I am posting Martin Hutchinson’s latest Bear’s Lair piece, which addresses what, currently, is the hottest European potato: the conflict between the grand ambition of EU enlargement and the practical difficulties it poses.  It is dated today, 2nd October, and is published on the Prudent Bear website.

GW

The EU Tuesday finally agreed to admit Bulgaria and Romania on January 1, 2007, but expressed deep concern about the level of corruption in both countries. Is this a problem that affects only the countries concerned, or might it affect the EU economy as a whole, bringing it new diseconomies from EU enlargement?

The political arguments for and against EU expansion are clear.  On the one hand, the EU wants to take in its poorer neighbors, to include them in a greater European federation that can pull its weight in world affairs and produce prosperity for its people.  On the other hand, as the EU goes further East and South, it comes to countries which are either exceedingly poor (hence possibly a burden on EU social funds and other programs) or culturally sufficiently different from the European majority (for example, primarily Moslem) that their assimilation might prove difficult.  There is no hard dividing line – Bosnia is a Moslem country that is historically well within the European heartland, while Armenia is a Christian country whose history has little connection with Western Europe. Nevertheless it’s clear that politically, while the absorption of culturally close entities such as East Germany and Hungary was supported by the great majority of EU citizens, expansion beyond the European heartland poses progressively more difficult problems.

Economically, at first sight it’s a question of scale and pace.  Slovenia—tiny, relatively well off and subjected to a form of Communism that was barely more collectivist than several EU members—was easy to absorb. Poland, unquestionably part of Europe but much bigger and somewhat poorer, has proved much more difficult, with free movement of labor producing an oversupply of immigrant Poles in Britain, already too crowded to wish for more population.

Nevertheless, by delaying entry until the economy was both capitalist and as rich as the poorer parts of the EU, and staging it so that no more than 5%-10% was added to EU population in each decade, it would theoretically have been possible to expand the EU seamlessly, with both old members and new benefiting enormously from the expansion.  Companies in old EU member countries would enter a free trade zone with a supply of labor that was cheaper than at home, allowing them to become more competitive in world markets, while new member countries would find a steady supply of foreign investment arriving, improving the nation’s capital stock and permitting a rapid growth in local wage rates and living standards.

However, in reality economic frictions make it more difficult for the EU to absorb new countries than at first sight appears.  Countries such as Poland, and later Turkey and Ukraine with large and impoverished populations cause a major strain on the EU economy, because the mechanisms that pull those countries’ living standards up to an EU norm require enormous amounts of capital and a long time to take effect. Thus even more than Poles, Turks and Ukrainians would rationally seek a better destiny in large numbers in Western Europe, overwhelming Western Europe’s capacity to absorb new labor and welfare recipients without great hardship to its own populations.

As expansion moves to poorer countries, it must thus proceed at a slower and slower pace, to prevent those countries from being hollowed out by emigration. Slovenia or Estonia, with small populations and relatively strong economies, can be absorbed much more quickly than Moldova, whose economy is much weaker, even though Moldova’s scale is tiny compared to that of the EU as a whole.  Turkey, huge and relatively poor (though richer than some of its neighbors because it escaped Communism) will require many decades to absorb, most of which time must be passed in a state without free movement of labor between Turkey and the rest of the EU. Thus even if Turkey joins the EU in 2015, free labor movement for Turks would be impossibly disruptive to the EU as a whole if granted before 2035 or so.

The most important difficulty of all in absorbing some new countries into the EU is their lack of progress towards a free market economy. In such cases, the transition from Communism has proceeded only a modest distance, or has stalled altogether, so absorption by an EU that is at least nominally capitalist would be very difficult, even though the local nomenklatura are generally quite keen to join.  Belarus is an extreme case of this. It has made almost no transition from Communism, with a rating of only 1.9 on the European Bank for Reconstruction and Development’s Transition Progress Indicator, the second lowest of the restructuring countries (Turkmenistan is lowest) yet it is only moderately poor and culturally and geographically unquestionably part of the European heartland.

Oleg Havrylyshyn, author of “Divergent Paths in Post Communist Transformation (Palgrave Macmillan 2006) spoke at the Cato Institute Monday and made the point that, whereas Central European countries had essentially completed the transition from a communist to a capitalist economic system, as you go further south and east the transition becomes progressively more incomplete. In countries like Belarus the process has come to a halt, since the economy has been captured by post-Soviet elites, who as “red directors” dominate the business sector and extract rents from the economy by constructing monopolies that are not subjected to a freely competitive process. The elites have both economic and political power; in this respect they differ from the early stage Russian “oligarchs” such as Yukos’s Mikhail Khodorkhovsky, whose political power was limited and who therefore lost control of his business empire and ended up in prison in Siberia.  Once political and economic power are in the same hands, in an economy where free competition is not permitted, the chance for further change has disappeared.

If an economy with a stalled transition is admitted to the EU, even if that economy is quite small, the positive effects of EU membership disappear and negative externalities intrude.

