The effect of historical experience on present-day economic policies

One of the first countries to receive bail-out funds from the IMF and the EU in the wake of the 2008 crisis was Hungary – to the tune of € 20 billion. As is usually the case in financial crises, the peripheral countries are the first to come under pressure, and in the European periphery,  Iceland , the Baltic nations and Hungary felt the heat first.  In Iceland's case we can probably state that the nation has now come full circle – from fishing to banking and back to fishing.

 

The Baltic nations were typical currency peg cases. The peg at first set off an unsustainable credit boom when the ECB's interest rates were set very low, which caused their current account deficits and asset prices to soar. Once the boom ended, foreign capital fled, money and credit became tight, and the inevitable bust ensued.

However, the Baltic nations represent a special case – they could have dropped their pegs, but haven't done so. They would rather suffer a severe deflationary contraction than give up their link to the euro. The reason for this is found in their history. The Baltic nations have been the victims of hegemonic big power politics since about the late 17th century.

An interesting side note here: in the 14th century, Lithuania was the largest nation-state territory in Europe, incorporating parts of Russia, Poland, and all of the modern-day Ukraine and Belarus. In 1410 Lithuania, in alliance with Poland (the two nations had become a personal union in 1385) defeated the Teutonic Knights in the Battle of Grunwald, one of the biggest battles of the medieval era, which marked the beginning of the decline of the 'crusader states' under the influence of the Teutonic Order.

The 14th , 15th and 16th century were the height of Lithuania's power, culminating with the formation of the Lithuanian – Polish commonwealth in 1569, which was an attempt to keep the growing power of Moscow at bay (Lithuania and the Grand Duchy of Moscow had fought five wars by that time, largely over ethnic Russian territory that was part of Lithuania).

Latvia and large parts of Estonia were in this time period incorporated into Livonia, or 'Terra Mariana', after having been conquered by the German Knights of the Teutonic Order early in the 13th century (Northern Estonia continued as the Duchy of Estonia under the control of Denmark and was later sold to the Teutonic Order – for 19,000 Cologne Marks –  and still later occupied by Sweden, which then lost it to Russia).  In the  18th century, the Baltic nations were first incorporated into the Russian empire, and only managed to regain their independence in the wake of the Bolshevik revolution after World War One.

This period of independence didn't last long – the Molotov-Ribbentrop pact of 1939 (secretly) declared them to be in the 'Soviet area of influence', and Soviet incursions began in parallel with Germany's invasion of Poland. In 1944, Stalin's red army occupied the Baltic nations and they became 'Soviet Socialist Republics' –  in other words, fate had once again dealt them the worst possible hand, and independence was only regained again after the Soviet communist regime collapsed  in 1990.

It is from this long time of Russian domination, first under the Czars from the 18th century onward and later under the Soviets, that the Baltic nations feel the urgent desire to become inextricably linked with Western Europe. One way to become so linked is by adopting the euro – hence the currency pegs that have led to an unsustainable boom followed by a wrenching bust, and hence the willingness to 'toughen it out', pursued by all the governments in charge since the crisis began (as is often the case in harsh economic times, governments  frequently change).

 


 

Lithuania in the 13th and 14th century – the largest nation-state in medieval Europe.

(Map credit : Wikimedia commons)

 


 

Terra Mariana, or Livonia in the 13th century after the conquest by the Teutonic Knights. The crusaders were sent in to hasten  the recalcitrant pagan population's conversion to Christianity (which preferred Perkūnas, Dievas and Patrimpas to Jesus, an aberration that at the time was thought to be best cured with a few well-placed whacks to the head combined with a spot of pillage and plunder). The Order of the Livonian Brothers of the Sword was an off-shoot of the Teutonic Knights. In 1215, one year before his death, Pope Innocent III. declared Livonia, which had become a principality of the Holy Roman Empire in 1207, a  subject of the Holy See.

(Map credit : Wikimedia commons)

 


 

The  willingness of the Baltic nations to endure economic hardship for the sake of ensuring the closest possible ties with the EU finds a strong parallel in Hungary, as discussed further below. Specifically the subjugation by the Soviet Union during the cold war/iron curtain era produces plenty of motivation to this day.

 

Loose lips sink ships … and currencies … and bonds … and stocks

In April this year, Hungary's conservative Fidesz Party came to power, replacing the previous socialist minority government. One of the  reasons why the socialists lost power was probably the austerity program they had to impose as a condition of the IMF-EU bail-out. In fact, Fidesz appears to have inherited a hitherto fairly well managed effort by its predecessors.

