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The Czech Economy and Its Ten Years of Transition

English Pages, 12. 3. 1999

Discussing Czech Republic (and implicitly Central and Eastern Europe) in the spring of 1999, it seems appropriate to mention both the non-negligible and undeniable positive results which have been achieved during the last nine years, and the not less undeniable problems connected with such a unique historical manouvre – with the transition from communism to free society.

At the beginning, nine years ago, practically in all the countries in question, fundamental systemic reforms were initiated and, in the meantime, have been partly realized. The transformation activity was directed to the following basic tasks:

- to liberalize (trade, investment and prices);

- to deregulate (markets);

- to privatize (state property)
as fast and as comprehensively as possible. I have been always adding to it the supplementary condition to pursue sufficiently cautious macroeconomic policies. At least some of us were aware of the fact that to loosen fiscal and monetary controls, when economic imbalances, inherited from the communist past, dominated the macroeconomy, would have been destabilising and would have led us into what I used to call the reform trap.

We knew as well that there had to be a parallel evolution of the appropriate institutional infrastructure which – when in a functioning form – minimizes the inevitable transformation costs and makes the market economy efficient and “just”, but this evolution was not – for many understandable reasons – achievable as fast as the liberalization and deregulation processes.

With the benefit of hindsight, we know – that

- the institution–building takes years, if not decades, which is a totally different time–dimension than in the case of price or foreign trade liberalization;

- the role of the government was – after our communist experience – so discredited that nobody believed in its capacity to do a positive constructivistic activity (not to mention the fact that nobody possessed the knowledge how to do it);

- it was impossible to stop the spontaneous evolution of the market economy, to stop the spontaneity of behaviour of millions of market “players” and to wait for the emergence of a perfect market infrastructure. It can be done – perhaps – in a laboratory, not in a real world.

It is relevant to say that the whole transformation process started at a moment when the economic profession believed in several straightforward ideas:

- government failure is much bigger and much more dangerous than a market failure;

- fixed exchange rates represent a reliable and inevitable nominal anchor of any transition economy;

- privatization has almost no costs and can be achieved by means of standard procedures;

- politicians should be able to guarantee the optimal sequencing of reform measures, etc.

It seems to me that some of these ideas survived the decade but some of them do not belong among the most fashionable ideas of the profession now.

How to describe our experience?

In the first stage, the reforms “worked”. After a short and inevitable economic decline which lasted two-three years and represented the healthy shake-off of non-viable economic activities associated with the old economic system, the economy began to recover.

The rate of growth of GDP reached 4-6% range (in the four consecutive years in our case), investment ratio was extremely high, real wages and domestic spending visibly grew, imports skyrocketed, foreign capital inflows were very high (as a share of GDP).

I have to admit that I believed in the possibility of a longer continuation of a relatively smooth development. The experience of the last two years, let’s call them the second stage, tells us, however, that we underestimated the enormous vulnerability of such economy (and that we made some costly mistakes, especially in the field of monetary policy when we wanted to handle the increasing instability.). The Czech economy was – prior to the current open crisis – characterized

- by dangerously growing expectations of all economic agents (consumers as well as investors) and by our inability to slow them down;
- by an overinvestment (from the macroeconomic point of view), which led to investment-savings imbalance;

- by growing trade deficit which was followed by deficit in the balance of payments’ current account;

- by imperfections in the institutional framework, by weak regulation of monopolistic or otherwise non-perfect markets and by problems with law enforcement;

- by the disturbances connected with aggressive and merciless global capital markets, especially when they were confronted with weak domestic banking and financial intermediation;

- by an overreaction of the central bank which slowed down the economy much more than was necessary.

As a result of that, the second stage led to an economic slowdown and to a political crisis.

The extreme vulnerability of a small, open, transition economy is connected with the underlying structural factors, but the overrestrictive monetary policy started the domino effect which was the amplified by the fact that the markets became nervous about both the trade deficit and the strong currency. As a result of this triangle of reasons:

- objectively existing vulnerability of the economy;

- overrestrictive monetary policy;

- loss of confidence of markets;

- capital inflows stopped, interest rates rose, the economy slowed down, tax revenues declined, fiscal balance deteriorated, the state budget expenditures had to be dramatically cut, the economy slowed down even more, capital was pulled out of the country, the currency depreciated, some firms and banks got into troubles, the economy went into a very sluggish growth and finally to a decline. Everything was rather simple (and well-known).

The story could be presented in a more extensive version but the basic lesson is clear and straightforward. It was not identical in all emerging markets, but the most “clean” case happened perhaps– to my great regret – in the Czech Republic because of

- its higher degree of openess and deregulation;

- extensive, non-standard, domestic financial transactions connected with the Czech invention called voucher privatization;

- our problems with unexpectedly rapid emergence of capital markets and their regulation;

- its extremely high investment ratio (33% in 1996);

- 75 months of the stability of the nominal exchange rate which led to an enormous appreciation in real terms;

- grave mistakes in monetary policy introduced in the middle of 1996 and after;

- inability to guarantee political stability (which was very unusual between 1990 and 1996).

There is no doubt that we are slowly moving to the third stage. It will be characterized by consolidation and macroadjustment, by the residual privatization and by institutional maturing. It will be the period when the “first generation” reforms will be already only marginal (because they have been already done) and when the “second generation” reforms will be more radically realized. I have a moderate optimism in this respect, with two necessary qualifications:

1. I do not believe that the second stage could have been eliminated. I do not believe in the possibility of a smooth and stable transition path in politically and socially difficult, but highly democratic, pluralistic and open societies (and economies) as the Czech Republic. We are not in a “brave new world” of perfect markets and of perfect government. The unpleasant adjustment (or realingement) was necessary and I do not believe that the changes could have been made “voluntarily”, that they could have been intentionally “introduced” ex-ante. The adjustment had to be – in my opinion – involuntary and therefore, enforced by circumstances.

2. I agree with those economists who – now – keep stressing that “if nothing has been relearned in recent years, it is that laissez-faire does not work in banking” and in institution and legislation formation. This is true. But the second generation reforms will be less radical, less visible, less headlines-creating, less ideological, much slower, and much more influenced by lobbyism and rent-seeking, etc. They will be, therefore, connected with a serious danger which did not exist at the beginning: they may be used for the creeping change of the whole system from free society to interventionism, statism and neocorporativism.

It is our task to prevent it.

Václav Klaus, Notes for the speech at the Federation of Indian Chambers of Commerce, New Delhi, March 12, 1999.