IMPACT OF THE 2007-2010 RECESSION ON CENTRAL AND EASTERN EUROPE AND THE SOLUTION DILEMMA, FOR PRESENTATION AT THE 18TH ANNUAL NISPAcee CONFERENCE, at the GENERAL SESSION, WARSAW, POLAND, MAY 12-15, 2010; by Donald E. Fuller, Senior Lecturer, Anglo-American University, Prague, Czech Republic

PROBLEM. The 2007-2010 recession has caused problems in Central/Eastern Europe (hereafter CEE) prompting speculation regarding the role of governments in intervening to lessen present and future impacts.

RESEARCH QUESTION. To what extent should the state intervene in CEE private/public sectors in response to the 2007-2010 recession?

ISSUES.

  • Should governments intercede to increase regulatory control over behaviors such asmoral behavior that seem to cause and exacerbate recessionary impacts?
  • How have CEE countries compared economically with EU 15 countries?
  • Should EU members in the Euro zone that do not meet the Maastricht criteria be denied further access to the Euro zone?
  • What factors should guide CEE countries in responding to the 2007-2010 recession?
  • Does democratic government have a responsibility to ameliorate recession

economies rather than pursuelaissez faire or command economic principles?

THEORY. Krugman[1] argues for stimulus programs; Galbraith[2] asserts a struggle among Keynes, FDR and Milton Friedman; Akerlof and Shiller[3] argue that animal spirits inform significant behaviorist phenomena that weaken traditional safeguards such as the market and/or government regulation. Demography has not acted to buffer the recession.[4]

There is a public/private conundrum. Post-communist perturbations have exacerbated income differences while distributing effects differentially among workers involved in low, medium and high value added work. One might categorize low value added work as “transaction-oriented”; medium added as innovative and/or social intelligence oriented; high value as professional knowledge work more oriented toward copyrights and patents. The recession has been most unkind to transaction work; less unkind to social intelligence, and least unkind to knowledge oriented work (e.g., R and D).

Schumpeter’s creative destruction[5] suggests that during negative economic cycles (e.g. recessions), structural economic changes cause marginal firms and employment to fail. Presumably, human capital then re-locates into profitable enterprises presumably utilizing the same skill sets. During recessions, more likely to extend into multiple month job losses, human capital may (a) either lose skill sets,or (b) suffer from misalignment as sectors contract out available jobs. Transaction oriented workers would be the most vulnerable to such misalignment, although manual labor and construction workers might find revivified vacancies in a post-recession recovery period. Though their loss of skill sets might be minimal, living adaptations, particularly for migrants, may transfer them quickly to state supported subsidies such as wage supports and/or unemployment pay. Certain states have even offered airline tickets to home countries for migrant workers; the impact on the home country may be pro-cyclical.

Thus, Schumpeter’s creative destruction may have social, if not economic externalities, as large numbers become temporarily, if not longer term, structurally unemployed. While stimulus programs may stimulate jobs for the large number of transaction-oriented employees, there exists a certain period of hysteresis during which jobs lag behind investment. In the meantime, job security and social capital may deteriorate. Tax revenues will decline. Fiscal remedies may not be countercyclical since ex-workers will hoard savings until job security is again obtained.

Thedemographyof CEE does not respond to recession. Ageing has skewered employment profiles for two reasons: a) the elderly may be persuaded to retire early, if not, (b) they are likely to be retained, as employers seek to avoid making severance payments Consequently, the young, in high demand, may be shifted to part-time pay or laid off. Youth unemployment in Europe hovers around 25%. Yet youth is the culture; it constitutes a declining demographic resource, except among emerging economies, most prevalent among low skill sets. A second demographic phenomenon is the increasing life expectancy of the elderly. The spectacle of governments funding extended pensioners well into their 80s seems fiscally fragile since youth are not contributing sufficient pension payments. It is likely that individual defined contribution plans will predominate. But, were that to occur, elderly might well be retained to continue working beyond retirement. Only advanced earnings would make this plausible though the elderly would gradually demonstrate reduced skill sets, causing further fiscal distress

Knowledge work may be the wave of the future, but educational institutions arepoorly prepared to prepare potential workers for knowledge society. Tacit knowledge is particularly wanting. Medical personnel are in high demand. The supply seems constrained by educational processes. Despite this, bio-medicine is likely to explode. Continuing demand seems likely in medicine, pharmaceuticals and bio-medical computer applications as well astransplants, stem cell research, DNA analysis and multiple medical interventions to enhance health and life. Cost figures may well provide competitive pressures both from accessibility and reimbursable applications. The U.S. is well aware of medical demand and attendant cost figures to ensure accessibility.