Since then an increasingly bewildering narrative has emerged from the new government. The first rumblings were heard in late April, when prime minister-elect, Victor Orbán, let it be known that Hungary's budget deficit was unlikely to remain withing the IMF-proscribed guidelines this year (this once again confirms the idea that shortly after major stock market tops, a stream of bad news often begins to emanate from the periphery, which it would be a mistake to ignore).

The Forint was pummeled on April 27 as a result of this ominous declaration. Suddenly rumors began to circulate that although nominally a center-right political party, Fidesz may plan to pursue a somewhat looser fiscal policy to enhance its chances of staying in power (not an entirely unreasonable assumption – we must keep in mind here, the political labeling of parties is almost irrelevant in modern democracies. The same 'pragmatism' informs all elected leaders – and it is mostly about gaining, and then keeping, power.

The long term health of a nation's capital stock is generally of little interest to career politicians. One should a priori always assume the worst, as exceptions to this rule are very rare).

Fidesz next gained notoriety by beginning a feud with Hungary's central bank (link broke on July 28th, unfortunately) and calling for the conversion of foreign currency loans (the famous 'household carry trade loans') into Forint.

Last Thursday, one Lajos Kosa, a vice-chairman of Fidesz, muttered about 'Hungary having only a slim chance of avoiding the Greek situation'. Just in time for unenjoyment Friday in the US, the new government let loose Peter Szijjarto, a spokesman for prime minister Orbán. This veritable Hiob from the Puszta launched into fresh apocalyptic warnings with some verve.

 

According to the Financial Times:

 

“The government has accused the former administration of lying about the country's true economic health. It is expected this weekend to unveil findings from a fact-finding committee on the economy, followed by an action plan. Peter Szijjarto, Mr Orbán's spokesman, said yesterday the economy was in a "grave situation". He added that it was "not an exaggeration at all" to talk about a default.”

 

Lying about the data? Default? The markets were none too happy to hear it – it definitely had what one might call 'Greek undertones' (Greece's main claim to fame are its shoddy budget and economic statistics, which it used to hide its deteriorating debt situation; whether on purpose or merely due to ineptitude is not quite clear). Hungary's central bank immediately moved to dispute this assessment. As the FT also states:

 

“Hungary's central bank, previous government and many analysts immediately insisted the warnings were exaggerated and that the country's finances were much sounder than those of Greece. “

 

If this is true – and it probably is, since possessing 'sounder finances than Greece' should be easy to do, unless you're California – then one wonders what exactly the government's dire warnings about imminent default are supposed to achieve. One suspicion that kind of almost suggests itself, is that Fidesz wanted to put pressure on the IMF by creating an atmosphere of crisis on purpose – with the aim of getting the IMF to loosen its austerity prescriptions. Another motive may have to do with domestic political reasons – Fidesz promised tax cuts, and possibly wants to find a way to wiggle out from that promise without losing face. Given that markets everywhere are on the edge, it is playing a dangerous game.

 


 

The Hungarian Forint shortly after Szijjarto launched into his litany of woe.

 


 

Not surprisingly, CDS on Hungarian debt gapped up and added 111 bips on Friday alone, to a new high of 425. Hungarian bond spreads over US treasuries reached the highest point since April 2009, of 477 bips (up 158). Unfortunately for the euro-area member nations, trouble in the European periphery tends to promptly lead to contagion in markets with related problems, which is to say, the PIIGS. The sell-off in Hungarian debt and the related CDS spike brought CDS spreads on Spanish and Italian debt to new wides as well.

This immediately produced a medial appearance of the EU's chief distributor of chill-pills, Olli Rehn, who briefly emerged from the G-20 pow-wow to comment on the situation.

 

“Market concerns over the risk of a sovereign default from Hungary are "widely exaggerated," Olli Rehn, European commissioner for Economic and Monetary Affairs, told reporters at the G20 meetings here Saturday. Rehn said Hungary "has made serious progress in projecting its public finances over the last several years," and is "on the way to recovery."  Rehn also pointed out that comparing Greece's debt crisis with Hungary was "unnecessary."  "We don't consider comments on recent comparisons between Hungary and Greece and Hungary," he said.”

 

'We may not consider them, but the markets have adopted the  'shoot first, consider later' method of dealing with such news. Fear not though, someone is apparently on the case. Some EU big-wigs presumably made a phone call to the Fidesz HQ and demanded a retraction of Friday's statements. A new, somewhat less apocalyptic spokesman was found, and proceeded to dispute nearly everything Szijjarto had said previously.

