Transition in Eastern Europe: Current Issues and Perspectives [1 ed.] 9783428491070, 9783428091072

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Beihefte der Konjunkturpolitik Zeitschrift für angewandte Wirtschaftsforschung Applied Economics Quarterly

Heft 45

Transition in Eastern Europe: Current Issues and Perspectives

Duncker & Humblot · Berlin

T r a n s i t i o n i n Eastern E u r o p e : C u r r e n t Issues a n d Perspectives

Zeitschrift für angewandte Wirtschaftsforschung Applied Economics Quarterly Heft 45

Transition i n Eastern Europe: Current Issues and Perspectives

Duncker & Humblot · Berlin

Die Zeitschrift Konjunkturpolitik wurde 1954 von Albert Wissler begründet. Die Deutsche Bibliothek - CIP-Einheitsaufnahme [Konjunkturpolitik / Beiheftel Beihefte der Konjunkturpolitik : Zeitschrift für angewandte Wirtschaftsforschung. - Berlin : Duncker und Humblot. Früher Schriftenreihe Reihe Beihefte zu: Konjunkturpolitik ISSN 0452-4780 Transition in Eastern Europe : current issues and perspectives / [Schriftl.: Herbert Wilkens]. - Berlin : Duncker und Humblot, 1997 (Beihefte der Konjunkturpolitik ; Η. 45) ISBN 3-428-09107-8

Schriftleiter: Herbert Wilkens Alle Rechte, auch die des auszugsweisen Nachdrucks, der fotomechanischen Wiedergabe und der Übersetzung, für sämtliche Beiträge vorbehalten © 1997 Duncker & Humblot GmbH, Berlin Fremddatenübernahme und Druck: Berliner Buchdruckerei Union GmbH, Berlin Printed in Germany ISSN 0452-4780 ISBN 3-428-09107-8 Gedruckt auf alterungsbeständigem (säurefreiem) Papier entsprechend ISO 9706 ©

Inhalt

Bernd Huber and Friedrich L. Seil Introduction

Ulrich

7

Blum

Greed and Grief i n East Germany - the Socialist System's Crisis, Collapse and Transformation

11

Henning Klodt: Comment

35

Klaus-Dieter

Schmidt

Transition i n Eastern Europe: The Integration of Goods and Factor Markets into the World Economy

39

Markus Mende : Comment

67

Baas van Aarle Currency Substitution and Currency Controls: the Polish " B i g Bang" of 1990

71

Nina Budina and Sweder van Wijnbergen Debt Management and Inflation Stabilization i n Bulgaria

93

Clemens Fuest and Bernd Huber Government Deficits, Inflation, and Economic Transition

Ill

Dietmar Wellisch : Comment

135

Johannes Bröcker and Bernd Raffelhüschen Fiscal aspects of German unification: Who is stuck w i t h the bill? Frank D. Weiss : Comment

139 163

6

Inhalt

Antonin Rusek Transition to Markets i n CEFTA Countries. A Comparative Overview

167

Hubert Grabisch : Comment

189

Daniel Gros and Andrzej

Gonciarz

Stabilization and Economic Reform i n Russia, Ukraine and Belarus

197

Rolf J. Langhammer:

219

Comment

Introduction By B e r n d H u b e r and F r i e d r i c h L .

Sell

This special issue of " K o n j u n k t u r p o l i t i k " brings together a selection of papers presented at the conference "Transition i n Eastern Europe: Current Issues and Perspectives", held at the Dresden University of Technology on March 27 - 29, 1996. We w o u l d like to thank our main sponsor, the Volkswagen Foundation, who enabled us to organize a meeting of more than 25 economists specialized i n the field of economics i n transition. Additional financial assistance by the Dresdner Bank and further support by the Centre for Economic Policy Research (CEPR) and the Irving-Fisher-Gesellschaft (IFG) is also gratefully acknowleged. The aim of the conference was to discuss (i) some fundamental issues i n the economics of transition, (ii) aspects of liberalization/privatization/stabilization and (iii) the experience of selected countries. I n this volume, U l r i c h Blum's paper is a contribution to (i); Klaus-Dieter Schmidt, Clemens Fuest / Bernd Huber have worked on (ii) and Bas van Aarle, Nina Budina / Sweder von Wijnbergen, Johannes Bröker / Bernd Raffelhüschen as well as Antonin Rusek and Daniel Gros / Andrej Gonciarz have presented case studies of the recent past (iii). Rather than glancing through the abstracts of the papers included i n this volume, we would like to present what we t h i n k were major outcomes of the sessions / discussions. I n doing so, we focus on the 'perspectives' notion mentioned i n the conference title and we hope to offer to the public a number of hypotheses which, i n our view, are worth further discussion. 1. First of all, i t seems to be quite important to tackle the economic reasons for the failure of the socialist system of central planning. A t the same time, one should analyze historical and economic phases of relative success during the socialist experiment and try to identify which factors jointly contributed to this outcome. 2. The distribution of personal incomes and wealth appears to be an extremely important if not critical variable for the success of the trans-

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Bernd Huber and Friedrich L. Seil

formation process. This observation not only applies to episodes of stabilization and / or liberalization but also to the chosen modes of the privatization process and their relative success. I n a way, one may ask whether there exists an "optimal change of personal income and wealth distribution" during the process of transformation. 3. When trying to assess the costs and benefits of reform policies and the results achieved, any methodological approach should take into account an intertemporal perspective. 4. The discussion on how countries of Central and Eastern Europe can be integrated into (or how they can find access to) the w o r l d economy, should not be conducted solely under the auspices of a future membership i n the EU. Instead, economists are challenged to investigate among other things - how much the E U continues protectionism against countries which w i l l not become members of the E U i n the foreseeable future. 5. The Dresden conference has confirmed that one should deal carefully w i t h the role of the institutional environment when i t comes to analysing the process of transition. Among those institutions, financial markets figure prominently and are of great relevance for a sound development. From today's point of view, i t cannot be expected that countries i n transition w i l l show balanced budgets i n the (more or less) near future. Hence, the financing of these deficits must take into account a number of issues. If, for example, the aim is to minimize the present value of future costs associated w i t h the process of transformation, i t is important for the government to issue not only short and medium-term but also long-term debt instruments. 6. Most interestingly, the role of exchange rate policy as a factor contributing to the success of reform policies is given much less weight today than a few years ago. On the contrary, the independence of central banks from public finance obligations receives more and more attention (as can be observed i n the case of Russia). A number of contributions claim an early status of independence for the central bank which helps to eliminate the monetary overhang. This can be combined w i t h a variety of exchange rate regimes. 7. I n comparison, the relative success i n countries of Central and Eastern Europe seems to point at the comparative advantage of a quick, almost instant liberalization strategy. Gradual liberalization along w i t h interventionism of trade policy (see Russia, Ukraine and Belarus

Introduction

9

as examples) has proved to be much less successful. Protectionism tends to postpone structural adjustment and reduces the (external and internal) competitiveness of the country i n question. Finally, we would like to thank the publisher, Duncker & Humblot, who made this special issue possible, its managing director, Prof. Dr. Norbert Simon, and the managing editor of " K o n j u n k t u r p o l i t i k " , Herbert Wilkens, whose support and cooperation were invaluable. Dresden and Munich, January 1997 Bernd Huber Friedrich L. Sell

Greed and Grief in East Germany the Socialist System's Crisis, Collapse and Transformation By U l r i c h

Blum

1. The rise and the decline of the CPE Previous studies have explained the rise and the fall of the CPE as a result of poor institutional and property rights arrangements. However, they fail to properly account for the problems of transformation. I n a recent paper, we have pointed to the relevance of information processing which can be shown to have a major impact on economic performance (Blum, Dudley 1997): supervisors are essential to the vertical f i r m when information transmission costs are low but information storage costs are high. If technological shocks lead to reduced costs of information storage, as i t occurred i n the 1970s, hierarchical firms may become obsolete. However, this transformation d i d not take place i n the Eastern countries. The ability to monitor supervisors fell, economic performance worsened and, consequently, the rent that the state could extract declined. As an extension to this idea, this paper aims at an analysis of the socialist f i r m and its performance over the years following World War I I w i t h a focus on the development of its efficiency. This worsening of the general economic situation lead to a reduced ability of the principal to reward or punish the supervisors. This decreased clout on the economy encouraged internal slack and collusion which lead to a further erosion of economic performance. Historical analysis shows that many non-democratic institutions rely on competitive types of leadership by exploiting mutual mistrust 1 . This improves effort, the quality of the information system, the control of the principal and, finally, the efficiency of the economic system. I n an earlier study (Blum, Dudley 1991), we have portrayed the state as a rent maximizing unit that increases its efficiency through the spatial 1 This is especially true for the Leninist-type totalitarian state, i n which a second bureaucracy not responsible to government, but party oriented, was introduced; this "parallel hierarchy" is described by Arnold (1961).

