Illiberalism and Foreign-Led Growth: An Unlikely Romance

Since Fidesz (Orbán’s party) and PiS began their quests to subjugate the domestic political institutions (in 2010 and 2015, respectively), the main “economic” criticism voiced by the liberal opposition came down to the following: rule of law violations will deter foreign investors, and we need them to ensure uninterrupted growth. The argument made sense; Poland and Hungary follow a growth model based on foreign direct investments (FDIs) made by transnational companies. The socialist legacy in the form of a well-educated workforce and an able industrial base was a bargain for Western manufacturers in the 1990s, looking to reduce their production costs in the face of increased competition from East Asia. These investors allowed Poland and Hungary to become the poster children of successful capitalist transitions, in contrast to post-Soviet neighbors like Ukraine, which was one of the poorest countries in the region even before Russia’s invasion.

With the rule of law under threat, European liberals hoped, the companies which fostered Poland and Hungary’s economic development would not want to risk operating in an uncertain legal and political environment and would move elsewhere. A decade after the “illiberal turn,” this prediction has not been borne out by the facts. Poland and Hungary have sustained high levels of growth and continue to attract foreign investments, especially in manufacturing and business services. The reasons for that continuity can be found in the hybrid approach to the economy and an unspoken political-economic consensus mastered by the far-right: giving leeway to the markets in one domain, but exercising a hands-on approach in another.

Eastern Europe: The Place Where Illiberalism and Capital Meet

The collapse of the Eastern bloc in 1989 was followed by a sharp turn toward a neoliberal economic model. The Washington Consensus aimed at dismantling the socialist economies and taming the raging crisis in Eastern Europe through the privatization of state-owned enterprises and liberalization of foreign trade. Currently, standard neoliberal policies persist in both nations and neither PiS nor Fidesz seem to object.

Poland and Hungary have low income taxes and high VAT rates, highly regressive tax regimes devised to attract investment; transnational corporations are still being lured to invest by the promises of “special economic zones,” a code name for low corporate taxes. Flexible labor markets and weak worker protections make both nations attractive destinations for FDIs. Although back in the day Poland was the cradle of the labor movement Solidarity, and both countries retain a potent industrial base, their union membership rates are abysmal, rendering these organizations virtually irrelevant in big politics.

In 2021, PiS made an attempt to reform the tax code and strengthen the link between personal income and tax rates, but ultimately yielded to pressure coming from capital owners, and the reform lost its bite. Once Fidesz came to power in Hungary, it swiftly presided over an unprecedented tax reduction, phasing out progressive taxation and reducing corporate tax rates to the lowest levels in the whole European Union. In 2018, in spite of protests, Orbán’s government deployed the so-called slave law, allowing firms to bind employees to complete as many as four hundred overtime hours a year.

Regressive taxes and lax labor regulations were a sacrifice meant to protect two ingredients on which post-accession growth depended: FDIs and exports. The Fidesz and PiS governments saw the first instances of positive current account balance since the early 1990s and oversaw a rapid expansion of the share of exports in the Polish and Hungarian GDP. Taking advantage of the proximity to the German industrial hub and its supply chains, both countries specialized — to differing degrees — in the manufacturing of cars and electronics. Their industry is currently going through the process of technological upgrading, occupying increasingly high-tech niches in the supply chains — enough so to mention the Hungarian city of Debrecen, a newly established European powerhouse in the production of electric car batteries.

Even if neither Morawiecki nor Orbán are too ecstatic about economic competition coming from wealthy nations like Germany, they accept the trade-off of globalization for growth. The main reason is simple: growth allows them to advance their conservative but highly redistributive social policy agendas.

Illiberal Economics and the Rebirth of the Social Agenda

One institution that survived the pro-market revolutions of the 1990s is the welfare state. Originating from the Bismarckian tradition, both countries have retained high social insurance spending levels, mostly concentrated around pensions. Early retirement schemes were widely used in the post-transformation period to deal with the high unemployment. The political scientist Pieter Vanhuysse has labeled this strategy the “great abnormal pension boom,” as it led to the establishment of a powerful pensioners’ constituency. Until today, pensioners remain the main support base for the right-wing populists, as well as the key guardians of the central role of the two respective welfare states in economic policymaking.

Both Morawiecki and Orbán have successfully used these strong existing welfare state legacies to rally political support through a series of sizeable cash transfers aimed at their core constituency: pensioners.

Since 2015, PiS has presided over the deployment of the so-called thirteenth and fourteenth pensions (an annual, flat-rate “pension bonus”), lowered the retirement age, and secured generous pension indexation rates. It also introduced a generous universal child benefit, Family 500+, equaling to roughly €110 per child of monthly payouts, the first such comprehensive and universal family benefit since the transition.

Fidesz was initially more cautious, coming into power in the years directly following the 2008 financial crisis, but in recent years also moved toward cash handouts. Orbán commissioned a pension bonus similar to the Polish one ahead of the 2022 elections, which, together with some further tax cuts, amounted to €5 billion. These policies have followed the renationalization of the compulsory private pension scheme and a sizeable increase in the level of benefits. Outside pensions, the Hungarian agenda has been generally centered around families, with tax cuts, benefits, and preferential mortgage rates becoming conditional upon childbearing.

Overall, this “illiberal” policy agenda is motivated by two aims, advancing a socially conservative politics and building a base of support for the Right. Benefits, while frequently devoid of means-testing, are targeted at childrearing families or the elderly. The recipients of the benefits are numerous, which allows the Right to build a base across a broad section of society. In Poland, over 3.5 million children are eligible to receive the Family 500+ benefit; the program is also credited to have cut the child poverty rate by three quarters only in the first year of its functioning. In the still “emerging” Eastern economies, where policymakers often viewed social sustainability as an obstacle to growth, the kind of programs that PiS and Fidesz have deployed were a genuine game changer.

