President of the European Bank for Reconstruction and Development (1990-1993)
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I hope not to disappoint you after so many flowers. I must say that I am very happy to be in this country, where the market economy and democracy were practically founded; which demonstrates that tolerance, diversity and openness are keywords of civilisation and key lessons Europe can give to the world at a moment when Europe can also be seen as a place where barbarism is being reborn.
‘Destroy the greater part of a nation’s fixed capital... and dislocate the whole economic structure. Eventual recovery from this chaotic state of affairs will be rapid, giving a growth rate of 8 to 10% annually.’
Milton Friedman’s comment in the 1960s, in relation to Japan, might at first sight seem relevant to post-Communist Eastern Europe today. There has, after all, been wholesale economic dislocation since 1989. National production has been severely curtailed. Trade has collapsed. And – in some countries – there is even evidence that growth could now rebound.
But is it strictly true to say that Eastern Europe has started from a position of absolute destruction, on the scale of Germany and Japan after the war? Would it not be more accurate to say that a specific economic shock occurred when the Communist system tried to convert to a capitalist system: and that prior to that shock a long process had been already under way whereby the east European economies became increasingly, but only gradually, detached from world economic norms?
We forget now, but only a very few years ago East Germany was considered the number fifteen economy in the world. The Soviet Union was reckoned a superpower – and not just in military terms. The remark that the Communist system would bury the West was rhetoric – but was not taken lightly in the West. US President Kennedy put in motion an entire civil space programme because of competition by Moscow.
In a fantasy by the Argentinian writer Jorge Luis Borges, mapmakers in a desert empire achieve such perfection in their skills that the map of a single province covers the space of an entire city. The map of the empire itself covers an entire province. ‘In the course of time,’ wrote Borges,’ these extensive maps were found somehow wanting, and so the College of Cartographers evolved a map of the Empire that was of the same scale as the Empire and that coincided with it point for point.’
The paper world of Communist production, with its central systems of quotas, production targets and planned outputs, had something in it of this virtual reality. It looked economically like the real thing: but was as different from it as one dimension is from three.
The Charter of the Council For Mutual Economic Assistance of 1959 spoke innocently in terms of ‘deepening and perfecting cooperation’ among member countries; of ‘the acceleration of economic and technical progress’; of the ‘raising of the level of industrialization’; of ‘a continual growth in productivity’; and of ‘a steady increase in the well-being of peoples.’
Likewise, the preamble of the 1955 Warsaw Pact reaffirmed the desire of the contracting parties ‘to create a system of collective security in Europe based on the participation of all European States, irrespective of their social and political structure, whereby the said States may be enabled to combine their efforts in the interests of ensuring peace in Europe.’
It is tempting to remark that this is a formula that might apply once again to Europe today!
However, as the years went by, the paper world in the east of Europe corresponded less and less to reality. The real economy, comprising real people, real goods and real capital, diverged increasingly from the theory. Real living standards deteriorated. Real life expectancy shrank. Real pollution grew. Real nuclear power stations exploded.
Borges concluded his fantasy of the map that was the same size as the empire in this way: ‘Less attentive to the study of cartography, succeeding generations came to judge a map of such a magnitude cumbersome, and, not without irreverence, they abandoned it to the rigours of sun and rain. In the Western deserts, tattered fragments of the map are still to be found, sheltering an occasional beast or beggar; in the whole nation, no other relic is left of the discipline of geography.’
Today we are faced with the question of how to re-unite the two halves of Europe. There is a wide consensus that such integration will produce lasting benefits in the long term for both sides. But what of the short term? What is the real difference between the two sides, now that they are to be measured together? And what will be the costs, in socio-economic terms, of the adjustment that will have to be made?
We have one useful tool for measuring the size of the divergence that has grown up between the two systems, and thus of assessing the magnitude of the adjustment.
