A ring of semi-reformed planned and patronage economies

In the countries surrounding the expanded EU it is rare to come across an unambiguously development-oriented economic policy rooted in a democratic system governed by the rule of law. On the contrary: many societies, after years of half-hearted liberalisation, are characterised by a crumbling mixture of market-economy structures and patronage networks. In Eastern Europe sections of the old nomenclatura, and south of the Mediterranean the élites who control rent income, are trying to hang on to their power while formally creating institutions to carry out democratisation and economic reform.

Decades of planned economy and party dictatorship have left their mark on the countries of Eastern Europe. With a few exceptions it was not democratic opposition movements which led to the rejection of this system, but new élites with ambitions for national independence or old élites simply trying to hang on to their supremacy by switching labels (especially in many of the CIS republics). Often they are involved in local conflicts with an ethnic background. The exceptions are largely those countries which, thanks to the progress they have made with reforms, will join the EU (and, in some cases, NATO as well) in the first expansion round. The Eastern neighbours of the expanded EU will predominantly be countries where the reform process is making sluggish progress.

Partial liberalisation and privatisation have often enabled elements of the old élites to get rich quick and get control of major portions of the national wealth. Even in the few cases where they do not also control the state apparatus, policy-makers and the civil service are hardly in a position to create the framework conditions to encourage development and modernisation. Instead the networks use the banks and larger companies to look after each other, and there is no competitive growth or comprehensive modernisation of the economy.

Where countries really have been democratised the disillusioned population may try to elect to power parties promising genuine reforms. But these forces are also faced by the dilemma that the voters are not unconditionally prepared to accept protracted periods of austerity, and the new élites are in a position to interfere with economic development, creating considerable chaos.

In the neighbouring Arabic Mediterranean countries there have been no dramatic changes of system. The traditional élites carried out modest steps in the direction of liberalisation when the decline in the rent income from oil, transfer payments and other sources undermined the internal stability which that money had previously bought, triggering foreign-debt crises. Progress in making structural adjustments has been just as mixed as democratisation, which was also slowed down by fear of the strongest opposition force, political Islam. While Tunisia and Morocco are diversifying their economies, and have already succeeded in increasing their exports of finished goods, other countries continue to suffer from their dependence on traditional sources of income and from even more authoritarian regimes.

The richest country in the region, Israel, also has the best democracy, relatively speaking - but it withholds important rights and opportunities from its Arab citizens. The unresolved conflict with the Palestinians and its Arab neighbours restricts Israel's scope for economic integration, increasing its dependence on foreign - principally American - aid.

The only Mediterranean country in the region with an Islamic character and a (though not exactly unblemished) democratic tradition is Turkey. Its economy, originally heavily state-controlled and oriented towards import substitution, has been perceptibly opened up and liberalised in the course of structural adjustment and integration with the West. The continuing tensions with Greece over the Aegean and Cyprus, as well as the Kurdish problem, will make it difficult to expand relations between it and the EU beyond the customs union agreed in 1996.

The overall situation in the EU's neighbouring countries is not encouraging. In critical sub-regions like the Balkans, the Caucasus and Palestine/Israel it is hard to see how democratisation and modernisation can make further progress without a secure peace. In most countries the élites - rhetorical declarations notwithstanding - are not convinced of the need for political and economic reforms. Most countries therefore lack the most important precondition for the rapid growth and development which have been successfully achieved elsewhere by means of the policy mix described above.

Oppositions rarely look like promising alternatives, as their identity is often based on fundamentalist or nationalistic convictions. In many countries there is a danger that social groups suffering under economic liberalisation and structural adjustment (employees in the state sector, recipients of transfer income) will join these forces, seeking their salvation in a ”Djihad” against the ”McWorld” supposedly dominated both economically and culturally by the West. They see the EU as their enemy, and any movement towards openness as capitulation to exploitation by the wealthy centre.

If, in spite of everything, countries on the periphery of Europe want to take the course which leads to success, what kind of regional order would be essential to them - or at least helpful? To what extent can and should the EU try to encourage its poor neighbours to adopt this strategy? What lessons can the EU learn from the successes and problems of the other regions in the fields of trade, capital flows, migration and political co-operation?

