NATO1997     Year of Change

David D. Hale

The real future of NATO should be observed not through military implications alone but by the economic realities that will face Europe. We should focus first on the economic takeoff now occurring in Eastern and Central Europe; second, on the changes in the Western European economy and how they could affect NATO, expansion, and other issues over the next four or five years; and, finally, on the whole issue of the tradeoffs of public policy that we have now. The question should be asked whether, in fact, global economic integration—the growth of trade—will by itself guarantee a stable security structure in the world economy and the world political system, in the 21st century.

The economic changes in Eastern Europe, in 1997, will mark a very important year in the history of Eastern Europe and Russia. If you look at official gross national product (GNP) data for this region, 1997 will be the first year that we finally have a level of economic output which is officially above the level of economic output that prevailed in 1989. This is the first year for reversing the big decline in production output in the early years during the transition away from communism.

These numbers are not very significant because the economy that existed 10 years ago in that region produced lots of goods nobody wanted to buy. And that outlook is greatly overstated when you look at what people actually wanted. But there’s no doubt that in the next six to nine months you will see lots of press coverage in The Financial Times and The Wall Street Journal about how in 1997 Eastern Europe now has an official measure of GNP in industrial production back where it was seven or eight years ago.

The reason we reversed that big decline, the reason we now see in many of the countries in Eastern Europe the size of this economic takeoff is because this region now has gone a long way toward making the transition from the communist economic system to a market economy. First, if we look at the level of privatization, in almost all countries in the region the private sector now accounts for 60, 70, or even 80 percent of GNP. As recently as 10 years ago, in every country except for Poland, the private sector was less than 5 percent of output. Poland was a very special case, because even in the communist period, the farms and many small businesses were not nationalized. As recently as 1988 about one-third of Poles were employed in the private sector. And, indeed, one reason Poland is now the new growing economy in Europe is because Poles have more experience. They have more recent history working as private businessmen, as entrepreneurs. Elsewhere in the region, people are still catching up with the psychology, the reality, of what it means to be self-employed or running your own business. There has been a significant reorientation of trade. Poland, Hungary, the Czech Republic, and Slovakia now have typically two-thirds or three-quarters of their trade with Western Europe. Almost half of Poland’s exports now go to Germany alone.

We’re seeing a rebound now in trade with Ukraine and with Russia, but this is very recent. The dominant trend from 1990 until 1996 was a complete refocus toward Western markets for the very simple reason that that’s where the income is. The Russian economy’s been in a recession for five or six years. There are now signs that it is bottoming out. I would add that in the case of Poland, there is also $7-8 billion of unreported trade. Poland is now evolving into the shopping mall of Central Europe. Germans, Czechs, Ukrainians, and Russians all drive there every weekend to buy consumer goods. The Germans go because their stores are closed on the weekend. The Russians and the Czechs go because the prices are low and in many cases the quality is good. There’s even a big flea market on the outskirts of Warsaw that now generates a billion dollars a year in retail sales.

Another phenomena which explains the success has been the ability of the region to make itself attractive to foreign investors. In the past year, Poland had $4 billion in foreign investments. Hungary had that level three and four years ago. It slowed recently, but it also has a lot of foreign investment. This has many advantages: it gives those countries a stable capital flow; access to technology; and access to management. This investment is now so great that I think it will help to lock in successful economic performance for some time to come. Again, I don’t want to focus on Poland too much, but it is an outstanding example. Because it is a country of 40 million people, a large market in its own right, all the world’s major auto companies have now decided they have to have a plant there. General Motors and Ford are going into brand new plants, a half billion dollars each. A few weeks ago, a Japanese auto parts company made a $400 million investment. And a Korean firm is investing a billion dollars. So we have a critical mass of activity, which now, I think, with the right political environment, can be self-reinforcing. When you have those kinds of large investments, the supply companies, the component companies, others have to follow.

