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April 23, 2009

The Financial Crisis and the European Union

Dr. Marek Wroblewski (University of Wroclaw, Poland) Visiting International Fellow at the Alworth Institute has contributed this web log on financial crises. He writes: It is general knowledge that there is a financial crisis not only in the United States but also amongst European economies and in the world more generally. It would be hard to miss such significant news. But what is a financial crisis? How is it experienced, in the various countries of the European Union (EU), and what are its consequences?

A financial crisis is a significant event or circumstance that hinders the routine functioning of financial markets. Financial markets help distribute financial resources to, amongst other things, investment projects. Crisis events may appear in various forms and affect different segments of the market. A financial crisis may be experienced in a variety of ways: as a dramatic fall in the external value of a currency; a breakdown in the banking sector; a crisis in the stock market; a debt crisis. A crisis in one area may have a consequence in another. This may be considered normal since financial markets and processes permeate all aspects of the national and international economy. The very nature of this part of the economic system facilitates a speedy transmission of market information from one country to another. This makes contemporary international economic relations particularly susceptible to financial crises. Their highly destructive implications place a heavy burden on the global economy as a whole.

The financial crisis as experienced in the countries of the EU is highly complex. The financial crisis has impacted all European financial markets. Stock markets have experienced dramatic falls in stock values. Capital markets have been disrupted. The operation of a number of significant financial institutions has been hindered by the lack of liquidity and some banks have been threatened with bankruptcy, leading to special action by the financial authorities. Building sectors, construction and property have encountered problems but only the UK has experienced losses in value in the private housing market that are equivalent to losses in the United States. The consequences of all of this taken together have been felt in the real, as opposed to the monetary, economy. The impact has been significant.

The present economic breakdown in Europe is possibly the most serious economic crisis since the end of the Second World War. Highly destructive effects of the crisis with more expected to come have already been experienced. Industrial production in the EU taken as a whole fell in 2008 by 11.5% (EUROSTAT estimate). GDP in the same period fell by 1.3%. The deterioration in members states has varied with dramatic declines in GDP having been seen in Estonia (-21%), Spain (-19.5%) and Sweden (-18.5%) and less dramatic outcomes experienced in Germany (-2.1%), France (-1.2%) and Italy (-1.8%). During 2008 however the most recent members of the EU maintained slow growth. Since then most of the Central European economies have experienced significant problems as the impact of the financial crisis has come to be felt in Hungry and, given the financial interrelationships, also in Austria. Unemployment grew overall by 1.2%. This overall figures masks significant problems in Spain. Germany is the biggest European economy and if the situation in Germany continues to deteriorate with the further loss of international and regional export markets, further problems will be experienced. European countries outside the EU, particularly Russia and the Ukraine, have also felt the negative consequence s of the financial crisis.

Most European countries are attempting to muffle the impact of the recession. The really significant measures are taken by national governments and these are of an internal and independent nature. Most government expenditures to counter-act the recession are focused on infrastructural projects and to support banks and other financial institutions. There is a problem in that increased government expenditure results in increased government deficits unless fiscal policy is also tightened. Benefits through expenditure must be set against the loss of consumer spending through tightened taxation. Countries in the Euro-zone are constrained to keep any deficit within prescribed limits and this in itself, in principle, imposes a form of financial discipline not applicable, for example, to the UK. Fiscal tightening is, as of this week, now also part of the UK’s approach. The concern is to avoid future inflation. The European Central Bank has acted to reduce interest rates and is prepared to take further action should this be required. It is worth noting that amongst economists, there is no settled view as to the effectiveness or otherwise of the package of measures that have been put in place.

With respect to the EU as a whole, the commission has accepted a stimulus plan but this is, when compared to actions by national governments, relatively modest (amounting to US$ 5 billion). Energy-saving investment projects and rural development projects are targeted. The EU has also accepted a US$50 billion aid package for new member states and has allocated funding to strengthen the International Monetary Fund. Such actions will have potentially beneficial consequences for some Central European economies such as Hungry. The development of a European Institution concerned with financial supervision to help prevent future de-stabilizing bubbles is under investigation.

