• Transformation of the Czech Republic: New Challenges and Problems

  • By Ilona Svihlikova | 17 Mar 16 | Posted under: Central and Eastern Europe , Czech Republic
  • The transformation process in the Czech Republic is a complex combination of economic and political dynamics. It represents the same logic that has underlain similar post-1989 processes in other countries of Central and Eastern Europe (CEE). We will first briefly summarise the parameters and failures of state socialism, which constituted the initial conditions of the transformation process. We then consider the form of capitalism (or ‘market economy’, the preferred term) that the states of Central and Eastern Europe took over, which had several stages; we have had to limit our focus to certain aspects such as privatisation and the exchange-rate mechanism. Finally, we look at current problems whose essence is an outdated economic model represented by a form of the middle-income trap. The consequences of the transformation process of CEE countries are an issue of course not only for them but for the entire EU. As we will show, in some cases these countries served as guinea pigs, especially in destroying the welfare state.

    The failures of state socialism

    There is no consensus on what to call the economic system that prevailed in CEE countries from the 1950s. The economic and political systems were intertwined because the ruling (communist) parties exercised decisive control not only of the political but also of the economic sphere. The economic system was based on central planning and state-owned enterprises. The signalling role of prices was blocked, and prices were artificially created by the central institutions. Very important quantitative indicators contributed to a lag, especially since the 1970s. State socialism proved to be effective when it came to mobilising resources (for example, in infrastructure projects and heavy industry), but incapable of ‘switching’ to quality, especially in the consumer goods sector. Quantitative indicators made it possible to count the macroeconomic aggregates in tons of coal and steel, but they could not grasp technological improvement, which in the end proved fatal for the system.1

    In Czechoslovakia, there were several features of state socialism that are important for understanding the transformation process. From a political point of view, the failed attempt to modernise state socialism through the socalled Prague Spring (violently terminated by Soviet military intervention in 1968), ended with the hard conservative wing of the Communist Party coming to power. Later, as the system collapsed, the governments of neighbouring Poland and Hungary had already initiated talks with the opposition or launched their own (mostly unsuccessful) reform efforts.

    The situation in Czechoslovakia was very different, as there was strong resistance to the Gorbachev-led reforms (perestroika). At the end of the 1980s, the Czechoslovak regime remained ‘tough’, which it could do in part because of the healthy state of the economy – relative, that is, to other CEE countries. The internal and external imbalances were relatively small, in contrast to indebted Poland and Hungary. The economic structure was oriented to heavy industry (hence the role of quantitative indicators for controlling the economy), while the service sector was small. Of all CEE countries, Czechoslovakia had the best starting position when entering the transformation process. However, this advantage was, as we will see later, mostly squandered by many failures, especially those resulting from the application of a neoliberal model of capitalism.

    The beginning of transformation

    Understanding the transformation process and its consequences requires an understanding first of all of domestic conditions and second of the ‘external’ environment. It is essential to realise that CEE countries began their reintegration into the world economy under the influence, and sometimes under the domination, of the IMF. It was the IMF and the World Bank that created a ‘manual’ of the ‘perfect model’ for CEE countries to follow in the form of the Washington Consensus. In Czechoslovakia, as in other countries (for example, Russia as an extreme case), the paradigm was neoliberal capitalism, and the Washington Consensus served as the guideline in realising it. There were countries that tried to find their own way (Slovenia, and in part Hungary); however, in most cases the Washington Consensus prevailed, sometimes with Jeffrey Sachs’s personal intervention. Its policy recommendations are usually summarised as ‘liberalisation, privatisation, and deregulation’. In addition, it meant a deeply depreciated exchange rate that led to de facto price competition and retarded the efforts to restructure the economy. In all transformation efforts, great emphasis was placed on speed, echoing Jeffrey Sachs’s ‘leap into the market economy’, where

    institutional conditions or path-dependency specifics were completely ignored. Oversimplified economics ruled the day and the general belief was that transformation could easily be accomplished in only a few years. It should be noted, however, that in Czechoslovakia the word ‘capitalism’ was almost never used, and even the most right-wing neoliberals used the term ‘market economy without adjectives’. The domination of the Washington Consensus meant contempt for the welfare state, or the state as such. With the rhetoric of ‘the market will solve everything’, private property and curtailed state influence were turning Czechoslovakia into a capitalist state.

