Economics of Transition

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Economics of Transition

• Module C20EE1
• Semester 1 (Autumn 2009), Weeks 4, 10 Lectures
  by Professor Paul Hare, Mary Burton Building,
  Room 1.04
• E-mail p.g.hare_at_hw.ac.uk
• Website www.sml.hw.ac.uk/ecopgh

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Week 4. Start of Transition
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The 1980s system in crisis

• Growing symptoms of crisis in the socialist
  system during the 1980s
• Slowing growth rates, with a few countries (e.g.
  Poland) barely growing at all
• As a result, living standards stagnated
• Sluggish foreign trade, with these countries
  accounting for a declining share of world trade
• Growing (hard currency) indebtedness in some
  countries, in part due to poor responses to the
  1970s oil price increases
• Inflationary pressures and other signs of
  macroeconomic imbalance (such as trade deficits,
  government deficits, etc.) intensifying.

4
Crisis (2)

• The result was some signs of political tension in
  the region, but probably less than one might have
  expected.
• No real sign that the communist system was about
  to collapse from within, though in economic
  terms, it was clearly a failing system.
• Poland was the most unsettled politically, with
  martial law in force under General Jaruzelski and
  increasing pressure from the Solidarity trade
  union movement also a rapidly worsening economic
  crisis.
• So in late 1988, the principle of multi-party
  democracy was conceded, with elections planned
  for mid-1989 some seats were guaranteed to the
  communists but they still lost badly, and
  Solidarity supporters were invited to form a
  government.
• Note key role of Soviet President Gorbachev his
  declaration that the socialist countries had to
  choose their own path. But who could believe him
  then?

5
Crisis (3)

• Soon after Poland, Hungary agreed to hold
  multi-party elections, under the leadership of
  Miklos Németh (to whom Heriot-Watt eventually
  awarded an honorary degree)
• Then there were big demonstrations across East
  Germany and demands for liberalisation there
  eventually, the Berlin Wall fell, and the Iron
  Curtain was removed
• Demonstrations in CSFR led to the velvet
  revolution there.
• By end of 1989, most of Central Europe had moved
  away from communist rule, towards democracy and
  the project of building a market-type economy
  (with a view, ultimately, of joining the EU)
• Two years later, end-1991, the Soviet Union
  disintegrated.

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The end of central planning and the start of the
transition to the market

• Central and Eastern Europe late 1989
• Former Soviet Union end-1991
• Reform stages (not always in this order)
• Political consolidation or reconfiguration
• Dismantle old economic system
• Build a new market-type economic system
• Macroeconomic stabilisation
• Liberalisation of prices and foreign trade
• Privatisation and restructuring
• Institutional transformation

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Political consolidation/reconfiguration

• Economists usually assume that countries stay the
  same we tend to assume a degree of political
  stability.
• So at start of transition, we tended to assume
  that country boundaries would be stable, and that
  these would be accepted by all.
• Of course, the Soviet Union did split into 15 new
  states, but these were already Republics within
  the Union, so it was expected.
• But the post-communist world was more unstable
  than expected.

8
Political consolidation/reconfiguration (2)

• Thus in 1991, Yugoslavia started to disintegrate,
  and by now, after several nasty wars (both
  inter-state and civil/inter-ethnic), we are left
  with Slovenia, Croatia, Bosnia-Herzegovina,
  Serbia, Montenegro, Macedonia, and Kosovo (whose
  final status is still not determined).
• On January 1st 1993, CSFR split peacefully into
  two states Czech Republic, Slovakia.
• Early 1990s, civil war in Moldova, secession of
  Russian part of the country to form Transnistria
  (still not recognised by anyone!).

9
Political consolidation/reconfiguration (3)

• Wars between Armenia and Azerbaijan over the
  status of various regions.
• Civil wars in Tajikistan, Georgia
• Disputes between Russia and Ukraine over status
  of Crimea, and access to Black Sea ports for
  Russian navy.
• Proposals from Belarus for an economic and
  political merger with Russia this is still
  official Belarus policy, but I dont think Russia
  is very interested.
• By now 18-20 years after the start of
  transition the political landscape finally
  looks more settled. But for many countries,
  warfare has delayed economic reforms, and that is
  evident in the economic data.