All these countries are also trying to make themselves more attractive for portfolio investment—for financial investments, stock and bond markets. Poland now has a stock market capitalization of $15 billion; the Czech Republic, $20 million; Hungary, approaching $10 million; and, believe it or not, Russia has a $50 billion stock market now. Russia has been the second best stock market in the world over the last year. Share prices are up almost 200-300 percent for Russian blue chips. You could buy Russian utility stocks—before the election last June when there was still concern about Zuganos winning—for a fraction of today’s price. Utility stock holders have had a capital gain now on average of 200 or 300 percent, and a few companies gained 500 and 600 percent. What distinguishes the best performers among global investors over the last year is not whether they have played the U.S. equity market right. It’s how much exposure they have to Russia. And I can tell you all the best performing funds have been those that have money in Russia and also, I would add, the stock markets of Hungary and Poland, because they were also up last year 80 and 90 percent.

These countries also have the benefit of, in some cases, an expatriate community. Poland, for example, has a population of 40 million with 17 million people of Polish extraction elsewhere in the world. I live in Chicago, which is the world’s second largest city for people of Polish descent, where a million people speak some form of Polish. But we’re also speaking about significant population groups in places like England, Australia, and Canada. It has given Poland access to an elite pool of talent and capital, which is helping to play a role in rebuilding the economy. Indeed last year I was raising 50 or 60 million dollars for this new public investment fund. I got a wealthy Hong Kong banker to put in a half million dollars because he knows so many Poles all over the world.

We have evidence of an economic takeoff, and we have output at much higher levels than it was in 1989. However, there is still a great divergence in the region. Any discussion about NATO expansion has to reflect these divergent economic performances among the transitioning democracies seeking NATO membership.

There are seven countries, now, that are clearly experiencing economic tradeoff, with Poland at the top of the list. I could also have said the same for the Czech Republic, Slovakia, Slovenia, Estonia, Hungary, and believe it or not, now after two years of transition, Croatia. Croatia is enjoying five to six percent growth. Two of these countries, Slovakia and Croatia are clearly not democratic.

A year ago, I could have said Albania was an economic success. Albania did have in the first year following communism eight or nine percent GNP growth. Instead, Albania is consumed by a terrible banking crisis. Several months ago, the European Albanian Central Bank governor asked our treasury to intervene and to warn the governor about the danger of reckless credit union experiments, but the fact is that these institutions have been making campaign contributions to the ruling political party. As a result, no effective action was taken to prevent fraud.

Latvia, Lithuania, and Romania were experiencing sluggish, moderate growth but now have potential economic strength. Latvia and Lithuania were compromised by major banking crises 12 and 18 months ago that wiped out a third to a half of their bank deposits.

Romania, of course, still had enough of a corrupt regime until a year ago, that it was not attracting foreign investments. But with the new regime taking power in recent months, I’ve seen a major upsurge of interest. Romanian investment opportunities are growing.

Russia and Ukraine remain significant players in the region, but the reality is they have great divergences. Moscow is booming. There’s lots of construction, lots of commercial activity. Even some military-industrial areas are recovering now because they’re developing export markets.

In the last 12 and 18 months I’ve met many Russian businessmen who remind me of Polish businessmen four and five years ago. They’re now selling 50 and 60 percent of their output in Western Europe and the United States. But they have had no history in the private sector since 1920. In contrast to Poland, the Czech Republic, and Hungary they have far more serious problems with corruption and lack of the rule of law. But the fact is they’re coping; we are seeing adjustments; and the private sector is developing.

Ukraine has many of the same characteristics, so I’d say at this point it’s is well behind Russia. Whereas Russia has privatized many of its large enterprises, Ukraine is very much paralyzed. All I can say is the movement is in the right direction. They’ve brought in a new currency; they’re trying to stabilize. More and more of my friends are going into investment projects, so 12 or 18 months from now we could also see the Ukraine enjoying moderately positive growth.

The four big disasters are Belarus, Serbia, Bulgaria, and Bosnia. Belarus is basically a tragedy. It’s regressing very rapidly because it’s not begun any transition away from communism. Many of my Russian business friends tell me they don’t want to see Russia merged with Belarus. Their impression is that Yeltsin may say it’ll cost the Russian government a great deal of money to merge because this country is an economic basket case. It’s getting no foreign money, yet still has very much an old-fashioned regime. Serbia is suffering from a combination of corruption, the ill effects of the war, and basically has no consensus about how to reform. Things are likely to get worse before they have the political change required.

