LIBERALISM vs. SOCIALISM

Today's Hardtalk on BBC World News (link) discussed the political, economic and social aspects of communism versus liberal capitalism with Slavoj Zizek ,a philosopher and professor at European Graduate School.

Mr. Zizek discussed the role of liberal capitalism in the modern age. He condemned communism as a failure of the mankind and reaffirmed the liberal capitalism as the greatest invention of the mankind. The topic discussed was the future of liberal capitalism. In arguable words of Mr. Zizek, liberal capitalism, although dynamic and powerful in delivering ends of political and economic freedom, is doomed to fail and it thus requires new politico-economic alternative, divisible at the intersection of market and the state. Despite the interactive debate, I would like to add some points to the discussion which were, in my opinion, either mismatched or misinterpretated.

The evolution of liberal capitalism throughout the course of human history has been emphasized by the expansion of economic, political and human freedom. The greatest inventions in human history were not conducted under dictatorial political regimes. But they were conducted during the age of limited government and free innovation environment. Anytime the powerful wit of government was enforced, innovation and discoveries suffered. Although Mr. Zizek recognizes the failure of totalitarian regimes to stimulate intellectual creativity, his analysis of liberal capitalism inherently neglects its role.

The ability of individuals and firms to pursue their own goals in liberal capitalism is enabled not because of the design of desirable goals but because the free-market capitalism evolved as an undesigned system of ideas under strong rule of law. If liberal capitalism, as Mr. Zizek argues, would be doomed to fail, the individuals never witnessed an unparalleled increase in prosperity and in the 20th and 21st century.

What has distinguished communist political regimes from liberal democracies are the institutions of economic freedom. There is a clear and remarkably positive empirical relationship between economic freedom and standard of living. The experience has shown that political liberty is a neccesary but not sufficient condition for prosperity. Both, the neccesary and sufficient condition for the pursuit of prosperity is economic freedom. Without economic freedom, when governments replace the rule of law with the rule of man, and heavily interfere with free-enterprise activity, these countries are doomed to stagnate. Totalitarian political ideology, claiming to create heaven on earth, has always turned towards the hell on earth.

During the interview, Mr. Zizek argued several times that liberal capitalism can eat itself and fail in a similar vain as communism did. The Soviet Union and the communist block certainly hadn't failed because of the lack of technological investment, but because communist political ideology erased the system of incentives. Even today, when several politically totalitarian countries sustained high growth rates, the superiority of liberal capitalism is even more obvious. The motion behind the economic miracle of Gulf countries, such as UAE, Bahrain and Qatar, is the institutional arrangement that promotes solid economic performance under robust system of law, market economy and incentives that allocate scarce resources into the most appropriate uses. In the interview, Mr. Zizek described Dubai's miserable labor conditions as "labor concentration camps" where workers from other countries reside. Although this view sounds very compelling to Marxist philosophers and political thinkers, no government agency forced foreign workers to go to Dubai and work there.

In fact, the economy of United Arab Emirates went through a remarkable restructuring with the creation of the robust financial and service sectors. As productivity growth and capital investment soared in recent decade, wage rates in Dubai are much higher than in other Arab countries. Still in doubt? Ask foreign workers in Dubai how many of them would leave the place and returned to work in their home countries; and why they don't do that. In addition, in Mr. Zizek's home country, labor conditions for foreign physical workers mostly from ex-Yugoslavia are not the envy of the world despite the most regulated labor market in the world.

There is also a wide array of case studies from recent economic history that show how economic freedom crucially determines the wealth of nations. In 1955, Hong Kong was a miserable place flooded with refugees from the mainland China. In 1960, Hong Kong's average income per capita was 28 percent of that in Great Britain. In 1996, it rose to 137 percent of that in Britain. Neither the dictatorial political regimes led to the economic boom in Hong Kong, nor the desire to create heaven on earth. It was a set of strong rule of law of British origin, limited government spending and free markets that propelled Hong Kong to the climb up the ladder.

Mr Zizek arguably enforced the proposition that global financial crisis led to the crisis of liberal capitalism. Although the global financial crisis led to the recession, high unemployment and deflating prices, it certainly has not put the existence of liberal capitalism into doubts.

The origins of the last year's financial crisis go back to the New Deal and presidential time of Jimmy Carter and Bill Clinton whose administrations, as benevolent social engineers, enforced numerous acts to boost home ownership. Back in 1996, president Clinton signed Community Reinvestment Act which forced banks to allocate housing borrowings to low-income neighborhoods. In the aftermath, Fannie Mae and Freddie Mac securitized risky sub-prime mortgage loans to save banks from default. Meanwhile, they inflated debt-to-equity ratio to 60:1. It means that for deposit of USD, there were 60 USD behind in debt that nobody was willing to bear.

In addition, the monetary policy of the Greenspan era kept low interest rates for too long which causeed an asset bubble and led to the decrease of mortgage values It led to the federal bailout of Bear Sternes and the failure of Lehman Brothers. It also triggered innumerable quests for federal bailout of financial institutions. Thus, it would be foolish to speak about the crisis of liberal capitalism after the financial meltdown. Is liberal capitalism to blame? Of course not. It is rather the greedy political apetite for destructive policies that compromised the stability of the world economy for the sake of short-term political goals.

Mr. Zizek wisely avoided the question of the post-communist politico-economic status of Slovenia after the collapse of Tito's Yugoslavia. True, Slovenia's superior economic performance in Yugoslavia was mainly due to its export orientation and higher growth compared to the rest of Yugoslavia. At the beginning of the independence in 1991, Slovenia was, by all measures, the most developed former communist country; far ahead of countries such as Czech Republic, Slovakia and Estonia. Today, Czech Republic virtually caught-up Slovenia's level of standard of living. In 2008, Czech Republic's GDP per capita was 94 percent of that in Slovenia. In 1991, it was merely of 60 percent of that in Slovenia. The politicians, of the same "market socialist" politico-economic beliefs as Mr. Zizek, designed the statist economic policy based on high tax rates, state-owned enterprises, weak rule of law and rigid market structures. Today, Slovenia's economic and political system more closely resembles Russia's mafia state than a liberal society based on economic freedom, rule of law and limited government. In a great part, thanks to the political ideology of "market socialism."

IS SLOVENIA THE NEXT SICK MAN OF EUROPE?

Recently released data from OECD Economic Outlook (link) suggest that the recessionary period is likely ending as the output in world's major economies is reversing the trend of the past year. In 2009, the U.S economy is expected to contract by 2.8 percent annually. Germany, suffering from a significant decline in inventory orders and foreign demand, is set to contract by 6.1 percent and Japanese economy is likely to decline by 6.8 percent. The end of the global recession will be continued by a slow recovery as the economic growth in the OECD economies is most likely to reach 0.7 percent in 2010 after a 4.1 percent decline in 2009.

Besides Israel and Estonia, Slovenia is the next country to join the OECD. The macroeconomic outlook for Slovenia, unfortunately, remains sluggish. In Q2:2009, Slovenian economy contracted significantly. The output decreased by 9.3 percent. In Q1:2009, the economic activity decreased by 9.However, the data on GDP decline is too optimistic compared to the real sector. According to the latest availible data, the industrial production in April contracted by 28.26 percent, followed by double-digit consecutive declines each month. Investment, which in 2008 accounted for 28.9 percent of the GDP declined significantly. In Q1:09, the business investment contracted by 32.3 percent.

The pre-crisis boom in business investment was surged by quantitative easing and low interest rate which contributed to historic highs of credit stock. In addition to deteriorating macroeconomic outlook, the export of goods and services, which once used to be the core engine of Slovenia's economic growth, contracted by 21.1 percent in the Q1:2009. Thus, during 2008, the economic activity experienced unusually high rates of economic growth spurred by investment, foreign demand and historically high consumption spending. Throughout 2008, the economy was starting to exhibit strong signals of overheating.

By the beginning of the crisis, the economic policy pursued a radical debt-driven infusions of liquidity in the banking and bailouts to the real sector. Consequently, the state of public finance changed dramatically. For decades, Slovenia maintained on of the lowest public debt/GDP ratios in Europe. As a fiscal measure, low public debt had been of the merits that enabled the fulfillment of convergence criteria before entering the EMU.

As a result of government intervention, debt guarantees and surging public spending, the public debt is likely to soar from 21.5 percent of the GDP in 2008 to 32.6 percent of the GDP in 2009. The public debt is expected to rise further. If the current trend continues, the public debt is estimated to soar up to 53.7 percent by 2013 (link).

The black line and the left axis on the graph show general government balance while the left axis and yellow bar show public debt. Both categories are expressed in percent of the GDP.


