.

Table 2. Trends in disposable income inequality, selected countries, 1989-2006

Figure 1. Gini coefficient of income distribution in China and Russia, 1978-2006[3]
Source: Popov (2009).

Poverty

Post-socialist transition, by itself and together with the associated deep and protracted recession, brought about a drastic increase in poverty. By 1998 it was estimated that, in the transition countries of Europe and Central Asia, one out of every five people survived on less than $2.15 per day (at 1996 Purchasing Power), whereas a decade earlier “fewer than one out of twenty-five lived in such absolute poverty” (World Bank, 2000). “There is little doubt that poverty has increased dramatically in the region. Moreover, the increase in poverty is much larger and more persistent than many would have expected at the start of the process.” By 1998 the people living in poverty had reached 20%. Poverty began to fall after 1998, with the generalized resumption of economic growth; by 2003 the poor represented only 12% of the population.[4]

With respect to the predicament of the poor in developing countries, the material hardship associated with poverty in the transition was made much worse by the drop from earlier achieved levels and expectations, and the loss of security. Sudden large scale unemployment, prolonged nonpayment of salaries, unpaid or decimated pensions, hyperinflation and loss of savings, the loss of free or subsidized social services “made people feel unusually vulnerable, powerless, and unable to plan for the future.” For most of the new poor, transition brought “the destruction of "normal" life and accustomed social patterns.”[5]

“The highest levels of absolute poverty are in poor countries of Central Asia”: Tajikistan (70 percent), and the South Caucasus (with Georgia with a poverty rate of 50 percent in 2003). “Yet most of the poor and vulnerable in the transition countries of the Region are in large middle-income countries such as Kazakhstan, Poland, Russia, and Ukraine.” Those most at risk are “the young, residents in rural areas and in secondary cities. The unemployed, people with little education, and those belonging to underprivileged minorities, such as the Roma are also at great risk. Most of the poor are working poor”.[6]

Russian $-Billionaires

Conversely, in the early 2000s Russia saw a spectacular increase in the number of dollar billionaires. In the Soviet era there might have been, at most, a dozen dollar-millionaires in the shadow economy. In 1995 there were no billionaires in Russia. In 2007, according to Forbes, Russia had 53 dollar-billionaires, in third place after the US (415) and Germany (55), but in second place in terms of their wealth, which in Russia totaled $282 billion ($37 billion more than Germany’s billionaires). In 2008 the number of billionaires in Russia increased to 86, with a total wealth of over $500 billion, corresponding to one third of a year’s GDP. Russia’s “primitive accumulation” took the form of privileged access to natural resources at prices lower than in the world market, to subsidized credit and to privatized assets also on privileged terms.


Trends in the current recession


In a recession such as that of 2008-2009 it is plausible to conjecture that initially inequality falls – because the rich lose proportionally more than those who have less to lose – and poverty rises because the poor cannot afford to lose what they have (viceversa in a boom). This is probably what has been happening in transition economies, though it is too early to tell. If the crisis lasts, losses among the poor – primarily through unemployment – become more substantial, and inequality as well as poverty may increase.

Lack of markets can be expensive. But so can the operation of markets. Is this an integral part of the human condition?

[1] World Bank (2000), Making Transition Work for Everyone: Poverty and Inequality in Europe and Central Asia, Washington D.C.
[2] UNICEF (2009), Innocenti Social Monitor 2009, Florence.
[3] Popov Vladimir (2009), “The long road to normalcy: where Russia now stands”, Conference Paper, UNU-WIDER, Helsinki, 18-19 September 2009.
[4] Alam Asad, Mamta Murthi, Ruslan Yemtsov, Edmundo Murrugarra, Nora Dudwick, Ellen Hamilton, and Erwin Tiongson (2005), Growth, poverty and inequality – Eastern Europe and the FSU, World Bank, Washington.
[5] World Bank 2000.
[6] Alam et al., 2005.

Plans and Markets: A Matter of Life and Death

The twentieth anniversary of the Fall of the Berlin Wall on 9 November 1989 has generated a mushrooming of conferences on the subject on the run-up to that date, often taking place in parallel. On 18-19 September 2009 in Helsinki, WIDER – the World Institute for Development Economics Research, United Nations University – organized a major international conference: “Reflections on Transition: Twenty Years after the Fall of the Berlin Wall”. One of the most exciting papers was presented there by Elizabeth Brainerd (Brandeis University), on “The Demographic Transformation of Post-Socialist Countries: Causes, Consequences and Questions” [still password protected until the end of the month; I will provide a link anyway in the near future]. This excellent paper really drives home the fact that plans and markets are a matter of life and death. In the past twenty years transition countries have experienced spectacular demographic changes, remarkable both in scope and speed, in many ways converging towards Western Europe.

Fertility, marriage, childbearing

“The formerly socialist countries were characterized by a distinct pattern of fertility and family formation: marriage and childbearing took place at relatively young ages (compared with Western Europe) and were near-universal”. Rates of childlessness were near the biological limit of about 5 per cent; in 1965-1989 the Soviet fertility rate had stabilized at about the replacement level of fertility of 2.1 children per woman. Abortion rates were high.

In contrast, “Virtually every country in Eastern Europe and the Former Soviet Union [FSU] experienced a steep decline in fertility beginning in the late 1980s or early 1990s”, as illustrated in Figure 1. Bulgaria and Ukraine fell below the lowest fertility level ever recorded in a European country during peacetime. The abortion rate actually fell (in Russia it plummeted from over 100 per 1000 women aged 15-49 in 1990 to 50 in 2000; in the early 1990s Poland introduced a near-ban on abortion). The decline in birth-rates was due to contraceptives being better and more readily available and to the rapid increase in the financial cost of abortion.

There was a rapid shift towards later (first) childbearing throughout Eastern Europe (see Figure 2); former Soviet republics continued early and near universal first births, with the postponement of second and higher-order births, but are generally moving in the same direction.

Figure 1. Total Fertility Rate. Selected Countries.

Figure 2. Age at first birth. Eastern Europe and France, 1970-2007.

The connection between this trend and the post-socialist transition process is confirmed by these changes being slower in the transition laggards like Belarus. Age at first marriage has also increased, approaching that of Western Europe (Figure 3).

“The share of extramarital birth increased across the region beginning in the early-to-mid-1990s; the highest rate is in Estonia (nearly 60% of all births) which rivals the out-of-wedlock birth rates of Scandinavian countries.” In Russia – and probably elsewhere – the increase in extra-marital births reflects to a large extent a shift from registered marriage to cohabitation.

Figure 3. Age at first marriage, women, 1970-2007

Figure 4. Percentage of births out of wedlock. 1970-2007

A most disturbing development is the “striking upward trend in the sex ratio [of males to females] of children age 0 to 4 in all three Caucasian republics”: Armenia, Azerbaijan and Georgia, where it has risen above the biological norm of 1.05, matching the ratios prevailing in India and China. This may reflect selective abortion, due to wider availability of sex detection before birth, and/or an actual or perceived deterioration in the condition of women.