The new guy's name is Mihaly Varga, a former minister of finance, possibly chosen for this function for being easier to pronounce. He was careful to keep the story-line about accounting irregularities alive, firmly fixing the blame on the preceding government, but otherwise back-tracked from 'we're as good as bankrupt' to the much milder  'everything will be fine if we take immediate action'.

 

Per the WSJ (link broke on August 5th 2010):

 

“ "The prime minister [Viktor Orbán] supports our proposal that in the current state of the world economy the government should aspire to deliver a budget deficit as small as possible," Varga said at a press conference presenting the initial findings of his committee. The budget deficit this year could reach as high as 7% to 7.5% of GDP without fiscal measures, the new government's officials said in the previous weeks. The National Bank of Hungary estimated in its latest policy paper May 31 that current revenue and expenditure trends will lead to a 4.5%-of-GDP budget deficit this year. Varga declined to state how wide the 2010 budget deficit would be without the government's future measures and blamed the previous two Socialist governments for misleading the public about the true state of the budget. "In the current situation, the only target we may have is that the planned [budget deficit] goal come true, and that the government aspires to regain credibility and reach a change in the [country's] credit default swaps on international markets," he said. [….] "The colleague's remark about the sovereign default was unfortunate. Hungary is not among the countries that face a default. Here the debate is about how to reach a 3.8% deficit and the situation is totally different from places where the deficit is over 10% [of GDP]," Varga said, adding that the remark on default was an "exaggeration." [….] The IMF's regional representative is in Budapest "for unofficial talks to learn about the planned measures," Varga said.”

 

As you can see from these remarks, CDS markets on sovereign debt fulfill an extremely valuable function, namely that of keeping spendthrift nations on their toes. It is in this light that we must see the barrage of verbal attacks against 'speculators' that has recently emanated from politicians in the EU. The presence of the IMF's regional representative for 'unofficial talks' meanwhile may explain some of the brinkmanship preceding this retraction of the 'exaggeration'.  The markets are worrying for a good reason however – the global economic recovery story looks increasingly doubtful. When an 'already bailed out' nation like Hungary indicates that it is on the brink of default again, it represents yet another nail in the coffin of the recovery story that is currently under construction. It is noteworthy that Hungary is also eager to join the currently somewhat shaky euro. Hungary's history includes an extended stint as a member of the communist Eastern Bloc as well, i.e. as a vassal state of the Soviet Union following WW2, a state of affairs that only changed with the economic and political collapse of the unworkable communist system in the Soviet Union in 1989/1990. In short, Hungary too has a strong incentive to bind itself to the West, stemming from this experience – which is detailed further below (Hungary is already part of the EU's common market since late 2004).

 

Some Hungarian History

 

Hyperinflation

Hungary was once home to the biggest hyperinflation event  in all of  economic history, surpassing even the infamous Weimar Republic inflation in its extent. This occurred right after the war, between 1945 and 1946, and is worthy of mention for the sheer insanity of the numbers involved. Hungary's currency at the time was the pengö. On the eve of the currency reform that introduced the Forint, it is estimated that all of the pengö currency in circulation was worth about one-thousandth of one US dollar. The highest pengö denominated bank note was the 1,000,000,000,000,000,000,000 pengö note (1 sextillion, 1021).

Prices doubled every 15 hours, rising at a monthly rate of 1.3 x 1016 percent. When the Forint was introduced, the exchange rate was 1 Forint per 400 octillion pengö – which when written out reads as: 400,000,000,000,000,000,000,000,000,000 (or 400 x 1027).  It seems possible that the total amount of pengö in issue in the summer of 1946 slightly exceeded the estimated number of all particles in the universe (which was approximately one sesvigintillion last time we looked, or 1081).

Presumably the chart of gold in pengö looked rather 'overbought' at the time as well (in fact, not enough pengö existed in banknote form to pay even for a single ounce of gold). You may be unsurprised to learn that Hungary was one of the first nations in Europe to install a printing press in Buda in the year 1472.

Such experiences often remain indelibly etched in the national psyche, in the construct of the 'collective subconscious' as posited by Jung or something akin to it – this is at least very much evident in Germany, home of the stern Bundesbank, which has yet to send a representative to the ECB board who is not an unmitigated hawk.

 

The communist era

Perhaps the appreciation of inflation is slightly different in Hungary, due to the adoption of communism shortly after the hyper-inflation event, which 'saved' the Hungarian people from experiencing the increase in wealth and rising living standards generally associated with evil capitalism.