Public debt and general government balance as a percent of the GDP (2004-2013)

Source: Ministry of Finance (link)

As we can see, the primary budget deficit will move from -0.27 percent of the GDP in 2008 to 6.58 percent of the GDP in 2009. By 2013, the deficit is estimated to move to -7.4 percent of the GDP. Compared to small and open economies, Slovenia's primary budget deficit is higher than in most small and open economies. It is, for instance, higher than in Denmark, Greece, Austria, Czech Republic, Finland, Luxembourg, Netherlands, New Zealand, Slovakia, Sweden, Switzerland and Norway. As far as I know, Norway is the only developed country without budget deficit in the near future (According to the OECD and Norges Bank, Norway will post 8.6 percent budget surplus in 2009, down from 18.8 percent in 2008. In 2010, the budget surplus will likely increased by 0.4 percentage point).

The government intervention in the real sector further regulated the labor market by introducing subsidies to employers to retain the employees and discourage layoffs to prevent the rise in unemployment. However, recent data suggested that public sector employment grew significantly while private sector employment declined respectively. In Q2:09, private sector employment decreased by 9.3 percent. Public sector employment, on the other hand, increased by 1.4 percent on the annual basis.

For at least two decades of transition, Slovenia's gradualist economic policy favored rigid and inflexible labor market embodied in collective bargaining, high tax rates on labor supply and barriers to entry. The economic policymakers created discriminatory labor market structure which still discourages young graduates from entering the labor market after graduation. Consequently, unit labor costs are among the highest in the EU. Recently, The Economist snapped a nice chart, showing that tax burden on labor supply in Slovenia is the highest in the world (link). In combination with ageing population and of the youngest retirement generations in the world, the abovementioned labor market dualism further encouraged policymakers to raise health and social security contribution rates. It lead to one of the lowest growth rates of private sector employment in the EU. It further lead to the highest tax wedge in the EU and the unusually high growth of unit labor cost relative to productivity growth. In addition, strongly regulated labor market is the major cause of Slovenia's low productivity convergence relative to the EU15. The majority of central European and Baltic countries have been lowering the productivity gap behind the Euroarea much faster than Slovenia.

In 2009, Slovenia reach 90 percent level of EU27's GDP per capita. Compared to the Euroarea, Slovenia reached 83 percent level of the GDP per capita. Compared to EU15, which is a reasonable measure of comparison, Slovenia reached 81.7 percent level of GDP per capita. Compared to Switzerland, Slovenia sustains only 64 percent level of Swiss GDP per capita (link). Interestingly, if Slovenia were a part of the U.S, its GDP per capita would be at the 54 percent of the U.S level, even lower than in Mississippi and West Virginia - the least developed states in the U.S.

Although Slovenia is often cheered as being the "Switzerland of the East" and the most developed former communist country, its economy will likely resemble slow growth in Italy, Germany and France rather than dynamic growth in Singapore, Hong Kong, Australia and Switzerland. Current economic policies are the recipe for eurosclerosis, experienced by pre-Thatcher Britain. If such pattern of economic policy will continue, the Slovenian economy will, sooner or later, exhibit economic stagnation with low economic growth, onerous tax burden, high structural unemployment and rapidly ageing population.

SLOVENIA: ELECTION AND THE ECONOMY

In Sunday, voters in my native Slovenia elected left-leaning political party that will presumably hold the majority in the national parliament, given favorable majority conditions for left-leaning political parties as well as the distribution of votes and preferences of political agents. Political analysts and comments have said that Slovenian voters now turned to the left. Aside from political populism of welfare state, it is time for a brief economic view on the future of Slovenian economy and consequences that left-leaning economic policy may induce.

Some Facts about Growth

In 2007 and 2008, the output of Slovenian economy grew by historically high rates, averaging around 6 percent. Economists have different views and analytical opinion what pushed growth onto such high rate. One group of economists believe that output increase is a consequence of demand boost through government spending on infrastructure that boosted economic growth, bringing demand-pull inflation as a consequence while another group of economists believe that Slovenia's economic growth is a result of higher investment rates, favorable global economic conditions such as lowering interest rate and tax cuts. After reviewing the data and forecasting assumptions, I analytically believe that the phenomena of economic growth in recent years in Slovenia has mainly been the outcome of robust investment, reductions in marginal tax rates on labor and capital, and low interest rate. However, given the state of low interest rate, capital deepening is not a key to aggregate productivity growth. What Slovenian economy experieneced was surging investment and small supply-side tax cuts that boosted output growth. In the long run, the growth of productivity is essential to economic growth. Without it, the output growth would slowly diminish in relative terms since a continious lowering of interest rate would lead to deflation trap such as experienced by Japan in 1990s. As first, I would like to refer to the pioneering work of professor Moses Abramovitz on economic growth and output trends (here, here and here). Professor found out that there are huge growth residuals in the measurement of economic growth. For example, when the emergence of new economy propelled innovation, the latter was perceived as an exogenous shock, leaving a huge part of economic growth unexplained. While the static measurement of growth was an empirical practice as long as measuring samples of output growth were based on simplified input assumptions, dynamic advancement of innovation into production, at first, seemed as a measure that is decreasing productivity growth. However, productivity paradox revealed that assumptions in the measurement of economic growth are not a static experiment but rather an experiment that needed empirical renewal. Today, we measure economic growth through endogenous growth model where engines of growth do not come from the "outside" (exogenously) but from the "inside" (endogenously). An advantage of the endogenous model of growth is that, in general, there are not many residuals since shocks are already entailed into the model of growth. However, economic policy can significantly affect the economic performance over the future horizon.

The Greed of Political Agents

In the political market, political parties are utility-maximizing agents that seek anticipated rents through time and power they aim to achieve in the political arena. Therefore, their existence depends entirely on the distribution of economically absurd promises to different interest groups and stakeholders. In Slovenia's pre-election period, political parties delivered countless promises about the prospects of economic development, inflation and other economic issues. If there's a widespread virus of economic illiteracy, then the ideas such as "inflation is a fiscal phenomena" and "government is to be blamed for poverty" can really stick to the conventional wisdom.

Economic Scoreboard

In the fiscal year 2006-2007, the Ministry of Finance launched the first tax reform in the history of independent Slovenia. Top tax rate on personal income was reduced from 50 percent to 41 percent. Also, the entire tax code was gradually reduced from 5 tax brackets to 3 tax brackets with progressive income tax structure - 16 percent, 27 percent and 41 percent. Although tax burden remained high, consuming approximately 47 percent of the GDP, there was an intial supply-side effect on jobs, investment and tax revenue that reached historic highs after tax reductions were imposed. Also, budget deficit (in percent of the GDP) has been reduced and public spending (in GDP's share) reduced as well. Some economists blame tax reductions for poverty. In Slovenia, there is a wrong perception of poverty. The latter cannot be defined by confusing income and net wealth. Using Gini coefficients, the income inequality in Slovenia is among the lowest in the EU, just behind Sweden and Denmark. Also, using Eurostat data (here) as an analytical source, the risk of poverty in Slovenia is among the lowest in the world. Also, Slovenians owe the highest share of owned tangible households in the world. Thus, the rate of poverty in Slovenia is approximately 3 percent of the individuals above the age of 15. In the last four years, the rate of economic growth reached historic highs. Even though Slovenia is a transition economy, output growth throughout transition period was among the lowest in Eastern Europe. However, in the last four years, output growth exceeded 5 percent; the most rapid economic expansion in the economic history of independent Slovenia. Unemployment shrank sharply with its natural rate averaging 4 percent. Although "higher wages" are a popular manifest nowdays, it must be recognized that, in the long run, wages and productivity correlate. In the short run, it is evident that wage growth is behind the productivity growth. Recently published data by the Eurostat have shown that Slovenian economy has not completed the convergence of productivity relative to EU27. Today's level of real labor productivity in Slovenia is 84 percent of the EU27 level, and between 60 and 70 percent of the EU15. Estonia is the regional leader in productivity convergence from 1997-2008, while Slovenia is a regional laggard. From 1997 to 2008, the overall productivity improved by 12,5 index points. For example, in 1997, the relative level of real productivity in Estonia was 38,7 percent of the EU's. In 2008, today's level of real productivity in Estonia compared to the EU is 65,4 percent. Not surprisingly, there is an obvious empirical relationship between bargining power of the unions and slow productivity growth since economies with higher bargaining power of the unions tend to have lower productivity growth. Social democrats, the winners of the election, pledged to raise taxes on productive behavior. In that case, the growth of productivity would reduce to at least 2,5 percent in the medium run. In that case, Estonia's standard of living would catch-up Slovenia's standard of living in 13-14 years, assuming Estonia's 4,5 percent average productivity growth over the medium term. Unfamously, Slovenia is known for the highest rate of inflation in the EMU. Neither the introduction of euro, neither "fiscal impulse" are the flames of inflation which is (by the way), monetary phenomena True, lower interest rate in previous periods by the ECB may have boosted output activity and, at the same time, boosted the level of prices but, in retrospect, high rate of inflation is a consequence of rigid market structure that spills supply shocks into higher prices either because of oligopolistic market structure that imposes mark-ups on input prices, spilling it into consumer prices.