Foreign investment into the country is stolen, since property rights are not respected, so enriches only the elite and fails to provide jobs and living standards for the populace.

Since the initial foreign investments turn out unfavorable, new foreign investment is soon deterred in spite of the country’s cheap labor, and the economy stagnates.

Risks to foreign businessmen remain high, since the oligarchs compete with foreign intruders through staged assassinations (“car accidents” in the winter months are popular in the Balkans) as well as though rigged state administration and outright theft.

Organized crime discovers the country as a haven, doing deals with the elite, and uses it as a base to spread prostitution, drugs and gambling throughout the EU.

EU grants and subsidies are embezzled by the elite (this also happens with agriculture subsidies in long standing EU members Greece or Italy of course, but the process will be more opaque, and an even smaller percentage of EU money will reach its proper destination.)

Finally, as the economy fails to advance, the country’s productive citizens emigrate to the West, legally or illegally, leaving behind only pensioners, the disabled and the oligarchs.

At that point, the EU might as well abolish the country’s membership (unless it contains oil wells) – there will be no gain to the EU as a whole from its membership, nor to the country and its inhabitants, only a continuing “black hole” for EU private and public money.

If the simplistic free market view was correct, Romania and Bulgaria would pose few absorption problems. Both are part of the European heartland, predominantly Christian and fairly small – Romania’s population is 22.3 million and Bulgaria’s 7.4 million – together considerably less than Poland alone.  While poor—Romania’s GDP per capita at purchasing power parity is $8,200, Bulgaria’s $9,600 – they are not desperately so, and not hugely poorer than Poland at $13,300. Historically, Romania even had oil, although today it is only 50% self-sufficient. One would expect a “rush to the West” if immigration is freed immediately, which would cause problems since it took place so quickly after the flow from Poland and the other 2004 EU entrants, but that can be solved by delaying free labor movement for a few years.

The difficulty with Romanian and Bulgarian EU accession lies entirely with their “Transition Progress.”  According to EBRD, both countries scored fairly well, at 3.4 for Bulgaria (the same as Slovenia) and 3.2 for Romania in 2004 – Russia is at 3.0, for example. However, in both countries, their history since 1991 is unpromising.

In Romania a post-Communist coalition continued to govern the country in the interests of the nomenklatura until 2004; privatization was dominated by insiders and economic reform was modest at best.  The post-2004 “nationalist” government has made reforms, and offers hope for the future. (“Nationalists,” while disliked by the EU since they are generally Euro-skeptic, are often the most reformist forces in Eastern Europe because they lack deep political connections with the ancien regime and the “red directors” power structure.) Nevertheless if Romania follows the normal East European pattern, the next elections, due in 2008, will once more return to power the post-Communists and their “red director” allies.

Bulgaria at first sight offers more hope. It ousted the post-Communists by street demonstrations in 1997, and enjoyed first a reformist if corrupt anti-Communist government from 1997 to 2001, then the extraordinary spectacle of the former Tsar Simeon II returning to Bulgaria, winning an election and governing the country as prime minister Simeon Saxe-Coburgotski in 2001-5. Since Simeon was of German descent and education, Bulgaria enjoyed for that period a government of German Christian Democrat outlook and near-German intolerance of corruption. Unfortunately in 2005, the electorate obeyed the normal East European pattern and returned the post-Communists to power. It is thus by no means clear that a truly open and free economy has been securely established in Bulgaria.

Bulgaria and Romania could go either way, with Bulgaria’s chances of success and absorption into the rich west being somewhat better than Romania’s. If they become more open to new investment and free competition, both political and economic, their living standards will rapidly improve and Bulgaria in particular will provide the EU with an excellent new source of cheap engineering and design talent. If on the other hand, the centralization of power produced by the EU bureaucracy serves to entrench anti-competitive power structures, the ‘red directors” will continue to dominate political and economic life, corruption will remain rampant, organized crime will flourish, the economies will stall and both countries will become staggeringly large drains on the taxpayers and economies of the EU as a whole.

Whether or not Bulgaria and Romania succeed, if the EU continues to expand, at some point one of the new EU entrants will fail to adapt to the free market, remaining controlled by the old oligarchy, becoming a pit of corruption and crime and dragging down living standards and political stability throughout the EU.  Croatia, more “transitioned” than Slovenia, small and richer than Poland, will not pose that problem and should be admitted quickly to the EU.  Beyond Croatia, however, the road is much rockier; as European Commission President Jose Manuel Barroso said Tuesday, it would be “unwise” for the EU to bring in further member states in the near future.

At some point, the EU has to stop absorbing new countries.  Politically, Moslem Turkey may be the expansion that proves too difficult to absorb, but economically, the only real problem with Turkey is its huge size. However the undeniably European, fairly small (except Ukraine) and apparently easy to absorb countries of the remaining Balkans and the European ex-Soviet Union may economically, because of their corruption prove an expansion too far.

The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long ‘90s boom, the proportion of “sell” recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

Martin Hutchinson is the author of “Great Conservatives” (Academica Press, 2005)—details can be found on the Great Conservatives website.