New Perspectives on
Political Economy
A bilingual interdisciplinary journal
Vol. 11, No. 1–2, 2015
A bilingual interdisciplinary journal 3
New Perspectives on Political Economy
A bilingual interdisciplinary journal / Vol. 11, No. 1–2, 2015
New Perspectives on Political Economy is a peer-reviewed semi-annual bilingual interdisciplinary
journal, published since 2005 in Prague. The journal aims at contributing to scholarship
at the intersection of political science, political philosophy, political economy and
law. The main objective of the journal is to enhance our understanding of private property-,
market- and individual liberty-based perspectives in the respected sciences. We also belive
that only via exchange among social scientists from different fields and cross-disciplinary
research can we critically analyze and fully understand forces that drive policy-making and
be able to spell out policy implications and consequences. The journal welcomes submissions
of unpublished research papers, book reviews, and educational notes.
Published by CEVRO Institute Academic Press
Editorial Address:
New Perspectives on Political Economy
CEVRO Institute, Jungmannova 17, 110 00 Praha 1, Czech Republic
Manuscripts should be submitted electronically. All manuscripts and correspondence
should be addressed to nppe@vsci.cz.
Full text available via DOAJ Directory of Open Access Journals and also via EBSCO
Publishing databases.
Information for Authors
Authors submitting manuscripts should include abstracts of not more than 250 words and
JEL classification codes. New Perspectives on Political Economy edits for clarity, brevity,
and in accordance with the Chicago Manual of Style. Authors should use footnotes rather
than endnotes or in-text references, and must include complete bibliographical information.
Authors should include information on their titles and professional affiliations, along with
e-mail address.
ISSN 1801-0938 (on-line)
ISSN 1804-6290 (print)
New Perspectives on Political Economy4
Editor-in-chief:
Josef Šíma, President, CEVRO Institute, Prague
Managing editor:
Pavol Minárik, CEVRO Institute, Prague
Advisory editor:
Ladislav Mrklas, CEVRO Institute, Prague
Associate editors:
Pavel Pšeja (political science), Masaryk University, Brno
Michal Kořán (international relations), Institute of International Relations, Prague
Alena Zemplinerová (political economy), Institute of Economics, Academy of Science,
Prague
Roman Cardal (political philosophy), CEVRO Institute, Prague
Jakub Kříž (law), CEVRO Institute, Prague
Book review editors:
Jan Jireš CEVRO Institute, Prague
Language editor:
Jamie Munden
Editorial Board:
Terry Anderson, Hoover Institution,
Stanford University
Peter Boettke, George Mason University
Hardy Bouillon, Trier University
Enrico Colombatto, University of Turin
Christie Davies, University of Reading
Frank van Dun, Ghent University, Faculty
of Law
Richard Ebeling, Northwood University
Richard Epstein, New York University
School of Law
Robert Higgs, The Independet Review
Jesus Huerta de Soto, Universidad Rey
Juan Carlos
Jorg Guido, Hulsmann Université Anger
Zdeněk Kühn, Charles University, Faculty
of Law
Miroslav Novák, CEVRO Institute
Svetozar Pejovich, Texas A&M University
David Schmidtz, University of Arizona
Gerald Steele, Lancaster University
A bilingual interdisciplinary journal 5
Monetary Union without Fiscal Union?
The Euro Crisis and the Move Towards
European Fiscal Union
Francesca Spigarelli1
 and Nikolai G. Wenzel2
Abstract
This paper examines the European Monetary Union (EMU) and the euro crisis through
the lens of a robust political economy. Based on the history of monetary unions, monetary
union is unlikely to survive without a fiscal union or strong constitutional constraints. The
EMU has neither, and its institutional structure makes it unsustainable. Since the euro
was (and is) fundamentally a political – rather than economic – project, we argue that
policymakers will not allow the EMU to fail. Rather, continued movement towards greater
EU-level fiscal, and ultimately a fiscal union, are likely.
Keywords
monetary union, fiscal union, euro, crisis
1	 University of Macerata, Italy.
2	 Flagler College, USA. Corresponding author, email: nikolaiwenzel@hotmail.com
	 For feedback and comments, the authors thank Jerry O’Driscoll, David Hebert, Larry White, and participants
at the 2012 meeting of the Association of Private Enterprise Education, and Andrea Caligiuri. Special thanks
to Daniel Rottig for organizing the Florida Gulf Coast University faculty exchange program. Financial support
from the H.B. Earhart Foundation is gratefully acknowledged. The usual disclaimer applies. An earlier version
of this paper appeared as F. Spigarelli and N. Wenzel, “Unione monetaria senza Unione fiscale: un binomio
sostenibile?, in La Crisi Dell’eurozona E La Riforma Del Governo Economico Dell’unione Europea, Andrea
Caligiuri (ed.) (forthcoming). The usual disclaimer applies
New Perspectives on Political Economy6
1. Introduction
The European debt crisis has multiple causes ranging from politics to culture, and from public
finance to monetary policy. At the heart of the matter lies the institutional framework
of European and national entities – a competing and messy web of conflicting interests. A
monetary union without a fiscal union is not sustainable unless there exists a commodity
backing or some effective constitutional constraints; the EMU lacks all three. However,
we argue that the EMU was (and is) fundamentally a political, rather than an economic
project. Thus, it is no surprise that the EMU is moving towards fiscal union, rather than an
end to an unsustainable monetary union.
Section one reviews the history of the European Union (EU). Section two examines the
current crisis, along with special measures developed by the EU to respond to this crisis
(and consolidate its power in the process). Section three discusses possible futures – that
is, once the temporary band-aids and postponements have failed (as they must and will) –
what institutional arrangements are likely to emerge from the rubble. We foresee three
possibilities: the end of the euro; some sort of managed split of the EMU; or increased
“harmonization” of fiscal policy towards, perhaps, a European Fiscal Union. We argue that
the last possibility is the most likely. The final section concludes.
2. The Origins of European Monetary Union
The EU was born, in the form of the European Coal and Steel Union, from the ashes of
World War II with the purpose of intertwining the German and French economies sufficiently
enough to prevent any future wars. From the 1957 Treaty of Rome to the 2007 Treaty of
Lisbon (which established an EU constitution by treaty after a proposed constitution failed
in national referenda), the EU story is one of incremental federalism and acquis communautaire,
or increase in central prerogatives over member state powers (see, e.g., Sidjanski 2000,
de Jasay 2003a and 2003b, Wenzel 2007, European Constitutional Group 2004, Petroni
2004, Schwartz 2004). In short, the EU has grown gradually from a common market to a
regulatory state, with gradual but steady central growth and erosion of national prerogative.
2.1. From Economic Community to Monetary Union
The idea of an economic and monetary union in Europe started well before the treaties
established the European Communities after the Second World War. In 1929, German
foreign minister Gustav Stresemann called for a pan-European currency as a remedy to the
economic division ensuing from the increased number of Nation-states after World War
One.3
There were several unsuccessful attempts throughout the 1960s and 1970s to realize
3	 See ec.europa.eu/economy_finance/emu_history/part_a.htm
A bilingual interdisciplinary journal 7
an economic and monetary union. In June of 1988 the European authorities called for an
Economic and Monetary Union (EMU) and mandated a committee chaired by Jacques
Delors (President of the European Commission) to study and propose concrete stages
leading to a union. The resulting Delors Report proposed that an economic and monetary
union should be achieved in three discrete, but evolutionary, steps.4 As reported in table 1,
the third stage, beginning on the 1st of January 1999, marked the effective start of EMU.
From that date, the European Currency Union (ECU) came to be based on a currency in
its own right, renamed the euro, with a quotation and exchange rate corresponding to supply
and demand of the markets. For the first three years, the currency was used as a “book
currency” on the financial markets (for accounting, electronic commerce and transactions
between banks), while the old currencies continued to be used for cash payments. On the
1st of January 2002, euro banknotes and coins were introduced in twelve Member States of
the European Union, effectively replacing the old national currencies. The introduction of
the euro was a major step in European integration: roughly 330 million citizens in 17 of the
EU’s 28 member states now used it as their currency.
Table 1: The Emergence of the Euro
1st
Stage starting 1 July 1990 Complete freedom for capital transactions
Increased co-operation between central banks
Free use of the ECU (European Currency Unit,
forerunner of the euro)
Improvement of economic convergence
2nd
Stage starting 1 January
1994
Ban on the granting of central bank credit
Increased co-ordination of monetary policies
Strengthening of economic convergence
Process leading to the independence of national central
banks, to be completed at the latest by the date of
establishment of the European System of Central Banks
Preparatory work for Stage Three
3rd
Stage starting 1 January
1999
Irrevocable fixing of conversion rates
Introduction of the euro
Conduct of single monetary policy by the European
System of Central Banks
Entry into force of the Stability and Growth Pact
4	 See: http://www.ecb.int/ecb/history/emu/html/index.en.html
New Perspectives on Political Economy8
2.2. The EMU within the greater EU Project
Four particulars regarding the EMU are worth mentioning.
First, the euro represents, at its base, a public choice story with multiple sets of interests.
On the one hand, there are the various national interests vying for closer integration of
economies and polities, balanced with worries about inflation. On the other hand, we see a
Eurocrat and Euro-centralizing interest. The EU interest clashes with some national interests
but agrees with others. More specifically, the European Central Bank (ECB) is subject
to member-country and EU pressures. Bagus (2010, p. 100 et seq.), for example, refers to
the Euro as a tragedy of the commons, whereby “several governments are able to finance
themselves via a single central bank: the ECB.” Vaubel (2004) explains the public choice of
national jockeying on the ECB board, concluding that “the government which most closely
shares the inflation preferences of the median national central bank governor will have the
strongest bargaining power” (see also Schwartz 2004).
Second, there was no clear economic case for launching the euro (and possibly a weak
argument against adopting it). The literature overwhelmingly agrees that the Eurozone is
not, and was not in the 1980s and 1990s, an Optimal Currency Area (OCA)5
due to institutional
and structural disparities among member countries; differing labor regulations;
and divergences in fiscal policy, public finances, and debts levels. In addition, language
barriers led to lower labor mobility among countries; and the soon-to-be EMU countries
had surprisingly low levels of intra-European trade – a problem compounded by lingering
barriers to trade, including exceptions nationales, such as technology and energy “national
champions” that were exempted from free trade arrangements (see Krugman et al. 2012).
Therefore, only small gains from trade, based on reduced exchange rate costs and continued
integration, were expected. Finally, the adoption of the euro involved a significant risk
of overall inflation, as well as higher interest rates (for Germany and other countries with
relatively sound public finances). For more details on the weakness of the economics justification
for the Euro, see Salin (1990), DeGrauw (1996), Eichengreen (1993), Feldstein
(1997), or Von Hagen and Eichengreen (1996).
Third, economics was ultimately irrelevant: the euro was launched for political reasons,
as part of the process of explicit European integration, and implicit federalization; Feldstein
(1997), for example, bluntly concluded that “[it] is clear to me… that the decision will not
depend on the economic advantages and disadvantages of a single currency.” Likewise, Bordo
and Jonung (2003, p. 63) explained “the EMU is basically a political project, reflecting a
strong will to eventually create political unity within Europe.” For details on the primacy of
5	 An OCA is defined as an economic zone whose economies are so thoroughly integrated, in terms of trade,
institutions, regulatory environments, culture, etc., that they are optimal for a shared currency (Mundell
1961).
A bilingual interdisciplinary journal 9
the political over the economic in the euro’s genesis, see Schwartz (2004), Vaubel (2004),
or Salin (1990).6
Fourth, the adoption of the euro was fraught with lies and “creative” data ab initio… surely
a bad omen for economic stability. The “good” countries (France and Germany) tinkered
with the rules almost immediately, so they could join the EMU even though their public
finances violated the founding requirements. Greece, in addition, outright lied and faked its
accounting to gain admittance (see Pisani-Ferry 2004).
3. The Current Crisis
3.1. Problems of Structure and Patterns of Intervention
Three fundamental difficulties compound the problems that were present from the beginning,
in what Pisani-Ferry (2004) call “the impossible trinity.” First, a strict policy of no
monetary financing of national debts by the ECB exists (even though the ECB has repeatedly
circumvented this, and despite the fact that this policy creates a moral hazard for countries
that “won’t be” financed by an institution that is committed to preserving the euro).7
Second, the EMU countries suffer from strong bank-sovereign interdependence (a polite
way of describing the effects of crony capitalism or national corporatism: undercapitalized
banks are dependent on the solvency of heavily indebted states, and vice-versa).8
And, third,
an official rejection of co-responsibility for public debts leaves member countries simultaneously
unable to conduct monetary policy or engage in strategic devaluations, and able to
hijack supranational monetary policy by engaging in reckless fiscal policy that jeopardizes
the entire Europroject.
However, within all these considerations we must remember the underlying moving force
for the EU: the political primacy of the Europroject, as part of the EU’s institutional growth.
6	 James (2012, p. 1) offers the dissenting view that the quest for European monetary coordination “was not…
a fundamentally political project.” However, while James (2012) is a good source on history, we must remember
that it offers a quasi-official account that was commissioned by the ECB and the Bank for International
Settlements (James 2012). For another rich, insider’s history, see Thygesen (2005). See also Capie and Wood
(2003) on the primacy of the political over the economic in the formation of monetary unions, generally; for
a history of monetary unions, see Bordo and Jonung (2003).
7	 Interestingly, Issing 1999 predicted that, through EMU safeguards, “the separation between public finance
and monetary policy is… ensured” – a sentiment echoed by Huerta de Soto’s (2012) claim that the Euro offers
a disciplinary mechanism against monetary nationalism. Alas, this did not account for the moral hazard of
the EMU as political project (as pointed out by such prescient voices as White 1999) or the temptation of any
central bank to succumb to inflationary biases (see Boettke and Smith 2011; Hayek 2008[1978]; Mises 1949).
One need only look at the ECB’s new project of Quantitative Easing.
8	 This would later affect EMU rescue policies: not surprisingly, sovereign debt holders were exempted from the
haircuts in the Greek debt restructuring.
