The European Debt Crisis – A View from Hungary

It is proper to claim that 2011 is the “year of Europe” in Hungarian economic policy making, and only partly because of the Hungarian presidency of the European Union (EU) in the first half of 2011. Subsequent government initiatives, such as the fiscal consolidation plan named after Kálmán Széll (a prominent statesman in Hungarian history), aimed at satisfying the policy requirements of the EU. European events dominate the economics news because of a growing number of financially distressed member states: Greece, Ireland, and Portugal. Hungary is not among them this time, but in our interconnected financial universe no economy is safe from the effects of crises in other countries.

European economic policy makers are busy this year. The EU machinery, at last, changed gear in early 2011. Again, not in anticipation of future risks and opportunities: member states and Union bodies reacted to events. In this essay, I will review recent developments from a Hungarian perspective.

A crisis again

The Euro zone crisis broke out, somewhat unexpectedly, in late 2009 in response to news about the potential insolvency of Greece and Ireland. By that time, global financial turbulence had already started to calm and the European recession had reached its turning point. However, financial markets suddenly realized that sovereign defaults were possible within the Euro zone.

It is curious how fast expectations and anticipations can change in the world of finance. Not long ago, in 2008, the fallout from the American subprime crisis caught European societies and political circles by surprise; a year later a drop in market confidence similarly surprised the European Union. Euro zone states to go bankrupt? It was hard even to imagine. Yet the difference between the borrowing costs of Germany and other EU states (Irish, Portuguese, and Greek) indicated that the financial markets had learned to tell good risk from bad.

The European sovereign debt crisis is as much a crisis of market confidence as of liquidity. The trigger can be anything: a fiscal slippage in one country or news of faulty government statistics in another. But it is important to note that underlying, fundamental causes are also present: competitiveness and structural problems exist in the EU, particularly on the periphery of Europe.¹ Hence the dual task facing national and European decision makers: avoid a debt crisis, but also turn around the economy. Or to put it differently: Europe needs institutional mechanisms to ensure fiscal discipline inside the Euro system (since the present ones have clearly proven to be insufficient), but also needs immediate boosts to dynamism and competitive drives. What follows is a short overview of events with the conclusion that European policy makers have finally reacted to the first challenge by adopting new fiscal roles in order to calm market anxiety – but the second, longer term tasks are still ahead of us.

Slow reaction to changes and shocks

It has taken the EU a considerable amount of time to recognize these dual tasks. There must be plenty of reasons for the delay: intellectual, political, institutional.

The intensity with which the subprime crisis turned into a global financial crisis has cast doubts on the relevance of the main tenets of economics. The sudden and deep decline of output in Europe has thrown into question the efficacy of the existing institutional framework and policy instruments. The relatively high European standard of living and the widespread belief in the transitory nature of the credit crunch in Europe may also have been among the reasons why the new public debt scare surprised voters and politicians in 2010. As Lorenzo Bini Smaghi, a key decision maker of the European Central Bank (ECB), has admitted, the institutional design of the Euro did not take into account the possibility of a crisis like the current one.²

It is one thing that society in European core countries believed for so long in gradual improvements and crisis-free growth; but politics and society should have been more alert on the European periphery, where, in contrast, economic changes have never been incremental; life on the periphery has been full of tension for decades. Let us recall the years of transition recessions and banking collapses in former planned economies after 1990; or the period of hectic economic growth in European emerging and transitional economies. These years were anything but tension-free. Third, on top of all this, the turbulence of the international financial markets after 2007 dragged trade-dependant peripheral economies into deep recession, particularly the transitional economies that had exemplarily opened up their markets to trade and financial flows. Hungary was saved from sovereign default only by turning for help to the International Monetary Fund (IMF) and the EU – a case we will revisit below.

2009 delivered a blow to the European economy: EU27 suffered a contraction of 4.2%. Yet this crisis year was followed by economic growth of 3.1% in 2010. Corresponding figures for certain member states are as follows.³

The whole of Europe, and Germany in particular, has accomplished a classic U-shape cycle in 2009–2010: decline followed by a similar recovery. But this is not the case in the periphery (with the interesting exception of Poland). In some cases the depth of the recession was spectacular. Now, financial market players are quick to identify an economy suffering from deep recession, particularly if the recession year is followed by prolonged stagnation. The spectre of sovereign default, however unlikely it seemed only a couple years ago, haunts even some Euro zone countries.

