To Stand the Test of the Market

30 june 2013

Europe and Russia After the Crisis

Olga Butorina is a Doctor of Economics, professor, head of the European Integration Department, Advisor to the Director of the MGIMO University of the Russian Foreign Ministry, and a member of the Board of Advisors of Russia in Global Affairs.

Resume: The EU has encountered an unforeseen deformation of market mechanisms. While the EU is rethinking what has happened and working on a new strategy for economic development, Russia is returning to the “good old” practices that imitate democratic institutions and market mechanisms.

Economically, the European Union and Russia are not very much alike. Per capita GDP in the EU is twice that in Russia (U.S. $30,000 and $15,000, respectively). The EU exports high-tech goods, whereas Russia exports raw materials. However, the crisis has affected both: GDP in 2009 decreased by 4.4 percent in the EU and by 7.8 percent in Russia; in both of them the state budget deficit exceeded 6 percent of GDP, and unemployment approached 10 percent. Although the crisis had come from the United States, its grave consequences were caused by local factors: lack of structural reforms, insufficient competitiveness, excessive salary growth, bloated and inefficient state apparatus, and swollen and unstable financial markets.

The current recession is the first worldwide crisis in the era of globalization and universal triumph of the market economy. This is also the first universal crisis in the de-industrialization era. Before the previous global recession, caused by the oil shock, industrial production accounted for 40 percent of global GDP, and the service sector, for 50 percent. Now these figures are 27 and 72 percent, respectively; that is, the formerly almost equal ratio is now 3:1.

WHAT’S GONE WRONG IN EUROPE?

The creation of an economic and monetary union in Europe was intended to make the European market truly homogeneous  and bring it closer – in terms of quality – to a national market, similar to that existing in the United States. This was presented as a main  benefit  of  the single  European currency. It was assumed that a vast European market would boost opportunities for European producers, increase their efficiency, and thus ensure sustainable development and long-term employment growth in the EU. Price equalization in the European Union was to increase the well-being of Europeans and improve the business environment. Deeper and more liquid financial markets promised low interest rates, while the European Central Bank pledged long-term price stability. Add to this the bonus of no conversion costs and foreign exchange risks.

All these arguments were repeatedly voiced by EU leaders during the ratification of the Maastricht Treaty and the transition to the euro. However, the advocacy campaign had its tricks. Experts knew well that the removal of barriers would result in stiffer competition. Incidentally, one of the first issues of the ECB’s corporate newspaper drew a parallel between bank employees of the 1990s and coal miners of the 1950s. A parallel between the monetary union and the European Coal and Steel Community was evident. Indeed, integration is useful as it strengthens mechanisms of competition and thus forces countries to seek ways to revitalize their economies. However, these efforts presuppose winners and losers, and EU officials prudently kept silent about the latter, so as not to deprive the project of broad public support.

Another thing that was kept secret for the public at large was that the euro was not intended to supplement the EU single market, created by 1992, but to save it from destruction. The removal of capital controls (which was one of the items in the 1992 single-market program) was slowly but surely undermining  the European Exchange Rate Mechanism where national currencies were pegged to the ECU, de facto to the German mark.  The crisis of the European Monetary System in 1992-1993 only proved that. Normal trade within the EU was impossible without fixed exchange rates, as contracts concluded in a foreign depreciating currency would be disadvantageous to suppliers, whereas contracts concluded in a foreign appreciating currency would be disadvantageous to buyers. A similar situation had already arisen in the European Economic Community after the collapse of the Bretton Woods system. The European “currency snake” saved the situation then. It would have been very difficult to explain all that to the general public. Jacques Delors, then president of the European Commission, and his team opted not to scare ordinary people and not to burden them with complex economic calculations.

The global economic crisis revealed the ulterior motives. Europeans felt they had been deceived. “Why did the authorities not say that the introduction of a common currency would require great sacrifice? And if we were misled, then the authorities must take back their vaunted single currency and restore everything the way it used to be.” Perhaps, this was how the Greek man-in-the-street, feeling impotent resentment, reacted to the austerity measures announced by his government. Indeed, citizens’ interests were not duly reckoned with, as the principles of democracy would imply. It has to be said in fairness that all great projects are imposed on societies in one way or another, and authorities usually lack enough ability or time to achieve their full public approval. Alas, the ideals of democracy and everyday practices do not coincide.