Income, Education, Uncertainty

Traditional economic theory (exemplified by Gary Becker’s A Treatise on the Family, 1981) predicts an inverse relationship between income and fertility: while children are a ‘normal good’ (“when income increases couples desire more children”), the time-intensive nature of their rearing represents a significant opportunity cost, and its increase holds births down. Brainerd notes that “women’s relative wages have increased on many East European countries” after the transition, thus validating this theory. The trouble is that, for all or most of the ‘nineties throughout the area income per head actually fell, by more than could have been compensated for women by the rise in their relative wages. Thus, pace Becker, the impact of income on fertility that he predicts should have had the opposite sign.

A related explanation offered by Brainerd is “the increase in the [rate of] return to education which has occurred across nearly all transition countries, in turn inducing large increase in tertiary enrollment rates”. Empirical studies “indicate a negative relationship between education levels and the timing of the first birth, and … the strength of this education effect has increased significantly since the start of transition. Women with more education are also more likely to be childless than women with less education”.

But there is a much more convincing argument. “In the context of the transition countries … it seems likely that the uncertainty surrounding the change from a socialist system to a capitalist one would influence a couple’s decision to have children”. Investment theory predicts that “for investment decisions which are irreversible (e.g. children) and which can be postponed, there is an option value in waiting to make the investment”. The role of economic uncertainty is confirmed by a number of empirical studies (showing, for instance, the impact of unemployment uncertainty especially for women on the probability of childbirth in Germany 1992-2002).

There are additional factors: “One of these is the decrease in the number of state-supported nurseries and pre-school facilities and the near-disappearance of daycare facilities provided at enterprises.” Another “simply the decrease in the number of middle-aged men” due to the dramatic increase in mortality rates among men aged 25 - 54 in the 1990s (discussed below); “if women are reluctant to raise a child as a single mother, this too would be expected to account for at least part of the decline in fertility over the period.”

On lower fertility rates, later marriages and childbearing, high and rising extra-marital births, transition countries have come to look more and more like Western Europe.

Mortality

Mortality trends diverged sharply in the FSU and in Eastern Europe. After a rise in life expectancy in the late 1980s, undoubtedly due to Gorbachev’s anti-alcohol campaign, “between 1990 and 1994 the death rate among working age men in Russia increased by 70 percent, from 759.2 to 1323.7 deaths per 100,000 population. Male life expectancy at birth fell from 63.7 years to 57.4 years during that period, while female life expectancy at birth fell from 74.3 years to 71.1 years. A similar increase in mortality rates occurred in many other countries of the former Soviet Union in the early 1990s, in particular in Belarus, Ukraine, and the three Baltic countries.“ Some of these declines were reversed in the late 1990s but their size and large and erratic swings are unprecedented in European countries in peace time and the absence of famines or epidemics.

These mortality trends coincided with the process of transition to a market economy, but the same process was accompanied by opposite trends in Eastern Europe, where “mortality rates fell and life expectancy rose throughout the region”, in spite of similar – though milder and less protracted – trends in GDP losses and unemployment. In particular, “The unprecedented increase in cardiovascular mortality in the former Soviet Union in the early 1990s was nearly matched by an unprecedented decrease in cardiovascular mortality in Eastern Europe.” The difference between the two groups is summarized in Figures 5 and 6.

Figure 5. Male life expectancy at birth. Selected FSU countries



Figure 6. Male life expectancy at birth. Eastern Europe


In the 1990s infant and child mortality declined almost everywhere in the region; the traditionally vulnerable groups, children and the aged, avoided significantly higher mortality during the transition. In the FSU the mortality crisis affected primarily middle-aged men. “In Estonia and Russia (and many other former Soviet countries), the increase in death rates for men age 25 to 54 between 1989 and 1994 was astonishing. In Estonia, for example, the death rate for men aged 40 to 44 increased from 5.93 deaths per 1,000 men in this age group in 1989 to 13.19 deaths per 1,000 in 1994, an increase of 122 percent. Over the entire transition period …, the increase in death rates among middle-aged men remained high in Russia, but had begun to decline in Estonia and the other Baltic republics.” An initial deterioration in life expectancy at birth occurred at the very beginning of the transition in other countries, especially Hungary, but the “pattern of large declines in mortality rates across most age groups by 2007 is similar for all East European countries for which data are available, including the Czech Republic, Poland and Romania”.

The mortality crisis among middle-aged men in the FSU republics was primarily caused by a tremendous increase in deaths due to circulatory diseases (heart disease and strokes; also rising in Bulgaria and Romania in 1989-94) and due to external causes (including suicides and homicides). After the mid-nineties these death rates declined but remained at least as high as before the transition. In the other East European countries, deaths due to circulatory diseases for men in the age-group 25-54 declined substantially between 1989 and 2007; among other things, because of improved diet and better medical care. “… the speed and magnitude of the [mortality] decline in Eastern Europe may be unprecedented”.

“Did Russians drink themselves to death?”

“Most analysts believe that alcohol consumption is one of the major causes of the large swings in mortality in the western former Soviet Union in the 1990s,” together with stress and possibly diet as contributory factors. Stress has been associated with unemployment, increase in inequality, migration and divorce. Artificially low prices for food, especially meat and fats, and scarcity of fruits and vegetables, made for a bad diet. Otherwise, other risk factors – smoking, hypertension and high cholesterol levels – in the FSU were lower than in western countries and mildly improving over the 1990s. Individual alcohol consumption is virtually impossible to estimate; probably two factors raised the impact of alcohol, namely binge drinking (leading to increased arrhythmias and heart attacks) and the consumption of “surrogate” alcohol. Surrogates, all untaxed and cheaper than vodka in alcoholic content, include homemade alcohol (samogon), and “non-beverage” alcohol, such as after-shave, anti-freeze and lighter fluid, all characterized by high content of ethanol and other toxic ingredients ”… Autopsy studies and surrogate alcohol studies provide persuasive evidence that alcohol consumption played an even more important role than previously thought in the increase in deaths due to both cardiovascular and external causes in Russia”.

Brainerd stresses that there remain unanswered questions. “Does alcohol consumption also explain the large swings in mortality in the other countries of the former Soviet Union besides Russia? … Why did drinking become so lethal in the 1990s? … Did alcohol consumption increase a great deal, or the frequency of binge drinking?” We know for certain that the price of food relative to the price of alcohol rose dramatically in the early years of transition in Russia, by a factor of three. The problem is that we do not know the price and income elasticity of demand for alcohol, nor the cross elasticity of demand for alcohol and its surrogates.

Population decline

The arithmetic of falling fertility, plus mortality rising above fertility, leads inexorably to a falling population, and indeed in the last two decades there were significant population decreases in most FSU countries. In Russia the population fell from 147 million in 1989 to 142 million by 2008. The loss, of 3.4 per cent, is much more dramatic if one excludes the substantial migration inflows of over 6 million (net) immigrants into Russia, between 1989 and 2008 – a fall of 11 million in the native Russian population. Table 7 shows that the Russian population decline is much smaller than that of other FSU countries: 20 percent in Moldova and Georgia, nearly 15 percent in Estonia and Latvia, 4 to 10 percent in Kazakhstan, Armenia, Lithuania and Ukraine. Similar declines occurred in Bulgaria and Romania. In the same period populations grew in the Central Asian republics (except Kazakhstan), Azerbaijan and Hungary.