Bulgaria is experiencing political change. There’s no doubt that Bulgaria has potential. But Bulgaria has a crippled economy and a very large external debt. In contrast, Romania, which never borrowed, or Poland which restructured, Bulgaria is still trying to honor an enormous external debt burden. At the same time, its economy is suffering the ill effects of seven years of quasi-Communist rule. It has no effective privatization, and what privatization it has is corrupt. The country is suffering a systemic crisis in terms of confidence, attitudes, and so on.

Bulgaria does have the outline for what could be, over a year or two, a very encouraging plan. But sadly, the price for making this adjustment will be a loss of output in the short term and then perhaps a worse recession before things get better.

Bosnia, of course, is a country that has been consumed by war. It’s going to be attracting so much more money in the next year or two it may it may wind up with a Marshall Plan in terms of the country’s potential GNP. If they can work together, it will certainly give them a huge advantage compared to the other countries in the old Yugoslav confederation. But the concerns there are political, not economic.

So the focal point, of course, for NATO expansion has to be the three states ready for near term candidate status: Poland, Hungary, and the Czech Republic. They have the potential to contribute population resources to NATO on the scale of Spain a few years ago. If we have the GNP purchasing power adjusted as developed by the World Bank to measure real output not just nominal paper values, it comes to about 350 billion dollars for a population of about 60 million people. This GNP could easily expand by five to seven percent. Perhaps in 10 years it can be 700 to 800 million dollars. If we go out for 10 or 15 years, this means $2 trillion . . . it could be as significant a region as Italy is as a country.

A further advantage of including these countries in NATO is the fact that they have very different demographic structures than Western Europe. The fact is they’ve enjoyed in the modern period much higher birth rates and still enjoy, even in the post-communist transition period, higher birth rates than many countries in Western Europe. This is, I think, a critical issue for the future of Europe. What will these population divergences mean if we take a 40- or 50-year view on the changing composition of European democracy.

At the present time, the population of these countries under the age of 65 is 56 million. If we take away Slovakia, it’s 51 million. If we look out to the year 2020, it will still be 51 million, and in the year 2,050, it will be 50 or 51 million. If we look at the major countries of Western Europe (Britain, Germany, France, Italy, Spain, and so on), their current population under the age of 65 is 264 million. By the year 2020 it will be 245 million; by the year 2050 it will be 200 million. If we look at the United States by contrast, we’re also more like Poland than like Germany or Britain. Our population under 65 is currently 229 million. In 30 years it will be 270 million, in 60 years 280 million. Russia is much more like Western Europe because of the economic shocks and other changes going on there. Its population under 65 is currently 129 million, in 30 years 118 million, in 60 years 100 million. The fact is the Russian birth rate has fallen very sharply while the death rate accelerated as a consequence of the recent upheavals.

If we look just at the population of men of military age, say 15 to 44, we’re looking, again, at major divergences. Poland right now has about nine million men of military age. It will have that same number in 2,050. Germany has 18.5 million; in 60 years they’ll have nine million. In the case of Italy, we go from 17 million down to 6.4 million; for Spain 9.3 million down to 4.7 million.

Anybody developing the security strategy for Europe in 21st century has to look at these coming changes in population. There has never been any industrial revolution in which we have the kind of depopulation about to occur in several countries in Western Europe. We could debate all day why it’s happening. The reality is that it's happening. It has major implications for the economies and the security policies of these countries.

We have in the countries of Eastern Europe states that can contribute to NATO over a 20- to 30-year period. We are talking about countries enjoying growth; we’re talking about countries with increasing populations; and, finally, of course, enthusiasm. The fact is you cannot get the support today in Western Europe as you can in countries like Poland, and the Czech Republic. In many of the countries of Western Europe you’ve got complete indifference. The risks, of course, are also there even if we fail to have effective NATO expansion over the next year. The fact is that if we don’t see Poland, the Czech Republic, and Hungary get an effective security guarantee, they will replay the past crises in the private and political sectors. There’s no doubt that direct investment will continue in the next few years whether they join NATO or not. People who engage in that investment will make a reasonably long-term deal and think things will work out. But a portfolio investment could be, in the future, much more volatile if it’s foreseen by people in London, New York, and Frankfort that the security situation in Poland is not fully secure.

