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The Political Economy of
Financial Crisis in Central and Eastern Europe:
Poland and Hungary Compared
Mitchell A. Orenstein
Johns Hopkins University SAIS
[email protected]
Draft paper; comments welcome
September 2010
Introduction
Poland and Hungary belong to the dependent market economies (DMEs) of Central and Eastern
Europe (Nolke and Vliegenthart 2009; Bohle and Greskovits 2007; King and Sznajder 2006). These
highly open economies differ from developed Western states insofar as the primary nexus of
economic decision-making lies outside the country – typically with transnational corporations.
Foreign direct investment, rather than stock markets or bank-firm networks, provides the main form
of investment and many leading companies are wholly-owned subsidiaries of foreign firms, including
in the banking sector, which is majority owned by foreign banks (Epstein 2008). The dependent
market economies’ main source of competitive advantage is formed by a combination of low labor
costs and high skills, making these countries an attractive venue for manufacture and assembly of
relatively high-value consumer durables. The main governance challenges they face is to preserve
this cost advantage in the face of rapidly growing consumer demand and to manage the inflow of
capital, problems that intensified during the boom years of the mid-2000s. Not surprisingly, the
financial crisis of 2008-09 had a unique effect on these countries, highlighting their dependence on
foreign banking and financial flows.
Despite their similar varieties of capitalism, Poland and Hungary experienced the crisis very
differently. Poland was the only European Union country to (narrowly) avoid recession in 2009; as a
result, Poles saw the crisis largely as an affirmation of their economic policy choices. Low pre-crisis
budget deficits and total debt gave Poland the ability to respond to the crisis by stimulating its
economy. Hungary, by contrast, was the first EU member state to request assistance from the IMF
to cope with devastating fiscal and financial imbalances that had built up for a number of years
before the crisis. Hungary received a commitment for $15.7 billion from the IMF on November 6,
2008 in exchange for a package of debt- and deficit- reducing austerity measures. In particular, wage
increases and pension bonuses (13th month pension) were suspended. The European Union
contributed an additional $8.4 billion and the World Bank $1.3 billion in a joint rescue package that
set the pattern for agreements in other member states of the European Union including Romania,
Latvia, and Greece. Poland also received a flexible credit line from the IMF to reassure markets in
May 2009, but it was praised for its macro-economic management in IMF surveillance reports.
Seeking to maximize its advantage, Poland lobbied against a general European Union crisis program
to assist Central and East European countries, arguing that assistance should instead be on a caseby-case basis, to avoid being put in a category with worse-affected states.
Since Poland and Hungary weathered the crisis very differently and responded with stimulus in one
case and severe austerity in the other, it is impossible to say that their common variety of capitalism
determined their crisis or response. Instead, the crisis demonstrates that the DMEs have managed
the challenges of dependent development very differently in ways that depend on their politicalinstitutional set-up and the size of their internal markets. In particular, the crisis revealed that the
key challenges for DMEs include constraining consumption by keeping labor costs low and
managing the inflowof non-FDI foreign capital.
The ability of countries to manage these complex tasks has depended on a number of factors, but
one prominent one is the structure of political competition. While Poland and Hungary are often
compared as most similar cases, they actually differ considerably in political-institutional setup and
the ideological nature of their leading parties. Hungary’s politics have been marked by a highly
polarized competition between two major parties in the context of more majoritarian political
institutions. Hungary’s dominant right party has taken on a populist right orientation in recent years,
and after the 2010 election, gained enough seats to form a constitutional majority. Poland, by
contrast, after a brush with semi-presidentialism in the 1990s, became a parliamentary democracy
after 1997 with multiple veto points and a strong tradition of civil society organization and
mobilization in politics. As a result, Poland has a more fragmented party system in which the
populist right generally cannot rule without the liberal right. More consensual democratic
institutions appear to have enabled Poland, along with the Czech Republic and Slovenia, to make
more sensible decisions before the crisis, avoiding its worst effects.
In addition, Hungary is a much smaller country with a greater exposure to foreign trade, whereas
Poland has a population nearly four times the size, a consequently larger internal market, and less
exposure to foreign trade shocks. Poland has shown a greater ability to manage financial inflows
and shocks due to its lesser exposure to foreign trade and healthier banking institutions.