Looking to the Future

After the political turmoil, it is likely that left-leaning political parties will continue the statist course of economic policy with high tax burden in the share of the GDP, hostility towards financial markets (with enormously high tax rate on derivates) and foreign direct investment, postponing privatization with political management and meddling of inefficient state-owned companies. Tax rates will likely remain the highest in the region and Slovenia will, after Hungary and Croatia, remain the only country without flat-rated income tax. As in previous periods, there is little prospect for labor market deregulation that severely hampers productivity growth. In the long run, productivity is everything. After decades of market socialism, Slovenia's unique gradualist approach to economic reform, there is still much to be reformed immediately. Without tax cuts, market liberalization, reduced public spending, the economic growth, and consequently, the standard of living, would decline. Economic theory and practice teach us that there's no better welfare state than high economic growth, enabled by economic and individual freedom.

Rok SPRUK is an economist.

Copyright 2008 by Rok SPRUK

THE REAL FACE OF PUTINOMICS

Aleh Tsvynski and Sergei Guriev wrote a brief article on Russia's state of the economy and political stability. Here's a slice of the article:

"The other major barrier to growth is corruption. In another World Bank-EBRD survey, 40% of firms in Russia reported making frequent unofficial payments, and roughly the same percentage indicated that corruption is a serious problem in doing business. Unlike in other emerging markets, corruption has not declined with economic growth; it remains as high as in countries with one-quarter the per capita income of Russia."

ECONOMICS AND THE RULE OF LAW

Last week, The Economist posted an article (link) describing the relationship between economics and the rule of law. Until recently, the rule of law has been regarded as a matter of political and moral philosophy while neoclassical economists paid little or no attention to the rule of law in the course of economic analysis. Thanks to the contributors of Austrian school of economic thought and institutional economists, the rule of law was shown as an influential motherhood in economic development. Douglass C. North, a distinguished recipient of the Nobel prize in economics back in 1993, demonstrated the significance of the rule of law in his book "Institutions, Institutional Change and Economic Performance" where he wrote that the inability of societies to develop low-cost effective institutions being able to reduce transaction costs is the very reason of economic stagnation in both, historical and current perspective.

Seriously, is there a thing such as market failure?

In the course of economic thought, the rule of law emerged as an issue together with the collapse of the socialist economies of the Eastern block. After the fall of the Soviet empire, Eastern Europe had become a laboratory of testing economic macro and micro theories. Nevertheless, many curious conclusions were made. Among them, the rule of law and the ability of institutional flexibility were recognized as a driving vehicle in the process of economic growth and development. The essence of the rule of law could hardly be defined from a utilitarian perspective. In fact, former communist countries grew tremendously after the ideas of Karl Marx and Vladimir I. Lenin were put into practice. The industrial production and overall output grew several-fold but in the end, the economic growth in the socialist world failed because market incentives to work, save and invest were a deadlight line and the economies from the former socialistic empire were likely to be a balloon, virtually inflated by illusion waiting to explode.

Learning from Hayek and Locke

In economics, the idea of the rule of law was initiated by two distinguished economists. In his book, The Constitution of Liberty, Friedrich August von Hayek wrote that the aim of the rule of law is to set a basic framework of general rules perceived without coercive action. Simply, the more specific the law becomes, higher the magnitude of coercion. In 1690, enlightenment philosopher John Locke captured the essence of the rule in a brilliant sentence: "Wherever law ends, tyranny begins."

Current economic issues confirm that Hayek and Locke were right. When Asian crisis (1997-1998) deflated the expectations of the right policies, the essence of the rule of became obvious. Without a low-cost institutional setting of policymaking based on the rules rather than discretionary action, no macroeconomic reasoning (whether it is intuitive or analytical) may give desirable results.

Effort in the short run, 300 percent dividend in the long run

The first lesson I met when I opened my first economics textbook was that resources are scarce and therefore the optimal allocation of resources together with a given budget constraint is the precise mechanism that solves the basic economic problem displaying the limits of allocation for particular desires. However, it seems that modern postulates of political reasoning seem to neglect the first and very basic principle of economics. Thus, without a high-quality governance and the rule of law, the great divide between different countries is about to start. Economists Daniel Kaufmann and Aart Kray published a challenging working paper called "Growth without Governance" (link). What they showed is a 300 percent dividend, meaning that in the long run, country's income per head rises by about 300 percent, if its governance is improved by one standard deviation point.

Discretion returns discretion

The indices of the unruly law are the object of discretion settled deeply into the institutional framework. By itself, executing discretion among economic agents is more fatal than obviously perceived. In a more technical economic terminology, discretion leads to suboptimal allocation of scarce resources and into a more rigid institutional framework. Thus, discretion is the first step to the point where the law ends. There has been a lot of discussion about discretion (link) but honestly what discretion really means. Three economists, Vishny, Schleifer and Murphy (link) showed how rent-seeking negatively affects economic growth. The outcome of the institutional chaos when private agents seek anticipated benefits via public means. For example, using Nash Equilibrium, the outcome of the bargaining between two agents depends on the type of strategies. A dominant strategy undertaken by one agent is based on the setting of infinite utility given the information, status and unique preferences derived from the lack of the rule of law.

Rent-seeking and infinite demand for private wants by public means

In a rent-seeking model, the demand for public goods in mostly infinite while the supply is limited as shown by a fixed supply curve in a given space and time. The infinite demand is derived from incentives and preferences of the interest groups targeting the maximization of benefits at any price, given the monopoly status that enables the control and access to information needed to bargain a desirable slice. The comparative difference between market outcome and bargaining outcome is the rent, and the interest groups hindering the quality of the rule tend to change their behavioral responses to maximize the differential between market rate and bargaining outcome.

The long run consequences of the lack of the rule of law, meaning rigid and unchangeable institutions, are lower economic growth and structural defects such as corruption and rent-seeking incentives to abuse the rule of law and attain the outcome unavailable in the market with an unchanged productivity performance.

There is no such thing as growth without economic freedom

The question is why economic growth soared in places without changeable institutions and quality governance. The answer can partly be explained by the fundamental laws of macroeconomics such as the law of diminishing return or/and catch-up effects. A country Y with low per capita GDP attains higher growth rate than a country X with higher GDP per capita. In the long run, growth differential gradually disappears. The quality of governance and institutions cannot be neglected. The answer to the question why Ireland is richer than Mozambique is that institutional change and non-discretionary rule of law in Ireland enabled an economic performance that resulted in a decade of stunning growth and an unparalleled prosperity.

Paying the price of the status-quo

As the first former communist economy which recently adopted Euro as a single currency, Slovenia is often praised for its achievements. One side of the coin is certainly true but the other side of the coin shows a completely different picture. In 1990, the GDP per capita of Slovenia and Ireland was merely the same, measured in USD and adjusted for inflation. Today, Ireland's GDP per capita is 1,77 times (PPP) and 2,66 times (in current USD) higher than Slovenia's GDP per capita. Today, it would take between 50 and 60 years for Slovenia to "catch-up" Ireland's GDP per capita, adjusting it for inflation. Surely, Irish economy enjoyed the benefits of stable and non-discretionary institutions that helped sustained an incredible economic performance. On the other side, Slovenia's envious economic performance is mostly a continuous leap with little change in innovation and productivity performance. In fact, according to Eurostat, Slovenia is among those transition economies that have sustained a slow-motion productivity growth compared to Baltic tigers. Gimmick and backbone perspectives and shadows wavering over Slovenia's economy will sooner or later deliver a menu of price - a price of the absence of the rule of law and the price of the status quo. Period.

Rok SPRUK is an economist.

