Many Western observers believe that attaining the pre-transition GDP level is an important indicator of success in the medium-term path of transformation of centrally planned economies towards Western standards. Although some East European economies are showing real GDP growth, the levels of GDP are still lower than pre-transition levels (with the sole exception of Poland). Eastern Europe is continuing to follow conservative economic policies, but these may come at a cost because of the belief that the traditional Western objectives of zero inflation, coupled with a balanced budget, are always the best economic objectives. There is a rationale for implementing a multiple-goal strategy in the formulation of Eastern European economic policy and, in my opinion, such a rationale applies more strongly to the transition economies than to the developed economies.
In this article, setting aside an analysis of the zero inflation objective, I have disputed the popular view that a strictly balanced government budget is the best criterion of measuring economic progress in Eastern European countries. Rather than starting from preconceived economic ideas which may look feasible on paper but sometimes fail when applied to concrete cases, I've tried to address many current problems that are faced by reformers in Eastern Europe. Indeed, solving these problems may require a limited budget deficit. In my view, in order to reach lasting recovery, the fiscal policy strategy as part of a multiple-goal strategy, should hinge on a simple budget principle of observing a constant ratio between debt and GDP.
In this article I propose the following arguments:
I argue that a reformulated Keynesian policy may directly foster the first two sources of investment and indirectly facilitate the exploitation of the third source, FDI. The above points enable us to address important issues related to the need for fiscal stability in transitional economies, particularly such issues as whether and to what extent transition countries may be able to expand their fiscal policy, and where the problem of balancing the budget fits into this picture.
The major objective of these ambitious transformation programs can be viewed as an attempt to reach comparable living standards to those in the Western countries. In recent years Western Europe has become the main trade and political partner of Eastern European states. In addition, the countries of Central Europe set themselves tough objectives in order to qualify for joining the European Union.
There is a need for restructuring the economies of many of these states through adopting new technologies thus opening the way for sustained growth in their populations' income. In order to bring the much-needed recovery, such an ambitious program should be based on a sound economic strategy and a wise budgetary rule. A successful fast-track transition requires a combination of fundamentally sound policies, namely: the encouragement of rapid accumulation of savings; the extended use of the advantages of having a highly-educated population; stimulation of growth in physical capital investment; a healthy banking and public sector; an open policy towards FDI; increased labour productivity through the adoption of foreign technologies, services and, not least, eco-industries.
The Eastern European economies have already undergone major changes since the years in which the state sector played a dominant role in production and employment management. Currently in order to win investor confidence many Eastern European governments need to support the interlocking of domestic markets with the international economy by identifying initiatives to encourage inflows of foreign investment, enhance trade, improve services, and create a Western-style banking and financial sector. Such a radical change will require a significantly more active state policy, efficient management and intensive use of all available resources. I suggest that it is wrong to say that the reforms which were carried out have been inadequate; they were adequate, but now these reforms need to go further . The latter should include much use of investment opportunities (for the Russian case, see Tikhomirov, ) which carry a potential of significantly raising the low levels of productivity.
An analysis of the current state of public finance in Eastern European countries brings me to the conclusion that 'transition governments' should follow a less rigid fiscal policy (even if these governments have demonstrated their firm commitment to the differing views of Schumpeter and Keynes on economic development and Galbraith's 'affluent society' theory, in the aspect which deals with the poor state of public infrastructures). My theoretical approach is based on the Schumpeterian microeconomics, which is dynamic and endogenous, and Keynesian macroeconomics, which is static and exogenous. I believe Keynesian teaching may support the Schumpeterian theory of capitalist capacity to develop new technology via innovative investments. However, it is also important to consider the differing views of Schumpeter and Keynes. While projecting the dynamics of capitalism, Schumpeter seems to have been motivated primarily by a desire to discredit Keynes-Hansen's view of market saturation and to downgrade the role of non-state investment opportunities. In his view, only exogenous forces (e.g. government expenditures) are capable of pulling the economy out of crisis. At odds with the neo-classical view of the consumer as sovereign, Schumpeter drew attention to the significance of development as being endogenously generated by permanent 'innovative' monopolists, where profits boost incentives and technological change thereby allows capitalism to overcome the crisis.
Schumpeter has also made the most convincing argument for the adoption of new technologies. He worked out a theory of economic growth as a cyclical process which fluctuates around growth of innovation and new methods of production which, in turn, spread throughout the economy. An economy without innovation would fall in a situation of zero net growth characterized by a zero interest rate and inflation. It needs noting that Schumpeter also believed that a capitalistic society is doomed because of growing social contradictions, despite the continuous capitalist drive towards industrialization and innovation. This theory is different from Marx's theory of economic decline of capitalism. According to Schumpeter, innovative competition among capitalists has to be tense and allow them to adopt new technologies and new products, to upgrade manufactured goods that are more affected by international competitiveness, and to increase industrial production and R&D expenditures.
