The Velvet Divorce: An Economic Analysis of Cause and Effect

In light of EU enlargement and discussion of the Eurozone, Czechoslovakia has emerged as a role model for comparison. The two central European countries of the Czech Republic and Slovakia present an interesting case study on the optimum currency area and on political unification. Despite economic, social and demographical convergence as well as an overwhelming majority opinion in favor of unification, the two countries split less than five years of having political autonomy. Following their split, Slovakia and the Czech Republic took different approaches towards approaching a market-economy, yielding somewhat surprising results. This paper will analyze the viability of Czechoslovakia as an optimum currency area, recount its history in the context of economic and political differences, and then illustrate how differences in political philosophy affected their economies today. Unlike most other research this paper aims to prove that, while political differences may have been the deciding factor in dissolution, it was really economic differences between the two, originating from geographic differences and early history, that necessitated the divorce.
Economic Analysis and the Optimum Currency Area When analyzing the dissolution of Czechoslovakia, and particular when searching for truth as to its cause, it’s important to note that it was in fact a two part split – first the political union and then the monetary union. The second divorce would typically imply that the split was in fact economically motivated, not politically. In order to test this fact, this paper will test Czechoslovakia’s position as an optimum currency area (OCA), which is essentially the range of territory within which one currency should/can be used. This is important because if Czechoslovakia was not an OCA, we can conclude that the split was more likely a result of economic factors than a difference in political opinion. This paper will explore the traditional measure of an optimum currency area using symmetry of economic shocks, intensity of mutual trade, diversification of industrial structure, degree of labor mobility, fiscal transfers, and degree of economic openness as the criterion. For this section, my paper will rely heavily on the economic analysis of Jan Firmuc and Július Horváth. Looking at the symmetry of economic shocks is in essence looking at the effects of changes in the economy on the two nations. Whether or not the two areas experienced asymmetrical shocks is pivotal in deciding if the area is an OCA because if two countries experience asymmetrical demand shocks and can’t change their policies independently in order to adjust, the interests of the two groups will necessarily diverge. This is our basis for assessing Czechoslovakia, for if demand and supply shocks were asymmetrical then the two groups would have incentives to dissolve. Economic analysis of Czechoslovakia during this period shows that, while shocks were positively correlated and fiscal policy did mitigate some asymmetric shocks, the correlation between Czech and Slovak lands was actually less significant than equivalent unions at the time (Fidrmuc, Hovráth 1998). Asymmetric shocks likely occurred and played a role in the eventual dissolution. Intensity of mutual trade is the measure of how dependent the two countries were on each other for exports and imports. This is important because, with one currency, the higher the volume of trade between two nations, the larger the benefit from lowered transaction costs. Looking at Czechoslovakia we see that there was a high degree of interdependence before (and after) the split, and that the intensity of mutual trade was high enough to qualify as an OCA (Fidrmuc, Hovráth 1998). Diversity of industry is important in mitigating the effects of asymmetric shocks to particular industries. If outputs and exports of a country are sufficiently diverse, shocks against one industry will not have as profound an effect on the entire economy – as other industries can still be stable. In Czechoslovakia we see that not only do both areas seem to be sufficiently diversified, but also they have similar commodity structures (Fidrmuc, Hovráth 1998). This means that both countries should have been able to deal with asymmetric industrial shocks independently, and that they experienced very similar shocks as a result of having similar products. The only caveat to this is that Slovakia’s high dependence on heavy and military industries as a result of the transition period may have caused asymmetric developments despite their commodity structures and industry diversification. The degree of labor mobility is the ease with which employers from one area can commute and work in another area. This is important because it allows workers from regions that are affected by high unemployment, like Slovakia, to take up jobs in other parts of the union. If labor mobility is high, then the area is suitable for a monetary union so long as there aren’t significant cultural, religious, or language barriers – all of which did not exist. In Czechoslovakia and still today there is a substantial difference in unemployment that is particularly based on a patter of regional distribution. This would suggest that the two areas experienced asymmetric developments during the transition and that labor mobility was not sufficient enough to mitigate the adverse economic effects (Fidrmuc, Hovráth 1998). Inter-regional fiscal transfers are perhaps the most important factor behind symmetry of economic shocks. In a centralized area there will always be pressure for the government to provide tax-soothing and stabilization services, often through the redistribution of tax revenue. In Czechoslovakia there were two periods: one of significant net transfers from the Czech republic and one of no transfers at all. The size of transfers increased during the start of the transition period, but was ceased during the bottom of the reform-induced recession in Slovakia. In order to counter adverse economic developments Slovakia was eventually forced to adopt new monetary policies and devalue their own currency. A close look at the union shows that it was actually relatively unstable and had an increasing need for exchange-rate adjustments, only possible with a currency split. Lack of fiscal transfers can be largely attributed to the monetary union collapse because “in the absence of fiscal transfers, and given continuing economic decline and persisting unemployment differences…monetary union would have been costly for Slovakia even in the short run,” (Fidrmuc, Hovráth 1998). The degree of openness in an economy amounts to how much interrelation there is between domestic and foreign activity, largely through trade. The more open an economy, the more it will be inclined to use fixed exchange-rate arrangements in order to handle transactions with foreign entities. This is important because fluctuations in exchange-rate arrangements undermine efforts to maintain stable price levels in an economy (Fidrmuc, Hovráth 1998). In Czechoslovakia there was a sufficiently high degree of openness before the split, especially when considering mutual trade between the two areas.
