In the back of our minds, we all somehow know that governments play a decisive role in the well-functioning of economies. The conduct of bad governments, while from a theoretical point of view logical and somewhat obvious, is quite difficult to imagine as actually being put into practice to the extent of severely damaging whole economies.
Corruption, lack of credibility or discouragement of economic growth and stability are but a few of the aspects that deem regimes harmful. Although such characteristics are clearly detrimental to the health of an economic system, they are still somewhat abstract. Therefore, this article is meant to provide a clear-cut example of governing gone wrong by taking the reader on a fascinating odyssey through a dystopian world, that of Romanian politics.
Our journey begins in 2017, when the government began its carefully laid plan and started raising (completely unsustainable) pensions and the wages of public servants. Naturally, subsequent increases followed in 2018. Note that 25% of all employed Romanians are public servants. To put things into perspective, public sector wages have increased by 25% in 2018 alone and by 50% in the last three years. As a result, they constituted a whopping 11% of Romania’s GDP in 2018, a 30-year maximum.
But this hike must have had some kind of real basis such as more investments in the form of improved technology, new firms or growth in the productivity of workers…right? The answer is (remarkably!) no. One might wonder, then, how did the government manage to sustain such increases in wages. Far from surprising, they borrowed the money. Not once, but several times. Even less surprising, they will (preferably) have to pay it back at some point. How exactly shall they do that? They do not know either. Or do they?
For the time being, the government still has to approve the budget for 2019. Not that there’s anything wrong with that, 2019 has only started for little more than a month now. In addition to that, the ruling party announced in October 2018 that the budget will be ready in a few weeks’ time. After all, we should give them some credit and stop being so critical about everything they do, right? In their words, most of the population is misinformed and just can’t grasp their genuine generosity.
This growth in wages, not backed by an increase in productivity ultimately leads to inflation. More money circulates throughout the economy and given that the supply of goods is more or less the same in the short run, prices will rise. Although nominal wages rise, real wages will stay the same or even decrease. There is, however, yet another issue. Despite public servants not necessarily being worse off as a result of the wage raises, other employees can suffer. Prices in the economy rise but the private sector employees’ wages stay fixed, which means that their real wages fall. This can be, among others, because of long-term working contracts or simply the reluctancy of employers to raise wages.
In August 2018, Romania had the highest inflation among European countries, 5.1%, although the unofficial figure might have (almost certainly) been considerably larger.
However, the government still had to come up with a solution to solve the widening budget deficit. They ultimately did, not without wreaking havoc throughout the whole economy. To begin with, just before Christmas they invented a tax on banks’ financial assets if ROBOR, the rate at which banks lend money to each other, exceeds 2%. The tax will be 0.1% for ROBOR between 2 and 2.5%, 0.2% for 2.5-3%, 0.3% for 3-3.5%, 0.4% for 3.5-4% and for a ROBOR above 4%, every additional half percentage point will be taxed with 0.2%. At the moment, ROBOR ranges from 3.06% for 3 months to 3.48% for a year. Not to mention ROBOR is correlated with the inflation rate in the economy, and given that the inflation rate is moderately high, so is the ROBOR.
Given the tax, banks will be reluctant to loan further money in order to not increase their amount of financial assets. This implies that the selection procedure will be more carefully assessed and fewer economic agents will receive loans. It’s either that or raising the active interest rate while lowering the passive interest rate. As the fact that Romania had one of the biggest interest rate spreads in Europe was not enough. As we shall see, the latter option may bring about some serious consequences. However, most small and medium enterprises (SME’s) that are dependent on bank loans in the incipient phases might even file for bankruptcy which can subsequently lead to a loss in competitiveness and a more abrupt concentration of market firms which ultimately goes against consumers’ interests.