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Ulrich B l u m

discrimination of taxes and public goods. Instead of a concept of geographic space, we could apply this to firms' space, i.e. the control span of directors: Recently, Olson (1995) has argued that socialist dictators are rent maximizing war lords; their long term interest leads to long term maximization of rent and, consequently, to a sustainable exploitation of national resources. Through measures of tax discrimination they can i n crease exploitation as they also do through the setting of low wages. Competition among managers and bureaucrats i n the early periods of autocratic or totalitarian government generated sufficient productivity and transmitted the w i l l of the dictator; w i t h reduced authority of the principal and emerging collusion among managers and bureaucrats, effort i n firms was reduced. So why did the authority of the principal fall and further reduce the efficiency of the socialist economy which added to its final collapse? I n this paper, we analyze this process of competition among supervisors i n a game theoretical context. I n the second chapter we first look into the scientific coverage of theories of the CPE and its development u n t i l transformation. Then we proceed by modelling the socialist f i r m i n the t h i r d chapter and show how the reduced authority of the principal affected economic performance. We conclude i n the fourth chapter that this development has had long-term "cultural effects" on economic behavior and, consequently, on the quality of transformation.

2. Scientific coverage and alternative paradigms 2.1 Stylized facts

Transformation processes from the Stalinist-type Centrally Planned Economy (CPE) to the Market Economy (ME) started i n Eastern Europe early after the closing of the Iron Curtain. They were always rolled back by the USSR, and only Hungary and Poland were able, at the beginning of the 1970s, to secure themselves a certain degree of economic and market autonomy. Ever since then, researchers have devoted increasing attention to the systemic characteristics of different economic systems and problems arising if a transformation from one to the other system is taking place. Although they have studied i n detail the different states of each economic system, they have paid much less attention to the dynamics of transforming one into the other. Exceptions to a certain degree are found i n Raiser and Nunnekamp (1993) and Raiser (1994).

Greed and Grief i n East Germany

13

A still rather not discussed field i n the present literature relates to the analysis; why the i n i t i a l take-off of CPEs i n their process of industrialization, especially i n Europe, was rather successful and why transition is so hard and so time consuming. Contrary hereto, the analysis of the CPEs decline has exploded. As we w i l l see i n the second part, the most outspoken explanations for the decline and final collapse of communist countries relate to the inappropriateness of the monetary - and more general economic - system, the inferiority of the social system and the organizational inability to properly generate and handle the information necessary for efficient resource allocation. But each of these arguments is also valid for the 1950s, a period i n which these countries were much more successful. We propose the following stylized facts, which a theory on the "life cycle" of the CPE and the socialist f i r m must be able to answer: (1) CPEs had been successful i n the process of rapid industrialization. (2) CPEs declined w i t h the change from heavy industry to high-tech i n dustries, were unsuccessful i n the tertiarization of the economy and finally collapsed 2 . (3) Industrially developed CPEs have difficulties to transform into developed market economies If we take East Germany as a reference case, this is portrayed by the development on next page 3 . We w i l l distinguish among four categories of contributions into the economics of transition 4 : (1) old institutional economists, which explain behavior as a result of particular institutional arrangement that developed through tradition and corresponding routines and heuristics. (2) functionalists, w h i c h explain behavior through the functions defined and / or performed i n society (3) new institutional economists, which explain behavior as a result of particular institutional arrangements which are the outcome of 2 Among other reasons, the MPS as accounting system did not encourage tertiary activities; i n West Germany, over-industrialization u n t i l the end of the 1980s was a result of a undervalued currencies u n t i l the 1960s. 3 A n excellent and detailed description on the transformation process from Marx to market i n East Germany is given by Dennis (1993) 4 A n interesting survey on what different "institutional" schools exist is given

by Reuter (1994).

14

Ulrich B l u m

GDRPC94 Figure 1: Growth rates of per-capita income, East Germany, 1948 - 1994

property-rights arrangements; they base their approach on methodological individualism and especially emphasize the importance of the individual and competing social groups, for instance i n the process of rent seeking. (4) structuralists, which explain behavior (the "suprastructure") as a result of the structural setup i n a systemic approach of society. Two of these categories were already proposed earlier by Burrel and Morgan (1979) i n the context of the reorganization of firms. They distinguish among radical change and regulation on the one hand, subjective and objective methods on the other hand. They combine four combinations: radical humanists , which focus on discrepancies between reality and the cognitive consciousness of people; radical structuralists , which analyze how reality steers the economic or societal system; interpretative economists, whose view focuses on change i n a voluntaristic approach, and functionalists, whose view relates to scientific and objectivistic approaches.

Greed and Grief i n East Germany

15

2.2 Old institutional economics

Old institutional economists which comprises the German-Austrian school of institutional economics as well as the American institutionalists see the contribution of the individual as the outcome of institutional arrangements (List 1848) that have developed through tradition and their respective routines; this pragmatic and empirical approach has strong relations and identities to the school of evolutionary economics. Institutions l i m i t choices and reduce uncertainty and, thus, define the efficiency of private action. Political and economic routines are not independent, an argument already stressed by de Tocqueville (1840) who was very skeptical about the ability of the state to interfere i n the economic and the social field. The discussion on the different allocation properties of CPEs and MEs is highlighted by the famous controversy between L u d w i g von Mises (1920) and Oskar Lange (Lange et al. 1938) on the question, whether the allocation paradigm of the CPE can be understood as the dual problem of the ME. I n a recent article, Richter (1992), a new institutional economist, reviews this discussion of duality between the M E and the CPE and points to the vastly higher information gathering and processing capabilities of the M E as the main counter argument against such a view. The control over decision making can be accumulated indefinitely, but not the respective competence for decisions. This is the major reason why the concept of a " T h i r d Way" between Capitalism and Communism was never convincing and why the marrying of the systems was never successful (Blanchard et al. 1991). This becomes especially clear if we look at the role of an efficient prices system i n information exchange something that heals the individuals constitutive innocence (v. Hayek 1945) but still has to be appreciated i n the east. Markets under a system of competition are anarchic i n the sense that they are free from power, whereas socialist pseudo-markets are not and are incapable of properly handling information on scarcities. On a more general level, we may argue that most of the routines learnt i n a CPE environment are of little value i n a M E environment, even though they had been successful before. Pelikan (1992) argues that a distinction has to be made between institutional rules and organizational structures: the first is close to the German "Ordnungsrahmen", the constituting principles i n the words of Eucken (1952), the second to the way

16

Ulrich B l u m

these rules are filled w i t h material structures (Schumpeter 1912), w i t h regulative principles (Eucken 1952) or w i t h routines (Nelson, Winter 1982), which runs contrary to the structuralists view: i n fact, i n CPEs i n stitutional rules i n the liberal sense are of no value as they can only be defined through the materialistic base of society. From a liberal point of view, CPEs failed since the property rights arrangements were not compatible w i t h the functioning of the individual. Thus, the corresponding rules were not efficient. Eucken (1952) had pointed out earlier that these rules w i l l not evolve entirely through competition, but have to be a priori institutionalized by government i n any type of society. W i t h i n this framework, the interdependency of orders (Inderdependenz von Ordnungen, Eucken 1952) has two components: internal competition i n the political and the economic field, and external between national states (Streit 1995). The internal interdependence between the political and the economic system has been forcefully stressed by v. Hayek (1944) by relating social / political innovation to economic innovation. We know that economic growth has always occurred i n those areas i n which a reasonable share of power had been centralized i n order to enforce cooperation of the individuals (for the necessity, see game theory). However, the transfer of property rights to a government is only a necessary condition (North 1981), and Roemer (1994) even casts doubt on any simple explanation between political democracy and economic development. Liberal society is the economic counterpart of competition: the first leads to societal, the latter to economic innovation which both i n crease efficiency. Even Olson (1993) accepted that democracy w i t h the challenges of rent-seeking, free-riding, lobbying and the destructiveness of interest groups is conducive to long-term economic growth. Dornbusch and Wolf (1992) see a positive effect i n the import of institutions to Eastern countries and postulate an advantage on the part of East Germany where this could be based on old structures: i n fact, these structures hardly existed, were to no avail (Derlien 1991, Szablowski and Derlien 1993) and their fast import shortened the period of (heuristic steps in) a trial-and-error process towards economic and societal efficiency. The inability of eastern managers to react to economic crisis was recently stressed by Dressier (1994); he points out that this behavior leads to the strange situation that existing threats to a firms survival cannot be seen as they are paralleled by societal crisis and, thus, no proper action is taken: each individual is nested i n a very personal environment

Greed and Grief i n East Germany

17

("Lebenswelt") which defines his capacities, his intuitive information and ability to react to a situation. "Lebenswelt" is perceived through the institutional setup of a society, i.e. through rules and institutions. If the "Lebenswelt" changes, all formerly acquired competence becomes useless, but new competence has not yet been accumulated. I t could even be that i t needs more than one generation to internalize efficient routines if we believe Max Weber's theory on the development of capitalism (1905) where the Protestant ethic encourages an educational style that induces motivation for efficiency and performance: This is exactly what the institutions of real socialism have partly destroyed. Old institutional economics explains the fast industrialization of CPEs i n terms of very limited information requirements. Correspondingly, i t foresees their decline at later stages of industrialization, when society has became more complex. It fails, however, to provide us w i t h any i n sights on the problems of transition.