For the DMEs, it is impossible to speak about government responses to the crisis without
considering the role of international institutions. Crisis decision-making was heavily influenced by
external forces, with direct interventions from the IMF and European Union in particular. In both
countries, the financial crisis has sparked a public discussion of the mode of capitalism in the
dependent market economies. Commentators began to question whether the rapid liberalization of
the 1990s had created a trap and made these economies particular vulnerable to international shocks
such as those experienced in 2008-09. To forestall such a discussion leading to a fundamental
critique of Central and East Europe’s dependent market integration, the IMF and European Union
quickly provided reassurance that Central and Eastern Europe would not be left out in the cold in
the form of comprehensive assistance packages. These international responses helped to prevent a
collapse in mass and elite support for dependent market development. As part of these packages,
foreign (mostly European) banks committed not pull out from Central and Eastern Europe during
the crisis, but instead maintained loan commitments, if not previous rates of credit growth. As a
result, a continuation down the path of dependent market development seems secure.
While focusing on the structure of political competition that seem to explain the economic policymaking differences between the two countries, the broader explanatory frame employed here is
based on ideational and discursive institutionalism. Policy in these countries reflects a region-wide
move to implement neoliberal policy ideas in the 1990s. However, the structure of political
competition has played an important role in determining how effectively neoliberal reforms are
implemented in each country, what interests are best represented, and what choices are made.
The Neoliberal Era
Neoliberal policies came to Central and Eastern Europe suddenly and with great force after 1989,
when both Poland and Hungary experienced major political breaks from communist rule. In both
countries, roundtable talks between governing communist parties and broadly-based opposition
groups in 1988 and 1989 created compromise constitutions that allowed for democratic elections in
1990. The first post-communist government initiated a broad program of liberal economic reforms
and periodic bouts of radical neoliberal reform continued throughout the 1990s. Poland’s
Balcerowicz Plan of 1990 made the Polish currency convertible, established a new exchange rate
regime, liberalized foreign trade overnight, liberalized corporate and labor law, provided for leasing
and privatization of state property, and created new programs of unemployment insurance. In the
mid-1990s, Balcerowicz II addressed institutional reforms in pensions, health care, and education.
Hungary likewise enacted many initial liberalization measures in 1990 and 1996, when the so-called
Bokros reforms combined fiscal austerity with structural reforms. It is interesting that the short
“window of opportunity” that policy-makers initially expected for radical reforms turned out to be
open periodically for far longer than expected, as these countries adjusted over the medium term to
a newvariety of capitalism.
In contrast to Western countries, the scale of economic change in post-communist Hungary or
Poland was tremendous. On one widely-cited index of economic liberalization, Central and East
European countries since 1990 have liberalized more quickly than nearly all other countries in the
world, far outpacing the speed and extent of reform in the West or most other middle-income
developing countries (Gwartney and Lawson 2010). Rapid institutional change took place in Central
and Eastern Europe because the prior institutions of communism were widely discredited and the
political system that backed them up fell apart so quickly. Institutional change was the rule rather
than institutional stasis. No doubt legacies of various sorts remained important. Stark and Bruszt
(1998) emphasized that institutional design took place in the context of constraints created by the
building blocks of the past regime. Yet a radical reshaping of these legacies surely occurred. In
welfare states, for instance, whereas previously under communism, there had been little or no formal
unemployment, after 1989, unemployment was legalized, people were laid off, and unemployment
benefit systems created. Many unemployed were also absorbed by pension systems, which strained
under the burden, causing contribution rates to soar and eventually creating the conditions for
radical pension privatization in the mid-1990s. Systems of preferential benefits were undone in both
countries. By the 2000s, welfare state institutions were significantly transformed. Yet, as Haggard
and Kaufman (2009) rightly point out, welfare state spending in Central and Eastern Europe
remained very high compared to middle-income countries in Asia and Latin America, showing that
some legacies of the communist period remain.
