Feb 1, 2006: Interview with Steve H. Hanke for The Region - business magazine for South East Europa
Q: Almost 4 years ago you said in your market economy manifesto that Bulgaria is still not a market economy. What has changed since then and what are the challenges still facing Bulgaria?
S.H.: Bulgaria has been officially classified as a market economy. That represents a change. However, the reclassification has more to do with politics than with economics. When you look at standard metrics for measuring economic freedom, you find that Bulgaria has a relatively low rating. Interestingly, the major reason that Bulgaria's rating is as high as it is results from the high scores Bulgaria receives for the sound, convertible currency produced by its currently board-like system. Instead of declaring Bulgaria as a market economy – as the politicians have done – I would simply say that Bulgaria has made steady progress toward becoming a more market-oriented economy during the past four years.
The challenges facing Bulgaria are the same ones I identified in the manifesto I presented at the Investment Forum 2002 in Sofia. And so are the solutions:
1. Fiscal order and transparency must be established. Bulgaria lacks the fiscal institutions to guarantee that budget deficits and government spending can be controlled. To put its fiscal house in order, Bulgaria’s government should begin to publish a national set of accounts which includes a balance sheet of its assets and liabilities and an accrual-based annual operating statement of income and expenses. These financial statements should meet international accounting standards and should be subject to an independent audit. Among other things, these fiscal reforms would reduce waste, fraud and corruption.
2. Supermajority voting must be established for important fiscal decisions, such as increasing taxes or the deficit. Many countries require supermajority voting for important decisions. Such a voting rule protects the “minority” from the potential tyranny of a simple “majority.” A supermajority voting rule is particularly important for the protection of minorities in countries, like Bulgaria, where the democratic process is not circumscribed by a firm rule of law.
3. The tax system must be simplified and tax rates must be lowered. Bulgaria’s tax system is too complicated and tax rates are too high. In consequence, economic incentives are distorted and the formal economy is unnecessarily burdened. Not surprisingly, corruption is widespread and the gray economy flourishes. To reform the tax system, Bulgaria should adopt a flat tax system – one in which the same low, uniform tax rate is applied to business and personal income.
4. Commercial law must be privatized. At present, Bulgaria’s legal and judicial systems are unreliable and do not meet market-economy standards. This is one reason why corruption is widespread, why private property and contract rights are not properly protected and why foreign direct investments are lower than they should be. This is unacceptable. After all, the enforcement of the rule of law, which encompasses the sanctity of private property and contracts, is the foundation of all private morality and the foundation of every sane social order.
For commercial activities involving property and contracts, there is a way to provide a reliable, low-cost alternative to the state’s monopoly of the legal system. History offers many examples of legal regimes that were designed and administered by private entities. Indeed, commercial law has its origins in purely private regimes: the merchant guilds of medieval Europe. Lex mercatoria—the law governing the relationships between commercial traders—was a privately-designed and administered system that was made effective by the power of the sovereign to force compliance. And today, private arbitration under the auspices of the International Chamber of Commerce in Paris serves as an example of such a system. Bulgaria should privatize commercial law. The adoption of these policies would result in a major confidence shock and a large improvement in Bulgaria’s economic freedom ratings.
Q: Do you approve of the government's determination to stand firm in its social commitments in the budget? Do you think that the Central Bank should implement extra measures to curb bank lending?
S.H.: I don't really know what the phrase "social commitments" means. It is one of those nebulous concepts employed by politicians to justify more government programs and spending. The public should -- and usually does -- worry when terms like "social commitments" are thrown around by politicians. Indeed, this is why the Bulgarian public remains skeptical about the new government. To win the public's trust and confidence, the new government must prove that it is committed to transparent budgeting and spending control. If the new government fails in that fiscal sphere, it will not be able to generate the level of public support required to develop and sustain positive momentum.
Also, if government spending can not be controlled, current and future taxes will have to be raised, and higher taxes are much more damaging than commonly understood. For example, in the United States, the cost of each additional dollar of tax revenue collected is USD 2.75 - not one dollar. Consequently, for each additional dollar of government spending (taxing) to be justified, that spending would have to generate more than USD 2.75 in benefits. In the U.S., it is hard to imagine any government programs for which an additional dollar spent generates USD 2.75 in benefits!