Copyright 2008 by Rok SPRUK

SLOVENIA: GERMANY OF THE BALKANS

By January 1, 2008, Slovenia took over the chairmanship of the EU presidency. In its latest article Slowenien: Deutsche vom Balkan, Der Spiegel described Slovenia as Germany of the Balkan region. Although the EU presidency would normally mean a final stage in leaving the Balkan region, such argument is very far away from the truth. My colleague Rado Pezdir once wrote a brilliant article on how unambitious Slovenian government really is in its intentions to discuss presumably relevant topics on behalf of EU presidency. Rado wrote:

"...the EU as it is today, is definitely not sustainable. Slovenia integrated into the union of nations instituted upon market capitalism. Regarding the negative experience we had with previous regimes of dictatorship, rational voters would agree that the only positive feature of current Slovenian government is that the latter attempts to pursue the agenda over democracy and market capitalism. Everything else is a zero-sum game as it was in Habsburg Monarchy, Kingdom of Yugoslavia and Tito's communist Yugoslavia. That's why, bluffing with all sorts of speech, banquets, inaugurations and fantasies about the relevancy of Slovenian Republic in foreign policy, will nevertheless be a clear signal, that Slovenian government has absolutely no idea what is it doing in the European Union. Nonetheless, given the current state of political and economic climate, Slovenia could easily be integrated into the African Union, leaving behind local monopolies and nation-wide cartels."

Source: Rado Pezdir, Croats and Banquets - The Radius of Janez Jansa's Government, Finance, July 9, 2007 (link - subscription required).

In 1991, Slovenia emerged as the wealthiest former communist state with the highest GDP per capita in Eastern Europe. That was a sign that Slovenia's socialist politico-economic system allowed some (!) private initiative. For example, manufacturing companies were allowed to operate with private means of production, but only if there were five or less employees. However, the entrepreneurship under production means of private property and ownership was strictly prohibited. The manufacturing sector was hardly seen. Later, the hope of the most successful economy in Eastern Europe suddenly disappeared.

Slovenian politicians quickly embraced the idea that the country must progress gradually by a beguiling path of non-reform. The consequences were terrible. The mainstream economists embraced the idea that foreign direct investment must be highly limited and prohibited in some sectors. Therefore, the privatization was delayed. By 2005, Slovenian government ownership share in major Slovenian companies was 35 percent of the GDP; the highest share in Eastern Europe.

Government ownership can be seen everywhere, managed by para-government funds - in Krka (pharmaceutical company), Triglav (insurance company), NKBM (banking company), Nova Ljubljanska Banka (banking company), Gorenje (household appliance producer), Petrol (oil company) etc. Slovenia has an unreasonably high tax wedge, among the highest in the EU. Taxes levied on labor supply and productive behavior negatively affect economic performance. High tax burden in the share of the GDP does not stimulate productivity growth and the growth of GDP.

There's a dozen of empirical arguments in favor of private ownership. Capital management under private ownership is better at approximizing the information and seeking cost-efficient solutions needed for a successful investment and return on equity as well as for other parameters of the firm. At the same time, looking at the productivity data, Slovenia hasn't yet reached a convergence of the productivity in line with EU15, EU25 and EU27.

The political map of Slovenia is perhaps the most terrible saga that has been continuing in historical cycles. Currently, there is no political party that would launch reform agenda to boost an ambitious political program in favor of higher and stable growth in the long run. Slovenia's economic policy is based on Keynesian ideas such as heavy public investment, inefficient public administration and government intervention into the free market. Each year, the World Bank composes a ranking of countries in accordance with the ease of doing business. This year, Slovenia was ranked as 55th most friendly environment for doing business.

This year's rank has arrived from 53th place last year. For example, in Iceland (link), the enforcement of commercial contracts is easy and payment disputes almost do not exist. In average, it takes 393 days to reach a full enforcement of commercial contract until the actual payment. In Slovenia, it possibly takes (link) 1350 days until the commercial contract claims and obligations are fully enforced after dozens of lawsuits and payment disputes. A research by Slovenia's Office for Macroeconomic Analysis and Development has shown that the major obstacle to starting a business is weakly protected rights of entrepreneurs regarding payment disputes.

Slovenia's Balkan ethics lies firmly into its unique political culture. Recently, Johnny Munkhammar wrote a book entitled Guide to Reform (here and here), where he showed how policymakers can achieve great results and win re-election by implementing long-range economic reforms. Slovenian political parties, whether they are left or right, always opposed full privatization, pro-growth tax policy, labor market deregulation, the rule of law and reductions in public expenditure.

Instead, interest groups control all types of decision under public policy. Trade unions, for example, roared against tax reform, denied labor market deregulation and stood firmly against education reform. Urban planners have controlled nearly every possible instrument that could enable the liberalization of housing sector. The ongoing consequence is that the prices of urban flats, housing and land are stratospheric. Slovenia's agricultural lobby can easily be compared to the "state-within-the-state".

Besides holding a complete control over land resources, they boost artificially high land prices, given a flat downward sloping curve of land supply. Protectionism has arrived at the cost of enormously high consumer housing prices. In addition to the pedigree of central planning, Slovenian Apartment Fund, under government control, runs a policy of full price control. Nevertheless, price controls fail sooner or later.

Slovenia's political system is marred by dusts of old-style protectionism and anti-competitive mentality. State Council is holding an enormous power of public decision-making. It can simply block the decisions which have been democratically approved by the parliament. State Council is a symptom of Mussolini's idea of the corporate state where the interests of stakeholders are firmly protected in the economic system.

In addition to obscure institutions such as State Council, there is also an ESS, which could be called Economic Schutz Staffel. It is a cooperative body called Economic Social Council where employers, government and trade union impose wage-control policies. This particular council indeed has terrible consequence for the growth of living standards which are, by the wisdom of economic theory, determined by productivity. In the long run, productivity is everything.

At last, Slovenia's blurred image is further degenerated by the inefficient and cumbersome judicial system. Property rights are very weakly protected. According to Heritage Foundation's 2007 Index of Economic Freedom, Slovenian courts are inefficient and procedurally slow with a bulwark of reports about legal corruption. The latter is widespread. It enables everything what is legally prohibited under the rule of law.

In Balkan region, Slovenia is the most developed country according to official parameters. Its eastern neighbors call it "Slavic Switzerland" or "Balkan's Germany" as Der Spiegel wrote in the abovementioned article. The reality is quite different from official reports of a happy sub-Alpine nation enjoying an ever-lasting prosperity.

This myth has been erased when Slovenia entered the European Monetary Union when country's inflation skyrocketed because of structural inflexibility. But nevertheless, depression, anti-competitive mentality, status quo, degenerated legal system, slow economic progress, violence against intellectual and productive individuals, psychological torture, public unsafety and spurring corruption are the best signs of country's international rank. However, structural misery cannot escape the pen of history.

Rok SPRUK is an economist.

Copyright 2008 by Rok SPRUK

PRIVATIZATION OF STATE ENTERPRISES: THE CASE OF SLOVENIA

Dr. Joze P. Damijan, the professor of economics at Vienna University of Economics and Business Administration, recently wrote an article about the need to accelerate the privatization of state enterprises in Slovenia. The article can be read here and here.

In Slovenia, 65 percent of the GDP is composed of private sector while public sector is extensive, accounting for about 35 percent of the GDP. There is a numerous empirical evidence in favor of privatization. In fact, the allocation of scarce resources is the key argument for privatization. Managers in state enterprises have different interests than private investors. That's why, private enterprises are more risk-taking in particular investment opportunities. Thus, as an empirical matter, private investors usuallly sustain higher rates of return on equity than managers in state companies.

In Slovenia, the government has been controlling the economy by extensive ownership participation in all major enterprises, ranging from insurance companies (Triglav), pharmaceutical industry (Krka), manufacturing sector (Gorenje) to retail industry (Mercator), banking sector (Nova Ljubljanska Banka, NKBM) and even telecommunication sector (Telekom Slovenije, Mobitel).

There is also a proof that sizeable state entrepreneurship reduces growth and distorts capital allocation nevertheless. In China, there is an average estimate that a decrease in state-owned enterprise share of industrial production increases real GDP growth by 1,14 percent (Phillips, Kunrong 2003).

In Slovenia, political and popular attitude toward the privatization is somehow negative. Yet, the privatzation is urgent. Some privatization is already taking place. Unfortunately, it is taking place very slowly and non-transparently. The withdrawl of government ownership of enterprises is essential to sound economic performance and economic liberty nevertheless.

STREET SOCIALISM IS THE LAST SHELTER OF SCOUNDREL

Following the headlines of the international media, Slovenia is a fine land consisting of happy people, whose country's nobility is enriched by the fact that Slovenia is the wealthiest post-communist economy which recently entered the European Monetary Union, and a country enjoying the highest GDP per capita and standard of living in the Eastern Europe.

However, the reality is something completely different as I try to demonstrate in the words below.

Being a student is a nice slice of lifetime. I do not pay attention to attending student parties and thus, I rather wisely invest my time into sitting at the library and studying the economic theory, policy and philosophy besides regular study courses. The fact is that the opportunity cost of attending parties is huge and it'd be completely irrational to neglect it or ignore it respectively. For example, Kobe Bryant understands his opportunity cost very well. He can, for instance, spent 2 hours mowing his lawn, having low overall return.

