The economics – is the Brussels-Washington model still applicable?

Adam Bennett

The seminar which I chaired on the future of the Brussels-Washington model for the development and convergence of South-east Europe generated a lively discussion and some interesting observations.

The Brussels-Washington model never was a single immutable model. The model was and remains multifaceted and has kept evolving in light of events. The first phase of reforms emanated mainly from Washington and eschewed gradualism in favour shock therapy—with recommendations to cut fiscal deficits, open up capital accounts, privatize as quickly as possible, and liberalize prices across the board. This version of the model ran into the Acemoğlu dilemma—economic reform without political reform can bring new problems, especially in governance. Sequencing became a watchword in a more differentiated second phase. The third phase saw the lure of EU accession as a key driver of the region’s systemic transformation, with the acquis communautaire and associated reform programs devised in Brussels. The multiplicity of reform targets and their wide range over social and economic issues, however, threatened to overburden the accession countries, and seemed untargeted. This was in contrast with the Washington side of the model which was ramping down structural elements in its programs. The fourth phase, which is where we are now, has seen the model go through some serious soul-searching, as first the global banking crisis and then the Eurozone crisis both rocked the economic foundations of South-east Europe and also raised profound questions about the benefits of accession, as well as about the appetite of the EU for further enlargement.

The sudden stop in capital flows to the region not only helped spread the recession but also crystalized doubts about the logic of European integration and of the whole associated political-economic dynamic. What can be learned from the pattern of capital flows on the fringes of the Eurozone? They differed considerably according to region. The capital account of the € periphery (e.g., Ireland) was dominated by massive portfolio inflows and perversely by foreign direct investment (FDI) outflows. The Baltic countries likewise experienced large portfolio (mainly bank finance) inflows, but also (on a smaller scale) FDI inflows. The Balkans and Central Europe (Czech Republic, Poland and Slovakia), at the other end of the scale, saw a more balanced mix in roughly equal proportions of both FDI inflows and portfolio finance. The consequence of the € periphery’s over-reliance on portfolio (mainly bank) finance was (or at least should have been) predictable—a colossal banking system collapse and a prolonged recession. Why wasn’t this mirrored in the Baltics? This was perhaps because the banking inflows were smaller (and they were also subject to active concertation by the home governments of the banks), while wages and prices were much more flexible, so that the internal adjustment could proceed rapidly enough to shorten the (albeit deep) downturn. More intriguing is to compare the performance of Central Europe with the Balkans, given the similarity of their capital accounts. FDI is generally regarded as a “good” form of capital inflow, because it is more stable and less reversible. However, in the case of Southeast Europe in the run up to the crisis, an increasing share of FDI was going into construction, real estate and non-traded goods industries serving the local economic boom. Arguably, it had become a source of instability and contributed to an unbalanced growth model. When the FDI halted, it triggered an immediate recession, on top of the spillover from slower growth in Europe. So what do we learn from this? Capital inflows are all very well, but they need to be complemented by macro-prudential management of their scale and nature, as well as by active use of traditional policy levers, especially fiscal policy (if fixed exchange rate regimes rule out monetary policy independence).

In reviewing the experience of Southeast Europe during the Great Recession, three Balkan paradoxes were identified. First, why has political support for European integration remained undiminished, despite the global downturn and the apparent failure of the accession process to protect the Balkans from its effects? Second, why is the region (with a few exceptions) doing so badly economically, compared to other regions neighbouring core-Europe? Third, how has social and political stability been preserved, notwithstanding the dire economic environment? The key event that may have helped avoid a meltdown in the region and kept policy-makers focused on accession was the June 2012 election in Greece, which sent a strong signal that Greece (at least) intended to stay in the Eurozone—come what may. This perhaps serves to underscore an important point for Southeast Europe, which is that the goal of European integration and the reform program that that involves is still the only game in town. In other words, there is no obvious alternative model. The Brussels-Washington model is dead. Long live the Brussels-Washington model!