Macedonia's Economy 2008 - Dialog with Dan Doncev

I have often accused Trajko Slaveski, Macedonia's Minister of Finance, of mismanaging the economy. But, you got to hand it to him: he has a great sense of humor. On Saturday, August 16, 2008, he visited Bitola and made these announcements, hereby copied faithfully from MIA and Nova Makedonija:

"Инфлацијата во земјава е под контрола, изјави викендов министерот за финансии Трајко Славески во Битола, одговарајќи на новинарски прашања.
- Инфлацијата во јуни во земјава падна за еден процент, а што е поинтересно, во САД на пример таа порасна за еден процент. Последниве четири месеци имаме многу ниски месечни стапки. Од почетокот до крајот на годината стапката на инфлација ќе биде 3,2 отсто, а проекцијата беше таа да изнесува околу 5,5 проценти, што значи дека инфлацијата во Република Македонија е под контрола - истакна Славески, кој додаде дека во моментов во државниот буџет има суфицит, односно повеќе приходи од расходи.
Во врска со економскиот пораст во земјава и различните процени на Меѓународниот монетарен фонд (ММФ) и македонската влада, Славески рече дека до крајот на годината се очекува порастот на бруто-домашниот производ да ја надмине проектираната стапка со ММФ и таа, според процени на Владата, да биде над шест проценти.
- Потребен е уште еден месец за да ги добиеме конечните показатели за порастот на бруто-домашниот производ во вториот квартал. Првиот квартал беше 5,1 проценти. Неофицијално, според последните анализи на податоците, во вториот квартал, до 30 јуни, бруто-домашниот производ ќе биде со нешто повисока стапка и очекуваме до крајот на годината да ја надминеме проектираната стапка со ММФ, која според нашите проекции ќе биде над 6 отсто - појасни министерот."

The Minister later responded to my request for clarification (to his credit, he always does). Apparently, he was misquoted. What he did say is that cumulative inflation being 3.2% in January-July, it looked as though the target of 5.5-6% annual inflation in 2008 is well on its way to being met.

It's uncanny how the government of Macedonia - alone in the whole world - gets all its predictions right, courtesy of the ever-pliant Bureau of Statistics here.

Moreover, the Minister, aware of the abysmal ignorance of both journalists and citizenry, manipulates public opinion by comparing oranges to apples: inflation in the USA is not the government's doing. It is the fault of the Central Bank there (the Federal Reserve). Inflation in Macedonia, on the other hand, is, in large part, an outcome of the government's outpouring of populist generosity. Its unbridled and irresponsible spending led to a wage spiral in the private sector, for instance. It also failed to take steps to counter inflation imported from abroad through the prices of oil, electricity, raw materials, finished goods, and luxury items. Consequently, Macedonia's trade deficit is among the highest in the world (and in history) and jeopardizes the country's macroeconomic stability.

As for the impressive growth in GDP - it is far less impressive when we realize that the economies of all the countries in the region have grown more or less by the same percentage. The British have a saying: "The incoming tide lifts all boats". When the economy grows (unexceptionally), the government takes credit. When something goes wrong with the economy, it is never their fault, the global economy is to blame.

More to the point, the growth in GDP, like much else in Macedonia is, to a certain extent, a mirage. It is fuelled by rampant construction, government outlays gone amok, and remittances from Macedonian Gastarbeiters. The real sector is no doubt expanding, but is far from making a sizable or lasting contribution in terms of gross factors of production.

Finally, the Minister brags that the government's budget is in surplus. Let me get this straight: the government takes 42% of GDP in taxes and then spends some of it on churches and basketball halls and media campaigns and it thinks that this gross misallocation of scarce economic resources deserves praise. With its all-pervasive economic presence, the government has transformed itself into Macedonia's biggest employer and advertiser. The private sector is crowded and cowed. There is no economy to speak of. Foreign direct investment (FDI) - touted as the panacea to the country's economic problems only two years ago - is now no longer the top priority, maybe because Macedonia last year has again been ranked as the least attractive in the region. A pretty picture this is.

