This post is invited and was written by Professors Schomaker and Wentzel, based on a paper present ed by Professor Schomaker  in the "Arab Spring" session which was part of  the Middle East Economic Association conference that was held in Chicago during the period January 5-7, 2012. The opinions expressed are those of the authors. I plan to organize a new session on Arab Spring for the Western Economic Association International (WEAI) conference which will be held in San Francisco during the period June 28-Jule 3, 2012.

Same same, but different? MENA countries in transition

By Rahel Schomaker and Dirk Wentzel

Current developments in the Arab countries show that the political systems and its leaders, which have been the partners of European countries for a long time, are rapidly changing, and it is likely to assume that the whole Middle East will not be the same afterwards. The initial political nature of the change in these countries should not lead to an underestimation of the role played by economic factors. Even with a view on potential outcomes, economic factors remain relevant as the current developments will affect not only the MENA economies themselves, but also the political and economic relations with the European countries.

The perception of the “Arab Spring” in international media as well as amongst politicians and researchers worldwide is often like a “one-of-a-kind” situation, unique and not foreseeable in its outcomes. But this may not be the whole truth, as the chances and challenge emerging from the revolutions in the Middle East and North Africa are not very new, but are comparable to some way to the developments in Central and Eastern Europe and the fall of communism twenty 20 years ago. The analogy might be in particular important with a view on the reactions of the European Union, which faced regime changes and the necessity of a stronger openness towards its neighbors then, and might have learned some lessons.

The implicit assumption of most analyses on that issue is that the long-run target of the MENA countries is some form of market-driven economy – an assumption which is, at least partly, backed by the statements of the provisional governments as well as the previous actions undertaken in the reform process, but can not be taken as granted, recognizing the MENA-specific cultural framework and the political orientation towards Islamist parties in many MENA countries. Anyway, if there is a political consensus in favor of market economy and more democracy, the so-called “economics of transition”, originally coping with a country’s change from a centrally planned economy to a free market, can provide helpful insights, as well as evidence from Eastern Europe. Several factors can be identified which play a pivotal role in obtaining efficient, stable and economically successful regimes after the transformation:

• Liberalization and privatization – There is specific need for a transition process which allows (most) prices to be determined in the markets, and lowers trade barriers which precluded a connection to the price structure of the world's market economies. Privatization has been a great issue in the former socialist countries – the transition from state-owned and centrally administered companies towards competition and innovative firms. Also in the Arab world, most major companies were run by the state or owned by families from political elites.
• Macroeconomic stabilization – Taming inflation and lowering it over time is of specific importance, especially with a view on the initial inflation burst that mostly follows from liberalization. This process requires budgetary discipline and discipline in the growth of money and credit as well as a progress toward sustainable balance of payments.
• Restructuring and privatization – The creation of a viable financial sector in this context is of pivotal importance. The strong influence of the state has to be reduced also in this area. A specific cultural issue for the Arab countries stems from the demand for a financial system which is – at least in parts – in accordance with Islamic values.

· Legal and institutional reforms – The re-definition of the role of the state, establishing the rule of law, the introduction of appropriate competition policies, as well as the creation of trusted institutions in general (“good governance”) can be seen as the necessary base for the transition process as a whole.

Two general approaches to how the transition process should be conducted can be distinguished: “Gradualism” vs. “Shock therapy”. The main question in this context is whether to take reform steps more slowly, or achieving the most rapid possible changes, do anything as quickly as possible? Sequencing and timing, the question when to introduce single measures, is of pivotal importance, even if there is no unambiguous evidence which way may be the better one.

In this context, the important role of culture, history and path dependencies for economic performance and transition processes in single countries has to be emphasized. The transition process in Central and Eastern Europe followed the main directions of development of “Western” civilization: In the economic dimension towards a capitalist economic system, and in the political dimension in the direction of democracy. Additionally, it was a complete transformation, parallel in all spheres: In the economy, in the political structure, in political ideology, in the legal system, as well as in organizing social issues. The transformation in the CEE was mostly non-violent, it took place under peaceful circumstances and the changes were not forced upon society as a result of foreign military occupation, but where induced by the people of the respective countries. Furthermore, the transformation took place speedily, within a time-frame of 10 to 15 years.

In many former socialist economies the economic transition process started with an appreciation of the respective currencies and a rapid liberation of prices from artificially low levels, e.g. due to subsidies, which led to inflation bursts, inflation rates of between 450 and 1000 percent (Central East Europe and the Commonwealth of Independent States, respectively) were the consequence early in the transition process. The same developments are likely to occur in the reform countries in MENA, as there has been some inflationary pressure for a while, not only since the reform processes started, but also accelerated by higher commodity prices.