One clear point of principle has emerged from the otherwise unsatisfactory, and indeed politically disputatious, process of finding a unified and coordinated approach to the various crises. Essentially countries have made their own responses that relate to their self-interest as interpreted by the politicians. The European Commission has made it clear that the Single Market is not to be sacrificed to economic expediency. France, for example, had tried to impose protectionist conditions on any state-aid to industrial firms such as car makers. This is a significant point of principle. There will be further strains to encounter particularly if new members in Central Europe continue to experience long-term problems when the crisis has passed elsewhere.

April 16, 2009

The Development of the Russian Economy and its Impact on Eastern Europe

In this guest weblog, Visiting International Fellow, Dr. Marek Wroblewski writes: Russia is the largest country in the world as far as the occupied land is concerned, with a great natural resource potential, and a strong political and military position in the international arena. These attributes for a long time predestined Russia to imperialism and global power. Imperial collapse, however dramatic and painful for the country, only temporarily undermined its role of a hegemonic leader. Russia’s marginalization and exclusion of did not deprive the former superpower of effective instruments to influence decision-making processes taking place in the region and in the world. How does Russia use its economy to influence its immediate external environment?

The economic interest of Russia in the Commonwealth of Independent States (CIS) and Eastern Europe is minor, although its activity in the region is characterized by political concerns and fluctuating economic intensity. Russia’s main economic interests are in the countries of the EU. During downturn in the economy and internal crisis, Russia did not have sufficient means to impose significant and permanent pressure on the situation in its region, as it defines it. However, when the prosperous economy was reflected by a visible improvement of public finance, this enabled it to operate actively both in the region and in the international sphere. Therefore, given this link between economic performance and Russian political ambitions, it is worth paying attention to economic evolution in Russia during last two decades and the economic results achieved.

Russia, during the system transformation away from central planning introduced many changes in its economic environment in ways that superficially looked similar to many other countries of Middle and Eastern Europe. Russia started constructing the framework of a market system. However deep-seated cultural characteristics and historical background meant that a more moderate model of transformation emerged in Russia when compared, for example, to Poland. Planned economic reforms concerned large state, economic units which during last decades of central planning almost completely implemented socialist economic guidelines. The first policy actions were accompanied by the severe and deep crisis that was essentially the outcome from the previous and ineffective model of economy. This crisis was observed in all sectors of the Russian economy, the general result of which was a dramatic decrease of the generated GDP or GDP per capita. Significant decreases of industrial production, investment and private consumption took place and strong inflationary pressures as well as rise in unemployment were felt. Despite this “economic shock”, the first stage of implementation of system transformation of the economy was continued largely through the support of international organizations. Internal prices were partly liberalized, gradually widening the scope of market forces; privatization of public enterprises was initiated as well as creation of the basics of the capital market. Russia became more open to the external influences and trade. Foreign trade became subject to limited liberalization and conditions were created for the inflow of the foreign capital. Reorientation in international cooperation was visible. The EU became significant in the supply of capital and of goods. The results of the above actions were a gradual macro-economic stability and the initiation of a slow process of economic growth.

However, those positive trends drastically stopped in the middle of 1998 when a severe currency crash took place in the Russian economy. The profound financial crisis uncovered the weaknesses of transformation process. This crisis resulted mainly from faulty methods applied for reform and for the construction of market mechanisms. Lack of the right institutional arrangements for an effective federal state was of key significance. Public finances went into deficit. System changes, as it turned out, were of an ostensible nature which in reality implied escalation of former malpractice. The appropriation of elements of national economy by the newly-born oligarchic groups was one of the most significant abuses. Strong national control (direct and indirect) in many branches of industry, trade and services reduced the chances of realizing the advantages of market-oriented production. What followed was low competitiveness in the main sectors of the Russian economy. With low prices for the energy exports, problems persisted with respect to maintaining the internal and external balance in the economy.

Visible improvement of the economic situation, observed systematically from 1999, came with increasing export prices of oil and underground gas, a gradual inflow of foreign investments and partial order of internal economic affairs. Taken together, these events created conditions for the restoration of economic growth. Special attention should be paid to terms of trade which were beneficial at that time and enabled Russia to improve economically. Significant increase in GDP and GDP per capita was noticed as well as the abrupt increase of foreign exchange revenues. Over 1996-2007, GDP of Russia increased by 65%; foreign investments amounted to USD 76 billions and the surplus in the current account and central budget appeared.

