The Czech Republic is sometimes regarded as a smaller version of Germany. This small Central European country is amongst the least indebted in the EU, and can fairly be characterized as a nation of small savers . The Central Bank’s commitment to fighting inflation as its overarching goal is rivaled only by that of the Bundesbank.

The economy is firmly export-focused, with car manufacturing the largest single business sector, and there is a long industrial tradition. And Germany is by far the Czech Republic’s largest trading partner, making the country’s economic performance highly correlated with that of its northern neighbour. No surprises, then, that when the German economy experienced a sharp downturn in 2009, the Czechs followed a similar path.

The Czech economy contracted by 4.7% in 2009, with the biggest drop in the first quarter ; this was one of the biggest falls in output in the EU, though smaller than Germany’s 5.1% contraction. After the initial shock, both economies began a steady recovery, with the Czech economy growing by 2.6% during 2010.

In many ways the Czechs were in a strong position to weather the crisis. The economy had been growing steadily, progressing towards convergence to western European living standards. Public debt, at 41.2% (2011), is still one of the lowest in the EU, and safely within the Maastricht criteria. Moreover, private sector debt levels are also low: household and non-financial corporate debt accounts for 71.6% of GDP as of the end of 2011 , making the country the second-least indebted nation in the EU after Romania. And the current low interest-rate environment has been matched by relatively low rates of inflation; at its present level of 3.2%, inflation is only slightly higher than the EU average.

Despite these strengths, however, the economy has taken a markedly different path to that of Germany since 2010. Whilst Germany’s economy has also experienced something of a slowdown in recent months, the Czechs are now firmly in double-dip territory. Throughout 2011 growth slowed; the rise in GDP for the whole year was 1.7%. This slowdown was deeper and faster than that experienced in the rest of Europe.

Third- and fourth-quarter 2011 year-on-year growth in the EU as a whole was 1.4% and 0.9% respectively. The same figures for the Czech Republic were 1.2% and 0.6% . And this year the country’s economy has returned to recession proper. The year-on-year GDP growth figure for the second quarter of 2012 was -1.0%. Whilst unemployment has remained stable at 8.4% (compared to last year’s 8.5%) the number of people in self-employment has risen. The number of long-term unemployed (out of work for 12 months or more) has grown to some 44.3% of all those unemployed.

So why has the Czech economy taken such a sharp downturn? The answer would appear to be rooted in developments in the domestic economy.

Despite the openness of the economy, some 70% of GDP is still accounted for by spending by domestic consumers and the public sector, and the slowdown in the export sector related to the ongoing Eurozone crisis started well after the Czech Republic started to run out of steam. Indeed the export sector has been the only source of growth for much of the past year or so.

The answer, therefore, must lie in the fall in spending in the domestic economy, in particular in the public sector. The two years since the last general election in late May 2010 have been characterized by an aggressive austerity policy. From 2010 to 2011 the deficit was been cut from 4.8% of GDP to 3.1%. This decrease in government consumption matches that in countries such as Greece, Spain and Ireland.

And the burden of austerity has largely taken the form of spending cuts – the flat income tax rate of 15% has remained unchanged throughout the crisis. The reason for such a hardline approach to spending, despite such a low debt level, lies in the rigid ideological stance of the current centre-right coalition, especially the finance minister, whose small party campaigned on a slogan of ‘cuts, cuts, cuts.’ Neither the logic of the paradox of thrift nor the numbers seem likely to sway the thinking of economic decision makers.

Nevertheless, the coalition is fractious, riven with divisions, and clinging on to power with a wafer-thin majority. Speculation is rife that the government will fall before the end of the year, leading to early elections. Perhaps events will hasten a change of policy, and bring the hope of a turnaround.

Tanweer Ali is a finance lecturer with the State University of New York, currently based in Prague.


The Czech Republic’s Disastrous Austerity Experiment
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