Categories:Investments

Shadow lands

  • Print
  • Comment

Twenty years after the fall of the Berlin Wall, the crisis in the eurozone flared up. But how does the turmoil in the monetary union mirror the collapse of the Soviet Union and what is the human cost? Tomas Hirst and Nick Rice investigate.

On November 9, 2009, Europe marked the 20th anniversary of the most recent of its many revolutions: the fall of the Berlin Wall. Since the 1960s, the wall had divided communist East Berlin and the city’s capitalist half to the west, and had become a symbol of the more constricting aspects of communist rule.

Although few were to realise it on the day itself, the fall of the wall would herald the end of the Warsaw Pact, communism in central Europe and - on December 25, 1991 - the collapse of the Soviet Union. A giant swathe of Eurasia from Berlin to the borders of Alaska was freed from the ideological and economic constraints of the most expansive totalitarian regime on earth - albeit to suffer bitter austerity on the path to capitalist rule. In the words of Marcus Svedberg, the chief economist of East Capital, “almost everything changed except the location” in eastern Europe since the wall was dismantled.

Few would have predicted that, just a month after the Berlin Wall anniversary, Europe would hand itself another systemic upheaval - initially only on an economic level, but later spreading to its entire political structure. On December 8, 2009, Fitch downgraded Greece’s credit rating after the country’s incoming government admitted its budget deficit would be more than 12% of GDP, rather than the 6% it had previously projected. Greece’s subsequent fiscal austerity was not enough to save it. Following a bail-out by the European Union (EU) and the international community, its economy and society were left broken and its government all but bankrupt.

As the 20th anniversary of the collapse of the Soviet Union approaches, many other countries in the eurozone - Ireland, Italy, Portugal and Spain - appear to be taking a similar path. Former Soviet euro members like Estonia - as Svedberg puts it, “a poster boy for economics - probably the most innovative economy, one of the least corrupt and most business friendly” - have been sucked into the vortex. (Cover story continues below)

 

At first glance, Berlin’s wall and Greece’s creditworthiness appear to have little in common. The wall was a security barrier which prevented freedom of movement. Greece’s creditworthiness was an economic barrier against its insolvency. However, the wall’s specific significance was dwarfed when it became clear that East Berlin and the rest of East Germany no longer wished to fulfil its political obligations to the Soviet Union and to the international communist community, and the latter would no longer force it to do so. By leaving communism, moreover, East Germany and later other communist states were forced to embrace capitalism, and all the pains of economic restructuring.

”There was no unemployment and then suddenly 10-15% were unemployed”

Twenty years later, Greece similarly revealed a black hole in its budget which made fulfilling its economic obligations - its euro-based debts - impossible. But by running such a high budget deficit, Greece had also violated its political obligations to keep its deficit under 3%, according to the terms of the Maastricht treaty, the EU’s founding document. Just as protestors tore down the Berlin Wall stone by stone, investors ripped Greece’s solvency to shreds.

According to Eurostat, most of the other EU states were violating the same deficit rules as Greece in the lead-up to 2009. Then again, following the Soviet Union’s perestroika and glasnost in the 1980s, most eastern European countries were not fully communist by 1989 either. In both East Germany and Greece, however, the political and economic upheaval spread throughout society. The result was partial or total freedom from burdensome obligations, but with all the chaos and austerity of collapse.

The inequality that was suffered by eastern European states was longer and arguably more wrenching than that of Greece. As Svedberg says, “in the old days, everyone was equal except party officials. The majority were underprivileged compared with the West. The Gini co-efficient [a statistical measure of inequality] was low. There was no unemployment and then suddenly 10-15% were unemployed.”

 

Click to enlarge

 

According to Emily Whiting, a client portfolio manager at JPMorgan Asset Management, emerging European countries have broadly pulled through the disaster and, economically speaking, are developing the freedom they craved as consumers. They are also becoming a more integrated part of the global economy, rather than just hopping from the Soviet Union to its European equivalent. “Over the past 10 years, the percentage of exports to the EU has come down,” says Whiting. In fact, Svedberg says one of eastern Europe’s hardest challenges is boosting incomes from the middle to the upper end of the range - a challenge poorer states would envy.

This long-term vision of a more prosperous future was one of the original drivers of the Soviet collapse and may yet drive eurozone countries into a future outside the strictures of the single currency. Despite the threat of immediate penury, by the middle of 1991 and 2011 respectively, non-Soviet Warsaw Pact and peripheral EU countries had shaken off their communist and capitalist obligations. Soviet republics, or core EU states, were moving in a similar direction. In August 1991, hardline communist party members temporarily removed Mikhail Gorbachev, the Soviet president, in a coup, only for Boris Yeltsin, the head of the Russian republic, to arrest the perpetrators and reinstate him. Just over 20 years later, in Greece and Italy, democratically elected heads of states resigned, only for EU-friendly technocrats to be reinstated in their place. Some commentators see the logical next step as a revolution that will destroy the euro itself.
journey similar, destination unclear

Unfortunately for Europe’s rebellious investors, the timeline so far ends there. It is clear momentous changes in the eurozone are on the way - the most significant in Europe, in fact, since the collapse of the Soviet Union in 1991 and the signing of the Maastricht treaty in 1992. But just as it was unclear what the endgame for the Soviet Union would be in the autumn of 1991, it remains equally uncertain what the equivalent would be for the eurozone.