New Perspectives on Political Economy10
The EMU created a moral hazard by leaving member countries free (if only de facto) to
engage in profligate fiscal policy – especially due to the system’s “no-exit” clause. While this
could be construed as an incentive for member countries to manage their national fiscal
affairs with an eye to preserving EMU-wide fiscal health, the unintended consequences are
obvious. In sum, member countries, (a) maintain independent fiscal policy; (b) may not
exit the euro; and (c) operate under supranational institutions dedicated to advancing European
centralization, preserving the euro, and maintaining EMU-wide economic stability.
What could offer a stronger incentive to let national fiscal policy run wild, secure in the
faith that the ECB and other European institutions will do everything in their power to preserve
the Euro… including bailing out bankrupt states? In the words of Bagus (2010, 108):
“the tragedy of the euro is the incentive to incur higher deficits, issue government bonds,
and make the whole Eurogroup burden the costs of irresponsible policies – in the form of
the lower purchasing power of the euro.”
3.2. The New Economic Governance
The economic and financial crisis has revealed a number of weaknesses in the economic
governance of the EMU. The EU economies are characterized by a double disparity. First,
while financial markets are recovering from the global crisis, the real economy remains
weak. Second, growth differentials across member states remain very large. Member states
have different external and internal rebalancing needs, labor market situations, and export
capacities (Commission Staff Working Document, European Economic Forecast, Winter
2013, pp. 8–9).
The EU and its member states have therefore taken a series of important measures to
strengthen economic and budgetary coordination for the EU as a whole and for the EMU in
particular. Within these new measures and tools, we see two telling patterns. First, member
countries routinely violate the terms of the euro contract.9
Second, we have seen supranational
bailouts of individual countries for the sake of preserving the overall project. But
outright bailouts are only the most glaring example. We have also seen a number of policies
that look suspiciously like bailouts: cheap loans to banks by the ECB and ECB sovereign
bond purchases (if indirect), all the way to an implicit inflation-tax on all EMU countries,
caused by low interest rates. See Bagus for more information (2010).
In all of the following actions and institutions, the attitude of federalization and centralization
lurks not so discreetly in the background – from wider fiscal review and enforcement
powers for the European Commission, to increasing mutualization of bail-outs.
9	 And, in all fairness, why should such peripheral countries as Portugal, Ireland, Greece and Spain behave
responsibly if the core countries of France and Germany bent the initial rules to accommodate their own
shortcomings?
A bilingual interdisciplinary journal 11
a. Preventive and Corrective Action
To ensure maximum EU surveillance of member-state economic and fiscal policies, a new
set of rules for economic governance entered into force on the 13th of December 2011.
The new measures aim to ensure that member states discuss their budgetary and economic
plans with their EU partners. Budgetary, macroeconomic and structural policies are coordinated
to allow member states to take EU considerations into account at the early stages
of their national budgetary processes, and in other aspects of economic policymaking. The
EU can give policy guidance to member states before decisions are finalized at the national
level. Four programs can be examined.
First, stronger preventive action is targeted through a reinforced Stability and Growth
Pact (SGP).10
The SGP is a rule-based framework for the coordination of national fiscal
policies in the EMU; it is based on preventive and dissuasive arms. Under the provisions of
the preventive arm, member states must submit annual stability or convergence programs;
through these programs, they must show how they intend to achieve or safeguard sound
fiscal positions. Expenditure benchmarks will now be used alongside the structural budget
balance to assess progress. An interest-bearing deposit of 0.2% of GDP will be imposed on
non-compliant EMU countries.
Second, a stronger corrective action has been set. The SGP’s dissuasive arm is based
on the excessive deficit procedure (EDP), which can be triggered by excessive government
debt or deficit. Member states with debt in excess of 60% of their GDP must reduce their
debt; if it is discovered that a member state’s deficit is excessive (greater than 3% of their
GDP), the EU will issue recommendations to the concerned member state for correction of
the excessive deficit and give it a timeframe for compliance. A non-interest bearing deposit
of 0.2% of GDP may be requested from an EMU member country that has been placed in
EDP. Non-compliance with EU recommendations triggers further steps in the procedures,
including the possibility of sanctions.
Third, minimum requirements for national budgetary frameworks have been set. Member
states must ensure that their fiscal frameworks follow minimum quality standards and
are comprehensive (i.e. they involve all administrative levels). National fiscal planning must
adopt a multi-annual perspective. Finally, member country fiscal rules also promote compliance
with EU deficit and debt guidelines.
The fourth milestone has do to with preventing and correcting macroeconomic imbalances.
The new Macroeconomic Imbalance Procedure (MIP) involves EU monitoring of
macroeconomic trends. This surveillance mechanism aims to identify potential risks promptly,
prevent harmful imbalances and correct existing imbalances. The MIP is based on a
graduated approach that takes into account the gravity of imbalances. Sanctions on EMU
member states are enforced on those that repeatedly fail to meet their obligations under the
corrective arm of the MIP. The enforcement regime is based on a corrective arm, made of
a two-step approach: after one failure to comply with the recommended corrective action,
10	 See: http://ec.europa.eu/economy_finance/
New Perspectives on Political Economy12
an interest-bearing deposit can be imposed; after a second compliance failure, the interestbearing
deposit can be converted into a fine (up to 0.1% of GDP).
b. New tools to assist EU member states financially
To preserve the financial stability of the EU and the EMU, a package of EU financial assistance
for member states was created. The new framework – based on financial assistance
mechanisms linked to macroeconomic conditionality – has a stronger focus on debt sustainability
and more effective enforcement measures. Prevention is the key strategy, with the
aim of reducing substantially the probability of a future crisis.
In May of 2010, in the midst of the global crisis and severe tensions amongst sovereign
debt markets, the EU and the EMU set up a stabilization mechanism based on the European
Financial Stabilisation Mechanism (EFSM) and the European Financial Stability Facility
(EFSF). The EFSM and the EFSF can be activated only after a request for financial assistance
has been made by the concerned member state and a macroeconomic adjustment
program has been approved by the EU, in liaison with the ECB. In addition, in October
of 2012, the European Stability Mechanism (ESM) was introduced as the primary support
mechanism to EMU member states, complementing the new framework for reinforced
economic surveillance in the EU. Alongside the EFSM, EFSF and ESM, funding from the
International Monetary Fund (IMF), and ECB purchases of sovereign debt on secondary
markets are both available. Those measures create a safety net, providing financial stability
support. Furthermore, for member states that have not yet adopted the euro, Balance-ofPayments
assistance is available.11
Although this framework allows for loans solely from the
EU, in recent practice the assistance has usually been extended in co-operation with the
IMF and other international institutions or countries.
First, the EFSM provides financial assistance to EU member states in financial difficulty.
Under EFSM, the EU is allowed to borrow up to a total of €60 billion on international financial
markets under an implicit EU budget guarantee. The EU then lends the proceeds to
the beneficiary member state. This particular lending arrangement implies that there is no
debt-servicing cost for the EU. All interest and loan principal is repaid by the beneficiary
member state via the EU.
Second, the EFSF was created specifically in response to the ongoing financial crisis.
As the financial difficulties experienced by member states posed a potential threat to the
financial stability of the EU as a whole, it was deemed prudent to establish the EFSF to
provide temporary stability support to EMU member states. The objective of the EFSF
is to preserve the financial stability of the EMU by providing temporary support to EMU
member states, linked to appropriate conditionality. It obtains its financing by issuing bon-
11	 Under Balance of Payments, the EU can provide mutual assistance to non-euro area member states when a
Member State is in difficulty or is seriously threatened with difficulties with regard to its balance of payments.
BoP assistance is designed to ease a country’s external financing constraints. See http://ec.europa.eu/econo-
my_finance/european_stabilisation_actions/index_en.htm
A bilingual interdisciplinary journal 13
ds or other debt instruments on the financial markets, backed by guarantees of the shareholder
member states. The EFSF can use several instruments to support member states
temporarily, including loans to governments for the purpose of recapitalization of financial
institutions, and interventions to the primary and secondary debt markets. In addition, on
the 26th of October 2011 the capacity of the EFSF was boosted by two additional lending
mechanisms: sovereign partial risk protection and a co-investment fund. The EFSF provides
partial protection to newly issued bonds of a member state, giving the holder a fixed
credit protection in the range of 20–30% of the principle amount of the bond. Furthermore,
the co-investment fund allows a combination of public and private funding, which could
then be used to purchase bonds on either the primary or secondary markets on behalf of a
beneficiary member state.
Third, the European Stability Mechanism (ESM) plans to take over the providing of
stability support to euro-area member states. This permanent international financial institution
assists in preserving the financial stability of the EMU by providing temporary
stability support to EMU member states facing financial instability that may pose a threat
to stability of the EU as a whole. The ESM can issue bonds or other debt instruments on
the financial markets to raise capital in order to provide assistance to member states. The
ESM is based on the same tools that are available to the EFSF; however, the ESM ensures
more robust capital and an enhanced governance structure. It can provide immediate help
to member states in difficulty, and it is not affected by volatility of the rating of member
states. Finally, interventions of the ESM are not charged to the public finance statistics of
member states.
4. Avoiding a Meltdown: Towards European Fiscal Union?
4.1. The Scene
The euro crisis continues, the Eurozone hobbles on, and euro leaders find themselves in a
difficult position. To summarize the situation, Greece is insolvent and flouting the terms of
repeat bailouts while other countries follow close behind. France and Italy, while relatively
solid, are heavily indebted and struggle with messy public finances. For better or for worse,
the EMU was indeed successful at integrating its member economies; in addition, banksovereign
interdependence continues, along with core-periphery interdependence. All of
this means that a chaotic “Grexit” (Greek exit) or break-up of the EMU would be costly to
all members. The ECB is statutorily forbidden from engaging in the monetary financing of
debt (even though it has provided cheap loans to banks and indirectly purchased sovereign
bonds – and, even now, is engaging in Quantitative Easting). The EMU officially rejects
debt mutualization… yet it has approved various bailouts and implemented what are, in effect,
Eurobonds. The German electorate is tired of bailing out the profligate Greeks – who
are ungrateful for what they perceive as German tutelage. Finally, the weaker EMU member
New Perspectives on Political Economy14
countries, by and large, lack the political will to engage in the structural reforms that would
make them more competitive (in the absence of monetary policy, and without engaging in
further deficit spending); Mario Draghi specifically reminded EMU member countries that
Quantitative Easing was not sufficient for growth and that member countries had to engage
in structural reforms for increased competitiveness (see, e.g. Draghi 2015). One can only
assume, given the magnitude of the Quantitative Easing and the continued rumblings of a
break-up of the Euro, that the ECB governor is not particularly optimistic about countries
taking the necessary steps.
Euro-area leaders have sought to avoid a disorderly breakdown of the euro, which could
occur if Greece were to exit the euro unilaterally. But this could also occur if a Greek collapse
were to lead to a run on Greek banks – and thus a run on the euro itself, with systemwide
repercussions. Bordo and Jonung (2003, p. 61) explained before the crisis, that there
could be many possible causes of an EMU collapse – and all of them would come down to
political will.
4.2. The Options
In order to avoid chaos, policymakers have three options: first, end the euro now; second,
split the euro (through a “Grexit”, “Gerexit” or two Eurozones); or third, continue the current
situation but with stronger supranational fiscal safeguards. Which is likely to prevail?
A total end to the euro is unlikely. The euro was, and is, fundamentally a political project
of European integration. Beyond the high economic and transaction cost of disintegration,
an end to the euro would be an embarrassing political failure and an abrupt break in the 60
years of progress towards European integration. It is a small wonder that ECB Governor
Mario Draghi was recently quoted, stating that: “within our mandate, the ECB is ready to
do whatever it takes to preserve the Euro.” In this European parallel to the “Greenspan
put,” the euro is “irreversible,” according to Draghi.12
It is very unlikely that policymakers
will intentionally dissolve the euro, and they will do everything in their power to prevent a
messy, accidental break-up.
The jury is still out in regards to the other two options (splitting the euro, or continuing
with stronger fiscal safeguards). Both have high costs, and both are unpalatable to Germany
(see the delightful, tongue-in-cheek, “memorandum” to German Chancellor Angela Merkel
on breaking up the Euro, in The Economist, August 14, 2012). The EMU could expel Greece
(and, in the future, other insolvent countries that don’t reform their public finances or fail
to adhere to bailout conditions). This would avoid the cost of further bailouts, especially
since the Greek government has lost all credibility and the German electorate is fed up with
bailing out its irresponsible southern neighbors. But the consequences of a break-up would
be costly – from the cost of printing new money, to the possibility of a Greek bank run or
default, which would lead to EMU-wide contagion (not to mention the political cost).
12	 See The Economist, August 14, 2012. On the “Greenspan put”, see “’Greenspan put’ may be encouraging complacency”,
by Peronet Despeignes, The Financial Times, December 8, 2000
A bilingual interdisciplinary journal 15
Ending the euro, expelling Greece, or creating two euros within the euro might be the
best solution in the long run, as Germans and others grow tired of throwing good money
after bad. Any of these, nonetheless, would be an admission of political defeat. The third op-
tion – a revamped EMU – seems much more likely. Indeed, we are already seeing stronger
EU-level reviews of national budgets; de facto mutualization of debt (how long before official
Eurobonds?); penalties that are actually enforced; real strings attached to further bailouts;
and increased “harmonization” (which, in EU code, translates to the movement centralized
of power away from member states and into EU institutions).
The EMU and EU are already moving – slowly and surreptitiously as always – towards
increased EU powers and… European Fiscal Union?
5. Conclusion
It is, of course, impossible to predict policy actions, let alone the delicate balance between
the interests of powers like the German electorate, the ECB, individual politicians, the
Greek street, financial markets, the EU bureaucracy, etc. Needless to say, however, things
cannot continue as they are – economically or institutionally: that much is certain. It is also
unlikely that any politician wants to be associated with a potential break-up (especially accidental
and disorganized) of the euro, if such a political failure can be avoided.
The mechanisms recently adopted certainly look a lot like a movement towards a European
Fiscal Union (especially EU review of national budgets, and increasing mutualization
of debt, if unofficial for now); James (2012, p. 400) explains that “most of the innovative
solutions…to address current weaknesses involve some measure of fiscal federalization.”
