When Reform Doesn't Pay the Bills

After the buzz of E.U. accession, economic change is getting Eastern Europe down

What's gnawing at Slovakia? Its economy is booming — up 50% in the past four years — and a series of radical free-market measures, including flat taxes, have helped to attract billions of euros in foreign investment. Some salaries have doubled, home mortgages are all the rage and the

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country (pop. 5.4 million) will soon become the world's top producer of cars per capita.

Yet when they voted in elections this summer, the Slovaks threw out the government and replaced it with one headed by Robert Fico, a lawyer turned politician who's promising to tax the rich and raise pensions and other benefits. Teacher Jana Huljakova, 25, is one Slovak disillusioned with the belt-tightening reforms of the previous government. Economic reform "was good for the country, but not for the people," she says. "It doesn't matter that the state debt is so and so and the gdp is so and so. We won't buy our food and pay our bills with that."

Call it the accession blues: just as they start to reap the fruit of tough post-communist economic reform, most of the eight countries of Eastern and Central Europe that joined the European Union in 2004 are undergoing a big mood swing. Populist leaders promising to end the pain of tight budgets and spread prosperity are on the rise across the region. Their message goes down well among public-sector workers, the old and those who think they've lost out amid the changes. And it's transforming the political landscape.

In Slovakia's neighbor, the Czech Republic, a fragile minority government formed after June's elections tore up plans for the country to adopt the euro anytime soon, but then itself collapsed last week. It was the fourth government to resign since 2003, prompting President Vaclav Klaus to wonder out loud "what it says about our country." In Poland, a free-spending but fragile coalition headed by Prime Minister Jaroslaw Kaczynski has been feuding with the central bank; its governor, Leszek Balcerowicz, says the government's budget is "irresponsible."

The biggest drama has taken place in Hungary, where a huge increase in government spending has created an ever-widening budget deficit that has now reached precarious levels. Street violence exploded in Budapest last month after Prime Minister Ferenc Gyurcsany admitted lying to Hungarians "morning, noon and night" about tough cutbacks needed to bring spending back into line.

Is this political shift just a temporary interlude, or does it indicate a fundamental change of economic direction in Eastern Europe, one that would raise troubling issues for the E.U. as a whole and especially for foreign investors in the region? These eight countries only account for about 6% of the total E.U. economy, but their dynamism has been a shot in the arm at a time when Germany, France and Italy have performed sluggishly.

For the moment, many people are giving the new E.U. members the benefit of the doubt. Katinka Barysch, chief economist at the London-based Centre for European Reform, reckons the cooling of reformist zeal is a natural reaction to the raft of measures these countries had to enact to join the E.U. "Most of the Central and East European countries are small and open. There is no danger of them renationalizing their industries. The worst that can happen is that they will not be allowed into
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the euro zone any time soon," she says. Krisztian Szabados, director of the Budapest think tank Political Capital, concurs. "What we see in the entire region is a fight between strong reformers and strong populists," he says. "And right now the populists are winning. But I don't think they will in the long term."

Yet concerns are growing. The World Bank recently warned that this is not the time to ease up on reform. Recent elections in the region "have revealed a high degree of fragmentation, forcing parties to make fragile alliances and allowing populist forces to gain influence," the bank said. "This is hampering reforms, complicating the required fiscal and macroeconomic stabilization, and delaying euro adoption."

So far, populism is not hurting short-term economic prospects. Growth remains robust throughout the region, from an eye-popping 12% rate in Estonia to 4.6% in Hungary. True, inflation is on the rise, but not yet alarmingly so, and foreign investment is continuing to flow. Yet all eight of the new E.U. members remain far behind their Western neighbors in terms of per-capita income and productivity. They need to maintain their reforming ways if they are ever to catch up. Foreign investment is a case in point: in Poland alone, that will amount to $10 billion this year, according to the state investment agency paiz. But Roman Rewald, chairman of the American Chamber of Commerce in Poland, says that the pace and scale of that investment "should be 10 times higher, taking into account the potential and size of Poland."

Hungary is the biggest cause for concern. It has allowed its budget deficit to swell to an unsustainable 10% of gdp this year, and the government is now under huge pressure to reduce it. It has announced plans to raise taxes and cut spending, including axing 12,500 public-service jobs.
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The World Bank and other economists predict that growth will drop dramatically next year, to between 2 and 3% or about half the current rate, as a result of these austerity measures.

Foreign investors are applauding — and waiting to see if the government will do as it says and how the public will respond. "Obviously the austerity program is the ultimate answer to the question of investor confidence and economic stability," says Istvan Varga, the chief executive of Shell Hungary, who believes that "the political and cultural environment is mature enough to cope with these problems." He may be putting a brave face on it. Erkki Raasuke, chief executive of Estonia's largest bank, Hansabank, recently met with institutional investors, and was surprised by their tough questions about the economic environment.

Plainly, despite heady growth, many in Eastern Europe feel left out of the new prosperity, and equally plainly, those left out don't like it. Michal Kajan, a train conductor in Slovakia, says that to maintain his standard of living, he is working for more than 60 hours a week, up from 40. "People were not against the reforms, but it was getting unbearable," he says.

Membership of the E.U. does bring some significant political commitments, and they alone may prevent Eastern Europe drifting too far off the path of reform. Slovakia is a good example. Fico, the new Prime Minister, has already abolished payments by patients for doctors' visits, and he's proposing a "millionaire tax" on earnings above $1,600 per month. Still, he learned an early lesson when the Slovak koruna tumbled after he announced that the country may not rush to adopt the euro as planned in 2009; and though the budget he unveiled last week lifts spending, it nonetheless keeps within the 3% deficit limit set by the E.U. Political populism combined with continued fiscal rectitude make for an odd mixture. But if it allows the discontented of Eastern Europe to let off steam without blowing up their economies, it may be the best alternative around.

With reporting by Leo Cendrowicz/Brussels, John Nadler/Budapest, Beata Pasek/Warsaw and Katerina Zachovalova/Bratislava

©TIME. Printed on Sunday, January 7, 2007