Contrary, he can record a TV commercial, earning $10,000 USD in two hours. His neighbor, Sally, might spent 2 hours working in McDonald's, earning $8 USD. Despite the fact that Kobe might mow the lawn faster than Sally, it'd be rational for Kobe to record a TV commercial while it'd be equally rational for Sally to mow the lawn, because of the opportunity cost.

Economically, my interest as a student is to finish the undergraduate study as soon as possible and get an overall return from the education. The opportunity cost of the education is, of course, my time. But in a broader perspective, higher earnings and human capital value is what shall count as a compensation for investing my time into the education, getting both: better education and better job opportunities.

As an economist, I strongly favor free choice; an ability to choose among the greatest possible set of alternatives in the course of human life. In fact, individual, economic and political liberty and individual responsibility to the fullest possible extent, is what has unlocked creative and talented entrepreneurial and intellectual minds to pursue intuitive and powerful ideas that shaped the economic future.

But I don't understand, why on earth, should the students jump on the streets, wear red suits, head old Soviet flags and shout in favor of the welfare state extensively. Slovenia's student organization, pensioners, public sector employees and trade unions claim that wage increases should be more robust subject to Slovenia's sound current economic shape and, on Saturday morning, they will march on the streets of Ljubljana and promote the spellings of socialism, social security and generous welfare services respectively. Slovenia's student organization says the following:

"An accessible education without scholarships for all, higher pensions and greater social justice. These are the ideas that will make everyone better off."

Over at the faculty field, I noticed a socialistic parole, saying: "Factories in the hands of workers, universities in the hands of the students!" added with Soviet-styled propaganda and typical communist star. This situation rather reminds on a retarded Soviet satelite grunged by Leninism and Marx's diallectical materialism. The origins of socialistic mentality in Slovenia are strong roots of collectivism. In this post, I explain why student protests against pro-growth tax and economic policy, school choice and competition in higher education, reform of the budget-funded health care system and social security reform are based on the false assumptions, myths and hostility against individual, economic and political liberty.

1. Population crisis in Slovenia is estimated to hit negative numbers. Aggregate labor supply is falling respectively and the number of retired persons is growing significantly. In Slovenia, when a person retired, the main slice his pension in financed through 1st pillar of pension fund which is funded directly through taxes on labor supply. The impact is clear: tax burden on labor supply is rising, public debt is growing respectively and fiscal outlays are expanded every year.

Consider the gross cost of an educated and intelligent worker in Slovenia, which an employer has to bear. Assume that monthly salary of the worker equals $3500 EUR in gross terms. The contribution rate to the retirement fund is 15,5 percent. Basic health care insurance deducts additional 6,36 percent. Personal income tax rates are composed into three brackets; 16 percent for the lowest quantile, 33 percent for the middle-income earners and 41 percent for the workers in high-income groups.

Obligated voluntary health insurance contribution rate is small compared to basic coverage rate of contribution, but it deducts the disposable income respectively. Additionally, employers have to pay the payroll tax and enhance the worker's income by compensating the costs of food and transport. In addition, an employer in Slovenia has to slice a contribution share to health care, social security and pension fund, at the expense of worker's productivity. Now, calculate the disposable income of the employee and see the tax wedge, squeezing his productivity after the hours he spends on the market.

2. Moderate tax cuts by the center-right government stimulated the growth of incomes by a narrow rate. Modest cuts in the labor taxation showed that tax cuts are self-financing, the unmistakeable notion of the Laffer Curve. Recently, the growth of economic activity in Slovenia reached historic highs. In 2007, the growth is estimated to reach 5,6 percent, which is quite uncompetitive compared to Eastern European economies. In 2006, Estonian economy grew by 7,9 percent, Latvia accounted 10 percent rate of output growth, Slovakia recently announced the data, revealing 9 percent annual growth rate.

By 2012, Slovenia's economic growth is estimated to diminish straight-forward to 3,6 percent respectively, reflecting weak structural advancement, age-dependency pressures and rapid increase in retirement activity. In 2006, the rate of inflation sparked up primarily due to higher food prices and intensive demand for food in Asian high-growing economies. Economically, inflation is a monetary phenomena arising from too much money, chasing too few goods. In a simple equilibrium, the result is the increase in overall price level. By January 2007, Slovenia entered the European Monetary Union, and after fixing the monetary emissions, the growth of money supply calmed down which normalized the inflation rate.

Subject to deteriorating exchange rate regime and periodically stimulated high inflation in the past, it will take time for Slovenian economy to adjust to new stream of monetary policy whereby the money supply is determined through interest rate setup by the ECB.

3. There is no such thing as free education. In fact, somebody has to pay the equipment, rent and maintain the facilities, lecture rooms, provide the electricity and heating. In addition, somebody has to hire and pay the academic services. Somebody has to pay and provide computers, internet access and modern means of study. Saying that education is free is like claiming that you can go into the mall and take away some furniture without payment. There is a dozen of proofs that private sector education is competitive in terms of quality of the future graduates.

The best and most respected universities in the world are private ones. Eight Nobel-winning economists have come from Chicago University which is funded by private means as well as Stanford University. Investment in education provides the best interest in the future. The time you give up to consume, is the cost you have to bear to have greater returns and personal welfare in the future.

There is no such thing as free lunch, and the education has never been a free lunch. Scholarships, by empirical proof, improve the standards of education and provide opportunities for thousands of individuals to unlock knowledge potentials and empower the intuitive mind whether it be in entrepreneurship, design, economics, medicine, mathematics and everywhere else.

4. The essential to understanding complex phenomena in society is the economic literacy and education. Thus, Slovenes should know that despite the same length of working time as Austrian or German workers, the latter earn more because of higher productivity and technological progress which stimulates the productivity through effective individual management of creativity and knowledge. In addition, Slovenia is, as shown above, one of the most taxed countries in the world (link), thus giving investors a sign of avoidance as an investment location. Empirically and practically, labor supply is highly sensitive to tax rates, meaning that the labor supply is elastic, ceteris paribus.

It means, that the labor supply strongly responds to the marginal changes in taxation of income. As a result of higher taxes, gross labor cost in Slovenia is huge, discouraging job formation and denying the opportunities to thousands of intellectual and entrepreneurial minds to show their skills and talent. I wonder whether trade unions and its anti-growth intellectual leaders will bear full responsibility for the actions they presume as socially just. To say it again, social justice is a mirage and a trojan horse riddled by the totalitarian governments and supported by the individuals who deny economic and personal liberty to others. Those who deny the enforcement of economic and personal liberty as a property right to others, neither deserve it for themselves.

The demands of trade union such as full employment, high taxes on productive behavior, high wages, expanded income and profit redistribution, extensive welfare and social security services, would propel the stagnation of growth as well as the productivity potentials which is the main engine of growth in standard of living. Claims of egalitarian pursuit of redistribution, material and income equality, under which trade unions in Slovenia delegate the course of living order, can only be met under governments with totalitarian powers. Extensive unionism and its influence on structural and economic policy is perhaps the most powerful evidence that Slovenia is de facto the most socialist country in Europe.

5. At last, Slovenia's economic policy in the past 15 years is the most notable proof about the negative impacts of gradualism entailed into the course of public policy. Slovenia kept persistently the highest inflation among advanced countries in Eastern Europe. When the left-wing government took over the chairmanship in government, wages in public sector trimmed up enormously by 40 percent, creating an additional source of inflation pressures. The deadweight loss from economic depression was vast. Meanwhile, Slovenia's international competitors grew rapidly and thus a development was geared-up. In addition, the policy of early retirement enabled the formal retirement before the age of 50. In just one year, between 1992 and 1993, the number of retirees rolled-up by more than 100 percent.

Over the years, Slovenia's pension system, in terms of outlays, has been financed through budget and the first pillar of retirement insurance is estimated to be depleted in the medium run consequently because of the abovementioned reasons including early and beneficial retirement, high pensions and sky-rocketing continual spirals of wage increases in the public sector, adding a burden to high government spending.

6. In 1950, in terms of current prices, Slovenia's real GDP per capita was higher than Austria's which suffered war losses. From 1960 onwards, Austria's prosperity increased tremendously after Austrian early reformist government and its minister of finance Reinhard Kamitz adopted low taxes, imposed deregulation and liberalized trade and prices, while Slovenia's GDP growth started to trick towards relative stagnation. When Austria's technological development accelerated productivity growth, its standard of living grew tremendously, at the fastest pace in Western Europe.