Table 7. Population change 1989-2008

“Population declines are likely to continue in many countries due to the much smaller cohorts of women entering their childbearing years” – a factor which is nearly impossible to offset by the hypothetical increase in fertility that might occur thanks to Putin’s fertility ‘bonus’. Increasing life expectancy and higher immigration may make a more significant contribution to reduce population decline. But it is no accident that Goskomstat forecasts the Russian population to decrease from 142 million in 2008 to 137.5 million in 2025.

Implications

Elizabeth Brainard sees an immediate benefit from population decline, namely the “Solow effect” of raising the average capital/labour ratio and therefore, presumably, labour productivity. This effect is unlikely to materialize: existing capital equipment almost invariably embodies a technique designed for employing a given amount of labour per machine. The scope of ex-post substitutability between capital and labour is bound to be much lower than that ex-ante. Higher capital per man and higher productivity may happen only as a result of new accumulation, but this takes time. It may take twenty years for the higher investment per man (and the higher productivity of labour associated to it) to be diffused throughout the economy. In the meantime, lower capital utilization is more likely to occur than higher labour productivity on old equipment – while in the longer run the population ageing effect of demographic decline will still be operational. Demographic decline also leads to some destruction of human capital. Therefore population decline is bad for economic growth on all counts, in the short as in the medium and the long term.

Economic Determinism?

Elizabeth Brainerd’s riveting study is an eye-opener. It reveals how much our lives are influenced by the policies and institutions of the economic system in which we live, and how rapidly we can adapt to the transition from one system to another. It is frightening to see how much our individual decisions, literally on matters of life and death, are governed by economic incentives. When the state takes care of people from cradle to grave, there are simply more cradles but there may be a faster route to graves.

The EBRD and Foreign Banks in Transition Economies

La lingua batte dove il dente duole. The tongue always finds the aching tooth. No-one can help thinking and talking about worries and fears, hoping to chase them away, almost to exorcise them. Clearly the EBRD is very worried about the possible withdrawal of funds by foreign banks from transition economies. Its officials keep talking about this, ambivalently both envisioning the dangers and denying them in the same breath. Economics can be controversial: if it is quite common for an economist to disagree with herself, it is even more common for an international financial institution, like the EBRD. But for an outsider this insistence is a very worrying signal indeed.

On 7 May 2009, inaugurating the newly founded EBRD blog, the Bank’s Chief Economist Erik Berglof strikes a pre-emptive attack: “Eastern European governments can … damage the international bank groups by preventing them from transferring profits or adjusting their exposures. The public pressures to interfere are great.” And in the EBRD Press Release on the same day, Berglof notes that “Over the past six months important bank bailout programmes in Western Europe have helped stabilise the international banks operating in Eastern Europe” and assumes “continued external engagement, particularly from the western parents of banks in the region”.

I pointed out, in a Comment, that in turn “international bank groups can damage Eastern European governments by the abrupt withdrawal of funds in a crisis.” And that the EC Spring forecasts 2009 tell a different story: “The repatriation of capital by foreign banks has been particularly abrupt in some cases. …the presence of EU banks in the region creates further potential negative spill-overs via the financial channel” (p.22). And “If a foreign bank with big exposure to the region—Swedish, Austrian or Italian—needs to raise more capital but finds that outsiders think its loan book is too risky, what happens? The price of rescue may be that it sheds a troubled foreign subsidiary. Signs of shareholder twitchiness are growing“ (The Economist, 26 February 2009). Not unnaturally, when capital becomes scarcer in the country of origin, foreign capital tends to go back home.

Berglof readily admitted the problem: “I do indeed think that there is a serious risk that some banks could decide to withdraw or be forced to withdraw from the region. We should not kid ourselves, the forces on the banks to retrench are extraordinary - some deleveraging and adjustment to lower credit demand is unavoidable and essentially healthy.” He actually strengthened the point adding that “The current situation has elements of a prisoners’ dilemma where the banks as a collective want to stay involved, but in the short-term an individual bank has incentives to be the first to withdraw.” But he relied on the “Vienna Initiative” (illustrated in his post) and other forms of concerted and conditional support by international financial institutions.

On 14 May 2009, at the Bank's Economic Policy Forum, EBRD President Thomas Mirow took comfort from the fact that, in the “spectacular slump which now seems to suggest that the only way is down” – and which he regards as exaggerated as “the earlier spectacular success when the only way seemed to be up” – “we did not see the withdrawal of any of the leading western banking groups who own most of the financial sector in eastern Europe.” This he attributes to “the fact that financial integration generally went along with long term commitments, particularly on the part of international banking groups”. “A measure of the progress achieved so far is the fact that the danger of large-scale retrenchment or withdrawal of western parent banks from eastern Europe has been averted and seems more unlikely now than only a few months ago”(my Italics throughout).

The trouble is that on 11 May two other EBRD officials, Piroska Nagy and Stephan Knobloch, in an excellent post on the EBRD Blog, on “BIS data on cross-border flows” produced substantial and disquieting evidence of the seriousness of cross border outflows. In the last quarter of 2008 BIS-reporting banks significantly reduced their asset holding across major world regions ($1.8 trillion or 5.4% of their stock). In absolute terms advanced countries were hit harder ($1.3 trillion), but in relative terms emerging markets did worse. So far the EBRD region was the least affected, but the decline ($57 billion) was “still very significant”.

Moreover, within Emerging Europe: 1) the decline was concentrated on a few countries: Russia, Turkey, Ukraine, as well as Poland, the Czech Republic, and Slovenia; 2) the decline happened in the most financially integrated countries, not necessarily in countries with weaker fundamentals, “with large outflows both from countries that have already been hard hit by the crisis (Ukraine) and countries that have been resilient so far (Poland)”. “This is in line with earlier crisis experiences which showed that investors withdraw liquidity not only from countries with weaker fundamentals but also from markets in the same region that are deeper and more liquid” (Nagy and Knobloch, Ibidem). Thus asset outflows in the last quarter of 2008 were 15.5% of the stock in Russia, 9.4% in Ukraine, 8.2% in Poland, 7.5% in Turkey (which is also a country of operation for the EBRD), 7.2% in the Czech Republic, 4.1% in Moldova. In absolute terms, the outflow was $33bn in Russia, $12bn in Turkey, $11bn in Poland, $4bn in the Czech Republic and in Ukraine.

Data refers to all cross-border loans, deposits, and securities held by bank offices located in one of the 41 BIS-reporting countries. This includes assets held vis-a-vis all economic sectors, i.e. private and public, or bank and non-bank. BIS uses the category "developing" countries; this note uses "emerging" countries instead.

“Looking forward, – Nagy and Knobloch conclude – similar trends are expected to have continued – if not deepened - in Q1 of 2009. De-leveraging is an inevitable part of banks’ balance sheet adjustment in the context of the global financial crisis.” While the average picture is reassuring, for the individual countries where the phenomenon is concentrated it is intensely worrying.

