The Chokehold of Populism - Hungary’s Economy

While the five-year and annual plans were not done away with in 1968, and the Planning Bureau no longer dictated to enterprises what would be produced with which resources, and where and at what price it would subsequently be delivered, quasi-market conditions prevailed in many sectors. Thus, in 1968, enterprises could buy and sell on the domestic market at partially liberalised prices. By contrast, the state monopoly in foreign trade remained untouched, enterprises could not go bankrupt, and open unemployment was not tolerated.

Due to the immense inefficiency of the centrally planned economy, even this modest liberalisation brought about spectacular success. The economy grew considerably faster than before, and there was significant improvement particularly in the supply of goods – a phenomenon referred to as “goulash communism”. Under pressure from the orthodox wing of the Hungarian Communist Party, however, certain reforms were withdrawn in 1972. The central idea of the new economic mechanism based on limited economic planning was impaired. While frequent interference by the Party in the economy thwarted the efficiency-improving effects of the 1968 reforms, there was no return to a classical centrally planned system.

A second wave of reforms was launched in 1981, after increases in the price of oil in 1974 and again at the start of the 1980s had led to fundamental changes in Hungary’s international environment. Due to the cheap – only seemingly advantageous – oil deliveries from the Soviet Union, the Hungarian economy missed the opportunity to adapt in a timely manner to the new situation following the oil crisis. Rapid technological advances in the West made it increasingly difficult for Hungary to sell its export goods there. As a considerable portion of imports already came from the West, deteriorating international competitiveness led to increasing trade deficits and growing foreign debt.

The measures implemented by the authorities to alleviate these problems caused the standard of living to decline, which led to growing popular discontent. The 1981 reforms were intended to channel this dissatisfaction in constructive directions. Accordingly, small-scale private enterprises were permitted, and citizens were called upon to supplement their personal incomes. These enterprises could have various legal forms. Small-scale entrepreneurs could use the physical assets of state-owned enterprises, or open their own small-scale enterprises. In a very short period of time, a broad spectrum of entrepreneurial activities appeared – from part-time taxi drivers to small cooperatives in the agriculture, industry and service sectors with dozens of partners. Nevertheless, state ownership of those means of production which had existed before the reform remained untouched until 1989.

The pains and gains of transition

From 1986 on, it became increasingly clear that the prevailing institutional framework of the centrally planned economy was no longer tenable. As early as 1986-1987, a tax system was introduced which was similar to that of a market economy, and five new commercial banks were established from various departments of the Hungarian National Bank. At the same time, the state monopoly in foreign trade was eased, and the first incentives were created for foreign enterprises to establish joint ventures with Hungarian firms. Thus, by 1989 when the communist system collapsed, Hungary was already on the verge of a market economy. The country was far better equipped for the transition than the GDR, Czechoslovakia, Romania and Bulgaria, with their unrelentingly rigid centrally planned economies.

But while the institutional preconditions for a successful transition were in place, Hungary initially fared only as well as the other post-communist countries. Between 1990 and 1993, Hungary’s gross domestic product contracted by 20%. [1] The reasons were the same throughout East Central Europe: The protected export markets of the Comecon countries had collapsed, and the liberalisation of foreign trade had allowed Western imports to crowd out many products and services supplied by Hungarian enterprises even on the domestic market. [2] Industrial production declined between 1990 and 1993 even more sharply than GDP, contracting by 30%, and agricultural revenues dropped by 33%. The unemployment rate jumped from a negligible level in 1990 to over 13% in 1992, while monthly average real net earnings dropped by 16% between 1990 and 1993. In 1989, 11-12% of the population lived below the minimum subsistence level, but by 1993 this proportion had grown to 35%. The situation was not as bad, however, as these figures – based on official statistics – reflect; unreported economic activities played an increasing role, and a considerable portion of the population drew hidden incomes.

Nevertheless, the “creative destruction” of the transition had shown its destructive side. Some one million jobs had been lost in just a few years. Even though the statistics of the socialist regime had been misleading, concealing a significant level hidden unemployment (improved productivity and efficiency in enterprises and public administration could not be achieved through redundancies), the now official unemployment level was traumatic for Hungarian society.