DONCEV

Sam you don't spend much time on small talk - straight to the point. But before I respond to the many issues you have raised, let me just say for the record what an absolute pleasure it is for me to be engaged in this dialogue with you. I seem to recall that the last guy who had an open dialogue with you ended up as Prime Minister of Macedonia. Judging from the tone of your opening remarks though, it would seem that at least as far as you're concerned Macedonia passed the crossroads of ten years ago only to hit a dead end!

The economy has certainly been mismanaged, but I don't think Trajko Slaveski is entirely to blame in this case. He is not in an enviable position. The previous two Ministers of Finance (Popovksi and Gruevski) were both in a much stronger position in the sense that they had no higher political authority who was considered as an authority in economics. Now by this I am in no way making a judgment on the actual competence of Popovski and Gruevski as Ministers of Finance or ignoring the fact that they too had political masters, but it is fair to say that they both had a much freer hand to manage (or indeed mismanage the economy) than what Slaveski has today.

Slaveski is not in a strong position as Minister in the sense that he has Zoran Stavreski above him (who is stronger politically and considers himself as a higher
authority in economics than Slaveski) and of course you have Prime Minister Gruevski of whom many in his Government will tell you is the most brilliant economist in Europe. So Slaveski I am sure is conforming to the economic wishes of Stavrevski and Gruevski even in cases where he may disagree. In analyzing the performance of Macedonia's economy over the last two years we have to take into account the political dynamics between this troika, which has significant influence on the actual economic policy decisions that have been taken.

You know the old saying that there are lies, damned lies and statistics! The Macedonian Bureau of Statistics and Trajko Slaveski can quote whatever figure on inflation they want, but the one thing they cannot manipulate are the prices people pay for their goods and services. The Macedonian consumer knows very well the prices he is paying for basic goods such as bread, milk, eggs, meat, rice and cooking oil, compared to the prices two years ago. Indeed the prices of almost all goods and services have gone up to various degrees, and in almost all cases they have been well into double digits. Add to this the expected astronomical rise in the prices of electricity and heating. Measured properly, Macedonia's inflation rate for 2008 would be at least 12%.

Three observations I want to make here. First, at various stages of this year, different Ministers have quoted different rates of inflation ranging from the above
mentioned 6% by Slaveski to 10% by Stavreski. It seems they can't even agree on the rate among themselves. Second, we have often heard the excuse throughout the year that inflation is high but it's imported. Macedonia has a fixed rate of exchange pegged to the Euro. This effectively means we import all our goods and services at a constant Euro rate. Thus by definition the inflationary effect from increased prices of imports cannot be higher in Macedonia than that in the Euro zone. The 2008 Euro zone overall inflation rate is only 4%. Third, for the first time in the last ten years, we now have negative real interest rates (interest rates minus inflation rate) of at least 3%. The savings and wealth of Macedonia's citizens is being eroded every day. As people realize this effect, they shift their savings to consumption which in Macedonia's case also leads to a direct increase in the trade deficit.

Therefore, I concur with you that inflation in Macedonia is in large part, an outcome of the government's outpouring of populist generosity, and unbridled and
irresponsible spending leading to a wage/price spiral. Over twelve months ago, I had the unfortunate experience to watch an interview on a television show which claims to represent the voice of the Macedonian people. Clearly amazed by the fact that the government had just announced significant increases to the public administration wages and the pensions of the senior citizens, the interviewer asked Gruevski if he was in fact the "Wizard of Oz"? If only it were so easy. If the history of economics shows one thing, it is that every time wages in a country are increased, and the increase is not as a result of increased worker productivity, inflation always follows!

I want to really expand on your final point. I think there is such a misconception among society at large (and in this regard I think the media in general have much to answer for) as to what the Budget actually represents. First of all, when you say that the government takes 42% of GDP in taxes, two things must be made clear. First, on average, 42% of the yearly income of every citizen goes to the government by way of all the direct and indirect taxes which exist in Macedonia. All these taxes are collected from the Private Sector in the economy. Second, it follows by definition that should the government choose to reduce its share of GDP to say 30% (by reducing the overall tax burden by 12%) the 12% reduction of the Government sector will result in a 12% increase in the Private Sector. The converse is true if the Government chooses to increase its share of GDP by raising the overall tax burden. This is in fact the "crowding out" effect you refer to. This is why it becomes almost laughable when Macedonian media report front page news that we have the lowest taxes in Europe.