This makes sense for two reasons: Primarily, due to the EU’s long tradition of backdoor
federalism and increased power to Brussels, as the EU continues its relentless move from a
customs union to a regulatory apparatus of economic central planning we are reminded of
Wilhelm Roepke’s (1964) prescient warning that, in any proposed European Union, “the
highest degree of inflation in any member country will be adopted by the others along with
the longest paid vacations and the greatest measure of intervention or planning.” Secondly,
the theory and history of monetary unions predicts that a monetary union is unlikely to
survive without an accompanying fiscal union due to the inherent moral hazard, unless,
of course, some other effective constraint is present.13
It is not surprising that 37 of the
49 monetary unions have strong fiscal restrictions, while the others rely on constitutions,
tradition and other effective guardians (Hagen and Eichengreen 1996). This is because in
13	 On the relationship between monetary and fiscal union, generally, see Chadri and Kehoe 2008, Beetsma and
Bovenberg 2001, Cooper and Kempf 2004, Kirsanova et al. 2007, Fuchs and Lippi 2006, Dellas and Tavlas
2005, or Dixit 2000. However, we find that these mainstream contributions tend to be very mathematical and
theoretical, and thus somewhat detached from the institutional context of the EU’s political economy.
New Perspectives on Political Economy16
order for a monetary union to be successful, it must have a commodity backing, strong constitutional
constraints, and/or a fiscal union. Otherwise, the members will have incentive to
engage in profligate fiscal policy to affect macroeconomic outcomes (generally, see Huerta
de Soto 2012). Schwartz (2003, 110) concludes “fiscal autonomy must be sacrificed by the
member countries along with monetary autonomy for monetary union to be successful.”
More specifically, Bordo and Jonung (2003, 43–44) explained, even before the crisis, that
the absence of a fiscal union was the shortcoming of the EMU. Even James (2012, 400), the
official “biographer” of EMU, conceded that “in the 1990s, critics often pointed out that
monetary unions were fragile without some measure of fiscal union. In the aftermath of the
post-2007 Great Recession, this lesson has become brutally apparent.”
One has to wonder if the Maastricht framers were really naïve… Indeed, it is much more
likely that they knew full well that (a) they couldn’t get fiscal federalism quite yet, for lack
of political readiness in the EU; (b) monetary union without fiscal union was doomed to
fail, as a result of moral hazard and because the EMU was not an OCA; and therefore (c)
fiscal union would be demanded when monetary union inevitably failed (and would thus be
obtained through the usual EU “backdoor to federalism”). The Delors Report, which paved
the road to Maastricht, did indeed foresee that “monetary policy alone [was] insufficient.”
This theory would certainly fit within the pattern of EU expansion and mission creep that
has existed ab initio.
As economists, we remain champions of “EU Mark I,” the reduction of trade barriers.
We remain skeptical of “EU Mark II” – the growing bureaucratic apparatus of regulation
and central planning into which the EMU has sadly been lumped – and even though EMU
has some characteristics of Mark I, it has become another instrument of EU central planning
and implicit federalization. Central bankers – like any other central planners – lack
the requisite knowledge and incentives to avoid damage, as they will face inflationary biases
(see Boettke and Smith 2011; Hayek 2008[1978]; Mises 1949). This general problem is
compounded by the public choice particulars of the ECB; as member countries lose control
of national monetary policy and face constraints on national fiscal policy, they seek to capture
the central bank (see Bagus 2010, Vaubel 2004, Schwarz 2004). Economists who are
skeptical of central banking have proposed different alternatives – both in theory, and in the
particular case of an integrating Europe. For example, Hayek (2008[1978], p. 126) argued
that a system of competing currencies would be “both preferable and more practicable than
the utopian scheme of introducing a new European currency, which would ultimately only
have the effect of more deeply entrenching the source of all monetary evil, the government
monopoly on the issue and control of money.”14
Under such a system, the market could
have sorted among the different European currencies and the most stable (presumably
the Deutschmark) would have emerged as a Euro-wide currency. Alternatively, Huerta de
Soto (2012) advocates the more radical abolition of all central banks, with a return to the
14	 For examples of currency competition, see White (1992), Selgin (1988), Hayek (2008[1978]), Smith
(1990[1936]) or Hogan 2012.
A bilingual interdisciplinary journal 17
gold standard and the reestablishment of a 100-percent reserve requirement.15
Under such
a system, market disciplinary forces prevent any of the money-issuing banks from engaging
in credit expansion.16
Unfortunately, given the political primacy of the Euro, neither of the economically more
viable systems of currency competition or free banking is likely. And, while central banking
poses great difficulties, we must also remember the Misesian theory of the dynamics
of intervention predicts that limited intervention is unsustainable, as intervention begets
intervention (see Mises 1979). The second best option (after currency competition or free
banking) is not a lonely monetary union, as such a system will fail due to the absence of additional
constraints. Instead, a more interventionist system (monetary union with fiscal union)
is emerging in the European case. Alas, this compromise is a very distant second-best.
The EMU is not yet out of the proverbial woods. Unfortunately, there will be more pain.
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A bilingual interdisciplinary journal 21
INFORMATION, SHADOW BANKING AND
FLUCTUATIONS
Vladimir Khrapko1
Abstract
This paper attempts to emphasize the role of information, and new financial schemes and
instruments in the creation of monetary trade cycles in the framework of Austrian economics.
Using an approach initiated by F. A. Hayek, the classical mechanism of credit creation
is exposed. The shadow banking role and its informational features that played significant
role in the recent creation of the Great Recession are explained within the Austrian ap-
proach.
Key Words
Austrian school, Cycles, Shadow Banking, Information
1	 Associate professor at the Taurida State University, Department of Management and Marketing.
New Perspectives on Political Economy22
1. INTRODUCTION
The recent economic downturn draws the attention of economists to the potential causation
of this phenomenon. The Austrian Business Cycles Theory explained this event with
consistency and logical clearness. It is worth noting that the basic concepts of the theory
were elaborated at the beginning of the 20th
century and the roles of banks and the distortions
of interest rates were emphasized. At present, the development of financial markets
gives us new examples of possible causes for the distortions of markets, so a wider informational-based
discussion may be possible.
The information retrieving and processing in an economy is an important issue. Unevenness
and asymmetry of information access may create conditions for economic effectiveness.
On the other hand, the lack of relevant data creates a environment prone to incorrect decisions.
This article discusses the following closely related issues: financial markets, information
and its role to the economy, and new financial instruments and their role in market downturn.
F. A. Hayek emphasized the importance of the information issues in his work on the role
of knowledge in society (Hayek 1948). “Which of these central or decentralized systems
is likely to be more efficient depends mainly on the question under which of them we can
expect that fuller use will be made of the existing knowledge.”
Economic problems concerning human actions and interactions are sometimes quite
difficult to tackle with precision. Nevertheless, in practice and with relative success, businessmen
solve their tasks in most cases using available data, and as a result the economy
develops smoothly.
When starting the decision making process, the subject almost always has some prior
information. This data may be consciously gathered through purported efforts, hoping
to use the information beneficially in the future; or, on the other hand, an economic
agent can rely on his previous knowledge based on his prior experience. The planning to
achieve a desirable outcome includes not only data, but also the process of transforma-
tion – using logical rules; previous experience; previously discovered laws; and methods
or algorithms that help to reformulate data in short, clear and applicable statements to
make decisions in different situations. The process of planning is a crucial aspect of entrepreneurial
activity.
The planning usually prioritizes economic calculations. These calculations aim to transform
available data into concrete magnitudes that guide the entrepreneur to his goals of
economic efficiency (expressed in the profitability and/or riskiness of his or her economic
actions). If calculations are incorrect, this results in poor decisions and malinvestments.
Therefore, malinvestments are basically the result of information deficiency, or errors in
data processing. Considering the significance of data and decision-making, we shall discuss
interrelationship between risk and information in the markets.
A bilingual interdisciplinary journal 23
2. INFORMATION, MARKETS AND RISKS
Information is the basis for predictions and foresight. If anticipations are correct, then errors
are absent and decisions are made correctly; alternatively, outcomes do not coincide with
anticipated situations and are perceived as an error. The absolute knowledge is not accessible
to any particular participant in the economic process; it is impossible to be omniscient
economic agent. Every entrepreneur has his or her limited volume of information and scope.
Foresight – as argued by Hayek (1948) – is one of the important issues in dynamic
economics. He wrote: “It has become more and more obvious that, in the treatment of
the more “dynamic” questions of money and industrial fluctuations, the assumptions to be
made about foresight and “anticipations” play a(n) … central role…” This ability to forecast
future situations is a crucial point in economic development and competition.
When market interaction (exchange) takes place, one of the information sources is price.
Usually price reflects the level of compensation for received value and includes the seller’s
costs. In many markets, prices are easily available, although their sufficiency for correct
economic decision and prognosis is disputable. This idea of prices as an important informational
signal is strongly expressed in the definition of different forms of security market
efficiency. Although, the applicability this hypothesis to the real markets is still questionable.
But even if we accept this hypothesis, the risk still remains for an investor, and malinvestments
are possible.
The process of economic decision typically consists of several steps including the identification
of information sources, the extraction of relevant subsets of data, processing said
data, and making conceivable conclusions and foresight.
The interaction is an important feature of the human society as a whole and in economic
relations as well. This interaction is established through the interchange of information and
coordinated actions. The more complex the structure of interactions, the more difficult and
error prone the process of decision making is in regards to effective resource allocation
between different economic actors.
We have two possible situations, the first of which is when two interactive agents have
the same information and similar goals. If their preferences and forecast possibilities are the
same, they will act in the same manner. As a result, these two interacting parts have to find
a compromise to solve the contradiction or start competition. On the other hand, if agents
differ in their available information set and/or goals then they may find a synergetic solution
that can help each other make more profit: e. g. the value creation through a supply chain
to the customer, different unions, associations etc.
When the quantity of actors is increasing and links between them become numerous or
complicated, the risk becomes larger and more severe. For example, if there are two interacting
agents only one link exists between them. Three agents have three links with each other. A
dozen has already 66 links and so on. This complexity is increasing exponentially and it has
negative influence on the accuracy of decision process because of additional uncertainness.
As noted earlier, an additional source of risk and uncertainty originates from the
natural desire to have exclusive information that gives competitive advantage to an in-
New Perspectives on Political Economy24
dividual or a firm. It implies the possibility to have internal information unknown to
others with commercial value that is not available to competitors. This situation creates
the basis for an advantage, at the very least, for direct competitors. Such exclusive knowledge
usually is defended by law as trade secret, and helps the secret possessor to gain
monopolistic position to extract additional profit compensating the costs produced by
innovations. Monopolistic profits stimulate rivalry companies to copy the advantageous
innovation. (Cf. von Mises 1944, 1998, p. 27) This means that information asymmetry
may be useful and stimulating economic efficiency by the creation of a new method of
resource use. Patents and goodwill support the stimulus for economic improvement and
overall progress.
When an entrepreneur wants to increase profits, usually it relates to their decision in
regards to the future. The situation of future markets cannot be known in details, and there
is always some degree of uncertainty and risk. Risk, as defined by the Webster dictionary is
the possibility of loss, possibility that something bad or unpleasant (loss, injury) will happen.
Rational human behavior implies that an actor should try to identify such possibilities,
enumerate them, evaluate the degree of possible costs and make appropriate provisions.
Such possibility always implies absolute or relative insufficiency in data or data processing
and forecasting efficiency.
The source of risk embedded in the interaction of different agents because of their diversity.
The actions of partners in the course of economic intermediations and propensity
to extract informational rent during this process makes interacting parts take additional
efforts to hide proprietary information about “knowhow,” and retrieve more information
about the reality of the counterpart.
Economic agents have different sources of possible errors: insufficient data, incorrect
data or inappropriate mechanism to infer conclusions. The last statement may be illustrated
by the stock market example. If both investors want to be in a long position when one sells
a share and the other buys it, then the first investor believes the future price will fall; on the
other hand the second believes that the price will grow. This means that two agents having
practically identical accessible data came to two separate conclusions. If the information
set is approximately, or even absolutely, the same for all investors, their decisions and actions
may be substantially different. In this case, the ability to forecast future changes in the
market is crucial to success for the investor.
Different circumstances lead to limitations on economic decisions, making them local
with less forecasting power and poorer prognosis value. Consequently, during a boom,
when the relative cost of capital is low, businesses may overestimate opportunities and
underestimate future risk. Concerning incorrect estimations, one recent example may be
explored: the president of Bear Stearns (global investment bank and brokerage agency)
stated that the company did nothing wrong and did not take risks they did not understand,
even when the bank was going toward bankruptcy.
In general, activities in finance and financial markets are always exposed to risk and
error, and this might lead to remarkable downturns in financial markets with widespread
repercussions on a global scale.
A bilingual interdisciplinary journal 25
3. FINANCIAL MARKETS
In a modern economy, financial activity is very important for economic relations, and it
concentrates not only on traditional bank related areas, but also on financial markets where
shares, bonds, CDOs and other instruments are traded.
So not only banks supply the necessary
funds to business, but other possibilities exist for entrepreneurs to obtain necessary
finances. The financial markets are well known for their volatility; prices change because
participants are influenced by information and circumstances. Therefore, these markets are
information sensitive, and especially risk prone.
During last twenty years, the growth of financial markets was spectacular. For example,
as reported by Security industry and Financial Market Association (2014), a growth of
IPO from $4.5 billion in 1991 to $58.7 billion in 2013 was observed, and the same rate
was matched by bond financing. U.S. Corporate Bond Issuance rose from $343.7 billion in
1996 to $1.3659 trillion in 2013. These instruments (shares and bonds) are traditional ways
to attract funds from investors. The modern financial market works with traditional methods
(bonds and shares), and new instruments such as CDO, MBS, ABS, etc. These innovations
in finance create complex and complicated schemes of intermediation, creating hazy
relationships between market participants and the generation of asymmetric information.
Sometimes modern banks create new entities to give them the riskiest businesses, avoiding
the disclosure of the real situation with their assets position.
By nature, financial markets create the possibility for poor decisions. Newly introduced
financial instruments may enhance this possibility, creating grounds for the undervaluation
of risk exposure in the investments of assets. That is, complexity and information uncertainty
hide the intrinsic value and risk relationship for entrepreneurs who act as investors.
(A. P. Mueller 2001)
Usually the entrepreneur’s decision in investment may be represented in such a manner.
At the beginning the entrepreneur finds a market opportunity from which he or she can
profit, then they try to acquire the necessary resources to implement this new business idea.