But this is not the end of the story. If the post by Nagy and Knobloch pulls the rug from under their President and the Chief Economist, Piroska Nagy adjusts her aim with another post, on “The ‘invisible hand’ of advanced country central banks in emerging markets”, while EBRD senior economist Ralph De Haas writes another post “In defense of foreign banks”.

Piroska Nagy notes that “most emerging market economies have limited policy room to deliver massive counter-cyclical crisis response”, but “there is an invisible channel through which advanced country quantitative easing can benefit emerging markets”, trickling down to subsidiaries of international banking groups. She regards the “invisible hand” of the European Central Bank as particularly important.

I would argue that the ECB hand is, indeed, invisible, because it is not there. The ECB is notorious for not having the function of Lender of Last Resort, which rests with the national Central Banks for their national banks, leaving open the thorny and often unanswerable question of bank nationality. True, the ECB is often said to have functions of ELA - “Emergency Liquidity Assistance”, understood as lesser responsibilities than those of Lender of Last Resort – except that the IMF uses the two expressions interchangeably. Willem Buiter worries about who would re-capitalise the ECB if it went bankrupt; I worry about the impossibility of the ECB ever going anywhere near bankruptcy as a result of its non-existant operations as Lender of Last Resort, with Eurozone banks going bust instead.

And anyway, quantitative easing does not seem to work in the Eurozone, as banks are still reluctant to lend; why should liquidity trickle down into Emerging Europe. Furthermore I have heard other promises, for instance of prosperity trickling down, but I have also come across trickling up. Quantitative easing by the ECB and national Central Banks in Europe is much more likely to spill-over into a commodity price boom than into Emerging Europe.

Finally, in his post In defense of foreign banks, Ralph De Haas distinguishes between cross-border foreign bank lending, which he recognises does shrink during the crisis, and local lending which he regards as generally more stable. He refers to a 2004 study which he co-authored to argue that in central eastern Europe “reductions in cross-border credit were generally met by increases in lending by foreign bank subsidiaries”. But that was then and this is now, and much worse than then; and in any case foreign and local funds are not perfect substitutes, for local funds do not help the stability of the currency.

So, now we know. The EBRD President, its Chief Economist, the Senior Adviser to the Chief Economist and her co-author, and at least another Senior Economist, go to considerable lengths to tell us that there might be trouble ahead, but to reassure us that all is under control, and that foreign banks will behave selflessly, readily and adequately to support and stabilise credit in Emerging Europe. Excusatio non petita accusatio manifesta, as it were.

Clearly they are all worried stiff, and so they should be. I wonder if there is an agreed plan for providing Emergency Liquidity Assistance to one of the Currency Boards of Emerging Europe if it went bust; there should be one. Or two.

How Normal Is Russia Now?

This is a Guest Post contributed by Professor Vladimir V. Popov, of the New Economic School, Moscow.

From 1989 to 1998 Russia experienced the transformational recession – GDP fell to 55% of the pre-recession 1989 level. In 1999-2008 the Russian economy was recovering at a rate of about 7% a year and nearly reached the pre-recession peak of 1989. But in 2009 due to the collapse of oil prices and the outflow of capital caused by world recession Russian GDP is expected to fall by 5-10%. Now, with some luck, the pre-recession level of GDP is to be surpassed only in 2010-12. For two decades there was no improvement in living standards for most of the Russians.

In 2004-05 Andrew Schleifer and Daniel Treisman published various articles claiming that Russia was A Normal Country (for instance, in Foreign Affairs, March-April 2004). They compared Russia with Brazil, China, India, Turkey and other developing countries and argued that in terms of crime, income inequalities, corruption, macroeconomic instability, and other typical curses of the third world Russia is by far not the worst – somewhere in the middle of the list, better than Nigeria, worse than China. In short – a normal developing country.

The USSR was an abnormal developing country. The Soviet Union put the first man into space, had about 20 Nobel Prize winners in science and literature, with universal free health care and education – the best among developing countries – low income inequalities and relatively low crime and corruption. By 1965 Soviet life expectancy increased to 70 years – only 2 years less that in the US even though per capita income was only 20-25% of the US level.

The transition to the market economy in the 1990s brought about the dismantling of the state – the provision of all public goods from health care to law and order fell dramatically. The shadow economy, which the most generous estimates place at 10-15% of the GDP under Brezhnev, grew to 50% of GDP by the mid 1990s. In 1980-85, the Soviet Union was placed in the middle of a list of 54 countries rated according to their level of corruption, with a bureaucracy cleaner than that of Italy, Greece, Portugal, South Korea and practically all the developing countries. In 1996, after the establishment of a market economy and the victory of democracy, Russia came in 48th in the same 54-country list, between India and Venezuela.

Income inequalities increased greatly – the Gini coefficient (ranging from 0 to 100%, the higher, the higher are inequalities) increased from 26% in 1986 to 40% in 2000 and 42% in 2007. The decile coefficient – ratio of incomes of the wealthiest 10% of the population to incomes of the poorest 10% – increased from 8 in 1992 to 14 in 2000 to 17 in 2007. But the inequalities at the very top increased much faster: in 1995 there was no person in Russia worth over $1 billion, in 2007, according to Forbes, Russia had 53 billionaires, which propelled the country to the second/third place in the world after US (415) and Germany (55) - Russia had 2 billionaires fewer than Germany, but they were worth $282 billion ($37 billion more than Germany's richest). In 2008 the number of billionaires in Russia increased to 86 with a total worth of over $500 billion – 1/3 of GDP.

Worse of all, the criminalization of the Russian society grew dramatically in the 1990s. Crime was rising gradually in the Soviet Union from the mid 1960s, but after the collapse of the USSR there was an unprecedented surge – in just several years in the early 1990s crime and murder rates doubled and reached one of the highest levels in the world. By the mid 1990s the murder rate stood at over 30 people per 100,000 of inhabitants against 1-2 persons in Western and Eastern Europe, Canada, China, Japan, Mauritius and Israel. Only two countries in the world (not counting some war-torn collapsed states in developing countries, where there are no reliable statistics anyway) had higher murder rates – South Africa and Colombia, whereas in countries like Brazil or Mexico this rate is two times lower. Even the US murder rate, the highest in developed world – 6-7 people per 100,000 inhabitants – pales in comparison with the Russian one.

The Russian death rate from external causes (accidents, murders and suicides) by the beginning of the twenty-first century had skyrocketed to 245 per 100,000 inhabitants. This was higher than in any of the 187 countries covered by WHO estimates in 2002. It was equivalent to 2.45 deaths per 1,000 a year, or 159 per 1,000 over 65 years, which was the average life expectancy in Russia in 2002. Put differently, if these rates continue to hold, 1 out of 6 Russians born in 2002 will have an ‘unnatural’ death. To be sure, in the 1980s murder, suicide and accidental death rates were quite high in Russia, Ukraine, Belarus, Latvia, Estonia, Moldova and Kazakhstan—several times higher than in other former Soviet republics and in East European countries. However, they were roughly comparable to those of other countries with the same level of development. In the 1990s these rates rapidly increased, far outstripping those in the rest of the world.