Because of these legacies of high social spending, the Visegrad countries (Hungary, Poland, the
Czech Republic, and Slovakia) did not entirely converge on the liberal market economy (LME)
model. While some countries, particular the Baltic republics of Estonia, Latvia, and Lithuania, more
nearly approximated the LMEs, and one country, Slovenia, converged with the European
coordinated market economies (CMEs) (Feldmann 2007), the Visegrad countries fell somewhere in
between, seeming to many to adopt a hybrid form of capitalism (Bruszt 2002; Cernat 2002; 2006;
Bohle and Greskovits 2006; 2007; King and Sznajder 2006). Nölke and Vliegenthart (2009) were the
first to label the Visegrad countries DMEs, based on the extensive foreign control of their
economies and their reliance on foreign capital and direct investment.
The implementation of neoliberal policies in DMEs has been highly controversial. Some believe
that neoliberalism in CEE was effectively implemented by surprise, as Stokes claimed of reform in
Latin America (2001). Certainly, the first Solidarity governments in Poland made an extreme about
face to adopt policies that were certain to harm their main constituencies in 1990. Ost (2005) argues
this initial betrayal set in train a politics of anger that led to populist reactions. Yet others suggest
that neoliberal policies have been popular throughout the transition. Roberts (2009), for instance,
suggests that these reforms have been pushed through by democratically elected governments of
both the right and the left and that opinion polls showsignificant popular support.
Significant debate has turned on the nature and accountability of democratic institutions during the
neoliberal revolution in Central Europe. Some argue that neoliberal reforms were made possible by
weakly accountable politics in which parties in power, whatever their mandate, imposed liberal
economic reforms to please much-needed foreign capital. As a result, voters continually voted out
incumbents: very few incumbents have one re-election in Central Europe since the transition began
and confidence in democratic institutions has eroded. Others suggest that liberalization policies
were beneficial and only possible to implement under democratic regimes that allowed interest
groups to push for liberal reforms. Whatever the case, liberalizing financial and social reforms in
Central and Eastern Europe far outpaced those in other parts of the world.
Financial and Fiscal Policies
The DMEs are characterized by extreme liberalism in the financial sector. This is epitomized by the
high level of foreign ownership of the banking sector. Foreign share of the banking sector in the
DMEs is higher than most countries in Europe and the world. The decision to sell the banks
occurred as a result of privatization programs and liberal regulatory regimes put in place with the
advice of liberal international organizations (Epstein 2008). Financial sector openness has been an
important institutional pillar in the creation of DME regimes since they are heavily reliant on foreign
capital. Note (from Table 1) that Slovenia, the only CME in Central and Eastern Europe, has a far
lower share of banking assets in foreign-owned banks. Estonia, the leading LME in Central and
Eastern Europe, has nearly total foreign ownership. In Hungary, four of the five leading state banks
under communism were sold to foreign investors by 1997. The state savings bank, OTP, was
privatized but only a third of its shares were sold to foreign investors and it has remained a
successful, largely domestically-owned bank. The sale of Poland’s banks to foreign owners took
place a bit later than in Hungary and was facilitated by the European Union accession process
(Bonin and Wachtel 2002). Foreign bank ownership was widely seen as an important means to
transfer both capital and know-howto Central and Eastern Europe. Foreign banks were perceived
as more efficient than domestic banks and necessary for economic growth. FewCentral European
countries were concerned about possible negatives, such as a loss of domestic control over the
economy, difficulties of managing currency inflows, and the like.
Table 1. Foreign Ownership of Banking Assets in CEE Member States of the EU
Country
Share of Total Assets in Banks >50% Foreign Owned
Bulgaria
73%
Czech Republic
77%
Estonia
97%
Hungary
74%
Latvia
60%
Lithuania
80%
Poland
69%
Romania
57%
Slovakia
77%
Slovenia
17%
Source: Delis (2010) on the basis of EBRD data.
Fiscal policies have differed significantly between countries in CEE. Generally, there has been a
tendency towards deficit spending as governments have come under pressure to compensate people
for the effects of economic openness. Hungary has typically run higher government deficits than
Poland, which has had a more conservative fiscal policy. Both countries have VAT taxes required
by the European Union and both countries are currently considering implementing a “flat tax”
personal income tax regime.
