Monday, 4 March 2013

The Collapse of the Soviet Union: A Warning for Europe

On June 5, 1989 the attention of the world was grabbed by the image of an anonymous man standing in front of a column of Chinese tanks in Tiananmen Square. Elsewhere, however, in the People’s Republic of Poland an equally momentous event was unfolding in the narrative of the Cold War.

Solidarity, a Polish labour union movement born in the Gdansk shipyards at the start of the decade, was poised to shake the Communist stranglehold on power for the first time since 1944. In the first multi-party elections since the country’s liberation from the Nazis the party, led by shipyard worker Lech Walesa, won between 70-80% of the vote and shattered the semblance of Soviet political invulnerability.

The impact across the USSR’s expansive empire was seismic. By the end of 1989 Azerbaijan, Hungary and Czechoslovakia had declared their sovereignty and these were soon followed by Georgia, Lithuania, Estonia, Latvia and ultimately Russia itself the following year. Over 12 months the Eastern European bloc that had been one of the defining features and central obsessions of the 20th Century imploded at a pace that confounded politicians and commentators alike.

This was the inglorious endgame for Europe’s last monetary union. While its significance to the global balance of power and to political discourse can hardly be said to have been underappreciated, its relevance to the current woes of Europe’s single currency has been largely ignored.

A great deal has been written on the numerous failings of the Soviet system by the 1980s. The USSR was overstretched, haemorrhaging money to its vassal states and fighting an increasingly costly proxy war in Afghanistan, and was quickly becoming victim of its own closed economy.

Theoretically it was impossible for the Soviet Union to run a budget deficit. If its liabilities exceeded its revenues the state could simply raise the costs of the goods and services it provided to compensate. Nevertheless when Mikhail Gorbachev took office in 1985 he took on a social system that was struggling to pay its bills.

“The heaviest burden we have inherited from the past is the budget deficit, which was carefully concealed from society, but nevertheless existed,” Gorbachev acknowledged in 1989. “And, of course, the deficit has a pernicious influence on the entire economy…at the practical level the most urgent and immediate task…is to restore a balanced market and normal financial relations.”

No doubt many of today’s politicians trying to untangle the complex financial history of southern European economies will have sympathy with the former General Secretary.

Yet the Soviet Union’s deficit appeared a manageable 2% in 1985. Even by 1989 as it neared collapse the deficit of the Soviet bloc amounted to only around 9%. Furthermore fiscal transfers, which have proven such a point of contention between euro member states, were an inherent part of the USSR’s structure. Kyrgyzstan and Uzbekistan, for example, would receive over 10% of annual gross national product (GNP) from other republics while more developed countries such as Belarus would traditionally pay out a net 15-20% of its GNP.

Of course within this system Russia was the largest source of credit for its satellite republics. Just as Moscow was the political centre of the Soviet project so too it became the biggest regional investor.

“The Soviet Union was a peculiar empire in that it didn’t simply exploit its colonies for material gain but actually provided for them,” says Gabriel Stein.

Increasingly there are voices calling for Germany to follow the Russian example and play a similar role for struggling eurozone countries. Gavyn Davies, chairman of Fulcrum Asset Management and co-founder of Prisma Capital Partners, wrote last year in his column for the FT that it could be more informative to view troubles in the eurozone not as a public debt crisis but as a balance of payments problem.

The struggling eurozone periphery, made up of Italy, Spain, Portugal and Greece, are running a combined budget deficit roughly equal to the current account surplus of Germany. Davies contends that what needs to happen is not some external bailout but the annual transfer of around 5% of German GDP from the eurozone core to the periphery.

This does not mitigate the pressing need to reform uncompetitive economies but it should provide the breathing room for these reforms to happen without exacerbating the economic slowdown. Neither a condition-free bailout nor a simple policy of enforced spending restraints are likely, by themselves, to return these countries to a sustainable growth path.

For European politicians, however, the concept of fiscal transfers has provided them with something of a mental block. A number of politicians, with Angela Merkel, the German chancellor, foremost among them, have proven wary of sleepwalking into a fiscal union under the pretext of addressing the crisis.

“A necessary but not sufficient condition for the survival of the euro in its current form would be fiscal union,” Stein says. “But everyone knows that it would be political suicide to attempt it.”