Secondly, the government instituted a tax on all firms in the energy domain, more precisely 2% of their total earnings from the previous year. Many of those companies are (partly) state-owned and struggled to prosper even in the absence of the new tax. Now, they will probably be on the brink of insolvency. Not only that, the tax will have to be borne by every player in the production chain, from transporters to suppliers and producers. The producing company will raise its prices to accommodate the new tax, which will result in higher costs for distributors, who have to take into account both the fact that they themselves have to pay a 2% tax from their earnings and a higher price for the electric energy. This process will be undertaken by every player in the chain, leading to a vastly increased market price for energy.
Had this not been enough, the same government decided to put a low ceiling on the price of gas and energy for households, in order to “help consumers”. Summarizing, although the costs for energy companies have risen significantly, they are not allowed by law to charge households higher prices. Do you see the solution? Tax corporations! While an inconvenient for all companies, the SME’s will be the most affected. As a result of having to pay higher bills, firms will need to raise prices or lose profit. SME’s will be particularly affected because they will require raising prices more than corporations. As a result, they might be driven out of the market, which will in turn harm consumers. They pay less money on energy but more on everything else. Seems like a fair trade-off to me. Although a rather simplistic explanation of otherwise complex mechanisms, it gives one an idea of the bigger picture.
Thirdly, local administrations will receive considerably fewer money in 2019. To be more precise, around 10% of the budget will be allocated to them, compared with 33% in 2018. This has a wide spectrum of implications, ranging from less money for education and basic health care in rural areas to lower development of urban regions.
To emphasize the agony of the actual government, they even instituted a tax on cryptocurrency gains. While this may seem a relatively normal practice, in the context of the Romanian current political situation it is definitely not. It only shows the desperate need of funds of the government.
Because of, among others, the highly uncertain business environment and the loss of credibility, with the government passing overnight laws without any prior debate or thoughtful analysis, the Romanian currency considerably depreciated against the euro in January 2019. While in 2018 the exchange rate was more or less constant at around 4.65 Ron/Euro, during January alone it depreciated to 4.75 Ron/Euro. This can be due to several reasons, such as Romanians converting their savings in other currencies, international firms closing some of their branches or even outright speculation not backed up by the central bank. In any case, the demand for the Romanian currency has fallen while the supply has risen given the increased wages. Needless to say, if the actual environment persists, large firms will eventually seek business elsewhere. As they leave the country, they will exchange the Romanian currency for other currencies further contributing to the former’s depreciation.
The central bank can, however, use its foreign currency reserves to buy the Romanian currency and keep the exchange rate somewhat stable. This is difficult under the status quo. Buying the national currency will inevitably lead to high interest rates and thus to high levels of ROBOR, since the latter is an average of several banks’ interest rates. The ROBOR is expected to skyrocket if the central bank attempts to make any significant changes to the exchange rate. That would imply a serious burden on banks and thus an even more serious burden on the population and on small firms. The central bank is therefore faced with a dilemma: they can either let the currency depreciate or hit the banks (and the whole population for that matter) hard. In both cases, consumers lose. More importantly, the country as a whole loses.
What is more, the ruling party attempts to blame the governor of the Romanian Central Bank for not protecting the national currency. We are talking here about the same individuals that imposed the tax in case ROBOR exceeds 2%. While I’m quite certain some of them understand what is going on around them and deliberately make certain comments, most of them unfortunately do not and blindly follow orders.
When questioned in the European Parliament or in any other civilized setting about policy regarding the economy or corruption, government members usually invoke misinformation and bad intentions from the part of commentators, more often than not by means of not so memorable oratorical skills. After all, the ruling party wants to protect Romania. Indeed, they want to protect it from foreign investment, healthy laws and independent institutions.
In the end, most people don’t understand or don’t even care about what happens in the economy. All they see and hear is a guy dressed up in a costume that seems smart and says some seemingly complicated stuff. They can easily be influenced by empty words and audacious lies when the discourse of politicians’ is convincing enough. Their opinions are as fragile as the mood of the people they sanctify. Yet they have the right to vote.
Socrates might have been right.