Industrial Relations
Both countries have moderate levels of union density, consultative tripartite institutions, and firmlevel wage bargaining. Neither qualify as CMEs, but more closely approximate LMEs in industrial
relations (Ost 2000; Crowley 2004; 2005). Both have relatively weak tripartite consultative councils,
though Poland’s trade unions are far stronger as a political force. There are two major trade union
confederations, one associated with the center-right and another with the center-left in parliament.
Welfare State
Poland and Hungary have similar welfare state policies, with similar levels of spending on pensions,
unemployment benefits, and social assistance. Hungary has a tradition of family benefits that has
been more generous than other CEE countries. Both countries partially privatized their pension
systems in the late 1990s with World Bank support.
The Crisis and Policy Responses, 2008-2010
While the history of neoliberal reforms are similar, Poland and Hungary differed greatly in their
macro-economic policies in the run-up to the crisis. These differences proved decisive in
determining the effects of the crisis and policy responses.
Hungary suffered from highly irresponsible fiscal policies that culminated in a major political crisis
in 2006, shortly before the global economic crisis hit. At the same time, Hungary experienced a
dramatic run-up in foreign currency loans. While Hungary implemented austerity measures before
the crisis in 2006 and 2007 in an effort to reign in its budget deficit, foreign currency loans
continued to expand and the country’s economy proved highly vulnerable to the crisis. When the
crisis hit, Hungary’s currency, the forint, devalued sharply and foreign currency loans denominated
in Swiss francs and Euros became harder to repay. An IMF package agreed in 2008 imposed even
more severe austerity measures. Hungary’s economy plunged by 6.3 percent, before turning around
in 2010. As domestic demand shrank, Hungary became even more dependent on exports.
Hungary’s crisis demonstrated the irresponsibility of high pro-cyclical borrowing and the needed to
be more careful in managing capital inflows.
Just after winning re-election in 2006, Prime Minister Ferenc Gyurcsany of the Socialist Party was
recorded saying that his party had “lied morning, noon, and night” to cover up the extent of
Hungary’s fiscal deficit during the election campaign. Hungary’s fiscal deficit had reached 10
percent of GDP and the government needed to impose severe austerity measures. This revelation
caused a massive public reaction from right-wing and extreme-right parties that mobilized often
violent public demonstrations. Total government debt reached 153 percent of GDP in 2008, among
the highest in Central and Eastern Europe, putting the economy in severe risk on the eve of the
financial crisis that dramatically increased the cost of borrowing.
In addition to government debt, domestic private credit also ballooned during the high-growth years
of the mid-2000s. During these years, Central and Eastern Europe became a major target of foreign
direct investment and cross-border lending from Austrian and other European banks lending into a
booming economy. As an economy dependent on capital inflows, it should not be a surprise that
Hungary, like other Central and East European countries, experienced high levels of credit growth.
However, some countries managed these flows more effectively than others. Hungary and the Baltic
states were outliers in the region in the extent of private borrowing and the high proportion of loans
denominated in foreign currency, often the Swiss franc or the Euro. Net foreign currency assets as a
percent of GDP reached 47% in Hungary, one of the highest in the region (Kattel 2010, 4). By
2007, 85% of mortgages were denominated in foreign currency, mostly Swiss francs, which were
attractive to consumers because of their much lower interest rate compared to Hungarian forint
loans. However, when credit expansion stopped in 2008, the forint devalued by about 10% against
the Euro making these foreign-denominated loans became that much harder to repay.
Poland, though also a DME, managed its government deficit and capital inflows much more
conservatively. Poland’s government debt, at a total of 60 percent, was moderate to low for the
region. And like the Czech Republic, the country had prevented a massive expansion of foreigndenominated credit. When the crisis hit, Poland was not forced to implement severe austerity
measures but instead had room to expand through “automatic stabilizers.” Its general government
deficit increased from 2 percent in 2007 to 7 percent in 2009. As a result of these factors, its
economy continued to grow through domestic demand, despite the export shock. For Poland, the
avoidance of recession was celebrated as a major affirmation of its existing policies. Former finance
minister Leszek Balcerowicz promptly went on a lecture tour promoting Poland’s exceptionally
good performance during the crisis.
Explaining Differences
Were the macro-economic differences between Poland and Hungary caused by idiosyncratic or
structural factors?