The final criterion I will discuss is political. In order to be considered an optimum currency area, Czechoslovakia would need to demonstrate the political willingness of authorities, and the public, to pursue a civil union. In Czechoslovakia,
“the key role was played by the differences in conceptions and opinions concerning the division of powers between Czech and Slovak political institutions. [….] in spite of extensive efforts by politicians and intellectuals in the interwar period and partly also after the Second World War, the idea of a common Czechoslovak state did not put down deep roots in Slovak soil,” (Musil 1995).
Ultimately it was political differences, which was a catalyst to the Slovak drive to have an independent state, highlighted after the demise of the communist regime – and subsequently the removal of centralized political constraints – that caused dissolution. Excluding political criterion, we can conclude from our analysis that Czechoslovakia was indeed an optimum currency area. But while this may seem to imply that political diversion that drove the inevitability of the Velvet Divorce, these political differences were in reality engendered by systemic differences in economy and the history of the nation. In order to observe the evolution of political and cultural perspectives as a result of economic differences, we must take a historical analysis starting with the Habsburg monarchy.
Austro-Hungarian Empire
In 1918 following the collapse of the Habsburg monarchy, Czechoslovakia was formed. From the very beginning of Czechoslovakian history, there were noticeable differences in economic development between the Czech people of Bohemia and the Slovak people of the Western Carpathian Mountains, despite their many cultural similarities. Under the Austro-Hungarian empire the Slovak lands were heavily dependent on an agrarian economy, accounting for less than 10% of Czechoslovak industrial resources, and had a much lower population density than the Czech lands (Grubal 2011). This initial population and market disparity is the initial seed that would eventually grow to split the two nations.
The First Two Republics (1918-1945)
Throughout the first couple of decades, a series of global events continued to further divide the Czech and Slovak people due to their economic differences. The first of these events was the Great Depression. The more industrial, and thus more heavily export-driven, Czech economy was more largely impacted than their Slovak counterparts. Shortly after, threat of German occupation in 1937 led to a surge in heavy industry in Slovak lands, and subsequently a substantial increase in both employment and total production. And in 1939, shortly after German occupation, the First Slovak Republic was formed; although this was largely a German puppet state and of little political significance, it helped to solidify national identity differences between the Czech and Slovak people in a time of rising economic prosperity in Slovak lands.
The Communist Era (1946-1989) Following the end of World War II, the two states were reunified into the Czechoslovak Socialist Republic. Under communist control Czechoslovakia began a reconstruction movement with the goal to balance the economies of the two lands called the Two-Year Economic Plan, marking a transition period for Slovakia and further bolstering them as a viable independent economy. Both countries saw a decline in economic activity during the Cold War as trade with the west is ceased, but the Czech lands was still more heavily damaged. This period played a very important role in setting the stage for political dissolution. During the 1960s, and particularly in the Prague Spring of 1968, political parties began voicing disapproval with the central government and economic reforms. Despite the skilled labor force there were inadequate incentives for labor that resulted in high turnover, low productivity and poor quality. Czechoslovakian people began looking for full-scale economic reforms and rallied under Alexander Dubcek. While ultimately the majority of reforms from the reformist Dubcek were later reversed under Gustav Husak, one remained: the split of Czechoslovakia into the Federation of the Czech Republic and the Slovak republic. Under communist control the two largely operated as a centralized nation, but a Slovak nation whose economic output had increased twice as quickly as their counterparts had an even prouder identity going into the fall of communism.

