Hungary is going down a risky path - Are they blowing yet another inflation bubble?
Ez itt az on the other hand, a portfolio vélemény rovata.
In fast-changing times, promising economic policy recommendations and economic theory trends follow one another in rapid succession (the latter no so rapidly). In the first two decades of the century, when inflation in Western economies was moderate, interest rates fell to historic lows and growth decelerated, giving rise to a vision of secular stagnation. Economic policy was built on this.
High-pressure economic policy
Today, in the light of the inflationary surge from 2021 onwards, the steepest in thirty years, and the central bank's response to it, it is an odd memory that only a few years ago, in a situation invoking a sense of deflation, and in the face of an extraordinary abundance of money, there were advocates in decision-making circles for simultaneous fiscal and monetary easing.
It's a notoriously dangerous combination, which subsequently really caused trouble, but when it appeared in the policy of the U.S. Federal Reserve around 2016, professional precedents could still be cited. In 1960s America, Arthur Okun, a renowned post-Keynesian macroeconomist, argued strongly for a so-called "high pressure economy" based on the labour market conditions of the time.
The point is that a strong employment-increasing and (not self-evidently) productivity yield can stem from an economic policy that deliberately maintains output above potential for as long as possible without inflationary bursts (Okun: Potential GNP: Its Measurement and Significance, 1962).
One does not, however, think of a view that is divorced from reality and from the recommendations of the economics schools: the debate between the proponents of the cooled and the heated economy in the United States in the early 1970s was whether it was possible to move from a (cool) state of 5% unemployment to a (high-pressure) economic condition of 4% without the threat of inflation.
Socio-political, value differences were also evident in the debates: left-wing, progressive advocates of a consciously heated economy argued that the economy's sustained increased demand for labour was attracting people (women, young people, people of colour) into the labour market who would otherwise have poorer job prospects, while the booming economy was also improving the wage prospects of those (white male) workers already in the market. The cautious, conservative side's objections were, of course, directed at the risks of macroeconomic imbalances.
However, the debate was put to bed for a long time by the sudden surge in inflation in the late 1970s.
The concept resurfaced in the United States much later, in the deflationary period following the 2008 crisis, albeit briefly, as full employment was effectively established during the long business cycle up to 2019.
The concept resurfaced in the United States much later, in the deflationary period following the 2008 crisis, albeit briefly, as full employment was effectively established during the long business cycle up to 2019. The experimentation with deliberately expansionary economic policy returned in 2020-21: the Covid shutdown and the subsequent temporary threat of deflation have given rise to public economic inflation in the U.S., Europe and elsewhere. But the inflation shock of 2021-2022 brought another radical shift in economic policy thinking and practice: a sharp rise in central bank interest rates and a resurgence of concern about the level of public debt signalled a shift in thinking and policy-making.
The risks of overpressure
The theory itself and the economic policy recommendation based on it soon appeared in Hungary towards the end of the long business cycle of 2010-2019, which now seems almost like a golden age, in professional literature, and even in the monetary policy stance of the MNB at the time, under the name of "high-pressure economy".
The "high pressure" is an Anglicism in which the word "high" as an expression has - to put it in style - supplanted the adjective "big", probably for good. But that is not my main problem with it. In the favourable cyclical conditions of 2013-2019, with the massive inflow of EU funds, there was no longer a professional argument for a high-pressure economic policy. It was difficult to recruit new workers from the inactive strata of the region's specific social background, but inflationary pressures gradually increased, with the MNB's permissive attitude - as indicated by the fact that the Hungarian concept of "price stability" was practically pushed up to 4 percent per year by assigning a plus/minus one percent band to the inflation target, which was already higher than in the region (3 percent). In addition, our public debt was stuck at too high a proportion of our level of development.
Then, suddenly, a new phase opened up in Hungary too. In 2020, there was indeed a justification for public dampening of the pandemic shock. But even after the shock had passed, expansionary fiscal policy and loose monetary policy continued for two years. It is this combination that is the main explanation for our inflation, which has become European champion by 2023, while the Hungarian economy is no longer overheated and is in recession.