While it is tempting to suggest that Poland and Hungary simply happened to take different
approaches to managing international economic integration, there is reason to believe that the
differences are structural. In particular, one major differentiating factor between CEE countries has
been the structure of political competition: especially extent of executive insulation and
concentration of power, executive-legislative relations, the concentration of the party system, and
the extent of civil society and particularly organized labor representation in politics. Here, Hungary
and Poland diverge considerably. Hungary’s 1989 constitution established a mixed-ballot
parliamentary election system that combined features of first-past-the-post with proportional
representation, magnifying small pluralities of the popular vote into large parliamentary majorities.
In addition, its political system has been polarized between a center-left Socialist party and a centerto-extreme-right Fidesz party, each of which tend to exclude the other from consideration during
times in government. Hungary also suffers from weak civil society organizations and trade unions
that are tied to political parties through patronage. Poland, by contrast, has a proportional
representation parliamentary system with a relatively unstable and fragmented party system creating
multiple veto points. Civil society is relatively highly mobilized and trade unions, in particular, play a
significant role within each of the major parties. The result has been a more democratic, inclusive
policy process in Poland. By contrast, economic policymaking in Hungary has followed a patronage
logic as each successive party takes control of and loots the state, at least since 1998 when Fidesz
took control and ruptured the previous Hungarian practice of power-sharing in government
(Grzymala-Busse 2007, 67).
This political-institutional setup and policy-making style translated directly into the high deficit
spending and weaker financial regulation that made Hungary’s crisis far more difficult than Poland’s.
In Hungary’s polarized, majoritarian political system, there appears to be a stronger impetus to
spend rather than conserve resources; economic electoral cycles are stronger; and the state budget
suffers. One of the peculiarities of Hungary is that it has generally been the left (after a while) that
imposes austerity, not the populist right. In Poland, by contrast, the right liberal parties have been
more fiscally conservative and the left socialists have been heavily in favor of EU membership,
which has tended to make them also relatively conservative in fiscal policy. Governments have
often been weak and reliant on opposition support at times, in particular for economic policy
decisions, even the passage of the original Balcerowicz Plan in 1990. It seems, therefore, that the
different patterns of political competition in the two countries have produced very different politics
of fiscal policy that determined the level of crisis and nature of the policy response after 2008.
Another factor is size. Poland has a population nearly four times larger than Hungary and is
consequently less vulnerable to trade and financial shocks.
Conclusions
Central and East Europeans will continue to debate whether their dependent market economy
model of capitalism makes sense over the long run. Critics argue that without the development of
national champions, Hungary and Poland cannot be like South Korea, but will instead suffer from
lowinvestment in research and development, giving them lowprospects of achieving high long-term
growth (Kattel 2010). They will occupy a niche as low-cost producers and have difficulty moving up
the value chain. Their position will remain insecure as investment could move to poorer countries
once labor cost advantages are exhausted.
International assistance to prevent a banking collapse and government debt defaults has helped to
prevent a backlash against dependent market development for the time being. And as the
comparison between Hungary and Poland shows, the DMEs of Central and Eastern Europe
experienced the crisis very differently depending on their willingness and ability to manage
government deficits and the inflow of non-FDI foreign capital. Neoliberal economists have taken
the lesson to be that fiscal prudence helps during a crisis, which is undoubtedly true. Supporters of
a more state-directed capitalism have argued that the crisis underscores the dependent development
in CEE and that a more strategic industrial policy based on state-sponsored investment in key
sectors would work better over time.
This paper has aimed to show that, while there are no doubt several factors differentiating Poland’s
crisis and response from that of Hungary, size and the structure of political competition are the
major causal factors. Smaller economies are more dependent. And features of political competition
in Hungary appear to have made that country’s democracy more vulnerable to electoral business
cycles that accelerate budget deficits and prevent the type of fiscal prudence seen in Poland. The
combination of majoritarian institutions and a right party that is populist in character has eliminated
one of the key factors facilitating fiscal restraint in Poland: a strong right liberal party that often
gains control of the finance ministry.
DMEs can therefore be seen as taking different routes to managing the key challenges of
dependence, ones that have had very different impacts in the current crisis.
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