DISCUSSION. State economic interventions are not inherent. Yet state vs. market regulation/mediation continues to be a salient discussion. Attendant to both strategies are behaviors pressuring barriers beyond acceptable limits of the 2007-09 recession. Such behaviors raise serious questions vis-à-vis economic strategies particularly addressing the tradeoffs between state regulation vs. market mediation. Says David Stockman,

Make no mistake. The banking system has become an agent of destruction for

The gross domestic product and of impoverishment of the middle class.[6]

The thrustof this paper is whether or not CEE must choose between state regulation and market mediation. Both have their functions on the output side. That is. world governments and bankers have been arguing in favor of one or the other (bankers for the market; governments for regulation). But while the issue is clear on the output side: we tinker with the law or rules and manipulate the outcome, it is less clear on the input side: we constrain behavior or provide incentives to produce intended consequences. Roosevelt changed the output side: change the law; impose new regulations, and the devils will respond. This is easier. It worked for over 70 years (about the same as post-Revolutionary Russia). The Soviet system seemed unwilling to change input or output. Capitalism tinkered with output: unfortunately removing Glass-Steagall,[7] and permitting branch banking across U.S. State borders. Then, the bottom fell out.

It is moral hazard that energizes I. Wallerstein and the neo-Marxists. Capitalism cannot handle it, they say. The populist moral outrage has been too strong. We will see. Naturally as the green shoots[8] appear, less pressure will inhere to change. But Jabobinist attacks on capitalism are likely to have their effect. Bankers will rise to their minimum protective demand; politicians will rise to their minimum populism. We can be sure of two things: increased reserve requirements, second, lower CEO bonuses. But none of this addresses the problem. EvenRoosevelt’s reforms deteriorated as moral hazard much later found an opening in unregulated consolidated debt obligations and derivatives.

Reform is confronted by behavior: mostly normative. The task is to find intended consequences. We have enough unintended consequences. Set a rule and the bankers can work around it. As the former Soviets have remarked, “…we spent half our time making up rules and the other half trying to figure out how to get around them.”

Thus, the answer is somewhere on the input side. What incentives exist? Not what carrots and sticks exist? Those are based on fallacies. Provide a reward and people will respond. Unfortunately these have usually been extrinsic(money). Intrinsic rewards have been languishing. The Canadians have an answer: make banking boring. They suffered very little during the past two years. Their returns on equity have been less volatile than those in the U.S. But more steady. More to the point they have not destroyed the production economy as the Americans have done. That can, theoretically, be repaired. We can revivify the greed economy. Yet the American loss of dignity, and assets among the middle class has been appalling. American lower class citizens may have been reduced to food stamps. These losses cannot be recovered. A peripheral question is to what extent have sets of jobs skills been lost? What reforms will transform economies into meaningful life experiences supported by gradual economic systems linking the financial economies toproduction of valued goods and services?[9]

What of CEE? CEE’s primary problem is not cascading sub-prime mortgages, CDOs or derivatives. It is borrowing upscale during the boom: i.e. borrowing in hard currencies. Thus, the cost of borrowing gradually increased as bond spreads increased and currencies outside the euro faded; inside the euro, Greece, having a reasonable per capita income and gini coefficient ($27,995, with a gini of 34.3)[10] apparently can’t collect enough taxes. Thus, debt levels there and in Spain, Ireland and Portugal added additional borrowing costs. This afflicted Estonia as well. The smaller economies have not prevailed particularly well: only Poland and the CzechRepublic have threaded the needle of debt payments vs. growth.

CEE isdependent on demand being restored (as is everyone else). Germany, using kurzarbeit,[11]managed to retain large sections of its workforce. Not so in most CEE states. Low labor participation rates and high unemployment figures have simply mirrored the productioneconomy. It can be restored The question is, at what price? And in what direction?

Germany seems to have linked one aspect of its production economy not only to the finance economy but to growth and development. Through Siemens, it is developing huge turbines that could envisage a breakthrough into green technology.[12] Pressured, perhaps, by China and other emerging national planners,the Germans sense a market opening in green technology that capitalizes on large manufacturers such as Siemens, rather than the American proclivity to turn toward smaller, even boutique IT firms, inherently thought to be more innovative and flexible. One can note, however, that IBM has penetrated software and business applications, to some extent lowering its footprint in hardware; certainly not eliminating it. This could be the reverse of size turning to large turbines rather than software consulting.[13]

THE INPUT SIDE. The fact remains that our integration of behavioral knowledge with respect to moral behavior and intended consequences is largely resident in research settings. Accordingly, we muse about constraining capitalism by rule or law in hopes of diffusing such things as credit and investing. So far, at least since the passageof Glass-Steagall, we have observed a banking or finance glut in the direction of rationalized economic man theory. The defense is weak, whether it is the efficient market hypothesis[14] or inhibited practices of Canada and the subjugation of risk to control, rather than managed adversity. Canada has eschewed this psychological end run while demonstrating steady banking returns without social dumping[15]

Does Power Corrupt? The Economist reports work done in The Netherlands and U.S. testing whether power corrupts or merely attracts the corrupt.[16] Exploring states of powerfulness and powerlessness in the minds of volunteers, they simulated experiments to test reactions. Their findings: power does tend to corrupt and promotes a hypocritical tendency to hold others to a higher standard. Interestingly, their exploration of hypocrisy concluded that they break the rules not only because they can get away with it, but also feel they are entitled to “take what they want.” While laboratory experiments in social science may be more aligned to correlation than causation, present day finance leaders arguing for portentous bonuses are unconvincing in their defensive arguments. In effect, this self protection argument has led to lack of trust causing political reactions toward populism in vengeance.

