Falling into the Middle Income Trap

The Central European policy of using cheap labor as an instrument of growth is reaching its limits.

A factory for 2,800 workers has begun to spring up in the fields northwest of the Slovak city of Nitra. Indian-owned British Jaguar Land Rover, currently constructing its fourth car factory in Slovakia, certainly cannot complain about a lack of interest in jobs—as of early 2016 ten times as many people as the new factory can employ have registered their interest on a website set up by the Slovak Ministry of Labor specially for this purpose. However, as any owner of even the smallest Slovak engineering firm will confirm, finding workers with the requisite specialist skills is becoming increasingly difficult, if not impossible. Besides, Slovak wages have been rising, which means that cheap labor costs will soon cease to be an advantage—not just in Slovakia but also in the Czech Republic, Poland, and Hungary.

Jaguar may therefore not be able to avoid what has, until recently, seemed inconceivable in Slovakia: importing workers from abroad. Last year Prime Minister Robert Fico did everything in his power to pip to the post competitors in Poland and the Czech Republic for this investment, which is worth 1.5 billion EUR. By doing so he contributed to the gloom of local businesses since tax benefits or special industrial zone status are perks local investors can only dream about. Luring foreign investors to the country is not just a useful election ploy—the government signed the contract six months before the March general election—but is actually a lot easier than coming up with a long-term development strategy based on research and innovation, making sure state institutions are fit for purpose and accepted by society.

However, unless Slovakia and other Central European countries take a new approach to thinking about their economic future they face the risk of falling into what is known as the middle income trap. This is the term economists use to refer to countries that may have moved out of the poverty zone to relative prosperity, yet lack the long-term capacity to join the most developed countries. Their GDP begins to stagnate and they gradually lose the edge provided by cheap labor costs and raw materials. “We can safely suggest that there is a real danger in the V4 of getting stuck in the middle, and falling into this mid-income level trap,” says Polish economist Marta Golonka in her introduction to a study of the middle income trap, published last year by the Polish Kosciuszko Institute in cooperation with other Central European partners.

The crux of the matter is that the EU and NATO accession substantially accelerated the transformation of post-communist economies. The rapid influx of EU funds and the pressure to transform institutions forced politicians to act with determination, and gave them a goal that had to be achieved. However, this development slowed following the 2008 and 2010 crisis and the trend might be reversed altogether as a result of the current rise of populists and conservatives. To avoid being caught in the middle income trap Poland, the Czech Republic, Hungary, and Slovakia need to restart reforms, devise development strategies and invest in them.

Let us stick with the Slovak example. The automobile industry in itself is not all that bad for Slovakia, Vladimír Baláž, an economist with the Slovak Academy of Science believes. “Being a small nation we can’t afford ten major industries. The auto industry is very complex, and in addition to car assembly Slovakia also produces metal sheets, tires, plastic parts, and software, so we’re not talking solely about an assembly shop but an entire complex of industries,” claims Baláž. “What we’re lacking is research and innovation—these are areas in which we lag behind other European countries. We need to radically reform higher education and the Slovak Academy of Science, and concentrate on excellence instead of a blanket support for low quality education, if we want to ensure that our best students don’t flee abroad. Fifteen percent are already studying abroad and most of them will never return. Without them we can’t build a modern economy.”

Unfortunately, even though the hopeless state of Slovak education was one of the key political and social issues debated before the March election, not a single political party tackled it in the revolutionary way that might have proved attractive to a substantial proportion of the electorate, while offering a transparent and clear solution.

The fundamental problem lies in the state of the body politic, a conclusion also reached by the authors of the Kosciuszko Institute study mentioned above. The key obstacle to further development is an unpredictable political situation, the interpretation and stability of the rule of law as well as the inadequacy of the fight against corruption.

While politicians are keen to talk of innovation, all four countries are at the bottom of the league when it comes to investment in research and development. Slovakia, which ranks seventh worst in terms of GDP share in investment in research and development, as well as Poland, which ranks ninth from the bottom, spend less than one percent of their GDP on this goal. The Czech Republic comes closer to two percent of GDP.

Thinking out of the box is still regarded as an obstacle rather than an advantage in Central Europe, particularly should there be any clash or cooperation with the state sphere, whose development potential is primarily oriented at extracting European subsidies instead of creating conditions for the independent development of business, entrepreneurship, and talent. Given that in the new EU budget period after 2020 Central European countries will hardly be eligible for the same level of subsidies as hitherto, this represents in real terms a further contribution to the threat of middle income trap. Rather than fostering long-term research and innovation potential, investment, including that from the EU, helps to increase employment (direct foreign investment and setting up of assembly shops) and infrastructure building, provided of course that it is not—in the case of EU subsidies— embezzled or ploughed into overpriced or pointless projects. Private companies invest dramatically more in research and development than does the state.

For instance, the Czech Republic has over forty times more science centers built and equipped with EU money, yet it totally lacks not only competitive programs but also workers who have an appropriate level of education and can engage in research in cooperation with production companies. And, as in the case of Slovakia, the system of financing science is set up in such a way as to ensure that funding is rolled out to everyone, i.e. averaged out, instead of focusing on the best projects that have the greatest chance of long-term development and might contribute the highest added value in future, thus boosting the economy as a whole.