10
Political consolidation/reconfiguration (4)

• Even though more stable, it certainly cannot be
  said that all the new states are consolidated as
  democracies, though most are inclined towards
  democracy.
• But some states are not yet democratic at all,
  e.g. Belarus, Uzbekistan, Turkmenistan.
• Others have yet to develop full respect for rule
  of law, or to accept constraints on executive
  power (e.g. Russia).
• More recently, even some apparently settled
  democracies in Central Europe have elected
  strange governments or are experiencing
  political crises (e.g. Hungary, Slovakia, Poland,
  etc.) one could interpret this as normal
  growing pains of democratic systems.

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Dismantle old economic system

• This is the easiest part of transition, since
  closing something down is normally easier and
  quicker than building something new.
• Central planning ended so planning offices
  closed.
• Centralised price fixing ended so price offices
  closed or changed their role (some became new
  offices for competition policy).
• Liberalise exports and imports so offices that
  administered most of the former restrictions were
  closed.

12
Macroeconomic stabilisation

• Especially important in countries where macro
  imbalances at start of transition were severe.
• This means severe shortages, sometimes a big
  government deficit (esp. as socialist era taxes
  on profits disappeared), inherited external debt,
  and trade deficit.
• Hungary few shortages, little inflationary
  pressure at start, so only a modest initial burst
  of inflation, not much active stabilisation
  needed.
• Poland, widespread shortages, large monetary
  overhang, massive inflation in late 1989 (several
  hundred percent), so drastic steps needed in
  January 1990 to stabilise the economy (part of
  the Balcerowicz plan).

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Macroeconomic stabilisation (2)

• CIS countries severe inflationary pressure,
  problem of establishing new currencies, but need
  for active stabilisation underestimated or failed
  to get political support.
• Massive inflation in 1993, everywhere over 1000,
  in Ukraine around 10,000. Most individual
  savings wiped out.
• Hence effective stabilisation delayed until
  mid-1990s.
• In 1993/4, Serbia experienced the worst inflation
  ever seen anywhere, essentially due to financing
  wars by printing money (not good economics!).
  The new currency was tied to the DM, now the
  Euro, and its introduction followed inflation
  over a billion billion percent!
• In all cases, stabilisation means getting the
  government budget and the external balance under
  control, operating a sound monetary policy (often
  with a new currency).

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Liberalisation of prices and foreign trade

• In part this aspect of transition was already
  covered under an earlier heading
• But in practice there was the question of how
  rapidly, how fully the various controls over
  prices and trade should be removed.
• Prices
• Some countries liberalised prices in a single
  step
• But most proceeded more gradually, keeping some
  control over sensitive prices such as public
  utilities, housing, public transport, culture,
  etc.
• This then resulted in some big price distortions,
  e.g. energy prices, for a while, seemed even
  cheaper than before.
• Some prices failed to cover costs, and required
  massive state subsidies.
• But shortages disappeared almost everywhere, very
  rapidly.

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Liberalisation of prices (2)

• Shortage and Prices
• Lipton and Sachs (1990) present a model to show
  that the initial post-transition price rises can
  improve welfare.
• Queueing costs in the old system are a deadweight
  loss, and they disappear once transition under
  way.
• While price rises relative to incomes normally
  lower welfare, this might not be so if people
  also save queueing time depends on the balance
  of costs and benefits, which then becomes an
  empirical question.
• In countries with little queueing (e.g. Hungary),
  the initial jump in prices was also less, but
  almost certainly made people worse off.
• In countries with a lot of queuing (e.g. Poland
  and Russia), the initial price jump was much
  greater. True, queueing did end, but most
  peoples cash balances (savings) were devalued,
  and this represented a big loss.

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Liberalisation of trade

• A few countries, notably Estonia, Poland, both
  ended all physical controls on trade, and
  abolished all (Estonia) or most (Poland) tariffs
  very bold!
• Most countries removed trade barriers more
  gradually, e.g. Hungary over three years (but had
  started in 1987).
• Limited controls remained, and tariff structures
  in early 1990s were very diverse, with some high
  peaks in rates.
• Why retain tariffs at all?
• Revenue raising
• Protection of domestic firms
• Bargaining counter with EU.
• No country liberalised its capital account until
  much later.

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Privatisation and restructuring

• Most firms were state owned in 1989/91
• General notion of market economy is that most
  productive activity should be in private sector
• Hence main element of transition had to be
  privatisation of all or most state-owned firms.
• But as Kornai stressed, privatisation not the
  only way to build a private sector (he criticised
  those who demanded more or less instant
  privatisation).
• Also need to create the conditions for massive
  amounts of new business formation to put right
  the bizarre size structure of firms under
  socialism. This was neglected in some countries,
  and many still have far too few firms.

