Europe View 101 Pipelines and pyramids

Europe.view

Oct 2nd 2008
From Economist.com


The world's headache becomes eastern Europe's migraine

WHAT does the collapse of the pyramid scheme formerly known as the western financial system mean for the ex-communist world? The short-term answer is bad, and the longer-term answer even worse.

In the 1990s, a downturn in western markets proved to be surprisingly good news for new Europe: rich-world managers wanting to cut costs turned to outsourcing in countries that they had previously seen as too risky. The burgeoning private sector in the former planned economies had a huge productivity advantage: lots of under-employed and well-educated workers who regarded salaries of a few hundred dollars a month as a fortune. Low costs compensated for bad infrastructure (remember those dreadful telephones?) stifling bureaucracy (“I’ll be at the customs office all day”) inexperienced management (team-building exercises, anyone?) and a rudimentary banking system (“Cash only, please”).

This time will be different. Land and labour cost more—though as Neil Shearing of Capital Economics, a consultancy, notes, wages in the new EU member states are still only 20% of the eurozone average. Still, good workers are far more mobile and choosy: that’s nice for them, less so for their bosses. Failure to reform the education systems in most countries has blunted the competitive edge further. So has demography—the end of communism sent the birth rate plunging, so most countries in the region risk growing old before they get rich. The biggest question is what happens in big west European economies: dependence on export markets there is up to 40% of GDP for countries such as the Czech Republic. In short: if Germany gets a headache, eastern Europe gets a migraine.

East European countries are lucky that none of them has built up a big financial centre. That was a dream in the 1990s. It would be a nightmare now. Still, modern financial practices (ie wild lending to property speculators) have created new vulnerabilities. The comforting thought in countries such as Latvia has been that even if the local banks go bust as the property boom pops, their foreign shareholders will assuredly recapitalise them. The nagging worry now is that they may have other calls on their cash. That creates a political danger: Russia could make a tempting offer to take over such a troubled subsidiary. Countries that do not already have legislation that would allow them to nationalise their banks in such an emergency would be wise to draft it now: once it is on the statute books, it is less likely to be needed.

The verdict on the wasted years that followed EU membership is likely to be harsh. At a time when politicians could have boosted their countries’ underlying competitiveness, by pressing ahead with tough structural reforms of public finances, power generation, the labour market, public services and infrastructure, they did next to nothing. Now they will have to grapple with these problems in what for some may be the nastiest recession in their countries’ history.

It won’t happen overnight: Those countries that have experienced crises already (such as Russia) are in a better state than those that haven’t. Growth in Poland, for example, the biggest economy in the region, is still remarkably strong. But other countries—particularly those with big current account deficits, such as Bulgaria and the Baltic states—may be facing serious trouble.

It would be nice to think that economic gloom will concentrate politicians’ minds on the tasks they neglected in the past. In some countries it will. But history suggests that rising unemployment and falling living standards can also encourage voters and politicians to choose dangerous short cuts. The weaker the political system, the greater that likelihood is.