2.3 Functionalist economics

The functionalist approach tries to explain the change of societies through the analysis of particular functions. From an individualistic view, this relates to the individual contribution to maintaining social cohesion i n a CPE or i n a ME, which is a result of loyalty and efficiently learned and accepted rules and routines. Following the theory of bureaucracy, Niskanen- or a Migue / Belangertype models (Niskanen, 1968; Migue, Belanger, 1974) would show that the inefficiency i n allocation increases the more the state bureaucracy is able to control society, especially its economy, as Apolte (1992) has proposed. Among the most important coherence principles of a society is loyalty. As Hirschman (1970) had pointed out, the possibility to voice discontent stabilizes systems and holds exit at bay. I n totalitarian CPEs, complete exit is near to impossible (sunk costs are high if certain property rights arrangements have survived, sometimes even deadly). By restricting exit and, thus, severely impeding voice, CPEs have largely deprived themselves of an effective coherence principle. The fall of East Germany shows that once exit became possible via Hungary, voice also appeared w i t h negotiations at the round table which resulted i n negative renegotiation expectations (Buchanan, 1975) of the social contract which lead to a very fast process of unification through general elections. 2 Konjunkturpolitik, Beiheft 45

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Ulrich B l u m

The functionalist approach is able to explain the i n i t i a l industrial successes of the CPE: the underlying economic goals were widely accepted and those who did not comply were able to exit. It also explains the difficulties of transition through a distortion of social cohesion. However, i t is not able to provide satisfactory reasons for decline and why the CPE was not able to properly organize.

2.4 New institutional economics

New institutional economists contrast to old institutional economists i n their methodological individualism and their stress on the importance of the pursuit of self-interest. Following this school, economic problems can be seen as the result of missing or inadequate property rights arrangements which, at the economic level, result i n adverse incentive schemes. Individual contribution to the system is governed by incentive schemes and is expressed through coordination costs and rents. The form of restoring efficient property-rights, their sequencing and scheduling has drawn high political attention (Krelle 1991) as well as the foundations of property rights arrangements (Sturn 1993). I n addition, a reform of property rights is impossible without relating this reform to the existing arrangements because an open and pre-constitutional situation does not exist i n these societies (Apolte 1992). As one major consequence, transaction costs govern the organization of economic activity (Coase 1937; Williamson 1975). Once transaction costs exist, institutional arrangements matter. The institutional arrangement of a system leads to network externalities and the emerging of i n centive schemes, which are both among the major reasons for triggering institutional change (North, 1992, p. 8). They w i l l lead to inefficient economic structures compared to the M E at the firm and at the national level if institutional arrangements are inadequate. Political competition is formulated i n a way analogous to neoclassical theory (Wittman 1989). Additionally, interest groups w i l l seek to gain rents, and the efficiency of the system w i l l decline further (Olson, 1965, 1988; Tullock 1967). I n an inefficient economic environment rent dissipation processes (Posner 1975) are hardly able to restore the system to second best conditions. Olson (1988) and Brennan and Buchanan (1993) argue that societies, out of their collective insight, would be able to escape this process - contrary to old institutionalists, which see a solution i n systems competition.

Greed and Grief i n East Germany

19

Differences i n incentive schemes as outcomes of institutional arrangements were discussed by Kornai (1980, 1982) and later augmented by Kowalski (1983), who have forwarded a systems analysis of capitalistic and socialistic firms and have identified the differentiating role of financial and physical resources: the former are constrained i n the capitalistic world and the latter arbitrarily available whereas i n the socialist world an inverse relationship prevails. This explains the economic slack i n CPEs through the tendency of hoarding physical goods (even if they are not needed immediately as there absence could impede the plan and the stock is at no cost) and, consequently, their extreme scarcity. We may add that the value of property rights arrangements is only independent from the primary allocation if they can freely be exchanged. However, this is often not the case. I n the communist countries, this was impeded by the dominance of central planning i n physical terms and today, i n the privatization process i n East Germany, i t is prohibited by binding requirements for the privatized company i n terms of labor and investment. New institutional economists provide us w i t h deep insights as to why, through the definition of inappropriate property rights, the decline of the CPE was to be expected i n the long run. They partly explain, why transition is hard because new property rights arrangements must be i n stituted, and the importance they attribute to the functioning of information exchange i n society. Beyond the analysis of old institutional economists, they fail to explain the i n i t i a l successes of the CPE, especially w i t h respect to incentive schemes and institutional competition. Furthermore, the completely neglect the impact of technological change, which severely hampers their potential of explaining economic growth and decline.

2.5 Structuralist economics

Structuralist economists share w i t h functional economists their objectivistic perception of the world. However, this paradigm is completely a-historic i n that reality is b u i l t from a limited number of elements according to a master plan. Of course Marx (1867) was the most important structuralist w i t h his postulate that the control over private capital defines the setup of society. Here, the Marx-type structuralist school shares w i t h the institutionalist school the importance they give to property rights. 2

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Ulrich B l u m

Parts of growth theory fall into this classification: the Solow-model (Solow 1956) explains economic growth i n a neoclassical economic structure. Endogenous growth theory (Romer 1986, 1987, 1989, 1990) added the importance of externalities w i t h i n an socio-economic and, i n fact, structuralist reinterpretation of the institutionalists view, especially formulated by List (1848). This also applies to the concept of deep structural adjustment (Brezis, Krugman, Tsiddon 1993; Lipsey, Bekar 1995) who argue that technological changes triggers new information systems which, again, lead to organizational innovation. This is basically a Schumpeter-Mensch argument (Schumpeter 1912; Mensch 1975). Although this school is able to describe the i n i t i a l take off of the CPE, i t fails to explain, why decline and, later, transition of the CPE took place for a given and constant material basis of society (in a Marxist view) and why i t was not able to make use of the accumulated human capital. 2.6 Synthesis

We w i l l draw on all three theories i n our subsequent analysis of the East German firm: • The micro-foundation of the model w i l l be taken from the incentive schemes stressed by the new institutional school. • The importance of information i n the process of creating, through competition, reliable market signals w i l l be the contribution of the old institutional school. • According to the functional school, cohesion principles and loyalties vary across societal positions, which are important once a firm is headed by directors w i t h different responsibilities. • The model w i l l be structuralist, as we analyze the interaction between directors of the socialist firm i n a game-theoretical background.

3. Games among supervisors 3.1 The principal-agent background

Let us assume that the rent seeking dictator sets up supervisors to r u n firms. I n order to properly monitor them and enforce his w i l l , he w i l l create two parallel hierarchies: one for pure production, and one for information. Soviet-type armies as exemplified bureaucracies, for instance,

Greed and Grief i n East Germany

21

incorporated the position of political officers that were added to men of military competence. Consequently, at each level of the hierarchy two loyalties emerged, one of functional competence and one of political reliability. Let us first analyze this approach i n the context of a principal agent model and then later evaluate the problem of supervisor behavior:

Figure 2: Interaction between principal, supervisor and agent i n the socialist economy

The surplus extracted w i l l depend on • the effort of agent, a, • the effort of production supervisor, e or ep if supervisors are paid differently, • the effort of information supervisor, e or e1, • salaries to agents and supervisors, w and s, w i t h premiums for supervisors,/, • punishments to call supervisors to order, ρ , • g(e), which describes the (monetary) disutility of effort. W i t h i n the usual principal-agent setup, the states of nature are unknown and the principal cannot always observe the effort of the agent or

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Ulrich B l u m

the supervisors respectively. If the principal only controls one supervisor, the latter may cheat by claiming that the low surplus is the result of the sorry state of the economy although he himself had invested a lot of effort, when the opposite, no effort but a good economic situation, is actually true. This can only be prevented by sufficiently lowering the income of the supervisor, thus, however, further cutting his motivation. Here we take a somewhat different approach by arguing that competition among supervisors allows the principal to control the system better. Our analysis w i l l focus on the interaction between supervisors given a certain state of the system, i.e. the principal-agent background w i l l be left behind from now on. We assume that salaries and effort differ across states of nature (productivity) but not w i t h i n a given state. Consequently we obtain a pay-off matrix for a given state. Furthermore, incentives play a dominant role for the motivation of the two supervisors, namely wages and premiums, which is compatible w i t h the efficiency wage theory approach to socialism (Chilosi 1976).

3.2 Description of the model

Following the tradition of the socialist firm, we assume that all premiums and punishments are equally distributed among supervisors. As each of the two supervisors may work or slack, this leads to the following outcomes: • I n the state of autocracy , both work. This may be called a system of socialist competition i n which the clout of the principal is essential. I n this efficient state of the economy they are rewarded by a premium that they share (which increases their net salary). • I n the state of technocracy , the production supervisor works and dominates the slacking information supervisor, who has a diminished position because of the still satisfactory state of the economy. As the p r i n cipal does not receive information (but realizes of course satisfactory profits), she w i l l not pay out any premium but punish the supervisors (which reduces their net salary). • I n the state of stasicracy, the information supervisor dominates the production supervisor; because of his control, the f i r m still functions. As the principal receives information on the slacking production supervisor, she w i l l not pay out any premium but punish the supervisors (which reduces their net salary).