Living dangerously on the periphery should, logically, make society and politicians more perceptive to unfolding risky events. Yet interestingly enough, decision makers and the broader public have been repeatedly caught by surprise even on the periphery. One can still recall that at the outbreak of the transition crisis in former planned economies in 1990, governments and opinion makers (as well as the IMF and western advisors) were convinced that the recovery from the unavoidable output collapse would be relatively fast. In reality, the recession turned out to be deep and long, even in better prepared former central planned economies such as Hungary or Czechoslovakia.

Similarly, anticipations proved to be overoptimistic during the “golden years” in emerging European economies around 2000. Spectacular current account deficits in some new member states (in the Baltics, for example) and in Southern Europe should have sent warning signals to national policy makers and international bodies. Yet “irrational exuberance” prevailed far too long. Then the sudden contraction right after the Lehman Brothers collapse in September 2008 came as a surprise.

Now, as we know more about the psychological factors in economic decision making (see for instance Akerlof – Shiller /2009/), it should be less of a novelty that businesses, governments, and households tend to misread warning signs. The question now is what we have learned from the events, and what we should do differently this time.
 

Keynes is back? Or: are most policies heterodox this time?

A lot has been written about the causes and drivers of the present financial problems emanating from the subprime crisis. Interestingly enough, while previous financial turbulence typically burst out in less advanced countries, this time emerging economies, such as India and China, have not suffered much from the direct effects of the financial storm. At the same time, however, the recession turned out to be nasty for the peripheral countries of Europe. Economic openness, until now an unquestioned tenet of “good policy”, seems to have contributed to the deeper than expected contraction of open, trade dependent economies. This is why it is not enough to deal with the general causes that led to the global turmoil: one must identify the particular policy mistakes and/or institutional weaknesses that led to the present state of affairs.

J-C.Trichet, president of the European Central Bank, has summarized the current debt problems in advanced economies as results of a long gestation over the past few decades, originating in the financial deregulation and innovation of the 1980s and 1990s (Trichet, 2010). During this “golden period” modern finance promised to be a broad welfare-enhancer: families could smooth their spending over time easily and mortgage finance became available for the segments of the population that had been previously excluded from the market. But all these promises ended in bitter disappointment about markets, financial finesse, and supportive social policies – and also about economics as an uncontroversial and all-encompassing science.

Up until the crisis, politicians, central bankers and influential economists declared the battle successfully won against inflation and damaging macroeconomic volatility. Certainly, for some time the promise was delivered: financial innovations and liberalised capital markets promoted wealth accumulation both in core Europe and even more so on the periphery. Then came the financial disturbances. Hubris claimed a high price in economic output, employment, and household wealth.

Most European governments engaged in massive spending in a classical Keynesian fashion, and central banks applied various measures of monetary easing. It seemed to work: a Great Crash ŕ la 1930s was avoided – at a price. Government deficits as percentage of GDP in 2009 were so high in some cases that it was hard to believe: Ireland (-14.3%), Greece (-13.6%), the United Kingdom (-11.5%), Spain (-11.2%), Portugal (-9.4%), Latvia (-9.0%), Lithuania (-8.9%), Romania (-8.3%), France (-7.5%) and Poland (-7.1%) (Eurostat, 2010).

Now, Hungary is not among those applying a Keynesian spending cure to a weak economy. The explanation is simple: the official lenders did not allow it to happen in 2009 and 2010. Therefore, the recession in Hungary proved to be deeper than necessary, but the budget and debt figures started to look quite tolerable compared to those of other nations by 2011.

The consequences of such massive deficit spending are serious even if advanced countries have easy access to financial markets under favourable conditions. Financial markets at first did not bother about EU member states’ creditworthiness, presuming that a European country could not go bust. But the Greek sovereign debt scare in early 2010 revealed that markets had learnt to differentiate among customers: bond spreads increased immediately. In bad times there are simply no good policies.

Risks in openness?

Let us repeat that 2010 was preceded by experiences of near-default shocks in 2008. The European chapter of the story of financial turbulence opened with Iceland, a rather rich island, and Hungary, a member state of the EU. These were the first two European countries in three decades to turn to the International Monetary Fund (IMF) for funds to avoid financial collapse, soon to be followed by Latvia, a Baltic state, and then Ukraine, not a member of the EU.

