The Hungarian crisis

Akos Valentinyi, 19 March 2012



Hungary was the front-runner in market reforms among the former socialist countries in Central and Eastern Europe, gradually liberalising its economy in the 1980s. In the early 1990s, it seemed to be in the best position to converge fast with the European Union, both in terms of income level and institutional quality. However, convergence has stalled since 2005. The expansive fiscal policy and the build-up of a large external debt prior to the worldwide economic crisis in 2008 turned Hungary into one of the most financially vulnerable countries in Europe. Moreover, recent policy measures aiming to improve the fiscal balance and the household financial position have undermined the security of property rights and of private contracts. By the end of 2011, Hungary was asking the IMF for help.

Growth performance

Hungary showed relatively rapid growth in terms of GDP per capita between 1995 and 2004, keeping up with its Visegrad peers (the Czech Republic, Hungary, Poland and Slovakia) and converging with the old EU countries. However, since 2005 it has been growing more slowly than its peers and no longer appears to be converging. Breaking down growth into the contributions from various factors reveals that its total factor productivity (TFP) has grown relatively slowly since 1995. Only the faster capital accumulation and the increasing number of hours worked made Hungarian growth comparably respectable. Unless TFP picks up, Hungary will eventually diverge from the rest of Europe as margins of convergence through hours worked and capital accumulation are gradually exhausted. Weak investment in recent years suggests that this process has already started.

Figure 1. Convergence to EU-15

Source: Total Economy Database, Conference Board 2011.

Labour market trends

One of the key questions facing Hungarian policymakers is how to increase labour force participation, given that the country has a comparatively low employment-population ratio. Higher employment would increase income relative to the old EU member states for a given level of labour productivity, as well as raise the tax base and reduce government expenditure on benefits and pensions.

Hungary’s tax wedge, defined as the difference between the total labour cost to the firm and take-home pay as a fraction of the former, was on average the second-highest in the EU, after Belgium, from 2000 to 2008. The greater the wedge, the lower the take-home pay for a given total labour cost. Lower take-home wages reduce labour supply at the extensive margin, primarily for younger and older workers. In 2011, the wedge in Hungary decreased thanks to the introduction of a 16% flat income tax rate, but it will rise again in 2012 due to the increase in labour-related taxes levied on firms. Evidence suggests that the transfer system or increasing take-home wages are likely to have a significant positive effect on labour supply at the extensive margin, and hence on participation (see Benczúr et al. 2011).

The effect of a minimum wage on labour supply is non-standard in Hungary, just as it is in several other Central and Eastern European countries (Tonin 2011), inasmuch as it interacts with tax evasion – firms and workers may decide to under-report workers’ earnings to avoid taxes and social security contributions. In this case, workers receive cash-in-hand wages in addition to their reported wages. Minimum-wage legislation affects the decision about how much of workers’ earnings to report. When firms have to report at least the minimum wage, an increase in the latter is equivalent to an increase in labour income tax, since a rise in minimum wage increases the fraction of workers’ earnings that has to be reported, and hence increases the proportion of these earnings subject to taxation and social security contributions. The evidence suggests that take-home wages decline in response to the minimum wage hike for those workers earning the minimum wage, whose numbers tend to be disproportionately high when the minimum wage interacts with tax evasion. This has a negative effect on labour supply and on participation (Kertesi and Köllo 2002).

Fiscal policy

Unlike its peers, Hungary has been under the excess deficit procedure of the European Commission ever since it joined the EU in 2004. Between 2002 and 2010, the general government deficit has either exceeded or been close to 5% of GDP. In addition, fiscal policy is characterised by a strong election cycle, broken only by the financial crises in the run-up to the 2010 election. This policy often led to rapid debt accumulation followed by a large fiscal correction, before starting over again. These developments clearly indicate that the Hungarian fiscal institutions are weak. To strengthen the fiscal framework, Hungary set up an independent fiscal council in 2008 with its own staff to provide forecasts and monitor detailed fiscal expenditures in a transparent way (see Calmfors and Wren-Lewis 2011, about the role of fiscal councils). However, when this council was critical of the government’s 2011 budget proposal, it was replaced by a three-member panel whose remit is merely to express their broad opinion about the budget bill. Without independent forecasts, analyses of fiscal policy and fiscal transparency, it is unlikely that the new institutional arrangements will eliminate the election cycle and ensure that fiscal policy becomes sustainable. The recent announcement by the European Commission that it proposes to suspend €495 million of cohesion funds for Hungary for 2013 for failure to address the excessive deficit signals that Hungary’s fiscal policy is still viewed as unsustainable.

Financial crises and recent policy measures

At the end of 2007, most emerging economies either had high external debt or high government debt. Hungary was the only country with both, which made it financially very vulnerable. As the 2008 financial crisis hit, Hungary was the first to ask for IMF assistance.