In East Germany – the foremost economy in the CMEA – the union with West Germany in 1990 gives some pointers. At the time of union average productivity in East Germany was about one third that of West Germany. Capital stock was technologically outdated, with an average age of 18 years, compared to 8 years in West Germany. East Germany, like other Communist economies, was reliant on trade with the other CMEA states and on the Soviet Union for the supply of raw materials, in particular oil. And East Germany was running up foreign debt and repayment problems due to its shortage of foreign currency.
The Treuhand set about reducing the state role in the East German economy, primarily through privatisation, and establishing a competitive and commercial economic environment. The first step was transforming the 84 big industrial conglomerates – ‘Kombinate’ – into stock companies, and their subsidiaries into companies with limited liability. In this way a Treuhand portfolio of over 12,000 companies was built up for privatisation. Of these, only 2,500 were still on the books at the beginning of this year.
But what have been the costs? When drawing up opening balance sheets for its companies, the Treuhand found that most were insolvent by West German standards: their total liabilities exceeded the realisable value of their assets. They would, in other words, be due for liquidation if normal economic rules were applied. Indeed a proportion – around 30% of the total portfolio – were beyond salvage and were liquidated at the outset.
Because it was politically unacceptable to liquidate all insolvent companies, privatisation had to be accompanied by an array of subsidies and guarantees. The Treuhand took on the old debts of companies to a sum of around DM 70 billion. In addition, it is estimated that the Treuhand will eventually have helped company liquidity through cash injections to the order of about DM 115 billion. Costly incentives were also provided to would-be purchasers: companies and property were sold below market value; the Treuhand took on some operating losses for an initial period; loan and payment arrangements were granted on favourable terms; environmental clean-up costs were assumed by the Treuhand; major tax incentives were provided by the German government to encourage investors. The total level of aid for investors, both direct and indirect, could be as much as 50% of the investment sum for property and 60% for capital stock.
The Treuhand estimates that if it continues to privatise at the current rate of 10 to 20 companies per day, it will soon reach the final 300 to 500 companies which can neither be privatised nor liquidated. These will therefore require subsidies for restructuring. And – since some of the largest companies are currently producing losses of more than 50% of turnover – this will run into further billions of DM.
To give a global figure, the net value of the companies on the opening balance sheet of the Treuhand was minus DM 179 billion. Total privatisation receipts by the end of 1993 will be only DM 30 billion. These are much less than at first expected. Thus the question arises – how much will all this cost? At present the overall cost is estimated at DM 250 billion.
But let me give you one more final stark statistic: The total amount of public sector funds transferred annually from the western half of Germany to the new lander of the unified Germany has risen to DM 118 billion in 1992 and is expected to rise to DM 135 billion in 1993.
My point is this: if East Germany was the most developed of the CMEA economies, and if experience has shown that most East German firms cannot be integrated directly into the market system without very high costs, it is highly likely that by the same standards most of the industry of Eastern Europe is in an even worse position. In other words, if there were an immediate union of the two halves of Europe, as in Germany, a large part of the economy of Eastern Europe would stand to be wiped out.
The situation might in fact then begin to resemble the catastrophe scenario with which I opened.
But luckily for east European firms and their employees, and luckily for Western European taxpayers – who might otherwise be faced with astronomical bills for subsidies along East German lines – this will not happen. There are three main reasons.
First, the union of the two halves of Europe will not be an overnight affair. Even on an optimistic scenario it will be many years before a common economic area develops. The union of Europe is not a question of two parts of a divided nation coming together: it is rather a question of many nations, at many different levels of development, arriving at sufficient common rules and institutions for them singly to take advantage of shared economic activity. As in the European Community of today: there are marked disparities of economic performance among the member states, but that has not prevented a Common Market from functioning.
Second, the union of Eastern and Western Europe is unlikely to be a simple joining of one block with another. There is a growing differentiation of economic performance among the various post-Communist states, with those in Central Europe showing better skills at adapting to the market economy than those of the former Soviet Union. So although the union of Europe could be framed in terms of one treaty and common pan-European institutions, there is unlikely to be a big bang on German lines. Instead there is likely to be a series of little bangs as groups of countries join the mainstream European economy: each bang, it is to be hoped, providing some ignition for the next.