The mortality rate grew from 10 per mille in 1990 to 16 in 1994, and stayed at a level of 14 to 16 per mille thereafter. This was a true mortality crisis, a unique case in history, when mortality rates increased by 60% in just 5 years without wars, epidemics or volcanic eruptions. Never in the postwar period had Russia such high mortality rate as in the 1990s. Even in 1950-53, during the last years of the Stalin’s regime with high death rate in the labor camps and consequences of the war time malnutrition and wounds, the mortality rate was only 9-10 per mille as compared to 14-16 in 1994-2008.

Russia became a typical “petrostate”. Few specialists would call the USSR a resource-based economy, but Russian industrial structure changed a lot after the transition to the market. Basically, the 1990s were the period of rapid deindustrialization and “resource-lization” of the Russian economy, and the growth of world fuel prices since 1999 seems to have reinforced this trend. The share of output of major resource industries (fuel, energy, metals) in total industrial output increased from about 25% to over 50% by the mid 1990s and stayed at this high level thereafter. Partly this was the result of changing price ratios (greater price increases in resource industries), but also the real growth rates of output were lower in the non-resource sector. The share of mineral products, metals and diamonds in Russian exports increased from 52% in 1990 (USSR) to 67% in 1995 and to 81% in 2007, whereas the share of machinery and equipment in exports fell from 18% in 1990 (USSR) to 10% in 1995 and to below 6% in 2007. The share of R&D spending in GDP was 3.5% in the late 1980s in the USSR, but fell to 1.3% in Russia today (China – 1.3%, US, Korea, Japan – 2-3%, Finland – 4%, Israel – 5%). So today Russia really looks like a “normal resource abundant developing country”.

To understand Russia now one has evaluate the record of the last 20 years. In the late 1980s, during Gorbachev’s perestroika, the Soviet Union was aspiring to join the club of rich democratic nations, but instead degraded in the next decade to the position of a normal developing country that is not considered either democratic or capable of engineering a growth miracle. For some outsiders a “normal developing country” may look better than that of an ominous superpower posing a threat to Western values. Those on the inside however feel differently. Most Russians want to find a way to modernize the country so as to make it prosperous and democratic. But they also feel that something went very wrong during the transition; the policies and political leaders of the 1990s are totally discredited. And so we find ourselves with Putin-Medvedev’s policy getting 50% plus approval rate even in the midst of economic recession.

Eastern Europe: from Slowdown to Nosedive

On 15-16 May next the EBRD – European Bank for Reconstruction and Development, founded in 1991 to assist the post-socialist transition of Central-Eastern Europe – will hold its Annual Meeting in London. The Bank “could be set for a big increase of its €20bn capital to help deal with the economic crisis” (Stefan Wagstyl, EBRD considers big rise in capital, FT, 7 May 2009 http://www.ft.com/cms/s/0/5c560d04-3b35-11de-ba91-00144feabdc0.html). The case for capital increase is greatly strengthened by the publication, on 7 May just before the Meeting (http://www.ebrd.com/new/pressrel/2009/090507gdp.pdf), of the latest EBRD forecasts for 2009-2010 for all the 28 transition countries where it operates plus Turkey which was added in October 2008.

On average, in these 29 countries the EBRD forecasts a 5 per cent contraction in real GNP. Such nosedive comes after the growth slowdown from 6.9 per cent in 2007 to 4.2 per cent in 2008, and is followed by a modest recovery of 1.4 per cent, anticipated for the second half of 2010. The peak of unemployment is yet to come. These forecasts are much more pessimistic than the EBRD own forecast of January 2009, of imperceptible but positive growth at 0.1 per cent, itself a significant deterioration with respect to the November 2008 forecasts of 3.0 per cent growth, which in turn had been slashed from 5.7 in May 2008.

The latest EBRD figures are also – on average but not for Central Europe – worse than the most recent growth forecasts by the IMF, in the World Economic Outlook of April 2009, on Crisis and Recovery (http://www.imf.org/external/pubs/ft/weo/2009/01/pdf/text.pdf). The European Commission Spring Forecasts 2009 (European Economy 3/2009, 4 May 2009, https://webmail.london.edu/exchweb/bin/redir.asp?URL=http://ec.europa.eu/economy_finance/publications/publication15048_en.pdf) are much more optimistic about Russia (only -3.8 per cent in 2009) but more pessimistic about Hungary and Poland, and otherwise only marginally different. The forecasts of UN/DESA Monthly Briefing on the World Economic Situation and Prospects (http://www.un.org/esa/policy/publications/wespmbn/sgnote_8.pdf), published on 7 May 2009, the same day as the EBRD forecasts, are consistently slightly more optimistic (The next set of forecasts, by the UN World Economic Situation and Prospects Update as of mid-2009, is to be released on 26 May 2009).

The EBRD is an institution suffering from three existential problems. It is supposed to lend to the private sector in transition economies, at commercial rates, but if it does this its existence does not make any difference. It is a public financial institution whose raison d’être is the inefficiency of public financial institutions. And we will know that it has fulfilled its mission only if and when it is liquidated.

In fact, before the crisis, the EBRD government-shareholders (about 60) were considering reducing the scale of its activity – perhaps also because of the EBRD own over-generous assessment of transition progress in its yearly Transition Reports. Now an expansion is being considered instead because of both the envisaged large scale of the recession in its countries of operation, and the need to fill the gap abruptly left by the drop in current capital inflows into the area.

There is no reason to believe that the pessimism of the latest EBRD forecasts has been exaggerated in order to strengthen the case for the Bank’s capital increase. EBRD Chief Economist Erik Berglof says that "There are downside risks to these predictions. But now there is also upside potential. Our underlying outlook assumes continued external engagement, particularly from the western parents of banks in the region." (http://www.ebrd.com/new/pressrel/2009/090507k.htm) Such an engagement on the part of foreign parent banks in the area is an over-optimistic assumption (see below). If anything, the withdrawal of foreign parent banks from transition economies is precisely what strengthens the case for an EBRD major capital increase in the near future, already before the review of the EBRD capital is due in 2012.

Within the aggregate forecasts given above, the heterogeneous group of 29 countries naturally exhibits a highly diversified economic performance. In Central Europe and the Baltics in 2009 Poland fares best, with zero growth. At the other end of the range, all three Baltics are contracting by more than 10 per cent: Estonia (already in recession at -3 per cent in 2008) at -10.5, Lithuania -11.8, Latvia -13.2. Hungary is doing rather poorly: after stagnation at 1.1 per cent in 2007 and 0.5 per cent in 2008, its GNP is poised to fall by 5.0 per cent, with zero growth next year. On average this area’s GDP is expected by the EBRD to decline in 2009 at 2.9 per cent, and to resume growth at only 0.2 per cent in 2010. In the April 2009 World Economic Outlook the IMF was even more pessimistic, with a 3.7 per cent GNP decline, but more optimistic for Russia and the rest of the Commonwealth of Independent States.