From a macro economic point of view, the hundreds or thousands of individual taxes are only important insofar as they determine the overall tax burden on the Private Sector. (Of course individual taxes analyzed on a stand alone basis play an important role on the micro economic level of activity).

It thus becomes a real choice for society (through its elected leaders): Do we want a society which allocates a larger or smaller portion of the GDP of the country in the hands of the Government? And once that choice has been made, it then begs the second choice as to how we actually allocate the funds within the Budget itself? Do we spend it on churches, basketball halls and media campaigns as you say, or do we choose to build roads, schools and hospitals with the same funds? In this context, the self serving media campaigns of this Government (amounting to tens of millions of Euros) are in my opinion one of its
biggest sins.

A pretty picture indeed!

Alas, something happened on the tortured way from 1998 to 2008. Macedonians have become so downtrodden and destitute that they now knowingly choose to live in fantasy rather than face their dismal reality. It is a state of mass psychosis, a delusional hysteria, fostered by an endless stream of Big Brother advertisements and inane hype. People refuse to wake up and resent the few truth-speaking messengers left to the point of branding them "traitors".

And what is the truth?

(1) Macedonia's macroeconomy hasn't been in worse shape since 1996 and (2) This government has failed in literally all its efforts: geopolitical, political, and economic.

Admittedly, there have been some improvements in what Stavreski keeps calling "business climate": the introduction of streamlined taxation; the decrease in red tape and regulation (through the mechanism of "regulatory guillotine"); the (partial) implementation of a one-stop-shop process of company registration; and the reform of various business-related institutions (such as the Customs and the Cadastre). But the microeconomic sphere is subordinate to the macroeconomic climate. In an unstable environment of high inflation, for instance, business cannot thrive.

Zoran Stavreski is my biggest disappointment. While Nikola Gruevski is an outstanding and gifted manager, he is hardly an economist. Not so Stavreski, who used to be a conscientious and well-informed monetary expert. Yet, probably tempted by power and fame, he has transformed himself from a first-rate economist to a third-rate politician.

The government's new strategy: never admit to failure. Declare victory and retreat with dignity intact. Thus, they pretend that Macedonia's economic malaise is actually a sign of its growing economic health and an inevitable outcome of the government's sagacious and farsighted policies. The record-shattering trade deficit? Nothing to worry about: it is a mere reflection of growing foreign interest in Macedonia's industry. Inexorably rising inflation? A normal by-product of the meteoric growth of Macedonia's economy. Unemployment? Give it a decade or two and it, too, shall be conquered. Macedonia's failure to join NATO and the EU? Will only serve to attract foreign direct investors in the next four years up to accession.

Those who disagree with them are accused of getting paid either by the shady opposition or by Macedonia's enemies.

The government's attempts to re-write and revolutionize the economic sciences is probably a sign of desperation. But, the people at its helm also tend to believe and vehemently defend the veracity of their own propaganda claims. This is where the real danger lies. Gruevski, Stavreski, and Slaveski are not confabulators and con-men. They are self-deluded ideologues, trapped by their own verbosity.

Three cases in point: FDI (Foreign Direct Investment), labor productivity, and the trade deficit.

First, FDI. The government tells us that close to 240 million euros flowed into the country in the first 5 months of the year. This is the same as all of 2007.

Yet, close to 80% of this amount are in the form of acquisitions: foreign companies (mainly banks) buying Macedonian firms (mainly banks). This is meaningless FDI that has little effect on the domestic economy (though it does enhance the net worth of certain individual shareholders).

Moreover, economic studies demonstrate conclusively that foreign banks tend to do business with foreigners, not with local firms and that the profits they repatriate (the foreign exchange they take out of the country) exceed their initial investment.

But, what about the remaining 20%? We are still talking about 50 million euros!

Most of this money is invested in construction of objects such as shopping malls. What do shopping malls contribute to the economy? Zilch. Shopping centers are non-productive. They don't increase exports. They barely increase employment (except temporarily, during the construction phase). They do elevate the trade deficit (by importing goods) and inflation (by encouraging consumption). This is the wrong kind of investment.

How much new foreign money was invested in greenfield industry and manufacturing? A negligible amount. During the election campaign of 2008, the entire government embarked on a flying circus of sorts, signing up foreign companies and touting their achievements to a retinue of obsequious (and happy to travel free of charge) journalists.