Often he approaches banks or other financial market intermediaries trying to gather the
necessary funds to start or enlarge a business.
Modern financial markets are information sensitive and volatile. A hypothesis in regards
to their efficiency was proposed to describe such features. This hypothesis of efficient
markets argues for the informational efficiency of security markets and asserts that all information
processed by markets is reflected in the asset prices. From this standpoint, the
conclusion is drawn that all fluctuations in the short run are random, and in the long run
there is no inefficiency that leads to downturns in security markets and the economy as a
whole. When this hypothesis is accepted then the prices are believed reliable indicators for
decision-making, because they reflect intrinsic asset value. But in practice, the information
conveyed by prices often is insufficient to make valid economic decisions. The downturn of
the stock market in 2001 (dotcom bubble), and in 2008 (start of Great Recession), show
that the hypothesis of stock market efficiency does not always hold true. The financial crush
in 2008 started a bust in real economy all over the world, Europe especially. (J. H. Tempel-
New Perspectives on Political Economy26
man 2010). These facts support the Austrian theory that points out the causes of trade
cycles are rooted in finance and related to money and banks.
4. THE CORE OF THE AUSTRIAN BUSINESS CYCLE THEORY
F. A. Hayek (1933) and von Mises (1953) described in detail the banks’ role in the economy
and in the generation of economical fluctuations. Banks’ ability to create additional
money is one of main causes of creating economy deviation from the equilibrium (see
Hayek 1933, 147 and further). A bank as a part of banking system creates new credit money
from obtained deposits. For example, when the Bank A receives a loan, the definite part of
it is stored as a reserve to compensate unexpected reduction in money inflow. The bank may
grant the rest of money as a loan. The depositor does not know exactly that his money gone
away and is not available, although the bank gives an assurance to the depositor that money
is available at any time, which is confirmed by the deposit contract. This position is not absolutely
guaranteed, but only with a certain degree of probability. Such a situation of informational
asymmetry gives the advantage to the banks, but makes their position vulnerable.
F. A. Hayek wrote: “the primary cause of cyclical fluctuations must be sought in changes
in the volume of money, which are undoubtedly always recurring and which, by their occurrence,
always bring about a falsification of the pricing process” (Hayek 1933). The main
issue regarding cyclical changes in economic activity is the excessive volume of fiduciary
money. This excessive quantity of money gives false informational signals, changes the equilibrium
perception for customers; suppliers; households; and firms, enforces them to adapt
their time preferences for current and future needs of resources to the current supply of
money. This supply changes the level of prices and time preferences, lowers interest rates;
these changes are not the same in different economic sectors or under different circumstances.
This leads to the disruption of equilibrium and generates boom-bust fluctuations.
The constant overflowing economy with fiduciary money and the possibility to receive bail
out support for banking systems distorts risk perception for the entrepreneur.
As argued by Huelsmann (1998), the main cause of economic fluctuations is the cluster
of errors created when an entrepreneur incorrectly assesses money volume and prices for
the future. If the entrepreneur knew relevant data, there would be a chance for them to
discover the incorrect decision earlier and avoid erroneous actions with greater probability.
The generation of additional money by a banking system is based on the information
asymmetry concerning the money deposited in the banking system. In fact, check accounts
and time deposits are also liable to withdrawal of deposited balances from the bank at any
time. The bank believes depositors will not simultaneously demand a major portion of their
balances, and after necessary reserving (usually small fraction of deposits), the bank will
legally grant the rest of money as a new loan. If the given money is absent for the reason of
partial reserve, the demand may be met not only from reserves, but also from other depositors’
money (de Soto 2009).
A bilingual interdisciplinary journal 27
To coordinate inflows and outflows is a nontrivial task for bank management. Different
deposits and loans have different conditions; especially as their maturity and risk levels
differ significantly. Mismatching maturities creates additional risk for serving time deposits
and deposits on demand. The ABCT asserts these situations in banking system activities
as the main source of economic fluctuations and crises (Salerno 2012; Miller 2012). As of
2003, the range of bank reserves in different countries around the world fluctuates from
zero to 20 per cent of deposit volume and issued banknotes.
To create a critical downturn in economy, several interlinked circumstances have to occur.
Firstly, malinvestments are made as a result of incorrect signals given by unnaturally
low interest rates. Secondly, soft financial policies combined with the readiness of governments
to bailout banks in trouble occur and distorts the perception of risk. In addition,
nowadays banks participate in so-called shadow banking schemes. This activity is new to
the ordinary entrepreneur; essentially the shadow bank entities try to hide information
about the risk level of their instruments from the entrepreneur. It is worth noting that the
last new world recession brought to the light the role and importance of shadow banking
activities.
5. SHADOW BANKING
The innovations in the financial intermediation and structures are developing constantly,
and new methods and financial instruments are always appearing. This process of facilitating
credit creation has inherent drawbacks and risks and may lead to economic fluctuations.
Like any usual banking system, shadow-banking institutions deliver loan facilities to
the public and enterprises, making it easier to obtain the necessary financial resources for
business or consumer needs.
The shadow-banking system may be defined as the financial intermediation activities
that involve entities external to the usual banking system. In the papers discussing the
shadow-banking system, authors often argue that the demand for money-like, relatively riskless,
debt instruments is high. The supply from the side of the US government Treasuries
is insufficient for large institutional investors and corporations. One of the reasons for pursuing
new forms of savings is the growth of demand from corporations for the safe, shortterm
money instruments from corporations. Usually the guaranteed redemption of a bank
deposit, before the 2007–2009 crisis, was no more than $100,000. For corporations such an
amount is relatively small. The demand for new possibilities was growing rapidly. Some estimations
show a tenfold growth of the assets mentioned above during the past decade. The
volatility of the market was remarkable, e.g. in 2005 about $30–40 billion of short-term,
money-like instruments were issued in the US financial markets according to the information
from the Securities Industry and Financial Markets Association. Then, in the following
year it grew to $100 billion, followed by a growth volume plummet to a mere $5 billion
per quarter – twenty times lower (Coval et al. 2008). After the financial crisis of 2008, the
New Perspectives on Political Economy28
recovery of activities outside the bank system rose. By the end of 2013 the activity of other
Financial Intermediaries grew to $71 trillion worldwide. The size of assets belonging to the
shadow-banking system was estimated to be 24% of total financial assets. The 20% growth
demonstrated by emerging market economies overcame the growth of developed jurisdictions
(FBS 2013). Like usual banking systems, these institutions delivered loan facilities to
the public and enterprises, making it easier to obtain the necessary financial resources for
business or consumer needs. Often these entities affiliated with usual banks, helping banks
to make their activities more flexible, use leverage, and avoid regulation restrictions. Such
entities may be organized as special purpose vehicles (SPV). SPV is a fixed income maturity
transformation fund that adapts instruments with different maturity condition to specific
needs. Usually, it transforms risk and opaque, long-term obligations into short-term moneylike
instruments. Shadow-banking system functions are implemented through the chain of
activities using debt in different forms: commercial papers, student loans, mortgages etc.
The activities of shadow banking are more complex than the usual bank loan/credit poli-
cies.
In the first step, a bank receives money as a deposit, and after reserving the definite part
of it, the rest of money is granted as a loan. When this loan is issued then the newly created
loan contracts may be combined with similar loan contracts in a portfolio or a bundle. This
bundle may be sold to the other entity, a part of shadow banking system, with the intention
of further slicing it into liquid financial instruments. When receiving the payment for the
bundle, the bank creates a new additional loan starting the second round of loan expansion.
We can see the interlinked complex of banks and other financial institutions, which use a
collateral to obtain cash. For example, the first level entity that needs money may supply,
as collateral, some quantity of riskless Treasury bonds when approaching bank #1. Then,
this bank #1 may use the collateral for insuring funds which it procures from bank #2, and
so on. The chain mechanism described is one of the mechanisms used to provide new debt
money-like instruments; another one is pooling debt instruments.
To manipulate liquidity and maturity, SPV entities use portfolios or bundles as collateral
for newly issued debt instruments – pooling debt contracts into a bundle, selling these
bundles, restructuring the bundles by issuing asset-backed obligations, and then selling the
obligations in the markets.
Through this mechanism, the SPV may issue debt obligations with higher quality than
the underlying collateral. Methods of slicing the primary portfolio may be illustrated by a
simple example. Let us examine a collateral portfolio (bundle) consisting of two bonds.
Every bond has a nominal value of $1. Every bond was assigned with probability of default
equal to q. When they are combined in a portfolio, we create four combinations A={1,1},
B={0,1}, C={1,0}, D={0,0}, where 1 on the first place means no default of the first bond, and
0 means a default outcome. The use of this portfolio as a collateral may be direct without
additional transformations. In this case there is no changing the quality of newly issued collateralized
debt obligations (CDOs); all risks are transferred. But when the SPV slices the
underlying collateral into two different tranches the situation changes. Let us divide the collateralized
issue into two tranches. The first (senior) tranche defaults when both underlying
A bilingual interdisciplinary journal 29
bonds default, that is when outcome D occurs. This event has the probability equal to q × q
or P(D) = q2
when the defaults are independent. The other (inferior) issue defaults when
outcomes B or C or D occur, or in other words: W = B + C + D and its probability P(W) is
2×(1−q)×q + q×q, or P(W) = 2q−q2
. Let us suppose that the underlying collateral default of
q = 10%, then the probability of the senior tranche default is P(D) = 1%, and the probability
of the inferior tranche default is P(W) = 19%. The senior tranche has a probability ten times
lower to default than the underlying collateral. In this manner, the SPV generates a much
less risky asset from the risky one.
To compare risk formulated by a default probability, the empirical data from one Moody’s
rating agency is provided. The process of assigning rating to debt instruments is mainly an
informational process conditioned by uncertainty with the goal of assessing the level of the
issuer’s creditworthiness. The rating assignment processes infortmation with the goal of aggregating
the available data and knowledge of obligation issuer fundamentals, and shaping
it in a concise and consistent manner in the form of a conclusion on quality and risk level
in regards to the instrument in consideration.
During the last century, obligation ratings became very popular among investors. There
are three world known rating agencies: Moody’s, S&P and Fitch. The rating process as described
by the rating agency is a typical process of drawing a probable and dynamic conclusion
based on economic and financial data. The rating is an opinion of creditworthiness for
the future, and is calculated by using credit and fundamental analysis, including financial
statements and management performance analysis. This scheme is applied to different scenarios
and external conditions – from good to pessimistic and stressed. The rating agency
activities improve and facilitate access to economically important information for investors,
reducing information asymmetry and the costs of gathering and processing information.
Hopefully, assigning the correct rating score will increase the information efficiency of the
market. Rating information gives the probability of default associated with level of rating A,
B, C. This empirically derived probability differs significantly. When assigned high-level A,
the probability of default is very low (see Table 1). The agency Moody’s (1996) published
empirical probabilities of default, conditioning on the assigned rating grade (see Table 1).
Table 1: Empirical default probabilities associated with corresponding
rating grades by Moody’s using proprietary data from 1928 to 1996
Rating grade Default Probability
Investment grade Aaa 0.00%
Aa 0.03%
A 0.00%
Baa 0.13%
Speculative grade Ba 1.42%
B 7.62%
(Source: Moody’s, 1996)
New Perspectives on Political Economy30
This research uses only standard (not CDO) bonds, which does not collateralize so-called
single corporate issues. Only 1% of them are rated as AAA, in contrast with about 60%
of the asset-backed issues that received the highest rating level. As we see above, the use
of collateralizing and tranching low-rated collaterals may transform into CDO with a
remarkably higher quality. Starting from the speculative grade B, a new instrument may
be graded as Baa, or even A. But when economic conditions change, the statistical independence
disappears. In this case, tranches with low rates of default acquire the same
default probability as underlying assets, and high quality tranches deteriorate and become
tranches of low quality.
Additionally, shadow-banking entities do not take deposits, so they are not subject to
central bank surveillance or tight regulations. On the other hand, they do not have access
to central bank reserves and debt-guarantee facilities.
As in usual bank practice, the shadow-banking activities can create additional loans on
the stage of bundling. In this case, additional uncertainty and risk is added because the
conversion through the bundling into asset-backed obligations increases not only funds for
credit creation, but also the complexity and fragility of financial intermediation, and has
inherent additional risk when economic conditions worsen. The increasing risk augmented
by the creation of new entities without reserves and appropriate central bank overview and
control may add volatility to financial markets. As Z. Pozsar et al. (2012) argue in their report,
the shadow-banking system intermediates credit creation using a large set of different
financial instruments and complicated chain of intermediaries.
Compared to usual banks that have access to public source of liquidity as FRS discount
window and Federal Deposit insurance, the shadow-banking system relies only on private
sector money generation. The basic mechanism of credit creation in shadow banking uses
liquidity and maturity transformations. When the bank grants a credit, e.g. a credit for a
house purchase, the bank can get additional cash by selling packaged debt obligations to
another shadow-banking entity. The bank uses the cash to grant additional loans. A shadowbanking
entity issues short-term commercial papers with shorter maturity and lower interest
rates to pay, receiving profit on the maturity and interest gap.
Following the dotcom bubble burst, the soft FRS policy stimulated low interest loans
for housing and made the policy in loan creation less responsible by lowering interest rates
and easing loan qualifications. In addition, the fore mentioned risk transfer by securitization
made errors in investment decisions more proliferous. Easy and allegedly safe money
leads to errors in calculations and business planning. These factors lead to the expansion of
the housing bubble and the following burst with global economic consequences (Fligstein,
Goldstein 2010).
The novelty and complexity of new instruments combined with the willingness of banks
to hide risk associated with new methods of debt generation and the overoptimistic high
grade assignments by rating agencies creates and environment prone to incorrect conclusions
made by ordinary investors. To avoid such a situation it is necessary for investors/
entrepreneurs to study carefully not only the financial position of the issuer, but also the
structure of the proposed collateralized instruments. In addition, they have to review their
A bilingual interdisciplinary journal 31
portfolio, taking into account that in some situations the quality of such novel instruments
may deteriorate to the quality of underlying assets.
