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Star Czech

Prime Minister Vaclav Klaus, architect of the Czech Republic’s “economic miracle,” dazzles foreign investors with his sharp wit, salesmanship, and command of policy. Critics dismiss central Europe’s most visible and acerbic leader as “Mr. Sound Bite.” CE separates image from reality.

A lone among such former Eastern bloc countries as Lithuania, Poland, and Hungary, where former Communists have returned to power in the guise of social democrats, the Czech Republic endures in its commitment to free markets and anti-interventionism. Why this is so has something to do with history. After the fall of the Berlin Wall in 1989, Central Europe‘s planned economies faced similar problems: inefficient industries, environmental devastation, and an unmotivated work force, to name the obvious. Unlike their neighbors, however, the Czechs started out debt-free with an industrial base that dates from before World War II.

But another reason for the Czech advantage is the stewardship of Prime Minister Vaclav Klaus, specifically his aggressive leadership and transformation strategies. Since the 1992 elections, which brought to power a coalition government headed by his Civic Democratic Party, the Czech leader has launched two waves of voucher privatizations transferring a total of $11.5 billion in property and other assets from the state to its citizens. Coupled with low inflation and unemployment rates, conditions appear ripe for robust economic expansion. Because of such progress and prospects, the general public has embraced the new order. According to a recent Gallup survey (see chart), the Czech Republic is one of the few relatively developed Eastern European countries in which a majority-56 percent-prefers life in the post-communist era.

In the following conversation with Chief Executive in Prague, Klaus claims that transformation in the republic is complete. Not quite. Following are a few correctives.

  • As noted in a nearby sidebar by Kalman Mizsei, an economic scholar with The Institute for EastWest Studies, the Czech Republic‘s performance in attracting direct foreign investment has been outpaced in some areas by both Poland and Hungary. “This clearly indicates something is wrong” with Klaus’ DFI strategies, Mizsei says.
  • The Czech private housing market is almost non-existent with a bureaucratic distribution of units and low, state-supported rents. Poland, Hungary, and even Russia are more advanced in creating liquidity in the sector.
  • Klaus’ voucher scheme may facilitate nominal privatization but may be inadequate when it comes to enterprise restructuring. Does the policy merely delay an inevitable day of reckoning?
  • The Czech Republic has a law prohibiting state-owned companies from declaring bankruptcy. Compare this with Hungary‘s far-reaching bankruptcy law and progress in developing a legal framework for capitalism.
  • Klaus abruptly dismisses the idea of privatizing telecommunications despite spotty service in the republic and radical demonopolization of the industry worldwide. By contrast, Hungary has undertak en deregulation and forged links with outsiders such as Ameritech and Deutsche Telecom. Time will tell the superior approach.

To be fair, Klaus has much to tell the West about the snares of socialism and industrial policy. Working without a blueprint-explicitly rejecting the advice of Harvard’s Jeffrey Sachs and others who have sought to guide privatizations in Poland and Russia-Klaus and his cabinet have crafted a working market economy. Perhaps most important, they have managed to remain in power, advancing their republic’s prospects for EC membership and placing it on the brink of what Klaus describes as a “post-transformation” phase.

“The heroes of this phase are not the reformed politicians such as myself” Klaus says with uncharacteristic modesty. “The entrepreneurs must go to work and make the new system succeed.”

FIGHTING FIT

Your country has emerged from the “Velvet Revolution” with a revamped economic and political philosophy. But in terms of putting those ideas to practical use, is the transformation complete?

The transformation process for post-communist countries such as the Czech Republic, Poland, and Hungary consists of three stages. Countries first sit in the hospital waiting room, knowing surgery is inevitable, but wondering whether pills might be a viable alternative. These countries hesitate to undergo the necessary transition from a totalitarian Communist regime to a free-market economy.

Countries in the next phase are undergoing surgery in the operating room. Finally, some are in the hospital’s rehabilitation or fitness center. That’s where we are now. Our transformation is practically over.

