East European economies. East, west and the gap between

Assessing whether the poorest post-communist countries can ever catch up

A DOLLAR a day or less is the World Bank's standard definition of poverty. But in the cold ex-communist countries of central and eastern Europe, where more is needed for heating and clothes, $2.15 is the poverty line. Many people have now climbed above that level: between 1998 and 2003 alone, more than 40m moved out of poverty; 60m remain. The best performer, Hungary, has almost no people living in poverty; in the worst, Tajikistan, the figure is 70%. But the bigger question is which post-communist countries stand a chance of catching up with the rich world within a generation, and which will stay poor for the rest of the century.

The sunniest outlook is in the countries that have done best so far: the eight new members of the European Union, plus Croatia, which hopes to join soon. They have got two big things right. The first is openness to foreign trade, which is strongly associated with economic growth (see chart 1). Competition from foreign firms, whether at home or in export markets, sharply raises productivity.

The second, harder to measure, is having the institutions to make capitalism work, create confidence, bust cartels, rein in greedy officials, enforce contracts and safeguard property. Why some countries are better at this than others is hotly debated. Steven Fries, of the European Bank for Reconstruction and Development (EBRD), highlights "political contestability and the rule of law" - when incompetent politicians and officials risk losing their jobs, and corrupt ones may go to jail.

Quantifying this is hard. One approach is to look at the banks, which flourish only when the right institutions are in place. Banking requires confidence among firms and lenders that the institutions that underpin the business environment are reliable. When it grows, it brings big benefits. Getting money out of suitcases and into bank accounts means that it can be lent and borrowed more efficiently. There is a strong correlation between the growth of credit and of the economy (see chart 2).

The countries of central Europe and the Baltic area have grown fast in the past ten years, and are starting to regain the ground lost under communism. Slovenia is richer even than Portugal, the poorest of the old EU members. The Baltics are growing at 8% a year or more. At that rate, their standard of living will double in a decade.

But the detailed scores in the EBRD's annual transition survey of the region's progress* show that even the best are only inching forward on what is called "economic governance" - customs and labour codes, tax and judicial systems, and so on. Slovakia is the only exception this year, with sharply improved scores on all fronts. "The big story in the region is that the private sector is really delivering the goods, both literally and figuratively," says Mr Fries. "But the state sector's performance is lagging far behind."

EU membership has boosted trade. That surprises observers such as Willem Buiter, the EBRD's former chief economist: "I thought the free-trade arrangements agreed in previous years had already exhausted the potential. But it seems that quite a few people were willing to make the necessary investments only when these countries were in the EU."

But there are some negative effects. Estonia is widely regarded as a star. Mr Buiter terms it the "most competitive economy in the entire EU". But it has had to adopt EU farm subsidies and protection. Estonia's previously liberal labour market, too, is scoring worse in the EBRD assessments - another side-effect of EU membership.

The wider effect of the EU on public administration is still unclear. It may have given bent bureaucrats more cause to worry about outside scrutiny. But others have found even more rules that they can use to extort money from hapless firms and individuals. "The rent-seeking industry has grown since we joined," comments Ugnius Trumpa of Lithuania's Free Market Institute. He notes that new high tobacco prices set by the EU have been a huge windfall to local smugglers.

An even bigger difficulty is reforming the most complex bits of the public sector: health and education. Employers are increasingly complaining of labour shortages, especially skilled tradespeople and production workers. Along with labour regulations, employers say that skill shortages are the biggest problem they face. But the education system is not producing the right kind of workers. Indeed, it seems to be deteriorating. School scores, like health statistics, are worsening, notes Mr Fries. These bits of the public sector are still rooted in communist-era thinking: inefficient, old-fashioned, largely immune from competition. In countries that have liberalised higher education, private-sector entrants have begun to make a difference. But schools almost everywhere still prize memorisation and regurgitation over critical thinking and creativity. That encourages cheating and corruption - and is bad for long-term competitiveness.

To be fair, even west European countries find reforming health and education very difficult. But the ex-captive nations do not have the luxury of time to dither about reform. They need growth and better public services to stop their best people emigrating and to end absolute poverty. They must improve their competitiveness if they are not to lose markets to rivals.

What about the even poorer countries farther east and south of the new EU members? There are a couple of bright spots. The 12 former Soviet republics are the fastest-growing bit of the ex-communist world. That is partly due to the windfall of high energy and commodity prices, and also because poor countries tend to grow faster. Unlike their richer counterparts, growth is creating more jobs than restructuring is destroying. The 12 are also doing better at keeping people in work. The poor are benefiting from the rebound more than the rich; wages and benefits may be meagre, but these are now mostly paid on time.

These modest pluses are, however, dwarfed by other problems. Public services are cash-strapped. Georgia spends under 1% of GDP on health; Croatia over 7%. Household utilities are becoming more costly as subsidies dwindle. In some countries, even such basics as water, electricity and universal education are starting to crumble.

The biggest immediate problem is a lack of good jobs. In Kirgizstan, for example, the share of workers in farming has shot up from 35% to 55% since 1990, as people have turned to semi-subsistence farming after jobs in industry vanished. In the Czech Republic, by contrast, it has fallen by more than half, to just 5%. World Bank statistics{dagger} show why new jobs aren't being created. Firms in the richer countries complain about an over-regulated labour market; in the poorer ones they worry less about the rules and more about corrupt bureaucrats who enforce them.

The debates about the economics of transition that raged in the mid-1990s are over. Few now seriously contest that macroeconomic stability, openness to trade, strong institutions and liberalised prices are preconditions for success. The trouble is that the countries most in need of faster reforms, more growth and better public services tend also to have weak institutions, bad geographical locations and unhelpful neighbours that give them the least chance of achieving success.