The balance of the EU presidency for small nations

Six months of the presidency of the European Union is obviously too short a term for any government to solve complex problems. Smaller member states do better not to entertain ambitions for striking deals or setting directions; country size matters. But they invariably want something more: to win notice and appreciation. The presidency means a great deal of extra work and additional expenditures, but there are benefits that offset these costs. Such a job comes about every thirteen years, offering a rare opportunity to leave your mark on the Union, and perhaps also to include a few of your issues in the common agenda.

Slovenia, the first among the post-communist countries to get the presidency, passed the efficiency test in the first half of 2008 and strengthened its image as a small, low-key, but efficient nation. Then came France with undisguised ambitions to reshape the European agenda, but the second half of the year turned out to be a hectic period for the EU, marked primarily by the Russian-Georgian hostilities and the credit crunch in the western financial world. The Czech government took over when Europe had just sunk into deep recession, and on top of that the government in Prague had to resign for domestic reasons in mid-term, proving once again that however prestigious the EU presidency may be, in a democracy domestic politics comes first. The Czechs, as a matter of fact, had been doing rather well in terms of the transition from planned economy to market based economy and in approaching the Union average, so they did not badly need the extra foreign interest that the presidency supposedly generates.

Hungary’s case is very different. Hungary needs better PR and has important issues to sell within the Union. Hungary is the only one of the ten post-communist member states that has been unable to approach Union averages since accession in 2004. In 2008 Hungary became the first European country for decades to turn to international financial institutions for a bail-out. Hungary’s economy suffered more than those of most member states during the financial crisis in 2009. The new government that came to power in May 2010 inherited the serious socio-economic consequences of the erratic policies of the outgoing Socialists, including such highly sensitive and complex issues as very low rate of labour participation, poor integration of the Roma, and high public indebtedness. Prime Minister Orbán’s cabinet vowed to restart the economy and restore order and self-esteem in Hungary, drawing a line between the past and the present.

In Spring 2010 Hungarians voted for change. The incoming Fidesz government did not hesitate to use its newly gained and constitutionally very strong democratic mandate to change policy direction, rewrite laws, reorganize institutions, and replace people serving in individual positions, all in a rather self-confident fashion. Not surprisingly, such events create a stir and foster tensions within and outside the country. Hungary has had extensive press coverage in recent months. The country does not simply need more press and more interest in things Hungarian. Rather it needs better press and a wider focus of interest.

Will six months of EU presidency help in this respect? Can Hungary, with its present economic headaches and accumulated social debts, add much value to the strategic issues of the European agenda? What follows is an attempt to take stock of the most pressing macroeconomic problems and to review key areas of Hungarian socio-economic development and their links to the European context.

Revisiting the road to present policy disputes

In order to grasp the complexity of the tasks confronting the country in 2011, it is useful to start by pointing out the contrast between Hungary and most other member states in terms of fiscal room of manoeuvre. Data indicate that the majority of European states reacted to the recession of 2008–2009 with sizable fiscal stimulus packages aimed at protecting the financial sector and, to the extent possible, employment and domestic demand. Fiscal stimuli led to deficits of various sizes in 2009, with a range of 1 per cent of the GDP in Bulgaria, a new EU member state, to 12 per cent in the United Kingdom, a mature market economy. As for 2010, Ireland set a world record in deficit with 32 per cent of its GDP. Most member states already have much higher gross debt per GDP figures than 60 per cent, an official threshold, although all member states are supposed to meet the criteria of the Stability and Growth Pact (SGP) designed in 1997 and redesigned in 2005 to safeguard the value of the common currency and harmonize policies across the Union.

One can arrive at the obvious conclusion on the basis of the deficit and debt figures that the SGP and other policy harmonization institutions of the EU have simply failed to restrain national decision makers. But another possible conclusion, or another way of looking at the same story, is that in crisis the national governments follow policies of their own, relegating EU rules to a secondary position. Conditions differ, of course. While most governments decided to spend abundant public money to soften the consequences of the recession, Hungarian governments had to accept the strict loan conditions of the EU/IMF lenders during the life of the loan, a topic Gy. Barcza and I discussed in the preceding issue of this Review.

The international lenders had reason to insist on a strict fiscal policy course in a country with a reputation for fiscal slippages and overspending. This reputation is only partly justified, however. Consecutive governments in recent times have not been identical in this respect. The first Orbán cabinet of centre-right parties (1998–2002) essentially pursued a cautious fiscal policy, managing to cut the public sector deficit and reduce the share of public expenditures. The economic growth was fairly strong at the time, helping Hungary meet two of the four Maastricht fiscal and monetary criteria for introducing the common currency. Prime Minister Orbán backed the idea of an early entry into the Euro-zone. However, he lost the parliamentary elections in 2002, and the Socialist–Free Democrat coalition returned to power with a grand spending scheme (“Welfare regime change”) under Prime Minister Medgyessy. Runaway spending soon undermined the fiscal position of the Hungarian state, and high public sector wages (plus a wage drift in the private sector) weakened Hungarian international competitiveness. Medgyessy had to resign once the damage done to the economy began to surface.