6. SOME CONSIDERATIONS ON PUBLIC POLICY
Though the problem of information does not pertain solely to the economy, the economic
information problems influence practically all sides of economic process. Informational
openness provides economic agents with the ability to make their planning process more
coherent, relevant to goals pursued by them. As remarked by Hayek (1945), the pieces of
information are dispersed over the total population, so the correct and overall picture is
not accessible to just any economic agent. Additional efforts to provide information to
market participants are plausible and lead to increasing market efficiency. This, in turn,
leads to decreasing errors in decision-making and diminishes the probability of busts. The
government efforts, to induce market agents for disclosing their financial information, will
make markets more predictable and less error prone. Special attention needs to be drawn
to new forms of financial intermediation, such as shadow-banking activities. Its functions
are useful for the economy, though some measures of transparency and correct assessment
of risks are needed.
7. CONCLUSION
Austrian theory proposes one of the comprehensive monetary explanations of economic
fluctuations. One of the main proponents of Austrian school F. A. Hayek argues the role of
information and ability of foresight in economic decision. The modern, more complicated,
structure of credit generation may create new credits in modern finance framework, and because
of its complexity it does not provide sufficient information to make valid investment
decisions. These new features of the modern financial system stimulate malinvestments and
inevitably lead to booms and busts.
REFERENCES
Coval, J. D., Jurek, J., Stafford, E. (2008) “The Economics of Structured Finance”, Working
Paper 09–060, Harvard Business School, 2008.
Financial Stability Board (2011) „Shadow Banking: Strengthening Oversight and Regulation,
Recommendations of the Financial Stability Board“, Basel: Bank for International
Settlements.
New Perspectives on Political Economy32
Fligstein, N., Goldstein, A. (2010) “The Anatomy of the Mortgage Securitization Crisis”,
in M. Lounsbury and P. Hirsch (eds.) Markets on Trial, Bingley, UK: Emerald Publishing,
2010.
Hayek, F. A. (1933) New York: Sentry Press.
Hayek, F. A. (1945) «The Use of Knowledge in Society”, American Economic Review 35(4),
519–530.
Hayek, F. A. (1948). Individualism and Economic Order. The University of Chicago Press.
Huelsmann, J. G. (1998) “Toward a General Theory of Error Cycle”, Quarterly Journal of
Austrian Economics 1(4), 1–28.
Miller, R. C. B. (2012) “Systemic Appraisal Optimism and Austrian Business Cycle Theory”,
Quarterly Journal of Austrian Economics 15(4), 432–442.
Mises, L. von (1944, 1998) «Monopoly and prices», Quarterly Journal of Austrian Economics
1 (2), 1–28.
Mises, L. von (1953) The Theory of Money And Credit. New Haven: Yale University Press.
Moody’s Investors Service. Corporate Bond Defaults and Default Rates from 1938 to 1995.
January 1996, pp. 1–40
Mueller, A. P. (2001) “Financial cycles, business activity, and the stock market”, Quarterly
Journal of Austrian Economics 4(1), 3–21.
Pozsar, Z., Adrian, T., Ashcraft, A., Boesky, H. (2012) Shadow Banking, Federal Reserve
Bank of New York, Staff Reports, no. 458, July 2010: revised February 2012.
Salerno, J. T. (2012) “A Reformulation of Austrian Business Cycle Theory in Light of the
Financial Crisis”, Quarterly Journal of Austrian Economics 15(1), 3–44.
Security Industry and Financial Market Association (2014). Online at: http://www.sifma.
org/research/statistics.aspx
de Soto, J. H. (2009). Money, Bank Credit, and Economic Cycles. Second Edition. Auburn,
Alabama: Ludwig von Mises Institute.
Tempelman, J. H. (2010) “Austrian Business Cycle Theory and the Global Financial Crisis”,
Quarterly Journal of Austrian Economics 13(1), 3–15.
A bilingual interdisciplinary journal 33
Economic freedom, reforms and
entrepreneurship in Georgia
Pavol Minárik, Marek Vokoun, Alena Zemplinerová1
Abstract
The role of entrepreneurship is recognized in economic theory as well as in economic policies,
particularly in post-communist countries. This paper examines environment for small
and medium enterprises in Georgia, a country that is highly ranked for its institutional
environment. In a survey of local stakeholders we have confirmed that institutions are not
the major obstacle for Georgian entrepreneurs. However, we have discovered additional obstacles
responsible for the hindrance of entrepreneurship in Georgia, particularly difficult
access to finance and adequate human capital.
Keywords
Economic freedom, transition, entrepreneurship, Georgia
1	 All authors are from the Department of Economics and Management, Cevro Institute College, Prague, Czech
Republic. Correspondence shall be directed to Pavol Minárik, email: pavol.minarik@vsci.cz.
	 This paper has been prepared within the project “Transfer of know-how for small and mid-size businesses”
financed by the International Visegrad Fund (IVF) and the USAID. Support of both institutions is gratefully
acknowledged. Authors have also benefited from cooperation with the CASE-Georgia and the International
School of Economics at the Tbilisi State University (ISET), in particular with Lasha Labadze, Irakli Galdava
and Maya Grigolia.
New Perspectives on Political Economy34
1. Introduction
Entrepreneurship is the cornerstone of economic development. Austrian economists have
recognized this fact for a long time and it is also accepted among other mainstream economists.
Reforms in many post-communist countries have aimed at restoration of institutional
conditions in which entrepreneurship can flourish. Of all the post-Soviet transition economies
Georgia is often cited among the most successful. Although this assertion holds some
credibility, caution should be advised as to not overestimate Georgian advances.
Georgia’s economy still faces many problems. Even with the successful reforms of past
decades, a considerable portion of the population faces economic hardship. There are aspects
of the institutional environment that have made significant improvements, but various
problems remain. In this paper, we explore the benefits of the Georgian reforms in contrast
to their shortcomings.
This paper combines the knowledge from publicly available sources with our own data
from local stakeholders. Among these we have not only included entrepreneurs who are the
usual target of surveys but other representatives of Georgian society as well. This diverse
dataset highlights a unique contrast between the typically bright picture portrayed by various
indices and reports, and the reality experienced by local actors.
The paper is organized in the following manner: Part 2 summarizes theoretical concepts
regarding entrepreneurship and institutional environment; Part 3 briefly outlines economic
development in Georgia over past decades; Part 4 outlines improvements to Georgia’s institutional
environment as measured by different indices reflecting the quality of institutions;
Part 5 presents our findings from local stakeholders; Part 6 concludes our findings.
2. Entrepreneurship, institutions and economic growth
Since the famous contributions to the understanding of market economies by Israel Kirzner’s
1997 “How Markets Work: Disequilibrium, Entrepreneurship and Discovery,” the role
of entrepreneurship in market economies is hard to overlook. For these purposes, however,
merely acknowledging the importance of entrepreneurship will not suffice; more is needed
to gain a better understanding of the current entrepreneurial situation in Georgia. Persistent
research has successfully identified influential factors key to the decision making of
individuals in regards to the engagement of entrepreneurial activities. An overview of these
factors is discussed in the following paragraphs succeeded by a breakdown of the institutional
environment.
It is important to understand that several methods can be utilized to better understand
the determinants of entrepreneurship. The first of which used in our analysis was one developed
by Audretsch, Grilo and Thurik in 2007, which distinguishes the demand for entrepreneurship
as well as the supply side of entrepreneurship. In regards to the demand for entrepreneurship,
factors such as technology developments, demand shifts and resource availability
A bilingual interdisciplinary journal 35
help create business opportunities. Typically, incumbent businesses or potential new firms
(latent entrepreneurs) are the first to capitalize on such determinants. Alternatively, the
supply curve of entrepreneurship is subject to the abilities, resources, preferences and attitudes
of a given population; factors that heavily depend on demographics and culture. Thus,
in this instance the intersection of supply and demand reflects the decisions of individuals
to either pursue entrepreneurial opportunities or the available alternatives, such as outside
employment or unemployment.
A decomposition into individual factors, like the ones mentioned above, allows us to
determine which types of interventions have effects on which types of determinants of
entrepreneurship. The framework provided by Audretsch, Grilo and Thurik (2007) also
explores potential consequences of public intervention. For example, public interventions
can potentially influence the demand, the type, the quantity and even accessibility for entrepreneurial
opportunities. There are a plethora of examples where public outcry has ceased
important research and development, which otherwise likely would have yielded important
technological advancements. In addition to the effects of public intervention on the determinants
of demand, determinants of supply are also subject to public interference. For
example, population policies (particularly policies related to migration) can greatly affect
the preferences and/or attitudes of a population.
Alternatively, the supply of entrepreneurship may actually benefit from interventions.
Primarily, public interventions can improve the abilities and resources available to potential
entrepreneurs. These improvements are reflected both in material resources [typically
understood as access to finance or financial capital], and the knowledge and skills of people
(human capital). Further interventions may be directed towards changing the attitudes
regarding entrepreneurship as an alternative to employment. Although these attitudes and
risk preferences are embedded in culture and difficult to change as a result, they may respond
positively to increased education and media coverage on the topic of entrepreneur-
ship.
Another set of public interventions affects the choice between entrepreneurship and
(un)employment. Different policies regarding taxation, the regulation of businesses and labor
markets, unemployment benefits, bankruptcy laws, etc., can have crucial impacts on the
choices of individuals. On the demand side, public policy also determines whether or not
new entrepreneurs, rather than incumbents, would use new market opportunities. Competition
policy plays an important role in this respect, as well as the protection of intellectual
property and the regulation of the business establishment.
We may produce yet another classification of problems and obstacles to SMEs development
based on the problems’ source. The two principal sources are inadequate environment
for entrepreneurs and inadequate resources, both material and immaterial. The
environment is composed of many different aspects. It comprises political stability, legal
framework for entrepreneurship (particularly property rights and contract law), taxation,
regulation and law enforcement (including impartial judiciary and corruption).
Availability of resources may limit entrepreneurship even when the environment is perfect.
Regarding material resources, the chief limitation is typically access to finance and the cost of
New Perspectives on Political Economy36
credit, if accessible. Additional limitations stem from the availability of required skills, both
of the aspiring entrepreneur and the necessary workforce. Finally, inadequate information
might restrict entrepreneurship: information about the market opportunities (domestic and
foreign), financing options, regulatory environment, etc. Ignorance of market opportunities or
insufficient skills to expand into new markets decreases the de facto size of the market.
The different shortcomings of each environment and each market call for different interventions.
The general policy regarding the environment shall provide a “level playing field”
for entrepreneurship; that is, equal conditions for all entrepreneurs. Further measures shall
address particular market failures. In line with the “level playing field” idea, competition
policy attempts to prevent excessive market power. Asymmetry of information is another
source of market failure; it is particularly pronounced in the credit market. Finally, various
positive externalities are connected to entrepreneurship, especially their contributions to
innovation, productivity growth, product diversity and job creation. Without public intervention
the production connected with such externalities may be suboptimal.
This paper focuses on the institutions as the key determinant of entrepreneurial activity.
The impact of the institutional environment on other economic variables is now widely
recognized among economists. Limitations of choice faced by individuals include those
that are not only physical in nature, but also man-made intangible constraints. Thus, the
framework for economic activity is formed by a combination of scarce productive resources
and institutions that limit their use in different ways.
Following Aoki (2001), we may distinguish three views of institutions based on gametheoretic
perspective. First, institutions may be viewed as they are in daily conversation,
as prominent organizations (i.e. as players of the game). Second, following North (1990),
institutions are viewed as the rules of the game, distinct from the players. As put by North:
“Institutions are the rules of the game in a society or, more formally, are the humanly devised
constraints that shape human interaction.”(North, 1990, p. 3)
There are two types of rules in the game: formal ones (constitutional, property rights,
contract law) and informal ones (norms and customs). The key issue with establishing the
institutions as the rules of the game is their enforceability. While the formal rules may be
transferable from country to country, the informal rules are more resilient. Thus, borrowed
institutions may be neither enforceable nor functional. Including the issue of enforcement
and the enforcer’s motivation into the analysis leads to the third view of institutions. As
put by Aoki (2001, p. 2), “[t]he most reasonable way of approaching institutions from this
perspective is then to conceptualize an institution as an equilibrium outcome of the game.”
In the end, however, “[a] proper formulation of a concept, such as that of institutions, may
depend on the purpose of the analysis.” (ibid.)
For these purposes, we understand institutions as the rules of the game. Enforcement
of these rules is viewed as their characteristics (qualities).2
Defining institutions as the
2	 Following another definition by North (1988, p. 4): “Institutions are rules, enforcement characteristics of
rules, and norms of behaviour that structure repeated human interaction.”
A bilingual interdisciplinary journal 37
rules of the game still leaves us with a great selection of different measures. There are
many different rules that govern life in a society. As we mentioned above, there are formal
rules, best represented by constitutions and statutory laws, but also binding court decisions
(precedents) and such. Furthermore, there are different informal rules, ranging from wellknown
and well-described conventions to obscure customs having the nature of Hayekian
tacit knowledge. As for enforcement, methods range from self-enforcement to enforcement
by the power of state.3
In the following analysis we focus on several broad categories of institutions affecting entrepreneurship,
particularly the rules related to property rights and contracts. These seem
to have the most direct effect on economic activity. Property rights generally define who has
the decision-making authority over use of particular assets. Limits to contractual freedom
put restrictions on which property rights can be traded among individuals and under what
conditions. We examine the impact of various settings on economic performance below.
Finally, we explore the importance of process law. It determines the quality (especially the
cost) of enforcement. As we have defined enforcement of particular rules as one of the
characteristics of those rules, we will not deal with process law further, and we consider it
subsumed in the quality of property-rights and contract rules.
The term “property rights” stands for a complexity of rights; each of which represents a
different aspect of property ownership. Among these rights is the right to use an asset, the
right to exclude others from using it, and the right to transfer the asset to others. Property
rights allow the owner to determine the uses of the asset and to derive value from the asset
(Anderson & Huggins, 2003). The notion of property rights allows us to better interpret
property and government intervention. In fact, nominal ownership may be incomplete;
i.e. the owner may not have all the property rights. For example, if there is a requirement
to obtain a license for particular use of an asset, part of the property rights belongs to the
government, who can decide whether the asset can be used and the manner in which it can
be used.
