Source: Carnegie
Originally published in the Washington Post, April
25, 2004
Next Saturday, the European Union (EU) will admit 10 states, eight of them former communist countries. This is a moment to celebrate: In the 12 years since the fall of the Soviet Union, these countries have become fully democratic and are now, to varying degrees, integrated into the West.
But it is also a moment of economic concern. For the past five years, the new Central European members -- Poland, the Czech Republic, Slovakia and Hungary -- have had a mediocre economic growth rate of 3 percent a year. Those four countries constitute almost 90 percent of the population of the entering states. (The other six -- Estonia, Latvia, Lithuania, Slovenia, Malta and Cyprus -- are mini-states, with only 10 million people among them.)
The EU has many advantages, but economic dynamism is no longer one of them. In order to qualify, the applicant countries had to adopt all the bureaucratic EU regulations, including the most moribund of them, known as the Common Agricultural Policy -- a system of subsidies paid to EU farmers. As a result, the Central Europeans should expect their growth to slow: This year, the 15 preexpansion EU members were expected to post an economic growth rate of less than 2 percent. By contrast, the U.S. economy and that of the world as a whole are set to expand by 4.5 percent.
Admittedly, the new Central European members have benefited from generous access to EU markets. The entering states already trade more with the EU than the old members did with one another. But the Central Europeans have achieved everything they can gain from EU membership, and they will stagnate if they do not liberate themselves from the petrifying EU model.
Meanwhile, in a development that has gotten little notice amid the EU expansion hoopla, the post-Soviet countries further to the east have been booming since 1999. The nine market economies in the former Soviet Union (Russia, Ukraine, Kazakhstan, Moldova, Georgia, Armenia, Azerbaijan, Kyrgyzstan and Tajikistan) have on average grown annually by no less than 7 percent for the last five years. The new tigers are Kazakhstan, Russia and Ukraine -- far more so than Poland, Hungary or the Czech Republic. The three Baltic countries are doing significantly better than the Central Europeans, but not as well as their eastern neighbors.
This is a dramatic turnaround.
During the first decade of economic transformation after communism, Poland, Hungary and the Czech Republic seemed to do everything right -- swiftly building normal market economies, privatizing state enterprises and establishing proper democracies -- and sound economic growth ensued. Most of the former Soviet Union, by contrast, undertook only gradual reform, privatized slowly and did little to develop democracy or the rule of law. Output slumped until 1998, when the Russian financial crash passed a severe judgment on partial reforms.
To be sure, Russia has benefited from high oil prices and devaluation. Yet growth in the post-Soviet region is accelerating, while only Russia, Kazakhstan and Azerbaijan are oil exporters. Clearly, something else is going on. The post-Soviet countries have returned to growth because their market reforms are finally succeeding. They have privatized most state enterprises and put their public finances in order.
Why are the post-Soviet market economies doing so much better than the Central European ones? Part of the explanation is that the post-Soviet countries were poorer and far less developed in the first place, and poorer countries tend to grow faster than rich ones if all else is equal. But this explains only a small part of the difference.
The truth, which may shock you, is that the post-Soviet countries have a more efficient economic model than the Central European ones because they are free from the harmful influences of the EU. This is most evident in public finances.
In Central Europe, public expenditures amount to no less than 46 percent of GDP, as in Western Europe. Consequently, taxes are high and social transfers excessive. The Hungarian economist Janos Kornai has labeled the Central European countries "premature welfare states." Worse still, the Central European countries have maintained an unsustainable average budget deficit of 7 percent of GDP for the last three years. They seem reassured that the EU will bail them out.
By contrast, the Russian financial crash forced the former Soviet republics to cut public expenditures sharply, to no more than 26 percent of GDP -- that is, just over half the level in Central Europe. Taxes also have been slashed. Russia and Ukraine have adopted a 13 percent flat personal income tax. Kazakhstan has undertaken a Chilean-style pension reform, privatizing its social security system. Even so, these countries have nearly balanced budgets.
Low public expenditures and high growth go together in most former communist countries. Communism bred corruption, and the longer it lasted, the worse the corruption, so the post-Soviet countries were and are more corrupt than the Central European states. The best cure for a pervasively corrupt state is naturally to cut public expenditures and revenues.
Another major difference between the Central European and former Soviet countries is that the Central Europeans have much more regulated labor markets and higher taxes on labor, because Central Europe has adopted Western Europe's strict regulations. As a result, Poland has an unemployment rate of more than 20 percent compared with Russia's 8 percent. Regulations might be intimidating also in the former Soviet countries as well, but most are circumvented.
Thus, the economic dynamism in Kazakhstan, Russia and Ukraine is in no way sheer luck. Their new economic model is reminiscent of East Asia's. Japan took off after World War II, and it was imitated by four East Asian tigers: Taiwan, Hong Kong, Singapore and South Korea. China, Thailand, Malaysia and Indonesia followed suit two decades ago. India has risen in the last decade, and now the nine former Soviet economies mentioned above have benefited from the same model of open markets and limited state intervention. Kazakhstan's President Nursultan Nazarbayev and Russia's President Vladimir Putin seem to see Singapore or South Korea as their economic ideals. The post-Soviet countries are facing stiff protectionism in Europe, so they export the steel and chemicals that the EU does not want to East Asia instead, notably to China's insatiable market.
Nor is the poor economic performance of Central Europe an accident. Slovakia's Minister of Finance Ivan Miklos put it bluntly: "Europe is hindered by labor market inflexibility, heavy tax burdens, bloated public sectors and other competitive constraints, and the gap between the United States and Europe continues to widen rather than shrink."
This is not to whitewash the post-Soviet countries. They are both corrupt and authoritarian, while Central Europe is eminently democratic and richer. Some draw the dubious conclusion that democracy is bad for economic development, but this holds true for Central Europe as much as it does for the rest of the world, which is to say not at all.
The point, rather, is that the EU model generates stable democracy but little economic growth. Today, Russian economists no longer look to Poland for a desirable model but to the thriving free markets of Kazakhstan, Singapore, South Korea and Chile. To them, Europe is both inhospitable and stagnant.
Democracy advocates face the new challenge of clarifying that Central Europe's sluggish growth is an effect not of democracy but of EU regulations. The EU needs to liberalize its economy and reduce its fiscal profligacy, not only for its own benefit, but also for the reputation of democracy. Countries such as Ukraine should not have to choose between democracy and growth.
Rather than requiring its new members to adopt every regulation in its 80,000 pages of common economic legislation, the EU should have used this opportunity to do away with its most harmful regulations, such as the Common Agricultural Policy. With 25 members and no effective political institutions, the new EU appears set to be stuck in economic stagnation for the foreseeable future.