Pruning the economy for future growth

The government will need to cut nearly 30 billion additional crowns from its budgets this year to balance out slower revenues. Mandatory expenditures such as pensions and social insurance will be untouched, but other payments will be slashed to the bare minimum. Hungary's government recently had a standoff with its lenders, the EU and the International Monetary Fund (IMF), over their calls for greater austerity measures. The government claimed if it cut any more, Hungary's growth would grind to a halt. But fiscal austerity can boost the economy, says Dalibor Roháč, a research fellow at international investment group Legatum. He told The Prague Post that the Czech Republic is in a great position to set an example for the rest of Europe.

The Prague Post: You've said austerity measures can boost the Czech economy and set an example for other Central Europe countries that must do the same. Do belt-tightening measures strangle growth, as others have argued?

Dalibor Roháč: I don't think they have to. Especially given the condition of the Czech economy. There has been this argument, especially in American circles, because of the fact that the United States did have major stimulus spending last year. But continuing to spend that money would be unwise, so they had to cut spending, and there was a big drop. But I don't think that argument really holds, because in the United States the stimulus spending didn't even work as planned. With the exception of a few countries, there hasn't been a lot of stimulus spending outside the United States, including the Czech Republic.

Some commentators, like [New York Times columnist and Nobel Laureate] Paul Krugman, would argue that cutting the deficit before the economy has recovered from the recession is risky. There is an economic rationale for believing this, but you have to realize that in the Czech Republic - unlike in some other countries - the current public debt isn't a result of deficit spending meant to stimulate the economy or a result of massive bank bailouts. Czech public finance had been on an unsustainable path before the crisis hit, and while the crisis naturally exacerbated the debt dynamics, the planned fiscal belt-tightening doesn't mean eliminating a pre-existing fiscal stimulus.

TPP: On the flip side, how could austerity measures encourage growth?

DR: Fiscal prudence has to change the incentives within the economy. It's not just about blindly following short-term goals to reduce the deficit and debt level to some arbitrary levels. Most fiscal consolidations in history happened as a result of revived economic growth, instead of through discrete changes to public finance. So fiscal austerity can, to a large extent, go hand in hand with reshaping incentives in a way that supports economic growth. For instance, what seem like small changes in social benefits and marginal tax rates can have big effects on individual behavior. Moving the tax burden away from capital and labor and toward taxing consumption, eliminating loopholes and making welfare benefits less desirable of an option can at the same time boost employment while being congruent with immediate fiscal consolidation.

We can't forget the Czech Republic is a small economy open to capital flows. Foreign investors react to changes in fiscal regimes, and the examples of Central and East European countries that transformed their tax systems through what is known the "flat tax revolution" are something that can be learned from and possibly repeated in the Czech conditions.

TPP: Hungary told its lenders that further austerity measures would kill growth next year. Are they one of the exceptions?

DR: Hungary has come to the point where the fiscal cuts they need to do are going to be terrible. Hungary has had a serious problem with its banking system, unlike the Czech Republic, and it's come to an impasse with it. There hasn't been an effort from the government to really tackle that. Hungary is a case where the irresponsible fiscal policy has gone too far thanks to public spending and a lack of basic prudence in banking supervision. They've gotten into a difficult situation, not unlike Argentina. It's not unlikely a country like Hungary or Greece could default on their debts.

It's also an unwillingness to cut spending that comes from political considerations. There are regional elections in October, and [Hungarian Prime Minister] Viktor Orbán is the kind of person who really puts considerations for his own political agenda first. His unwillingness to cooperate with the IMF over austerity measures really has to do more with political benefit; he's playing his game so he doesn't have to do anything too unpopular until elections. It's not exactly responsible, and it might be too late by October.

If Hungarian bonds get downgraded by ratings agencies, the cost of servicing debt will go up astronomically, and investors will no longer believe Hungary will be able to repay its debts.

TPP: In the past, a foundering Hungary was bad for the Czech Republic, as investors got flighty over the CEE region and local currencies. Could that scenario reoccur if Hungary's problems worsen?

DR: My impression is the market has started to distinguish between Central European countries. If you look at the ratings of Czech government bonds and the rate of payments, it appears the markets have a greater deal of trust in the ability of the Czech government - or the Slovak and Polish government - to behave responsibly and put fiscal measures in place so that public spending is not on an unsustainable course.

I think that's one of the good [results] of the crisis: The Czech Republic is seen as much more a part of the "German economic space" than the rest of Central Europe.

TPP: I'm also curious how austerity packages influence credit rating agencies. In one instance, Spain suffered ratings downgrades because the agencies saw its austerity measures as difficult and a hindrance to growth. How do ratings agencies like Fitch and Moody's react to austerity measures?

DR: I think ratings agencies look at fiscal austerity in a case-by-case way. Spain has serious issues with labor-market rigidity and competitiveness ... and can't use independent monetary policy. Therefore, in Spain, a serious austerity program might have adverse effects on economic recovery. It's also unlikely that whatever fiscal measures Spain introduces in the short run will be able to get spending by regional governments under control. So the downgrades that occurred in April and May are not so much a sign of austerity measures being detrimental as rather a sign of the difficult situation Spain got itself into. And it should be stressed that the Czech Republic does not have the same problems, which makes the policymakers' job much easier. But this doesn't mean Spain shouldn't consolidate as well. The crucial thing here is that well-designed structural reforms accompany the budget cuts.

Claire Compton can be reached at
ccompton@praguepost.com