Well-defined property rights affect economic activity in two ways. First, they are a solution
for the tragedy of the commons, and second, they provide, or rather promote, incentives
for savings and investments. Both of these outcomes originate from clearly defined
and protected property rights that establish precisely who has the right to use an asset and
derive benefits from it, or – otherwise stated – to exclude others from using it. The combination
of open access and scarcity results in conflict and/or destruction of the scarce resource
in the well-known “tragedy of the commons.” If a society fails to develop a solution, either
by establishing private property or some form of communal property governance, the effects
are grave.4
3	 For details see Voigt (2002, chapter 1).
4	 More on this subject can be found in Eggertsson (2003), or the chapter 2 in Anderson and McChesney
(2003).
New Perspectives on Political Economy38
Moreover, well-defined and enforced property rights encourage investments. In a free
access setting, everyone is motivated to maximize present use of a resource. However, if the
future revenue from investment is guaranteed to the owner, he has an incentive to maximize
the present value of future returns. Therefore, he is willing not only to economize on scarce
natural resources, but also make improvements to enhance their productivity. Overall benefit
to economic welfare is thus enhanced.
After the rather lengthy discussion of property rights, let us add a short remark on
contractual freedom. It is generally assumed in economic theory that voluntary exchange
increases welfare of both trading parties.5
Therefore, it is the role of institutions to facilitate
exchange by decreasing transaction cost. However, some rules are specifically designed to
increase transaction costs and to limit contractual freedoms. These rules may follow some
social purpose other than maximization of welfare to contractual parties, e.g. the elimination
of some kind of externalities or the enforcement of moral principles.6
Generally, high
transaction costs caused by government regulation or insufficient contract enforcement,
discourages specialization and division of labor, and ultimately slows down economic de-
velopment.
Economic growth and development is significantly dependent on the institutional environment.
Generally, institutions work to reduce strategic uncertainty naturally involved
in all interactions among people. In other words, institutions do reduce transaction costs.
As a result, the number of transactions increases, allowing division of labor and greater
specialization in society. As pointed out by Adam Smith, division of labor is the key to
economic growth.
Furthermore, this analysis focuses mainly on formal institutions (i.e. institutions enforced
by the state). North (1988, p. 7) points out “a critical and neglected aspect of economic
history: the essential role of third party enforcement of contracts for human economic
progress.” As opposed to personal exchange that solves the problems of contract
fulfillment by repeated dealings and a network of social interaction, modern societies must
rely on different institutional settings.
Therefore, formal institutions and government performance in general are important
elements of economic development. As noted further by North “while third party enforcement
is far from perfect, there are vast differences in the relative certainty and effectiveness
of contract enforcement, temporally over the past five centuries in the Western world, and
more currently between modern Western and third world countries” (ibid.). It is precisely
these differences and their impact on productivity that is the subject of present research, as
Georgia’s transition is characterized primarily by the adoption of Western institutions and
the Western mode of enforcement.
5	 Abstracting from various discussions on rationality, ex-ante and ex-post utility and exchange between persons
with limited capacity.
6	 Examples may include drug prohibition, occupational safety and health regulation, prohibition or regulation
of Sunday shopping, production and sale of pornography, etc.
A bilingual interdisciplinary journal 39
3. Institutional development in Georgia
Georgia has a small open economy that transformed from a Soviet-type economy to a modern
market economy. For the Georgian transition, weakened by military conflicts, the role of
the International Monetary Fund (IMF) and other institutions such as the World Bank and
the European Union was crucial. The IMF helped coordinate the transformation process
(Papava, 2003). As a result there were important achievements in the 1990s: A new financial
system with national and commercial banks was established: hyperinflation was curbed, price
liberalization began, the privatization of state banks was completed, Parliament was approving
the national budget, foreign trade was liberated, foreign debt was restructured, and Georgia
became a country capable of paying its debts. In 1993 Georgia withdrew from the ruble
zone and introduced a national currency in 1995. In the same year, prices were liberalized and
privatization began. Although this was an economically efficient solution, it also led to much
confusion. More than 90% of retail turnover was private by 1997, and 11.5 thousand small
businesses (with less than 50 employees) had been privatized mainly by insider sales by the
next year. The energy industry had unbundled and was privatized in 1998, followed by other
industries including land, water supply, ports and telecommunications.
In general, economists do not possess a universal blueprint that can successfully transform
a communist economy into a competitive market economy with limited government.
Traditionally, the transformation process in post-communist countries includes an establishment
of political and market competition; that is, it removes the previous authoritarian
regime and initiates the deregulation and trade liberalization, which leads to massive
structural and institutional changes and a new market orientation. These reforms require
countrywide support for the new regime, which includes national elites and new regional
leaders. Transparent cooperation without corruption and rent-seeking behavior is necessary.
According to Gould and Sickner (2008), this was not the case in Georgia, where
corruption and rent seeking was common practice among economic and political agents.
The support of regional and national elites was very limited up to the Saakashvili reforms.
Nonetheless, the Georgian economy saw significant growth over the last decade. From
2003 until the financial crises the average growth rate was 9.3 percent. Georgia experienced
a setback, however, due to the coinciding financial crisis and armed conflict with Russia in
2008. In 2009 the growth declined to −4.0 percent. Despite achievements in the last decade,
Georgia still remains in an unstable macroeconomic environment majorly impacted
by political challenges. It suffers from a high unemployment rate and low income for most
of its population.
4. Measuring institutional change in Georgia
The key problems of institutional analysis are measurement and quantification. In this paper
we use different indices that reflect quality of institutions in Georgia and its changes
New Perspectives on Political Economy40
in time. These indices reflect different aspects of institutional environment. Altogether
they show a positive image of Georgian institutional development – a picture that Georgia
proudly presents to the outsiders.
The Economic Freedom of the World project conducted by the Fraser Institute produces
annual reports of economic freedom around the world. The index measures the degree to
which the policies and institutions in different countries are supportive of economic free-
dom – defined as “personal choice, voluntary exchange, freedom to enter markets and compete,
and security of the person and privately owned property” (Gwartney, Lawson, and Hall,
2014, p. v). The chief components include the size of the government (expenditures, taxes,
and enterprises), the legal structure and security of property rights, access to sound money,
the freedom to trade internationally, and the regulation of credit, labor, and business.
In the latest report that reflects the situation of 2012 (Gwartney, Lawson, and Hall,
2014), Georgia was ranked as the 16th
economically freest country in the world. It excels
mainly in the field of international trade (eighth in the world), business regulation (ninth)
and credit market regulation (14th
). The index does not allow tracking institutional change
far back, as complete data for Georgia are only available since 2004. However, it is fair to
say that Georgia was a free country in that year and its ratings have improved even further
since then.
The Heritage Foundation and the Wall Street Journal publish the Index of Economic
Freedom jointly. It defines economic freedom as “the fundamental right of every human to
control his or her own labor and property“ (Heritage Foundation 2015). The index is based
on 10 quantitative and qualitative factors reflecting four broad categories of economic freedom:
the rule of law (property rights, freedom from corruption), limited government (fiscal
freedom, government spending), regulatory efficiency (business freedom, labor freedom,
monetary freedom), and open markets (trade freedom, investment freedom, and financial
freedom). Thus, the approach roughly corresponds to that of the Fraser Institute’s Economic
Freedom of the World project – although, it should be noted that the data sources
and evaluations somewhat differ.
In the latest report (Heritage 2015), Georgia is ranked as the 22nd
economically freest
country in the world. It is highly rated in trade (seventh in the world) and business (16th
)
freedom, as well as monetary freedom (22nd
), which combined mean stable currency for
Georgia. The index also allows tracking institutional improvements in Georgia since 1996.
The Georgian economy has improved from controlled (rating 44.1 out of 100) to one of the
freest economies in the world (the latest rating is 73.0). The world average over the same
period has changed from 57.1 to 60.4: Georgia has significantly outperformed the world in
this respect.
The Global Competitiveness Report published by the World Economic Forum (2014)
evaluates different aspects of an economy’s competitiveness. Out of twelve pillars of competitiveness,
as defined in this evaluation, institutions are the first and they are included
among the most basic requirements of competitiveness. The Global Competitiveness Index
allows for cross-country comparison over several criteria – although due to the infancy of
the index it does not allow for comparison over time.
A bilingual interdisciplinary journal 41
Georgia’s overall performance as measured by the Global Competitiveness Index is 4.2
out of 7, which ranks Georgia 72nd in the world. The score has improved even further in
recent years. Institutions are among the relatively best components of Georgia’s score; the
score of 4.0 out of 7 places Georgia at the 64th place in the world. According to the Global
Competitiveness Report (2014) major obstacles to conducting business include access to
financing, inadequately educated workforce, poor work ethic among national labor forces,
and policy instability. The latter two problems are basically institutional, although they are
not easily solved by economic policy.
The Doing Business survey by the World Bank (2015) presents a rather different picture
of Georgia. The survey focuses on 11 areas that affect the ease of doing business: starting
a business, dealing with construction permits, getting electricity, registering property, getting
credit, protecting minority investors, paying taxes, trading across borders, enforcing
contracts, resolving insolvency, and labor market regulation (not included in 2015 edition).
Georgia is ranked as the 15th best country in the world for doing business. In several
components it has received even better rankings: starting a business (5th), dealing with
construction permits (3rd), registering property (1st) and getting credit (7th). Georgia’s
institutional performance has continuously improved over the past decade according to the
Doing Business survey and it appears to be one of the best places in the world to start and
conduct a business.
5. Persistent hindrances to entrepreneurship in Georgia
Economic performance of Georgia does not conform to the bright picture portrayed by
several indices presented above. There are manifold obstacles that prevent the Georgian
economy from achieving higher outputs. We present findings from our survey of Georgian
stakeholders that point to certain problems hindering entrepreneurship in Georgia.
Georgian small and medium enterprises have a lower share of employment and output
in comparison to developed European countries. Papiashvili and Chiloglu (2012: 22) show
that “there is a set of macro factors (for example, unstable legal environment, low purchasing
power of the population, lack of qualified human resources, lack of market information,
etc.) and micro factors (such as low coordination between organizations supporting the
SME’s, lack of proper marketing and managerial skills, uncompetitive products, and the
like) that still brake the development of the SME sector in Georgia.” It is an important task
in economic policy to identify and address these problems.
5.1. Findings from a uniform questionnaire
In our research project a uniform questionnaire was prepared and sent out to various stakeholders
and experts. To help the respondents, the questionnaire was translated and distributed
both in English and Georgian. The selected group included 13 respondents. In the
first part of the questionnaire template respondents were asked to evaluate to what extent
New Perspectives on Political Economy42
the factors listed were impeding the development and activities of the SMEs in the country.
On a scale from 1 to 4, 1 represented “not at all”, 2 represented “somewhat”, 3 represented
“significantly”, and 4 represented “very significantly.” An NA option was provided in case
the respondent did not know.
Parallel to this exercise, respondents were asked to mark “help” in case they thought that
an intervention would be advised and welcomed.7
Some respondents marked “help” parallel
to giving a number from 1 to 4, thus signaling the importance of the given topic. Other
respondents understood “help” as the way of expressing that the issue was of crucial importance
and policy recommendations and knowledge transfer were most welcome regarding
the given issue; they marked only marked “help” instead of giving a value from 1 to 4. We
coded these responses as 4.
The questions targeted six domains relevant to the development and daily activities of
SMEs. The main domains were: Labor and skills, Red tape/bureaucracy, Tax burdens, Law
and order, Market specificities, Finance and other issues. Statistics on survey responses are
summarized in the Appendix.
Evaluations of the Georgian institutional environment in various indices presented above
are generally confirmed by our survey. As we expected, red tape and bureaucracy domain was
considered to be the least important problem for the Georgian small and medium enterprises
(SMEs). Similarly, the taxation system did not seem to be a major source of difficulty – although,
some point to frequent changes and certain ambiguities (e.g., Kuriakose 2013). Regarding
the rule of law, survey respondents cited weak property rights and weak judiciary as
problematic areas. Again, this confirms the existing information on the situation in Georgia.
The most impeding factors identified by our respondents were within the domains of labor
and skills, and market and finance. In the first domain, respondents cited low market skills
of entrepreneurs and lack of business experience. Low availability of high skilled workers
was another problem in this area that hinders the development of businesses in Georgia. In
the market domain, the most impeding factors were weak market position of SMEs, which
could be linked with the excessive market power of some of the companies, and perhaps also
linked weakly to unfair competition and weak SME organizations. Furthermore, respondents
pointed to political and macroeconomic instability and barriers for exports.
To sum up, the problems for enterprises in Georgia are not dominantly institutional.
However, the situation is not very favorable for Georgian entrepreneurs. Among the institutional
problems political instability is perhaps the most serious. Otherwise, entrepreneurs
face problems with regards to resources, both human and material. In this respect, our findings
are in line with previous observations from the literature.
Political stability is an important factor in the entrepreneurship environment. This may
be especially important for foreign trade partners and potential investors. In this respect,
the recent history does not provide a very optimistic picture of Georgia. Political instability
7	 Our research was part of a larger project seeking to provide suggestions for interventions in SME policies in
cooperation between Visegrad countries and Georgia, Moldavia and Ukraine.
A bilingual interdisciplinary journal 43
is cited as the main obstacle by representatives of small, medium and large firms in Georgia
(World Bank 2013). However, the political situation and international relations can hardly
be seen as a possible target of entrepreneurship policies. Regardless, we shall be mindful of
these limitations within the environment for the activities of the SMEs. Also, the image of
a country vis-à-vis (potential) foreign business partners can be improved in a planned and
coordinated manner.
Unlike the institutional environment, the availability of resources is not very favorable
for entrepreneurship in Georgia. This is true both for material and immaterial resources.
Existing literature as well as our survey point to problematic access to finance, inadequate
skills of entrepreneurs and labor force, and insufficient information among SMEs. Our
survey confirms that access to finance is an important domain to be addressed by public
interventions. Respondents pointed to difficulties in accessing financial services and high
cost of credit. Help in this area is needed to overcome the existing problems.
Inadequate skills are also cited as a problem both in previous studies and our survey. The
World Bank report (Kuriakose 2013) lists “difficulty recruiting highly skilled employees”
among the most frequently cited obstacle to SME’s development and recommends reforms
to education systems. The World Economic Forum’s 2013 Global Competitiveness Report
ranks this issue as the second most important (access to finance being the first). In our survey,
respondents point to low skill or education of entrepreneurs, lack of experience as well
as low availability of high skill workers. Low labor market flexibility and lack of language
skills are also rated as significant.
