The latest progress report by the European Bank for Reconstruction and Development (EBRD) on ex-communist countries in central Europe and the Baltics, holds important lessons for those regions of the world that still doubt the benefits of free trade and open markets. The Transition Report 2005 actually focuses on many areas where reform is still pending, including the remaining inadequacy of many institutions in some central and eastern European countries. But what has been achieved so far is impressive and also needs to be understood by Africans and Latin Americans if they are to shake their current morass.
The first lesson is that in almost all central and eastern European countries a consensus has been reached about the benefits of free markets. The real debate hinges on the depth of reform, but the general trend is not in real question. Whereas in Africa and Latin America free trade and open markets are still under fierce debate, with some countries pulling in one direction and others going the opposite way, ex-communist nations are beyond that stage. Some of the most backward countries have now become bold reformers and are reaping the benefits. Romania, long considered a lost cause, has finally undertaken some meaningful changes, including an across-the board slashing of taxes (which have now been reduced to a 16 percent flat rate), labor market deregulation, and the privatization of major state symbols like the steel mammoth Sidex. Slovakia, considered a dysfunctional state when it separated from the Czech Republic under the leadership of a scary demagogue, Vladimir Meciar, has overtaken its sister republic and is doing better even in areas such as the institutional protection of property rights under the rule of law.
The second lesson is that those countries that opened trade most radically are also the ones doing best. In Africa and Latin America (as well as in other developed countries, for that matter), the debate about trade tends to focus on the gradual phasing in of tariff reductions because of the need to adapt to competition. In central and eastern Europe, the countries that have come out strongest and proven most adaptable to competition are precisely the ones that worried least about transition periods. The country with the best economic performance continues to be Estonia, which 15 years ago unilaterally eliminated all its tariffs. Unlike central European countries, where trade reform was slower and GDP growth has hovered around 4 percent, Baltic countries, especially Estonia, have been consistently growing at a rate of 7 to 8 percent after eliminating tariffs, which means their standard of living is doubling every decade. Estonias exports now total the equivalent of 80 percent of its GDP, which, contrary to the widely held view that countries should aim to export more and import less, means that removing barriers to imports is the best way to boost exports.
A third lesson coming out of ex-communist countries is that reform needs to be comprehensive. It is no use opening trade--that is, removing external barriers--if you dont also remove internal impediments to enterprise and exchange. Again, Estonia was the first country, in 1994, to replace a labyrinthine tax system with a low, single, flat rate--a measure that had the effect of drastically lowering the overall burden of taxation, simplifying the system, and eliminating the distortions that come with progressive taxation, that Marxian legacy. Latvia and Lithuania followed suit. Eventually, central European countries joined the party, with so much success that Germany and France complain that those newcomers to the European Union are competing disloyally to attract investments. In the years prior to radical tax reduction in that country, Estonias economy was actually experiencing a rate of growth of minus 8 percent. Drastic reform turned the countrys fortunes around quickly.
A fourth and final lesson has to do with labor markets. Many developing countries that decide to engage in fiscal and commercial reform fail to free labor markets, without realizing how critical it is for a country to have a flexible labor market if it is to respond quickly and positively to the opportunities that come from lowering taxes and kicking away trade obstacles. Whereas Hungary, which has a reasonably free labor market, has virtually eliminated poverty altogether in the last 15 years, Poland, where high payroll taxes, a high minimum wage, and restrictive policies on hiring and firing have slowed the creation of new jobs, has only 51 percent of the working age population employed.
Thanks to bold reform, ex-communist countries have taken some 40 million people out of poverty in the last seven years. It is easy to forget that only one generation ago these republics were in the hands of regimes that had obliterated the institutional foundations of the free society. They all started from a position of disadvantage with respect to other developing nations where intrusive and corrupt governments had not debunked the institutions of the free society in any comparable way. Today, the best hope for the latter countries lies in heeding the lessons from central and eastern European nations that have turned themselves around.