When Austria enjoyed the fruits of market economy and remarkable output growth rate, Slovenian economy was mischiefed by socialist self-management which demolished the efficiency of entrepreneurial investment by wrongful decisions embraced by politicians, political entrepreneurs, workers and union leaders, who knew neither risk nor ambitious agenda, as there was no private means of production under socialism.

Finally, when Slovenia gained independence from communism, Austria's economy advanced the output growth while "the wealthiest ex-communist country" slid into depression while its central bank tacitly led the policy of high inflation through deteriorating exchange rate. Thus, the hourly output per average Austrian worker is higher relative to the output of Slovenia's worker per hour, because of higher productivity, greater innovative and entrepreurial capacity, and succinctly utilized gains from hours spent in the market.

7. Tomorrow, the streets in Ljubljana will shout and scream again, reflecting the misery of sub-Alpine socialism, which has always known nothing else but envy, misery, lies and deception. I will rather spend my time studying and reading Friedrich August von Hayek's The Constitution of Liberty, Greg Mankiw's Principles of Economics, Imre Lakatos's Proofs and Refutations, Karl Popper's Logic of the Scientific Discovery, James Buchanan's Demand and Supply for Public Goods, Kenneth J. Arrow's Social Choice and Individual Values and Wilhelm Roepke's Economics of Free Society.

Rok SPRUK is an economist

Copyright 2007 by Rok SPRUK

MONTENEGRO'S ROAD TO FREE MARKET ECONOMY

The International Monetary Fund recently released the report on Montenegro's overall economic performance, emphasising basic fiscal and macroeconomic policy perspectives. In English the report is availible here while it can also be reached in Montenegrin (here).

Two years after gaining a formal independence from Serbia, Montenegro's economy operated at a full capacity, having seen robust output growth rates estimated to exceed 7 percent by the end of 2007. The growth, mainly driven by a significant amount of foreign direct investment, seems to remain robust in the medium-run despite particular tensions referring to the signs of overheating. Nearly 85 percent of capital value of companies was privatized. Banking sector, telecommunications, oil distribution and import services are 100 percent privately owned. Foreign direct investment is reaching record highs. In 2006, according to Montenegro's central bank, foreign direct investment reached $680 million USD, six times higher than in 2004. In the first half of 2007, foreign direct investment increased by 78 percent, while from January to July 2007, the amount of FDI was $650 million. Thus, Montenegro has one of the highest FDI per capita, $ 1,100 USD, one of the highest shares in Europe.

Montenegro's business environment is weak by international ranking, despite of significant improvement in since the independence year. Montenegro ranks 81st in the world according to the ease of doing business. The failure of public administration to provide the operating business environment at sound quality, long licensing procedures, severe difficulties faced when registering a property, bureaucratized trading environment, and a high level of difficulty in enforcing commercial contracts, reflect the disadvantages of Montenegro's business environment (link).

Affected by international financial turbulence, Montenegro's asset prices soared in the last two years, leading to a remarkably rapid growth of credit which further fueled the investment into real estate industry. However, rapid credit growth posed signs of an overheating economy which has been a particular backlash of Montenegro's domestic economic environment.

On the other side, Montenegro's growth is not drifted by inflationary pressures. Subject to concentrated market structure, retail inflation peaked slightly ahead of central bank's expectations, particularly in the electricity sector which has not yet been demonopolized by the infusion of competitive mechanisms and price liberalization. Electricity shortages occured despite tariff increases.

The economic reforms, such as the privatization of state-owned assets and the openness to foreign trade and investment, contributed to stable macroeconomic position. The budget remained anchored in surplus. Public debt does not currently evince any sign of quick consumption-inflated indebtedness. Total public debt peaked at 38 percent of the GDP while loans denominated into foreign currency presented 27 percent of the GDP by the end of 2006. As a matter of fact, overall public debt was reduced from 88,3 percent of the GDP where it stood in 2002 (link). Foreign indebtedness is expected to decrease in the years to come due to large amount of inflows from the investors' buy-outs of state-owned assets and enterprises.

As a transition economy, Montenegro has experienced typical short-term and medium-term problems due to the rapid convergence of GDP and robust economic growth as well. Transition process, by itself, poses a lot of risk and challenges, ensuring economy's vitality and growth sustainability. First, in Montenegro, real estate and equity prices skyrocketed due to signficant demand-induced pressures and country's valuable tourism potential, which folded residential and coastal property prices upward.

Second, according to IMF, credit growth accelerated at 170 percent by August 2007, pushing the the household indebtedness to record highs. Credit growth has surpasses the amount of inflows from foreign direct investment which Montenegro has received in this year. However, deteriorating current account deficit is not alarming, neither a sign of recession or downturn, whether it applied to established economy or an economy in transition. In case of Montenegro, widening current account is a result of accountable investment imports and capital inflows whose contribution to overall output growth is significant. In relation to credit growth, it is the question whether banking industry is strained by the lack of ability to assess loans in real estate.

Third, external demand-supported pressure on wages poses a significant threat to overall competitiveness of Montenegro's booming economy. If productivity expectations are high, the spiral of wage-increases claims could have been eased by the fact of productivity outcome. But if the productivity expectations are low, the wage-increasing claims could have bursted the triggering of inflation-pressing spiral. In case of Montenegro, public sector has claimed wage increases several times. It is the question whether the sector whose contribution to growth is relatively low relative to the components of the private sector, could claim wage increases on a legitimate basis subject to distortionary effects of wage-increasing claims under conditions of low and possibly rachitic productivity performance. The rigidity of wage claims is mainly derived by the lack of labor market reforms, whereas outdated labor legislation returns uncompetitive effect respectively.

Montenegro's abundant potential of a flourishing tourist industry propelled by market optimism and Stabilization and Association Agreement with the EU, provides sound opportunities to address the abovementioned concerns. Years ago, Montenegro adopted euro as a common currency, thus eliminating the possibility of currency and exchange risk. Monetary policy's ability to tackle demand pressures is thus partly limited and that's why a prudent fiscal stance is needed in lines with transparency and restrictive expenditure agenda.

In a booming economy, such as Montenegro, fiscal policy is a powerful tool in managing the fluctuations and brisk economic progress. In the state of robust output growth rates and soaring private sector productivity, fiscal policy is ought to be countercyclical to prevent the possiblity of overheating where the expansionary fiscal policy could turn a non-inflationary economic performance into inflationary economic growth generated by fiscal expenditures on infrastructure and public or/and foreign indebtedness, while seeing the overheating of economy's overall capacity. Fiscal balance or possible surplus is favorable to the business cycle for two particular reasons: (1) it faces adverse shock with low risk and (2) it gives support when revenue growth cools the impact on public finance. Also, significant import growth, reflecting the current account deficit, presented 4-5 percent share of imports in the GDP.

The role of fiscal policy is ought not to be undermined. As a powerful tool in responding to cyclical fluctuations during a "catch-up effect" period, fiscal stability and low government spending are usually based on surplus mechanisms. By avoiding budget deficit, policy responses may prevent the demand shocks and low level of public spending is a sign of maturity that helps to detach the anticipation of inflationary pressures and its impact on macroeconomic stability.

Tax cuts implemented in previous years may be seen as a policy failure in generating greater revenue. As the Laffer curve succinctly explains, it is able to reach higher tax revenue from a broader tax base, by reducing the rates on corporate and individual income. Since the implementation of low flat taxation on major sources of productive behavior, revenues have increased rapidly. Currently, public spending stands at 45 percent of the GDP (link), and the share of capital investment is 3 percent in this respect.

As a negative aspect of fiscal and structural policy, Montenegro's policymakers approved a significant 30 percent wage increase in the public sector, which is far ahead of current productivity and output growth measures. Such expansionary effects should be wisely avoided to prevent the loss of incentives to boost the economic performance when the growth performance slows. Robert Barro, a professor of economics at Harvard University, has shown empirically that reducing the size of public sector by 10 percent, stimulates growth by 1,3-1,8 percent. As a sign of innovative policy, public sector employment and expansion might be frozen and possibly reduced to prevent further unanticipated shocks such as wage-increasing claims.

