The Third Way, with its optimistic mix of economic openness and protection for society's most vulnerable, was touted in the 1990s as a good economic model by and for central Europeans. But its appeal is proving short-lived.
A more competitive form of capitalism is taking root as governments fight to
attract a limited pool of inward investment. Increasingly aggressive and pro-active inward investment agencies targeted massive tax breaks with promises of infrastructure upgrades and land development. Ever-lower taxes are puncturing central
European solidarity but proving highly effective in luring overseas companies
and money to some countries.
In the 1990s, the Third Way did generate significant interest in central Europe and caught on with leaders such as Vaclav Havel in the Czech Republic. It seemed to offer a pragmatic mid-way between US-style capitalism and the European tradition of a strong welfare state. It emphasized economic growth with social stability and was pitched as a new path, taking elements from previous political systems and re-combining them. Hardly surprising then that it caught the eye of ex-Communist states as they dismantled old systems.
Broadly, the authors of the Third Way saw it as modern social democracy, updated for the globalization era. Governments should not fetter the economy. That led to a laid-back approach to privatization, an emphasis on the maintenance of fiscal discipline, a balanced budget and sound macroeconomic policies. Socially, however, it called for intervention to protect the most vulnerable in society and provide quality and equality in social goods (education and healthcare, for example), calling for active labour-market policies to ensure job creation and environmentally-sound policies.
Third Way/Third World
But if it was popular in the 1990s, the Third Way's star waned fast. In the Anglo-Saxon world, it fell out of favour after George W. Bush's election. A staple with the UK's Tony Blair in the run-up to the general election in 1997, it was noticeably absent in the run-up to this year's election. In central Europe, it was also no longer flavour of the month and by 1999, Havel's rival Vaclav Klaus called the Third Way "the quickest way to the Third World". What was behind this downgrading?
It was always a difficult trick to combine the Utopian economic liberalism and social protectionism of the Third Way. In rich, highly advanced economies, for example the Scandinavian countries, the advanced welfare was under fire as it put a huge drag on economic growth. And, clearly, if governments there were struggling to balance books, poorer countries had little chance of protecting the most vulnerable.
Enter the tiger
The talk turned to a new model: the Celtic Tiger. Here was a country that lagged the EU's GDP per capita average but then overtook it. Leaders looked hard at the success of the Republic of Ireland in attracting investment and raising GDP through low taxes and targeted incentives. The policy mix seemed more relevant and was tried and proven. Already, the natural advantage of low wages and promised membership of the European Union had increased flows of foreign direct investment (FDI). Governments realized if they could get a bigger slice of the FDI pie, it would solve many problems (tax revenues, technological backwardness, unemployment) at once. And that's when things got nasty. Governments were not afraid to outbid their neighbours to get it.
Poland, the Czech Republic and Slovakia were successful in attracting leading car manufacturers using this model but with eye-popping amounts of government aid to attract manufacturers. And the flat tax took off. Estonia had introduced it in 1994, and neighbouring Latvia and Lithuania quickly copied. Russia adopted a flat tax in 2001, with Serbia, Slovakia and Ukraine all following. Slovakia's low rate of 19% covering income, corporate and sales taxes was especially key. Poland and Hungary are reportedly considering introducing a version of the flat tax regime soon.
Tony Giddens, director at the London School of Economics and proponent of the Third Way, acknowledges that central Europe will benefit from low tax regimes in the short to medium term, enabling them to catch up with the rest of Europe. He believes, however, that a 10-year period should be enough to generate sufficient prosperity to adopt policies that are more in line with the Third Way: spending more money on social goods through higher tax flows. It will be key for the new member states over time to provide a balance between growth and welfare, he notes.
The addition of more social welfare policies may or may not come to pass. In the meantime, the race to get the next FDI deal is causing its own distortions. Smaller countries, such as Slovakia, risk becoming too dependent on a few large, key employers and industries, making it highly vulnerable to exogenous shocks.
And the dependence on exports to Western Europe is proving contentious and unpopular in France and Germany. "They should take a far-sighted view of low tax regimes," Giddens says. But that prospect seems distant. The Germans are angry about EU subsidies, and in France, fears of the triumph of Anglo-Saxon capitalism and tax competition, are part of the backlash against the European Union's proposed constitution. In the long term, the insistence by "old" Europe on social cohesion is likely to break the central Europeans' giddy experimentation with capitalism.