These states risk their political systems. The fact is that because of Yeltsin, the Cold War, and so on, these people attach a tremendous importance to being firmly anchored to the Western system, and if they fail to get that admission their security solution is jeopardized. This may not guarantee that they’ll reject their current policies; in fact, they may try harder. But it will leave unresolved many questions and if Poland does not have an effective security anchor in the Western security regime political incidents and political events could interrupt economic relations.

These countries in Central and Eastern Europe do not have a lot of options. The fact is they want to be part of the West and they’ll keep trying whatever we do. But if we do disappoint them, there will be adverse side effects that we should attempt to quantify.

Another issue we should consider is the risk of instability in Western Europe over the next four or five years because of the economic crisis now engulfing many countries in the region and the danger that the movement toward a European monetary union will magnify this crisis, not in fact help to resolve it.

Western Europe, especially France and Germany, leaving aside Holland, are currently in the midst of an economic crisis that has three different dimensions. The first is a high unemployment rate. In the case of France, 13 percent; in the case of Germany, a level of unemployment they have not seen since the middle 1930s.

These high unemployment rates probably reflect a period of recession. They also reflect the fact that the European labor markets have become rigid and incapable of producing jobs because of a huge gap in pay and productivity. Over the last 20 years, the U.S. economy has enjoyed the luxury of almost 30 million new jobs for a labor force of 130 million. Western Europe produced only about 12 million for a labor force of 100 million. This is not going to change very quickly because we simply have too many rigidities, too high a tax burden, too many problems interfering in the market clearing process for creating jobs in Western Europe.

In the European Union as a whole, the ratio of public debt and GNP is in the 70- to 80-percent range compared to about 55 percent in the United States. We had great concern here 10 years ago during the Reagan years about the U.S. budget deficit and a debt crisis occurring at some point for a variety of reasons involving changes to the public policy and economy. That risk never came to pass. But in some countries such as Italy, we have ratios of public debt and GNP of 120 percent. On top of this, we also have huge pension plans because the public sectors of many European countries have provided income guarantees that won’t mature for 30 or 40 years.

The traditional way to measure public debt and GNP is to look at the history of wars over the last 200 years. At the end of World War II the ratio of public debt to GNP in the United States was 125 percent; in Great Britain, it was 200 percent. In the rest of the British Empire, Australia, New Zealand, and Canada, it was about 150 percent. If we look at Western Europe today, the current public debt plus the pension plans, we’re looking at ratios of public liabilities to GNP of 300 and 400 percent—twice what we had at the end of World War II in the countries that won the war. These will be a major tax burden on Europe almost indefinitely.

And, thirdly, because of regulation and ineffective public policy, in areas such as telecommunications and information technology, we are probably in the first period in over 100 years that Germany and France in particular did not have any successful companies.

Indeed, at a session a few weeks ago in Switzerland. It was largely a celebration of U.S. success and high technology. The Japanese were also behind but I think they will close the gap more quickly because they are much more willing to make the necessary changes. So we have quite a systemic crisis in Western Europe.

The German government has tried over the last year to address these problems. I was amused to see the cover of a magazine, Deutsch Wirtschaft, which means German economy. The cover artwork depicted Chancellor Kohl, all 300 pounds of him, trying to squeeze into a Uncle Sam costume. This was a metaphor for economic liberalization and market reform. But incentives have led to significant protests by the trade union, a whole series of strikes last year. And the very day I was in Bonn, a few days after being in Berlin, there was a march by 50,000 German shopkeepers protesting liberalized German shopping malls. I remember as a child going with my father to a protest over concerns that a lot of stores were open on Sunday, as we had a small business. In Bonn there were 50,000 German shopkeepers protesting proposals to have the stores be open on Saturday afternoon. And when you have this kind of attitude, this kind of culture, it’s very difficult to get the changes you need to get out of your unemployment crisis.