Additionally, there is the obvious danger that in the reform countries in MENA, as in the CEE countries 20 years ago, the output will fall initially – the case of the J-curve. As evidence from the CEE countries suggests, little of the initial decline in output had been induced by the tight macroeconomic policies applied, but by a kind of “disorganization” (like the disruption of the production network or the lack of material and inputs), associated with more political shocks. These disruptions led to a loss in output, a development which is to some extent evident in the MENA countries, where we can observe a sharp drop in economic activity within the first months in 2011. Additionally, in the CEE countries, differences in the ability to reorient trade toward the more developed economies in the EU and the US have been observed. We have to expect the same in MENA as some countries may face more “adverse initial conditions” than others – related to the degree of industrialization, governance quality, the share of agriculture in the economy, skill levels and so on. The institutional framework seems to be important just as well in this context, as the ability to stabilize the country’s political system rapidly, and to avoid corruption and rent-seeking might be higher in some states than in others. The longer uncertainty about the future political system exists, the more likely a large output gap seems to be.

For the MENA countries, as in Eastern Europe in the early 1990s, the transfer of state industrial property into private ownership is pivotal, with the governments’ willingness and ability to start the privatization process, if necessary by renationalizing industries, e.g. in reclaiming ownership and redistribute it to private enterprises afterwards, being of specific importance. This is as more important as, depending from the length of time the transition process takes, the hazard of single managers (especially members of the “ancient regime”) to take advantage from “spontaneous privatization" is high, as observable in the CEE and Russia in particular in the mid-1990s.

Generally spoken, access to finance, especially for small and medium enterprises, is limited in MENA, and loan concentration is high. A massive capital flight, which was a result of the uprisings (e.g. net FDI in Egypt and Tunisia declined by about 25 per cent during the first 6 months in 2011), additional to downratings by rating agencies, worseness the current situation. It is common wisdom that reforms towards a market economy require substantial amounts of capital – being it to facilitate the reallocation of investments, modernization measures or the improvement of infrastructure, as well as start-up aid for entrepreneurs, or for the necessary institutional reform processes. For the countries in Central and Eastern Europe during the first years of the transition process it was difficult to raise the required capital, but the possibility of becoming a member of the European Union later worked as an incentive to reform the political economy, and European investors were – relatively early in the transition process – willing to invest in these countries. There seems to be a lesson learned, as in the case of the MENA countries a multinational initiative, including G8, international institutions as the IMF, and some Gulf states, started to provide financial help to the economies, worth 40 bn. US-$ in sum, provided for 2011 to 2013. The extent and the allocation of the financial help can be crucial, even if lessons from other political and economic transitions – in Latin America, Central and Eastern Europe and East Asia – suggest that transitions can take a long time, and certainly cannot be planned from the outset. Balancing attention to short-term needs with considerations of medium/long-term sustainability and growth will be a central challenge. Periodic re-evaluation and reorientation will be necessary, as reliable external partnerships will be.

This is as more true with a view on the role of the EU: A closer economic co-operation has been a goal from the very beginning of the different cooperation processes, as e.g. the Barcelona Process or the European Neighborhood Policy, but the envisioned Free Trade Area with Pan-EU-Mediterranean accumulation has not been created yet. The countries from Central and Eastern Europe experienced a deep and rapid integration into the EU, marked by close trade integration, financial integration, the free movement of labor and not least the prospect of a closer monetary integration. Only three years after the fall of the Berlin Wall, the Treaty of Maastricht was negotiated which gave the Eastern European Countries in transition a clear perspective for further EU membership. That stabilized expectations and therefore reduced transition costs. The countries in MENA, on the other hand, despite more than a decade of preferential relationship, are not as strongly EU-oriented: Trade and financial barriers remain high, and despite the proximity of MENA countries to the European Union, signs of significant monetary integration within the Mediterranean basin are missing. A closer co-operation in monetary issues therefore might be necessary to exploit the growth potentials for the MENA region, and in general a greater openness of the EU markets towards the MENA region and its main export products seems to be useful. For a long time the benefits of trade remained mostly with the EU partners, on the backdrop of the current reform processes additional benefits for the MENA economies may be able to substitute direct financial assistance of the EU. This is even more the case with a view on the freedom of labor: While in the EU the demographic trend turned negative decades ago and at least in the medium-term workforce has to be imported, in many MENA countries unemployment rates are high and a so-called “youth bulge” provides workforce which can be exported. Increasing rates of illegal migration towards Europe, and a long evidence of intra-region work migration, demonstrate that the willingness to work outwards is given by a large part of the population, at least in the non-oil producing MENA countries. Migrant workers in this context not only disburden local labor markets, but trigger economic growth via remittances. While in the context of a closer integration for most CEE countries the freedom of labor has been given timely, this problem remains unresolved regarding the MENA countries.

Therefore, if the EU as a whole and its single member states want to play an important role in the future, as there is so much shared interest with the countries in the Middle East and North Africa – in terms of economic co-operation as well as political stability and security, a deeper engagement of the EU in the region and a clear signal – towards EU enterprises as well as the international market – that they are willing and able to support the reform processes is needed.