The alternative route is to go the way of allowing a limited break-up of the monetary union. By allowing Greece to leave policymakers would be free to focus their attention on the more strategically significant economies of Spain and Italy, while the Greeks could allow their domestic currency to devalue against the euro to plug its competitiveness gap.

Here the Soviet example offers a pertinent warning. On the face of it as the USSR’s main creditor the country that stood to gain most from its disintegration was Russia. Equally those with most to lose were the less developed republics that had become accustomed to central handouts.

A quick glance at how these republics have fared over the past two decades offers us some stark truths about this process.

Figures from the World Bank show that while per capita income in Russia has almost trebled since 1991 many of its neighbours have failed to keep up. The Kyrgyz Republic, for example, has seen per capita income grow by only 29% over that time, and it took the country almost 15 years for average incomes to return to 1991 levels.

Indeed excluding the Baltic countries, most of the former Soviet states have suffered since the break-up. A number of them were drawn into bloody wars over territorial disputes and huge swathes of their populations emigrated to the West. In the case of Armenia it is estimated that almost a quarter of its people were lost after it declared its independence.

The Russian Federation, however, was far from immune to the turmoil. The average life expectancy for men fell from 65 years in the mid 1980s to 57.6 years in the early 1990s. This exacerbated nascent demographic problems in the country and the population, having peaked at 148.7m in 1992, has declined to under 142m today.

Chris Weafer, the chief strategist at Troika Dialog, says the central problem was the failure of governments across the region to establish themselves:

“The reason we saw such a severe economic decline in the 1990s was that there was a sharp decline in government control. It may have marked the end of the Soviet command economy but the reason it took so long to recover was the lack of political leadership.”

Despite Merkel’s oblique reference to Europe’s troubled history, military disputes are highly unlikely to erupt as a consequence of the eurozone crisis. Yet it is surely of note that cutting Greece off risks forcing the country into years or even decades of economic and social strife.

It is important to remember that much of the German productivity miracle has been based on the disparity between faster growing southern Europe and the sluggish central European countries. While the austere Germans berate the profligacy of their neighbours now, it was this same consumption boom that fed directly into the country’s savings glut.

Moreover members of the single currency would be unwise to split its members between an expendable periphery and a necessary core. If Greece is forced to exit it could set a precedent that would encourage bond markets to look for the next vulnerable candidate.

This domino effect is precisely what was observed in 1989. Once Poland had been effectively allowed to separate from Moscow the rest of the “outer empire” fragmented and eventually shook the core until it shattered. With Portugal, Italy and Spain all potentially next in the firing line such a prospect would surely be unwelcome.

Certainly the underlying economic inflexibility of the USSR propelled it towards its demise but that in itself is only part of the story. Ultimately, the key lesson from the Soviet Union’s collapse is that the decision to break-up a monetary union is first and foremost a political and not an economic one.

As Gorbachev himself put it:

“The Soviet model was defeated not only on the economic and social levels; it was defeated on a cultural level. Our society, our people, the most educated, the most intellectual, rejected that model on the cultural level because it does not respect the man, oppresses him spiritually and politically.”

It is therefore imperative that policymakers convince the majority of people within the eurozone to remain supportive of the single currency if it is to survive. This is one reason why depriving the Greek people of a referendum on membership was such a poor judgement. Above all else they must maintain the cultural legitimacy of the European project.

Already we have seen a rise in the popularity of the extreme right on the Continent. A research paper from Demos concludes that many of these movements tend towards a fear that immigration and multiculturalism are destroying national...values and culture. Finland, the Netherlands and Slovakia all boast strong far-right parties while the National Front in France and Italy's Northern League have been gaining ground.

These nationalists are taking advantage of economic weakness and the understandable fears of the voting public to thrust their regressive ideas of ethic nationalism back on the agenda. Just as in Russia after the default of 1998, the opinion is growing that liberal politicians have failed to address a system in crisis. Attempts to absolve themselves of responsibility by blaming market behaviour is only likely to accelerate this process.

“History is against European leaders that the fundamental weakness [in the eurozone] is economic rather than political. They absolutely must have leadership if they are to convince people that the euro will survive,” Weafer says.

Abandoning a weak link may make pragmatic sense in the short term but it sends a message that the commitment to the euro is far from absolute. Those calling for its dissolution should think again about the both the human and the economic cost that such an act could entail. Europe needs a combination of renewed political resolve and trust in its citizenry if it is to avoid the Soviet outcome.

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