Today's peculiar situation (with core inflation still above 10% in annual terms in October 2023) comes as no surprise to those keeping an eye on policy developments. The demand conditions in the economy between the second half of 2021 and the summer of 2022 were largely determined by the expansionary economic policy that preceded the parliamentary elections, which pushed the economic growth rate up to around 7 (!) percent in the first half of 2022.
This has given a new impetus to rising inflation, and at the worst possible time: economic policy has reinforced inflationary trends at a time of global price rises.
The idea of a high-pressure economic policy is back on the agenda
The political backdrop is worth recalling because overheating can occur for two reasons. It can arise from an overshooting of the upward phase of the business cycle, to which monetary (or income, fiscal) policy reacts with some delay for some reason. Secondly, the main cause of the overpressure can be direct, deliberate economic policy itself.
In our case, the latter happened between 2016 and 2019, and then between summer 2020 and summer 2022, providing further examples of pro-cyclical economic policies that deviate from Keynesian recommendations.
According to the latter, the state should stimulate by spending more in the slowing phase of the business cycle, especially during a downturn, but not in the up-cycle. At most, Okun argues, over-pressure can be allowed to continue for a while if the economy is still far from full employment. If, however, there is no longer any meaningful labour reserve and unused production capacity (slack), the additional public funds injected into the economy will only result in a temporary and small increase in output, but inflation will pick up and the external balance may deteriorate.
This has become our case; but that is the recent past. Yet, strangely enough, the concept of a high-pressure economy has re-emerged in economic policy literature and policy speeches. In what follows, I will explain why, in our circumstances, I regard it as a mere political choice of direction rather than an economic policy or even economic theory, and what I see as the serious risks involved.
The re-emergence of the idea of growth is not surprising, given that the great stimulus was followed by a recession in 2023, with household consumption falling and investment activity declining - a situation that is uncomfortable for policymakers.
The central bank is no longer trying to "overtake in the bend by stepping on the accelerator", but is stabilising the exchange rate by applying the highest interest rate in the region, while cooling the investment cycle. Unfortunately, given our financial riskiness, we need a significant base rate differential compared to the Czech Republic, Poland and even Romania, and for this and other reasons, investment activity has indeed collapsed.
Arguments against heating the economy up again
Understandably, from a development policy perspective, the current financial policy stance is not favourable. However, the call for re-heating cannot be accepted, for several reasons.
- To begin with, this recession can safely be seen as a necessary correction phase following the previous artificial overheating, i.e. not one that occurred without reason.
- Another important point is that unemployment rates have not increased significantly during the downturn and then the recession; employment of those that can be employed is almost full.
- From a social policy perspective, is it advisable to reheat the Hungarian economy? Well, the social and growth returns from a temporary over-pressure on the economy can be expected if the input demand of the additional demand generated by state means gives jobs to those that are more difficult to emploey than those already in employment; but this would require proof. It would be more urgent to launch education, training and retraining programmes, to alleviate the problems of depressed regions and to improve Hungary's labour retention capacity.
- It should also be ensured that the over-pressurising experiment does not jeopardise the equilibrium conditions of the economy: the price level, the balance of payments, the budget balance.
This is not a time when such a notoriously risky intervention is likely to succeed. Persistent unemployment still exist currently, but this regrettably stubborn phenomenon is mainly driven by training issues (unskilled labour), territorial mobility and other structural problems. Artificial demand stimulation will not help these, but it will certainly push up prices.
Inflation risks
Is the solution excess inflation? This is countered by the fact that the rate of disinflation in Hungary is still spectacularly low compared to the rate of disinflation in the European region, and the hoped-for trajectory is being disrupted and prolonged by a wide range of direct state interventions in the areas of pricing, business policy and competitive relations. The inflationary threat is far from over in Hungary, and we are a long way from even the most loosely defined price stability.