EBRD forecasts for South-eastern Europe show a slightly better performance: on average growth rates in 2007-2010 follow the pattern (in per cent): 6.3, 6.6, -2.2, 0.4; in 2009 Romania is worst with -4.0. Eastern Europe and the Caucasus (meaning the non Asian members of the Commonwealth of Independent States, not counting Russia) in the same years exhibit actual and predicted growth of: 9.9, 5.0, -6.2, 1.3; Ukraine is expected to contract by 10.0 per cent this year and grow at a zero rate next year. Central Asia is the least affected area, with GNP growth rates of 9.2, 5.0, 0.4, 3.0 in 2007-2010. Finally, Russia is seriously affected: 8.1 and 5.6 in 2007, 2008; - 7.5 in 2009, the result of an even deeper fall in the first quarter and an expected improvement in the rest of the year; the green shoots of recovery are forecast by the EBRD at 1.0 per cent in 2010.

All these countries have either completed their transition to the market economy and their re-integration into the world economy and especially Europe (the ten new member states of 2004 and 2007, with Slovenia and Slovakia already members of the Eurozone), or have made steady and very substantial progress in that direction. What makes them so vulnerable to the pandemic financial and real crisis?

Initially, when the global crisis involved only the financial sector, transition countries – regardless of EU membership – seemed to be fairly resilient. Then, as the crisis impacted the corporate sector, they began to slowdown, and by the end of 2008 and the first quarter of 2009, when domestic consumption began to be affected, they went from slowdown to nosedive.
In general the current financial crisis confronted all emerging and developing countries – including transition economies – with two shocks: “a ‘sudden stop’ of capital inflows driven by global deleveraging, and a collapse in export demand associated with the global slump” (Atish R. Ghosh et al., IMF 2009)[1]. But there are different aspects and intensities, specific to country groups, discussed both in the IMF Staff Position Note just quoted and in other papers[2].

1. Home made sub-primes. The USA sub-primes crisis of August 2007 touched only marginally the transition economies. But a large amount of domestic loans, mostly for house-purchase finance but also in the enterprise sector – and in the government sector – were originally denominated in foreign currency because the national currency a) involved much higher interest rates and b) had been stable or (with the exception of countries with a successful Currency Board: Bulgaria, Estonia and Lithuania) appreciating. All these loans, amounting to $250 billion in Central Eastern Europe (Auer and Wehrmuller 2009)[3] promptly became sub-prime, as soon as the domestic currency began to depreciate for the reasons indicated below. Thus Polish borrowers in Swiss Francs in the last quarter of 2008 and the first quarter of 2009 have seen their zloty liabilities rise by 31 per cent due to the revaluation of the SF with respect to the Polish zloty.

Auer and Wehrmuller estimate that in the 10 EU member states from Central Europe total losses from private and public debt re-valuation amount to about $60bn, under 5 per cent of GDP in most countries but as much as 18 per cent and 8 per cent in Hungary and Poland respectively. The expectation that the state will ultimately bear the cost of bailing out the debtors, plus the cost born by the state on its own debt, has dramatically raised the spread on Credit Default Swaps for the eight countries for which data are available out of the ten new Member States (Auer and Wehrmuller, cit.).

The problem is serious: in 2007 in eight countries the foreign currency-denominated debt in the non-financial private sector exceeded 50% of total non-financial sector debt: Ukraine, Romania, Bulgaria, Lithuania, Hungary, Georgia, Estonia, Latvia; over 60% in the last four of these, almost 90% in Latvia (Connelly, 2009, p.23).

2. External imbalances. Connelly (2009, cit.) considers twenty countries which he labels “Emerging Europe” (the EBRD 29 minus Turkey, Albania; Bosnia & Herzegovina, Macedonia, Montenegro, Serbia; Tajikistan and Turkmenistan; Mongolia). He notes that “Emerging Europe is the only emerging market region to collectively run a current account deficit”: apart from Azerbaijan, Kazakhstan and Russia in 2008 all the other countries in this group have current account deficits, of which seven over 10 per cent of GDP: Bulgaria at -21.2 per cent, Georgia -20.6, Moldova -15.3 Lithuania -13.9, Romania -13.3, Latvia -12.1, Estonia -11.2.

Sustained current account deficits lead naturally to higher external debt. But it cannot be argued that the current account deficits were the result of fiscal profligacy. Between 2000 and 2008 the number of countries running a government surplus increased from one (Russia) to five (with the addition of Azerbaijan, Belarus, Bulgaria, Kazakhstan), while the deficits of another 13 countries out of the twenty reviewed by Connelly fell below 3 per cent. Thus the growth of external debt is clearly due, on average, primarily to the private sector. Yet the expected emergence of contingent liabilities and costly bail-outs reduces governments’ credibility anyway. Darvas and Pisani-Ferry (2009)[4] establish a significant correlation between the cost of credit default swaps (CDS), the insurance against default on government debt, and current account deficits. Moreover, non-Eurozone members pay a higher insurance cost, rising very much faster over time: “the crisis management in the euro area has had the unintended consequence of putting non euro-area new member states at disadvantage”. Probably, without the credibility bestowed by the euro, floating rates lead to overshooting devaluation, while fixed rates lose competitiveness to the country that maintains them and provide adverse shocks when the peg sooner or later must be altered.

3. Primary product exporters – primarily Russia, Azerbaijan and Kazakhstan – until mid-2008 were in a position to run current account surpluses and accumulate foreign reserves. But in 2008 oil, gas, cotton and metals fell in price. Foreign reserves were used – wasted, we could say to some extent – to support overvalued exchange rates and to bail out financial institutions and productive enterprises. The Central Bank of Russia foreign reserves (including gold) fell from $476.4bn in 2007 to $427.1bn in 2008 and $383.9 at the end of April 2009, plus another $32bn lost by the Stabilisation Fund in the first quarter of 2009 (https://webmail.london.edu/exchweb/bin/redir.asp?URL=http://www.bof.fi/bofit_en/seuranta/venajatilastot/index.htm , though other sources report larger losses). The EC Spring Forecasts 2009 (cited) are more optimistic than the EBRD yet expect a Russian budget swinging sharply from a hefty surplus to large deficits, of respectively 6.5% and 2.7% of GDP in 2009, due to the reduction in commodity prices and in economic activity, plus the large fiscal stimulus packages. Russia is also forecast to see major falls in both its trade and current account surpluses, respectively to 5.1% and 6.3% of GDP in 2009, and 1.4% and 2.7% in 2010.

4. Fall or reversal of FDI and portfolio investment inflows. “With net private capital flows to emerging market (and developing) countries projected to decline from an inflow of US$600 billion in 2007 to an outflow of US$180 billion in 2009, EMEs [Emerging Market Economies] are facing a severe credit crunch. Particularly affected are the countries with large current account deficits – many of which had asset price and credit booms” (Ghosh et al., 2009, p.6). Transition economies had been able to attract large and growing capital inflows thanks to privatisations at attractive prices, high interest rates net of devaluation cover or even plus revaluations, and production de-localisation thanks to low wages. These attractions have weakened, and the recession has made inflows even less attractive.

“The region [i.e. Donnelly’s Emerging Europe defined above] faces an aggregated adjusted gross external financing requirement of approximately $460bn, or around $930bn if short-term is added… The deterioration in the outlook for private capital flows to emerging markets makes ‘roll-over’ of these loans extremely unlikely, with the Institute of International Finance (IIF) projecting a fall in private capital flows to the region from around $254bn in 2008 to only $30bn in 2009” (Connelly 2009, p.4).