Third, and crucially, there is no currency union between Eastern and Western Europe. Currencies have in fact diverged rather than converged. The extremely low value of the rouble has this advantage: it allows Russian products to maintain their competitiveness and it allows Russia the possibility of adjusting the value of its output to growing productivity. And it also means that investments in Russia can be extremely cheap: a small amount of foreign money can go a very long way and buy a very great deal. This applies to private investors who may be interested in buying or taking shares in Russian capital stock or property. And it also applies to international institutions: as long as economic reform costs are ‘internalized’ and can be met in roubles, a relatively small amount of foreign currency is needed to match it.
The Russian government might, for example, incur costs in reforming the military industrial complex, which might then be expressed in a higher than otherwise budget deficit. At the mid February exchange rate of 560 roubles to the dollar, $10 billion of foreign assistance – shared, say, between foreign donors – could buy and liquidate an astonishing 5.6 trillion roubles worth of debt. If a mechanism for targeting the purchase was constructed, this might be a relatively cheap way of arresting armaments production that is surplus to requirements – and liable to be exported, possibly illegally, for hard currency.
Of course a cheap rouble should not be an unstable rouble. Monetary reform is now needed to rein back hyperinflation in Russia and stop the rouble from losing value altogether. But a reformed rouble – or a new rouble – should nonetheless be pegged at a level which does not price Russia out of the market. And it may be in the Western interest to buy and liquidate debt before such reform – while it is still going cheap.
For all these reasons it is clear that the unification of the whole of Europe is likely to follow a different track from the unification of Germany. Adjustment in the rest of Eastern Europe will take longer; industries will have more time to become accustomed to economic life outside, and above all economies will remain cocooned within exchange rate regimes which allow them to remain competitive, and which are only gradually aligned on West European norms.
All the same, this process of integration must not take too long. Unless there is clear prospect of general living standards in the East getting nearer those of the West, unless there is a sense of momentum carrying countries forward from the events of 1989 towards a better future, economic reform will get bogged down in sterile disputes. No reform can occur without creating both winners and losers. If the process drags on for too long, losers will become more vocal than winners – and winners will be tempted to leave anyway.
The costs to the people of central and Eastern Europe of the effects of the process which began in 1989 are by now relatively well known. They include:
Major falls in real GDP for all countries in the region – of an order of magnitude greater than anything felt in Western Europe and, of course, from a lower base;
A virtual collapse in trade between both the former parties to the CMEA and also the former parties to the Soviet Union;
The corrosive effects of hyperinflation on savings, purchasing power and the entire financial system in Russia;
A widespread flight of capital from the area through the banking sector, as foreign currency once obtained is invested in the West;
Strong growth in unemployment, as firms restructure and shed labour;
A shortfall in fiscal receipts, as economic recession hits the tax intake, and;
The major budgetary and social costs of military conversion – with the huge employment generator of the military industrial complex suddenly cut loose from its final purchaser, the Soviet Ministry of Defence.
While all these and other costs are real, there are grounds to suggest that with care and the correct policies the transition might nonetheless be manageable.
First, some of these negative effects are already partly offset by other positive effects. Economic growth, for example, looks now set to resume at a moderate level at least in Central Europe in 1993. Industrial production stopped declining in 1992 in Hungary and the CSFR, and picked up significantly in Poland, whilst exports from Poland, Hungary and the CSFR to the West grew rapidly in 1992.
To consolidate these first signs of recovery, it is of course vital that the West continue to open its markets to products from Central and Eastern Europe. I will return to this.
Second, the social safety net in all countries of the region could be made more effective.
In the West, social security and similar costs – pensions, health sector charges, education, unemployment compensation – have been taking a growing share of the GDP of virtually all countries since the 1960s. The growth of social expenses was about twice the growth of GDP in the period 1960 to 1980. Today, although funding methods vary, social costs represent between a fifth and a third of national GDP in all Western countries.