In my view, it is essential for transition countries to fully exploit any underutilized inputs and at the same time continuously improve the efficiency of production. However, because land and labour have very limited potential for boosting GDP growth, the role of capital and achievement of higher production efficiency becomes extremely important. In other words, increased volumes of capital invested in new technology, education and infrastracture may bring rapid GDP growth rates. With the increased competition, on domestic and international markets, as well as in basic and financial services, and in areas which have been privatised, technological advancements may present transition economies with a good chance of becoming more competitive and, therefore, more attractive to foreign investors. The spread of information technologies also makes it significantly easier for foreign companies to relocate part of production or even some of their office functions in lower cost areas, provided that the latter have "attractive" geographical position, labour market and investment climate. This factor has pushed many Eastern European leaders to lift state controls over labour markets and price systems, and to initiate massive restructuring of low-return state enterprises. Deregulation of former command economies was carried out through staging selling-off progammes such as the voucher-based privatisation in Lithuania. These policies were based on a premise that the economy could be channelled onto a faster growth path by the removal of all existing microeconomic and macroeconomic deficiencies. However, as a result of these policies the labour market became greatly strained by the growing rate of unemployment. The service sector was particularly affected by this process. It took time before new job openings could start to fill the gap in job vacancies. In the early 1990s this gap was growing rapidly in all Eastern European countries as a result of the continuous the decline of the state sector in the economy which was followed by significant falls in the GDP in many transition states. However, by the mid-1990s earlier reform attempts started to pay off with in some Central European countries which are now showing a sustained economic growth performance.
Despite some positive signs, the sustainability of the recovery and its tempo remain uncertain and fragile. This fact is causing concern about the prospects for the conduct of tight fiscal policy. In many transition states governments are aiming at stabilising of the absolute stock of public debt (i.e., by keeping deficit down to 0% of GDP) instead of stabilising of its relative level (i.e., the ratio of debt to GDP). Very few explanations were given how and why this goal was set up. Moreover, the possibilities of expanding fiscal policy raise certain questions about whether there is still a place for austerity in fiscal policies. Our combination of Keynes and Schumpeter to form a single 'active fiscal policy'(Sergi, 1997), revives an old debate about the role and place of budget deficit in stimulating of economic growth, and whether current public finances may continue to be explicitly supportive of recovery for some time to come.
Furthermore, central banks tend to become nervous when governments talk about confronting unemployment and entering into negotiations with trade unions. Central bankers demand a rigid mix of expenditure cuts and tax increases because they are sensitive to the danger that deficit spending may have on the level of debt and some crowding-out effects on private investment. Many policy-makers, too, are hostile to the idea of public deficit, without considering what the impact of a less rigid fiscal policy could be. In a continuing phase of economic transition, any consideration of the question of whether an increase in public sector borrowing would be harmful or not should take into account many domestic factors, as well as international competitiveness, rather than simply applying a single economic theory which says that prior deficit is always a government handicap no matter what its level, purposes or links to debt are.
In this situation the second source of investment, that we mentioned earlier, becomes increasingly important. It is based on a simple principle: a government is permitted (through a constitutional law) to set the level of deficit above zero percent but at the same time keeping a constant debt to GDP ratio. In other words, the government may run a deficit, but in doing so it has to prevent the ratio of debt to GDP from rising above a certain level which is considered optimal from a long-term viewpoint. It remains to be seen whether a policy of 'active deficit' (Sergi, 1997) is compatible with a policy oriented towards stabilisation of the degree of indebtedness. It will also be important to quantify a 'k-active deficit-rule', that is when Keynesian public expenditures and losses of revenue should sum up to sustainable 'equilibria deficits' as defined below:
| National Income Growth | ||
|---|---|---|
| Debt to GDP | 5% | 10% |
| 10% | 0.47% | 0.90% |
| 50% | 2.38% | 4.54% |
Let us suppose that a country starts from a 10% level of indebtedness and records a 10% increase in nominal income while policy-makers consider optimal to maintain the current debt/GDP ratio. This will render a deficit as high as 0.90% of GDP sustainable. In the event of a debt/GDP ratio of 50% and under the same nominal income growth hypothesis (10%) the deficit of equilibrium will be as high as 4.54%. Currently many Central and Eastern European countries show low domestic public debt compared with western standards, and high nominal GDP growth rates, which means that in these countries a manouevring space for pursuing a policy of 'active deficit' does really exist.