We are about to enter the post-transformation stage, in which we face the standard problem of completing difficult micro-restructuring at the enterprise level. The heroes of this stage are not the reformed politicians such as myself. They are the entrepreneurs and innovators such as economist Joseph A. Schumpeter. He was right in stressing the entrepreneur’s role in the most positive economic and social developments in this country. But he was wrong when he said that the entrepreneur’s role is vanishing. Our transformation proves that. Government only played a role in the early stages of the transformation because it was forced to-it had to drive the change from communism to a free society, from a command economy to a market economy. You can’t cross the river between one system and the other by anarchy as we see in some other post-communist countries. But now that we have safely bridged the gap, the entrepreneurs must go to work and make the new system succeed.

Why has your transformation plan succeeded while others have failed?

Our program primarily was based on rigorous management of macroeconomics. We controlled inflation. We instituted a cautious, restrictive monetary policy. We are one of the few countries in the world with a balanced budget. If you need experts to do balanced budgets, we are ready to come to your country and help your administration to do something about this.

In addition, we implemented deregulation and privatization policies. We have been undergoing a radical privatization process. In this regard, Britain‘s Margaret Thatcher is our hero, but we have done her one better. She privatized three or four firms a year. In the last three years, we have privatized three or four firms a day. However, our privatization concludes at the end of 1994, because there will be practically nothing left to privatize.

I believe that privatizing operations that have always been publicly run-such as the post office, railways, nuclear power plants, and utilities including the telecoms-is a less important, post-transformation task. It’s one I’m not overly concerned with now.

Why is that, especially given your market orientation?

You are missing the point. In November 1989, the task was not to privatize public utilities; it was to privatize everything, because at that time, there were no private grocery stores or hairdressers or anything.

You must admit that the U.S. is different from the rest of the world when it comes to utilities ownership. Western Europe had a standard market economy for the last 100 years, but the telecoms were state-owned. I have nothing against privatizing the telecoms, but I don’t think it has anything to do with the systemic transition we have been undergoing the last few years. The privatization of Czech Telecom may improve its efficiency-and it may not.

What percentage of your GDP is in the government sector versus the private sector?

I am not interested in that. I am interested in whether we are still privatizing three, five, or 10 firms a day. The percentage means nothing; it keeps changing. A few years ago, my sons, then ages 17 and 22, had never entered a private shop. Today, within a one-mile radius of our house, there isn’t one state-owned shop. Whether the share is now 63 percent or 71 percent is irrelevant to me. The last data I saw was for the end of 1993, which indicated the number was approximately 60 percent to 65 percent.

MUSCLING UP

Banks alone cannot support the growth and capital demands of private companies. Will the government subsidize privatized companies through this incubation period?

The government doesn’t want to help anybody. Firms must find ways to grow, modernize, locate foreign partners, and attract capital on their own. We are sometimes suspicious when we hear the Clinton administration’s ideas about industrial and trade policies. It often leans toward the ideology we are trying to fight. Companies here face a standard post-transformation problem-one that is addressed in the fitness center. Some develop stronger muscles and become more modernized. Others have troubles; that’s the market economy at work.

Aren’t there still many state subsidies in your country today?

There is practically nothing in the industrial sector. And there is only a small amount in the agricultural sector. Some of our farmers protest that they don’t have the same level of subsidies as in the European Community.

We are at a turning point right now: We have to make sure our new free, unregulated society is not overadministrated by bureaucrats. We know the fragility of the political, social, and economic system. Communism was just a little more bureaucracy, a little more political-social engineering. We are oversensitive in this respect. In a milder form, that exists in your country, as well.

Is the Czech Republic‘s low unemployment rate a function of its not having shed excess workers? What will happen when markets demand restructuring?

This is a standard accusation of our Eastern European neighbors, such as Poland, Hungary, and others. To make this point, they have taken out paid advertisements in the Financial Times and The Wall Street Journal. They argue that our low unemployment rate precludes a real restructuring and transformation in this country. That is wrong.

