The Czech economy needs state investment for the future, not financial cuts

17. 6. 2010 / Martin Myant

The first point is to be clear about the nature of the current world economic crisis and the stage it has reached. Its origins were in private banking and finance. It spread into production that depended on credits (especially motor vehicles and construction) as banks cut back drastically on the credits they granted. Central banks reduced interest rates to very low levels, but it made little difference. The problem was that banks were not lending even to customers who wanted to borrow. The Czech Republic was largely unaffected by the banking crisis but was hit by falling exports for motor vehicles and by growing caution from banks.

World depression was held in check by direct state interventions, to prevent collapse of banks, and by continued state spending. Levels of GDP stabilized because states continued to spend, both on basic services and on further emergency measures, such as car-scrap schemes. This was vital for the Czech economy which has even shown signs of growth in early 2010 thanks to continued spending on motor vehicles in EU countries. Sharp austerity measures in Germany and elsewhere would undermine that recovery.

In all countries state debt has increased. This was inevitable as state spending continued while tax revenues fell due to falling income levels. Rising state debt can represent a danger, but it needs to be kept in perspective. It is not the same as an individual or a business running up debts. State debt is largely owed to the population that will have to repay it. It is taken by banks, pension funds, insurance companies and other business within the country. It is one of the main, and most secure, ways in which the population's savings are used. Nevertheless, state debt carries interest charges and, while adding to incomes received on savings, these also add to state spending. The interest rate is often not high (the Ministry of Finance provides details on past debt issues and who they were sold to HERE and generally below the rate of growth in GDP in the years up to 2008. Rapid economic growth therefore led to a slight decline in the debt/GDP ratio from 2003 to 2008 even as governments continued to borrow. The international rating agencies have not been kind to the Czech Republic, judging it a greater risk than some more indebted western European countries. That does mean paying slightly higher interest rates on borrowing, but the level is still very manageable.

An ultimate danger is that a government may become dependent on borrowing but may lose the trust of lenders. It will then either be unable to borrow at all or will have to pay prohibitively high interest rates. This has been the case with a number of countries since the start of the world economic crisis. The simplest indicator of the danger is the level of debt relative to GDP, showing the Czech Republic in an extremely safe position with its debt/GDP ratio at around 37% compared with 115% for Greece. This does not give the full picture. It is possible that there could still be serious dangers if a lot of debt is coming up for repayment. The Ministry of Finance provides data on how much debt will mature in the near future and again shows the Czech Republic to be comfortably placed.

It is true that those working in international finance can be extraordinarily ignorant. They can confuse countries and can, for example, assume that the Czech Republic is no different from Hungary. That does carry a danger, but largely for currency dealers who make hasty decisions from very little knowledge. As far as debt issues are concerned there should be less of a danger. It takes only a few minutes to look up the true position of Czech state debt.

There are two other important features that help reduce risks. The first is that the Czech Republic has a trade surplus and very substantial export potential unlike, for example, Greece which has been running substantial current account deficits. Repayments to foreign lenders are therefore safely covered by export earnings. That might be threatened if depression is deepened in other EU countries, but the Czech economy has a substantial advantage. Most of the rest of the world is deeply concerned over the dangers of global warming and that has meant a shift towards emphasizing smaller motor vehicles, a trend that may well continue. These are precisely the kind that multinational companies have chosen to produce within the Czech Republic. That is a factor in the signs of possible economic recovery in early 2010.

The second feature reducing risk is the low level of debt in foreign currency. Most of Czech state debt is to businesses within the Czech Republic. Only 31% is held by `the rest of the world' HERE. For the most part, debt has depended on the healthy deposit base of Czech banks and other financial institutions. As they have become much more cautious about lending to Czech businesses, it is unclear what else they would do with their resources.

It might be better if governments never had to borrow, but it seems odd to be so easily panicked by developments in countries with completely different circumstances. The cost could be high. The Czech economy suffers from serious weaknesses from the country's inability to provide a base for its own innovative, internationally-competitive companies. It might seem that a priority would be investment in education, rather than threatening pay cuts. In fact, language teachers can often find better pay working in a routine job in a foreign company than in helping to develop the better-qualified workforce needed for the future.

Perhaps the oddest thing about the apparent panic over the budget deficit is that it does not seem to be taken seriously even by those who complain the most. The Czech Republic has developed an extraordinarily generous tax system, providing lower top rates of personal income tax than in any of the richer EU members. There is even pressure for further reductions in business taxes. This cannot be expected to lead to higher output or employment. Those have been cut by falling levels of demand and will improve if and when demand recovers. However, as profitable businesses are frequently foreign owned and are repatriating much of their profits, the main impact of cutting business taxes could be to increase outflows of finance and thereby to worsen the current account on the balance of payments.

A government genuinely concerned over the need for fiscal responsibility and also for the country's long-term future could be expected to maintain, or increase, spending in areas vital for that future while financing spending by accepting some increase in state debt and/or by moving towards a tax system more like that of more advanced countries. The level of debt can be allowed to rise during depression, but should reduce as growth brings in higher tax revenues. The alternative of cutting spending in areas that contribute to the future makes the renewal of strong growth an ever more distant prospect.

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