After an interim period during which the Smallholders party – which had won the first post-war election with a large majority – was forced into a coalition government with the communists on the orders of the Soviet occupation authority,  Matyas Rakosi moved to establish a fully Stalinist state in 1948 (the term 'Salami Tactics' was born in this time, describing Rakosi's 'slicing away of political enemies like slices of Salami') including the nationalization of industry and collectivization of land by force (there is of course no other way). In the initial phase this required the state-sanctioned murder of about 2,000 people and the imprisonment of another 100,000 , and eventually, over time, the 'purging' of some 350,000 intellectuals and officials from positions of influence and  the deportation of countless people to Soviet labor camps (a quasi-death sentence).

Presumably Rakosi thought it was 'worth it', so that the rest of the country could enjoy the blessings of full-bore socialism.

It should not surprise that the communists felt there were many enemies worthy of permanent removal. A communist coup shortly after WW1 under Bela Kun gave Hungarians a first taste of 'red terror' that they had evidently not yet forgotten. This first attempt to establish communism was long on promises, short on delivery and ended in mass murder.

The second attempt under Rakosi took up where his predecessors had left off, with the main difference in the greater effectiveness of the effort, due to the Soviet military presence.  Also, there has always been a strong nationalistic streak in Hungary, which is one of Europe's oldest nations (the Magyar tribes were first united under Arpad in the year 896). This nationalistic streak meant that in Hungary there was always a strong inclination in favor of political independence, a cause that ran counter to the 'internationalist' aspirations of the communists.

As an aside, this nationalistic streak was also one of the causes of Hungary's unfortunate decision to join the axis powers in WW2 – Hungary had been strongly linked to Germany economically and felt it could not afford to alienate the Germans. However, the nationalistic flavor of the axis surely appealed to Hungary as well – to the great detriment of Hungarian Jews, who soon found themselves persecuted as the governments of Gyula Gömbös and Bela Imredy tried to please Germany in the 1930's by introducing a number of discriminatory laws.

These governments also felt strongly that Hungary's post WW1 grievances were in need of redress (Hungary had lost a big chunk of its territory to neighboring states as a result of throwing in with the losers in WW1 as well), something they felt they had in common with Germany (the Trianon treaty was essentially to Hungary what the Versailles treaty was to the Germans).

The point we wish to stress here however is that Hungary has been well-known throughout history to regularly revolt against attempts to establish foreign rule. It was also one of the nations in the vanguard of the revolution of 1848 against Habsburg rule – and although this revolution was ultimately suppressed, it initiated a path of reform that ended with Hungary becoming a formally independent nation in personal union with Austria – the Austro-Hungarian empire – in the late 1860's.

It is difficult to imagine that living standards could actually still fall in the war-torn country, but the Rakosi government accomplished just that. By the time Stalin died in 1953, the  discontent in the country finally boiled to the surface, and when Imre Nagy became prime minister shortly after Stalin's demise, he decided to embark on a course of reform. He unmuzzled the media, released political prisoners, announced that he wanted free elections to be held and openly considered Hungary's exit from the Soviet sphere of influence.

Rakosi however remained chairman of the Hungarian communist party, and a power struggle ensued that ended with Nagy being deposed once more in 1955 (the party accused him of being a 'reactionary deviant'). Rakosi assumed the post of prime minister again, but soon found himself undermined by Nikita Krushchev's famous renunciation of Stalinism, which included a number of highly critical remarks regarding the execution of Hungarian communists Rakosi had ordered during the purges in the late 1940's.

On Soviet orders, Rakosi resigned, but managed to install his close friend Ernö Gerö, a fellow Stalinist, as the new prime minister. That was when Hungarians finally had clearly had  enough of the communists and beginning with student protests in Budapest, an uprising began, with pockets of resistance forming spontaneously all over the country. This led to violence in Budapest, with first the police opening fire on protesting students, and the fighting then spreading, with Soviet tanks battling a desperate, rag-tag militia in the streets of the city.

Apparently the Soviets encountered quite effective resistance in these first skirmishes, so that they decided to remove themselves to the countryside to lick their wounds. The Soviet leadership in Moscow was very dismayed by these developments and ordered Gerö to stand down as communist party chairman in favor of the reformist Janos Kadar.  Nagy, who was a friend of Kadar,  meanwhile joined the revolution and after Nagy , Kadar and their friends had wrested control of the communist party from the Stalinist faction in late October,  a new government was formed with Nagy once again becoming prime minister.

Then events took a nasty turn, as Nagy attempted to make good on his promise of achieving Hungary's independence from Soviet influence. He released all political prisoners and abolished the one party state,  allowing the political parties that had been banned by the Rakosi regime to reconstitute themselves.