The argument is the other way around. The faster you undergo restructuring, the smaller the economic and social costs and the lower the unemployment rate. On the contrary, the slower the restructuring, the higher the unemployment rate. To transform dramatically, you don’t have to have higher unemployment.

There are several explanations for our low unemployment rate, which averaged 3.3 percent of the total work force in recent months. First, the participation rate-which means the ratio of employees divided by the country’s population-dropped. Thus, the employment rate decreased, but the unemployment rate didn’t increase. If we had the same participation rate as in 1989, the unemployment rate would be around 10 percent, because we had more employees then.

In addition, the service sector is extremely labor-intensive. In the communist era, services were undeveloped. Today, the tourist boom has hit this country, and there is a tremendous increase in the service industry’s share of GDP. Many people formerly employed in the industrial sector are now employed in the service sector.

Most important, our workers didn’t accept wage indexation and the huge minimum-wage benefits prevalent in other countries.

What is the government doing to reduce the administrative burden and to release people from the government sector into the private sector?

My main problem is keeping people: Many of them are leaving government offices for private-sector jobs, because they earn three times more.

Your economic transformation plan is rather unique to Eastern Europe in that it didn’t use “shock therapy” as Poland did, and it is the reverse of the Hungarian approach of restructuring enterprises first and then privatizing them. How did you come up with this strategy, which was based in part on the voucher system?

My colleagues and I came of age in the 1960s. Most of us studied abroad. I spent one semester at Cornell University. The political climate in the Czech Republic was much less liberal than that in Poland or Hungary, so we had no chance to be involved in the Perestroika-style of reforming and restructuring. Thus, we didn’t spend 20 years of our lives being involved in various government commissions trying to slightly improve the existing system.

In the second half of the 1980s, 15 of us-including six members of the current Czech government-started to translate the 32 speeches of Nobel Prize winners in economics for a book. The task was enormous. But we learned how to discuss some sophisticated things in economic science that didn’t exist in a command economy. Please be aware that translating a Nobel Prize speech entails not just knowing English but understanding the topic. I would argue that no other government in the world has six out of 19 members who can translate a Nobel Prize speech on economics.

INEVITABLE DIVISION

Was the separation of Czechia from Slovakia necessary? Could their differences have been worked out?

It was an inevitable process. There was no way out of it. Slovakia had an identity crisis. The Slovaks wanted to be independent.

Will the separation make life easier or more difficult in the future?

In the short term, definitely more difficult, because we’ve lost part of our market. In the long run, probably the effect will be neutral.

Will reunification be possible in the future?

That is not a relevant question. It’s like asking a divorced couple whether they plan to be remarried.

CROWN HEIGHTS

Let’s switch gears and talk about the money system. It is said that the Czech crown is somewhat artificially high. Have you made plans to change the currency restrictions?

I’m under the impression the crown is artificially low. So, everybody wants a reevaluation of the currency, not devaluation of the currency.

One of our most successful accomplishments is the formation of our exchange-rate policy. We devalued the currency 45 months ago on December 29, 1990. The nominal exchange rate has not changed since then. If you are looking to invest in Eastern Europe but are afraid your assets are not safe because of a prospective devaluation of the local currency, rest assured that the island of stability-the hedge against devaluation-is the Czech crown.

But a warning to potential investors: We’re still in the midst of post-transformation problems, and the Central Bank of the Czech Republic faces a tough task of regulating the inflow of hard currencies without inflating the money supply. So, please, don’t all come tomorrow.


THE ACERBIC STATESMAN

Without a doubt, Vaclav Klaus is the most controversial figure in the transformation of Eastern Europe. Supporters describe him as a democrat, a freedom fighter, and a market reformer. Critics, however, insist he is a political adventurist who bears primary responsibility for the breakup of the Czechoslovak state, creates a multitude of enemies at home and abroad, and preaches drastic market reforms but sometimes follows a cautious path.