The same coalition under the new Prime Minister Gyurcsány (2004 to 2009) was vocal about restoring competitiveness, but it initiated further popular spending programs. It even declared cynically massive tax cuts in December 2005, just before the next elections, claiming that the “roaring Hungarian economy” would generate enough public revenue anyway. But the economic growth rate proved far from spectacular, and the tax cut, naturally popular with the electorate, quickly caused the public sector deficit to climb as high as 10 per cent of GDP in 2006, which was not yet a crisis year. On such promises, the coalition managed to win elections in 2006 and thus stay in power. Soon after the victory, accurate data on soaring state debts and deficits came to light. Then in September 2006 a leaked tape of a speech given by the Prime Minister to the Parliamentary party faction revealed the ‘hundreds of tricks’ used by the government to manipulate the real size of the deficit and the lies it had told about the real state of the economy.

The leaking of the speech was followed by uproar and riots, and the government made brutal use of police forces. Nonetheless, the Prime Minister refused to resign. Eventually, after a heavy defeat in European elections, Gyurcsány stepped down as Prime Minister in spring 2009. The Socialists suffered a crushing defeat in the 2010 elections, which gave Fidesz more than a two-thirds parliamentary majority.

Unorthodox measures, heterodox economic policies – the first year of Fidesz government

These antecedents explain a great deal about the motives and limits of the Fidesz government that came to power in 2010. Eight years of Socialist governments left behind an overstretched budget and low labour market activity. The combination of generous pensions and high taxes on labour had created strong personal incentives to retire as soon as possible. The economy lost momentum even before the recession. Industry is excessively dual by nature: most sectors are dominated by large foreign owned firms coexisting with a high number of under-funded micro, small and medium sized domestic firms. This foreign-domestic duality is not a specifically Hungarian issue. Most post-communist nations are similar in this respect. But Hungary, which has by far the highest public debt ratio, faces particular challenges. The weak and undercapitalized domestic businesses are not productive enough, they cannot pay high wages, and given their limited capacity (and willingness) to pay taxes, they do not contribute properly to the cost of running the state.

It is next to impossible for the national government of an EU member state to grant support legally to domestic businesses. Membership in the EU undoubtedly reduces the room of manoeuvre for any government to conduct structural policies. In established market economies there may be few reasons for the nation state to implement active structural policies, but in transition countries their historical belatedness would justify the adoption of methods no longer used in “old” Europe.

Again, these issues are not uniquely Hungarian. Yet the conditions in Hungary for promoting economic growth and simultaneously ensuring that the sensitive indicators of budget deficit and debt will improve as demanded by the Stability and Growth Pact are much worse than in other EU member states. The financial burden of servicing public debt in Hungary is three times that of countries of similar size and income (e.g. Slovakia, Romania). This circumstance has been critically affecting the manoeuvring room of Hungarian economic policy for some time.

The second Orbán government came to power with an election platform of “no further austerity leading nowhere” and a supply side program to kick-start the economy with a decisive tax cut. This policy is risky: tax reductions immediately deplete government revenues, while higher taxable growth may only come much later, if at all. True, the continuation of previous restrictive policies or toying with piecemeal policy reforms would not promise much either. Politics also enters the picture: the “read my lips: no more taxes” election promise is a particular political constraint on Prime Minister Orbán. The memory of the fate of Mr. Gyurcsány as a proven liar is vivid. It would be imprudent at best so much as to attempt a U-turn after an election win. Whether the Hungarian general public has really become that sensitive to dishonesty in politics, or there were many other factors behind the fall of Gyurcsány and his party is open to speculation. What is certain is that Prime Minister Viktor Orbán and his economic policy advisors seem to believe truly in the efficiency of a dose of supply side economics via tax cuts, and they also seem to be determined to deliver the election promises they made (albeit under different international conditions).