As for your question about the Bulgarian National Bank and extra measures to curb bank lending, I addressed this matter in an article published in the August 2003 issue of Central Banking. In that article, I predicted that the manipulation of the government’s “fiscal reserve” would set off a credit boom. This fiscal reserve account represents a number of government deposits distributed between the BNB and Bulgarian commercial banks. The deposits dept at the BNB are considered part of the monetary base. Accordingly, the BNB is required to fully back them with international foreign reserves. Since the fiscal reserve can be moved at the government’s discretion between the BNB and the commercial banking system (where liabilities don’t have to be fully backed by foreign reserves), it is an instrument of domestic credit policy.
To solve the so-called problem (excessive credit growth) the fiscal reserve account at the BNB should be retired. The foreign assets released from the BNB to the government should be put on account with a foreign commercial bank, not with Bulgarian banks. This would put a stop to the manipulation of domestic credit via the governments fiscal reserve.
Q: Judging from your experience in Serbia and Bosnia, do you think that the EU is the only guarantee for stable and democratic political development and market economy in the Western Balkans and the region as a whole?
S.H.: No. Stability and prosperity in the Balkans will be dependant on the establishment of free-market economies and free trade anchored in the rule of law. And on this last point, it is worth stressing that most people do not appreciate that the rule of law -- properly understood -- has as its primary objective the protection of individuals and their property from the State. When it comes to free markets and trade, as well as the rule of law, I do not think the EU can be relied on to set a good example. Each country in the Balkans must put its own house in order and set its own course for liberal economic reforms and the establishment of the rule of law. As an example, let's look at Montenegro. In 1999, I was advising President Djukanovic. At that time, the government wanted to establish an economic policy that was independent from Serbia's. To do that, Montenegro, among other things, abandoned the unsound Yugoslav dinar and replaced it with the German mark subsequently replaced by the euro. This successful change was not initiated by an EU mandate. Indeed, the EU opposed Montenegro's steps toward an independent economic policy.
Q: For all the countries in the region the EU is the beacon, the highlight of their foreign policy goals and the best-case scenario for the future. But what would be the worst case scenario for these countries?
S.H.: You imply that the best case scenario would be a Balkan dependency on EU leadership. I do not believe that is correct. one recent example illustrates my point. Francis Lamoureux -- who until recently was Director General for transport and energy at the European Commission -- asserted that his greatest accomplishment was to increase the number of pages in the EU energy and transport law from 3,782 in 1999 to 9,682 in 2004. With Western Europe's economies struggling under the burden of statist regulations, I am always surprised when it is suggested that the EU should provide a beacon for economic reform and modernization.
It is important to recognize one simple fact: there are no successful big reforms that have expanded liberty and economic freedom in any country that have been imposed from outside. China, Chile, New Zealand, UK, Ireland, Estonia, in diverse degrees, are the big success stories, and none of those had a program imposed from the outside from some super state or power telling those countries what to do. The IMF wasn’t involved in any of the big reforms in the countries I just mentioned. Local policies adapted and suited for the local population and supported by the local population explain why reforms were successful. I should mention that important local reforms can be taken in small, as well as giant steps. As part of Slovakia's recent liberal reforms, Finance Minister Ivan Miklo wanted to modernize the Ministry of Finance. Mr. Miklo's objective was to introduce private sector practices into the Ministry. He engaged private sector consultants and implemented the consultants' recommendations. These included cutting the staff from 800 to 250 and increasing the salaries of the remaining 250 staffers by 30 percent. This has resulted in the delivery of better policies in a more cost-effective way.
Q: Do you share the common pessimism that the Doha round of trade talks crashed in Hong Kong? How will this affect emerging markets like Southeastern Europe?
S.H.: I think that the talks in Hong Kong are ultimately a failure and crash -- as you put it. However, the politicians come out and say the talks have been a big success. I think, generally, for emerging market countries it is not encouraging particularly in the agriculture sector. The liberalization of agricultural trade will obviously not occur. The best way to achieve free trade is for each country to do what Hong Kong has done – just unilaterally adopt free trade and remove all trade barriers.
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Steve H. Hanke is a Professor of Applied Economics at the Johns Hopkins University in Baltimore, a Senior Fellow at the Cato Institute in Washington, and a columnist at Forbes magazine in New York. He is a well known currency trader and reformer. In 1995, he was president of the world's best performing emerging market mutual fund. In the Balkans, he is known as the father of Bulgaria's currency board and the architect of Montenegro's 1999 currency reform. He serves as an Honorary Member of the Board of Directors of the Bulgarian Economic Forum.