What is the truth about Klaus’ policies and influence, and the transformation of the Czech Republic under his guiding hand?

When the dust settles, the Czech transformation may prove to be the most successful in the region. In 1991, Czechoslovakia achieved macroeconomic stability through sweeping price and trade liberalization, and radical monetary and fiscal austerity. Klaus usually claims he was the first and only head of state to pursue such a course. This is inaccurate: Poland‘s Leszek Balcerowicz followed the same path a year earlier. It is true, however, that the Czech approach has been more stringent and sustained than any other; consequently, some projections show the country will be the first in the Central European region to achieve single-digit inflation. (According to Austria‘s Creditanstalt International Advisers, the Czech inflation rate this year will be 11 percent, compared with Hungary‘s 19 percent and Poland‘s 31 percent.)

Of course, Klaus had a head start, having inherited the most balanced economy of the three and one with no external or internal debt.

Nonetheless, in hindsight, it is safe to say that he was right, and that the Keynesians who pushed for demand-side stimuli were wrong. Discipline has helped the Czech economy to grow in a debt-free environment, and leaders of the republic now have room to gradually decrease taxes and-perhaps most important-to reduce extravagant Social Security contributions. This, in turn, will attract more investment. Among all European countries, only tiny Luxembourg and non-EC members Switzerland and the Czech Republic currently meet the macroeconomic criteria agreed upon in the Maastricht Treaty.

But more direct foreign investment is badly needed: The Czech Republic’s ability to attract such investment has been disappointing, particularly considering its low wages and proximity to Germany and Austria. Direct foreign investment has slowed from an already low level in 1993; this indicates flaws in the Czech strategy. Both Poland (population 38.5 million) and Hungary (10 million) outpace the Czech Republic in attracting direct investment. The Czechs absorbed a mere $517 million in 1993, while Hungary-with roughly the same size economy-attracted more than $2 billion.

One of the key achievements of the Czech transition is that Klaus managed to keep wages very low. That might be a powerful incentive for DFI; however, the process of privatizing companies by auctioning vouchers to the public does not allow sufficient room for foreign bidders. (The process also relies heavily on the secondary market to redistribute shares to efficient, new owners.)

There is another effect to the wage policy: Low wages enabled Prague to slow microeconomic transition on the enterprise level. One result: The failures of giant businesses that resemble their overcentralized, pre-privatization predecessors have proceeded at a slower pace than in Poland or Hungary. In time, these firms may hamper growth. But overall, the impact of wage controls has been positive, particularly with regard to inflation.

Direct foreign investment also has been hamstrung by the Czechs’ deep suspicion of foreign ownership. It hasn’t helped that several high-profile privatizations have had to be reversed, including the sale of a stake in CSA, the Czech national airline, to Air France.

Meanwhile, Klaus sometimes has been less than the consummate diplomat. The desire of he and his ministers to go it alone on a range of issues periodically has raised hackles among neighboring nations. For example, while Klaus’ opposition to the institutionalization of Visegrad cooperation placed him decidedly on the side of free trade, it also left him appearing isolated and arrogant. Outside Central Europe, the most vivid example of Czech shortsightedness was its attempt to parlay President Clinton’s visit to Prague last year into a one-on-one summit. The trip was intended by Washington to demonstrate U.S. solidarity with the Visegrad countries. Subsequently, talk intensified in Hungary and Poland about leaving the Czechs out of Visegrad altogether.

In sum, though the Czech Republic‘s economic transformation is encouraging, the jury is out on its ultimate success. Moreover, its prospects remain somewhat clouded by miscommunications and a tendency to overpromote its achievements.


Kalman Mizsei is vice president and director of economic programs of the Institute for EastWest Studies, which has offices in New York, Prague, Budapest, Warsaw, and Atlanta. A Hungarian national, he is a former adviser to the president of Hungary‘s National Bank.

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