So, we have a major systemic economic crisis with no immediate end. Moreover, most of the political capital of Western Europe over the last three or four years has been expended not on liberalizing labor markets, but in fact imposing on Western Europe a monetary union to introduce a new common currency to be called the "euro" in 1999 in place of the Deutsch mark, the French franc and the currency of other countries that might qualify. This is obviously the ultimate culmination of the dream of many politicians as a way to make Europe as an entity a more viable, competitive economic force in a world dominated by the Americans and the Japanese. The fact is Europe does not have a number of the characteristics of the United States—for example, as a federal country standing upon a successful currency rooted in the past. First, we can look at labor markets. Every year 17 percent of the American people move. Forty percent cross state lines, 30 percent cross county lines. If we look at Americans aged 20 to 30, a third of those people move every year. In the case of Western Europe, we have no probable data, but anybody who goes to Europe knows they simply don’t have liberal ability on that scale. It does not adjust the way California did four years ago or even 10 years ago, or Texas 15 years ago by people moving or leaving. It adjusts by simply having a high unemployment rate.

In addition, Europe does not have the fiscal transfer programs that we have to compensate for regions that are suffering from economic shocks. In this country, when a state suffers a major economic shock—say, an oil price collapse like Texas had 10 years ago, or the banking crisis England had five years ago—the federal government offset 40 percent of the income loss through a combination of income transfers and reduced tax payments. Obviously we have a significant federal economic infrastructure that helps regions that are in trouble. In the case of the European Union, the total budget is, at most, 1 or 2 percent of GNP and most of that is nothing more than farm subsidies, commodity prices in what used to be backward countries—like Ireland, Spain or southern Italy. This is not an adequate mechanism for dealing with the economic shocks that might come from imposing a common currency, a common single price on much of the European economy. In the case of France, 40 percent of the people have foreign grandparents. The fact is the French gene pool is not a good reflection of what Europe has to have in the way of structural adjustment to cope with the movement toward a common currency, a common price level imposed from the outside. Moreover, the French gene pool probably reflects a number of historical circumstances. Two world wars, the end of colonialism, the tremendous migration from north Africa, Algeria, and elsewhere. I doubt we’ll have those kinds of population movements over the next 50 years if Europe is going to be a successful and stable place.

There will be tremendous tensions, and they will take one of two forms. The first is the monetary union project will simply collapse, because of the inability in Germany and France to achieve their budget deficit targets. Italy is also a factor in this. Italy definitely wants to be in the monetary union in 1999 because for Italians the idea of Europe is not just a monetary union or economic union, it’s central to their whole political identity. The fact is the Italians have little confidence in their political institutions. They rely far more on Europe as a kind of anchor to give the guidance needed. The fact is Italy is the only country in Western Europe that lost the Cold War. The price for keeping the Communists out of power in the 1940s and the 1950s was that for three decades Italy became very corrupt, culminating in the great Italian political crisis of 1992, a crisis which led to the indictment of two-thirds of the Italian parliament and the incarceration of many senior corporate leaders.

Indeed, at an Italian prison a famous business newspaper delivers 100 copies each day. There is no prison in Britain that gets more than one copy of this newspaper per day. But Italy has a prison that gets 100 copies, because there, every day, sit a large share of Italy's corporate leaders as a byproduct of this crisis. So, for the Italians, the idea of being in the monetary union is not just an economic phenomenon; it is very much central to their whole new political structure.

At some point the governments of Europe will have to deal with the question: Can’t we achieve these economic trade conditions we’ve sought, with a small budget deficit, or do we budget, or do we simply defer? And the problem of deferral is that many officials in Europe think that deferral means death. If you try to postpone 1 or 2 years, the project will simply slip into the future indefinitely. This might be a good project. The problem, of course, is to try and compose it in the late 1990s when you have all the structural problems centering on high unemployment.

The second scenario is that they, in fact, fudge the numbers and go ahead and have a union anyway in 1999 with a core of six to eight countries that introduce this new currency. And this goes on for a few years because the unemployment problems are not addressed because we failed to have effective adjustments, sound policy, credible regulation, and fiscal transfers. The result could be a major feud about the conduct of monetary policy in the new European central bank. We have the famous speech by Williams James Bryant in 1896 attacking the cost of gold. If you read that speech, you’ll see most of it was an attack on the Bank of England. In the case of Europe, we could have the same kind of speech being heard in France or Spain or Belgium in four or five years’ time reflecting significant political tensions.