    Yet almost no one had had any real experience with the workings of a capitalist economy. The process was seen as one that simply followed the textbook models. The exchange rate of the Czech koruna (CZK) played a very important role. The koruna was sharply devalued, in accordance with the IMF’s prescriptions. The exchange rate was fixed and its importance for the transformation process was shown by the fact that it served as a so-called nominal anchor.

    To this day, the impact has been profound. It meant first that Czechoslovakia became artificially cheap. Companies were not motivated to restructure their production, as they could continue to export simple products with minimal value added and survive. At the beginning of the 1990s, many Czech factories survived on cheap labour, importing raw materials, doing simple processing, and re-exporting the product. The main characteristics of this type of integration into the world economy was the minimal value added and dependence on a weak exchange rate, thus confirming cheap labour as one of the main characteristics of this economic model. Czechoslovakia started to compete on the world market with developing countries because the devalued currency made necessary modernisation imports (machinery and technology) too expensive. Another factor in this development was the breakup of Comecon (Council for Mutual Economic Assistance). The Comecon countries constituted the bulk of Czechoslovakia’s export markets. Even in the era of state socialism, Czechoslovakia was a rather open economy and one of the most developed and industrialised within Comecon. The sudden loss of Comecon markets led the enterprises to search for new, western markets but under very different conditions. Many of them survived only as cheap subcontractors. At the beginning of the transformation process, the role of the state, for example in export promotion or even in economic diplomacy as such, was disdained and ridiculed. The experience of European Western countries was ignored and the textbook models applied.

    Privatisation was another key element of transformation. It was not clear what exactly was to be privatised or what was be maintained under state control. However, speed was the paramount criterion. Privatisation was to be rapid, in disregard of the need for a proper legal and institutional framework. Two notorious phrases are associated with Czech privatisations: first, ‘there is no dirty money’, and, second, ‘economists have to be faster than lawyers’. These two assertions reflect the social atmosphere in which the bulk of national wealth was privatised. From the beginning, privatisation was viewed as a goal in itself, not a means of creating a well-functioning economy. Later, the method and its application was sharply criticised by Joseph Stiglitz, but by then it was too late. The adopted method (in most cases) was privatisation by vouchers. This was justified as a way of establishing a ‘people’s capitalism’ in which every citizen would become a shareholder. But this naive idea did not last long. The privatisation (financial) funds were quickly introduced and gained popularity through slogans such as ‘you get ten times more than you invested’. Lack of experience with capitalism led people to misunderstand that this really meant the selling off of state property at a price at least ten times less than the real price.2 Privatisation of this kind, advocated by the World Bank at the time, created a deformed environment in which it was more advantageous to sell property and machines and cash in fast rather than really try to modernise the companies. The term ‘asset-stripping’ (in Czech ‘tunelování’) later gained currency in describing the privatisation process. Many companies with traditional brands were destroyed and disappeared. Altogether, the government’s slogan ‘get rich fast, no matter how’ was a clear incentive for opportunistic, in many cases criminal, behaviour that created a wealthy class connected to right-wing parties. Despite the radical neoliberal orientation, the right-wing governments leading the transformation process were cautious about privatising the banking sector. Most banks were under state control, which in the end created a perverse situation when companies were privatised and then kept alive by bank credits, that is, by the state itself. The performance of privatised enterprises was tragic, and was worse than that of all other categories. As the results of the privatisation process, with few exceptions, were quite negative, the banks began to pile up bad loans. A crisis was thus inevitable.3

    In general, the transformation process presided over by right-wing neoliberals had different impact in the Czech and Slovak parts of the country. In the 1992 election, the more developed and industrialised Czech population voted for right-wing reforms and belt-tightening, while the Slovak part of the federation was characterised by social problems and the general feeling that the harsh reforms were unbearable. In the end, a peaceful breakup of the federation was agreed on. Since 1993, there has been an independent Czech Republic and an independent Slovak Republic.

    Thus, one of the consequences of the transformation process was the end of Czechoslovakia, a state that had existed since 1918.

