Austerity Measures and Restructuring: The lessons we didn’t get

March 10th, 2013 → 4:44 pm @ Aris Aristidou

During the last few years I have observed with great satisfaction an increasing intervention by academicians in the dialogue about the economy, something that was missing during the first forty years of the Republic until the establishment and maturing of university life. The only pitfall is the lack of drawing lessons from the very rich experience gained through very hard times during the period after Independence. Had certain concrete efforts undertaken at times bore fruits, the present economic crisis would have had only some retarding effects on the economy and not its destruction. The present article has been initiated by Christoforos Pissarides’ very interesting recent speech with the above title, somehow revised.

1. These efforts were part and parcel of the Development Plans which aimed, not only at securing the highest possible rate of growth but promoting other basic goals: securing sustainable development without inflation through structural changes, more equitable distribution of income and progress in all other sectors. Unfortunately this targeted methodology for development, which led to two economic miracles, the exodus from under- development before the invasion and the successful handling of the tragic repercussions of the invasion, was interrupted eventually and replaced by ad hoc decisions, necessitated by party and other expediencies.
2. I agree that the ‘real drama of the present crisis rests with households because of the plague of unemployment and the young people who have not tasted yet their first job’. If the crisis emanated from the malfunctioning of the labor market alone, then, why underdeveloped countries, where labor cost is minimal and labor hands are abundant, do not develop automatically? If this theory applies to developed countries only, perhaps the reason lies in the fact that attention was one-sided, only on the issue of the labor market. Labor input is responsible for the largest part of the cost of production of GDP. Various pieces of research have concluded by now that ‘technical change’ is becoming all the more important input of production and, thus, of production cost. The same can be said about the macroeconomic environment in which production is taking place. According to the theory of automatic adjustment, the new conditions in the labor market in 1974 (40% unemployment) should have induced the economy to a speedy recovery and growth. However, a disorderly adjustment to the new conditions would have also meant disorderly conditions in the future. Instead, the situation was faced through common decisions of the social partners. Salaries and wages were reduced up to 25% and a Fund for Refugees was created where the reductions were deposited except if the employer did not dismiss employees. Analogous arrangements were made for other elements of cost of production. The Emergency Plan provided other incentives and facilitated reactivation.
3. I am not sure whether the cause of all undesirable social phenomena is economic stagnation. Unfortunately economic science alone cannot explain and cannot solve such social problems, which can be observed also at times of economic upswing. Perhaps the answer could be found through a joint effort by economists, sociologists and political scientists. Despite the Cyprus ‘economic miracles’, such phenomena did not disappear, as they did not in other developed countries.
4. Other lessons we should have learned from the experience of 1974 are the role of indebtedness of the State and the need to create the necessary environment for sustainable growth. Indeed high indebtedness does not allow continuous development. It is not surprising that households ‘save for rainy days’. The prudent policy followed during the 1960’s on public finances was the first cushion on which the reactivation efforts leaned on. The public debt was only 6.7% of GDP in 1973.
5. It was first the State and later the private sector that undertook to reactivate the bleeding economy in 1974. Personally I wouldn’t be so absolute on the role of the two parties, i.e. ‘their cooperation from a distance’. I support a mixed economic system in which the private sector should be encouraged, assisted and facilitated for creative movements forward. However, in those cases where the private sector is unable or unwilling to expand, then, the State should take the initiative. Also the State should keep under its own supervision vital economic sectors for safety purposes.
6. I have already referred to the great significance of a healthy public financial position. With the State finances in a relatively good position, when the present crisis started in 2008, the Government could have withstood the shrinkage of the economy and the explosion of unemployment through the implementation of public investment projects and/or the facilitation and encouragement of the private sector. At that time it was also possible to execute infrastructural projects through the method of BOT. This could have possibly averted the Cypriot banks from investing in bonds and other papers abroad.
7. After 1990 a new situation prevailed in the international economy, not only because of the collapse of communist regimes but, mainly, as a result of the liberalization of international trade and foreign exchange. In addition to its natural resources, a country can now exploit any comparative advantage it posses. Cyprus has exploited its geographic position and natural beauties, its highly educated human capital and the high quality legal, accounting, banking services and developed the sectors of international business. With the establishment of universities and research centers, Cyprus is now ready to develop other primary, secondary and tertiary sectors with technological and scientific depth.
8. For all these to happen we need much more than simply ‘labor market flexibility’. Certainly, a country needs ‘internal flexibility’ ‘in order to face quickly and effectively new situations which are beyond its control’ and certainly ‘the private sector needs quick response by the State without bureaucracies’. In parallel, however, the country needs the existence of such mechanisms to promote technological advancement and enhancement of its competitiveness, connected to the proper prices and incomes policy, etc.