In recent years, Montenegro's economic policymakers implemented a rigorous tax reform. Flat tax was implemented on personal and corporate income and it is expected to be dropped slightly in the years to come. Tax cuts were imposed procyclically. However, complex taxation structure such as numerous exemptions, loopholes, breaks and deductions have counter-effects as they raise the cost of paying taxes, notified as a difficult tax compliance and administrative burden which costs firms and taxpayers millions. The aim of tax reform and system is to pursue the efficiency and minimal tax burden levied on firms and individual taxpayers. High tax burden, empirically and practically, constrains growth and does not meed the indicated measure of efficiency. Fiscal reform, such as braking-up the size of government spending, is expected to pursue the objectives of fiscal consolidation which contains easing pressures to anticipated as well as unanticipated external or domestic shocks. The goal of prudent fiscal sustainability in the medium-term is to meet the demands of macroeconomic and structural stability. In the medium run, demands to invest rapidly in infrastructure may be tackled. However, it would be wise to avoid infrastructure investment through the expansion of state-owned enterprises. By the means of risk-taking and efficiency of capital and technology investment, infrastructural investment is easily attainable through private sector. In case if externalities and signs of market failure appear, then public infrastructural investment may be justified, also to prevent the emergence of public or natural monopolies where one firm, in public or private ownership, could substantially abuse its market power, such as in case of railway and highway infrastructure.

In monetary area, Montenegro has stabilized low inflation rate and the monetary policy remains anti-inflationary (link). In 2006, inflation rate peaked at 2,5 percent. In the first half of 2007, inflation rate was 1,1 percent (link). S&P has given Montenegro BB+ credit rating. The abovementioned rapid growth of credit has tightened banks to raise capital adequacy ratios. This could hamper the ability of banks as well as equity funds in responding to the demand claims of investors in real estate and stock market industry (link)

At last, structural reforms demand both; challenge and perspectives. One of the greatest potential of structural reforms is to boost economy's potentials. According to the data, the government and state, still own shares in 65 companies. In 53,8 percent of those companies, government has more than 50 percent ownership share. The argument for an accelerated privatization is the fact that the allocation of labor, capital and technology resources is better utilized as well as distributed in the channel of productive use. In fact, as an owner, government has severely different interest than private investors. In addition, the data shows, that privatized companies sustain higher level of productivity than state-owned companies.

The area in which radical reforms should not be postponed, is the labor market. The aim of the labor law is to pursue flexible and dynamic environment, allowing firms to dismiss non-performing employees without high severance costs. As every economist can confirm, collective contracts and bargaining such as oligarhic bundling between monopoly structures such as federation of employers and trade unions, does not match the needs of modern market economy. Instead, flexibility and deregulated labor market are essential to maximize productivity growth and eliminate discretionary wage-increasing pressures and also fight unemployment. In this respect, Montenegro's business environment is free of unnecessary regulation which boosts the potential of private sector growth. In the long run, fiscal risks are inevitable and Montenegro's abundant potentials may be implemented not by government intervention but by low public spending and first-class investment environment that underpins the role of private sector, free of corruption, in the economic performance respectively.

Rok SPRUK is an economist.

Copyright 2007 by Rok SPRUK

DEMOCRACY IN SLOVENIA - A GRAVEYARD SLUT

by Rado PEZDIR

In the fall filled with two national referendas regarding whether Triglav, Slovenia's largest government-owned insurance company should be privatized, and the epilogue of collective bargaining between trade unions and the federation of employers which reminds us on the last sequel of South-American soap-opera, someone could think that Slovenia is a climax of world democracy. It could be thought that this idyllic sub-Alpine landscape is a paradise dreamed by the premise of enlightenment thinkers; a paradise where the wisdom of the citizens tactically paves the road on which society's development takes its own walk. Unfortunately, the reality is completely different and it can be admitted that all sparks of hope for democratization of post-communist society are nothing else but a nostalgic stupidity. In Slovenia, for a long time, the individual does not vote for anything in the elections.

ELECTORAL JUNK

Let's have a look on presidential elections. I think that everyone who wants to explain why we need this junk will face big troubles. Why?

First, in Slovenia, the president has no authorized means of decision-making which would justify the existence of this particular instance. Of course, I assume that institutions are created to have legitimate authorization and not vice-versa.

Second, Slovenia's chaotic institution requires the intersection of legitimacies of democratic institutions, and consequently, there is an inherent probability of institutional conflicts. Mostly because Slovenian policymakers do not actually know which particular legitimacies are ought to be authorized to justify the existence of the institute of the president.

What this means in practical terms, is clearly demonstrated by the latest selection of future governor of the Bank of Slovenia; a situation in which prime minister and the president had an electoral mandate to appoint the governor. At the end, the technical dilemma turned out into an insensible political battle.

Third, some claim that the presidential function is necessary due to its role in representing Slovenia abroad in a remarkable flash. The truth is that the presidential function distorts the other branch of government, the Ministry of Finance, and thus it creates a splash of institutional conflicts. Just think of president Drnovsek's inspirations to solve the Darfur crisis. Was it necessary? At last, if Slovenians want a representative abroad, then gather some money, hire the little boy who knows how to recite the sonnets of William Shakespeare in thirty languages, lock him into the cage, and show him into the international arena. There is no need to waste taxpayers' money.

And at last, a large majority of Slovenians is evinced that the presidential function is necessary because of the need to have a discretionary moral authority such as Plato, Indian gurus, Vatican's cardinal or anti-globalist Joschka Fischer, to morally regulate our lives. Are they serious? Do they suggest voting the highest moral highlight? Excuse me, but this particular construct is a replica of a theocratic state where Ayatollahs are elected and then they submit their opinion on immoral youth and inadequacy of loud music. To exculpate the existence of particular institution with the assistance of an absolute morality is, in a normal democratic state, nothing else but an unrestrained absurdity. In effect, the presidential function is unnecessary and that's why, let's avoid further institutional crash of the splash. My colleague Mićo Mrkaić has thoroughly abstracted the irrelevance of presidential elections in Slovenia: ignorant people need an idol to command from emperor's rooms, the way it was conducted by Kaiser Franz, Maria Theresa, and Josip Broz.

NON-ELECTIONS

The second redundancy is the elections in the State Council this fall. State Council is the remaining creature of fascistic corporate system. Let's summarize how these elections go through. At the end of the mandate, interest groups get together and select a dedicated person who is then authorized to delegate our lives from Ljubljana. Then, the illuminant is sitting in the chamber of State Council by making decisions regarding our everyday lives; without being authorized to do so. How democratically. Suppose that a group of voters proposes a law bill to the parliament and democratically elected parliament passes the bill by a slight margin of votes. In a normal country, this would mean the end of the process, but in Slovenia, the story is going forward. If any of numerous interest groups with representatives in the State Council is not likely to embrace the law bill, it can use the veto and stop the entire process. And then, we're the one who should deal with elections and democratic institutions. The madness such as the undemocratically established body has shown its worth in the initiative of the State Council, suggesting the referendum whether Triglav, the largest asset-holding insurance company in Slovenia, should be privatized or not. Funny; the answer tp the technical question ought to be solved by democratically elected government is proposed by the unelected instance. We already decided to transmit the mandate to solve such a situation to the government, haven't we? I personally think that the State Council exists because a fraction of voters cannot embrace the fact that they're responsible for their lives on their own, while a share of voters would like to regulate the lives of other citizens through the power exercised by the interest groups represented in the fascist-styled State Council.

INTEREST GROUPS CONTROL THE ENTIRE COUNTRY

The fact that interest groups have their own debate luncheons at the expense of taxpayers' money and do whatever they want at any time, is simply a blockade of decisions approved by democratically elected institutions. And even more: it is a blockade that disables the functioning of a democratic system. An ability that interest groups without the approval of taxpayers, are dealing about the way of living that citizens will simply have to embrace and live with it, is coming from the constitutionally approved status of the State Council and collective bargaining. A procedure, in which workers' monthly salary is not determined by his output and productivity, but by the bargaining decisions approved by trade unions; the latter call social justice. As a side-effect, entrepreneurs must give up a fraction of profit due to decisions passed by non-elected institutions, namely trade unions. You're not wrong if you think that such process is a restitution of the situation once common in the Soviet Union. In Soviet Union, wages and salaries had no feedback measures to the output and labor productivity, but instead, salaries were determined collectively subject to central planning. As a matter of fact, what you produce in Slovenia has no effect on your monthly earning but the productivity of labor supply is restricted by the means of collective decisions of trade unions. In addition, there is always no study on how artificially determined salaries affect the economic performance of Slovenian economy. Instead, trade union leaders propagate the ideas that entrepreneurs should give up their own profit. By its means of collective power, trade unions aggressively aim to regulate and flip into the private property of entrepreneurs. It is interesting why trade unions do not invest in particular companies and then give up their profit for the benefit of the labor force. Whether you are asking, when you authorized trade unions to allocate your resources and boost income redistribution, your questioning has no effect since State Council and trade unions collectively make decisions about your lives without a check-up of their proposals in the general elections.