What happened with these deals? Nothing. They were not real. Macedonia had signed numerous memoranda-of-understanding and memoranda-of-intent, but very few firm contracts. Bunardzik is still an empty lot.

Now, to labor productivity. In his by-now infamous column in Dnevnik, on August 29, Stavreski claimed that labor productivity in Macedonia, by some measure, has gone sharply up. Well, wrong again: it hasn't. Neither has the competitiveness of Macedonia's products improved. The prices paid for Macedonia's exports are going up, thus creating the optical illusion that exports are rising.

The average salary in Macedonia is c. 250 euros per month and the cost to the employer - what with wage taxes and contributions to the pension and health funds thrown in - is c. 420 euros. That translates to c. 5000 euros a year.

According to the IMF, Macedonia's GDP this year would be c. 8 billion USD (or 5 billion euros). The World Bank and the CIA largely agree with this estimate. That's 2500 euros per every Macedonian, man, woman, and child (=GDP per capita).

Of course, only 20% of Macedonia's population are employed, so GDP per employee is c. 15,000 euros (excluding the 10% of those who do not get paid).

How does it compare to other countries?

Start with the region.

Albania's and Bosnia-Herzegovina's GDP per capita are equal to Macedonia's, but rising fast with impressive flows of FDI. Bulgaria's and Serbia's are 40% higher. Croatia's is three times Macedonia's. But, since the rate of employment in Croatia is double that of Macedonia, a Croat worker produces only 1.5 times as much GDP as a Macedonian one. Every Greek, Czech, and Slovene worker is four times as productive as a Macedonian worker (these countries' GDP per capita is 8 times Macedonia's) while the Romanians are almost twice as plentiful and the Russian workers beat the Macedonians 1.7:1 (Russia's GDP per capita is 3 times Macedonia's).

Of course, such a comparison is unfair. The Czech average salary is 722 euros. We should, therefore divide the GDP per capita by the cost of labor. This is known as GDP unit labor cost.

Even then, Macedonian workers are spectacularly unproductive. The Macedonian costs 5000 euros a year and produces 15,000 euros of GDP annually. The Serb costs pretty much the same (c. 5300 euros a year), but produces 20,000 euros of GDP every 12 months. The Czechs, Greeks, and Slovene employees do even better: they each cost between 9000 euros (Czech Republic) and 20,000 euros (Greece) a year, but give in return 60,000 euros of GDP!

This disparity is one of the reasons why Macedonia is not an attractive destination for foreign direct investors. Salaries here are actually way too high. Judging by this meager output, to render it attractive, the average wage in Macedonia should not exceed 50 euros a month, all included.

Are Macedonian workers lazier or more stupid than their counterparts elsewhere? Not so. Labor productivity does depend on the existence of a work ethic (longer hours and more effort and initiative). But, more importantly, it reflects the workers' level of education and skills, the age and quality of machinery and other capital goods and equipment used in the production process, the availability of knowledge and technology, and the proliferation of better management. Macedonia needs to work hard in all these spheres merely to catch up with the rest of the region, let alone the world.

The government can do a lot to render Macedonia a more attractive proposition as far as labor unit cost goes. It can reduce wage-related taxes and contributions drastically, or even waive them altogether for new employees. It took one halting step in this direction and leveraged it to the hilt for public relations purposes. This propensity to govern-by-gesture, to emphasize cosmetics over substance will be the undoing of the economy, I fear.

Finally, the trade deficit. It is a prime example of how populism (of previous governments as well as the incumbent one) trumped and trumps common economic sense.

There is only one path to reduce Macedonia's threatening trade deficit: to discourage imports. There are many ways to reduce imports. For starters, the government should correctly price items like electricity and fuel, which it is attempting to do. Subsidies need to be limited only to the neediest 10% of the population. Everyone else should pay much higher, realistic, global market prices.

Consider passenger cars - a major and recurrent components of Macedonia's burgeoning trade deficit. The government should make it very expensive to buy a new car and very attractive to keep a used one. Instead, the Ministry of Finance, eager to please the population and with an eye on the ratings of the governing coalition, spews out nonsense to justify its irresponsible acts. "New cars consume less fuel and need fewer spare parts", they say. True. But, a new car costs 10,000 euros, paid for with scarce hard currency. The savings that are the results of higher fuel efficiency do not amount, over the life of the car, to 10,000 euros.

