Transition:Macroeconomic Stabilization

1
TransitionMacroeconomic Stabilization

• Igor Lukashin
• ECN 365 / IBS 394 Lecture
• August 4, 1998

2
Stabilization Policies Definition

• A package of measures that are linked with the
  beginning of a structural reform
• Necessary for successful transition
• Different countries similar issues
• Matters of choice
• Speed
• Sequencing

3
The Standard Stabilization Package

• Price liberalization
• Reduction of subsidies
• Deregulation of price-fixing
• Liberalization of domestic trade
• Balancing the government budget
• Taxes increase (especially on excess nominal
  wages)
• Government spending cuts (beyond reduction in
  subsidies

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The Standard Stabilization Package, Continued (2)

• Restrictive monetary policy
• Interest rate increase by Central Bank to restore
  a positive real interest rate (retrospective?)
• Direct regulation of bank lending
• Incomes policy
• Aimed at stopping the inflation spiral
• Poland weak indexation of the nominal wage, tax
  on wage increases in the state sector
• Hungary tax on wage bill, alleviation if higher
  wages is an efficiency result

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The Standard Stabilization Package, Continued (3)

• Foreign trade liberalization
• Lifting of import export licenses
• Permission to enterprises to engage in foreign
  trade
• Lowering of tariffs
• Current account internal convertibility of the
  domestic currency (?)
• Devaluation of the domestic currency bringing it
  down to the (black) market rate

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The Standard Stabilization Package, Continued (4)

• Heterodox stabilization program combines
• Standard monetary fiscal restrictions
• Several anchors
• Nominal
• rate of exchange
• money wages
• Real
• money supply
• interest rate

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Creating a Private Market Economy

• Privatization
• De-monopolization
• Banking, financial tax reform
• Social safety net development
• Replacing of the old system
• Cushioning the impact of austerity measures
  structural transformation
• Industrial policy development
• Identify winners and losers
• Defining activities in need of support devising
  appropriate policies (subsidies, etc.)
• Taking care of the environment

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Tactical choices

• Gradualism or Shock Therapy?
• Sequencing of policies
• Is there the optimal recipe?

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Tactical choices Sequencing. Price Liberalization

• Stabilization before structural transformation
  Consensus
• Credibility problem early announcements of
  systemic measures recommended
• Price liberalization
• Surge in inflation concern state monopolies will
  inflate prices
• High monetary overhang gt fuel inflation as
  prices are liberalized
• Debate eliminate monopolies overhang first
• Demonopolization takes time State-run
  monopolies survival-maximizing
• Overhang was quickly wiped out

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Tactical choices Sequencing. Foreign Trade
Liberalization

• Standard package
• Opening of domestic markets
• Strong devaluation of domestic currency
• Current account convertibility
• Advantages Unquestioned?
• Price liberalization foreign competition
  prevents domestic monopolies from too sharp price
  increases
• Inherited distorted price structure would be
  corrected by an imported one
• Devaluation fixed or pegged exchange rate
  firm nominal anchor
• Depressed exchange rate deters imports

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Tactical choicesSequencing. Banking Financial
Reform

• Belongs to structural transformation phase
• Necessary for standard instruments of monetary
  fiscal stabilization to work
• CB influences money creation by commercial banks
  through an interest rate policy
• Modern tax system is required for deficit
  reduction
• Cut spending
• Increase tax collection through a new
  sophisticated code combining direct indirect
  taxation
• Banking financial reform too much time?

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Tactical choices Sequencing. Practical Solutions

• Sequencing gt political credibility
• Determination of the policy-makers to proceed
  with the announced measures found critical
• Whole front movement forward toward the
  envisioned measures
• Aim at stabilization
• Introduce piece-meal structural reforms to
  enhance credibility or to trigger correct
  responses to interest rate or tax increases
• Fine-tuning in primitive market conditions an
  illusion

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Tactical choices Speed.

• Empirical answers
• Stabilization swiftly
• Structural reforms feasible only over number of
  years
• Shock therapy versus Gradualism
• Out of necessity Poland
• Huge inflation, large budget deficit,
  unserviceable external debt
• Political victory signal Czechoslovakia
• Low inflation, low budget deficit, very low
  foreign indebtedness

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Tactical choices Speed. Political Agendas.

• Big Bang (Poland, Czechoslovakia)
• Political commitment to a monetarist vision
• willingness to break away from the past
• Insuring against the temptation of a third way
  (e.g. market socialism)
• Capitalized on political and social consensus to
  impose drastic, necessary but unpopular measures
• Gradualism (Hungary)
• Communism already discredited
• New ruling coalition split
• Already on the road feeling
• Prices largely free, forint near convertibility

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Tactical Choices Speed. Other methods

• Speedlargely a credibility issue
• Hungary gradualist measures self-proclaimed
  commitment to quick transition
• No theory of gradualism not to be confused with
  the evolutionary approach
• Shock without the therapy Russia
• Based on shock therapy concept
• Altered due to conflicts between parliament
  government government central bank
  nomenklatura-linked lobbies
• Prices not fully freed, credit not fully
  tightened, nominal wages allowed to overgrow
  inflation, convertibility not implemented

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Stabilization Measures Expected Outcomes

• Inflation decrease after once-for-all sharp rise
  in prices following end of subsidies
• Reduction in budget deficits
• Improvement in balance of payments
• Deterioration in real indicators
• Drop in output, consumption, investment
• Short lived, quick recovery
• Actual much bleaker picture

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Stabilization Measures Achievements. Money
Finance

• Inflation (Table 7.1 (a, b, c))
• Remained highQuestions to ask
• Is hidden inflation totally eliminated
• Shortages disappeared
• Did not immediately affect costs (?)
• Why is inflation was still so high
• Did not originate from household sector (overhang
  wiped out, weak wage indexation, nominal wage
  anchor
• Supply-side Increase in material costs low
  efficiency production
• Excessive money supply
• Were the policies wrong?

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Stabilization Measures Achievements Balancing
Budget

• Drop in output reduced revenues increased
  expenditures
• Difficult to find additional ways in reducing
  expenditures after cutting off subsidies
• Tax evasion growing, difficult to track due to
  absence of developed collection structure gt VAT
  taxes

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Stabilization Measures External Stabilization

• Over-devaluation of domestic currencies
• Coping with inflationary expectations, assuring
  stability of exchange rate
• PPP-rate comparisons Table 7.3
• Problems with over-devaluation
• restriction on necessary imports
• encouragement of wasteful exports
• Improvements in current account reorientation
  of trade to the West
• Foreign debt serious constraint (?)

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Stabilization Measures Fall in Real Output

• Fall in output
• Rise in unemployment
• Nothing went wrong
• Output HAD to fall, maybe not so deeply
• Alternatives?
• External constraint IMF-World Bank structural
  adjustment program