The figures we have for Eastern Europe are not complete, but in those countries where we can make comparisons it appears that, in terms of national GDP, global social expenses are comparable to those of Western Europe – between 20 and 25% of GDP in Poland, Hungary and the CSFR. So the basis of a social safety net exists.
But there are difficulties. Eastern European systems, designed for a totally different social order, tended to supply standardised low quality cash benefits and social services to the whole population. The state institutions involved included industrial enterprises, Communist trade unions and local governments. There was no significant correlation between the needs of the individual and what the state would provide. All these Eastern European systems are now under great pressure, squeezed by new demands and new budgetary constraints.
So there is now an urgent need for restructuring to provide a better allocation of resources according to needs, to provide new contributions and new efficient means of administration. But with reform there also has to be continuity – this is not the moment to pull the social safety net away.
Particular attention has now to be paid to labour market instruments. The West has developed an array of instruments in response to the high unemployment which has emerged since the 1970s. The East has had much more rapid shake ups, with unemployment indicators suddenly shooting up in the last two years, reaching now around 10% of the workforce everywhere. As well as unemployment assistance, networks of employment agencies and active employment policies will have to be put in place.
I would like to take this opportunity to welcome the new initiative launched by the Clinton administration last week, which aims to help Russia create a multi-billion dollar social safety net. The initiative addresses a crucial problem – to try to mitigate the hardships Russians are facing from hyperinflation and economic restructuring. This is a key area which needs to be addressed urgently. We need do more within this framework. I will shortly present a global proposal to the European Community Summit and G7 countries which seeks to address these needs first within Russia, and later on the other former Soviet countries.
With luck and planning the new democracies of European countries might yet avoid the problems the West has commonly faced in terms of rising demand-led social costs. If a way can be found to cap expenditure, to target resources, to limit supply to what is essential rather than what is desirable, countries in Eastern Europe will not only be able to finance a social safety net, they may in the long run be able to do it more cost-effectively than the West. That could prove over time to be a significant advantage.
The third area involves the role of the West in the transition process. As far as the West is concerned I address myself principally, although not only, to Western Europe. In the West it seems to me there is a double risk: that of both overestimating the difficulties involved in transition, and also underestimating the capacity to help. Overstating the problems – viewing Eastern Europe as some unique manifestation of catastrophe theory – brings the risk that we shut our minds to what is happening because we think we cannot resolve it. When we shut our minds collectively, that translates into a policy vacuum. As I have suggested, eastern Europe is not a catastrophe: at least not as the world has known catastrophes. It may yet become one: but that would be a different story. Millions of East Europeans may flee to the West if there is real disaster, but for the moment they are staying in the East. There is a Russian refugee problem at the moment: but it is that more than one million refugees have fled to Russia from troubles in the former Soviet republics.
And we underestimate what we can do that is useful. We suffer in the West, perhaps, from an excess of modesty. The scale of financial transfers which are in question is not enormous. It is not – I would emphasise – a question of taking the sums that have been transferred to East Germany and multiplying them by a factor of twenty or thirty. Eastern Europe is not East Germany. There has been no overnight union. Hard currency will go many times further.
What are the kinds of figures we are talking about?
Leaving aside private sector flows, official capital flows to Eastern Europe, including the former Soviet Union, are not gigantic at present. In 1990 about $2.2 billion was transferred from all sources – international institutions plus individual countries. In 1991 the figure rose to $8.6 billion. In 1992 it is estimated to have been $5 billion.
These are not small sums either. But let us make a couple of comparisons.
The five Western European nations of Germany, Italy, Spain, France and the UK devoted each an average of 0.5% of GNP to assistance to Eastern Europe in 1990. But in the same year they also devoted each an average of 2.6% of GNP to defence. This is a sum over five times greater.