The diversity of Europe's neighbouring countries suggests pursuing a variety of policies, tailored to the problems of individual countries and sub-regions. The EU itself is currently employing two or three different approaches: the Barcelona model for the South, and either association plus PHARE or trade and co-operation agreements plus TACIS for Eastern Europe. But there is not really any factual justification for this differentiation. The Mediterranean policy, in particular, applies the same principle to very different countries. On the other hand dividing East-European countries into three categories - first-round accession candidates, associates with accession prospects and the rest - is relatively arbitrary and controversial. In other fields - trade, for example - there are good reasons for adopting a single liberalisation concept.

Brussels trade policy: a pyramid with hub and spokes

A favourite description of the EU's external-trade policy is a pyramid of customs preferences. At its apex are the member states forming the internal market. The next-best market access is enjoyed by members of the European economic area, which after the EFTA expansion consists only of Norway, Iceland and Liechtenstein (Switzerland decided against in a referendum). Then comes Turkey, trade with which - at least in the final stage of expansion of the customs union - would be most liberalised. On the next level are the associated countries of Central and Eastern Europe, the Mediterranean region and the ACP states. The trade and co-operation agreements with the East-European countries also provide for free trade in manufactured products. Below them come other special agreements, some bilateral, others multilateral in character - the latter with different regional integration areas. Non-associated developing countries enjoy the benefits of the General System of Preference(GSP). Other industrial countries, as members of the WTO, are covered by the most-favoured nation provision. Below them there used to remain only the planned economies of COMECON, following the demise of which hardly any states are worse-placed - with the exception of a few countries which are neither eligible to be members of the WTO nor benefit from the GSP, for example wealthy oil exporters.

There has been a marked reduction in the height and steepness of this preference pyramid over the years. The GATT liberalisation rounds, most recently the Uruguay Round, have reduced average protection to levels so low that little scope remains for preferences to individual trading partners. The bulk of the EU's trading partners are at a more or less similar preference level, namely that of the associated countries. These are granted customs-free access to the EU market for manufactured goods, with the exception of sensitive industries like textiles and steel which are subject to special regulation. The EU's agricultural market - a particularly important one to many of its neighbours - is also protected. The EU has concluded a number of asymmetrical tariff agreements allowing trading partners to carry on protecting their markets for manufactured products, but it increasingly expects them to grant it free market access for its exports of manufactured products. And on top of that, many of the EU's treaties allow for contingent protection which can be applied against the neighbour's exports if the need arises.

The individual trading regions form a system often described as ”hub and spokes”, (HAS) for example by Wonnacott, Enders, Baldwin. The EU is the hub, and the spokes are its trading agreements with various partners. As a rule each partner is only connected to the EU hub, with no direct link to the rest of the spokes (if we ignore a few regional co-operation agreements like CEFTA, the Central-European Free-Trade Area, and UMA, the Union du Maghreb Arabe. This HAS model contrasts with the alternative of a large free-trade area to which both the EU and its partners would belong as equals.

The HAS model favours the hub to the detriment of the poor spokes, and it also reduces the growth prospects of the entire region as compared with a large free-trade area. This is because businesses in the hub have access to inputs from the entire region which are cheaper (because they are free of tariffs) and can freely sell their products in that region, while their competitors in the spokes can only obtain goods on favourable terms from the hub, and must overcome customs barriers in the markets of the other spokes. This also makes the hub more attractive to investors than the spokes, especially investors from third countries. Overall an HAS region offers lesser economies of scale than a large free-trade area, increases transport and administrative costs and presents more incentives for protectionist practices.

There is no doubt that this trade policy produces an environment which is far from ideal for neighbouring countries trying to close the development gap. The latent threat of EU protectionism, which can be applied in any field at any time, and the negative effects of the HAS system make indigenous businessmen and foreign investors less inclined to expand export-oriented manufacturing in the neighbouring countries. For the neighbouring countries the pressures to open their markets have a similar effect, particularly for investment projects with a flatter learning curve - which thus need a longer adjustment period before they can be internationally competitive. It is no coincidence that most Western car-makers have made their investments in Central and Eastern Europe conditional on the - temporary - introduction of protective tariffs.