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Privatisation and restructuring (2)

• Privatisation
• Objectives of privatisation (incl. separation
  from state)
• Speed of privatisation
• Methods (incl. sales vs. give-aways)
• Should there be restitution to former owners?
• Who should the new owners be? (former
  Nomenklatura, crooks, foreigners)
• Role of banks and financial markets in
  privatisation
• Should some sectors/firms be retained in state
  hands, and if so, how should these be managed?
  (e.g. Asset management companies, etc.)
• Should the state retain shares in some firms?
  Golden shares?
• Public utilities and regulatory issues.

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Privatisation and restructuring (3)

• Restructuring
• Many socialist firms were not in good shape to
  compete in the market
• Often over-diversified (made lots of their inputs
  instead of relying on supply system)
• Often produced a product mix not well suited to
  the new conditions
• Often had surprisingly poor information about
  costs and controlled them badly
• Many firms employed too many workers, used them
  inefficiently.
• Hence many of these firms needed to
  restructure/reorganise in order to compete and
  survive in the market.

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Privatisation and restructuring (4)

• Restructuring (2)
• Should firms restructure before or after
  privatisation? (can the government be trusted to
  do what it failed to do before?)
• How to restructure?
• Selling off units producing products outside main
  range (cf. some examples from UK privatisation)
• Cutting costs
• Focussing production on profitable lines
• Investing to develop new products
• Should subsidies/tax relief be available to help
  restructuring?
• Key issue of hardening the budget constraint.

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Institutional transformation

• Most difficult part of the transition, initially
  neglected
• Sometimes boring and technical, hence hard to
  mobilise political support, convince people it is
  important (e.g. accounting reform simplifying
  the tariff structure strengthening property
  rights)
• Example think of the institutions needed to
  make the standard S D model work.
• New laws property rights, contracts
• New organisations financial sector also
  various new types of regulatory body.

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Week 10. Institutions and Transition
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Introduction

• The standard transition policy package includes
  such elements as
• macroeconomic stabilisation
• price and trade liberalisation
• privatisation and restructuring
• institutional reforms
• In the early years of transition, most emphasis
  was placed on the first three elements.
  Institutional change was not wholly forgotten, of
  course, but its importance was perhaps not fully
  understood, it was often not regarded as
  politically very appealing (e.g. how do you make
  reforming business accounting systems seem at all
  exciting?? ), and reforms were often not
  perceived as especially urgent.

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Introduction (2)

• External advisors to transition economies -
  usually mentioned the need for institutional
  reforms, but it also tended to be downplayed
  initially.
• Interesting to note that in most Western-type
  economics courses we still teach rather little on
  the institutional underpinnings of the market
  economy.
• Example - standard S D analysis
• Think about property rights, contracts, etc.
  linked to the standard model

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Institutions - definitions, etc.

• In transition economies, problems of nature of
  the state, state boundaries (constraints on state
  action), objectives of the state, state
  competence.
• Economic institutions are social arrangements
  possessing a number of special features
• (a) they regulate economic behaviour in ways
  which, in the short run, often conflict with
  individual preferences
• (b) they are based on shared expectations,
  derived from custom, trust, legal provisions,
  etc.
• (c) they make most sense if the economy is
  thought of as a repeated game in which most
  types of transaction occur many times and
• (d) anonymity, in the sense that the functioning
  of a given institution should not be dependent
  upon the identity of the economic agents seeking
  to conduct the types of transaction to which this
  institution relates.

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Institutions definitions (2)

• The last is the most problematic feature, and in
  many small-scale and informal business
  activities, such as trading networks, it will not
  be satisfied.
• Given such characteristics, many institutions are
  likely to have the character of public goods.
  Among other things, this implies that the supply
  of institutions generated by the market
  mechanism left to itself is unlikely to
  correspond to the socially efficient level.
  Under these conditions, there is evidently a role
  for the state both in creating institutions which
  the market does not provide and regulating in the
  public interest those which it does.