Russia’s economic growth led to greater pro-activity in the region. Russia mostly undertook efforts towards reintegration by proposing and initiating many integration-focused initiatives. Currently, within the borders of the CIS, there are formally few integration groups most of which Russia is party to, and the main entity. Moreover, along with integration groups there are multiple bilateral preferential economic agreements, which connect Russia in many configurations with many countries of the region. Most significant examples of such economic integration in the region are the Common Economic Space (CES) or Eurasian Economic Community (EAEC). As a result in the area of the CIS there is a complicated network of economic connections, which are not yet transparent. Integration projects undertaken by Russia strengthen its impact on various countries of the CIS and secure the role of the regional hegemonic leader, particularly in Central Asia. The current expansion of Russia, Georgia notwithstanding, is not of military but financial or economic in nature. In particular, energy-related pressure imposed on many countries of that region sets the example. Integration groups being created, despite of the premises of the complete partnership and mutual economic priorities, in reality are a specific tool of Russian politics.

Russia acts to impose pressure not only on the countries located in its direct sphere of influence but also wider afield. Different types of economic pressure, such as the manipulation of the power to control the flow of natural gas, but still with political references are also visible in reference to Central Europe and indirectly in reference to the EU members as a whole. Therefore, there is a great need of an open dialogue and establishing relations based on partnership between the EU as a whole and Russia, which might be beneficial for both parties, and help protect countries such as Poland. Competition in this respect, which sometimes reminds of the Cold War confrontation, is not an appropriate strategy in the modern globalized world. The relationship is one in which the Russian economy needs markets for its oil and gas if it is to experience further economic development and Western Europe needs Russian imports. It seems that Russia with the support of the EU should concentrate more on continuation of the real system transformation, including further economic modernization and diversification of economy and constructive use of its own potential.

April 14, 2009

Economic Transformation in Poland: Success or Failure?

This guest web log by Alworth International Visiting Fellow Dr. Marek Wroblewski (University of Wroclaw, Poland) looks at changes in the Polish economy. He writes: Economic transformation in Poland is a product of the fall of the communist system and of the spread ofliberal capitalism. In the economic sphere, transformation initiated a difficult and costly process of transforming of a centrally planned economy into a market system. What were the changes and how were they implemented? What have been the outcomes for Poland?

In Poland, the first government after the fall of the communist regime was that of Prime Minister Tadeusz Mazowiecki. He started with the Minister of Finance, Leszek Balcerowicz the reorientation of the economic system. Due to a huge crisis caused by the failure of the previous economic model, it became essential to create, first, macroeconomic stability, which would then, in turn, enable implementation of a set of market reforms. Actions aimed at limitation of the national deficit were undertaken. These included the restriction of the volume of subsidies given to inefficient public companies and stopping the pace of pay increase. Further changes were included in the “Balcerowicz’s plan” covering key principles of the new economic policy and the transformation process. The strategy aimed at fighting inflation (hyper-inflation back then), restoration of the market balance, price liberalization and development of foreign trade. The instruments of monetary policy were actively applied; in particular the increase in interest rates became an important tool in macroeconomic stability. The plan included significant tax reform. The Act on Privatization of state enterprises was introduced and a special Ministry of Ownership Transformation was established.

The devaluation of the national currency started in reference to convertible currencies, enabling introduction of the internal exchange of the zloty. In settlements with the trading partners of the former block of the Council for Mutual Economic Assistance, transition to convertible currencies took place. The government decided to introduce the new exchange rate regime. Initially, it was a regime of the fixed exchange rate (1990-1991), later “moderate devaluation” (so-called “crawling pegs”), meaning fixed and gradual decrease of the zloty exchange and from 2000, the system of fully-floating rate. Liberalization of the trade of goods abroad was performed, breaking the former monopoly of public trade centers.

The whole process of economic transformation was established on the basis of new legal regulations. Private ownership in the economy became the main priority. Administrative reform, also focused on the needs of the new economic system, was implemented. In 1999 the significant changes were introduced to local government management. The institutional framework for a market economy was created.

The transformation was based on shock tactics and in Poland these partly brought the expected results. The policy towards macroeconomic stability turned out to be successful. The inflation rate decreased significantly. Slowly, balance between market and government was achieved in many economic sectors. In particular, on the consumer-related level, a permanent victory over the crisis-ridden, “shortage” economy was visible.