It is possible that the Czech Republic may have to pay back tens of billions of korunas to Brussels because the country is incapable of ensuring the sustainability of projects. However, the example of the crumbling buildings of the Metal Research Institute in Panenské Břežany or the building shell of the Science and Technology Park in Milovice are just another form of the notorious Spanish airports built with EU money, from which no plane has ever taken off.

By Central European standards the Polish Deputy Prime Minister Mateusz Morawiecki has taken a rather unusually broad and ambitious approach to the issue of further development and investment. Although his position in the conservative government is not particularly strong, the plan he proposed in February is unprecedented in Central Europe in that it envisages not only more emphasis on domestic firms and capital, which resembles the Hungarian government’s approach under Viktor Orbán, but at the same time sets specific goals and outlines specific steps to achieve them. The basic goal is fundamentally correct and logical: to exchange the competitive edge in the form of cheap labor cost for innovation and bolstering domestic capital. Morawiecki wants to centralize economic policy, create a strong state investment institution in the form of a Polish Investment Fund, and improve the allocation of public finances. While detailed plans will emerge over the next two years, we know that the plan is based on five pillars.

In terms of reindustrialization, Morawiecki wants to ensure that by 2020 industrial production will grow faster than GDP. This goal is quite realistic, as this has been more or less the norm over the past twenty years.

The second goal is a 25 percent share of investment in GDP by 2020. This is rather ambitious, so much so that Adam Czerniak, chief economic analyst of the Polityka Insight think tank, regards it as impossible to achieve. Over the past twenty years the level of investment has varied from 18 to 25 percent of GDP but has recently stabilized at 20 percent. “It might increase provided Poland starts to attract foreign capital on a mass scale. However, that would contradict other policies promoted by the Law and Justice party, such as the coming taxes on specific industries or the slowing of privatization,” Czerniak believes. In short, foreign investors are disconcerted by the political situation in Poland, although not to the same extent as in Hungary.

Deputy Prime Minister Morawiecki wants to find a way of stemming the outflow of capital from the country in the form of dividends or other ways of draining profits. It remains to be seen how he intends to keep this money in the country specifically in the form of investment.

Another way of increasing investment might be budget savings of up to at least five percent of GDP but that would again contradict the conservative government’s generous social promises. Another option might be savings by companies and households over around 27 percent, which in Czerniak’s view also contradicts the government’s policy of increasing consumption.

Morawiecki’s plans further include increasing the share of research and investment to two percent of GDP, a goal that can be achieved, compared with 0.9 percent in 2013. The government wants to grant income tax concessions for innovation to legal entities, but companies are most likely to exploit this to include investment in their research and development expenses. In addition, the drawing of EU subsidies and the quality of research and development at universities are also in need of improvement.

Another integral part of Morawiecki’s plan is increasing the growth of exports and foreign investment by Polish firms by 70 percent by 2020.

As a result, by 2030 Poland’s GDP is supposed to reach 100 percent of the EU average. While conservatives regard Morawiecki’s plan as a way of “re-Polonizing” the Polish economy while, at the same time, moving it forward, other economists including Adam Czerniak claim that it is a grab-bag of goals that could be achieved regardless of government policy on the one hand, and ambitions that are impossible to achieve in political and economic terms on the other.

Government plans and the growing influence of the state on the economy at a time of growing populism and nationalism are not conducive to long-term visions, bold plans, and economic globalization. But in fact it is global competition that should drive individuals and companies at a time when the traditional approach to economics is undergoing fundamental changes, and the shared economy and cybernetics are growing increasingly influential, while raising key questions about the traditional policy of creating thousands of jobs on factory shop floors, which represented the main appeal of the post-1989 economic transition.

In his ideology-laden book Postcapitalism British journalist Paul Mason concludes that in the impending era of the shared economy it will no longer be possible for everyone to hold down a job. He cites studies showing that developed economies will shed as many as half of the current jobs due to automation—the use of robots in factories and of artificial intelligence elsewhere. He believes that people will not only depend on the state to provide them with a basic income regardless of employability, an experiment already started in Finland, but that being able to function in this kind of economy will also depend on individual abilities and the willingness to participate in lifelong learning. Whether one agrees with his vision or not, US technology firms investing in artificial intelligence and advanced robotics in many industries clearly demonstrate that using cheap labor costs as a basis for building a future could be treacherous.

The education system preparing workers for scarce technical jobs will have to undergo a radical transformation in order to promote the need for innovation on the one hand, and to teach people to learn and contemplate a rapidly changing world on the other. However, this requires a clearly defined strategy devised in advance and the political will to implement it.

Moreover, nations such as the Czechs and the Poles lack the genetic predisposition of Estonian innovators who have taken into account the global market and global ways of acquiring the capital for development right from the outset. Central Europeans have been slow in learning from foreign experience. Politicians who champion economic nationalism and populism have not made this task any easier. As long as each new political group is bent on radically changing the rules of the game, as we have recently seen in Poland and Hungary, it will be much more difficult to bring about a major leap in development that could help Central European countries escape the middle income trap into which they have been gradually falling.

Martin Ehl

Martin Ehl has been working for various Czech print and online media since 1992, since January of 2006 he is the Chief International Editor of Hospodářské noviny daily. He runs a regular bi-weekly column Middle Europa at English language Internet magazine Transitions Online (www.tol.cz), for this column he was awarded “Writing for Central Europe” prize in Austria in 2012. He is a co-editor of Visegrad Insight magazine.

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