Central Europe: A great start that was wasted

Is Central Europe doomed to end up as a problematic region inhabited almost exclusively by old people?

Tomasz Kasprowicz
22 June 2017

The economic transformation in Central Europe has ended. Politicians that base their economic policy on avoiding the middle income trap failed to realize that the V4 countries have not been middle income countries for couple of years now. However, expecting politicians to be up-to-date with facts is apparently not realistic. Yet the success is likely to be wasted, as the old growth drivers are being abandoned in favor of actions that resemble pre-transformation policies: centralized government and state planned economy while being unprepared for the approaching demographic calamity.

Out of all the V4 countries, Poland enjoys the greatest success. It is not the wealthiest country of the region, but it started as the poorest. In 1992, the Polish GDP per capita was only 55% of the Czech’s, 66% of Hungary’s and 85% of Slovakia’s. In 2015, it was 83% of Czech’s, 91% of Slovakia’s and higher than Hungary’s. The pace of going from middle income to high income is historically comparable only with Korea, and was achievable without an authoritarian government focused on building local capital at the expense of local labor. Clearly Poland has done something right.

World Bank’s report “Lessons from Poland Insights for Poland” is trying to indicate the most important factors for the country’s success. Many of them may be combined into one word: westernisation. A key factor of success has been mimicking western institutions, liberalisation, privatisation and their embracing of globalisation. Clearly this model of transformation was most successful as compared to alternatives namely: “stealing everything with friends” (Russia, Ukraine) and “stealing everything with family” (mainly Central Asia, Belarus).

But why is the Polish case so much more successful than other members of Visegrad – especially Hungary? It seems that the main reason was the depth of initial reforms. Poland, being the poorest, had little room for shielding old structures; hence much was destroyed and rebuilt from scratch. This was painful at first but yielded better results in the longer run. It seems that whatever was not reformed at the start is a persistent problem for decades as examples from Poland now show: coal mining, the Post Office, LOT Airlines, PKP (railroad transportation) and most notably universities. All of these cases represent different sets of problems, but the latter is the most painful as a lack of serious research is a hindrance to both education and innovation.

Also, the level of liberalisation seems to go much further in Poland, which has yielded an economy based largely on independent SMEs. This creates a resilient, diversified economic structure that adapts to the changing environment much more easily than one based on large corporations. This was clearly visible during the latest economic crisis when Poland was the sole European economy that avoided recession. Currently the growth is robust and likely to continue on this impressive streak in the coming years.

Recently, economists have been warning V4 countries, especially Poland, that the sources of the impressive growth are about to end. Reliance on cheap but effective labour as a source of competitive advantage cannot continue indefinitely, and the countries should rely more on innovation. Strangely enough, these warnings have not materialised thus far, and seem to be of little importance in the short term, so bringing about the necessary changes feels onerous. Still, these forecasts are very pronounced in both economic and political debates. This fact alone seems to be one of the greatest threats to future growth.

See also the newest issue of Visegrad Insight on prosperity in Central Europe.

Politicians, quite traditionally, associate innovation with large, industrial companies. The problem is that in V4 countries there are not so prevalent. The existing ones are either state controlled or controlled by foreign corporations. Foreign corporations innovate abroad, and state owned companies are usually unable to innovate for political reasons: management is appointed as a political spoil of war regardless of any competence or incompetence they might display. This is especially visible in Poland and Hungary where high-ranking offices are assigned to people with no experience (e.g. Bartłomiej Misiewicz – a 27 year old with no higher education degree that was assigned to several posts in the government and state controlled companies, and was only recently fired due to public outcry).

Still, the belief that large, state owned companies can be the start of a new innovative economy is high. The plan of Polish Deputy Prime Minister Morawiecki is based on investing 4 billion PLN (about 1 bln EUR) in such state controlled ventures. That is 1 billion EUR that will be channelled away from Polish SMEs depriving them of the chance to develop and grow. SME innovation has not been trivial in past decades, but it is easily overlooked. The region has several global players in the software industry (e.g. Polish CD Project RED game producer know for the Witcher series or Czech Avast producer of one of the leading antivirus solutions). For some reason, home grown private innovation is not sexy enough for politicians that prefer e.g. electric cars – which was more innovative a decade ago. Becoming a player in this market requires huge investment and decades of learning while the potential for profits is small.

The quality of institutional infrastructure is rapidly deteriorating. Institutions copied from the west have worked pretty well under stable circumstances; however, the cases of Orban and Kaczyński have shown that they operated for far too short a time to gain a true foothold in the system. A determined politician is able to demolish most of them within a year – something that Trump was luckily unable to do in USA (so far). As World Bank’s report clearly indicates, institutional stability is paramount for private investment.

A larger problem lies ahead: The demographic outlook for V4 looks grim. The ageing society will put pressure on the job market, welfare and medical system while dragging down productivity. The current situation is unsustainable even within next 5-7 years, and this is not taking into consideration migration. Its level is subsiding from the boom just after joining EU, which was expected. The incentive to migrate is diminishing as V4 countries are getting richer.

However, what lies ahead is a completely different story. The tax wedge in the V4 is bound to increase as welfare and medical systems will require greater funding due to the aging population. At the same time countries of Western Europe, that face similar problems but have started to actively attract high quality migrants (and citizens of V4 are viewed in such a light). If they succeed, the taxation will have to grow even more, which will increase the pressure on migration even more. This may initiate a vicious spiral that will suck out most of young population from the V4.

At the same time, we are unable and unwilling to attract our own migrants. Our societies are actively opposing any migration, which is clearly visible in the political stances of all four V4 countries during the Syrian crisis. Moreover, the societies are simultaneously creating an unfriendly environment to newcomers, which makes competing for migrants from richer countries next to impossible. This will lead to an adverse selection of immigrants and may increase the already growing anti-immigration sentiment. As a result, this part of Europe may end up as a problematic region inhabited almost exclusively by old people.

Unfortunately, this scenario is more and more probable and there seems to be no easy or obvious solutions. I am afraid that the success story of V4 may soon be just an unusual episode in the history books. A great start that was wasted. The question that remains is: can we still do something to prevent it? Unfortunately, I am not optimistic as the last few years of prosperity that could be used to prepare for incoming crisis have been wasted on dreams of innovation via state companies. A similar road that led to the end of communism in the first place.

The author is an entrepreneur, a partner at Gemini and Matbud, and assistant professor at University of Dąbrowa Górnicza,