23

Greed and Grief i n East Germany

• I n the state of chaoticracy, both slack (which the principal deduced from the reduced profit he can extract) and, consequently, both are not paid and punished by the principal. The role of the information supervisor can, i n addition, be seen i n a very interesting light. I n the absence of a price system that reflects marginal costs, i.e. scarcity, the secret service becomes a sort of proxy for flexible prices since i t transfers information between different levels of the planning and production hierarchy. This implies that the more i m portant information becomes for production, the stronger w i l l the i m pact of missing flexible prices be on output, w h i c h w i l l strengthen the position of those controlling this v i t a l link.

Information System Slack

Work Autocracy (i=l) Work

Production System

s+f-g(e) s+f-g(e) Stasicracy (i=3)

Technocracy (i=2)

s-p s-p-g(e) Chaoticracy (i=4)

s-p-g(e)

Slack

s-p

-p -p

Figure 3: Pay-offs i n the socialist firm

3.3 Structure of the model

3.3.1 Summary of outcomes Let us look into the properties of the model: • the productivity of the f i r m w i t h i n the given system is explained by the effort of the two supervisors. • depending on the values of s, f t p, and g(e), the game may converge to a social optimum, to a chicken game or a prisoners' dilemma game.

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Ulrich B l u m

Note that the idea of reward and punishment is i n general, not specific to the socialist firm, as we know from the constituting principles of Eucken (1952) or from the analysis of the development of states (Dudley 1992). Let us look into this structure i n more detail.

3.3.2 The chicken game The formal structure of chicken game for the row player pay-offs is: 3 > 1 > 2 > 4; let us go into more detail: (1)

s-p>s+f S

- g(e) >s-pA

g(e) > - ρ . C

Τ

Let us first analyze terms S and A; they imply (2)

-p>f-g(e)=*fs-p-g(e)

=»/> -p .

Terms Τ and C again are trivial; for all non-negative punishments, we obtain: s-p-

g(e) > -p=>s-

g{e) > 0 .

The salary of each supervisor must exceed his disutility of effort. Under the circumstances described here, the game would normally converge to a Technocracy or a Stasicracy, the two possible Nash-equilibria, unless both players become so committed and so tough that the Chaoticracy emerges - which is normally the outcome of a prisoners' dilemma (Mueller 1989, p. 17).

Greed and Grief i n East Germany

25

3.3.3 The social optimum The Pareto-efficient and simultaneously socially efficient solution i n the first quadrant is obtained if the row player pay-offs are: 1 > 3 > 2 > 4: (5)

s+f - g(e) >s—p>s S

— p — g(e) > - ρ .

A

C

Τ

I n analogy to inequality (2), we follow / > g(e) - ρ for terms A and S. If we compare terms S and T, i t is easy to see that this result is guaranteed for all non-negative disutilities of effort. The comparison of terms Τ and C is already included i n the previous analysis, i.e. that the salary less the disutility of effort must be positive.

3.3.4 The prisoners'dilemma Let us now go into the analysis of the prisoner's dilemma situation w i t h pay-offs of the row player 3 > 1 > 4 > 2: (6)

s-p>s+fS

g{e) > -p>s-p-g(e) A

T

.

O

The calculation of terms S and A was settled i n part 2.3.2 w i t h the res u l t / < g(e) - ρ or / - g(e) < -p. Let us now go into the comparison of terms A and C: (7)

s+/-g(e)>-p,

Reward less disutility of effort must exceed punishment; this requirement is less restrictive than that found for the chicken game i n formula (4). The comparison of C and Τ yields:

(8)

— ρ > s — ρ — g(e)

s - g(e) 0 .

The salary of the supervisor less his disutility of effort is negative. U n der normal conditions, we would not expect this situation to emerge, since this implies that individuals work for a negative net wage [s - g{e)]. However, as g(e) is a monetarization of effort, we may imagine such situations, for instance of economic catastrophe. I n fact, during the late

Ulrich B l u m

26

years of socialism i n East Germany, workers were told to accept a negative net wage as reward for social cohesion. The outcome of the prisoners' dilemma game is the Chaoticracy. From what was said i n the preceding paragraph, a Chaoticracy is only likely to emerge once the economy has stared to slide into catastrophe. This is most likely out of a situation Stasicracy.

3.4 Declining reward and economic decay

Why would salaries and premiums tend to fall i n a socialist economy? We may offer two arguments: 1. Without competition among the supervisors, performance falls and reduces incentives for individuals to perform according to the plan even further; here we r u n into a rationality trap w i t h outcomes that are not self-stabilizing. 2. I n relative terms, exploitation had to increase i n order to remain competitive on decisive w o r l d markets because investments were far less efficient. Consequently, our results may be summarized as follows: (1) The social optimum is reached if 1. high premiums and high penalties are both attributed, and 2. salary minus disutility of effort is positive. This result is compatible w i t h that proposed earlier, i.e. that the communist warlord applies the carrot and the stick to maximize rent. (2) A chicken-game emerges once 1. low premiums coincide w i t h low penalties, and 2. salary minus disutility of effort is positive. This result again is compatible w i t h what was said earlier; however, the system guarantees that at least one supervisor does not slack. (3) A prisoners'-dilemma

game emerges once

1. low premiums coincide w i t h low penalties, and 2. salary minus disutility of effort is negative. This implies that both supervisors slack once the economic situation and the authority have deteriorated sufficiently, thus no longer pro-

Greed and Grief i n East Germany

27

viding for a salary structure that is incentive compatible. Here i t is decisive that no other opportunities to work exist. (4) The natural order of development is - if a Chaoticracy emerge -

is ever to

• Autocracy, • Technocracy, • Stasicracy, • Chaoticracy. Figure 3 displays the situation. The function discriminating between the social optimum on the one hand and the chicken and prisoner's dilemma games on the other hand is given by the direct comparison of states A and S over all three type of games: (9)

f =

9(e)-p.

I n the social optimum, relation is " > " , i n all other cases " < " . The second function discriminating among states compares situations A and C and is given by

(10)

/_flf(e)+e

=

_p.

The relation is direct for the prisoners'-dilemma game, indirect for all other states, and always " > " . The t h i r d function discriminating among states compares situations C and T: (11)

s-g(e) = 0.

It is " > " i n case of the social optimum and the chicken game and " < " i n case of the prisoners' dilemma game. The combined result is given as follows w i t h s = const as numméraire:

28

Ulrich B l u m

4. Conclusion I n our structuralist model we have formalized reward and punishment i n a game-theoretical context i n order to capture, (i), the incentive schemes stressed by the new institutional school based on methodological individualism, (ii), the importance of information for a market economy according to the old institutional school, (iii), the necessity to understand individual motivation through the functions performed according to the functional school. The destruction of the socialist competition morale and, ultimately through the worsening performance of the firms, economic efficiency, can be traced to the huge changes i n information technologies which rendered hierarchical firms obsolete (Blum, Dudley 1997) - but were neither abolished nor downsized. The CPE became more and more a mega-firm (Blum, Dressier 1994). This cultural misfit (Blum, Dudley 1996) is one of the major reasons of the erosion process described here:

Greed and Grief i n East Germany

29

viewed from the functionalists perspective, i t was not the rent seeking typical for democratic societies, but slack seeking that was so destructive. Reward and punishment exist i n both Market and Centrally Planned Economies, however w i t h a vastly different perspective. Here we see three fundamental consequences of the analysis: 1. Transformation substituted on incentive scheme for another incentive scheme; however, incentive schemes only gain value once those they are aimed at have learned to handle them either rationally or i n a heuristic way. This was not the case (see our second argument) and an institutional void emerged which becomes more apparent the more one moves to the east. 2. I n the CPE reward and punishment were personally attributed by the principal as the f i r m was firmly imbedded i n the economy and the state. This is not the case i n competitive market economies where the enterprise acts w i t h i n a flexible environment and where the market is a credence good and rules are to be set i n an auto-stabilizing way. Non-personal threats are not credible. 3. Finally, contrary to the view of the Marxist school, suprastructure (the political w i l l and the ideology) defined infrastructure (the organization of the economy) i n the late decades of the CPE - otherwise the outcomes of this game would never have become inefficient. This leads i n the process of transition to huge sunk costs not only i n terms of assets, but also human capital, as the value of certain organizational competences became nil. Beyond these findings, there is a lesson to be learned for market economies: most of them still harbor some combines, let alone the public bureaucracy. Unless we understand the reasons for the decline of the socialist enterprise, we are i n no way able to reform ourselves and our public sectors. Abstract A theory of the socialist economy should be able to explain, (i), its i n i t i a l success, (ii), its later decline and collapse and, (iii), the present problems of transformation. I n a recent paper (Blum, Dudley 1997), we have shown that a systems approach concentrating on information technologies and the way they influence i n stitutional arrangements is both theoretically sound and can be tested empirically. I n this paper, we take a more concentrated and thorough look at the directors of the East German combine and the effect of parallel hierarchical structures (pro-

30

Ulrich B l u m

duction / information) on efficiency. We follow an argument proposed by Olson (1995) that the competition among supervisors rendered the socialist economy efficient u n t i l i t collapsed and resulted i n collusion and slack. We analyze this argument i n a game-theoretical context and argue that the development from competition to collusion and slack also heavily influenced the transition process probably through the destruction of headquarter and leadership qualities.