Had this government been leading rather than following the opinion polls, it would have embarked on a campaign to encourage the use of public transport; would have cut the costs of owning and maintaining a used car; would have slapped punitive taxes and charges on buyers and owners of new passenger cars; and would have used remedies available to it under the WTO to impose import quotas and other duties, tariffs, and non-tariff (e.g., environmental) limitations on luxury, gas-guzzling vehicles.

Macedonians consume imported vegetables, imported chocolate, imported meat and dairy products; they buy imported "white electronics" and "black electronics"; they vacation outside the country, some of them in order to boast about it to their friends. A craze of conspicuous consumption has gripped this impoverished country that has no economy to speak of. Macedonians are living over and above their means and over and above their economic contribution to society. This will end badly: with a banking crisis, hyper-inflation, and massive indebtedness of both this profligate state and its gullible citizens, who want so much to dream and to fantasize.

DONCEV

I accept your assessment that Macedonians in general have become downtrodden and destitute. The words transition, reforms, EU and NATO have become a cognizant part of everyday life over the last fifteen years. Our lack of success in each of these fields has had a significant demoralizing effect on the nation as a whole. It seems at times that we are living through a never ending story whose plot is always the same, but the actors periodically change. However, I don't think that the Macedonian people knowingly choose to live in fantasy rather than face their dismal reality. I believe it is a failure of the leadership of the country and not of the people. One of my Harvard professors defined real leadership as "getting people to confront reality and change values, habits, practices and priorities to deal with the real threat or the real opportunity the people face". The converse of this he defined as counterfeit leadership which "provides false solutions and allows the group to bypass reality". I believe that the Macedonian people, deep down, are aware of the reality, but in the absence of real leadership that
leads people to confront reality, they are left with no choice but to conform and fit in as best they can and thus bypass reality. And at no time have we had greater counterfeit leadership than by the existing populist government.

The Government's failures in its political and geopolitical efforts in particular are of course a subject for debate in themselves, but they have certainly played a
significant role in increasing the political risk that potential foreign investors associate with Macedonia. This in turn greatly diminishes Macedonia as a destination for foreign investment.

Personally, I don't think the much touted improvements to the "business climate" have been anything more than window dressing. The much heralded so called "flat tax" is a gross misrepresentation of the truth. I have spoken out about this in Parliament and the media and to anyone who cares to listen, but for the record let me say it again. Macedonia does not have a flat tax! The tax rates are not the lowest in Europe! But this has not stopped the Government from paying expensive advertisements in foreign newspapers which proclaim the opposite.

Of course, any serious foreign investor who does basic level of due diligence on business in Macedonia quickly finds out that the tax rates are not what they were led to believe. In a debate in Parliament last December, I made an elaborate presentation which proves that Macedonia does not have flat tax. In fact the overall tax rate on wages varies from 38 to 40 percent on the gross wage, or, since every one in Macedonia is accustomed to the net wage concept, the overall taxes represent an add on of between 60 to 70 percent to net wages. The manner in calculating the overall taxes payable on wages is unbelievably complicated and antiquated.

So, the Government comes along and merely reduces one of the six components of calculating taxes on wages to 10% and then heralds with great fanfare that Macedonia now has a flat tax with the lowest rates in Europe. In his response to my speech, Trajko Slaveski said, and get this, that I was confusing personal income tax with contributions (to the pension fund, health fund, employment fund, etc). Now I should have said to him at the time, but I chose to be diplomatic then, that the Government can call these taxes a "contribution to Trajko Slaveski's Christmas cake" if it likes, but nothing changes the fact that they are taxes which business has to pay for every employee it has on its payroll. But this is the type of mentality we are dealing with here.

