Hungary, Trying to Keep Up With the Neighbors, Falls Back

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By Marc Champion

The trouble with Hungary is that it desperately wants to be like Austria, its old partner-in-empire, but is looking far too much like Greece.

This Austrian aspiration is on display when you drive into Budapest, as I did this month, on a road trip from Istanbul to London. The city's extraordinary wealth of architecture from Ottoman to Art Nouveau has been lovingly cleaned and restored to the point that it's looking as smart as Vienna.

Which is as it should be, from a Hungarian perspective. The two countries shared an empire with a dual monarchy from 1867 to 1918. It was Hungary's absorption into the Soviet bloc that forced it to fall behind, so the expectation after 1989 always was that Hungarians should catch up again with their wealthy neighbors.

For a while, that seemed to be happening. Then, on Sept. 17, 2006, Hungarians heard on the radio a leaked recording of a supposedly closed speech by their prime minister, Ferenc Gyurcsany, to legislators from his party. He admitted, infamously amid a string of expletives, that Hungary was beyond broke and the government had "lied morning, noon and night" about the state of the economy for years.

"No European country has done something as boneheaded as we have," Gyurcsany said. It turned out he was wrong about that: Greece's government had been as bad. That offered little comfort to Hungarians, who saw their Austrian-style futures slipping away.

I sat in on a lecture that Peter Akos Bod, Hungary's former central bank chief, was giving at Budapest's stately Corvinus University to a group of visiting executive-MBA students. He reprised Gyurcsany's speech for them, swears included. He also took them on a virtuoso's tour of Hungarian economic history, in an effort to explain how it was that the country had managed to get in trouble even before the global economic crisis began.

The key thing to remember, he said, was that history counts in this part of the world. Despite its imperial glory in the last half of the 19th century, Hungarians had, for the vast majority of their past, paid taxes to 0ccupiers -- Mongolian, Ottoman, Austrian and Soviet. As a result, taxes have an even worse reputation in Hungary than they do elsewhere, and Hungarians still have a deeply ingrained culture of tax avoidance. That creates a chronic budget weakness.

A second problem, Bod explained, was that Hungary's plucky anti-Soviet uprising in 1956 created a culture of compromise that has now become detrimental. Soviet troops crushed the uprising, but the Soviet Union then gave Hungary's local communist party bosses more leeway to run the country than other satellites enjoyed, creating a more liberal regime that earned the nickname "Goulash Communism." After 1989, the same spirit of compromise meant that there was no thorough housecleaning of the old regime. Hungary developed what Bod calls "Goulash Capitalism."

"The transition was a bit too smooth," said Bod. "It made us a bit Greek."

That translated into an overly large state sector relative to other ex-communist members of the European Union, at around 50 percent of gross domestic product, as well the same handing out of public sector jobs to secure votes that got Greece into trouble. Hungary's government failed to control budget deficits, despite repeated pledges to the EU to do so. At the same time the economy was open, attracting foreign investment and putting 80 percent of the banking sector in foreign hands.

Hungary's current prime minister, Viktor Orban, wants to fix some of these things. But his instinct is to use the state to do so, further expanding its role. He also wants to reduce the share of foreign ownership in the economy. In 2010, when he needed money, he turned to the (mainly foreign owned) banks to impose a levy. On Tuesday, he said that in the future, he wants 50 percent of the banking system to be "in Hungarian hands." The government is pursuing essentially nationalist economic policies, partly in an effort to revise the way the country transitioned from communism to capitalism.

Orban certainly has been radical. He introduced a flat income tax of 16 percent in 2011, but that failed to boost demand and reduced government revenue, putting further pressure on the deficit. Most controversially, his government took control of independent institutions. It changed the law on the central bank to strip its governor, Andras Simor, of the right to nominate members of the interest-rate committee. It then proceeded to pack the committee with government appointees. Simor's salary was cut by 75 percent, in a less-than-subtle effort to persuade him to leave. He stayed.

The result was a standoff between Hungary and the rest of the EU and a block on Hungary's bid for bailout aid. The Hungarian Parliament revised the central bank law, and talks with the International Monetary Fund started on July 19. They're unlikely to go quickly, as the IMF officials are demanding a "strong policy framework," with the clear implication that they don't think Orban's current policies qualify.

The bottom line, Bod said in his lecture, is that the government's policies don't work. Austria hasn't been doing so well either in recent years, but unlike Hungary, where GDP fell 0.7 percent in the first quarter, it is growing. That'll make catching up with the rich neighbors a lot harder.

(Marc Champion is a member of the Bloomberg View editorial board. This is the fourth in a series of posts chronicling his trip across Europe, from Istanbul to London. Read his previous posts on Greece, Bulgaria and Romania. Follow him on Twitter.)

-0- Jul/20/2012 21:44 GMT