References Apolte, Th. (1992) Politische Ökonomie der Systemtransformation, Duisburger Volkswirtschaftliche Schriften 14, Hamburg: Steuer- und Wirtschaf tsverlag. Arnold, T. (1961) Der revolutionäre Krieg, (Pfaffenhofen (Ilm):Ilmgau Verlag).

Blanchard, O.; Dornbusch , T.; Krugman, P; Layard , R.; Summers , L. (1991) Reform i n Eastern Europe, Cambridge, Mass. / London. Blum, L.; Dressler (1994) „Die " D D R - A G " - Eine Betrachtung des Transformationsprozesses aus der Sicht der Unternehmenstheorie", Strategien für nationale und internationale Märkte - Konzeption und praktische Gestaltung (H. Rehkugler, J. Engelhard ed.). (Wiesbaden: Gabler Verlag), 163 - 180. Blum, L.; Dudley, L. (1991) " A Spatial Model of the State", Journal of Institutional and Theoretical Economics 147, 312 - 336. - (1996) "Culture and Efficiency: Economic Effects of Religion, Nationalism and Ideology", Current Issues i n Public Choice (J. Prado , E Schneider ed.), Edward Elgar, Cheltenham, U K ; Brookfield, USA, 69 - 90. - (1997) "Technology and Institutional Decline: The East German Economy 1949 - 1989", Forthcoming European Journal of Political Economy. Brennan, G.; Buchanan, J. (1993) Die Begründung von Regeln, (Tübingen: J.C.B. Mohr). Brezis, E. S., Krugman P. R.; Tsiddon, D. (1993) "Leapfrogging i n International Competition: A Theory of Cycles i n National Technological Leadership", American Economic Review, Vol. 83, 1211 - 1220. Buchanan. J. M. (1975) The Limits of Liberty: Between Anarchy and the Leviathan. London. Burrel, G.; Morgan, G. (1979) Sociological Paradigms and Organizational Analysis, London. Chilosi, A. (1976), "Growth Maximization, Egalitarianism and Wage Differentials i n the Socialist Economy", Zeitschrift für Nationalökonomie, 319 - 332. Coase, R. (1937) "The Nature of the Firm", Economica, Vol. 4, 386 - 405. Dennis, M. (1993) Social and Economic Modernization i n Eastern Germany from Honecker to Kohl, (New York: Pinters Publishers, London, and St. Martin's Press).

Greed and Grief i n East Germany

31

Derlien, H. U. (1991) "Regimewechsel und Personalpolitik: Beobachtungen zur politischen Säuberung und der Integration der Staatsfunktionäre i n der DDR i n das Berufsbeamtentum", Bamberg: mimeo. Dornbusch, R.; Wolf, H. (1992) "Economic Transition i n Eastern Germany", Brookings Papers i n Economic Activity 1, 235 - 272. Dressler, S. (1995) Reorganisation und Krise, (Stuttgart: Schaeffer-Poeschel). Dudley , L. (1992) "Punishment, Reward and the Fortunes of States", Public Choice 74,294-315. Eucken, W. (1952) Grundsätze der Wirtschaftspolitik, (Tübingen - Zürich: J.C.B. Mohr). Hayek, F. v. (1944) The Road to Serfdom, (London: A r k Paperbacks (1986)). - (1945) "The Use of Information i n Society", American Economic Review 35, 519 - 530). Hirschman, A. O. (1970) Exit, Voice, and Loyalty, Harvard University Press, Cambridge, Mass. and London. Kornai, J. (1980) The Economics of Shortages, (Amsterdam: North Holland). - (1982) Growth, Shortage and Efficiency, a Macroeconomic Model of the Socialist Economy, (Berkley: University of California Press). Kowalski, J. (1983) "On the Relevance of the Concepts of "Centrally Planned" Economies", Jahrbuch für Sozialwissenschaft 34, No. 2. Krelle, W. (1991) "Probleme des Übergangs von einer Planwirtschaft zu einer Marktwirtschaft", Der Umbau ( U Jens ed.), (Baden-Baden: Nomos), 1 5 - 3 4 . Lange, O.; Taylor, F. M.; Lippincott , B. E. (1938) On the Economic Theory of Socialism, (Minneapolis: University of Minnesota Press). Lipsey , R. G.; Bekar, G. (1994) "Technological Change and Economic Growth: Continuous Random Shocks vs. Occasional Paradigmatic Shifts" Paper to be presented at the John Deutsch Conference on Technology, Information and Public Policy, Kingston, Ont. List, F. (1848) Das nationale System der politischen Ökonomie, (Jena: Fischer 1928). Marx, K. (1867) Das Kapital - K r i t i k der politischen Ökonomie, Frankfurt (1956). Mensch, G. (1975) Das Technologische Patt - Innovationen überwinden die Depression, (Frankfurt: Umschau Verlag). Migue, J. L.; Belanger (1974) "Towards a General Theory of Managerial Discretion" Public Choice 17, 27 - 47. Mises, L. von (1920) "Die Wirtschaftsrechnung i m sozialistische Gemeinwesen", Archiv für Sozialwissenschaft und Sozialpolitik, 47, 86 - 21. Mueller, D. (1989) Public Choice II, (Cambridge: Cambridge University Press). Nelson, R.; Winter, S. (1982) A n Evolutionary Theory of Economic Change, (Cambridge: Cambridge University Press).

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Niskanen , W. A. (1968) "The Peculiar Economics of Bureaucracy", American Economic Review 58, 293 - 305. North, D. (1981) Structure and Change i n Economic History, (New York: Norton). - (1992) Institutionen, institutioneller Wandel und Wirtschaftsleistung, (Stuttgart: JCB Mohr). Nozick, R. (1974) Anarchy, State and Utopia, (New York: Basic Books). Olson, Μ . (1965) The Logic of Collective Action, (Cambridge / Mass: Harvard U n i versity Press). - (1988) The Rise and Decline of Nations: Economic Rise, Stagflation and Social Rigidities, (New Haven: Yale University Press). - (1993) "Dictatorship, Democracy and Development", Science Review, Vol.87, Issue 3, 567 - 576.

American

Political

- (1995) "Why is Economic Performance even Worse after Communism is Abolished", mimeo. Pelikan, P. (1992) "The Dynamics of Economic Systems, or How to Transform a Failed Socialist Economy", Journal of Evolutionary Economics 2, 39 - 63. Posner, R. (1975) "The Social Costs of Monopoly and Regulation", Journal of Political Economy 83, 807 - 827. Raiser, M. (1994) "Lessons for whom, from whom? The Transition from Socialism i n China and Central Eastern Europe Compared", K i e l Working Paper No. 630. Raiser, M.; Nunnekamp, P. (1993) "Output Decline and Recovery i n Central Europe: The Role of Incentives before and after Privatisation", K i e l Working Paper No. 601 (Kiel: K i e l Institute of World Economics). Reuter, Ν., (1994) "Institutionalismus, Neo-Institutionalismus. Neue Institutionenökonomie und andere "Institutionalismen" - Eine Differenzierung konträrer Konzepte", Zeitschrift für Wirtschafts- und Sozialwissenschaften Jg. 114, Heft 1 , ( 5 - 2 4 ) . Richter, R. (1992) " A Socialist Market Economy, Can i t Work?", Kyklos 45, 185207. Roemer, J. E. (1994) "On the Relationship between Economic Development and Political Democracy", Economic Design 1,15 - 39. Romer, P. M. (1986) "Increasing Returns and Long-Run Growth", Journal of Political Economy 94, 1002 - 1037. - (1987) "Growth Based on Increasing Returns Due to Specialization", American Economic Review 77, 56 - 62. - (1989) "Capital Accumlation and the Theory of Long-Run Growth", Modern Business Cycle Theory (Barro, Β. J. ed.), (Oxford: Blackwell). - (1990) "Endogenous Technological Change", Journal of Political Economy 98, 7 0 - 102.

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Schumpeter, J. (1912) Theorie der wirtschaftlichen Entwicklung, (Berlin: August Rabe). Solow, M. (1956) " A Contribution to the Theory of Economic Growth", Quarterly Journal of Economics 70,1956, S. 65 - 94. Streit, Μ . (1995) "Dimensionen des Wettbewerbs - Systemwandel aus ordnungsökonomischer Sicht", Zeitschrift für Wirtschaftspolitik 44,113 - 134. Sturn, R. (1993) "Postsocialist Privatization and Agency-Related Property: from Coase to Locke", The European Journal of History of Economic Thought 1,1, 63 -86.

Szablowski, G. J.; Derlien, H. U. (1993) "East European Transition, Elites, and the European Community", Regime Transition, Elites, and Burocracies i n Eastern Europe (G.J. Szablowski and H.U. Derlien ed.), Governance Vol 6. No. 3. Tullock, G. (1967) "The Welfare Costs of Tariffs, Monopolies and Theft", Western Economic Journal 5, June, 224 - 232. Tocqueville, A. de, (1840) Über die Demokratie i n Amerika, (München: Deutscher TaschenbuchVerlag 1984). Weber, M. (1905), Die protestantische Ethik, (Gütersloh: Verlagshaus Gerd Mohn 1981). Williamson, Ο. (1975) Markets and Hierarchies. Analysis and Antitrust Implications, (New York: The Free Press). Wittman, D. (1989) "Why Democracies Produce Efficient Results", Journal of Political Economy 97, 6, 1395 - 1424.