In these circumstances devaluations are unavoidable but steering a course between floating and pegging is hard, as we have seen above. Higher interest rates are unlikely to bring back capital in a recession. Controls on capital flows will at best stop capital flight but not bring it back, and can be counterproductive. Official financing is therefore badly needed, by the IMF in the first instance with doubling access limits, Flexible Credit Lines, and Stand-By arrangements. With additional resources, support for debt re-structuring can come from national governments, for instance converting foreign currency loans to domestic currency and compensating banks for losses, maybe only partly.

5. Foreign Banks withdrawing funds. At the inception of the transition an under-capitalised and largely insolvent state banking system was partly cleansed of what today are labelled toxic assets, re-capitalised, privatised mostly to foreign banks, and new banks were promoted, also mostly foreign. By 2006, foreign ownership in the ten New Member States, excluding Slovenia (at 22 per cent), ranges from 74 per cent in Latvia to 98 per cent in Estonia (EBRD, Transition Report 2006). Foreign banks were to provide capital and know how, and through access to foreign parent banks provide foreign exchange and in practice access to lending of last resort in the country of origin.

Today the EBRD Chief Economist still relies on “the continued external engagement, particularly from the western parents of banks in the region” (cited above). And Darvas and Pisani-Ferry (2009, cited) still argue that “Several factors have mitigated the impact of the crisis on non euro area NMS [New Member States]: … [among other things] western European ownership of NMS banks (by indirectly stabilizing their NMS subsidiaries)…” (emphasis added).

Yet the EC Spring forecasts 2009 tell a different story: “The repatriation of capital by foreign banks has been particularly abrupt in some cases. For instance, in Ukraine real GDP growth is projected to decline by 9½% in 2009, due to a severely curtailed access to external financing, which has triggered the conclusion of a stand-by arrangement (SBA) with the IMF…”. “The significant and broad-based slowdown in the CIS could have direct growth effects in Central and Eastern Europe, and the presence of EU banks in the region creates further potential negative spill-overs via the financial channel” (p.22, emphasis added). “Paradoxically, it is precisely this characteristic – strong foreign banking presence – that renders EE countries (except for the CIS) region, much more vulnerable to the present financial turmoil” (Uvalic 2009, p.4)[5]. In turn, foreign parent banks risk downgrading as a result of the declining profitability and the losses on their operations in Eastern Europe; conversely, EE countries depend on their continued financial health.

Recently the EBRD made one of its larger investments, worth a total of €432.4 million, in UniCredit subsidiaries across eight eastern European countries, to provide medium and long-term debt and equity financing through UniCredit subsidiaries in support of SMEs, lease finance and energy efficiency projects. [6] This is precisely the kind of contribution that the EBRD can make to the region’s recovery, especially if its relatively modest resources of €20bn were to be raised by 50-100 per cent.

6. Reduction in external demand. Current projections for 2009 indicate for the first time since the last War a decline in world output (-2 per cent according to the IMF) and a much larger decline in world trade, by as much as 13% (WTO), thus reducing for the first time since the War the most common measure of globalisation, the ratio between world exports and world GNP. A sizeable de-globalisation episode is taking place. Output contraction and trade are larger in the EU, with which transition economies have grown to be increasingly integrated, with EU trade shares of the order of 60-90 per cent for the New Member States and South-Eastern Europe, all characterised by high foreign trade openness, higher than that of most old members of the EU (see the table below, penultimate column). Such openness makes the transition economies opportunities of “de-coupling” from downturns in the EU rather limited (Connelly, cit., p.5). Lower trade shares involve a slowdown in manufacturing and extractive industries, and in internal demand especially in construction and financial services.

7. Differences in initial positions and policy response. “Some [countries] were ripe for a homegrown crisis associated with the end of unsustainable credit booms or fiscal policies; others were just bystanders caught in the storm” (Ghosh et al., 2009, cit., p.3; “… the majority were just innocent bystanders”, p.2).

Uncharacteristically, the IMF has recommended, to advanced economies experiencing the global recession, easing monetary policy and lower interest rates. It has also “called for a timely, large, lasting, diversified fiscal stimulus that is coordinated across countries with a commitment to do more if the crisis deepens” (Ghosh et al., 2009, p.19-20). Naturally the IMF now is forced to recommend the same policies to transition economies in crisis, though with stronger warnings about the possible side effects: “Much of the spending and revenue policy advice for advanced economies remains relevant for EMEs [Emerging Market Economies], once scaled down for their small fiscal space” (Ibidem, emphasis added).

Thus transition economies and other EMEs are reminded that looser monetary policies involve dangers of exchange rate devaluation and consequent adverse effects on balance sheets. That it is dangerous to exceed the “policy space” and especially the “fiscal space” of a country, jeopardizing policy credibility and sustainability. Changes should be gradual (however strange this now may sound coming from the IMF) and sustainable; abrupt and non sustainable changes can be particularly costly and disruptive (see Ghosh et al., 2009).

Clearly an expansionary fiscal policy “ is likely to be more effective in stimulating aggregate demand if the economy is relatively closed to trade flows, uses monetary policy to prevent or limit the appreciation of the currency, has substantial spare capacity, has a high proportion of credit-constrained households or firms, and has a sustainable public debt position” (Ibidem, p.21). Which is fair enough, except that transition economies and other EMEs are most unlikely to satisfy these ideal preconditions.

A short digression on the euro. The question here is whether early membership of the Euroarea might assist recovery in the New Member States, of which only Slovenia and Slovakia are already members. The IMF now recommends it, speaking out of turn because it is not for the IMF to recommend anything to Europe other than possibly an application to join the Euroarea on the part of those new members that meet the Maastricht conditions for membership.

Small open economies would probably gain from being part of a large currency area in times of crisis, although Slovakia (not yet a member until 1 January 2009) and the Czech Republic have done rather well being outside it. Unilateral adoption of the euro is ruled out by the EU for both members and candidates; Currency Boards reduce the probability of a crisis at the cost of making the crisis catastrophic if and when it happens (as in Argentina); European Currency Boards are not yet out of the danger zone. The European Central Bank role as Lender of Last Resort is remarkably undetermined and left to informal arrangements with Eurozone members; non-members with hyper-fixed links to the euro (unilateral euroisation or Currency Boards) might be left high and dry in times of crisis.

The EU could have well admitted at least a few other New Member States to the Euroarea, by somewhat loosening the Maastricht criteria for fiscal and monetary convergence, and the two-year membership of the Exchange Rate Mechanism II. The Maastricht criteria for fiscal convergence are in theory looser than those of the so-called Growth and Stability Pact (GSP, which involves not only a 3% ceiling to government deficit but a stricter zero per cent over the cycle) applying to all EU members regardless of Euroarea membership. In practice however the GSP strictures and the associated penalties were considerably relaxed in March 2005, and further loosened during the current crisis, whereas Maastricht criteria for joining the euro have been very strictly enforced. It is unreasonable to subject countries that grow much faster than the Eurozone members and have relatively low ratios between public debt and GNP to the same fiscal stringency of stagnant and highly indebted Euroarea members (like Italy), moreover rigidly and inflexibly applied only to prospective members.