CONCEPTUAL NEXUS. One can determine whether or not the government should interfere in the recession struggle. Yet, at present, such policy proclivity centers upon output considerations. As green shoots[17] develop, pressures will exist to return to neo-classical economic considerations or neo-Weberian administrative tonics. Unfortunately, there is an input side. Tinkering with output changes may rest on a priori assumptions. This is not convincing. That is so since we know that moral hazard has steered between the rocks of Scylla and Charibdis. That needs to be addressed. Still, Europeans are cognizant of not separating lending from investment. They do not do it. Notably, it is the U.S. and Canada that do so. The results have been positive in Canada and negative in the U.S. (since the repeal of Glass-Steagall[18]). Yet Europe is not resting easily financially with no separation. What then is the dilemma?

Moral Hazard. It is not all banking that succumbs to moral hazard. By admission, our main concern is hedge funds, derivatives, consolidated debt obligations and credit default swaps. But these are not endemic to CEE. CEE suffers from a) incapacity (or inability) to police its own borrowing practices, b) its relationship with either the European Central Bank (ECB) or, if non-euro zone, its own central bank (UK, Latvia and the Balkans). Argentina recently extricateditself from central bank control by simply firing the chief and appointing a friend of prime minister Kirchner. Argentina now expects to extricate a very largesum of money from its cooperating central bank to pay off debt.

In the runup to recession reform, all bankers (with a few exceptions moving toward the margins) have favored accepting moral hazard. The argument would be that unless bankers can run their tasks with freedom, they will fabricate end runs such asArgentina’s without difficulty. Imposition of ruleswill be met by obfuscation and deceit. They can outwit any rule (they say, though the Canadians would object). On the other side, governments say, we need rules and regulations in order to disavow moral hazard. Only rules can provide a level playing field. Governments are in the mood for populism, at times reminding one of Jacobinism. Thus, the schematic appears as follows:

Figure. 1.

Supporters Factor Unintended outcome

Bankers / Moral hazard / Market failure
Governments / Rules/regulations / State failure

The bankers argue for professional freedom; the governments argue for Jacobinist punishment. At the intersection in the nexus, both would agree on increased financial reserves creating a partial component of risk aversion. But few would argue that the struggle or conundrum has been solved. From a behavioral view, the bankers are arguing for risk freedom and governments are arguing for populist retribution for destruction to taxpayer assets.

Market failure. In the banker case above, the market has tended to fail since free risk adversity has led to government bailouts using the “too big to fail” argument.[19] Governments would then say, “O.K., we will structure banking so that they are in smaller components and could fail without possessing destructive properties.” Yet, in the U.S., government moved in to save the banking system (that post-Glass-Steagall was empowered to issue structured securities [debt]). In Europe, we await the EU’s response (likely to involve the European Central Bank) to likely default by Greece of its financial obligations.

Rules/Regulations. In the government case above, the current recriminations in Congress, parliaments and executive branches have to do with moral repugnance at the capacious moves by bankers to award high banking bonuses despite market failure. Thus, governments, influenced by populism and electioneering, are responding to symptoms, not necessarily systemic infirmities. As to bonuses, bankers will simply increase base salaries and avoid bonuses. As to increased bank reserves, banks may simply scramble their accounting procedures moving funds into capital assets or other obfuscations. Thus, from a public view, very little would be accomplished on either side.

The Bureaucracy Perhaps duplicating Roosevelt’s attempt to reign in the privatesector, political leaders, in a heated populist mood, promise to eradicate the WashingtonConsensus and trickle down economics.[20] Having espoused liberalization of markets to Latin and South America, USAID and IMF[21] governments are now ready to postulate remedies to once again curtail the prospect of banking special interests, including illogical CEO bonuses. Armed with moral behavior arguments and voter “outrages,” governments are responding to a torrent of Jacobin predilections. Since Roosevelt,the master politician, is nolonger around, and the world has changed from Westphalian protectionsto network oriented neo-medieval constructions,[22] current proposals appear to block consensus for reform both at the political level and less so at the institutional level. There are cracks at the institutional level, however. A precious few number of bankers suggest that (a) it can’t be like before, and (b) if we don’t change, they will change it for us. Politicians,however, are not reading tea leaves. They are reading daily “recovery” reports. As green shoots appear in economies, less political pressure exists for reform. This, of course, is incongruous. Neither institutional nor special interest groups care about the long run (politicians are resigning and bankers will move on to new challenges). It is only the voters that care about reform. Yet they care less about CEO bonuses than jobs. Consequently, we witness the deepening debate among politicians for political advantage some of which is directed toward internecine battles with other bureaucrats (EU) or reacting to economic consultants not in agreement toward reform. In fact, the ‘seasoned’ investors such as Soros, Volker, etc.[23]express more direct measures borne from understanding conflicts at market interstices rather than punishment for a public that hungers for jobs.