EBRD @25: Central Europe’s progress is under threat

EBRD @25: Central Europe’s progress is under threat
The Visegrad Four.
By Erik Berglof of the London School of Economics May 2, 2016

The EBRD was formed in 1991 to support the countries of Central and Eastern Europe make the transition to democracy and a market economy. But just as we celebrate 25 years of the bank’s existence, alarm bells are ringing throughout the region, most loudly in Hungary and Poland – two countries thought of as leaders of systemic transformation. Political majorities threaten basic democratic principles and are persecuting those who resist these changes.

There are essentially two camps among close observers in how they see these developments. In one view, these regressive steps threaten the very foundations of the achievements over the last 25 years and even challenge their right to be part of the EU. Others take them as typical wobbles in immature democracies that do not affect the strong fundamentals.

The achievements in Central Europe are truly remarkable. Arguably, they represent the most dramatic and broadest institutional transformation in such a compressed time period in history. Perhaps most impressively, corruption has virtually disappeared as a concern for business and is now in many countries at levels below those of Western Europe. The last ten years have not been as positive as the previous ten, but half of the small number of countries in the world that have made it from middle-income to high-income status since 2000 are in Central Europe. Most of them had no particular resources, other than their high, but imperfectly tailored human capital, and their fortuitous geographic location.

The Central European countries made good use of their human capital and favourable location in shifting trade from East to West, in what must be the greatest reorientation of trade ever seen in peacetime. In large part through massive foreign direct investment, Central European companies became successful exporters, climbing up the value-added ladder and integrating into global value chains. Capital flowed downhill to exploit profit opportunities in Europe’s east and foreign banks facilitated these flows through what was a truly unprecedented positive interplay between financial development and financial integration.

Precisely because their progress was based on endowments that do not tend to lose in value easily, the achievements of Central Europe were viewed as particularly sustainable and resilient to external or internal shocks. Yes, Central and Eastern Europe was the world region most affected by the global financial crisis in 2008-2009, largely because of its deep integration into the global economy through trade and connection through global value chains, but most observers thought that, seen over a longer time period,the region would come out without deeper wounds from the crisis.

We have since learned that the European banking system was overextended and overexposed, not only in Central Europe, but more generally Europe had become overbanked. The necessary adjustment has come at a very high cost for the Central European economies, particularly for small and medium-sized firms that had just been given access to finance through their banks. Yet these economies now have most of this adjustment behind them and should be able to enjoy catch-up growth for decades to come.

But like in the rest of Europe, and arguably in much of the world, the financial crisis has come with a hangover in the political system. This impact was visible already in the 2010 “Life in Transition” survey, where citizens in most of the countries in Central Europe and the Baltics on average took a less favourable attitude towards markets and democracy. Interestingly, further east the crisis strengthened the support of markets and democracy. Voters seem to blame the system they think they have, an “incumbency bias” of sorts.

Centralisation of power

Central Europe is by no means alone in the world in seeing a surge of nationalist and populist sentiments, but their concrete expressions, particularly in Hungary and Poland, are more extreme than in most countries. The centralisation of power in Hungary by Victor Orban and his Fidesz party span everything from economic policy to media and culture, aptly captured by Janos Kornai, the region’s preeminent economist. The changes to the Polish Constitutional Court and restrictions on media introduced by Jaroslaw Kaczynski, the “ruler behind the screen” of the Law and Justice party (PiS), challenge the very principles of rule of law and freedom of expression.

The aftermath of the global financial crisis has been reinforced by strong anti-establishment feelings throughout Central Europe – at least in part a legacy of socialism, but also by a failure to deal decisively and appropriately with their difficult histories. “Rear mirror” politics that divert great political capital to “outing” former communists and resolving injustices of the past have become standard features of many of these young democracies.

Political turnover, for long viewed as a signal of the strength of these democracies after decades of dictatorship, has become a liability. Governing establishment parties have been overthrown by political leaders who seek to reduce political competition and consolidate the hold of their movements over the core institutions. Investors and public policymakers alike are concerned that Hungary and Poland no longer uphold basic democratic values.

Until recently, these societies have been climbing up the global rankings on voice and accountability as well as rule of law and regulatory quality. The business environment, measured for example by the World Bank’s “Doing Business” survey, has improved massively almost everywhere. Many of these achievements are due to the political and economic openness of the region. A comparison of the top-three countries in terms of institutions with the bottom-three performers suggests that trade and financial integration is by far the most important explanatory factor of the institutional differences between these countries, even once we have controlled for EU membership.

Critics of the alarmists say that these achievements are solid and we should not worry too much about the current ripples. It is very rare for high-income market economies to go from democracy to authoritarian government. The EBRD’s “Transition Report 2013” showed that countries more or less ended up with the political institutions they managed to establish in the first dramatic years of transition. Reforms strengthening democracy have mostly had positive impacts on economic institutions, like in Serbia and Montenegro, but Romania (1995) and Ukraine (2004) show that there are no guarantees.

But is there a risk that back-tracking on democracy would lead to similar steps backwards in economic institutions? There was only one country with a major authoritarian reversal, Belarus, and there economic reform subsequently came to a halt. The early signs from Hungary are mixed, but there are serious indications that core economic institutions are being compromised. In Poland it is too early to tell from the data.

So should we be concerned? Unfortunately, the answer is yes. The most important reason is that the institutions in Central and Eastern Europe are still less firmly established. The latest round of the “Life in Transition Survey” shows that attitudes towards markets and democracy were much less affected by the economic crisis in Greece than they were in Central Europe, even though the drop in output was at least as big. The responses from civil society in Hungary and Poland are encouraging, but they may not be enough to protect the core institutions.

Another problem is that these attitudinal shifts now are coming with increasing political polarisation. One early lesson from transition was that a more polarised electorate will make consensus-building more difficult and slow down reforms. Another reason to worry is the EU, and the Eurozone in particular, have lost much of their lustre in the eyes of the citizens of these countries. As a result, the leverage of the “outside anchor” in encouraging change has been weakened.

The ongoing tectonic shifts in the mindset and the associated undermining of institutions of Central Europe will hurt the attraction of the region as a place to start a new business and as an investment destination. Undermining the rule of law, limiting transparency and weakening democracy will eventually eat away at the confidence of investors and consumers. All these things are critical to the functioning of institutions and ultimately to the legitimacy of the political system and the laws it produces.

Unfortunately, outsiders can do little to affect the outcomes of these domestic struggles – in fact, external pressures are likely to backfire and further solidify nationalist and anti-establishment sentiments. At the same time, Europe cannot cave in on its core principles. Europe’s main responsibility is to get its own house in order – to re-establish the credibility of the European Union and its institutions. On some important issues, like that of migration, Central Europe is now frustrating the necessary changes in the EU. The EBRD should play a part in breaking down this resistance.

Erik Berglof is now Professor and Director of the Institute of Global Affairs at London School of Economics after serving 9 years as the ERBD’s chief economist. This is part of a series of articles marking the 25th anniversary of the EBRD.