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Typical institutions

• Private property rights and contracts
• Banks and other financial markets existence,
  functioning and regulation
• Reliable access to credit on reasonable terms
• Bankruptcy/liquidation policy in place to
  facilitate orderly exit
• Labour market institutions social policy and the
  social safety net

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Typical institutions (2)

• Clear fiscal environment for firms, perceived as
  fair, predictable and enforced
• This means, for instance, that in a multi-level
  country such as Russia it should not be possible
  for the regions to set taxes that conflict with
  national policies, and taxes should not be
  changed frequently
• Institutions dealing with competition policy,
  industrial policy and trade policy.
• Trust between economic agents, trust and honesty
  in public institutions (lack of corruption,
  reliable law enforcement, incl. as regards
  business taxation).

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How do institutions evolve?

• Often assumed, as central planning ended, that
  market institutions would just emerge, without
  needing any concrete action. This partly
  explains why the issue got little attention.
• But property rights, business forms, banking
  practices, etc., in market economies evolved
  slowly over centuries.
• Does this mean we have to wait that long in the
  transition economies for good institutions to
  evolve?
• Or are there steps we can take to help create the
  needed new institutions, to accelerate the
  process?

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Evolution (2)

• First, its crucial for policymakers to
  understand the need for reforms (cf. Russia,
  institutions to settle business disputes).
• Next, they need to design the reform, decide what
  to do and in what sequence of steps.
• Tempting to copy other countries can learn from
  their experience. But must also learn from their
  mistakes.
• Also reforms in different fields need to fit,
  can be risky to picknmix.

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Evolution (3) Transition examples

• Housing markets
• Property registers
• Mortgage finance
• Regulating public utilities
• Ministry vs. independent regulator
• Business environment
• Making it quick, easy and cheap to set up new
  firms
• Bankruptcy laws, facilitating exit

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EBRD transition indicators

• Bank set up in 1990/91 to act as a regional IFI
  with a remit to promote transition to the market
  economy in its countries of operations.
• Provides a little technical assistance, but
  mostly operates by providing loans for investment
  projects, now funding new activity at the rate of
  Euros 3-4 billion annually.
• The Banks board of governors soon wanted the
  Banks reporting to include information on the
  transition impact of its activities, and the Bank
  now provides this at project-level (in
  post-project evaluation reports), and for
  sectors. In addition, the Bank assesses each
  year, as part of the Transition Report, the
  situation of each country of operation in regard
  to transition progress.

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EBRD transition indicators (2)

• To make the country assessments, the Bank has
  developed a set of so called transition
  indicators. The main indicators are grouped into
  broad categories such as
• Enterprises
• Markets and trade
• Financial institutions
• Infrastructure

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EBRD transition indicators (3)

• There are also indicators relating to progress
  with legal reforms relevant for private sector
  business.
• All these indicators, and sub-divisions within
  them are assessed on a qualitative scale running
  from 1 to 4, 1 indicating that virtually no
  reform has occurred, 4 (or sometimes 4)
  indicating conditions equivalent to those of a
  well functioning market.
• See the EBRDs Transition Report for any recent
  year (handout) (discuss)

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Evidence - links between institutions and growth

• Numerous empirical studies, both specifically on
  transition economies and on economies around the
  world, linking growth in real GDP (or sometimes,
  GDP per capita) to a variety of explanatory
  variables, sometimes starting from neoclassical
  or new growth theory type models.
• On transition, the first papers were by Fischer
  et al. (1996 and 1997). Other work has regressed
  growth rates on measures of initial conditions,
  measures of macroeconomic stabilisation (such as
  the rate of inflation), measures of economic
  openness/trade liberalisation, and various
  combinations of the EBRD reform indicators
  discussed above.

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Evidence (2)

• General finding that growth does depend on reform
  progress, while conventional variables like
  factor inputs were usually insignificant in the
  early years of transition.
• However, as time passes the impact of initial
  conditions and reform indicators declines why?.
  
• For the countries that joined the EU in May 2004
  and January 2007, doubtful whether a study of
  growth and reform would now pick up much impact
  of (further) reforms.
• Still possibilities for picking up reform effects
  amongst the CIS countries, since in many
  important areas they have a great deal of reform
  still to do.

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Evidence (3)

• Note 1 extensive empirical work suggests that
  resource-rich countries tend to grow more slowly
  than countries lacking resources why?.
• In the CIS, this observation could apply to
  Russia, Kazakhstan, Turkmenistan in particular,
  though in recent years Kazakhstan has shown
  rather good performance how is it overcoming the
  natural resources curse?
• Note 2 there is an issue of causal direction
  when examining links between institutions and
  growth do good institutions cause growth or
  does growth bring about a demand for (better)
  institutions? discuss