The spoke countries could solve some problems themselves, simply by autonomously reducing or even abolishing their tariffs against other spoke suppliers. This would at least put their businesses on an equal footing with those of the hub as regards obtaining inputs. But other steps would have to be taken by the EU. One approach would be to change the original provisions on which the bilateral agreements were based. If a large degree of accumulation of value-added in HAS members were permitted, the HAS system would be far closer to a free-trade zone. However, in view of the low weighting of all the spoke markets in relation to the EU market as a whole (roughly equal to that of the Italian market), neither the disadvantages of the HAS system nor the advantages of replacing it should be overestimated.

What can be learned from East-Asian and North-American experience in the field of trade policy?

Given the experiences of the successful tiger economies, the EU ought to let its poor neighbours adopt a policy of ”protected export promotion” - i.e. allow them to protect their enterprises. But it is doubtful whether this would actually encourage investment, innovation and competitiveness in neighbouring economies. For in conditions of patronage-type economic policy neither the civil service nor business make much use of the instruments available to them, such as trade barriers and subsidies, in order to force a rapid adjustment to world-market conditions: instead they use them to cover up the refusal to adapt, and to fund sinecures.

Furthermore, the EU could respond by doing nothing to defend itself against export offensives resulting from successful export drives of this type. As a minimum this would mean removing the protection of sensitive industries within the EU, including agriculture - though this would encounter massive political resistance from the affected industries. It is instructive that Japan has only ever opened up its markets to the extent that it had to in order to import inputs on favourable terms. With the rise in the value of the yen from the mid-1980s, however, these included not only raw materials, as before, but also labour-intensive industrial products manufactured mainly by Japanese subsidiaries created by massive investment in South-East Asia . The US market was always relatively open to South-East Asian countries.

From the point of view of trade policy NAFTA has something to offer. In the first three NAFTA years Mexico's exports to the USA grew by 83%, its total share of US imports rising from 6.8% to 9.2%. In several sectors Mexico overtook prominent competitors, such as Taiwan, Brazil and Korea in steel and Germany in automobiles. Mexico also substantially diversified its range of export products. This export performance was also based on a massive rise in foreign direct investment, of which - thanks to NAFTA - Mexico became the second-largest recipient among the developing countries (after China).

But Mexico's success is probably only to a small extent due directly to NAFTA trade regulations. It is more a result of NAFTA's effects on investment behaviour and of the provisions which govern direct investment. NAFTA largely includes agriculture in trade policy, imposes tight restrictions on contingent protection and also governs technical trade barriers and access to public procurement markets. In addition there are comprehensive clauses dealing with investor protection, trade in services, competition policy and the protection of intellectual property. These provisions give investors more freedom of movement and reduce risk. NAFTA includes detailed provisions on the environment and labour relations, which both restrict the grounds on which environmental groups and trade unions can call for protectionist measures and alter their forms in ways which encourage institutionalised negotiated solutions.

The NAFTA model thus includes a number of incentives which the EU could well adopt in its trade policy vis-à-vis its poor neighbours. But the fact remains that their actual impact is heavily dependent on the efforts of the partner countries themselves. NAFTA's restrictive structure leaves governments less scope to neglect reforms or not actually to implement promised measures than the less exacting, traditional-style treaties which the EU has concluded with its neighbours. In the case of candidates for accession this may be enough, since they are in any case exposed to significantly heavier pressure to reform in preparation for full membership. But a clear treaty framework would be more beneficial to countries remaining outside the EU in the long term.

The most far-reaching step would probably be to extend the single European market, including agriculture, to the EU's neighbouring countries - which would require an even greater depth of integration than the EEA. This would require the neighbouring countries to submit to minimum European standards in many technical and other fields (norms, safety and health standards etc.). And reciprocally the EU, in its turn, would have to permit the unrestricted importation of products satisfying the (adapted or harmonised) regulations of the neighbouring countries.

Growth policies and monetary policies are the best trade policies

Even an EU trade policy making its markets more open and offering exporters from neighbouring countries greater opportunities and security would have only a limited effect on the development of actual trading volumes. For tariffs - with the exception of special cases - have on average been reduced to such a level that the influence on the competitive situation in the affected markets of reducing them further, or even abolishing them, would be more than cancelled out by other factors such as exchange rate changes, differing inflation rates and/or variations in productivity.

If we examine the development of trade flows between the EU and Central and Eastern Europe, or between the USA and Mexico, it becomes clear that the most important determining factors must be sought in the growth of the real national income overall, and the savings quota in particular, as well as in the exchange rate, i.e. with the effects of inflation excluded. Trade-policy problems and political crises arise against the background of changes in the trade balance or in wage-cost relationships, which are triggered by these factors.