Lithuania was left out of the euro only because its inflation exceeded the average inflation of the three least inflationary EU members by 1.6% instead of the 1.5% prescribed by the Maastricht Treaty – not exactly an enlightened or rational behaviour, especially considering that two of those three least inflationary countries were not Euroarea members.

“The EU can certainly be criticised for clinging to criteria ill-suited to catching-up countries and the case for reforming them is strong” (Darvas and Pisani-Ferry, 2009, cited). See also Nuti 2006. [7] Be that as it may, the middle of a recession is not the best time to change or, worse, bend the rules as drastically as it would be required by early admission of all or most New Members to the Euroarea. End of digression.

The heterogeneity of country experiences is pithily and efficiently synthesised by one-liners from two sources. The first is a table on Fourteen ways to slowdown from The Economist, 26 February 2009 (http://www.economist.com/world/europe/displaystory.cfm?story_id=1318459).

Fourteen ways to slowdown (italics=pegged to euro; underlined=in euro area)
....................GDP......S&P..........financing
.....................per.....credit...requirements
Country...person*..rating#..% of GDP°..Exports§............In a nutshell
Belarus...12,344.... B+...........7.3...........62.1.Autocratic, isolated, gained surprise IMF bailout
Bulgaria..12,372.....A...........29.4...........61.0 Strong finances back currency peg; sleaze rampant
Czech R...25,757....AA.......... 9.4...........80.1 Thrifty and solid but hit by export slowdown
Estonia...20,754....AA.........20.0 ..........72.0 Star reformer squeezes spending to stay afloat
Hungary.19,830.....A ..........29.9..........80.2 Currency crush could topple debt-heavy economy
Latvia.....17,801....BBB........24.3..........46.6 Clinging to currency peg amid turmoil & downturn
Lithuania.18,855....A+ ........27.1...........59.0 Painful spending squeeze to avoid worse
Poland....17,560.....A+.........13.2..........42.3 Regional heavyweight speeds up euro bid
Romania.12,698...BBB+.......20.2.........36.4 Spendthrift policies meet solid reality
Russia....16,161....BBB..........2.2...........31.7 Energy-based kleptocracy in denial about crisis
Serbia... 10,911......BB-........23.5..........22.2 Seeking more IMF help
Slovakia.22,242....AAA......12.5...........90.5 Smugly in euro-area, hit by car-factory slowdown
Slovenia.28,894...AAA..........-.............70.5 Self-satisfied, rich and still growing
Ukraine....7,634...CCC+......16.1..........45.0 No end in sight to political and economic chaos

* PPP$, 2008 estimate. # Standard & Poor’s, latest. ° Current account balance, principal due on public and private debts plus IMF debits, 2008 estimate. § Goods and services, % of GDP, 2008 estimate. Sources: IMF; Moody’s; Economist Intelligence Unit; The Economist.
From: Sarah Hanson, The whiff of contagion, The Economist, 26 February 2009. (Corrected in the 5 March 2009 issue).

The second source is the EC Spring Forecasts 2009 (cited), whose country chapters for transition economies (EU member states, candidate states and Russia) have the enlightening subtitles listed below:

Bulgaria: Vanishing budgetary surplus, external deficit remains large.
The Czech Republic: Output falls sharply driven by collapse in external demand.
Estonia: Adjusting to face gloomier years.
Latvia: Domestic demand and trade implode.
Lithuania: Deepening recession leads to wider fiscal deficits.
Hungary: Domestic financial crisis magnifies recession.
Poland: Mild recession knocking at the door.Romania: Growth contracts sharply.
Slovenia: Sharp falls in exports and investment point to competitiveness challenges.
Slovakia: Global downturn weighs on exports.
Croatia: a declining economy creates important fiscal challenges.
The Former Yugoslav Republic of Macedonia: Joining the general trend … albeit with a delay.
Turkey: Manufacturing faltering as exports decline.
Russian Federation: The first recession in a decade.

In the 1990s an unexpected, deep and protracted recession characterised the post-socialist transition of Central-Eastern Europe and the Former Soviet Union, with GNP decline ranging from 18 per cent in Poland over three years, to 65 per cent in Moldova over ten years. The decline may be slightly exaggerated especially at the top of the range, for well known reasons, but a reliable and unbiassed observer such as Bob Mundell reckons that the transition recession was not just deeper than the 1929 crisis, it was deeper than the recession that accompanied the Black Death in the 14th century, because then income fall was matched by population fall and living standards were preserved.

By comparison the current recession must be barely perceptible to the populations of transition countries. And at least this time they are benefiting not only from more generous assistance from the international community, but from more enlightened policies of monetary easing and low interest rates, fiscal subsidies and expansion, large scale state intervention – all policies diametrically opposite to the draconian hyper-liberal policies that contributed so much to aggravate the transition recession and the other costs of transition in the 1990s. Only two things have really changed since then: today the hyper-liberalism that inspired the course of transition in the 1990s has been thoroughly discredited by the global crisis associated with it, and the predicament of transition economies is vastly improved simply because they happen to share it with the advanced countries that control international financial organisations.

[1] Atish R. Ghosh, Marcos Chamon, Christopher Crowe, Jun. I. Kim, and Johnathan D. Ostry, “Coping with the Crisis: Policy Options for Emerging Market Countries”, IMF Staff Position Note, SPN/09/08, 23 April 2009, http://www.imf.org/external/pubs/ft/spn/2009/spn0908.pdf.
[2] . See for instance Richard Connolly, “Financial vulnerabilities in Emerging Europe: An overview”, Bank of Finland Institute of Transition-BOFIT Online No. 3, 4 May 2009, http://www.bof.fi/NR/rdonlyres/BA4C9028-D69D-45CB-ABF1-140ECB129E4C/0/bon0309.pdf.
[3] Raphael Auer and Simon Wehrmuller, $60 billion and counting: Carry trade-related losses and their effect on CDS spreads in Central and Eastern Europe, 29 April 2009 http://www.voxeu.org/index.php?q=node/3467 http://www.vox.eu/.
[4] Zsolt Darvas and Jean Pisani-Ferry, The looming divide within Europe, Breugel, 18 January 2009, http://www.eurointelligence.com/article.581+M5852b1b851d.0.html
[5] Milica Uvalic, “The impact of the global financial crisis on Eastern Europe”, Conference Paper, Bol (Croatia), 21-23 May 2009.
[6] “UniCredit is the largest banking group in the central and eastern European region, with over 4,000 branches in 19 countries. The group has invested around €10 billion of equity in central and eastern Europe and has around €85 billion of total customers loans in the region. Beside its own funding programs to its subsidiaries, it cooperates with international institutions including the EBRD in order to ensure continuing support to the local economies during these challenging times.” (from the EBRD website, http://www.ebrd.com/new/pressrel/2009/090507g.htm).
[7] D. Mario Nuti, "Alternative fiscal rules for the new EU Member States", TIGER-WSPiS Discussion Papers n. 84, Warsaw, 2006, http://www.tiger.edu.pl/publikacje/TWPNo84.pdf .