    Transformation crisis and solutions

    The period shortly after the inception of the transformation reforms is generally known as the transformation crisis. In many CEE countries it consisted of deep economic depression, inflation, and unemployment. In the Czech Republic there was no such ‘drama’ at the beginning; it came later and reflected all the failures of the process.

    The first sign of imbalances was the deterioration of the balance of payments. Large current account deficits showed that the exchange rate was misconceived and only contributed to large inflows of speculative capital. This hot money was encouraged by the positive interest rate difference, with the Czech Central Bank facing ever more difficulties in handling this inflow. The situation culminated in a modest financial crisis in 1997, in which the fixed exchange rate was abandoned. At the same time, austerity was implemented. It was mistakenly supposed that demand was too high and that more ‘belt-tightening’ was needed. However, the problem was exactly the opposite: supply was inefficient because of the failed transformation process. The next blow to the economy came in the form of a banking sector collapse. The volume of bad loans became critical, and the state had to intervene and bail out the banks.

    The biggest wave of banking problems occurred at the end of the 1990s when the social democratic party was in power. Its attitude toward the economy was rooted in a deep criticism of the privatisation process. Its response was to solve the problems of the Czech economy by selling banks and other enterprises to foreign companies. The next element of its economic strategy was the great emphasis placed on economic diplomacy, which also meant an incentive system to attract foreign direct investment to the country. It has to be borne in mind that the first years of the transformation process were connected, although not explicitly, to the objective of creating national capitalism. As the process failed, the social democrats turned for help abroad. This was in part because they were not popular with the newly created wealthy elite and were consequently looking for a ‘counterweight’ to hostile domestic economic forces. The investment incentive attracted a lot of direct investment, often in the form of assembly lines, taking advantage of cheap skilled labour with a long industrial tradition. The accession to the EU in 2004 accented these tendencies, and the Czech Republic consolidated its role as a subcontractor country, for the most part connected to Germany. Not only did companies considered to be national assets end up in foreign

    hands (for example, the Pilsner Urquell brewery), but all of the banking and retail sectors, etc. did as well. Even infrastructure (for example, water pipelines) was privatised and sold to foreign owners; this was tantamount to giving away a rent. The failed privatisation and economic policy as such created a combination of weak currency, cheap labour, low to medium value added in the economy, and an overall dependent economy that can only be called, quite simply, a colony.

    The current economic situation

    Before analysing the current situation, a few important moments should be briefly mentioned. EU accession in 2004 deepened the Czech Republic’s orientation towards European countries. This was reflected in investment inflows, but especially in trade. The balance of trade started to show tendencies to surpluses.

    Economic policy went through different stages partly depending on which parties were in power. A decisive moment was the period of rightwing governments beginning in 2006 after the period of social democratic governance. Their policy orientation was austerity and the privatisation of the remaining public services (for example, the pension system). One of their main political successes was making debt the top economic issue. Their 2010 election victory occurred in an atmosphere in which a dramatic reduction of government debt was assumed to be urgently necessary, otherwise ‘the Czech Republic will end up like Greece’. The absurdity of such a policy goal was obvious since the Czech sovereign debt was among the lowest in the EU. But despite the evident reality, the hysterical fear of state bankruptcy led to severe austerity measures that halted the Czech Republic’s adaptation to the EU average, resulting in increased poverty and insecurity in the society, with the economy entering prolonged and repeated stagnation.

    What is the current state of the Czech economy? A glance at its structural (not cyclical) features reveals that the ‘Czech’ economy is not very Czech, with companies under foreign control representing more than 40 per cent of total production. This trend is especially evident in the financial sector, where foreign banks (mother companies) control 97 per cent. Czech subsidiaries act mostly as price-takers. Since they are dependent on the decision of the mother companies, their ability to set price or other strategic elements of development is either non-existent or very limited.4 Other elements of the Czech economic model are logically related to this ownership structure. Production mostly involves processing, which means it is import-intensive.

