Eastern Europe: is opportunity knocking?

fedgazette Editorial

C. Ford Runge

Published September 1, 1990  | September 1990 issue

The events in Eastern Europe have created an international sense of hope and optimism that provides a useful counterweight to the domestic problems of savings and loans and budget deficits. I share in that hope, but will argue that we have rather badly misgauged the meaning of these events. Although greeted as a triumph of democracy and capitalism, I believe we have instead witnessed the total failure of totalitarian state planning. This failure is not equivalent to the victory of democracy or capitalism, and may leave instead a great void that must be filled with something else, which we are not presently equipped to provide. That something is money.

State Department Policy Planner Francis Fukuyama, in his now famous nostrum on the "End of History," suggests that the decline of the East has ushered in a kind of stillness in which the major problem will be to keep from yawning. I find this argument intellectually banal and politically naive. But, it was not me to whom Fukuyama's message was addressed; it was to the secretary of state, president and the Washington intelligentsia. Many seem convinced that the Soviets and Warsaw Pact have folded their hand, and that all that remains is to rake in the chips.

I would argue that rather than folding, a group of players across the table have in effect fallen off their chairs, dragging the tablecloth, cards and many chips toward them. The collapse of the Warsaw Pact and Iron Curtain is an implosion, a collapse from within, which promises to draw resources out of Western Europe and the capitalist economies without any promise of returning them. Into this hole we can pour aid and investment, but the returns are iffy, at best. Far from counseling the kind of relaxed and modestly informed nonchalance, which is the appealing message of Fukuyama on history's end, we are at the beginning of a new modern history. The simple division of world politics and economics that has marked the last 70 years, since Lenin arrived in 1917 at the Finland Station to spark his revolution, is no longer sufficient.

The implosion of the Warsaw Pact thus exerts a pull on Western resources that has important implications for both government and private sector investment strategy. Consider two dimensions of this issue. The first is the impact on Western Europe, and specifically on the European Community's plans for a unified market by 1992. The second is the impact on the United States, and the opportunities and risks for private investment and public policy.

Western Europe, in my view, is much better positioned for reasons of both history and culture to benefit from the developments in the East. Put simply, West and East Europeans know one another better than we do. A recently commissioned study of joint ventures by western companies in Poland indicated that nearly 80 percent were with companies in Western Europe. Of the 40 or so U.S. companies involved in Polish joint ventures nearly every one had some ethnic or family tie that linked them back in some way to Europe and Poland. In Poland, West German companies have formed more than 400 joint ventures, 10 times the number with American companies.

Will such investments pay off in the future? Consider the situation in Poland. Last winter, Poland's farmers were demanding a halt to the process of "marketization." In a remarkable convergence, like their U.S. and European farmer counterparts, they had rather grown to like state intervention to stabilize their prices, and feared market-oriented reforms almost as much as they hated the Communist state planning apparatus. The farm groups play a significant role in Solidarity, and will thus likely stall efforts to open up markets for staple commodities advocated by the World Bank and IMF grantors of aid.

The next several winters will be hard ones in Eastern European agriculture, for three very instructive reasons. First, while foodstuffs are probably adequate to satisfy total demand, chronic shortages are likely. This arises from the propensity, observed by anyone who has lived or worked in a Communist system, for the citizens of these countries to hoard scarce commodities in times of trouble. This hoarding instinct, which can clear shelves of basic commodities faster than a snowstorm in Washington, means that even if pockets of abundance occur, they will be hidden and will not move to pockets of demand.

Second, and related, is the breakdown of the state-controlled marketing and distribution monopolies. While some are nominally "cooperatives," these monopolies are now without force or guarantees. The lack of confidence in them thus makes moving goods from pockets of surplus to pockets of demand inherently difficult. This lack of confidence interacts with hoarding to lead anyone to think twice about putting goods on a train bound for Point A in the expectation that they will be receiving goods in return from Point B.

Third, a similar phenomenon affects liquidity in money markets. Poland's attempt to convert its currency to allow it to fluctuate on internal markets led to a run on the banks, as individuals became convinced that their small hard currency holding in dollars would be replaced by a converted currency that would be worth less.

Hoarding, marketing failures and monetary insecurity can add up to significant inflation, especially as the prices of commodities are allowed to fluctuate more freely. Having lost confidence in government quantity rationing, no new confidence exists in price rationing either. This is precisely why Polish farmers are in reactionary opposition to marketization. There is, after all, no Polish equivalent to the Chicago Board of Trade on which to hedge next year's crop. Having experienced government failure, Eastern Europe is getting set for market failure.

Western Europeans understand the problems of Eastern Europe better than we do, having lived through very similar problems after the Second War. This is partly why Germany, in particular, so fears inflation, and why greater confidence exists in a mixed system of state planning and market forces in Europe than in the United States. There is nothing like a winter of hunger or hyperinflation to sap one's confidence in the magic of the unfettered marketplace.