Significant costs of the transformation process were imposed on the society. Personal real income was reduced, which in the conditions of realistic prices, implied impoverishment of the huge part of the society and as a result a forced reduction of demand. At the same time, the process of restructuring, including liquidation of unprofitable entities and privatization of enterprises, led to unemployment. Given the previous system unemployment was a completely new phenomenon. Moreover, unemployment had a clearly structural (long-term) nature and simple methods of limiting its impact did not bring perceptible short and midterm results.

Transformation, at the time, was an unprecedented process. In fact, at the beginning of the nineties, none of the countries in the world was implementing such drastic changes in its economic and political system. Due to lack of both theoretical as practical research, as well as practical experiences Poland was on an extremely risky path.

The transformation in Poland partly brought expected basic effects: The framework for a functioning market economy was built (mechanisms and market institutions), a new financial system was built from the beginning and many legal regulations were introduced. There was a great opening towards the external environment, which meant liberalization and reorientation of foreign trade, as well as creation of conditions for the inflow of foreign capital. Significant changes took place in reference to the structure of economy and the level of its innovation. Moreover, transformation enabled preparation of the economy for meeting the economic conditions for integration with the EU.

The process of transformation also became a source of many serious problems. The introduced changes, though necessary, resulted inevitably in social stress including the rise of unemployment, unequal incomes, un-even development in the regional system and bankruptcy of many enterprises. There were also problems related to ineffective and sometimes controversial privatization, excessive bureaucracy, faults of the legal system and also general weakness of the central and local authorities' administration. Problems related to underdevelopment of infrastructure and too low competitiveness of economy, persist.

The process of transformation in Poland, after two decades, is not yet complete. It is essential to adapt the competitiveness of economy to dynamically changing conditions in the global economy. Further investment, leading to greater modernization of economy is required. The outward migration of skilled labor and visible demographic problems (ageing society and increasingly slower birth rate) are aspects that are worrying. There are those who have benefitted from the transformation process and those who have suffered. Overall, the transformation has been positive especially with respect to consumer interests. Problems remain including the issues of competitiveness, the establishment of an appropriate set of social and economic infrastructure to sustain an equitable market economy and adjusting effectively to international pressures.

April 8, 2009

Adam Smith is back, in a surprising way, on the ideas agenda

The global economic order is under serious scrutiny. The significant economic philosopher, Amartya Sen, has put Smith back at the centre of the discussion by reminding anyone who will listen that Smith was a moral philosopher, a friend of the poor (as Malthus described him) and interested in ethical issues and the market. He disliked monopolies (particularly monopolies of land and of trade). He admitted the role of “interest” in the motivation of merchants and business people. Smith did not, as far as I can establish, use the term “self-interest” but thought of interest in prudential (hence moral) terms. Sen stresses Smith’s understanding of institutions and the need for trust: repetition and consistency through trust are important in sustaining economic life. Prudent behavior is not to be underestimated as it contains within it the idea of honest-dealing. Sen’s article may be seen at Financial Times, March 11th 2009. This blog is simply going to give a few pointers, rarely quoted, to what I would like to call the radical-conservative Smith who we rarely here about, using Smith’s own words. Smith could be pithy as well as insightful and many of his comments on the behaviors of landlords and merchants are satirical.

Here is Smith looking at laws relating to property: “Laws and government may be considered in this and indeed in every case as a combination of the rich to oppress the poor, and to preserve to themselves the inequality of the goods which would otherwise be soon destroyed by the attacks of the poor, who if not hindered by the government would soon reduce the others to an equality with themselves by open violence. The government and laws hinder the poor from ever acquiring the wealth by violence which they would otherwise exert on the rich; they tell them they must either continue poor or acquire wealth in the same manner as they did”. Lectures in Jurisprudence iv. 23.