Since the main aim for maintaining sound public finances is to keep a sustainable and constant level of domestic indebtedness, it is therefore possible to ease the fiscal squeeze to a certain degree while keeping the level of debt stable. A way to judge the proposed deficit policy rule is to analyse the following scheme, which could clarify what might actually happen under a traditional Keynesian policy and in the case if our suggested policy rule is applied:
Keynes: deficit (temporary intervention through government expenditures) increase in aggregate demand - more income - increase in fiscal revenues - contraction of previous deficit and falling degree of debt/GDP ratio
My view: deficit (permanent intervention through oriented tax policy, FDI, government demand, subsidised interest rates for selected investment) - both increase in aggregate demand and improvement in the supply side - more income - increase in fiscal revenues - periodical resetting of deficit burden towards a constant debt/GDP ratio
In the Keynesian model the deficit spending becomes the only policy prescription when the economy falls into an equilibrium of unemployment. This is in contrast to the disequilibrium unemployment of classical economists, where real wages fall quickly in order to restore full employment. In the case of Eastern Europe, a classical approach would mean bringing labour demand and supply into equilibrium. However, this would not work because the level of real remuneration is already too low.
Keynes regarded the accumulation of additional debt used to pump demand as having a short-term effect, because the additional revenue that will come from an expected higher GDP will have to be used to pay off the previously created debt rather than to finance additional spending. According to our approach, even if the additional spending is used only on highly profitable government and private projects, the deficit will certainly raise the overall level of debt both in the short and in the long run. But this should not be viewed as a major obstacle because, according to our approach, the level of deficit should be quantified each year leaving the debt/GDP ratio unchanged. (Note that in the Keynesian model this ratio should fall over time and finally should come to a zero level.)
There are also common fears that higher deficits would give rise to economic deficiencies and distortions. However, while not all of public interventions produce deficiencies and distortions, I would like to stress that the policy suggested by us does not imply a 'compulsory upturn in public expenditures'; a constant debt/GDP ratio may also be achieved through keeping lower levels of budgetary revenues while giving certain incentives, like tax breaks, to domestic or foreign private investors. Therefore, state policies in countries of transition do not necessarily have to be overtly dependent on an increase in aggregate demand in order to accelerate growth, as is the case in the Keynesian model.
In my view, policy-makers in Eastern Europe have to choose case by case whether to pump additional demand into the market through deficit spending or whether to give out other additional incentives aimed at boosting economic performance through other means, e.g. revenue losses. Our idea is that any public intervention of this kind should create the necessary conditions for accelerating GDP growth by means of developing the supply side of the national economy on the basis of low inflation.
It is true that government spending may provoke a crowding-out effect on private investments. But, this effect can be overcome as the economy develops a Keynesian multiplier income mechanism or a Kaldorian mechanism of change in distribution of income and, ultimately, savings.
To summarise, we suggest that, in contradiction to the Keynesian model, government policies do not have merely to spread aggregate demand through state interventions in order to boost growth. In our view, the successful transition from command to market economies in Eastern Europe should rest upon a combination of sound policies aimed at stimulation of a positive supply response (Sergi, 1997) with low inflation risks. Thus, transformation of Eastern European economies might be accelerated through pumping additional government resources into the demand side (e.g., infrastructure) as well as by taxation incentives. Public intervention based upon this policy of 'active deficit' should also stimulate growth in the supply side of the economy in a low inflation framework.
To ensure a continuous flow of foreign investment it is essential that East European economies are able to offer to foreign investors an efficient infrastructural support which is also enhanced by a stable business environment. While many countries in Eastern Europe can offer one of the lowest wage costs to prospective investors, the low level of development of their infrastructure often plays a negative role in attracting FDI.
In my view, the major causes of inflation are growth of wages and import prices, and shortages on the supply side. It is also important to note that inflation in Eastern Europe as measured by the consumer price index may overstate the real power loss of the domestic currency because it may fail to account for an improvement in the commodity supply.
This funding should be accompanied by transformation of banking and other sectors of the transition economies. For instance, the level of bad debts in the hands of the banking sector is as high as 20% of their total assets which often hampers overall economic performance. It is also possible to significantly improve the level of productivity in many other sectors through investment in human resources, telecommunications, high technologies, financial infrastructures, etc. Current levels of investment in these areas in Central and East Europe are simply not comparable to their strong neighbouring markets. The state support should be selective and targetted towards special, 'sensitive' sectors and may come through special tax treatment and subsidised interest rates, or even by means of government-initiated demand where necessary.
My first argument is that transition economies may reach a higher level of income while maintaining low inflation rates only if they reorient their investment strategies towards production of new goods and technologies. The latter gives these countries a chance to raise productivity to a level comparable to that in the developed economies. Land or labour supply give them very little room for improvement.
Secondly, I argue that for any such policy to be economically viable it should make a full use of existing investment opportunities at home, as well as it should rely on foreign capital. And, thirdly, it is important to keep in mind that the current domestic debt in most of Eastern European states is low by any standard. Nominal GDP growth is sizeable while through applying a simple algebraic calculus, there is definitely some room for budget easing. In my view this recommended policy may also interpreted as a re-formulation of the Keynesian model of deficit spending in the light of Schumpeterian interpretations of economic growth and the modern affluent society of Galbraith.
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