9. All the above should be promoted through tripartite cooperation. The final aim is to promote sustained growth together with equitable distribution of income. This was the aim of the policies followed in Cyprus in the past. If Cyprus did not manage to avoid the present crisis, the reasons must be found elsewhere and mainly in the loosening of the efforts for sustainable growth and modernization of the economy after the successful reactivation of the economy in the 1970’s and 1980’s. When the international crisis appeared in 2008 Cyprus was not ‘highly indebted’ but with structural production weaknesses and, therefore, with ‘low levels of competitiveness’. The Government could not mitigate the situation as gradually it had developed a public deficit itself.
10. But how did we reach this economic ‘impasse’ at the beginning of the international economic crisis? After the spectacular reactivation of the economy following the invasion, a planned and coordinated effort was initiated to consolidate and secure the achievements, as well as to upgrade technologically and restructure the economy so as to become more and more modern and competitive. New economic activities were spotted and encouraged, such as international business and banking/financial services, in addition to the traditional sectors. Cyprus became a real regional, economic, trade, shipping and offshore/financial centre. Unfortunately all other sectors were neglected. Agriculture was continuously shrinking to the point to import ‘garlic from China and lemons from Argentina’. Manufacturing industry, which was planned to become the main lever for technological upgrading of the economy with the creation of technological parks and the introduction of systems of flexible specialization and modern technology, was abandoned to its destiny. Whereas the actions undertaken in the 1980’s led to the establishment of universities, the connection of academic life with the real economy has been limited up to now. A better utilization of the modern computerization methods could reduce cost and speed up work in the public and the private sectors and the development of a new sector of services on its own.
11. No doubt, the improvement of competitiveness of the economy depends a lot on both the prices of factors of production and their behavior and whatever else adds to the final cost, such as the cost of public administration. The question is how should the prices of factors of production, especially those of labor input, be formed, according to the market laws or with dialogue and agreement between interested parties? The free functioning of the economy leads to economic cycles. An agreement on the evolution of the price of labor input based on productivity would benefit all sides. It was towards this direction that efforts were made since 1968/9 with a view to develop and apply a prices and incomes policy based on real facts and not on the phase of the economic cycle. Despite progress made since then, good economic circumstances at times led to abandoning the efforts, as happened in many other cases, for temporary benefits. In the future we must try again to develop and adopt a healthy prices and incomes policy. Related to this                    is a close watch of the prices of basic products and raw materials.
12. With regard to the other cost elements, I will mention the administrative cost, which at the end is born by both productive units and households. During the last decades we have ignored the very small size of our country. A characteristic example is the case with Municipalities. In the wider Nicosia area, which is not more than a small neighborhood of London, about ten municipalities were established with separate services and organization structures. The only common element of these municipalities is that of the sewage system! In addition, successive Governments resorted to the enlargement of civil service.
13. Thus how we reached the point of bankruptcy. In addition and in view of the haircut of the debt and the situation in Greece, Cypriot banks are in need of State support to continue their function in the economy. What do we do now? The examples of England in the 1970’s and 1980’s, as well as of Germany in the 2000’s indicate that austerity measures lead to worsening situations. The fact that in both cases there was later an economic revival is due to the fact that both are mature economies and could take advantage of the competitive conditions created by the measures. In the case of Cyprus, however, in addition to austerity and other measures for the rationalization of the labor market and that of other factors of production, there is a pressing need to enlarge the productive basis of the economy. In addition we cannot ignore the banking dimension of the problem.
14. It is for these reasons that I have insisted that the Memorandum be supplemented by an Emergency Action Plan envisaging also measures leading to growth. A small amount could be added to the total loan for development projects to be executed by the Government or the private sector through targeted loans by the banks. The period of the loan could be adjusted to allow time for the progammes and measures to bear fruits. I don’t reject the idea for the creation of a Council for Public Finance or a Council for Economic Policy because I don’t reject the scientific study of basic issues that confront the Country. All political parties should establish their own advisory bodies consisting of people with the right experience to help them produce the right policies. Public finances are among the few macroeconomic issues that are debated by the House of Representatives through the Annual Budget and supplementary appropriations. So far the institutional measures by the ECB have not helped the establishment of an effective financial union. Irrespective of the present problems of the banking and financial sector we must try to safeguard it as a vital sector within Cyprus’s international activities. In addition we must see that the sector serves adequately the financial needs of the Country. It should be noted that in 1974 a 4% of total bank deposits was frozen to form the Priority Fund for the financing of the private sector in areas set out by the Emergency Plan and with Government guarantee for all those who lost their properties in the occupied area.
15. What is missing since the 1990’s is a flexible strategic planning mechanism for the whole economy, including public finance and banking. This mechanism should encompass both production and equitable distribution as well as the social, legal, institutional setup. This is the first requirement for social cohesion as it will induce all to work hard for more progress. In such a situation the celebrated system of flexicurity could be more easily applied. In the Cyprus’s long experience in tripartite cooperation and social welfare all these could be advanced through a continuous dialogue.

Dr. Iacovos Aristidou