Then he announced Hungary's withdrawal from the Warsaw Pact – the country would henceforth be neutral – and demanded the immediate withdrawal of Soviet troops from Hungary. Following this, he formed a coalition government between  the reform communists,  the Smallholders Party, the Social democrats and the Petofi Peasants Party.

This turned out to be way too radical for Krushchev, in spite of his condemnation of Stalin. Clearly the Soviet leadership feared that if Hungary were allowed to 'get away' with cutting its ties to the Warsaw pact, then the rest of the Eastern Bloc may soon follow. After all, not one of these nations had become part of the communist bloc voluntarily.

So instead of Soviet troops departing, reinforcements were sent and the revolution was quickly put down (it took 2,500 tanks and 150,000 soldiers). The Soviets installed Janos Kadar as prime minister, and Nagy and some 400 other 'counter-revolutionaries' were executed. A further 22,000 people were jailed. Some 20,000 had been killed during the uprising (just in case you thought the communists got any nicer after Stalin's death – no, they didn't really). However, the Kadar regime over time introduced what became known as 'goulash communism' (named after a famous Hungarian dish), i.e. the particular Hungarian variant of communism that was purposefully adopted in the early 60's in order to quell the popular resentment that continued to simmer under the surface following the violent end of the 1956 uprising. This allowed for some small scale free market type activity (small businesses), a greater tolerance of dissent, in short a generally more liberal environment than elsewhere in the Eastern Bloc.

The party specifically attempted to make sure that an increase in living standards occurred relative to the Rakosi era, which was not too tall an order given Rakosi's utterly dismal record. Uniquely among communist countries at the time, Hungary lacked the endless queuing in front of food shops, a miracle made possible by the minimal private sector economic activity the Hungarian communists allowed to take place.

Then the Soviet empire began to disintegrate beginning in 1989, Hungary played a major role in the dissolution of the Eastern Bloc by allowing people that were fleeing from communist East Germany to cross the border into Austria. People living in the Eastern Bloc at the time were only allowed to go on vacation in other communist nations, so as to minimize flight risk (socialism was such a grand achievement that people had to be imprisoned inside the countries practicing it – evidently they didn't know what was good for them).

However, the 'goulash communists' of Hungary decided that shooting people just because they wanted to cross a border wasn't really their thing, so East Germans soon flocked en masse to Hungary in order to escape into the West. In fact, Hungary had repealed all restrictions on foreign travel in early 1988.

The pictures of an endless stream of refugees leaving the communist bloc with practically nothing but the shirts on their backs underscored the utter failure of the communist system like few other things. What little was left of the Marxist propaganda effort was lost then and there, at the border between Hungary and Austria.

The government of Karoly Grósz, who had succeeded Janos Kadar, decided to reintroduce a multi-party system in 1989 due to 'popular dissatisfaction with the current system' as was dryly noted in the requisite press release. After receiving assurances from Mikhail Gorbachov that the Soviet Union would this time refrain from interfering with Hungary's internal affairs, the communist party finally relinquished its hold on power in October 1989, paving the way for free elections in 1990.

 


 

An iconic image from the Hungarian 1956 revolution: Stalin decapitated.

(Photo credit : Wikimedia commons)

 


 

Conclusion

We deduce from the above that similar to the Baltic nations, Hungary has a strong motive, based on its historical experiences , to integrate itself more closely with the EU. There is therefore still a strong consensus across the political landscape that joining the euro is a worthwhile goal – in spite of the sea of troubles the euro finds itself in these days.

This leads us to believe that the effort to reduce the budget deficit to within the required Maastricht guidelines must be taken seriously, even if the new Fidesz government tries to extend the time-line a bit in a bid to keep itself in power.  We certainly wish for Hungary to succeed in this endeavor – as we have frequently mentioned, the expansion of budget deficits in order to counter an economic downturn serves no good purpose. Ultimately it only prolongs the economic agony, by perpetuating malinvested capital and hindering the re-establishment of a sustainable balance between production and consumption.

Generally, governments find it difficult to make the choice in favor of sound long term economic policy, for the simple reason that an economic bust produces a fair amount of near-term pain, which tends to lower the chances of re-election. In Hungary, the political will to implement such sound policies may however be more pronounced than elsewhere and we certainly hope this will continue to be the case, for the sake of Hungary's long term economic well-being.

 


 

 

A disappointing unemployment report and bad news from Hungary combine to produce a 38 point plunge in the SPX on Friday.

 


 

Charts by Bloomberg, StockCharts.com

 


 

 

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