    Another feature that clearly shows the unsustainability of the Czech Republic’s economic development is the outflow of dividends from the country. It is clear that in the life cycle of an investment foreign companies start to withdraw profits when the investment is ‘mature’. Since 2006 the outflow of profits has been higher than reinvested earnings. The situation is worsening every year, and by 2014 the Czech economy experienced a record outflow of 219 billion CZK. As the Czech Statistical Office affirms, the official numbers are underestimated, as there are many creative methods foreign companies use to draw resources out of the country. These channels include overpriced services provided by the mother company (‘consultation fees’, IT services, etc.), and the extension of credits.

    From the macroeconomic point of view, this means that there is a huge difference between GDP and GNI. Because GDP is the index most often used, it distorts the economic reality of the Czech Republic. The level of profit outflow is one of the highest in the whole EU. This of course also means that the resources that leave the country are not available for investment or wage increases. The result is a perfect vicious circle that can be broken only by systemic, long-term government policy.

    The economic model is therefore that of a dependent country, or colony. This is also seen in wages and the overall standard of living. Compared with Germany, the wage level (counted in purchasing power parity) is 40 per cent of the average German level. However, the economic level (GDP) of the Czech Republic is about two thirds (66 per cent) of Germany’s level. The difference of 26 percentage points is huge. A part of the explanation lies in the flow of profits out of the country. Low wage levels make issues like working poverty important, and the policy of right-wing governments has played an important role here. By EU standards, the minimum wage is very low; the current government has started to raise it gradually. But the Czech Republic’s minimum wage in relation to the median wage remains the lowest in the whole EU. This is also confirmed by OECD research, which shows that single Czech parents have to work more hours (79) a week to get above the poverty threshold than do their counterparts elsewhere in the EU. Working poverty describes the condition of about a quarter of working women.

    In analysing poverty, former right-wing governments have normally attempted to disregard the issue by using indicators such as the Gini Coefficient that shows very little inequality or material deprivation, etc. It is true that in many indicators of this kind, the Czech Republic occupies one of the best positions in the EU. However, these simplistic interpretations are seriously flawed. First of all, from a methodological point of view, the Czech Trade Unions’ research has shown that the numbers of the poor are widely underestimated, as many households are left out of the research.5 These excluded households include people living in welfare institutions like social hostels, as well as homeless people. Social stability is indeed very fragile, as recent statistical research has confirmed that a significant proportion of households lies just above the threshold, a level that includes many households. One hundred koruna, which is not even four euros, is considered enough to classify a household as being officially above the poverty line.6

    In terms of the fiscal situation, the debt level of the Czech Republic is, as already mentioned, one of the lowest in the whole EU. However, the austerity policy carried out by the right-wing governments that made debt, especially sovereign debt, the main issue succeeded in nearly dismantling the state as such. Outsourcing and privatisation tendencies were so extreme that a situation of state capture resulted. By the time the right-wing governments got through with it, the state was no longer able to operate basic systems, such as car registration, or ensure the continued operation of job centres. The current government therefore aims to make the state functional again and at least to diminish the rent-seeking that has spread to all levels of public administration.

    In terms of economic policy, the Czech Central bank has decided to intervene and artificially depreciate the koruna to 27 CZK to the euro and fix it at that level. The stated purpose of this move is to combat deflation and provide an incentive that can boost the economy. It is doubtful that the move will have either of these effects, but the Central Bank (which is independent, though heavily criticised by all sides for this depreciation) announced that this is its long-term policy. This is not the exchange rate that purchasing power parity would determine, which would be about 21 CZK to the euro. The policy further consolidates the role of the Czech Republic as a cheap assembly factory and distorts its convergence with more developed countries. It evidences not only a counterproductive monetary policy, but also the scant capacity of policy makers to change the Czech Republic’s position in the world division of labour.

    Conclusion: The middle income trap of the Czech Republic

    To sum up, the Czech Republic got caught in a special form of middleincome trap. The situation of a dependent economy is nothing new in economic theory, but it poses a huge challenge for economic policy. The first positive signs of a recognition of the problem have come from the government office that published an analysis entitled Outflow of Profits as a Symptom of a Worn-Out Economic Model. Although, finally after many years, this is one of the genuine research papers to come from a government institution, its recommendations are not reflected in practical economic policy. Aside from gradual increases in the minimum wage, the current economic policy is anything but progressive; for example, a financial constitution has been adopted that contains a counterproductive pro-cyclical policy, and support has been given to investments like Amazon (which is notorious for its horrible working conditions), or coal extraction and the construction of more nuclear plants have been contemplated. Solutions for changing the current unfavourable economic situation have met with resistance from milieus connected to foreign investment, but also from political representation as such. The low level of the Czech Republic’s elites is seen in their unwillingness to change much so as not to appear radical. It is much more convenient for them to tell the public that changes are impossible and that certain measures have to be enacted (because Brussels requires them) than to try and implement a new economic model.