Key to the monetary union project is, of course, France. The major driving force of this process is German unification seven years ago. The whole French strategy, for looking forward is to try and control the growth of German power, to manage Germany by creating new European institutions, by having Germany rule from Brussels or for a new institution in Frankfurt, a European Central Bank, that France can guide, manipulate, and control. Indeed, France still hopes that one of their own men may be the first conservative governor of the European Central Bank.

For countries like Italy and Greece and Spain, the European anchor will no longer be an effective influence in driving their economic policy. They’re obviously still trying to maintain the current trade arrangements, the current year economic zone. But the Italian prime minister cannot go about getting a large tax increase through the parliament, because it is the only way Italy can join the monetary union. He would have to tell the Italian people and implement a responsible budget policy for purely domestic reasons. That has not worked in Italy for many years.

There are ricochet effects on the whole process of European integration. Europe has reasonably positive trade policies for the likely enlargement countries, but not yet for the Ukraine and Russia. Poland, the Czech Republic, and Hungary do enjoy good access to most of Europe’s commercial markets. The exceptions of course are agriculture, textiles, and steel because those have their own special trade regimes. Textiles are a global trading machine.

But the movement toward further integration can be handicapped by the French government. There is still a chance the west European states will muddle through; that in three-to-five years there will be tangible reform to accompany this monetary union project. The evidence of moving in the right direction is still limited. And even in Germany where they’re talking about it intelligently, under Chancellor Kohl’s leadership, the movement toward reform is still meeting lots of resistance despite high employment. The fact is the Europeans have created a whole lot of economic institutions to make middle-aged people comfortable. And they’re quite willing to live with high levels of unemployment for young people, for minority groups, for immigrants, and for others. And the danger is that this will, over time, influence the candidate nations external economic relations as well.

There is a crucial relationship between economics and security. I’ve been involved for many years now in doing economic scenarios for various parts of the world, most of all Europe and Asia but also in Latin America. There is a lot of optimism about the potential for economic integration, the expansion of trade investment, and its ability to guarantee the peace.

But, one must wonder about the parallels that can be drawn between the present and the world before 1914. There isn’t a lot of study about the world economy before 1914. It has far more in common with this time period than any decade in between. The phrase 10 or 15 years ago, the international economy, the world economy, was popular but misleading. As recently as 10 years ago, only about one-third of mankind lived what you’d call a modern existence. Before 1914, the whole of mankind, leading us out of backward countries, were a part of the global marketplace. We have an extraordinary movement going in the world economy because of the success of economies in having capitalist economic systems, private property, and the rule of law.

Believe it or not, the highest growth economy in Europe before 1914 was Russia. It was still a backward country emerging from feudalism, but the fact is it was attracting a huge amount of foreign investment and developing very rapidly. There’s no doubt in my mind that if we hadn’t had the terrible debts of 1914 and 1918, Russia would have been by the 1930s a major economic power and a successful constitutional power. But that future was lost in 1914, despite the desire to maintain it. That future was lost despite the economic integration between London, Berlin, Vienna, and Paris; and despite the societal integration—six of Queen Victoria’s nine children married Germans. We cannot regard the NATO issue and European issues as totally separate. The fact is that the European Union cannot be a complete substitute for NATO for having an effective security structure. The fact is 80 years ago Europe had as much if not more economic integration in place. In 1910 and 1911, the best selling book, The Great Illusion, by Sir Norman Angell made the argument that there would never again be a European war because it made no economic sense. In 1931 he got the Nobel Peace Prize because the book made sense.

Despite the tremendous economic growth in Eastern Europe, and despite the possibility that Western Europe will recover its economic footing, security issues remain relevant. Despite any progress over the last seven years, the tremendous expansion going on in many developing countries and post-Communist countries, with the end of the Cold War, and in spite of the reforming of economic ideas, there are dark political forces out there. They can take the form of populism, they can take the form of nationalism, they can take the form of religious fundamentalism, and they will from time to time come back to haunt us. NATO enlargement, indeed even the importance of the current alliance, remains an important issue in its own right, not one that we can replace by focusing just on European Union. European history shows that security issues will recur with every iteration; all that will change is the nature of the dispute and the format of their conduct.