The banking and financial crisis of Iceland could be regarded as an accident, or a sad but understandable consequence of bankers’ over-lending and shocking policy mistakes. In retrospect it is clear that this tiny country allowed credit expansion to proceed and a real estate bubble to build up in an unsustainable fashion (Gylfason et al.).

Compared to the Icelandic story, the Hungarian case looks more puzzling in the context of European institutional order. The Hungarian economy is closely interconnected with other member states of the EU, and as a member, the country is a party to a number of policy institutions of the EU geared to coordinate, control and harmonize national economic policies. Still, seriously flawed economic policies had been allowed for years. The case calls for explanation: why does membership in the EU not prevent a member state from accumulating serious imbalances that can trigger speculative attacks on the currency?

Now, the problems with Greece in 2009 make it obvious that the Stability and Growth Pact, the Maastricht criteria of entry into Euro zone, and similar institutions have not worked sufficiently to fend off serious domestic policy failures within the EU. In the Hungarian case, massive government overspending between 2002 and 2006, worsening sovereign risk rating, and no genuine reforms for a long time all reduced the country’s ability to withstand external shocks when they came. Greece committed similar, or more serious, policy mistakes – for too long a time, unnoticed.

What should and what must not be done?

First, should we reject economic and financial openness? Sweeping trade and financial liberalization, privatization and deregulation in European emerging and transition countries in previous decades have led to deep penetration of foreign firms, and in particular foreign financial institutions. Their entry has undoubtedly increased the level of productivity in the economy and sophistication in finance. Yet during the global credit crunch, this success story revealed its flip side: the periphery had become excessively dependent on foreign capital and markets.

After the crisis, it is less convincing to claim that a high dependence on foreign firms with their headquarters abroad is risk free for the host nations. Not surprisingly, public sentiment in Hungary (as in most societies) has turned against banks. When the Orbán cabinet placed a high extra levy on financial institutions in the summer of 2010 as part of the efforts to keep budget deficit within the limits rigidly defined by the IMF and EU, the general public warmly supported the measures, even if an additional tax, as a rule, would sooner or later be passed on to customers. A crisis tax, as a one-off measure, can be properly justified on economic grounds, and in this historical moment it was excellent politics. But one should be worried about signs of anti-capitalist and anti-bank sentiment in a society in transition. A well functioning financial system is unquestionably a crucial factor in catch-up in East and Central Europe. True, a more balanced relationship is required between business players (foreign and domestic) and the state and other domestic stakeholders. But it would be a big mistake to lose faith in the European model (open economy, shared responsibilities in economic affairs, social protection, and democratic institutions).

Second, is a set of new rules needed to stabilize the EU, or just better compliance?

The EU may have been slow to react, and institutions such as the Stability and Growth Pact (SGP) and the Maastricht criteria of entry into the Euro zone have proven suboptimal, yet the progress in less than a year has been significant. Euro zone members have approved a €110 billion rescue package for Greece, conditional on a drastic adjustment programme, created the European Financial Stability Facility with €440 billion, and have decided to create a permanent mechanism.

The European Council elaborated six proposals in its March 2011 meeting in order to “make Europe stronger” – to borrow the central slogan of the Hungarian presidency. They are mostly about strengthening the budgetary discipline. The provisions of the SGP would become more stringent, with equal focus on prevention and correction, but also sanctions if the deficit of a member state exceeds the 3% threshold. There would be more emphasis placed on gross public debt. The correction and sanctioning processes are meant to be rule-based and faster than they have been so far. Macro-economic imbalance, a new policy concept, would also be incorporated into the rule-based legislation, as a direct lesson from the Irish-type crises, where strong credit expansion and asset price increases led to market bubbles, causing later substantial deterioration of public finance. Under the proposals, macro-economic imbalances will be monitored and national governments will be called on to take corrective action and, unless authorities respond properly to warnings, penalised.

As we can see, this is partly about new rules and partly about tougher enforcement of existing measures. Hungary is not a member of the Euro zone, and the country is rather far from meeting the conditions for entry. But a more stable Europe and Euro zone would do Hungary good. The poor history of Hungarian macroeconomic management in recent years would justify a shift to a regime of clear rules and correct execution.