3 Konjunkturpolitik, Beiheft 45

Comment on: Ulrich Blum, Greed and Grief in East Germany the Socialist System's Crisis, Collapse and Transformation By H e n n i n g

Klodt

U l r i c h B l u m presents a concise theoretical interpretation of the economic performance of the socialist economy which is inventive and stimulating. His central objection to existing theories is the observation that they either explain the comparably good growth performance of socialist economies up to the late 1960s or the poor performance and eventual collapse thereafter. Among the first type of theories is the late works of Schumpeter (1943) who supposed that a fading out of technological progress and a corresponding decline of flexible adjustment requirements would give an increasing advantage to central planning. This approach may well explain the remarkable progress which was achieved i n transforming agricultural economies such as Russia and Bulgaria into industrialized countries during the inter-war and post-war period. The major proponent of the second type of theories was Hayek (1945) who argued that central planning would never be able to substitute the information-generating process of relative-price adjustments. His issue was supported and supplemented, for instance, by Kornai (1980) and Winiecki (1988) who stressed the importance of inappropriate incentives resulting from soft-budget constraints and rent-dissipating activities. B l u m concludes from his tour de horizon that the basic predictions of existing theories are quite inconsistent because they lead either to an optimistic or a pessimistic evaluation of the growth potential of the socialist economy, whereas i n reality a phase of remarkable growth was followed by rising disturbances and economic difficulties. 1 His own approach centers upon the role of different groups of bureaucrats, espe1 A growth-theoretical explanation of this pattern was recently provided by Krugman (1994) who argues that the high Eastern European growth rates of the 1950s and 1960s mainly resulted from forced capital accumulation and repressed consumption which promoted aggregate growth over some decades but inevitably led to diminishing returns i n the 1970s and 1980s. The Krugman approach hence covers both the i n i t i a l success and the eventual failure of the socialist economy.

3

36

Henning Klodt: Comment

cially upon the increasing disincentives for the secret service to provide reliable information to central planing agencies. Over time, the dynamics of the B l u m model are driven by the decline of the parameters s and / (which depend on the allocative efficiency of the socialist economy), while ρ and g remain constant. I n a broader sense, this interpretation of the historical development of the socialist economy could w e l l be reconciled w i t h the Hayek approach, because the decline i n efficiency may be explained by the rising importance of relative price changes since the 1970s. The breakdown of the Bretton Woods system made exchange rates much more volatile, the oil price shocks resulted i n dramatic price variations for several natural resources, and the emergence of newly industrializing countries required significant relative price adjustments for industrial goods on world markets. The socialist countries tried to keep these price disturbances out of their economic system by adopting an autarky strategy. But autarky itself gave rise to allocative inefficiencies, and closing the outside borders of the Eastern trading bloc was difficult to achieve i n face of rapidly developing information and communication technologies w h i c h significantly reduced the economic distances between countries. Under such conditions, not only Hayek, but also Schumpeter would probably have predicted rising difficulties of effectively managing a centrally planned economy. I n this broader view, the basic structure of the B l u m model seems to be not too far away from traditional approaches for explaining the economic performance of socialist countries over time. I n an narrow sense, however, the B l u m model has one rather implausible implication: if the mechanics of the model are taken as literally true, the collapse of central planing could have been avoided if production bureaucrats and secret service bureaucrats would have cooperated. I n other words, an effective and efficient secret service is regarded as a perfect substitute for the mechanism of relative market prices. I n such a narrow view the B l u m model is much less convincing than i n the abovedescribed broader view. I would like to conclude, therefore, that struggles among bureaucrats as described by B l u m may have added to the decline of the socialist economy without covering the whole story. Most observers have ignored the economic impact of the secret service hierarchy, whereas B l u m has demonstrated that the existence of different sets of hierarchies creates opportunities for strategic behavior of bureaucrats which hurts economic efficiency. Perhaps, this general lesson is also of some importance for

Henning Klodt: Comment e v a l u a t i n g t h e e c o n o m i c i m p a c t of c o r p o r a t i s m a n d c o m p e t i t i o n i n West e r n economies.

References von Hayek, F. A. (1945). The Use of Knowledge i n Society. American Economic Review 35: 519-530. Kornai, J. (1980). The Economics of Shortages. North Holland, Amsterdam. Krugman, P. (1994). The M y t h of Asia's Miracle. Foreign Affairs (November / December): 62-78. Schumpeter, J. A. (1943). Capitalism, Socialism and Democracy. Allen and U n win, London. Winiecki , J. (1988). The Distorted World of Soviet-Type Economies. University Press of Pittsburgh, Pittsburgh.

Transition in Eastern Europe: The Integration of Goods and Factor Markets into the World Economy By K l a u s - D i e t e r

Schmidt

1. Introduction: economic opening-up, trade reorientation and industrial restructuring 1 More than four decades, the Central and Eastern European Countries (CEECs) were effectively closed to open exchange w i t h the w o r l d economy. Their mutual co-operation was orchestrated i n accordance w i t h the principles of the "socialist division of labour" by long-term multilateral agreements and conducted by the Council of Mutual Economic Assistance (CMEA). Trade among CEECs (calculated on official exchange rates) accounted for about 70 percent of their total trade. I n contrast, trade w i t h the capitalist w o r l d was more or less used as a stopgap - i n order to serve the CEECs' basic needs. Exports to advanced western markets were dominated by a relatively limited number of commodities of very high energy content, high labour but low skill content and very low R & D content. Imports, i n contrast to exports, were overwhelmingly of the skill-intensive manufactured type. The CMEA trade regime had immensely distorted the structure of CEECs' trade and, hence, domestic resource allocation (Collins and Rod r i k 1991). The task of re-integrating into the w o r l d economy, therefore, poses one of the most unprecedented challenges to CEECs. I t entails not only removing all impediments for international trade and factor movements (including a certain degree of convertibility) but, as a consequence, far reaching structural adjustment on the firm level, especially industrial restructuring and trade reorientation. Re-integration is thus 1 The paper heavily benefited from the author's research co-operation w i t h economists from east and west involved i n the Commission of the European Union PHARE ACE programs. Consequently, this paper has several co-authors: among others Rumen Dobrinsky, Laszlo Halpern, Michael Landesmann, Giovanni Graziani and Fran9oise Lemoine made important contributions.

40

Klaus-Dieter Schmidt

an integral part of the transition process (Dobrinsky and Landesmann 1995). Meanwhile, there is rich literature on the economic integration between the CEECs and the western market economies. 2 I t emphasizes the massive geographic trade reorientation of CEECs towards western i n dustrialized countries, especially towards countries of the European U n ion (EU): CEECs are well on the way to exploiting the geographic proximity. I t also stresses the beginnings of a process of re-specialization there is an increase i n intra-industry trade and a decrease i n the strong comparative bias against skill-intensive branches. However, structural changes i n CEECs' exports have been much smaller than those i n i m ports. A l l i n all, CEECs are as much as before concentrated i n resourcebased and low skill-intensive manufactures when compared to their main competitors i n the w o r l d market. The "do-it-yourself bias" i n their foreign trade relations (Jan Winiecki) is still recognizable. After the demise of the CMEA, CEECs aimed at maximizing geographic reorientation of external trade w i t h a m i n i m u m of internal structural change. Therefore, the rapid expansion of CEECs' trade w i t h the west, w h i c h has often been praised as one of the most impressive success stories, should not be overrated. CEECs' integration into the w o r l d economy is just at its beginning. The paper reviews the state-of-the-art of research (including the author's own small contribution) i n order to identify the key issues. First i t looks at the question of what would be the best economic and political path to integration. Second i t presents facts and figures to describe the pattern of mutual economic integration w i t h respect to foreign trade, direct investment and migration. T h i r d i t evaluates the recent results of east-west integration. Fourth and finally, i t discusses policy conclusions. By now, there is evidence that CEECs' international integration proceeds at a widely different pace i n different regions. Generally speaking, those countries which have progressed most are i n the centre of attention - the four Visegräd countries, the Czech Republic, Hungary, Poland and Slovakia (CEE-4), and, by far less, Bulgaria and Romania (CEE-6). Above all, the paper analyses the emerging patterns of cross-border operations between these economies and the economies of the EU.

2 For example: Rollo and Smith (1993), Gäcs and Winckler (1994), Halpern (1994), Lemoine (1994), Dobrinsky (1995), European Commission (1995), Faini and Portes (1995), Havlik (1995), Landesmann (1995, 1996), Sheehy (1995), Drabék and Smith (1995).

Transition i n Eastern Europe

41

Some caveats should be made w i t h respect to the limitations of the analysis. The time span observed - four or five years - is rather short. Many of the observations are not conclusive but puzzling. U n t i l now, i t has been difficult to disentangle short-term tendencies and long-term trends. To a great extent ongoing integration and trade re-specialization of CEECs seem to reflect inherited production structures rather than true comparative advantages based on factor endowments (Halpern 1994). I n its own small way, this paper tries to sketch the route for further research.