With regards to the trade deficit I have four additional observations. First it never ceases to amaze me how successive Governments in recent years have been quick to point out the virtues of Macedonia's increase in its exports. Prime Minister Vlado Buckovski started this trend in 2005 and it culminated in, as you say, in Zoran Stavreski's "by-now infamous column" in Dnevnik, on August 29, when he proudly proclaimed that exports have increased by 38% in 2008 (ohh and by the way imports also increased by 55% at the same time). The major reason why exports have increased dramatically over the last four years is because the price value of the exports have increased and not because of material increase in the quantity exported. The world has gone through a commodities boom over the last seven years culminating in record prices for commodities such as nickel, zinc, lead, and iron ore. At the same time oil had more than tripled when it climaxed at $147 per barrel in mid 2008. But because our commodity exports are in large part import dependant, the value of our imports has also increased parallel to the value of the exports. But the actual value added to Macedonia's economy has remained roughly the same.

A couple of examples will illustrate this point. OKTA imports oil and exports refined petroleum. The import value of oil reflected in Macedonia's Balance of Trade account has tripled over the last four years. At the same time the value of the refined petroleum exported has also more than tripled. Or take FENI INDUSTRIES or MAKSTEEL. They too produce import dependant exports. The value of their exports has increased several fold over the last few years, but so too has the value of their imports. But once again, the value added to the Macedonian economy has not been much different.

Second, the only reason why the absurdly large trade deficit has not yet resulted in a total meltdown of Macedonia's economy is because remittances from the
Macedonian Diaspora and temporary Gastarbeiters have been steadily increasing over the last ten years. This is hardly something to be proud about and in no way represents a sustainable way to keep a country's economy going, but it has been the country's only saving grace to now. Bear in mind, total remittances in 2007 amounted to 1.4 billion dollars, or close to 20% of the country's GDP. This is mind boggling! In 2008 they are likely to be less than last year but will again be in excess of 1 billion dollars.

Thirdly, it is a truly amazing phenomenon how each successive government over the ten years has in a parrot like fashion repeatedly stated that it is their objective to have a fixed and stable rate of exchange. Thus we have had a fixed rate of exchange pegged to the Euro (and its Deutschemark predecessor) of approximately 61 Denars to the Euro. Any attempt to even debate the issue is usually linked to the period of 1990 to 1995 when Macedonia went through a period of hyper inflation and repeated devaluation of its currency. Of course every time the government prints money, hyperinflation and devaluation will follow. But an exchange rate policy that takes into account the economy's competitive environment and is designed to maximize exports and reduce imports should not
in any way be confused to the phenomenon which occurred in the early part of the last decade.

Finally, the growing balance of trade deficit over the last several years (and the last two years in particular) has been exasperated by the rapid growth of credit over the same period. As people's perception of the stability of the Macedonian banking sector has improved and as the memories of the late 80's early 90's begin to fade (when citizens lost vast amounts of their saving when the Yugoslav banking sector collapsed), the citizens of Macedonia have began to place more and more of their savings (which they previously held as Euros "under the mattress") on deposit with the Banks.

Normally this would be a fantastic opportunity for the economy if it was geared for investment. Unfortunately it is geared toward consumption, and as a result there has been an explosion in the growth of credit over the last few years. A large number of families with no savings of their own have taken out loans. This trend is visible even in farming villages.

This credit formation process has led to a credit fuelled consumption as people take out loans to finance current expenditure. Since the economy is incapable of meeting the increased consumption demand internally (paradoxically of course, owing to the lack of prior investments in the economy's productive capacity) the increased consumption demand has resulted in the ballooning of the balance of trade deficit.

We have painted a grim picture. Some may think it's malicious, some may think it's too pessimistic, some may refute it. The easiest thing to do is to ignore it. But
ignorance does not change reality. How our leaders choose to lead the people to confront this reality will also determine the policy measures taken to remedy the situation with an aim to genuinely improve the economic condition of all citizens in Macedonia. You have given a fairly grim prognosis of how you think this will all end - with a banking crisis, hyper-inflation, and massive indebtedness of both the profligate state and its citizens.

I should like to hope that we will sooner, rather than later, get leadership at the helm of the country that will not be as concerned with its rating as it is with the
wellbeing of the country's citizens. Confronting reality requires in some instances policies that are far from populist. Some policies will actually cause more pain in the short term. But close to twenty years of "transition and reform" have already passed and we are witnessing its fruits today first hand.

Something is rotten in the State of Denmark - but not hopeless! Our next dialog will deal with remedies, policies, and steps that can and should be taken that can prevent your dire prognosis from coming true.