Those leaving the official labour market could choose between early retirement, disability retirement, employment in the shadow economy, and official unemployment. Especially hard hit were unskilled workers in the eastern parts of Hungary, where unviable large state enterprises had been shut down and agricultural cooperatives dissolved soon after the transition began. In particular the Roma minority – overrepresented among unskilled labourers in the region – sank into poverty, from which they have not emerged to this day. [3]

At the same time, however, the modernisation of the economy was gaining momentum. Tens of thousands of new companies and hundreds of thousands of sole proprietorships were established. State-owned enterprises were first transformed into limited companies and then privatised – all at once or in parts – by management, employees or foreign investors. [4]

 As the state desperately needed foreign currency to service the foreign debt it had inherited from the previous regime, Hungary was far less cautious than other countries in the region with respect to the involvement of foreign capital. [5] The inflows of foreign direct investment were thus far higher both per capita and as a proportion of GDP than in the other post-communist countries. In turn, the modernisation of industry accelerated markedly, and the composition of Hungary’s exports changed dramatically.

Until 1989, Hungary’s exports to the West consisted principally of raw materials, agricultural and food products, semi-finished products and simple consumer goods. Engineering products, however, which represented more than half of exports to the protected Comecon markets, accounted for just 10% of exports to the West. As the transition progressed, however, engineering products became increasingly prominent in Hungary’s exports to the West, and by the mid-1990s they constituted almost half of deliveries to Western countries. [6]

By 1993, it seemed as though Hungary had overcome the transformation recession. With an eye to approaching elections and its own low popularity, the government attempted to stimulate the economy, starting in mid-1993, by relaxing Hungary’s strict monetary policy (i.e. by pushing down interest rates), introducing a generous income policy (1994 saw a 7.2% increase in real wages), and increasing public spending. In addition, the government retained its anti-inflationary exchange rate policy, which had led to a strengthening of the forint after 1991 and had gradually undermined the competitiveness of the export sector. Economic growth ensued, but with very uncomfortable side effects: The state of both public finances and the trade balance deteriorated. Although GDP increased by 2.9% in 1994, the current account deficit rose to 9.4% of GDP and the state budget deficit reached 8.2%. The conservative government was voted out in the spring of 1994, but Gyula Horn’s new socialist-liberal government dithered over tackling the unpopular task of stabilisation, and by the spring of 1995 it had become clear that growth could not be sustained. Due to Hungary’s high level of foreign debt, refinancing had become very expensive and developed into a serious problem. High interest rates on state debt clearly indicated that international investors had lost confidence in Hungary’s ability to cope with its mounting difficulties, and the country’s insolvency became an imminent danger.

The 1995 stabilisation – the “Bokros package”

In March 1995, Gyula Horn appointed Lajos Bokros to the post of Minister of Finance and empowered him to embark on a radical programme of stabilisation. Together with new Hungarian National Bank Governor György Surányi, he devised the parameters of the so-called “Bokros package”. The forint was devalued by 9%, a crawling-peg exchange-rate regime was introduced, an 8% surcharge was imposed on all imports except for investment goods and energy, and draconian cuts were made in public spending. Although the Constitutional Court later overturned certain important aspects of the package, the remaining parts were sufficient to facilitate a radical turnaround. 1995 saw real wages drop by 12%, private and public consumption diminish, and net exports improve. Measured in terms of unit labour costs, the competitiveness of Hungary’s export economy had risen considerably.

This resulted in a spectacular improvement in the balance of trade. Aided by high privatisation revenues, net foreign debt dropped by a quarter from the end of 1994 to the end of 1996. Net interest payments on foreign debt as a percentage of exports of goods and non-factor services dropped from 12% in 1994 to 6% in 1996. Public finances recorded impressive successes as well: By 1996, the government budget deficit had dropped to one-third of its 1994 level, and public debt had decreased from 86% of GDP in 1994 to about 74%. Despite a strong decline in domestic demand, GDP continued to grow – albeit marginally – at 1.5% in 1995 and 1% in 1996.

Although the stabilisation package proved successful, it came at a high price. The devaluation of the forint fuelled inflation, which approached 30% in 1995 and even in 1996 was still higher than before the stabilisation programme had been introduced. Investment, which had enjoyed 10% annual growth before the stabilisation programme, declined by 5% in 1995 and 4% in 1996. Declining real wages and severe cuts in public spending led to popular discontent. The government’s popularity dipped dramatically while Lajos Bokros, the “father of the stabilisation”, became an object of public scorn. After less than a year in office, Bokros was dismissed, as he was unwilling to participate in watering down his programme, which envisioned further unpopular public-sector reforms.