The Velvet Revolution (1989-1992) Political deadlock dominated the following years as a power vacuum was created following the end of communist control in Czechoslovakia. With the breakaway of Soviet Satellite nations, the political presence of the anti-socialist Havel of Czechoslovakia, Klaus of the Czech Republic, and the increasingly separatist Meciar of Slovakia, the 1992 elections were proving to be pivotal in deciding the future of the two nations – the main points of disagreement being the redistribution of power between the federation and constituency and the design of further economic reforms. Transfer payments from the Czech Republic had ceased in 1991 and the political and media presence of the Czech Republic dwindled, and vice versa. The leaders of the two nations were unable to meet eye-to-eye on economic reforms, as Meciar remained steadfast in demanding a confederation. More importantly, the Czech and Slovak nations were becoming increasingly culturally different in response to the problems with economic policy making during the reign of communism. The Czech Republic still boasted a 20% higher GDP per capita, but with the impressive GDP growth of the very different Slovak economy many began to question centralized political reforms. Ultimately, despite very low public support for total dissolution (only 10-20% of Slovaks), the two realized that a political union was impossible and the two agreed on a political split.
The Velvet Divorce On January 1, 1993, Czechoslovakia ceased to exist as a nation, but a monetary union between the newly independent Czech Republic and Slovakia. This union, however, was marred by a lack of commitment, low credibility, low exit costs, and lack of fiscal transfers. This union allowed the two to retain a common currency, customs union and common labor market but was still seen as a temporary measure. Despite the union, their still did not exist a single monetary authority as two self-interested, state-representative committees shared decision-making power. Each country established its own central bank, foreign exchange reserves declined, and the new Slovak currency (NBS) devalued. No longer bound by the centralized governments under communism or the political entanglements of being a unified Czechoslovakia, differences in handling economic variances between the two nations proved insurmountable. On February 8, 1993, just over a month after political divorce, the monetary union collapsed; a common labor market was maintained, easing the transition.
Immediate Consequences The economic split produced an immediate, negative economic impact on both countries as traditional links in international trade between the two countries were severed. Prospects of currency devaluation forced many Slovakian individuals and firms to transfer funds to Czech banks prior to the monetary split. Czech exports shot up 25% as Slovak importers sought to repay their debts and Czech’s sought to delay repaying theirs – for one of the first times, there was an outflow of currency from Slovakia to the Czech Republic. Further, "distrust in the monetary setup, devaluation speculation by importers, exporters and banks led to a quick depletion of foreign reserves in the Czech Republic and Slovakia." GDP in Slovakia fell by 3.7% and the NBS devalued by a full 10% (Lopatka 2011). With political and economic independence (largely), the two nations began taking different approaches toward reaching a market-economy.
Post-Czechoslovakian Economy and Foreign Direct Investment Following the dissolution, both countries would experience a decline in economic performance that would continue for the next several years. In order to combat the inevitable recessions related with dissolution, the two would turn towards attracting foreign direct investment (FDI) as a means to boost their respective economies. This is important because:
“Capital flows to developing economies afford those countries ways to take advantage of investment opportunities while providing savers with mechanisms to earn better return and reduce risk. Access to the international capital markets also allows countries to acquire foreign assets in boom times and use those assets in lean times, thereby creating a buffer to adverse changes in domestic income and production,”(Bernanke 2005).
