Czechs pay a political price for fiscal tightening

Petr Necas's determination to drive down the Czech Republic's budget deficit has been so strong that he sparked a political crisis which almost unseated his government and has many economists blaming him for the country's lengthy recession.

In the growing international debate over whether too much austerity can damage an economy (where even the International Monetary Fund is expressing doubts) the Czech prime minister and his finance minister, Miroslav Kalousek, have until now come down firmly on the side of fiscal tightening.

“The Czech government has the trust of international institutions and financial markets,” says Necas, worrying that the country will lose credibility if it retreats in its battle against the deficit.

The country’s deficit hit a high of 5.8 per cent in 2009, at the peak of the crisis, then falling to 4.8 per cent in 2010 and 3.1 per cent last year. Now, the government is fighting to squeeze the deficit
to 3.2 per cent this year instead of an earlier projection of 3.6 per cent and to reach the EU’s target of 3 per cent by 2013.

The problem is that the goal has become more difficult as the economy has slowed, due in part to the eurozone crisis, which has cut the demand for Czech exports, and to a slump in domestic demand. The result has been a fall in government revenues, which Necas and Kalousek have been determined to fill by slashing spending and increasing taxes – measures that could worsen the country’s recession and potentially set off a downward spiral of still lower revenues followed by even more austerity.

That policy leaves no space on the fiscal side for any stimulus and there is no room left for manoeuvre on the monetary side, after the central bank recently cut its benchmark rate to a record low of 0.05 per cent.

“The Czechs have failed utterly in monetary policy and the fiscal situation is even worse,” says Lars Christensen of Danske Bank.

However, the government has pushed ahead, even at enormous political cost.

Necas’s party was hammered in local and upper house elections and faced a rebellion by six members of parliament, who refused to go along with his tax increases which raise the VAT by a percentage point – that left Necas without a solid majority in parliament. In the end he only narrowly succeeded in pushing the legislation through parliament, but still has to get his bill through the opposition-dominated Senate.

“The government is unfortunately going to carry on the economic policy that has proved absolutely unsuccessful, pushes our country into recession, betting on cuts and raising indirect taxes,” says Bohuslav Sobotka, leader of the opposition Social Democrats.

Even President Vaclav Klaus, the founder of Necas’s Civic Democratic party, has been denouncing the austerity measures, vetoing a pension reform bill and threatening to do the same with the tax increases.

All this comes at a time when markets seem to be very forgiving of any fiscal slippage by recession-fighting governments. Poland paid no price when it let its target of reducing its deficit to 3 per cent slip from this year to next, and is currently borrowing at record low rates.

The Czechs are also borrowing very cheaply, which makes the country’s determination to continue with fiscal austerity surprising.

Neal Shearing of Capital Economics says that the Czechs have an “almost German bent towards austerity”, and there is something to the view that the Czech attachment to budgetary probity has deep historic roots.

Czechoslovakia was one of the best-managed European countries before the war, and even after the communist coup in 1948 the communists tended to be more reluctant to borrow than their Polish neighbours.

“In Czechoslovakia’s case, the communists were much more conservative than the Poles or the Hungarians,” says Pavel Sobisek, an economist with UniCredit Bank in Prague, noting that the Czechoslovak comrades preferred to cut imports and impose austerity on their people than allow foreign debts to grow too large.

That attitude continues today and is one of the reasons for Prague’s current aversion to joining the euro – policy-makers feel that they are much better at conducting a rigorous fiscal and monetary policy than the eurozone.

But the economic cost has been high. New data shows that the economy continued to slow in the third quarter – contracting at an annual rate of 1.5 per cent. That makes this the fourth continuous quarter of recession, making the current downturn even longer (albeit much shallower) than the one the country suffered in 2009.

That means Necas’s challenges are far from over.

“The weak growth numbers mean the political outlook is likely to be tested yet again, as the government needs to take additional budget measures which would probably lead to threats of no-confidence votes and the stability of the government being brought to the wire,” says Peter Attard Montalto of Nomura.

Although Necas shows no sign of backing down from his current tightening programme – his appetite for further political and economic pain may may have its limits. In an interview with Mlada fronta Dnes, the prime minister said that there would be no further austerity unless the economy returns to growth of more than 2 per cent – currently a pretty distant prospect.

That means earlier promises Necas made to not only reduce the deficit to the EU maximum of 3 per cent but to push on to running a surplus have been shelved, with the prime minister saying: “Ministers are not there to scare people but to give them hope.”

“I believe that the easing of savings and cuts is now what our economy needs”, Necas added.

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