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

Although they differed in many of the causes and motivations for their existence, the Soviet Union and the eurozone were founded in a key common crucible: the world wars originating in eastern and western Europe. Crudely, communists were only able to seize power in St Petersburg in the revolution of 1917 because the first world war had fatally weakened the already feeble Russian empire. Under the rule of Lenin, the communists exited the first world war, brutally suppressed internal opposition and used the industrial might of the Soviet Union to fight the second world war and envelop the non-Soviet Warsaw Pact countries during the Cold War.

Around the world, communists used related security measures to defend their interests, the regime in China being a notable example.

After the second world war, western Europe used a different tactic to unite its interests. Rather than resorting to armies and spies, it used the power of the markets.

The Common Market established in the 1950s was quickly followed by the European Economic Community, by the EU and by the eurozone. Just as the security measures of the Soviet Union and the Warsaw Pact unravelled in 1989, so investors speak of the common market - and perhaps eventually the EU itself - as being in danger of dissolution.

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.

 

Click to enlarge

 

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 grip 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 Lech Walesa, a shipyard worker, won 70-80% of the vote and shattered the semblance of Soviet political invulnerability.

The impact across the Soviet Union’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.

It should be remembered that this was the inglorious endgame for Europe’s previous attempt at 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 had been written on the numerous failings of the Soviet system by the 1980s. The Soviet Union was overstretched, haemorrhaging money to its vassal states and fighting an increasingly costly proxy war in Afghanistan, and was quickly becoming a 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.”

”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”

No doubt many of today’s politicians trying to untangle the complex financial history of the eurozone will have sympathy with the former general secretary. In 1985, the Soviet Union’s deficit appeared a manageable 2% of GDP. By 1989, as it neared collapse, the deficit of the Soviet bloc amounted to about 9% - taken as a bloc, in excess of the eurozone’s budget deficit today. However, central budget oversight and fiscal transfers, which have proven such a point of contention between euro member states, were an inherent part of the Soviet Union. 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.

Within this system Russia was the largest source of potential funding for its satellite republics, just as France and Germany are in the eurozone today. Just as Moscow was the political centre of the Soviet project, so it too 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, the chief international economist at Lombard Street Research.

Increasingly there are voices calling for Germany to follow the Russian example and play a similar role for struggling eurozone countries. Gavyn Davies, the chairman of Fulcrum Asset Management and the co-founder of Prisma Capital Partners, wrote in his column for the Financial Times 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 Greece, Italy, Portugal and Spain, are running a combined budget deficit of some $183 billion (£115 billion). Germany, meanwhile, is running a current account surplus of some $182 billion, or about 5% of GDP. Davies contends that what needs to happen is not some external bail-out but the annual transfer of about 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 bail-out nor a simple policy of enforced spending restraints is likely, by itself, to return these countries to sustainable growth.

The reform would in some respects parallel the creation of the Commonwealth of Independent States (CIS) after the collapse of the Soviet Union, albeit in inverted form. If communist republics were defaulting on their political obligations to Moscow, the argument ran, they would be independent states, but with residual links to other ex-Soviet authorities - hence the CIS. The difficulties some euro members are having in meeting their economic obligations has left them as a commonwealth of dependent states - dependent on overseas states for funding. If the international community refuses to step in, Germany would logically have to fill the gap - just like West Germany after reunification with its eastern sibling.

For European politicians, however, the concept of fiscal transfers has provided them with something of a mental block. Several 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 Italy and Spain, 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. As the Soviet Union’s main creditors 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 some stark truths about this process. Figures from the World Bank show that while income per head in Russia has almost trebled since 1991 many of its neighbours have failed to keep up. Kyrgyzstan, 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. Many 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 itself was far from immune to the turmoil. The average life expectancy for men fell from almost 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 also been based on the disparity between faster growing southern Europe and the sluggish central European countries. While the austere Germans berate their neighbours for their profligacy, it was this same consumption boom that fed directly into the country’s savings glut.

The weakness of the eurozone periphery has also helped prevent a Japanese yen-type sharp appreciation of the euro against the dollar, despite the latter undergoing two rounds of quantitative easing. Moreover, members of the single currency would be unwise to split its members between a perceived 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.

”They absolutely must have leadership if they are to convince people that the euro will survive”

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 Italy, Portugal, and Spain all next in the line of fire, such a prospect would surely be unwelcome. The underlying economic inflexibility of the Soviet Union 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 a political and not an economic one. As Gorbachev himself said: “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 support the single currency, if it is to survive. This is one reason why depriving the Greek people of a referendum on membership may prove a poor judgment. Above all else authorities must maintain the cultural legitimacy of the European project. “History is against European leaders in 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 in the form of Greece may score a short-term political point for some eurozone stakeholders, but it sends a message that the commitment to the euro is far from absolute. Any departure from the euro would cause gigantic knock-on effects throughout the eurozone’s banking system and would cause mass currency depreciation and hence default in the exiting country. Following the example of the Soviet Union 20 years ago, those calling for its dissolution should think again about the both the human and the economic cost that such an act could entail.

  • Print
  • Comment

Daily Email Updates

If you enjoyed this article, sign up to receive the latest breaking news and analysis for your industry from Fund Web.

The Money Marketing CPD Centre

Time spent reading about technical or regulatory issues can build your annual CPD hours. Log and plan your annual CPD for free with The Money Marketing CPD Centre.



Have your say Edit my profile/screen name

You must sign in to make a comment


Fund Data



Poll

As Hargreaves Lansdown posts its latest profits – who do you see as the biggest winners from the RDR?