Fortunately, the severe external fiscal imbalance in 2022 has been greatly mitigated by the (permanent? temporary?) moderation in global energy prices, and certainly by the recessionary domestic demand contraction. The current moderation in the current account deficit is therefore situation-dependent and rather unstable, especially given that the energy intensity of the Hungarian economy is twice the EU average. Hungary is a major energy importer, which means that its exposure to external factors is very high.
In this imbalanced situation, the policy suggestion to rapidly lower interest rates and to set the MNB's inflation target higher than the current one weakens the effectiveness of monetary policy and the credibility of the inflation targeting system. Moderating today's inflation expectations is already a very difficult task, and the emergence of recommendations to the contrary will make disinflation even more difficult, thereby actually increasing the loss of growth that further reduction in inflation would entail.
No fiscal manoeuvring room
And if the proposal refers to the fiscal rather than the inflationary mode of recovery, is there still fiscal room for manoeuvre?
No, Hungarian politics has already exhausted that option.
The government has not found any year of the "golden age" suitable for achieving a balanced ("zero deficit") budget. Thus, it has not been possible to bring the public debt ratio down to the average level of the Visegrád area. True, during the years of plenty, interest rates were pleasantly low, sources of credit were easy to find, and the amateur theorists of the time were loud in their proclamation of the "public debt doesn't really matter" creed; the political leadership obviously felt no urge to pursue a neutral fiscal policy.
This, in turn, would not have created the fiscal space for a stimulus that could be justified later on. (The development of countercyclical fiscal capacity would also have been hampered by the highly objectionable Financial Stability Law).
This is the past. And it is now much more expensive to finance public debt, which in itself rules out further fiscal stimulus. Moreover, the 3% of GDP deficit limit set by the EU institutions will come into force next year - it will be quite an effort to reach it.
Should there be stimulation via a weak exchange rate? But a further weakening of the forint would not increase the output of the Hungarian economy, which is closely integrated into global production chains.
Indeed, the volatility of the forint exchange rate is a particularly unpleasant handicap for economic agents.
Moreover, an even weaker forint than today would devalue domestic incomes and assets, further stimulating the exodus of market- and decision-ready workers. A severe weakening of the forint would immediately halt disinflation.
FDI inflow is the new mantra
Obviously, the advocates of a high-pressure economy are aware of this. The new mantra is to accelerate FDI inflows. This is not a new theory either. After 1990, the development strategy of all countries in the region included the attraction of working capital.
For a decade, the Hungarian economy, which was still among the leaders at the time, led the race to raise capital. But we badly needed FDI: in the face of 700,000 unemployed and our obvious technological backwardness, it was the most promising development path. Especially given that, with the region's record foreign currency debt inherited from the previous period, there was no external borrowing to rely on, and sources of aid only opened up after EU accession.
But today the situation is very different. There is no labour market reserve of hundreds of thousands of people.
Moreover, the type of FDI deals that the government is now pinning its hopes on for growth and dynamism are hardly suitable for the employment of the unemployed, inactive and the large number of partially employed Hungarians, who are geographically dispersed and difficult to mobilise. There is no substantive argument for employment in favour of an eastern geopolitical orientation.
Ongoing large investments, mainly in the automotive sector, will boost industrial production and exports (and of course imports). Net exports will also have an impact on GDP. However, I fear that subsidy contracts with corporations do not specify local content, so that the spill-over effects of the nominally huge investments from the Far East in terms of income and employment will be small. And their specific labour requirements foresee the involvement of foreign labour, with all its social and political problems.
This development path, I fear, cannot guarantee the kind of income and employment surplus that the high-pressure lobby claim as a counterweight to the increased financial risks.
The political arguments for extensive growth and the ideological motives for industrialisation remain. Moreover, balance sheet risks persist and even worsen in a situation where Hungarian inflation continues to stand out in the region and our sovereign risk perception is not much above the critical level not recommended for investors. High pressure: high risk.
THIS IS 'ON THE OTHER HAND', PORTFOLIO'S OPINION COLUMN
This article reflects the views of the author, which do not necessarily reflect those of the Portfolio editorial team.
Cover photo: Getty Images