The second argument – that the EU internal market would not exist today without a common currency – would have stood EU bodies and national governments in good stead if it had been driven home to the public. The realization of the fact that the integration achievements of the past 50 years would be ruined without the euro might have cooled the fervor of those who smashed shop windows and set fire to cars on the streets of European cities. A clear understanding of this mechanism would have helped leaders to agree on urgent measures to save the euro and would have facilitated finding mutual understanding with voters. Why European leaders still keep silent about this is hard to say. Apparently, highly placed officials do not have much faith in the population’s ability to hear the voice of reason and to move from emotional to rational, especially at a time when unemployment hits record highs, when social benefits are cut, and when frustration and anxiety grow in society.

The preservation of the common European market, the growth of its uniformity and the improvement of its quality expectedly benefited the strongest players and worsened the positions of weak ones. From 1999 to 2007, German exports to other EU countries increased by 50 percent against national GDP. Thanks to the high quality of German goods, the inflation rate in Germany has been lower than the average figure in the euro area ever since the single currency was introduced. Between 1999 and 2010, prices in Germany increased by 19 percent, compared to 25 percent in the overall euro area. In other words, the price competitiveness of German exports to other countries in united Europe increased. During the same period, prices soared by 43 percent in Greece, 36 percent in Spain, 31 percent in Portugal, and 28 percent in Italy.

Long-term high inflation rates, characteristic of Southern European countries, created inflationary economies in them, with their own rules and mechanisms. One of the goals behind the transition to a single currency was to reverse the situation and help all countries in the euro area to achieve sustainable growth, actually following the German model based on a strong currency with steady purchasing power, long-term low interest rates and a high rate of savings needed for investment. With the transition to the euro, periphery countries received a currency of much higher quality than their earlier national currencies. Yet, other levers of their economic mechanisms did not automatically switch to the German model.

The impact of money supply on inflation was under control, as it was only the European Central Bank that could now issue money. But cost driven inflation remained. Greek, Portuguese and Spanish goods and services gradually became more expensive compared to goods of the European core countries. Formerly, in order to stop the fall in competitiveness, national governments had resorted to devaluations, that is, they made other partners in the EU and third countries pay for their inefficient policies. Now, this “free rider” bonus came to an end. Germany, the Netherlands and some other countries with stable currencies rid themselves of the recurrent external tax. But weaker countries were left face to face with the results of their policies.

In an inflationary economy, business and the population become accustomed to the idea that money constantly loses its purchasing power; so it is no use keeping savings in the national currency. They should be kept in a foreign currency or used to buy something. In addition, currency depreciation often benefits those who took a loan before it happened. In simpler terms, a stable currency encourages savings and a long planning horizon, whereas an unstable currency encourages borrowing and a short horizon. When Greece and other periphery countries switched to the euro, they received a high-quality currency but continued to follow their old practices, especially as they received manna from heaven in the form of low interest rates. It became cheaper to take loans, and the range of borrowers broadened dramatically. Previously, German banks did not give loans to Greeks in drachmas, fearing their depreciation. This practice acted as an automatic stabilizer of the economy: currency risks limited the size of debts. The transition to the euro removed this limiting factor, and markets, confusing currency risks with country risks, began to neglect the latter. As a result, cheap loans poured into Greece and other weak countries.

In other words, with the introduction of the euro, markets fell under the spell of a strong currency and clearly underestimated risks throughout the pre-crisis period. In 2008, the situation was reversed. With the beginning of the crisis in the euro area, the interbank loan market stopped working, and the EURIBOR rate lost its economic content. As debt problems grew, markets became highly sensitive to risks; sovereign debt spreads of weak countries soared, and their government bonds were no longer acceptable as collateral by banks in other euro area countries. The recent influx of cheap loans in the euro area periphery gave way to the flight of capital, usually characteristic of developing economies. The result was the disintegration of the single financial market of the euro area, created through great effort of the EU (notably the ECB) and the markets themselves over the years of the euro’s existence. The division treacherously went along national borders, and no one will now dare speak of any timeframe for a “reassembly.”