Finally, there is a major issue concerning information of business opportunities, especially
concerning foreign trade. The size of the market is assessed as one of the weakest points of
Georgian economy in the World Economic Forum’s 2013 Global Competitiveness Report.
Expansion of exports requires specific skills and information on potential foreign partners
that are obviously scarce in Georgia. In our survey, lack of experience in foreign trade, particularly
with the EU, and lack of knowledge of EU regulations (coupled with institutional
differences with the EU) is marked as a significant problem that requires intervention. Lack of
language skills and contacts abroad is also considered as a somewhat serious problem among
our respondents, as well as foreign barriers to trade (although these are not specified). Finally,
our respondents point to lack of open communication channels with the EU.
5.2. Interviews with selected stakeholders
Interviews with stakeholders shed some light on the actual state of the Georgian economy
and revealed some serious problems. All interviews were carried out in Tbilisi in February
2014. We conducted 12 interviews, which took approximately an hour each. We interviewed
major public and private institutions dealing with SMEs and SME administration. The goal
of these interviews was to provide a first-hand experience and gain additional insight to the
Georgian economy. In other words, we wanted to unravel issues and possibly even expose
informal institutions, which are usually not visible to foreigners.
Many respondents described the problems mentioned above such as the lack of skilled
personnel, high collateral for SME loans and general lack of awareness about publicly
New Perspectives on Political Economy44
funded projects. However, we identified three additional major issues in the health sector,
banking sector and the system of public procurement.
One of the respondents described issues regarding the health sector and the establishment
of a non-profit, non-governmental organization (NGO). For an NGO it was problematic
to become registered and established in the 1990s. Later, a tax for NGOs was
introduced that destabilized this sector in Georgia. This tax led to salary cuts for the most
qualified workers, coincidentally the most difficult to find. In the health sector there have
been radical changes in nearly every political cycle since the 1990s. This has led to underinvestment
in the sector. Investors are very cautious when it comes to long-term investment
in the Georgian health-care sector because their predecessors were heavily indebted and
often went bankrupt.
Another respondent described issues in regards to the banking sector. Leasing officers
use the same restrictive approach to SMEs as their colleagues from the loan departments.
This makes both financial and operational leasing an inaccessible alternative to the problematic
loans. Moreover, we were informed that loan officers do not honor the secrecy of
business projects. However, we were not able to verify this statement because all major
banks in Tbilisi rejected our requests to meet and discuss the SME agenda and related issues
in the banking sector.
Yet another respondent stated that there were issues in the very modern and transparent
electronic system of public procurement. According to the respondent, large companies predominantly
control it and there are barriers for SMEs. The procurement specifications lack
more categories to ensure quality and they are tailored to the needs of large companies. Also
services such as catering and cleaning are secured and provided by internal sources from the
public sector. These services could be outsourced to SMEs. As we have stated above, large
companies are perceived as dominant in Georgia. However, Georgian ministries and statistical
office do not have the exact numbers of SMEs and large companies according the European
definition of enterprise categories, so the actual ratio is difficult to verify.
6. Conclusion
The institutional environment is undoubtedly an important factor affecting entrepreneurship
and economic progress. Post-communist countries have undergone a profound institutional
change in quest for institutions better suited for a market economy. Some countries
have been quite successful while others struggle. Georgia presents an interesting case in this
respect – some reforms work well and put Georgia on top in country ratings, while some
areas remain problematic.
Our survey aimed to achieve a perspective on Georgian economy that is different from
what is presented by existing surveys of institutional or business environment. Local stakeholders
point to certain hindrances to the rapid economic growth of Georgia. Predominantly,
however, these are not concerned with institutions. In fact, the institutional envi-
A bilingual interdisciplinary journal 45
ronment – with the unfortunate exception of political stability – is quite favorable. The
most important shortcomings are in the area of resources, both human and material. The
experience of Georgia highlights an important fact: although institutions do matter, they
are merely a part of the necessary infrastructure for economic development.
In the following years, political, economic and institutional development of Georgia will
be significantly affected by its cooperation with the European Union. The relations with the
EU present both opportunities and threats. The regulatory framework of the EU that will
be transplanted to Georgia may reduce some of the economic freedom developed by Georgians.
On the other hand, however, the cooperation with European countries presents vast
opportunities for enlarged markets; that is, both an increase in the potential demand and
the potential supply of resources in Georgia – including finance. Furthermore, European
countries could share some of the good practices in governance with Georgia. Improvements
to governance capacity combined with sound law on the books could improve the
Georgian economy even further.
References
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Prosperity. Stanford, CA: Hoover Press.
Anderson, T. L., McChesney F. S. (2003) Property Rights: Cooperation, conflict, and law.
Princeton: Princeton University.
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Press.
Audretsch, D. B., Grilo, I., Thurik. A. R. (2007) Handbook of Research on Entrepreneurship
Policy. Cheltenham, UK: Edward Elgar Publishing.
Eggertsson, T. (2003) “Open Access versus Common Property”, in T. L. Anderson, F. S.
McChesney (eds.), Property rights: Cooperation, conflict, and law. Princeton: Princeton
University, pp. 73–89.
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of post-privatization elites in Azerbaijan, Georgia and Serbia”, Review of International
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The Institute for Economic Affairs.
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Kuriakose, S. (2013) Fostering entrepreneurship in Georgia (No. 80673), The World Bank.
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ing-entrepreneurship-georgia
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http://www.enterprisesurveys.org/Data/ExploreEconomies/2013/georgia
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Edition. Geneva: World Economic Forum.
Appendix
Georgian experts’ survey results
Labour and Skills domain
1 Domain/Obstacle
M e a n
value
SE Obs.
A
Low market skills of entrepreneurs / Inadequate business
education
3.31 0.21* 13
B Lack of business experience 3.00 0.28 13
C Lack of experience in foreign trade, in EU in particular 2.54 0.18* 13
D Lack of knowledge of EU regulations 2.69 0.24* 13
E Lack of language skills and contacts abroad 2.69 0.24* 13
F Low availability of high skill workers 3.00 0.25 13
G Low availability of low-skill workers 2.08 0.14* 13
H
Demographics / low number of young labour market
entrants
2.15 0.25* 13
I High emigration 2.54 0.24* 13
A bilingual interdisciplinary journal 47
J
Expensive labour / Mismatch between labour cost and
productivity
2.31 0.29 13
K Employer-employee conflicts 2.00 0.25 13
L Low labour market flexibility 2.77 0.23* 13
M
High syndicalization / Excessive power of labour un-
ions
1.62 0.31 13
N Low labour ethics 2.54 0.18* 13
O Low business ethics 2.85 0.19* 13
1 Labour & Skills 2.54 0.23* 13
*) Mean value significant at 5 %
Red Tape and Bureaucracy domain
2 Domain/Obstacle
M e a n
value
SE Obs.
A Difficulties in registering company 1.25 0.25 12
B High cost of market entry 2.18 0.30 11
C
Difficulties to expand business activities / bureaucratic
obstacles
1.75 0.25 12
D Non-transparent / inconsistent regulations 2.00 0.16* 13
E
Poor overall regulatory framework / Excessive burden
of regulations
1.92 0.19* 12
F Foreign trade barriers 2.92 0.23* 12
G Institutional differences with EU 2.83 0.30 12
2 Red Tape /Bureaucracy 2.12 0.24 12.00
*) Mean value significant at 5 %
Tax burden domain
3 Domain/Obstacle
M e a n
value
SE Obs.
A
Unstable and non-transparent tax rules and/or their
applications
2.33 0.22* 12
B High cost of compliance 2.25 0.18* 12
C High effective SME presumptive tax rates 2.11 0.11* 9
D High effective personal income tax rates 2.33 0.26 12
E High effective corporate income tax rates 1.90 0.28 10
F High effective value added tax / trade tax rates 2.36 0.31 11
G High custom charges 1.91 0.25 11
H Other high taxes and fiscal fees/charges 1.89 0.35 9
3 Tax burden 2.14 0.25 10.75
*) Mean value significant at 5 %
New Perspectives on Political Economy48
Law and order domain
4 Domain/Obstacle
M e a n
value
SE Obs.
A Weak property rights / weak contract enforcement 2.69 0.26 13
B Crime and violence (low safety) 1.58 0.23* 12
C Corruption / Clientelism / Favouritism 1.83 0.27 12
D Weak judiciary 2.77 0.26 13
4 Law and order 2.22 0.25 12.5
*) Mean value significant at 5 %
Market domain
5 Domain/Obstacle
M e a n
value
SE Obs.
A Small market size / Weak demand 3.23 0.28 13
B Barriers for exports to foreign markets 3.15 0.19* 13
C
Unfair competition / Uneven playing field / Informal
economy
2.58 0.19* 12
D
Monopolization / Excessive market power of some
participants
3.00 0.23* 13
E Weak market position of SMEs 3.38 0.14* 13
F Weak professional organizations of SMEs 2.92 0.18* 13
G
Weak analytical and policy advocacy of SME organiza-
tions
3.25 0.13* 12
H Discriminatory practices of authorities 2.00 0.17* 12
I Unfair privileges for foreign investors 1.75 0.18* 12
J
Macroeconomic instability (demand, inflation, exchange
rate)
2.92 0.21* 13
K Political instability 3.00 0.23* 13
L
Insufficient market information/governmental support
for SMEs
2.92 0.23* 12
M
Weak support/lack of support by international organi-
zations
2.42 0.19* 12
N Low level of activities of venture capital 3.25 0.25 12
5 Market 3.03 0.20* 12.5
*) Mean value significant at 5 %
Finance and Other domain
6 Domain/Obstacle
M e a n
value
SE Obs.
A Difficulties in accessing financial services 3.15 0.27 13
B High cost of credit 3.31 0.24* 13
A bilingual interdisciplinary journal 49
C Inappropriate infrastructure 2.45 0.25 11
D Weak professional organizations of SMEs 2.75 0.18* 12
E
Difficult access to internet / Lack or low quality of
business websites
2.50 0.23* 12
F Lack of open communication channels with EU 3.00 0.19* 11
6 Finance and other 2.86 0.23* 12
*) Mean value significant at 5 %
New Perspectives on Political Economy50
Book Review
Does economic thought always reflect history? A book review
of The Economic Clashes of the Last Hundred Years by Larry H.
White, 2012. Cambridge University Press, 440 p
Is L.H. White’s book, The Economic Clashes of the Last Hundred Years (2012), a modern
text book of the history of economic thought? Kuhn (1970) argues that scientific development
is a matter of the competition between theoretical paradigms. Coase (1994) applies
this argument on the development of the economic theory. White (2012) tries to illustrate
this argument on the development of economic theory of the last hundred years. In my
opinion, this is how modern and advanced text books of the history of economic thought
might be written.
The fact is that since Schumpeter’s History of Economic Analysis (1994) a few quality
historical illuminations of the development of economic analysis were written. Even though
Schumpeter’s History of Economic Analysis (1994) is not a text book, almost all modern textbooks
of the history of economic thought uses it at least as a source of very valuable facts.
The point, however, is that this monumental opus ends with marginal revolution. Development
of the history of economic analysis after marginal revolution in such a large format
was not written yet. For this reason, we must appreciate all attempts to cover the history of
economic thought after marginal revolution. In Europe, a lot of very good economists were
trained in the history of economic thought. Advanced history of economic thought text
books thus significantly contributed to development of the profession. As Kuhn explains:
Textbooks thus begin by truncating the scientist’s sense of his discipline’s history and then
proceed to supply a substitute for what they have eliminated. Characteristically, textbooks of
science contain just a bit of history, either in an introductory chapter or, more often, in scattered
references to the great lessons of an earlier age. From such references both students and
professionals come to feel like participants in a long-standing historical tradition. Yet, the textbook
derived tradition in which scientists come to sense their participation is one that, in fact,
never existed. For reasons that are both obvious and highly functional, science textbooks (and
too many of the older histories of science) refer only to that part of the work of past scientists
that can easily be viewed as contributions to the statement and solution of the text’s paradigm
problems. Partly by selection and partly by distortion, the scientists of earlier ages are implicitly
represented as having worked upon the same set of fixed problems and in accordance with the
same set of fixed canons that the most recent revolution in scientific theory and method has
made seem scientific. No wonder that textbooks and the historical tradition they imply have to
be rewritten after each scientific revolution. And no wonder that, as they are rewritten, science
once again comes to seem largely cumulative. (Kuhn 1970, p. 137–138)
A bilingual interdisciplinary journal 51
What is the difference between history of economic analysis and Professor White’s history
of economic thought book? White (2012) does not describe, explain and classify theoretical
apparatuses in detail; he rather tries to cover the theoretical development within
the context of overall historical, political and economical circumstances and with its public
policy implications and their consequences. A lot of arguments on the context of the
historical development of certain theoretical apparatuses, explaining their relevance and
generality like for instance in the case of lord Keynes’ General Theory, were offered. White
(2012), aware of the fact that economic theories are usually developed by humans for humans
living at certain places and in certain time periods, gives us interesting insight into
the context of developing certain economic theories with their applications and with their
application’s consequences. This is why Professor White’s book gives us very good overall
coverage for history of economic thought courses. In this spirit, Professor White quotes
Keynes’ statement:
The ideas of economists and political philosophers, both when they are right and when they
are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little
else. Practical men, who believe themselves to be quite exempt from any intellectual influence,
are usually slaves of some defunct economist. Madmen in authority, who hear voices in the air,
are distilling their frenzy from some academic scribbler of a few years back. (Keynes 1963,
p. 383 according to White 2012, p. 3–4)
White (2012) introduces us into the development of economic thinking of the last hundred
years. In the first chapter Professor White offers an opposing hypothesis that economic
theories, i.e. the theory of Vilfredo Pareto, do not have any impact on practical public
policies. Even Keynesian public policies were adopted before Keynes’ General Theory publication.
Nevertheless, Professor White tries to prove Keynes’ or alternatively Hayek’s hypothesis
instead of the opposite one. Professor White introduces the reader to the several
clashes between the most influential theoretical opinions on the function of the government
with markets.
The second chapter starts with the historical description of the implementation of central
planning inspired by Marxist theory. Professor White realistically describes its economic
consequences and explains the Austrian critique. The major part of the chapter is dedicated
to the survey of the calculation debate including contributions of Ludwig von Mises, Friedrich
August von Hayek, Oskar Lange, Israel M. Kirzner, Thomas Sowell, Paul Samuelson,
William Nordhaus, and even an opinion of Joseph Alois Schumpeter. Nevertheless, Professor
White also explains the development of the theory underlining the calculation debate.