The best growth promoter for our neighbours would be a rapid expansion in EU demand. Since the beginning of the 1990s, unfortunately, the EU has been characterised by low growth rates. Critics of the Treaty of Maastricht maintain that the stability and convergence criteria laid down in it are responsible for forcing the member states to adopt a tight fiscal policy. But others object that deficits of more than 3% of gross domestic product are an indication of an expansionist fiscal policy, and that the deficit and the resulting new debt tie up savings which is then no longer available for investment - the basis of new growth.

Even adherents of a more responsible fiscal policy can imagine a more growth-oriented economic policy taking the form of a less restrictive monetary policy. While some hope that state austerity will relieve the burdens on the capital markets and thus reduce interest rates, others want the central banks to cut interest rates - both to stimulate investment and to reduce the interest burden on the public purse. In both cases the interest-rate level, which is higher in Europe than in both the USA and Japan, is deemed to be mainly responsible for weak European growth.

Many observers see the policy of the German Bundesbank - to safeguard the stability of a currency which, in view of low inflation in the USA and Japan, may not be under threat - as an obstacle to such a growth policy. On the other hand it would be sufficient for Europe to return to the growth rates which it achieved between 1986 and 1990, without any interference from the Bundesbank - though it was no less obsessed with stability then than it is now. The future European central bank could contribute to an acceleration in economic growth in the monetary union, because in view of the lesser importance of foreign trade for the Euro-zone it will not have to worry so much about importing inflation.

The fact that the Euro-zone is relatively closed also reduces the currency turbulences which have so often bedevilled export-led growth. A new European growth process could take place on the foundation of currency-policy stability, a solid budgetary policy and low interest rates. The central bank would then have no reason - either external or internal - to choke off growth in the interests of stability, as long as wages do not grow faster than productivity (as they largely did in the 1990s).

Apart from EU growth, which would of course benefit neighbouring countries, the objective would have to be growth within the neighbouring countries. Trade with the EU would be a major precondition for this growth - not only as a market outlet for exports, but also through the demand for imports which growth brings about and the financing of which restricts that growth. In this situation developing economies often slide into a cycle of crises.

• In the favourable phase the economy grows rapidly. Thanks to a marginally undervalued currency both exports and the inflow of foreign investment rise. The ”markets” assess the country positively as a competitive manufacturing location with excellent prospects.
• In consequence of strong growth and the relatively high import elasticity of demand, imports rise faster than exports. The balance-of-payments deficit swells, it can still be financed by capital imports. Inflation rises, but because of its good reputation the currency remains hard or even rises: either way it is revalued in real terms. This reduces price competitiveness and puts exports under further pressure.
• In the absence of economic countermeasures (increased saving, devaluation) the trend continues until the capital markets change their assessment. The currency comes under pressure. There is a sudden devaluation and heavy capital outflows. The country undergoes a massive crisis which forces deep cuts, and these reduce imports from the centre and jeopardise the liquidity of its investors. In extreme cases the centre feels obliged to mount a rescue operation.
• After the currency has been devalued and the budget brought under control, price competitiveness and, after a time lag, investor confidence are restored, exports and - though less vigorously - direct investment rise. A new cycle begins.

This pattern, though with undoubtedly major variations - could be observed in Mexico in 1994/5 and in the Czech Republic and Thailand in 1996/7. What is especially unfortunate about these crises is their infectious character. The markets' cumulative loss of confidence drags down other countries which are not in themselves affected. This was the case, for example, in Latin America in 1994 and in South-East Asia in 1997.

It is in the interests of both the centre and the periphery to avoid such cyclic crises, or at least to restrict the damage they cause - because they not only reduce exports from the centre, they also destabilise the capital markets when there is a sudden urgent need for investment in the periphery. Apart from that, crises like this threaten not only the prosperity to which the neighbouring countries aspire, but also their political stability.

These problems have traditionally been the province of the International Monetary Fund (IMF). It monitors the economic policy of its member states and issues warnings about developments which could lead to crisis. In the case of balance-of-payment crises it provides credits which, above a certain level, are linked to changes in economic policy. But the colossal transaction volumes in the global finance markets mean that its resources are inadequate to protect currencies from speculative attack.