WHAT DOES NOT GO WRONG IN RUSSIA?

Back in 2002, the European Union followed the U.S. in recognizing Russia as a market economy. However, although the Russian economy is no longer centralized and state-run, this does not mean that it has become a market economy in essence. The “crony capitalism” model built in the country markedly differs from a Western-type economy and has little chance to become one in the foreseeable future.

The characteristic features of this model include the absence of the rule of law (poor protection of property rights and contract fulfillment), a general lack of trust, high concentration of economic power and the intensive merging of the interests of business and the bureaucracy. There is an exorbitant “power rent” (bribes and kickbacks) in Russia. Kickbacks can reach 80 percent of the value of a government contract. Today, career development of young professionals in many state and semi-state organizations depends on their ability to offer their boss a project involving kickback payment. These factors drastically reduce the profitability of enterprises, increase risks and transaction costs, and worsen the investment climate. Not to mention the moral side of things and business practices.

Surprisingly, the 20 years of market reforms in Russia have not resulted in the full monetization of the economy. True, the government has put an end to barter practices and dollarization which prevailed in the 1990s, and raised the level of monetization of the economy (the ratio between M2 and GDP has increased from an unthinkable 11 percent to 40 percent). Nevertheless, two parallel worlds – a monetary and a non-monetary economy – continue to exist in the country.

Let me explain. In April 2011, 36 percent of employees had a gross salary of up to 12,200 rubles per month; of them, 16 percent were paid not more than 7,400 rubles. The take-home pay of these people was not more than 10,600 and 6,400 rubles a month, respectively, while the subsistence level was 6,500 rubles. In other words, 16 percent of the employed could barely afford subsistence, and another 20 percent were at the poverty level if two adults had one child. Needless to say, single parents and families with two or three dependents had an even lower standard of living. The question arises: How do these people survive and why do they not revolt? The answer is simple: a large part of the population subsists on farming on household plots, hunting, fishing and gathering.

If you visit a market in any small town in spring, you will see a lively trade in seeds, seedlings and all kinds of live animals for growth: chickens, ducklings, rabbits. By late summer, glass canning jars and lids are the top-selling goods. In order to save their garden harvests, housewives make jam and prepare juices, kompot, and pickles for days on end. In Siberia, the Russian Far East and Northern European Russia, men with secondary and even higher education regularly go hunting and fishing in order to provide their family with adequate protein food. Mushroom and berry picking is not only a national hobby in Russia but also a significant source of food for low-income people.

Whereas in Western Europe the de-industrialization process took several decades, in Russia it was accomplished within a very short period of time, simultaneously with the market reforms of the 1990s. Plants and factories were shut down one after another throughout the country. Hundreds of thousands of workers, engineers, technicians, accountants and other specialists were left without occupation, social status and livelihoods. The only thing many of them could do was take up farming on household plots to survive and feed their children. Formally remaining townspeople, these people against their will gradually lost many characteristics of the urban way of life. This hidden deurbanization threatened to acquire a national scale. Despite its Soviet industrial past, Russia found itself stuck between town and country.

The informal agricultural employment comes as a powerful social and economic stabilizer, much to the joy of authorities at all levels. In 2009, Russia’s GDP fell by 7.8 percent, but the real disposable income of the population, according to the Russian Federal State Statistics Service, increased by 3 percent in constant price terms. This phenomenon cements the existing system of non-market relations and creates long-term obstacles to modernization.

Families with low salaries have to strictly divide their budgets into monetary and in-kind parts. The former is used only to buy essential goods and services that they cannot produce themselves or acquire in exchange for the products of their labor. These include utilities, gasoline, grains, sugar, shoes, books and school supplies. The inelasticity of the money supply makes the consumption of these goods and services strictly limited. Even if a family has much food at home, it may not have enough money to buy a camera, books, medicine, or a train or flight ticket. Its members are thus cut off from the benefits of globalization, with the exception of mobile communications and, partly, the Internet. Teachers, health and social workers, mechanics, electricians and drivers taking up farming in their spare time cannot be vehicles of advanced practices at their official workplace, and their farming will always be technologically backward and inefficient.