In the face of these problems, Western European investments in the Eastern bloc will expand more rapidly than U.S. investments. The emergency meetings of prime ministers in Brussels over the implications of the implosion in Eastern Europe for the 1992 process is instructive. I believe that a three-tiered structure of trading arrangements will emerge. The first tier, or inner circle, if you will, will be the EC-12, for whom the harmonization toward 1992 will continue. In the second tier will be European Free Trade Area (EFTA) countries, including Austria, Switzerland, and the Nordic countries of Sweden, Norway, Finland and Iceland. These countries have already struck a bargain with the EC-12 that amounts to a sort of conditional most-favored-nation status in relation to the 1992 process. By 1992, the EC and EFTA countries hope to allow free movement of goods, services and capital among their 18 nations. Significantly, the only exception for the EC is likely to be agriculture, where duty-free imports from EFTA are unlikely to be allowed to breach the wall of the variable levy.

The outer circle or third tier of this European trading zone will encompass the Warsaw Pact and Comecon countries. But they do not have much hard currency to spend. With the exception of integration between the two Germanys, the major integration will occur according to older historical patterns. Parts of the Balkans with historical ties to the West dating from the Hapsburg Empire will be integrated more quickly than others. These include ties from Vienna to Budapest and Prague. Last fall, the foreign ministers of Italy, Austria, Hungary and Yugoslavia met as what the Economist called the old Austro-Hungarian "quartet" to advance a regional grouping. This grouping redefines Emperor Franz-Josef's "Mitteleuropa," or Middle Europe. The city of Trieste, an old Hapsburg port on the Adriatic, looks on this as a rebirth, and has reopened the old Cafe San Marco, a center of commercial and social intrigue until the wars. In general, East Germany, Poland and Hungary will be the first countries to become economically integrated into this third tier or outer circle. Weaker forms of reciprocity will be extended to them by EFTA and the EC-12.

If the bulk of investment opportunities (which, as I have argued, will be limited in the short term) are seized by Europeans, what will this leave for the United States? U.S. companies that have done business with communist regimes in the past have been willing participants in at least one aspect of socialism: largely guaranteed profits. Unfortunately, the breakdown of state planning will reduce the capacity to guarantee the new generation of Armand Hammers a tidy return. The more investors there are, the less it is possible to make such guarantees. Hence, the collapse of state socialism will actually raise the risks of investment in comparison with the past.

It will also raise the stakes for joint ventures now under way. Chubb and Son Inc., the insurance company, has formed a joint venture with the Soviet Union to offer property and casualty insurance to Western companies setting up business there. Insurers sell insurance on the supposition that things won't go wrong -- not that they will.

Some American companies have been unusually aggressive. United Parcel Service has started delivering packages in Moscow, Budapest, East Berlin, Warsaw and Cracow, although it demands payment in hard currency, limiting its market largely to other Western companies that don't trust the mails. General Electric has a light bulb venture with Hungary worth $150 million, and General Motors is working on a deal to buy East bloc automotive parts in return for greater import access for its cars. Because of limited hard currency, many deals will involve forms of countertrade, such as Pepsi's decision to take payment for its sugar syrup in the Soviet Union in the form of Stolichnaya vodka. However, the very move to decentralization and "marketization" means that comrade so-and-so in the Ministry of Planning has less to say about arranging countertrade deals than in the past. Bankers are especially wary, recalling the $15 billion loan debacle of the 1970s in Poland: loans that have not been repaid.

If winning through state-sponsored intimidation by investing in Eastern Europe and the USSR will become more difficult, the losers from the decline in military spending here at home are easier to predict. One of the striking features of the collapse of totalitarian regimes in the East is the tugging at the tablecloth under the piles of chips accumulated by U.S. military suppliers. Thanks to the cold war military buildup, Leslie Wayne of the New York Times reported in late 1989 that 85 percent of General Dynamics' $9.5 billion in annual sales come from government contracts. At Lockheed the figure is 91 percent; at Northrup, 92; McDonnell Douglas, 64; and Martin Marietta, 85. At Grumman, the figure is 90 percent, and the proposed cancellation of the Navy F-14 fighter would zero out 20 percent of sales.

This striking dependence on military procurement reveals one of the great ironies of the 1980s buildup in weaponry. As the pressures for democracy and capitalism in Eastern Europe mounted, the United States was converting a major share of its industrial base to a form of state socialism through guaranteed government contracts. The inefficiency and waste of $800-toilet seats are hardly news to the East bloc, nor the oft- heard phrase "good enough for government work," each of which tells what happens to incentives when government is the buyer and competition becomes a sham.

Despite the talk about a "peace dividend," I very much doubt that the aforementioned companies will share much enthusiasm for reduced military spending. These companies are likely, rather, to go to work on Congress to retain their state-sponsored contracts.

Nearly 40 years ago, Joseph Schumpeter asked, in his classic Capitalism, Socialism and Democracy (1943), whether the propensity for increasing size and concentration of industry in the Western democracies would not make these companies wards of the state, indistinguishable from state-controlled monopolies. His question was "Can capitalism survive?" It would appear, in light of recent events, that he might also have asked "Can socialism survive?" But perhaps he was partly right after all. In the new dawn of current history, we must ask whether either capitalism or socialism can survive as we have known them.

C. Ford Runge is associate professor and director of the Center for International Food and Agricultural Policy at the University of Minnesota, where he holds appointments in Agricultural and Applied Economics, the Humphrey Institute of Public Affairs, and the Department of Forest Resources. A Rhodes Scholar, he received a master's degree at Oxford University and a doctorate from the University of Wisconsin.

This column is based in part on remarks prepared for the 1990 annual meeting of investors sponsored by Piper, Jaffray and Hopwood.