First, he starts with the assumption of the labor theory of value, and then he explains how
calculation debate developed from labor theory of value determining the costs, hence distribution
of wealth, to the general equilibrium framework invented by León Walras.
The third chapter introduces the USA boom between 1921–1929. Professor White argues
that the great depression was inevitable because there was nothing to invest in. It is not
true that Keynesian public policies were implied only by Lord Keynes’s General Theory;
Keynesian public policies were also implied by Pre-Keynesian theory. As Professor White
stands: “Keynes and his followers would find these [Pre-Keynesian] explanations lacking in
New Perspectives on Political Economy52
various respects, but it can’t accurately be said that before Keynes’ General Theory the leading
economists offered nothing.” (White 2012, 82) Then Professor White explains and compares
Austrian business cycles theoretical argumentations, which, of course, are against
Pre-Keynesian and Keynesian public policies. First the Mises’s theory of business cycle
is surveyed, then the Hayekian triangle explained. Both Mises and Hayek argued that the
cure against business cycle is free banking organization. Background theory of interest rate
offered by Eugen von Böhm-Bawerk, Knut Wicksell and Banking School is also explained.
The exposition of opinions of participants in the dispute between Keynes and Hayek and
their opinions on Hayekian public policy suggestions is, however, interesting.
The fourth chapter is dedicated to institutionalism and its influence on Fascist, Nazi
and New Deal public policies. Professor White explains the influence of J.A. Hobson, Rexford
Guy Tugwell, Simon Patten Thorstain Veblen, Clarence Ayers, John Maurice Clark,
Gardiner Means, Wesley C. Mitchell, Richard T. Ely, John Commons, Adolf A. Berle and
Frederic Winslow Taylor. After criticism of NRA and NAA New Deal public administration,
White (2012) argues that institutionalism was significantly influenced by the German
Historical School and criticizes this approach as interventionism without sound economic
theory. Moreover, White (2012) argues that American Institutionalists have similar opinions
on social organization regarding the opinions of Socialists. He proves it by explaining
the opinions of Frederic Winslow Taylor on proper social organization which are, according
to White (2012), similar to Lenin’s visions. Then Taylor’s vision is described.
The fifth chapter is the chapter which might be referred as the one most connected with
Professor White’s hypothesis. It is dedicated to the influence of General Theory of Employment,
Interest and Money and Great Depression. First Professor White introduces Keynes
explanation of the Great Depression. Lord Keyness developed the argumentation based on
inherent instability of a market economy, thus governmental intervention is, according to
Keynes, necessary. The Great Depression was a result of stopping governmental intervention.
Professor White describes Keynesian public policy and theoretical apparatus. Moreover, Professor
White also explains the difference between Keynesian macroeconomics and Hayekian
macroeconomics and thus demonstrates his expertise. Keynesian argument that the macroeconomic
system creates involuntary unemployment due to underconsuption was not original;
therefore, the dispute between Thomas Robert Malthus, Jean-Charles-Léonard Simonde
de Sismondi, David Ricardo and Jean-Baptiste Say is explained with the original Keynes argumentation.
Then modern development of Keynesian economics, including IS-LM model,
Phillips curve, Post-Keynesian economics and New Keynesian economics, is explained.
The sixth chapter starts with the story of how Nazis came to power in Germany. Interestingly:
“Hayek… viewed Nazism as an offspring of the socialist doctrines promoted by the
German Historical School…”(White 2012, p. 197) Since Nazis refused the idea of classical
liberalism, F.A. v Hayek and Walter Eucken were strongly opposing to such a system
of political and economic control. In the famous The Road to Serfdom Hayek argues that
there is no principal difference between Socialism and Nazism, because both are dictatorial
regimes necessarily suppressing personal freedoms. In the sixth chapter, Professor White
presents several arguments how the lack of classical liberalism ideology in the historical
A bilingual interdisciplinary journal 53
evolution of German economic thought caused the benevolence of the German people
to Nazism. Hayek later opposed central planning in his series of essays on the inability of
central planners to collect enough information for successful coordination of economic
activities to fill this gap, but his crucial message was hidden in the emphasis of the inability
to control dictatorial behavior weather dictators are Socialists or Nazis. This argument was
explicitly presented in The Road to Serfdom. As Professor White argues, this was the crucial
message of F.A. v Hayek that started the thinking about weak parts of democratic planning.
The seventh chapter is dedicated to thepostwar era in Great Britain. British postwar Socialism
and Fabian Society organization was highly inspired by war planning.
The general belief that a peaceful society might be similarly successfully planned like
a war economy, British politicians created an organization full of strong economic interventions.
Fabians even led the labor movement to nationalization. Professor White describes
contributions of the most important Fabians-Sidney James Webb, Beatrix Potter, George
Bernard Shaw, Harold J. Laski and William Beveridge – to nationalization, and then he
explains how these contributions were influenced by works of Henry George, Jeremy
Bentham and John Stuart Mill.
In the eighth chapter Professor White describes organization of the first Mont Pelerin
Society (MPS) conference after World War II. According to Professor White, establishment
of MPS was one of the key steps in spreading classical liberalism ideas after the WWII. Together
with the Foundation of Economic Education in New York (NY) and the Institute of
Economic Affairs in London (GB), MPS became the most prestigious classical liberalism
think tank ever. The founder of classical political economy Adam Smith provided intellectual
background for MPS activities. Adam Smith has a great intellectual influence on the
western world, but as a typical Hayekian successor, Professor White also stresses Smith’s
opposition to exclusive privilege to issue bank notes dedicated to the Bank of England
(White 2012, p. 281). Then Smith’s contribution to economic science – spontaneous order
theory, his critique of mercantilism, his opinion on the role of the government in the economic
system and his opinion on banking and finance together with David Hume’s, Adam
Ferguson’s, Physiocrat’s and Carl Menger’s contribution to economic science is explained.
The ninth chapter describes the atmosphere after WWII in Germany together with explanation
of Ordoliberalism theory. Ludwig Erhard’s shock therapy strategy for German
recovery after WWII inspired by Ordoliberalism was successful. Walter Eucken’s theoretical
concept of Ordoliberalism was inspired by a younger historical school with stronger opposition
to state interventions. Ordoliberalism rooted at Freiburg; therefore, it is sometimes
referred to as the Freiburg School. The public policy implications of Ordoliberalism might
be simply explained as creating “conditions under which the ‘invisible hand’ that Adam
Smith had described can be expected to do this work.” (White 2012, p. 324) Another great
proponent of Ordoliberalism ideas was Wilhelm Röpke. Both Walter Eucken and Wilhelm
Röpke contributed to modern competition policy and theory of rent seeking.
The tenth chapter starts with the historical introduction into political development in
India. An independent Indian state was organized in the second half of the twentieth century
in more interventionist manner than in the spirit of free market ideology. Indian or-
New Perspectives on Political Economy54
ganization was inspired by communist philosophy and Fabian pragmatism. Many Indian
economists trained at western universities were arguing that the Indian economic education
system was targeted toward stressing the necessity of governmental interventions. Even
western economists were advising more planning for India. One of those was, for instance,
John Kenneth Galbraith. First, a central plan was developed for the period from 1951 to
1956. For the second stage of central planning experts from the Soviet Union were invited.
To describe some theoretical foundations for Indian central planning Professor White introduces
Wassily Leontief. An era of slow growth in the sixties was a result of central planning
failure. This fact was stressed by Bellikoth Ragunath Sheony. This opinion was also supported
by Milton Friedman. It took several decades till Indian liberalization was discussed.
The second planning stage from 1955 to 1960 started a theoretical debate on development
economics using mathematical and econometric arguments. Peter Thomas Bauer was an
economist who contributed to development economics theoretical debate with liberalization
arguments. Modern development economics, instead of relying on neo-classical growth
models, stresses the importance of freedom and rule of law.
The eleventh chapter is dedicated to Great Inflation and Monetarism. During WWII
American monetary policy was targeted to provision for cheap credit. Such policy of FED
resulted in the Great Inflation. While Keynesian economists were not able to explain
Great Inflation, Milton Friedman succeeded with update of quantitative theory of money
or rather quantitative theory of price level. To characterize Monetarist theory, Professor
White introduces its founder Milton Friedman and some of his theoretical contributions.
Even though Milton Friedman admits Keynesian theoretical apparatus, he stands on the
quantitative theory of money and stable money demand. Another economist introduced
by Professor White is Irving Fisher. Monetarist research became mainstream in macroeconomic
research and in 1970s, it rejected the Keynesian proposition of Phillips curve slope.
It highly inspired modern macroeconomics, including New Keynesian Economics with its
original public policy suggestions. In the end of the chapter Monetarists and New Keynesian
public policies implications and their problems are described.
The twelfth chapter explains historical development toward Bretton Woods and the International
Monetary Fund. It explains Lord Keynes’s rejection of the gold standard and how
the Bretton Woods conference accepted a Keynesian view of the international monetary
system. After this historical introduction, Professor White summarizes functioning of the
gold and silver standard. He starts with David Hume’s arguments based on quantitative
theory of money and connects it with Free Banking School proposals. Then some contributions
of Nassau Senior are explained. Nassau Senior, in essence, formulates equilibrium
conditions when production together with gold or silver standard generates inflation close
to zero. According to Professor White, despite several discoveries of gold and silver supplies
in the nineteenth and twentieth century, inflation under the gold and silver standard
was still pretty low. Then “danger” of Grasham’s law is explained. A very interesting part is
also dedicated to a political discussion on bimetallism in the USA. After some discussion
of monetary regime proposals made by Alfred Marshall and Irving Fisher, Professor White
describes gold standard exchange rate functioning and with an assumption of a benevolent
A bilingual interdisciplinary journal 55
despot such as a government and central bank, he closes monetary history and debate in
the USA.
In the thirteenth chapter the growth of the government in the twentieth century from the
perspective of Public Choice is described. It begins with the famous Coase theorem debate
in Chicago which resulted in The Problem of Social Costs article published in the Journal
of Law and Economics. Then discussion on how “good” government looks is presented.
It starts with Adam Smith’s idea of small and restricted government providing national
defense, civil justice and public goods. What are public goods, how Pareto efficiency normative
benchmark evolved and what did modern public goods theory look like? Those are
question answered in this chapter. A link to the problem of externalities is provided and
a solution from the Arthur Cecil Pigou’s theoretical framework and the Ronald Coase’s
theoretical framework is explained. With the emphasis on Coasian solution, the reader is
introduced to Public Choice economic analysis.
The fourteenth chapter is dedicated to free trade, protectionism, and trade deficit. Arguments
against tariffs and import quotas are well known, thus what is the justification
for existence of organizations like GATT and WTO? Professor White provides the answer
based on Mercantilism and Public Choice theory. He explains that even Adam Smith was
able to recognize how protectionism favors special interests. Professor White describes
Adam Smith’s example of British colonialism, and classical political economists’ Corn Law
discussion illuminating absolute advantage and comparative advantage theoretical arguments.
Then almost all for protectionism theoretical arguments are presented and from the
perspective of classical political economists rejected.
The fifteenth chapter connects Milton Friedman’s argument that protectionism can lead
to higher public deficits and explains theoretical discussion behind the emergence of sovereign
debts in countries like Greece or Ireland. More generally, it presents historical insights
into evolution of the theories which provided arguments for emergence and against prevalence
of the recent European fiscal crises. Short history and some forecast of European
and American fiscal deficits are therefore described. First Professor White explains that it
was Keynesian economics that provided a rational for loosing fiscal discipline in the USA
and other countries in the world. And again, it was Adam Smith, Jean-Baptiste Say, David
Ricardo, Milton Friedman, and Friedrich August von Hayek, who provided solid arguments
against loose Keynesian fiscal discipline. Then Professor White summarizes arguments
against Alvin Hansen’s and Abba P. Lerner’s fiscal Keynesianism emphasizing the fact that
the government is in essence a violent organization spending taxes in order to maintain its
power to the expense of future generations. This is the argument precisely formulated by
James M. Buchanan. After an explanation of Ricardian equivalence, Professor White closes
with Laffer Curve, Keynesian multiplier and its criticisms.
The great contribution of White (2012) is an explanation and comparison of the development
of the most influential contributions to economic thinking written by the most
influential economists of the last hundred years. Explained and compared economic theories
are given into the context of how they influenced politicians, bureaucrats, professional
economists and the general public. Such explanation and description gives to students an
New Perspectives on Political Economy56
essential overview of the development of economic theories, which moved with real public
policies, and thus it provides them with a plastic insight into the historical and economic
development of the last hundred years through studying history of economic thought. As
White (2012) stands:
The real point of picturing intellectual activity this way, though, is to give greater concreteness
to the view that to understand economic policy change we need to understand the preceding
developments in economic ideas from pure theory on down. (White 2012, p. 7)
In my opinion, an advanced textbook on the history of economic thought does not exist
which would not be theoretically biased. I am, therefore, very happy for such an impressive
neo-Austrian overview of the modern history of economic thought.
Tomáš OTÁHAL
References
Coase, R. (1994): How should economist choose? In Essays on Economics and Economists.
Chicago (IL): The University of Chicago Press, 1994.
Kuhn, T.S. (1970): The Structure of Scientific Revolutions. Chicago: Chicago University
Press, 1970.
Schumpeter, J.A. (1994): History of Economic Analysis. New York (NY), Oxford University
Press, 1994.
White, L.H. (2012): The Economic Clashes of the Last Hundred Years. Cambridge: Cambridge
University Press, 2012.
A bilingual interdisciplinary journal 57
List of Articles
Francesca Spigarelli and Nikolai G. Wenzel: Monetary Union
without Fiscal Union? The Euro Crisis and the Move Towards
European Fiscal Union .....................................................................................5
Vladimir Khrapko: Information, Shadow Banking and Fluctuations ......... 21
Pavol Minárik, Marek Vokoun, Alena Zemplinerová: Economic freedom,
reforms and entrepreneurship in Georgia .....................................................33
Book Review
Tomáš Otáhal: The Economic Clashes of the Last Hundred Years
by Larry H. White............................................................................................50
www.cevroinstitut.cz