Third, what about entry into the Euro club?

The proposed SGP measures are calibrated to be tougher for Euro zone members than for states that still use their national currencies. The logic behind this is the following. The actions (and inactions) of Euro zone member state governments have a direct impact on the health of the common currency. Thus such governments should be held responsible for their fiscal policies. States outside the Euro zone are, in contrast, exposed to financial market forces. Therefore, a national currency provides the government with additional policy freedom within the EU, but at a price of being under the impersonal scrutiny of financial markets.

The Hungarian government recently began to seem not terribly eager to join the Euro club, partly because of the turbulence surrounding the Euro. One can claim that the Euro club has been in a bad shape and that now is not the time to rush to enter the club. But it is important to see that the longer Hungary stays out of the currency zone, the longer the government and all other economic agents in Hungary are exposed to market risks.

Fourth: We like Euro plus – but not now

The EU member states – with the exception of, surprise, Great Britain, Sweden, the Czech Republic and Hungary – signed a declaration called Euro+. The initiative includes strategic actions, such as increasing research and development efforts, upgrading educational systems, and a series of competitiveness enhancing labour market measures. The Hungarian government decided not to join the Pact not because of the above objectives, most of which appear in a similar fashion in the Kálmán Széll Plan. The point in the Pact that was not welcomed by the Cabinet is the harmonized calculation of corporate profit tax base across nations – a rather innocent technical detail at first glance. But the Hungarian government’s concern is that this may be but the first step towards the unification of the corporate tax rate (not only of the base) in the EU.

The Orbán cabinet has placed high hopes in corporate (and personal) tax reduction as a key factor in restarting the sluggish Hungarian economy. Low corporate tax is also seen as a main component in inviting foreign capital. The hypothesis of lower than customary corporate tax as a super growth-enhancer is open to discussion. For my part, I am rather sceptical concerning the efficacy of tax reduction in job creation and international competitiveness; this is why I find Hungary’s “opt out” from the Euro+ initiative unjustified. But as János Martonyi, minister of foreign affairs, was quick to add, the Euro+ Pact is not closed for good, that is, member states can join later, and the Hungarian decision is not meant to be final.

In conclusion: the European Union has finally reacted to the new round of financial and economic crises, even if, again, belatedly. The accomplishments of Europe in reacting to these challenges in 2010 and 2011 may have been modest, but they do not justify Euro-sceptical views. Slow reaction time and the bureaucratic nature of decision making are unavoidable consequences of the diversity of Europe27. It is important to note that despite efforts to coordinate policies, national governments have made important decisions for themselves.

The main goal is to calm financial markets by restoring fiscal order in the public sector of member states. Time will tell whether recent efforts are sufficient to fend off the spectre of sovereign default in all problem cases. The second challenge, namely the one emanating from the structural weaknesses and insufficient competitive positions of some peripheral European countries, has received less attention. But the main responsibility in this respect rests with the national governments.

 

References

Akerlof, George – Shiller, Robert J. (2009): Animal Spirits – How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism. Princeton University Press.

Bod, Péter Ákos (2009): The Financial Landscape – Seen From a Converging Country. In: Otto Hieronymi & Alexandre Vautravers (Editors): Globalization and the reform of the international banking and monetary system. Palgrave Macmillan.

Bordo, Michael D. & Landon-Lane, John (2010): The lessons from the banking panics in the United States in the 1930s for the financial crisis of 2007–2008. NBER Working Paper 16365.

European Union (2009): Economic Crisis in Europe. Causes, Consequences and Responses. European Economy No.7/2009.

Gylfason, Thorvaldur & Holmström, Bengt & Korkman, Sixten & Söderström, Hans Tson & Vihriälä, Vesa (2010): Nordics in Global Crisis. Vulnerability and Resilience. The Research Institute of the Finnish Economy (ETLA).

International Monetary Fund (2010): World Economic Outlook – Rebalancing Growth. Washington DC. April 2010.

Reinhart, Carmen M. & Rogoff, Kenneth S. (2009a): This Time Is Different:

Eight Centuries of Financial Folly. Princeton University Press.

Trichet, Jean-Claude (2010): Central banking in uncertain times – conviction and responsibility. BIS Review No 111 .1 September.

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