A DEMOCRACY OF WAR MASSACRES

In addition, there are two non-elected representatives in Slovenian parliament approved on the basis of their nationality. What a democracy - a democracy on the basis of Slovenian shame, such as the genocide of Italian, German and Jewish community. Thus, Slovenians have collectively admitted not to aggravate if they have bloody conscience about their own past. Instead, for them it is admirable to have a handicapped democracy which places two non-elected representatives of minorities in the national parliament. If you perceive that as a hang of overdoing, think about suspicious role of those two representatives several times respectively. And if everyone is treated equally, where are the Roma, Serbian and German representatives? Shall we rather dissolve the entire parliament and put in suitable representatives? In case if anyone doesn't know - parliament is a democratic institution whose members are elected on the basis of individual preferences and not on the basis of individual ethical origin. To protect the human rights, there is a judicial system that defends individuals against violations of human rights of all the citizens, including ethnic minorities. It is simply not a seat in the parliament which protects the rights of the minorities.

So if you attend the elections, the impact of your vote will be the same as in the period of socialism - none. That is because of institutional chaos based on Slovenia's constitution. From this point of view, presidential elections are nothing else but a typical junk and wasting of taxpayer's money. In sum, democracy in Slovenia is like a a graveyard slut (also a song sung by Norwegian black-metal band Darkthrone) - it can be bought cheaply by anyone whereas no one cares whether it works or not.

Rado PEZDIR is an economist.

© Copyright 2007 by Rado Pezdir

*An article was translated in English by Rok SPRUK, an economist and the owner of the web log Capitalism & Freedom

MARKETS AND CHOICE: THE CASE OF KOSOVO

Once again, Economist offers an excellent analysis about the future status of Kosovo, predicting the effects of choice between the model of full independence and the self-governing status of minimal dependence on Serbia.

Nevertheless, the issues deserves the piece of attention through the prism of economic analysis.

First, assume that Kosovo's long term objective is to seek the course of output growth and good structural environment that could, in turn, boost both: growth and development. As an empirical matter, the correlation between growth and democracy is weakly negative, meaning that the case of full democracy leads to the loss of growth momentum as well as to the widespread increase of bureaucratic and administrative means which deprive the dynamics of growth in a broader perspective.

Second, one of the main engines of prosperity and growth is the country's business and investment environment. Assuming the "catch-up"effects of a country with comparably low GDP per capita, the Kosovo's GDP would streamline the convergence quickly but in a larger sense, the quality of investment environment determines the intensity of investment, since a degree of firm's interest, looking forward to invest in particular segments of the region, would largely depend on the quality of the legal environment, such as the absence of barriers to saving and investment.

The ability to open the enterprise quickly, is also a part of the ability of how quickly job creation could go on. In fact, one of the broadest standpoints on which nearly all economists agree is that job creation is the best way to reduce structural unemployment of a typical post-communist economy in transition. In addition, high quality of the business environment is a thorough indicator of country's openness to trade and investment.

Third, the area in which most of post-communist countries lag is the labor market. In fact, labor is product that is traded in a voluntary agreement between the employee and employer at a certain price called the wage. In this respect, the general equilibrium of labor supply and demand for labor works as in usual cases.

If there is a scare labor supply in concrete area (say IT) compared to derived demand, then the price per unit of labor will go up and so will the employee's return to education and skills derived from labor's human capital. On the other side, if there is an extensive labor supply in concrete area (say sociology) and demand for labor is low, then the return to education will fall, raising the probability of unemployment and causing an incentive to accept the fact of lower return on education in case if labor demand is low in quantity terms.

The price behavior in this exchange partly depends on the willingness of labor supply to embrace lower price than in comparable areas, since an employer is induced and given an opportunity to hire the labor supply at a lower cost than under conditions of high demand and scarce availibility of labor supply.

From labor market aspect, democracy entails a bulk of negative effects that hinder productivity growth and reduce the extent of flexibility of labor market through means of collective bargaining and monopoly power exercised by labor unions. By empirical and practical terms, productivity is the leading engine of growth of standard of living and thus, lower productivity growth correlates with a lower comparable standard of living.

Fourth, the comparison of benefits between multiple option of independence deserves a detailed study and empirical investigation. A macroeconomic quest for this particular choice, is the question of exchange rate risk but this also depends on the ability of the country to have its own independent central bank.

In fact, if the National Bank of Serbia suddenly started to manipulate with exchange rate such as subsidizing the export sector through inflationary policies, and if Kosovo had no central bank, then it could openly feel the negative effects of high inflation. On the other side, if National Bank of Serbia maintains tight anti-inflationary policies, then the absence of costs and risk could benefit Kosovo's economy. But of course, to analyze the effects of multiple options, there must be concrete data to start disseminating and analyzing the effects of political status regarding the future growth and prosperity.

And fifth, as an economist, I think that political mitigation of future status of Kosovo is overhaul. In fact, the systematic efficiency of political status includes the efficiency of institutions protecting the enforcement of private property rights and individual liberties. Nevertheless, individual rights emerge from the private property, i.e. from the ability to manage private property without external interference.

In fact, the question which country advances in economic and structural terms significantly and competitively, does not depend on whether country is fully democratic or not, but on which country is freer than others in terms of taxation, choice and deregulation, enabling faster and higher growth of output and productivity, and thus creating a comparative advantage.

Read also:
Steffen Ganghof, Phillip Genschel: Taxation and Democracy in the EU (link)
Amleto Cattarin: "Hands off my taxes!": a comparative analysis of direct democracy and taxation, NYU Law School (link)
Kosovo, Economic Profile, European Commission (link)
Capitalism & Freedom: Kosovo, European Hong Kong? (link)
The State of Kosovo's Economy; Perspectives and Development, CEEOL Südosteuropa Mitteilungen, Issue no.3/2005 (link)

THIS IS HOW BELARUS WOULD BE BETTER OFF

Nearly a week ago, I came across an interesting website entitled Economy.by, presenting the project "The Community of Young Economists and Entrepreneurs" which was organized as a reaction to the lowest level of education in Belarus. The project aims to give opportunities to young students in Belarus to support their scientific work. This particular initiative is very ambitious indeed. In fact, Belarus is croaching in Soviet-styled political dictatorship together with poor track on the respect of human rights, civil and personal liberties. Doing business is difficult and the economic environment is embroiled by government involvement, protectionism and widespread corruption. Also, the education system is instilled by staunch ideological propaganda (here and here).

Regarding the practicing of human rights in Belarus, State Department reports:

"Prison conditions remained austere and were marked by occasional shortages of food and medicine and the spread of diseases such as tuberculosis and HIV/AIDS. Leila Zerrougui, chairperson of a UN working group on arbitrary detention who visited the country in 2004, reported that conditions in detention centers were worse than those in prisons because of poor sanitary and living conditions and restrictions on visitation, phone, and mail privileges. According to human rights monitors, conditions in prison hospitals also were poor...The government restricted access to the Internet. Credible reports indicated that the government monitored e-mail and Internet chatrooms. Many individuals and groups could not engage in peaceful expression of views via the Internet, including by electronic mail. During the March 19 presidential election, there were numerous credible reports that the government blocked several opposition campaign and independent media Web sites. Many opposition groups and independent newspapers have switched to Internet domains operated outside the country because of the government's campaign against Internet freedom. There also were credible reports that authorities attempted to block Radio Liberty's Web site in the country during the March presidential elections. On November 7, the NGO Reporters Without Borders again included the country on its annual list of "enemies of the internet," countries that censor independent news sites and opposition publications and monitor the Internet to stifle dissident voices."

Disclaimer: Capitalism & Freedom strongly supports "The Community of Young Economists and Entrepreneurs" in their efforts to pursue the ideas of individual and economic liberty, human rights, international awareness and knowledge development in Belarus.

KOSOVO: EUROPEAN HONG KONG?

At Blic Online, I came across the article which predicts the model of autonomous sovereignity of Kosovo based on the status which is similar to Hong Kong.

Under such proposal, Kosovo would be able to join the international organizations such as World Bank and International Monetary Fund. Politically, the status could induce the formation of institutions as well as an independent political decision-making among which there is an ability to form the rule-of-law and slash government intervention. As a partly independent region, Kosovo would probably be able to induce the foundations of economic, personal and political liberty to gain the competitive position in the world and pursue the policies in support of economic growth and capital formation.

Hong Kong, which is entitled as the freest economy in the world, generated significant economic growth and structural advancement among which there had been the enforcement of competitive law and the creation of growth-friendly business environment which attracted a significant inflows of foreign direct investment. As a result of pro-growth economic and structural policy, Hong Kong's income per capita skyrocketed over the past half of the century.

Regardless of the solutions, the creation of autonomous region or an independent state is an opportunity to gain territorialy tax sovereignity in the region with sound property rights, openness to trade and investment, and enviable structural environment which would, in turn, energize economic growth and the pursuit of prosperity through economic, individual and political liberty.