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Open sore

Feb 5th 2009
From Economist.com

Unintended consequences of modernisation

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FIRST the financial crisis, then the economic one, then—soon—a social one, and after that a political one. The world economic crisis is hitting the countries of eastern Europe particularly hard. Events such as devaluations, ratings downgrades and shocking economic statistics that would be front-page news in normal times barely make it into a preoccupied world media.

It would be nice to say that the countries that followed the right (ie Western-mandated) policies in past years are surviving reasonably well, while naughty ones that failed to finish their homework are suffering. That’s true up to a point. Reckless policies (especially in the big ex-Soviet countries) are punished particularly hard. Prudent Estonia squirreled away a cushion of savings in good times that will make it a bit less vulnerable than its Baltic neighbours to the south.

The much bigger lesson is that what once looked like the right thing now seems to have been either useless or outright dangerous. As Katinka Barysch, of the Centre for European Reform, a think-tank, points out in a new paper*, the ex-communist countries now in the European Union have made themselves particularly vulnerable thanks to their energetic adoption of open economic policies.

First, they are hugely dependent on exports—close to 100% of GDP in some cases. Foreign trade is a fine thing. It brings in investment from outside and creates a wonderfully competitive environment at home. But when the export markets crash, the effect is immediate.

Secondly, the kind of foreign trade was particularly risky: these countries integrated into the global-supply chain in industries such as electronics and cars, which are proving far more cyclical than anyone suspected. That may prove a near catastrophe for a country such as Slovakia, which is one of the world’s top producers (on a per capita basis) of cars and car parts.

Even worse, it is the auto industry where politics is playing a role in the new era of bailouts. In theory, cash-strapped vehicle producers should be favouring low-cost locations as they try to cut costs. That would mean more investment in Slovakia and Hungary, but cut-backs in high-cost France and Germany. But the rich-Europe bailout packages include clear conditions: save the jobs at home.

Selling the banking system to outsiders is proving to be another vulnerable area. In the 1990s, that looked like pure common sense. Local banks were wobbly and sometimes outright dodgy. Foreign banks promised modernisation and a big capital base: just what an emerging economy needed. For a time that proved a huge success. Foreign banks drove down borrowing costs for firms and households who wanted to borrow, provided attractive investment vehicles for those who wanted to save, and made juicy profits in the process.

Now that looks very different. It is the western banks that look wobbly. Their loans are going sour (especially those made in foreign currency on wildly optimistic assumptions). A harsh political suspicion is in the air: are (say) Polish companies losing vital lines of credit because (say) Austrian managers are pulling the liquidity home?

It’s too late to put the clock back, but demography makes new thinking urgently needed. The great worry for the ex-captive nations was always that they would get old before they got rich. A long slump risks catastrophe.

The best hope now is to stoke competitiveness by improving infrastructure and education, and continuing with structural reforms of pensions, the labour market and so on. But these are painful. And from the public’s point of view, the reformers have some explaining to do.

"New Europe and the economic crisis” by Katinka Barysch is published by the Centre for European Reform.