Now, one might be forgiven for wondering whether this is a rational order of priorities. It is no military secret that the threat to Western Europe used to come from Eastern Europe. But today, who exactly is defending what against whom? Is not the best form of defence so to arrange things that there is a zone of peace and stability around one? If we accept that the greatest threat to Western Europe from the East is now an economic and political breakdown, rather than an armed attack, it would seem to be more logical to switch resources to pre-empting such a breakdowm in the first place.
Keynes might have called it drawing the economic consequences of the peace.
Or take another example. Gross official capital flows from the G24 and the EC to Eastern Europe together came to ECU 2.5 billion (at current exchange rates) in 1991. Yet, in the same year the EC devoted ECU 34.5 billion solely to agricultural support through the Common Agricultural Policy. That is a figure 13 times greater.
A rational man might again wonder if this order of priorities can be right. It would appear that Western Europe has resources to spend: the question is whether it is spending them in a rational way. Targeted assistance to the east – for military conversion, or to help fund social safety nets – would, like the quality of mercy in Shakespeare, bless twice – both the giver and the recipient. Helping the transition in the east, helping the establishment of markets and democracy and helping avert an overflow of arms production, would not be altruism. It would be serving the European interest.
But the principal area of mutual interest is in trade policy. Continental integration will be led primarily through trade and investment. However, the issue is not merely one of trade between Eastern
Europe and the EC – it is threefold: first, there is the question of intra-regional trade; second the question of trading with the EFTA countries and thirdly, trade with the European Community. European integration will not only be fuelled through the Eastern half trading increasingly with the Western half, but also through Eastern European countries reviving their own intra-regional trading relations. Eastern and Central Europe faces a deep trade crisis today, with the collapse of the CMEA the volume of intra-regional trade plummeted by 40 to 50% in 1991. Last year there were limited signs of revival but the key issues have not been addressed. What Eastern European countries must realise is that trade relations within the region are a valuable asset. An asset which needs to be reconstructed. Thus, these countries should not only seek to become viable trading partners with the West but also with each other. To revitalise intra-regional trade requires two components: institutional infrastructure for export credit and export insurance schemes, and the creation of stable and efficient payments systems. Action is urgently required on both issues to ensure intra-regional trade does not plummet further.
Secondly, there is the issue of trade relations with EFTA countries. The Visegrad Four countries have already signed trade agreements with EFTA, and other countries of the region are in the process of negotiating similar arrangements. These Agreements allow for associated membership for the countries of Eastern Europe in the EFTA trading agreement. But, as with the Association Agreements with the Community, restrictions remain on those goods in which our Eastern neighbours enjoy a comparative advantage. This does not work to help transition, rather to distort it. A remedy for the situation would be to give the countries of Eastern Europe immediate membership of EFTA, with a possible transition period of adjustment in which the Eastern European countries could strive towards harmonization of laws, regulations and standards.
The same also holds true in the European Community’s stance towards Eastern Europe. The mainstays of EC policy toward Eastern Europe are the Association Agreements. Negotiated in piecemeal fashion with individual Eastern European countries, they are unfair, unbalanced and again maintain considerable restrictions on those imports in which east Europeans enjoy a comparative advantage. The result has therefore not been a coherent approach to the challenge of integrating Europe. Instead, the Europe of the future has become a maze of trade protocols. This is no vision of Europe we can be proud of, and most definitely not a vision which will lead to growth. What we need is a unified approach.
The ideal situation would of course be for all these countries, both the Eastern European and the EFTA countries to be admitted immediately into the European Community, One could have immediate membership mitigated by a long period of transition. But we must admit, this is neither politically or strategically feasible. If so many countries were to join all at once, it may lead to the total collapse of the institutions of the European Community.
