Velvet Devolution

Is the "Czech Miracle" over? Or still to come? A report from Prague.

Thomas W. Hazlett from the March 1998 issue

When the Velvet Revolution politely bid adieu to 40 years of Soviet-style socialism on November 27, 1989, the Czech economy hosted the most anemic private sector in the entire Eastern Bloc, producing just 3 percent of the country's gross domestic product. But between December 1989, when an obscure bank economist named Vaclav Klaus became the country's first post-communist finance minister, and March 1995, when the second of two waves of privatization was completed, the country was transformed. In 1995 three-quarters of GDP was generated by private firms. With an economy shifting into high gear, Prague a lively tourist mecca, an amicable 1993 "Velvet Divorce" from Slovakia, and a political stability rare in the region, citizens could be proud of the "Czech Miracle," as it was enthusiastically described in the April 1995 issue of this magazine.

But the Czechs' mood has now turned darker. Klaus, the financial guru who became prime minister in 1992, resigned in November amid what the U.S. press called "scandal and a slumping economy." His fall has triggered a wave of obituaries in the American media not only for the Czechs' once-vaunted economy but also for the free market principles Klaus propounded. Yet an examination of the Czechs' difficulties indicates that, while there are mistakes to overcome and problems to solve, the only real bankruptcy to be found is that of American journalistic vision, and the only real poverty that of the newspapers' economic understanding.

Certainly, the "scandal" half of the press's indictment was juicy enough. It revolved mostly around reports that Klaus's Civic Democratic Party maintained a secret Swiss bank account filled with money from investors who were purchasing privatization favors. In 1996, the Czech press got hold of a party report that attributed substantial donations to a pair of men in Hungary and Mauritius; the Hungarian, it turned out, had been dead for 12 years, and the Mauritian, while alive, had never heard of Klaus's party. Last November, a Czech entrepreneur who had won a stake in a privatized steelworks admitted that he was the source of the money. He denied he'd received any favors, but he did claim that Klaus had known about the money. Klaus disputed this claim, and his party split into squabbling factions. After Klaus's own finance minister threatened to go public with what he said were dubious privatization deals, his home was bombed. So much for political civility.

In the meantime, the country had been suffering a series of financial setbacks, including a plunging stock market racked by conflicts among stockholder interests in 1995 and 1996 and a currency crisis in May 1997, when a burgeoning trade imbalance produced a run on the Czech koruna. After an expensive attempt to defend a fixed exchange rate--in effect donating $3 billion in taxpayer funds to international speculators--the central bank gave up and let the currency fall, resulting in a 15 percent devaluation. The central bank was then forced to tighten monetary policy, and the country's economic growth dipped sharply: Projected 1997 GDP growth of 5.3 percent fell to 1.2 percent in the first half of the year.

The country's fiscal slowdown naturally produced political fallout. The government reacted clumsily, seeking to co-opt opposition cries for state controls. Klaus refused to step down because, he explained modestly, there was simply no one who could take his place. But under the combined weight of the scandals and the wheezing economy, Klaus's popularity plummeted, and finally--eight years and three days after the collapse of Czechoslovakian communism--his government was dissolved.

The reaction in the American press was not restrained. "Czech's Downfall Shatters Hope for Economic Miracle; Outgoing Prime Minister's Failed Reforms Viewed as Too Absolute, Arrogant to Succeed," The Washington Post concluded sternly. Economic reform and prosperity had been but a fantasy, realized The New York Times: "For the Czechs, The Fairy Tale Is All Over Now." The situation was even more terrifying than real life, according to a front-page feature in the Chicago Tribune published last summer: "Czechs' Economic `Miracle' Looking More Like Nightmare."

The "Czech Miracle" was more heralded in its alleged death than it had ever been in life. But at least it didn't die alone. The Tribune declared a mass funeral for market forces. "[P]rime minister Vaclav Klaus had visited the University of Chicago and patterned his policies on the free-market teachings of the school's Nobel Prize-winning economist, Milton Friedman....Klaus once looked down on his neighbors Poland and Hungary, but now the economic boom is proving illusory....In the meantime, the University of Chicago is out of style in Prague."

Capitalism, one might easily conclude from all this, had been as much a bust in the Czech Republic as communism. So last fall I returned to Prague to see this purported collapse for myself. During annual pilgrimages from 1990 through 1994, I'd had the privilege of observing that glorious capital come roaring back to life after decades of Soviet-induced inertness. What had once been a city where a visitor had trouble finding a restaurant that welcomed customers or a shop that featured inventory was resurrected as a vibrant metropolis boasting superb dining and every consumer convenience, its once somnolent streets buzzing with commerce and ringing with Dixieland jazz.

What I learned in Prague on this journey was a lesson very different from those blared in the American headlines. Rather than finding a nation of shattered hopes and punctured fairy tales, I found an upwardly mobile country that still exudes the enthusiasm of a dynamic people newly liberated. Far from finding a place trapped in an economic nightmare, I found a land which still ranks at the very top of the "emerging nation" success stories.

It was impossible to miss the signs of lost economic momentum. The Czech economic trajectory, while still pointed up, is noticeably flatter than it was just a few years back. Even so, rather than discrediting all previous economic progress--as some Western press reports have perversely done--an investigation of the Czech situation reveals a rather conventional political failure, bred by an almost unique success and nurtured by the arrogance of power.

Indeed, the main source of difficulty in the Czech Republic now is the policy gridlock that followed the exhaustion of mass privatization from 1991 to 1994 --just as Klaus and other advocates of "fast privatization" had predicted. Extending the economic reforms further and deeper, including the establishment of legal protections for capitalists and entrepreneurs, are the devilish details that have been left for a new government to deal with. Rather than demonstrating the shortcomings of laissez-faire capitalism, the current travails of the Czech transformation exhibit the dangers of letting communist-era institutions, including courts that fail to protect individual rights and a state that refuses to take responsibility for its actions, survive into the modern era.

Most troubling was that despite Vaclav Klaus's brave rhetoric and well-reasoned essays on the radical transformation to capitalism, and despite an impressive start on rapid privatization of large enterprises, the Czech reform program had largely ground to a halt after 1994. Klaus's explanation of this failure was defensive, evasive, and shockingly unpersuasive.

The irony is that Klaus had made himself famous as an economic Johnny Appleseed sowing one simple idea: The key to a successful transformation from socialism is speed. Momentum for reform would be lost in a "reform trap," he argued, if the interest groups that stood to lose were given the chance to forge alliances and amass organizational strength. Quick turnaround of assets from public to private was the only reliable solution. Failing to seize the moment would "prolong the pre-privatization period of agony," Klaus reminded the Czechs and the rest of us in his many speeches and essays in the early reform period.

His logic was not subtle. In an economic netherworld where state-owned enterprises are slated to be taken over by new private proprietors, the incentives and opportunities for looting are abundant. The classic scheme in Eastern Europe has been for a state manager to sell off the lucrative pieces of "his" enterprise to his brother-in-law's company at bargain prices, turning over a debt-ridden shell for privatization.

Resources are squandered in this process of asset stripping, and the public soon loses patience with such "pirate capitalism." Demand builds for beefing up state enterprises--a happy outcome for the apparatchiks who control them--and liberalization slows. Russia has vividly demonstrated this cycle of reform and backlash, and countries throughout the region have shown how quickly anti-capitalist parties (including former communists) can gain the upper hand.

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