The rise of populism

After the successful stabilisation in 1995–1996, Hungary entered a period of sustainable growth, which facilitated the rapid modernisation of the economy fuelled by a massive inflow of foreign direct investment. The arrival of foreign-owned companies led to a robust expansion of exports in the manufactured goods sector – primarily vehicles, telecommunications equipment and computers. These “golden years” of post-communist Hungary came to end in the middle of 2001 with the start of the campaign for the 2002 parliamentary elections. The Fidesz government, which had been in power since 1998, began with a 60% increase in the minimum wage implemented in two steps. An irresponsible tussle for votes ensued between the two major political parties – the governing Fidesz (Fidesz – Magyar Polgári Szövetség, Fidesz – Hungarian Civic Union) and the opposition MSZP (Magyar Szocialista Párt, Hungarian Socialist Party). Both parties promised election gifts which far exceeded the Hungarian economy’s capacity. Since this campaign, economic development has been determined by political cycles, with devastating consequences.

The MSZP won the 2002 elections by a very narrow margin. The opposition questioned the legitimacy of the election results, which immediately placed the new government – as in the 1994–1998 period a coalition of the MSZP and the SZDSZ (Alliance of Free Democrats) – as well as the new prime minister, Péter Medgyessy, under heavy pressure.

A few weeks after the elections, it became known that Medgyessy had worked for Hungary’s secret police under the communist regime. The government found itself under permanent siege, and thus not only fulfilled its unrealistic election promises, but surpassed them. Among other measures, it raised the wages and salaries of public-sector employees by 50% and introduced a 13th monthly salary as well as a 13th month pension. The opposition Fidesz, which attacked the government on almost all issues, voted for these additional expenditures in parliament. While these measures temporarily raised the standard of living, they resulted in a catastrophic surge in public debt. As a consequence of this expansionary fiscal policy, household consumption increased by 33% between 2001 and 2005, while GDP increased by just 18%.

 For several years, extremely favourable borrowing terms on capital markets had concealed the fact that Hungary’s growing public debt was not sustainable, and that a departure from the economic policy pursued since mid-2001 as well as the introduction of social reforms were urgently needed. Ferenc Gyurcsány, who succeeded Peter Medgyessy as prime minister in 2004, was aware of this, but did not want to risk a defeat for the MSZP in the next elections.

The 2006 election campaign was again marked by generous promises on the part of the political parties. The governing coalition remained silent on the extent of the country’s fiscal troubles and the unavoidable corrections that would be implemented after the elections. The opposition Fidesz campaigned on the slogan “We are worse off than four years ago” and promised “everything and much more”, despite the obvious fact that excessive private consumption relative to the economy’s actual performance was the main cause of mounting public debt and the ever-increasing  current account deficit.

Coming down from the clouds – the 2006–2007 consolidation

The elections in the spring of 2006 were again won by the MSZP, but it soon emerged that the fiscal deficit was much larger and the outlook much worse than the government had admitted before the elections. After years of lax fiscal policy, the old-new MSZP-SZDSZ coalition was compelled to introduce painful corrections. The reforms began under a bad omen, however: In a speech delivered to MSZP politicians in a closed session, Prime Minister Gyurcsány admitted to having lied before the elections about the true extent of the difficulties in the Hungary’s public finances. When the speech reached the press, a wave of violent protests shook the country, and the opposition declared the prime minister, the entire government, and the austerity measures it had introduced as illegitimate. [7]

Despite the extreme political pressure exerted by the opposition, the government began to consolidate the economy. After years of deficit targets having been systematically set too low – only to be missed subsequently – the government now presented a real austerity package. Shifting away from the policy of excluding as many items from general government expenditures as possible, the amended convergence programme also included those items which had previously been concealed, such as outlays for the army’s new fighter planes, state expenditures for highway construction under public-private partnerships, and the financing of private pension funds. In addition, the government ended its deceptive practice of concealing the huge losses incurred by state-owned public transport companies MÀV (Hungarian State Railways) and BKV (Budapest Transport Company).

Among other measures, the consolidation package included cuts in ministerial staffing, a 4% solidarity tax levied on companies’ pre-tax profits, and a de facto increase in the corporate income tax rate from 16% to 20%. Higher taxes were also imposed on individuals earning more than EUR 2,000 per month. The bulk of the burden, however, fell on the broader public: The preferential VAT rate was raised from 15% to 20%, leading to price increases primarily in food, public transport, electricity, gas and water. State subsidies on gas and electricity prices were slashed radically, with partial compensation for only the neediest households.

With the help of the austerity package, the Hungarian government deficit was reduced from over 10% of GDP in the summer of 2006 to below 4% in 2008. Despite this spectacular success, the coalition pushed ahead with reforms in the health care, education and pension systems, as well as in local administrations, in order to secure low budget deficits in the long term.

The first stage of reforms in the health care system introduced fees for medical consultations as well as a daily rate for hospital stays. In the next stage, the number of hospitals was to be reduced. Also envisaged were the introduction of tuition fees in higher education and new accounting principles for local administrations.