2. Theoretical background: routes towards integration 2.1 Shallow versus deep integration

Countries can be considered fully integrated when goods and factor movements across borders are not restricted by boundaries, neither i n form of institutional nor i n form of market imperfections (e.g., customs duties, quotas, restrictions on capital transfers and labour migration, unbridgeable differences i n tax rates, local monopolies, risk asymmetries). I n an ideal w o r l d without any boundaries the process towards f u l l integration between countries on a different level of development is described by standard models of trade theory of the Heckscher-Ohlin-Samuelson type (HOS). These models suggest that a country's specialization depends on its relative factor endowment. Many researchers have followed this route i n order to predict CEECs' future trade patterns (Klodt 1993; Landesmann 1995). However, i t has been recognized for a long time that HOS models are misspecified by several assumptions such as internationally immobile production factors, perfect markets and constant returns to scale. If, e.g., capital swiftly flows around the world, i t cannot constitute a local characteristic and, hence, it cannot affect the factor content of trade. Then, generally, capital flows rather than capital endowment do explain a country's commodity structure of trade. A n d if international goods and factor markets are far from being perfect, then firms operating internationally have to take into account transaction costs which can be overcome best by internalizing external transactions, especially by establishing inter-firm networks. A remarkable and steadily growing share of international cross-border operations consists of transactions among firms which are more or less integrated - either by equity involvements or by contractual arrangements. Consequently, standard trade theory needs to be synthesized w i t h internalization theo-

42

Klaus-Dieter Schmidt

ry to provide a f u l l account of international integration of goods and factor markets (Casson 1995). The shortcoming of a large part of research about CEECs' international integration is that i t is restricted to the spreading of market l i n kages through arms'-length trade. This type of shallow integration neglects the participation i n international production by capital and labour flows. Actually, one of the most striking findings which emerges from recent studies i n international economics is the growing international integration of production by cross-border value adding activities of transnational corporations (UNCTAD 1994, 1995). The traditional form of integration through trade i n goods and services has been more and more complemented as well as substituted by international movements of capital and, although at a lower degree, by movements of labour. As Krugman (1995) has recently conjectured, the share of w o r l d trade i n world output has obviously reached or even passed its peak. Since the early 1980s, w o r l d investment and forms of non-equity involvement such as contracting or licensing have increased much faster than w o r l d output and world trade. As a result, the mode of integration has changed from shallow to deep. Deep integration means that firms are more and more optimizing their value chain globally. There is a clear trend to slice up the firms' value chains i n a number of separate stages and perform them at a number of separate locations, adding a b i t of value at each stage and location. Consequently, deep integration of production materializes i n intra-firm, i.e. internalized, exchange of goods and services as well as i n internalized exchange of other tangible and intangible assets such as technology or property rights. The advantage of this mode of integration is to l i n k trade reorientation and corporate restructuring. The majority of firms i n CEECs rely on strong partners from western countries who can offer what they need to eliminate their deficits: capital, technology, market access and management skills. Consequently, the degree of west-east i n tra-firm linkages can be considered an indicator for the quality of CEECs' international integration.

2.2 Economic versus political integration

International integration is seldom purely "market driven". I t rather follows the routes designed by policy makers. I n general, CEECs pursue three different forms of international integration: first by liberalizing

Transition i n Eastern Europe

43

multilateral trade i n the GATT / WTO framework, second by concluding bilateral agreements w i t h the E U and t h i r d by some initiatives of the Visegräd type, e.g. the reduction of trade barriers, the harmonization of customs valuations and other trade-related policy measures among themselves. The focus of most CEECs has been and still is to achieve f u l l membership i n the EU. For CEECs' economists and policy makers international integration has become synonymous w i t h EU-integration. Therefore, policy specific conditions of European east-west integration widely differ from those i n other parts of the w o r l d (Agarwal et al. 1995). However, the question arises whether CEECs have been well advised to concentrate all their efforts on the E U - and to neglect mutual relations. A n opt i m a l integration of CEECs into the world economy also involves a notable diversification of intra-trade and of other forms of cross-border cooperation. Although f u l l E U membership would favour CEECs' intra-integration (as trade barriers between them must be removed), i t may hamper integration w i t h the rest of the world (including former CMEA partners without an E U Association Agreement) i n the long run. As things are, only a small number of CEEC w i l l be sitting i n the train towards the EU. If several big countries w h i c h want to enter are excluded, this w i l l lead to a division between natural trade partners. I n the end, the degree of mutual trade relations w i t h respect to all partners i n the west and i n the east is the quality test for integration. Needless to say that mainly the CEECs themselves have to set the course for their integration into the w o r l d economy. Institutional reforms, macroeconomic stabilization and microeconomic adjustment i n the domestic economy cannot be substituted by any k i n d of integration policy.

3. Stylized facts: patterns of economic integration CEECs' international integration is featured threefold: • The geography of trade flows has changed dramatically as most of the CEECs have reoriented almost all of their exports and imports from CMEA-markets to EU-markets. The commodity structure has also changed - but is characterized by a growing asymmetry i n export and import adjustment: exports show a specialization towards labour-intensive branches and away from raw material- and capital-intensive

44

Klaus-Dieter Schmidt

branches, and imports show a specialization to cars, other transport equipment and consumer goods. Geographic trade reorientation has been much stronger than inter- and intra-industry re-specialization. • The integration into international production networks has made some progress. Western firms have taken a leading role i n CEECs' trade reorientation and expansion. However, they have promoted simple integration through sub-contracting relationships rather than complex integration through equity involvements. • Migration, a key issue of CEECs' integration, has developed rather slowly. Although large wage differentials should stimulate massive labour flows from east to west, i n reality, such movements only affected a small fraction of the CEECs' labour force. Restrictive immigration laws of E U countries as well as of CEECs have thwarted the integration of labour markets. Labour markets remain significantly less integrated than goods and capital markets. To put i t i n a nutshell, CEECs' integration is progressing - but on a very multispeed route. As the marching pace of a column is determined by its slowest part, the key policy question is how to synchronize the process of integration.

3.1 Comparative advantages and trade reorientation

CEECs' international integration has first of all proceeded w i t h geographic trade reorientation: the share of western industrialized countries i n total CEECs' exports and imports has increased significantly (Table 1). Because of this, CEECs have been able to compensate their dramatic losses i n former CMEA markets. Especially trade w i t h E U countries has expanded progressively. Notwithstanding, there is a strong regional heterogeneity: the CEE-4 have reached a much higher share of trade w i t h the E U i n total trade than the other CEECs. This indicates the great importance of geographical location as a determinant for trade. The other side of the coin is a sharp decline i n intra-regional trade among CEECs. Since the collapse of CMEA, intra-CEECs' trade has nearly become a 'quantità négligeable', except for trade between the Czech Republic and Slovakia (Table 2). I n this respect, the gains from west-integration have been partly outweighed by losses due to east-disintegration. Possibly, this strong move away from intra-trade is only a

45

Transition i n Eastern Europe

temporary phenomenon - i t might be understandable that at this stage all CEECs tend "to break w i t h the past". Achievements i n CEECs' westward-integration should not be overrated as trade intensity between CEECs and the rest of the w o r l d is still low. The share of the CEE-6 i n total imports of OECD economies, e.g., has reached just 1.5 percent i n 1993 and the share i n total imports of EU-countries has reached 4 percent. The marginal role of CEECs for developed market economies is also highlighted by the extremely low penetration ratio of total EU-manufacturing imports (IPR) from the CEE-6 which - according to calculations by Graziani (1995) - was 0.5 percent i n 1992 (Table 3). For comparison: the IPR w i t h respect to L D C imports was five times higher (2.7 percent). Even on a NACE 3-digit level CEE-6-IPR d i d not exceed the threshold of 5 percent. CEE-6 have been successful i n penetrating EU-markets only i n a few product groups: clothing (4.2 percent), household textiles (3.3 percent), footwear (3.3 percent), k n i t t i n g (2.6 percent) and leather products (2.6 percent).

Table 1 Redirection of selected CEECs' trade 1989 - 1993 Share of western industrialized countries i n total trade (in percent) 1989

1993

Exports

Imports

Bulgaria ex Czechoslovakia Hungary Poland Romania Slovenia Note: Russia

8.0 37.0 44.1 49.1 39.3 67.6

17.1 37.3 49.6 53.0 11.5 77.6

Bulgaria ex Czechoslovakia Hungary Poland Romania Slovenia Note: Russia

5.5 26.3 24.8 32.1 25.2 51.3

Exports

Imports

43.1 69.9 67.6 75.1

42.6 73.1 64.9 76.2

Total

-

-

-

69.6 44.3

-

73.4 33.0

of which EU-countries

-

Source: Landesmann (1995); own calculations.