An alliance between liberals and capital opposed this social policy agenda, citing concerns over public debt levels. But until the COVID crisis, both countries were persistently reducing their debt-to-GDP ratios and retaining deficit levels under 3 percent of GDP. How, one might ask, is that possible in the light of the loose fiscal policy of both Poland and Hungary? The Polish and Hungarian economic performance was so strong that the additional social spending got effectively watered down by the rising government revenues. The uninterrupted FDI- and export-led growth created enough leeway for the governments to be able to implement far-reaching social policy agendas. This growth had also direct implications on fiscal policy: low interest rates meant cheap debt and loose fiscal constraints.

But the concentration on cash transfers came at a cost. The pronatalist policies have failed to boost fertility levels, and the demographic outlook for Poland and Hungary remains as bleak as ever. The far-right governments have also effectively disregarded social services, leading to the “crowding privatization” of health care and meager funding of public education. The underpaid teachers, doctors, and nurses employed in the public system conduct one strike action after another, but both the salary levels and overall public expenditures tend to only anemically follow growth.

What’s Different About the Current Crisis

In spite of the drawbacks, the hybrid economic policy of the illiberals has so far been a success, both by the ballot box and in Eurostat country comparisons. Fidesz won the 2022 Hungarian parliamentary elections by a landslide; PiS has retained its pole position on the Polish electoral stage since 2015. For the last decade, both Poland and Hungary have enjoyed healthy GDP growth and some of the lowest unemployment rates across the EU. Even the COVID lockdowns did not undermine their economic modus operandi: bold emergency fiscal packages were deployed, and the recovery following the lockdown periods was initially looking smooth.

But this year, things have changed. The Russian invasion of Ukraine has exposed the weak spots of the central European growth model, centered around the cooperation with the German industrial complex, which is dependent in its core manufacturing industries on cheap exports of oil from Russia. While exports to Germany served as stabilizers when navigating the crises of the past, this time around its economy appears less resilient to the global turbulences. And although it is too early to gauge the impact of the Russian gas divestment on long-term industrial output by the Rhine, it seems that now the impending economic slowdown will be felt also at EU’s eastern outskirts.

But the German problems are not the most imminent threat to Morawiecki’s and Orbán’s economic policies — inflation is. Eastern Europe already tops the charts of EU’s inflation levels; Hungary has seen the rate hover above 20 percent for some time, and Poland is trailing close behind. In previous crises, especially during COVID, both economies took advantage of their national currencies and independent monetary policy, but this time, being outside of the eurozone seems more like a liability, given the additional uncertainty over exchange-rate fluctuations. Since inflation established itself as a key implication of the supply chain instabilities, the Polish and Hungarian central banks have increased interest rates to levels not seen anywhere else across the EU — even though the impact of these hikes on inflation is somewhat debatable.

To recap: the German economy losing its impetus will act as the first break backpedaling Polish and Hungarian growth. High interest rates are going to hinder domestic consumption, landing yet another blow to growth, and the suddenly expensive borrowing will constrain the potential fiscal response that worked so well in the past. So are the Polish and Hungarian economies on the brink of a catastrophe? Not necessarily. Their fundamentals — industrial production and growing services — are still relatively healthy, and will help them eventually power through the impending slowdown. The catastrophe may come from elsewhere.

Inflation Violates the Existing Social Contract

On its own, slower growth could be mediated by yet another instance of the income boost strategy: effective cash transfers to protect the most vulnerable. But in the long term, they will have a hard time catching up with double-digit inflation. Purchasing power declines are already felt and noticed. And a sudden halt to the modus operandi that became the watermark of the illiberals poses a new challenge to their popularity. The numerous people whose livelihoods have significantly improved over the course of illiberal rule will be the first ones to suffer from the suddenly rising living costs.

The middle class also has reasons to be worried — in both countries the mortgage market that was booming for years came to an effective standstill with the interest rate hikes, and the existing debtors are having a hard time keeping up with the ever-increasing mortgage instalments. Finally, the yearslong disregard of public services means that the population became increasingly reliant on private schools and health care, effectively shrinking the preexisting social safety net.

Politically, the problem is far less pronounced for Orbán. Fidesz just won the elections in a landslide, so the Hungarian prime minister has a lot of time to figure out the next moves before needing to mobilize his voters again. The outlook for PiS is less bright. The 2023 parliamentary elections are in sight, and although PiS still polls ahead, for now it seems on course to lose majority to a potential coalition of opposition parties. In this context, the recovery funds could be a ray of sunlight to the Polish economy and a much-needed electoral fuel. The money would be used to stimulate the economy and thus protect wages, but also speed up the green transition, of which both Poland and Hungary are serious laggards.

But the crisis of illiberal economics goes beyond Orbán and Morawiecki — the sheer paradigm of a hybrid, semi-dependent economic model that many countries outside of the Western European core have deployed is increasingly in need of an update. So do watch this space. We need socialist thought to partake in the updating process.

But Western Europe should also watch carefully for a different reason. The new Italian government led by Giorgia Meloni, while deriving its electoral base from the affluent and business-friendly north of the country, will also have to manage Italy’s elaborate welfare state and reckon with the large pensioners constituency in its political biddings. Marine Le Pen in France is still eying the presidency in 2026, and is known to maintain cordial relations with both the Polish and Hungarian governments. Poland and Hungary have been implementing the “illiberal” model with considerable success for a number of years. Depending how they fare now, the policy measures they employ may serve as inspiration or deterrent for the unveiling of illiberal governments in the West.