The government failed to communicate to citizens how critical the reforms were, however, and the coalition parties were in disagreement on important details. Perhaps most significant was the aggressive demagogy of the opposition Fidesz party, which declared the consolidation of public finances as well as the reforms to be unnecessary and inacceptable.

As a result, popular support for all these changes proved insufficient. In March 2008, the government was dealt a landslide defeat in a referendum on abolishing the newly introduced health care fees and the envisaged tuition fees. It never recovered, and soon the governing coalition fell apart, again leaving long-overdue social reforms unrealised.

The international crisis and the 2009 consolidation

Although the cause of reforms had stalled, the real economy survived the shock of the consolidation. Due to shrinking domestic demand, economic growth had slowed to below 1% in 2007, but GDP figures for the first two quarters of 2008 already hinted at an incipient recovery. It seemed that the Hungarian economy had overcome the critical phase of fiscal adjustment. The recovery was rudely interrupted, however, by the international financial crisis in mid-2008.

Despite Hungary’s progress in curbing fiscal deficits in 2007 and 2008, it continued to be perceived as one of the most vulnerable emerging market economies. In mid-October 2008, amidst enormous volatility in the forint’s exchange rate, the market for Hungarian government bonds dried up despite the high yields offered. Sovereign credit default swap (CDS) spreads rose sharply. Owing to Hungary’s dependence of capital markets to refinance its huge debt – public and private foreign debt amounted to 114% of GDP at the end of September – the threat of insolvency loomed. Only with the help of a EUR 20 billion rescue package – a EUR 12.5 billion stand-by agreement with the IMF, EUR 6.5 billion from the EU and EUR 1 billion from the World Bank – was this averted.

The main condition of the standby agreement was a reduction of the government deficit to 2.6% of GDP in 2009, under the assumption that GDP would contract by 0.9%. However, since growth prognoses for Hungary’s most important trading partners – in particular Germany – continued to deteriorate and Hungary’s domestic demand remained weak, it soon became clear that the drop in GDP would be much more severe. Since this also necessarily led to a decline in government revenues, it was obvious that the 2009 deficit target could not be achieved without further spending cuts.

It thus fell upon Gordon Bajnai’s caretaker government to implement new fiscal consolidation measures in the spring of 2009. These abolished the 13th salary and pensions, set indexation of pensions at the inflation rate, introduced a gradual increase in the retirement age from 62 to 65 years, reduced the sickness benefit from 70% to 60% of salary, and raised the standard VAT rate from 20% to 25%. This led to a 2009 government deficit of just 4.5% – one of the lowest in the EU. While this was nominally nearly identical to the 2008 deficit, however, diminishing tax revenues caused by the recession had necessitated a considerable fiscal adjustment, with painful pro-cyclical effects.

Nevertheless, the reforms’ success soon took hold, and the government was again able to finance its public debt on international capital markets. Yields on forint-denominated government bonds fell to pre-crisis levels, which enabled the government to stop drawing IMF, EU and World Bank resources.

The return of populism

Although the Bajnai government had achieved a successful consolidation in 13 months, the painful adjustments which had been necessary and the MSZP’s loss of credibility over the dishonest 2006 campaign led to a Fidesz landslide in the 2010 elections. The party secured a two-thirds majority in parliament, giving it enough votes to pass any law and even to change the constitution. After eight years in opposition, Fidesz returned to power with a fundamental critique of the previous government’s economic policy of fiscal stability.

Incoming Prime Minister Viktor Orbán outlined an ambitious economic programme: Growth was to be stimulated through radical tax cuts, a million new jobs were to be created within ten years, and wages were to be raised. These measures were to be financed by additional tax revenues – the government assumed annual growth of 5-7%. Yet the feasibility of such a programme was questionable in a highly indebted country struggling with chronic structural fiscal deficits. The Hungarian economy’s central problem – aside from persistently slow growth – was that a reform of the inefficient social redistribution systems had still yet to be implemented, but the government was not concerned about this desperately needed reform.

The Orbán government could not launch its economic programme without significantly expanding the budget deficit – temporarily, it hoped. Thus, immediately after assuming office in May 2010, the government began to lobby for a revision of the deficit target. Instead of the 4% limit agreed with the EU in the convergence programme and with the IMF in the standby agreement, a government deficit of 6-7% should be permitted. In view of Hungary’s pre-2006 track record of fiscal deficits, however, coupled with the summer 2010 panic on European financial markets over developments in Greece, Orbán was unable to sell this idea to either the EU or the IMF.