The policy measures taken so far, as partly discussed in the preceding issue of this Review, have immediately led to conflicts. First came the clash with external official investors (IMF, EU). The bank tax – a fairly high levy that financial institutions have to pay for several years – has been popular among voters, but has raised professional concerns about its impact on future economic growth and on the efficiency of financial intermediation. In a second round of reform measures special sectoral taxes were quickly introduced in the autumn of 2010. This made some member state governments complain, as the bulk of the levy is placed (in the spirit of “patriotic policy”) on foreign owned businesses. However justified the “crisis taxes” sound to voters and however unhappily accepted by the businesses concerned, the rapid introduction in the middle of the year of such tax measures casts doubt on the predictability of Hungary as an investment target. But the imposition of these sector taxes made it possible for the Orbán government to reduce general taxes. Personal income taxes are to be cut to an effective 20 per cent flat rate (16 per cent rate on gross labour income plus employers’ social security contribution), and corporate profit tax reduced to 10 per cent: delivery of election promises to the letter. This certainly amounts to a supply side push designed to create jobs. Such a deep tax cut may broaden the tax base by whitening the economy.

Yet, there is a profound weakness to such a policy plan: the government aims to finance the massive tax cut through temporary tax increases. The sector taxes have been declared to be in force for a finite period. When they peter out, Hungary may be left with a tax shortfall unless the economy has witnessed a spectacular boom. The national Fiscal Council did not fail to point out such risks and other contradictions in this economic policy, angering Fidesz in the process (which did not much like the concept of the council at its inception two years ago in the first place, having declared it too costly and bureaucratic; the 2011 budget summarily deleted funding to the Fiscal Council – meaning its de facto abolition). But even without the verdict of the Council, few investors would accept financing such a risky policy. This is why the government needed another source of revenue, even if only temporarily: hence the idea of nationalizing the private pension funds. Again, this may put the Orban government on a collision course with the Commission of the EU, not only because the private pension is a preferred form of social security, but also because the planned use of accumulated funds to finance current state expenditures goes against all rules and sound fiscal principles.

In addition, the recently chilled relationship between the central bank (MNB) management and the government also adds to the risks in the eyes of analysts. The MNB believes that economic policy needs an anchor, and this could be the entry into the Euro-zone, or at least its serious prospect. For that, Hungary should make efforts to meet the entry conditions. And this brings us back to the above policy dilemma: growth or balance. Debt and inflation reduction is a possible direction after years of imbalances, though in Hungary this policy would involve further restrictive budget measures, and would oblige the government to turn its back on election promises. Prime Minister Orbán does not want a U-turn in policy. Instead he hopes that the supply-side experiment will work. But it is noteworthy that when he met with OECD Secretary General Angel Gurria in Paris Orbán added: “There is always a chance of defeat in such an experiment. But we want to make the chance of success a reality.” True, the first, proven avenue to economic growth would fit much better into the present European concept of economic policy sustainability, while the latter, the “Hungarian way,” involves specific risks. What is more, some of its measures may put the new Hungarian government into further conflict with the European policy mainstream.

Any policy benefit from the Presidency?

Will the presidency of the EU offer the Hungarian government more room for manoeuvre in budgetary issues? Hardly. The so-called “European semester” in year 2011 has on its agenda the creation of a ‘permanent crisis resolution mechanism’ to replace the existing European Financial Stability Fund. The logic of such a resolution mechanism implies concerted action to address both public sector and private sector imbalances within the Euro-zone, but probably also outside it, since, as the case of Hungary proved in 2008, non-members can also cause headaches for the whole EU. A resolution mechanism still does not amount to a fiscal union, but it would only make sense if its ground rules could override national governments’ decisions (or indecisions) in case of faulty or unsustainable national fiscal plans. In short, the probable next step in 2011 is to beef up the macroeconomic powers of the Union vis-a-vis debtor nation states – a step most analysts would welcome but one that creates short term problems for nations such as Hungary, with its high debt-to-GDP ratio and unorthodox policy initiatives.

But Hungary has other issues perhaps more immediately pressing than questions of debt and budget. The Danube is relevant in this context as a link between peoples, countries, markets, and cultures. It is much more than a symbol of Budapest (a city right on the river) and a reference to water and nature. As a waterway it unquestionably has high potential, much of which has yet to be tapped. But the Danube also refers to a former high problem area: the Balkans. This is a part of our continent where the EU has duties to fulfill. Croatia, also a Danube country, is waiting for accession, an aspiration strongly supported by Hungary for cultural, political and economic reasons. Presidency is not about enhanced power to decide pending issues, but this six month job lends the Hungarian government more voice in debates, even if the matters are settled finally by counting the votes.

There are other policy topics that the host country should raise, including more protection for ethnic minorities and more support for poor regions, but experience shows that life tends to create new topics out of necessity. It is a safe bet that fiscal turbulences on the periphery of Europe will dominate the agenda in the first half of the year, even at the expense of other vitally important issues. Financial problems may again take the center stage; it is the responsibility of the host government to make sure long term social issues will not be pushed aside.

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