For all these reasons, therefore I would like to repeat my proposal of creating an economic space, a Continental Common Market. I envisage a framework for the progressive and asymmetrical removal of all trade barriers between the EC and EFTA countries on the one hand and those of Central and Eastern Europe on the other. This would provide a short cut to European integration. Just as the NAFTA agreement between the United States, Canada and Mexico will provide a powerful boost for growth in the North American region, the creation of a Continental Common Market in Europe would be the most important single step that Western Europe could now take to help the east and also the biggest single boost to Western European growth that is within our grasp. As I have said, there will be no big bang: parts of Eastern Europe will need a phased introduction into the Common Economic Area. Protection will be necessary. But the prize of an integrated continent is so great in economic and political terms that a period of transition would be well worth it. Such a transition period would allow time to address the sensitive questions such as the Common Agricultural Policy, the steel and textile industry.
Protection, if there is to be protection, should be transitional, of the weak and against the strong, and subject to common rules.
None of these criteria apply in Europe at present. There are no common rules: but rather unilateral decisions. Protection is not transitional: but rather growing. And it is not protection of the weak against the strong: but rather of the strong against the weak. In steel, in agriculture, in textiles, in any area where there is serious chance of earning foreign exchange, Eastern Europe seems still to be the scapegoat of the West.
Resolution of such issues – which will grow – can only come in a wider framework where all factors are taken into account. If each is looked at separately, we will be reduced to policy formulation by the loudest lobby. It is the duty of democratic nations to balance and represent the interests of everyone. It is the duty of European institutions to consider the strategic future of the continent as a whole.
Continental integration will be led through trade but it will not end there. Of crucial importance will be the adoption of a pan-European publics works programme for both Eastern and Western Europe. It would act as a boost for growth throughout the whole region. High priorities for this sort of programme would be expenditure on transport infrastructure, linking the continent, such as the trans-European motorway linking northeast to southeast Europe or the development of new trans-European oil and gas pipelines. Such a programme encompassing Western and Eastern Europe would have three distinct benefits. First, rebuilding post-communist Europe will be a motor for growth throughout Europe as a whole. Second, such a programme could provide jobs for the unemployed of Western Europe, suffering the effects of deep recession. It is of great importance that Western Europeans alter their terms of reference. They should not view their Eastern neighbours as a threat, instead they should view the region as a source of employment. Third, by bringing together the two halves of Europe it will act as an economic unifier, bringing together different methods and approaches on a common project that will allow experience and a common goal to be shared. The first steps to such a programme were taken at the Edinburgh Summit. A facility has been set up under the auspices of the EIB and the European Bank. I would like this proposal to go further at the next EC summit.
I am glad to make these points in the distinguished presence of Prime Minister Lubbers, whose wise counsel and far-reaching vision have long been of the greatest benefit to the European Community, as I have no doubt they will continue to be in the future.
A combination of a European-wide continental common market and a pan-European works programme will not solve all the problems which post-Communist Europe faces. Nor will it answer the need for a pan-European approach to matters such as political and security questions, where work must proceed through the CSCE, the Council of Europe and elsewhere. But what it would do is create an economic momentum and a mechanism by which solutions to some of the most pressing economic problems of today and tomorrow can be found, and most importantly, it would provide a vision for the leaders of tomorrow.
There is no reason why a conference could not now be called of all European countries, a committee of experts appointed immediately afterwards to produce a report analysing all the issues – another Spaak committee – and on that basis a treaty be drawn up setting out the steps leading to the early establishment of a Continental Common Market. The Copenhagen conference next month on the future of Central and Eastern Europe will – I hope – contribute to this process.
Four years have now elapsed since 1989, the year when the geopolitical landscape in Europe changed so dramatically: and the year when the Cold War came to an end. In those four years much has been achieved. Much has begun. Much has been consolidated.
Four years after the end of the Second World War Western Europe was still unsure of its future. It took vision, courage, patience to rebuild economies and integrate markets. At the time nothing was certain: no-one could be sure that the foundations of thirty consecutive years of growth, prosperity and security were about to be laid.
Today we are at the same phase in the cycle. A war has finished. Reconstruction has to take place. A market has to be built.
Today we have the chance to continue the work of the founding fathers of European construction: which is to build an ever closer union of all the peoples of Europe.