Partial monetization strengthens the idea, widespread in Russia, which regards money as some special substance endowed with almost supernatural powers. Money is mythicized, and various kinds of spells are used to attract money, as was done in medieval Europe. Very few Russians view money as an instrument and know how to handle it correctly. Worshipping money contributes to the conservation of symbolic exchanges and status tributes characteristic of archaic societies. Presents for teachers, doctors, bosses and officials are not just a soft version of a bribe but a deep-seated, almost obligatory form of manifesting respect. By the way, European companies operating in Russia use this dubious tradition to increase their sales. In the spring of 2012, one of the cosmetics market leaders came out with a billboard saying “The school year is ending; teachers are waiting for your presents!”

The deurbanization contributes to the proliferation of non-market practices and ideology.

For example, smallholders, who do not have legal rights of farmers, nor their technical and financial capabilities, seek to minimize their spending. Instead of paying for electricity, some of them prefer to illegally siphon it. Similarly, some people do not consider it shameful or unlawful to tap into the public water supply without authorization, or to freely use fertilizers, fuel or equipment from nearby industrial facilities.

Also, additional incomes work to perpetuate the low wage system and prevent the formation of a modern labor market. For example, even in large industrial centers one can hear phrases like, “She has got a job as a nurse in a hospital, and now every evening she has two buckets of leftovers for her piglet.” And this is happening in a country boasting space and nuclear power industries.

Dubious in-kind incomes in this case compensate for scanty salaries which, in turn, allow authorities to significantly understate the official unemployment rate. Whereas trade unions in the EU seek unreasonably preferential conditions for workers and thus make the labor market rigid, trade unions in Russia do not participate in collective bargaining and do not influence the wage rate, thus also deforming the labor market.

In addition, subsidiary agricultural employment prevents the formation of a modern urban environment. An overwhelming majority of small and medium-sized Russian towns retain features of the villages of which they grew out. Downtown squares often are simply expanded parts of roads along which people settled in the past. Buildings of stone or concrete are only found in downtown areas, beyond which there are private wooden houses, with sheds and vegetable gardens, and worndown dirt roads. There are large areas of private housing even in cities with a population of about one million, for example, Voronezh and Ufa. The longer Russian citizens engage in farming, the longer cities remain without a high-tech and user-friendly infrastructure.

The crisis of 2008-2009 dealt a heavy blow to the Russian economy. Russian GDP fell more than on average in the world and than in most countries of the Commonwealth of Independent States. Stock indices hit a record low. In order to prevent the ruble from falling, the Central Bank spent almost U.S. $200 billion in massive currency interventions. However, the relatively quick recovery from the depression and statistically small social costs created the illusion that the Russian economy was OK.

Unlike the European Union, where the crisis caused a painful yet vigorous reaction from the authorities and society, Russia showed no signs that the crisis had given it any motivating impulses. While the EU is rethinking what has happened and working on a new strategy for economic development, Russia is returning to the “good old” practices that imitate democratic institutions and market mechanisms.

*  *  *

Having created a quality single market and provided weak countries with a strong currency and a stable development model, the EU encountered an unforeseen deformation of market mechanisms. The euro area periphery proved to be unprepared for increased competition, and markets failed to assess risks correctly and in due time. The crisis resulted in the stoppage of money markets in the euro area and the disintegration of the single financial space. Automatic stabilizers of the economy, which had existed before the introduction of the euro, ceased to work and the economy lost balance for a long time.

Russia, by contrast, showed a high strength of its economic mechanisms, although they can be described as market mechanisms only with great reserve. The economic system is in a stable institutional balance, although social stability is based on high income polarization and poor quality of life for a large part of the population. At present, there are no forces in the country that would be willing and able to start a deep institutional and structural transformation of the economy. The duration of its delay depends not only on external factors but primarily on world oil prices. An impulse for reform may also come from within. This will become clear in three to five years when the generation born in the 1990s reaches working age. These are children of those citizens who have had to engage in farming. If most of the young people, who grew up with gadgets and social media, refuse to make compost and mash for piglets, a basically new situation will arise in society.

} Page 1 of 5