Regional inequalities and tools for development and "catching-up"

László Andor is an associate professor at the Budapest University of Economic Sciences and Public Administration. This article is adapted from a paper he presented to the Summer School on the Enlargement of the European Union organised by the French foundation “Confrontation” in Budapest, June 27-28, 2002.

Introduction

Finance and labour are not unrelated issues of the economy. Business in a modern market economy means a combination of various factors of production, and particularly labour and capital. Development, however, is an uneven process, and the market system produces areas with capital shortages and areas with labour shortages. In such cases of regional imbalance, one of the two factors must move in order to facilitate economic progress.            

In terms of regional development, the movement of capital plays a much greater role than the movement of labour. The flow of labour is a solution for individuals and their families, but it does not improve the chances for development in the region with labour surplus. The impact of capital import is not comparable to labour outflow, which can even undermine attempts by an underdeveloped region to catch up.              

In the EU context, much has been said about the obstacles to labour mobility but, from the considerations above, we must say the problems with capital mobility are much greater. The transition in the East has displayed a typical market failure. In a period of transformation, crisis, major imbalance and lack of transparency, capital is reluctant to move, and capitalists are reluctant to invest. Hence, there is a need for government intervention and financial innovation in order to generate economic growth.

Finance

When the Berlin Wall was just about to fall, the West (i.e. the European Community  and the US) immediately recognised that financial innovation is essential for the proper treatment of post-communist countries. This recognition resulted in the establishment of the European Bank for Reconstruction and Development (EBRD) as early as 1990. Jacques Attali, advisor for Francois Mitterrand, the Socialist President of France, was father of the project, and became first head of the new international institution. In the early period of the market transition, EBRD supported East-Central Europe's attempts to adjust to the new environment. After a few years, EBRD went further East to find new and deserving clients. However, the problems were not over so quickly in East-Central Europe. The Cold War was followed by a Cold Peace, when political friendship was accompanied with extreme economic rigour.                

The economic consequences of the Cold War and the Cold Peace remained with us much longer than expected by most experts in the early 1990s. We have no reason to be triumphant more than ten years after the transition began. The level of GDP has just reached the 1989 level in the year 2000 in Hungary, and only Poland displayed a faster relative growth rate in the region throughout the 1990s. Until the very end of the 1990s, living standards declined for the majority of the population of East-Central Europe.

Having seen the disappointing consequences of transition in progress, the debate as to whether there should be a new 'Marshall Plan' emerged time after time. The official response arrived on the 50^th anniversary of the original Marshall Plan from President Bill Clinton. He said: “No, foreign private investment does the job.” The problem, however, is that foreign private investment does not necessarily contribute to the catching-up process in the long-run, and it rather deepens regional inequalities (see Hungary and Poland in the recent decade). There is no strong correlation between the amount of foreign capital import and GDP growth in a given country.

For successful catching-up patterns, we have to look to East Asia, where the market system developed on the basis of a model that gave a significant role to special financial arrangements under public control. One can even claim that only favourable public finance can give hope for underdeveloped regions, though even that is clearly no guarantee, and mobilise domestic capital for a successful period of catching-up. The example of certain East-Asian countries, such as Japan and more recently South-Korea and Taiwan, clearly supports this argument.

The East-Asian experience showed that state-owned development banks are essential instruments of national development and catching-up (particularly, but not exclusively, in developing infrastructure). True, these institutions raise the risk of corruption, and not only in East-Asia. The fundamental question is whether development banks function under the guidelines of national development plans, which is a new endeavour in Hungary after more than ten years of economic transition.

Money

In the wake of the economic transformation, currency devaluation has been a main source of economic competitiveness in the countries of East-Central Europe. It should not be any longer, and it cannot be any longer, particularly after we join the EMU. Stabilising the exchange rate is already a general purpose of economic policies in the region. We have to understand, however, that monetary convergence is taking place in a period when the framework of economic policy is being rearranged in other areas too. Abolishing hitherto existing tax benefits simultaneously with real appreciation of currencies can cause a major problem in the near future, and lead to a crisis of disinvestment in the accession countries.              

The timing and arrangement of EMU accession is therefore a vital issue for economic competitiveness in the new Eastern members of the Union. Exchange rates can be mismanaged, as in Poland and Hungary, by the endeavour to produce impressive inflation rates. At the same time they may undermine international competitiveness. These risks of destabilisation demand special monetary arrangements for the Eastern zone. A carefully designed and operated ERM-II is clearly in the interest of a future Eastern zone, and it could as well be implemented before EU accession takes place. (The point is to provide  assistance to exchange rate stability for countries dependent on EU trade.)

Another hard job for the new member states is to meet the Maastricht criteria. When convergence began in the West, cohesion funds were introduced for peripheral countries in order to allow them to continue economic growth and retain the chance of catching up. Those countries were actually in much better shape than the Eastern newcomers are at the moment. The special needs of the East must therefore be appreciated if convergence is meant to be a complex process beyond law and finance. Pushing up the total sums of aid is not the only solution of this equation. One can easily imagine that the EU would create a more favourable set of conditions by lowering the rate of domestic contribution to financing projects with EU subsidies.

Conclusion

Financial innovation and special monetary arrangements continue to be important ingredients of economic development, and they are vital for the catching-up process of East-Central Europe. Eventually a larger EU budget must be created to hold a diverse union together. We are obviously aware of the political obstacles to any budget increase in the EU, but we also have to be aware of the economic necessity of creating a larger EU budget after a single market and a single currency have been introduced. The EU has been very successful in striking a balance between economic necessity and political obstacles in the past, so it will surely manage this in the future as well. In order to guide concessional finance, a European investment policy must be developed. To a large extent this is already part of the European model, and it should be strengthened deliberately. Europe cannot base its future on convergence to the American model of capitalism. Labour mobility will never be so high in Europe as it is in the US. Consequently, capital must be made more mobile and more responsible than it is in the United States of America.

László Andor is author of Market Failure (Pluto Press, 1999)