    In sum, Czechoslovakia and then the Czech Republic had favourable initial conditions reflected in low imbalances, including a low level of debt and a comparatively developed economic structure. These conditions, however, were squandered by a failed economic policy that resulted in domination by foreign companies.

    In addition, the policy space for independent decision-making is limited and so there are real limits to convergence, as UNCTAD has analysed in detail.7 The needs of economies trying to catch up are different from those of economies seeking to maintain their position, with the head start they have. In the EU, there are many policies that limit the scope for economic manoeuvring, the most notorious of which is of course the current form of monetary union.

    At the beginning of the transformation, CEE countries served as an experimental laboratory for neoliberal policy, as Greece does now. Later they developed into sites for cheap labour as dependent economies that suffer from an outflow of profits, disproportionately low wages, and low to middle value-added production fixed by the state. For western companies, CEE countries served as a lever to sink wages and lower social standards in their home countries.

    The position of the Czech Republic reflects the current power arrangement in the world capitalist economy, in which many advanced countries are pursuing a policy to limit the possibilities of convergence for transforming or emerging countries and adjustment costs are shifted to workers and the low and middle income classes.

     

    Literature

    Myant, Martin/Drahokoupil, Jan, Tranzitivni ekonomiky. Politicka ekonomie Ruska, vychodni Evropy a středni Asie, Prague, 2013.

    Myant, Martin, Vzestup a pad českeho kapitalismu. Ekonomicky vyvoj Česke republiky od roku 1989, Prague, 2013.

    Pick, Miloš, Stat blahobytu, nebo kapitalismus? My a svět v eře neoliberalismu 1989-2009, Všeň, 2009.

    Popelková, Hana, Vyvoj chudoby v ČR, ČMKOS, Prague, 2014.

    Stiglitz, Joseph E., Globalization and Its Discontents, New York: W. W. Norton, 2002.

    Švihlíková, Ilona/Zechowska, Sylwia/Terem, Peter, Political and economic features of transformation processes in the Czech Republic, Poland and Hungary, Prague, 2013.

    Šmíd, Radek, Lojka, Juraj, “Kdo tahá za nitky české ekonomiky?”, Statistika a my, 03 (2015), pp. 21-24.

    Šustová, Šárka, “Jak se měří materiální deprivace”. Statistika a my, 03 (2015), http://www.statistikaamy.cz/2015/03/jak-se-meri-materialni-deprivace/ (accessed 14 September 2015).

    UNCTAD, Trade and Development Report (2014).

     

    Notes

    1. Martin Myant and Jan Drahokoupil, Tranzitivni ekonomiky. Politicka ekonomie Ruska, vychodni Evropy a středni Asie, Prague, 2013.

    2. Miloš Pick, the late well-known Czech economist, estimated that with seven million citizens participating in the privatisation through vouchers (totalling 70 billion CZK) the real value of the assets was 240 billion CZK. ‘Selling off’ is thus an apt characterisation of the reality.

    3. For more on the consequences of privatisation, see Miloš Pick, Stat blahobytu, nebo kapitalismus? My a svět v eře neoliberalismu 1989-2009, Všeň, 2009.

    4. See the Czech Statistical Office’s analysis: Radek Šmíd and Juraj Lojka, ‘Kdo tahá za nitky české ekonomiky?’, Statistika a my, 03 (2015), pp. 21-24.

    5. Hana Popelková, Vyvoj chudoby v ČR, Prague, 2014.

    6. Šárka Šustová, ‘Jak se měří materiální deprivace’, Statistika a my, 03 (2015), http://www.statistikaamy.cz/2015/03/jak-se-meri-materialni-deprivace/ (accessed 14 September 2015).

    7. UNCTAD: Trade and Development Report, 2014.


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