This left the government with two options: It could either abandon the central element of its plan – radical tax cuts – and focus its efforts on other components of the programme, while continuing the fiscal consolidation launched by the Gyurcsány and Bajnai governments in 2006 and 2009, respectively, or it could push through the tax reduction and try to meet the deficit targets agreed with the EU and IMF by raising new revenues.

The Orbán government chose the latter option, and the radical tax reduction came into force at the beginning of 2011 [8]: A flat 16% personal income tax was introduced, replacing the existing two-tier taxation system of 17% and 32%. The corporate tax rate for the SME sector was reduced from 19% to 10%, and other minor taxes were also lowered.

These general tax cuts were accompanied by special tax rises: The government imposed a temporary levy on financial institutions, introduced specific temporary taxes for the large – predominantly foreign-owned – enterprises in the energy, telecommunications and retail sectors, and nationalised the accumulated assets of the mandatory private pension funds worth c. EUR 11 billion. About one-fifth of these one-off revenues went to finance current budget expenditures in 2011, while the rest were earmarked for paying down public debt.

The main problem with this scheme was that the revenues from the special levies were all temporary – the special taxes are to end in 2013 – and the assets of the nationalised pension funds are one-off revenues. In contrast, the revenue-diminishing effects of the tax cuts remain, raising the spectre of severe fiscal imbalances in the medium term.

In May 2011, nearly one year after taking power, the government dropped its position of “economic growth first and then a balanced budget” overnight, and declared war on public debt. The so-called Széll Kálmán Plan called for far-reaching steps in various segments of the pension system, the social welfare system, education and cultural policy. In the autumn of 2011, the government cut unemployment benefits and enacted a compulsory re-activation of army officers, policemen and fire-fighters participating in early retirement schemes. The number of universities is to be reduced as well. [9]

An uncertain future

Economic growth in the first half of 2011 was substantially lower than the government had hoped, and – instead of a clear upswing – at best minimal growth is likely for 2011 and 2012. The expectation that tax cuts would spur domestic consumption proved to be unrealistic. If the deficit targets for 2011, and especially for 2012, are to be met, urgent steps must be taken. In order to achieve a fiscal consolidation that will be sustainable in the long term, austerity measures in health care, the pension system, higher education, and local governments are indispensable.[10] Such decisions are never easy for any government in any country, but in Hungary political factors exacerbate its economic difficulties. Before the elections, Fidesz’s platform was spearheaded by the promise that austerity measures were unnecessary, and it strongly condemned the previous government’s consolidation programme. Had the Fidesz leadership shown a minimum of responsibility and foresight, they would have recognised that they would be confronted with the same difficulties once in power. Orbán would still have won the elections had he offered a more responsible programme, although not with a two-thirds majority.

Most Hungarians have remained passive while critical elements of democracy and the rule of law have been dismantled.[11] Even the nationalisation of the private pension funds’ assets – which was essentially a confiscation – and the flat tax, which has resulted in a growing wealth gap, have failed to arouse widespread popular discontent. This changed in the autumn of 2011, however, with a mass rally on 23 October, although the parliamentary opposition remains splintered and weak.

In connection with the turbulence in the euro zone, important indicators for financing Hungary’s foreign debt worsened in October and November 2011. The forint weakened against the euro, CDSs for Hungarian government bonds rallied, and a new bond issue failed in part. This led to a 180-degree turn by the government on 17 November: Minister of National Economy György Matolcsy announced that Hungary would approach the IMF to negotiate a new agreement on international financial assistance for Hungary.

In order to reach an agreement with the IMF – and necessarily also with the EU – Hungary in all likelihood will have to undertake significant corrections in its economic policy. Since the special taxes will expire at the end of 2012, the government will have no choice but to present a credible consolidation plan for the medium term. Regardless of how many propaganda smoke screens the government deploys, Fidesz will not be able to conceal the fact that the indispensable fiscal consolidation will involve spending cuts. The government and Prime Minister Orbán personally will soon have to face up to the fact that the dreams they sold as a programme in the 2010 election campaign have nothing to do with a realistic economic policy. Just as the populism of 2002–2006 had to collapse, the second populist phase – instituted by Fidesz in the spring of 2010 – must inevitably come to an end as well.

Should Hungary wish to find its way out of the blind alley it entered ten years ago, it must bid farewell to populism of any political stripe. Only if citizens call themselves unsparingly to account for Hungary’s true economic situation will the country have a chance for a new beginning and again take its place alongside the prosperous East Central European countries of Poland, the Czech Republic and Slovakia.

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English copy editors Petra and Evan Mellande, Prague