Figure 2. Public debt and external debt in emerging markets in 2007

Note: Net external debt = gross external debt − international reserves excluding gold.
Source: Quarterly External Debt Data Base at the World Bank llast accessed on 19 October 2011, World Development Indicators, September 2011.

Hungary’s past fiscal behaviour helps explain why public debt was high. One of the main factors driving external debt has been that Hungarian banks borrowed heavily internationally before 2008 and offered loans denominated in foreign currency both to households and firms. Borrowing in foreign currency meant a build-up of a large, unhedged foreign liability position in the balance sheet of households and firms (Ranciere et al. 2010, and Csajbók et al. 2010). These liabilities were largely denominated in Swiss francs and, to a lesser extent, in euros. By March 2009, the Hungarian currency had depreciated by 26% against the euro, and by 66% against the Swiss franc by November 2011, both relative to September 2008. This has put a lot of strain on many balance sheets.

In order to address the problems of the foreign currency loans, the Hungarian government passed legislation in September 2011 that unilaterally changed the terms of all foreign currency loan contracts by allowing debtors to make a one-off repayment of their loans at a discounted exchange rate. The costs are to be born entirely by the banks. In mid-December 2011, the government and the banks agreed to share the costs of further arrangements to ease the problems of foreign-currency debtors. These arrangements have worsened the banks’ capital requirements, prompting them to adjust by, among other things, reducing their balance sheet. This implies slow or even negative credit growth in the near future, which hinders growth.

Hungary’s centre-right government, which won a two-thirds majority in the parliament in spring 2010, has introduced taxes on financial institutions that are an order of magnitude higher than similar taxes being discussed elsewhere in Europe. It has levied crisis taxes only on sectors dominated by foreign-owned firms, introduced a 16% flat rate for personal income tax while raising other taxes on labour, and nationalised private pensions to plug the hole in fiscal revenues created by the flat tax. It has unilaterally changed the private loan contracts between banks and households to ease the strain on households’ balance sheets caused by borrowing in foreign currency before the crisis and by the large depreciation of the Hungarian currency since then. These measures have, on the one hand, introduced new distortions across sectors, and on the other undermined such fundamental institutions as private contracts and property rights. Such measures are unlikely to be conducive to long-term growth.

Lessons from the Hungarian crisis

  • An independent national fiscal watchdog may provide an effective constraint on fiscal policy. It is regrettable that the Hungarian government abolished it after it criticised the government’s budget for over-optimistic assumptions and a lack of transparency.
  • The absence of labour market rigidities does not necessarily ensure good labour market outcomes. Recurrent fiscal problems keep taxes on labour high, ultimately reducing take-home wages. This can have a negative effect on labour supply and, eventually, on labour force participation. Minimum wage legislation interacting with tax evasion can have similar effects.
  • A financial crisis and a perilous fiscal position often lead to government policies that are not conducive to long-term growth. The Hungarian government introduced exceptional taxes on the financial sector, and imposed significant costs on the banks, with its policy concerning foreign currency loans. It also introduced other measures that undermined property rights and private contracts. These measures will likely exert a negative impact on economic growth both in the short and long run.

Author’s note: This column is based on “The Hungarian Crisis” in The EEAG Report on the European Economy, CESifo, Munich 2012, pp. 115-130.
The EEAG members are collectively responsible for each chapter in the Report. They participate on a personal basis and do not represent the views of the organisations they are affiliated with.


Benczúr, P, G Kátay, A Kiss, and OM Rácz (2011), “Income Taxation, Transfers and Labor Supply at the Extensive Margin”, National Bank of Hungary, Budapest, mimeo.
Calmfors, L and S Wren-Lewis (2011), “What Should Fiscal Councils Do?”, Economic Policy, 26:649-695.
Csajbók, A, A Hudecz, and B Tamási (2010), “Foreign Currency Borrowing of Households in New EU member states”, MNB Occasional Papers 87, National Bank of Hungary, Budapest.
Kertesi, G and J Köllo (2002), Labour Demand with Heterogeneous Labour Inputs after the Transition in Hungary, 1992–1999 – and the Potential Consequences of the Increase of the Minimum Wage in 2001 and 2002. Budapest Working Papers on the Labour Market 2002/5, Institute of Economics, Hungarian Academy of Sciences, Budapest.
Ranciere, R, A Tornell, and A Vamvakidis (2010), “Currency mismatch, systemic risk and growth in emerging Europe”, Economic Policy, 25:597-658.
Tonin, M (2011), “Minimum Wage and Tax Evasion: Theory and Evidence”, Journal of Public Economics 95:1635-1651.

Topics: Europe's nations and regions, Global crisis
Tags: Eurozone crisis, Hungary

Cardiff Business School, Institute of Economics, HAS, and CEPR Research Fellow