While both countries possessed educated labor forces, an entrepreneurial orientation and available land, both also lacked capital, and how these two countries pursued FDI in the years after the split proved to have dramatic impacts on the two economies. When rating economies, Euromoney uses the criterion: political risk, economic performance, debt, credit rating, and availability of international financing. There exists a quantifiable relationship between the transparency of markets, social and political organizations, political risk, economic performance and the inflow of FDI – after an initial lag in policy reform, the social democratic Slovakia eventually proves to be a poster-child of accounting for these factors. Towards the end of the 1990s and in through today, Slovakia has made significant economic reforms related to taxation, healthcare, pensions, and social welfare systems while simultaneously maintaining cheap, skilled labor, low taxes, no dividend taxes, a relatively liberal labor code and a favorable geographic location (“Czech Republic vs. Slovakia”). The more conservative, inward-looking financial system in the Czech Republic along with foreign (even domestic) concern about corruption and an aging population has failed to attract the same growth. This is, in a sense, misleading. Despite the economic progress and liberalization in Slovakia, the economy is still underperforming, in an absolute sense, relative to the Czech Republic. Even 20 years later the Czech economy still boasts a GDP of $286 billion PPP and a $27 thousand per capita, while Slovakia comes in at $132 billion and $24 thousand respectively (“Czech Republic vs. Slovakia”). One year after their split in 1994, the Czech Republic considerably outperformed Slovakia in political risk (17.5 vs. 12.1) and economic performance (16.0 vs. 9.3), the two most important factors in attracting FDI. Starting in the late 90s, though, we start to see the effects of Slovakia’s more liberal use of government to boost economic growth. According to Euromoney, in 2001 Slovakia’s political risk had increased 1.93 points and their economic performance increased 2.55 – the Czech Republic saw a .78 and 1.88 increase in the same categories. A closer look at Slovakia shows that large investments to telecommunications, petrochemical and metal working industries with a broadening of FDI entry to include both share-based and branch based investments fueled the positive growth. This trend continued and can be expected to continue “as a result of the improved international image of Slovakia, local legislative conditions for the entry of FDI into Slovakia, and, last but not least, a relatively positive rating of the business environment in Slovakia by notable foreign investors already established there,” (Hošková 2001). The Czech Republic today has evolved into a stable and prosperous market-economy that is very interconnected within the European Union. Its small, open, export-driven economy is more sensitive to changes in external factors than Slovakia, though. For example, during the 2008 recession the Czech Republic experienced double-digit drops in industrial production and exports and a nearly 5% fall in real GDP due to decreased demand, and the same pattern was observed 4 years later. What seems even more astonishing is that the Slovak economy continues to outgrow the Czech Republic despite its membership in the Eurozone since 2009. One might have expected the opposite to be true after observing the effects of membership on countries like Greece and Spain, “Yet the result is exactly the opposition — the Czech economy, growing at a relatively weak 1.7% in 2011, fell into a shallow contraction in 2013, while the Slovak economy continues to grow — 3.3% GDP growth in 2011 and around 2.5% growth in 2012,” (Lees 2013). The difference in economic performance during the 20 years after the Velvet Divorce can largely be attributed to the political attitudes and policy making of the two countries. The center-right Czech Republic focuses more heavily on budget austerity, even recently experiencing protest towards a program that features tax increases and spending cuts. Slovakia, on the other hand, made efforts to shield the poor from spending cuts while introducing a more progressive tax increase in order to boost budgetary funds for transport infrastructure and educational opportunities (“Czech Republic vs. Slovakia”). A closer look at Slovakia’s entry into the Eurozone also shows that this may actually account for some of their growth, as a reduction of trade costs between Eurozone countries likely has a positive impact in the short run. Political opinions towards economic reforms seem engendered in the economic conditions of the two countries’ pasts. The economic transition period during the final decades of Czechoslovakia engrained very different positions towards socialist reform, as the Slovak lands prospered at the expense of the Czech lands during this time. The differences in political opinions, engendered by economic variances, allowed Slovakia to be more successful in attracting FDI and improving economic growth. According to Adela Hošková, “when it comes to the entry and operation of FDI in Slovakia, all these have in principle been accomplished: a high rate of growth of labor productivity, and that developing at a higher pace than in the case of comparable local partners, and internationally reaching the standard of parent organizations, a growing volume of output of adequate quality, maintained employment, etc.”
Conclusions
This paper has covered the dissolution of Czechoslovakia into the independent states of the Czech Republic and Slovakia. The key point of analysis rests on the fact that it was a two-part split, and the idea that the dissolution of the monetary union would not have happened if it were truly political differences that drove the two apart. We’ve analyzed Czechoslovakia as an OCA and concluded that, while it can technically qualify, different patterns of voter support for economic reform reflected unequal distribution of costs and benefits from reform, engendered by economic differences. Following the political split, low labor mobility and the cessation of fiscal transfers along with the maintenance of a common market made a monetary union unnecessary and destructive. Following their split, the difference in political opinion brought about by a history of economic differences caused the two countries to take different approaches in attracting foreign direct investment. The more socialist-friendly Slovakian public was more willing to have a liberal approach to government and became a poster child for success, seeing consistently greater annual GDP growth than the Czech Republic despite its membership in the Eurozone. While the Czech Republic still outperforms Slovakia in terms of total output and unemployment levels, the gap is closing. Slovakia’s relatively larger room for growth, short-run effects from membership in the Eurozone, and most importantly political policies have supported substantial growth in the years after post-Czechoslovakian recession. One would expect this trend to continue as the Czech Republic struggles with an aging population and political unrest, but Slovakia’s membership in the Eurozone may cause negative economic effects in the coming years.

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