Here is Smith on the laboring poor and the notion of relative deprivation. Smith throughout his writings is very good on the idea of relative evaluations.: “The labour and time of the poor is in civilized countries sacrificed to the maintaining the rich in easy and luxury. The landlord is maintained in idleness and luxury by the labour of his tenents, who cultivate the land for him as well as for themselves. The moneyed man is supported his exactions from the industrious merchant and the needy who are obliged to support him in ease by a return for the use of his money. But every savage has the full enjoyment of the fruits of his own labours; there are no landlords, no usurers, no tax gatherers. We should expect the savage should be much better provided than the dependent poor man who labours both for himself and others. But the case is otherwise. The indigence of a savage is far greater than that of the meanest citizen of any thing that deserves the name of a civilized nation” Lectures in Jurisprudence, vi. 26.

Here is Smith on the minimum acceptable social bonds: “Society, however, cannot subsist among those who are at all times ready to hurt or injure one another. The moment the injury begins, the moment the mutual resentment and animosity take place, all the bands of it are broke asunder, and the different members of which it consisted are, as it were, dissipated and scattered abroad by the violence and opposition of their discordant affections. If there is any society among robbers and murderers, they must at least, according to the trite observation, abstain from robbing and murdering one another. Beneficence, therefore, is less essential to the existence of society than justice. Society may subsist, though not in the most comfortable state, without beneficence; but the prevalence of injustice must utterly destroy it”. Theory of Moral Sentiments II.ii.3.3

So there is much more to Smith, as Sen also argues, than his construction as the so-called author of the “bible of capitalism”.

April 2, 2009

G20 and policy perspectives.

There were differences at the G20. Obama was willing to accept some blame on the part of the United States. Sarkozy wanted to energetically wave the finger and blame that old-French, Gaullist, target the “Anglo-Saxons” though in the face of the first black President of the United States this seemed always a non-starter. Was there a split between Europe and the United States? Policy stances, as outlined below, are taken along domestic political and often historically-determined lines.

Sarkozy stressed international financial regulation and said he would leave if regulation was not addressed, and most of his compatriots just shrugged their shoulders or laughed. The French administrative tradition in economic life, reinforced by Napoleon, goes back to before the Revolution. He did himself some damage by his ill-thoughtout grand gesture. Obama took a very pragmatic view: such big staged political events can be boring and so a little bit of positioning and sparkle simply added to sense of occasion. However Sarkozy is stuck with an inflexible French economy that he himself wanted to change along UK-lines. His reforms have stalled. He then proposed a protectionist policy for re-financing the French car industry. This caused a row in Europe and even the French car-makers seem to have rejected the idea. I doubt if he did himself much good at the summit.

Merkel, the German Chancellor, is a different and tougher personality. Her current political stance is based on a fiscal conservatism that is in marked contrast with the situation facing Gordon Brown. This is merely a current political expression of a long-standing German fear of inflation. In the post-World War II world, Germany, in a difficult economic climate will always chose unemployment over inflation. Its institutional arrangements were designed to avoid the hyper-inflation and instability of the Weimar Republic. UK leaders, especially in the Labour party, will favor inflation over unemployment. Merkel was opposed to a further stimulus package in German because of the long-standing monetarist approach to financial regulation and conservatism. That she became reconciled to increasing the Special Drawing Rights of the IMF, and IMF finance in general, suggest that she feels that a significant (absolute) contraction in World Trade would be deflationary (itself a problem as consumers postpone purchasing decision in the hope of getting the goods even cheaper in the future)with significant consequences for German exports. The prospects for international inflation in the longer-term are significant. Merkel, and Germany in general, do not really like money for poor countries without “strings attached”.

Gordon Brown has had a reasonably good summit. He seemed to be at the centre of the action though the role was very much shared with Obama. Obama seemed to have a good time, if his broad grin on many informal photographs is anything to go by. The President made the most of the diplomatic gathering to meet as the new guy of the block with significant world leaders, including the Presidents of Russia and of China. The world, not just France and Germany, will not be lectured to on economic policy by the Americans as a result of the crisis and it perceived origins in the United States. Obama, going for strong domestic economic stimulation, seems to have stepped with great care, though he was clear that world recovery needed additional action elsewhere. But Brown still has a domestic policy problem. His government is in debt. Further domestic stimulation is problematic. Increasing the debt even further takes away from the flexibility of future governments. Yes, inflation now is not a problem, but what about down the line? The UK preference differs from that of Germany but there is still domestic disagreement. He needs to see the world economy starting to expand as much as for the sake of the UK economy as for the rest of the world. He had a good summit but his political career is still under threat and his policy options are restricted..