10.3 26.5 29.0 33.8 5.7 56.9 -

28.1 54.6 46.5 63.2 -

57.4 -

30.2 51.4 40.1 57.2 -

55.7 -

Klaus-Dieter Schmidt

46

Table 2 Selected CEECs' intra-trade 1993 Share i n total trade (in percent)

Bulgaria Czech Republic Hungary Poland Slovakia 3 Romania

Exports

Imports

6.4 20.6 7.8 3.7 53.7 5.4

4.3 17.8 6.8 3.1 52.1 6.3

a

Only with the Czech Republic. Source: Agarwal et al. (1995).

Table 3 Import penetration ratios of total EU-manufacturing imports from CEECs 1989 and 1992 Share of imports i n domestic apparent consumption 3

World Extra-EU LDCs CEE

1989

1992

36.71 33.19 3.15 0.37

32.57 29.32 2.73 0.52

a

Production + import - export. Source: Graziani (1995).

A n obvious but crucial point is not only CEECs' relatively low market penetration i n general but also poor specialization. Textiles, clothing, leather and footwear, wooden furniture and other wooden manufactures, steal tubes, glass and glassware, and some other low value added goods still have a much greater weight i n the CEECs' export structure than i n average world exports, higher even than i n exports of LDCs. Several studies indicate that the traditional trade structure has changed, if at all, only at a very slow pace. Comparing specialization indexes for selected product groups before and after the collapse of the CMEA calculated by Lemoine (1994) suggests that the heritage of the past is still present (Table 4).

Transition i n Eastern Europe

47

Table 4 Specialization of CEE-6 relative to the world average 1988 and 1993 Specialization indexes 0 Bulgaria

Agricultural products Food Raw materials Chemicals Leather products Textiles Clothing Building materials Glass Iron and steel Engineering products Transport equipment Electrical machinery

ex Czechoslovakia

Hungary

Poland

Romania

1988

1993

1988

1993

1988

1993

1988

1993

1988

1993

172 278 33 210 57 94 190 170 239 272 46 6 31

150 77 239 39 82 70 120 158 317 104 125 138 294 140 328 387 259 1407 123 488 36 39 7 79 37 29

47 36 193 105 152 133 140 496 796 483 50 97 57

312 131 22 129 186 85 286 196 350 251 40 13 48

220 111 6 107 230 60 240 196 358 204 58 36 92

242 101 188 81 140 41 231 107 345 251 24 113 32

137 72 185 70 111 45 272 186 213 300 24 124 37

68 31 54 90 137 79 483 305 496 279 22 45 23

51 43 136 47 372 66 549 207 397 245 21 28 23

a Share of the products i n the country's exports to the E C / E U i n relation to the products i n the w o r l d exports to the E C / EU.

Source: Lemoine (1994).

Specialization towards labour-intensive, low value added goods may reflect to some extent the CEECs' current competitiveness, but presumably i t undervalues their potential comparative advantages i n skill-intensive, high-value added goods. Consequently, the emerging specialization pattern could be considered an indication of continuing disintegration rather than integration. However, as Landesmann and Székely (1995b) pointed out, the current factor endowment structure of CEECs is rather patchy - w i t h some strengths i n certain fields and some deficits i n others. This has resulted i n an inefficient utilization of capabilities. I n this respect, i t is not surprising that all CEECs have to go through a stage of downgrading of their export structure. Filling i n these gaps could thus lead to strong positive externalities and, hence, enable CEECs to catch-up. A significant hurdle for CEECs' trade reorientation towards skill-intensive products is the substantial quality gap which has obviously persisted over the recent period of transformation. Quality indicators calculated by Landesmann and Székely (1995a) for some broad groups of skill-intensive product groups impressively describe the difficult conditions under which CEECs had been operating i n western markets i n the late 80s and early 90s (Table 5).

48

Klaus-Dieter Schmidt

Table 5 Quality gaps and market shares of CEE-4 in EC-markets for selected product groups 1988 and 1991 Market shares b

Quality indicator 3 ex Czechoslovakia

Hungary

Poland

ex Czechoslovakia

Hungary

Poland

Mechanical engineering 1988 1991

0.539 0.512

0.598 0.546

0.490 0.492

0.23 0.64

0.30 0.45

0.40 0.91

Electrical engineering 1988 1991

0.489 0.447

0.564 0.533

0.385 0.384

0 0.01

0.01 0.01

0 0.18

0.413 0.523

0.445 0.524

0.495 0.470

0.10 0.25

0.01 0.03

0.18 0.07

0.427 0.397

0.433 0.620

0.451 0.484

0.05 0.07

0.04 0.06

0.05 0.08

Motor vehicles 1988 1991 Instrument engineering 1988 1991 a

EU-6=1. -

b

I n percent of total E U - i m p o r t s (including intra EU-imports).

Source: Landesmann and Székely (1995a).

The substantial quality gap might also fit another finding: the move to more intra-industry trade. I n this respect, all CEECs, especially Bulgaria and Romania, have caught up (Table 6). However, trade theories usually t h i n k of intra-industry trade as horizontal integration (products of rather similar quality, but adapted to different tastes). This concept is misleading if i t is applied to trade between CEECs and western countries as CEECs' intra-industry specialization is characterized by vertical product differentiation (similar products w i t h marked differences i n qualities). Catching up i n the integration process can be generally described by gradual upward movements i n quality - by a move from vertical to horizontal intra-industry trade. Calculations by Landesmann for different segments of machine tools exported by Poland, ex-Czechoslovakia and Hungary (1996) suggest that such a move is, if at all, less recognizable. To sum up: despite massive geographic trade reorientation towards the EU, i t is nonetheless doubtful whether CEECs have really caught up i n the integration process. There is a clear decline i n comparative advantage of resource intensive goods but no increase i n research intensive

Transition i n Eastern Europe

49

goods (Table 7). I t is r e m a r k a b l e t h a t a d e c l i n e i n t h e s t r o n g c o m p a r a t i v e b i a s a g a i n s t R & D - i n t e n s i v e b r a n c h e s is o n l y d e t e c t a b l e f o r t h e e x - C S F R .

Table 6 CEE-6' intra-industry trade 3 1988 and 1993 Standard-Grubel-Lloyd-Index

CEE-6 Bulgaria Poland Romania Czechoslovakia Hungary

1988

1993

0.55 0.35 0.53 0.35 0.52 0.52

0.62 0.58 0.56 0.43 0.65 0.62

a

Manufacture trade with OECD-countries. Source: Trabold and Berke (1996).

Table 7 Comparative advantages (RCA) of CEE-6 in trade with OECD-countries by factor intensities 1988 and 1993 of which Total

Bulgaria

ex Czecho- Hungary slovakia

Poland

Romania

1988 1993

0.91 0.35

1.07 0.29

Resource-intensive 0.67 1.16 0.64 0.37

0.85 0.31

0.49 -0.22

1988 1993

0.45 0.51

0.53 0.53

Lab our-intensive 0.32 0.75 0.42 0.60

0.51 0.49

-0.30 0.54

1988 1993

0.01 0.11

-0.13 -0.17

Capital-intensive 0.40 -0.25 0.29 -0.26

-0.04 0.14

0.04 0.39

1988 1993

-1.85 -1.74

-0.68 -1.13

Research-intensive -2.11 -1.10 -1.57 -1.51

-2,29 -2.22

-2,81 -2.35

Source: Own calculations.

4 Konjunkturpolitik, Beiheft 45

50

Klaus-Dieter Schmidt 3.2 Capital import and trade performance

The move from vertical to horizontal trade specialization depends on the speed of industrial restructuring i n CEECs. Removing the distortions of the command economy implies, above all, rebuilding the capital stock and reorganizing enterprises' operations i n a way that goods and services are efficiently produced and distributed. Enterprises i n CEECs, given their deficits i n technological and marketing know-how, financial resources and management capacities, are facing a lot of difficulties i n achieving these targets. Therefore, they rely on strong partners from western countries. Becoming part of global networks should thus be central to the developing strategies of enterprises i n transition economies. Usually, integrated production theory is concerned w i t h foreign direct investment (FDI). Production w i t h i n networks requires a high degree of internationalization i n order to overcome, e.g., deficient property rights, quality and delivery uncertainties and imperfect information flows. Nevertheless, a large part of cross-border activities can be facilitated by weaker or simpler forms of integration such as contract work trade (CWT), such as licensing, franchising and, last but not least, outward processing trade (OPT). By CWT the subcontractor is integrated into a transnational value-adding chain by functional and institutional l i n kages rather than by equity. I n contrast to complex integration strategies, production i n CWT networks frequently remains quite fragmented. The integration of CEECs into international production and delivery networks takes the form of CWT rather than of FDI. The significance of OPT for the rapid increase i n east-west-trade becomes obvious by looking at the shares of the E U imports due to OPT i n total E U imports from respective countries (Table 8). I n 1993 the shares of each of the countries under review were i n the range from one tenth up to almost one third. For Romania, e.g., OPT has become a decisive factor for extending trade relations w i t h the EU: almost 30 percent of the country's total exports into the E U stemmed from OPT activities. Also i n Poland, the country w i t h the largest amount of OPT i n 1993, exports due to OPT turned out to reach almost 20 percent. For all countries this share has risen notably since 1989. Given the huge wage differentials i t is not surprising that most of OPT w i t h CEECs is undertaken i n labour-intensive industries, especially i n clothing and footwear (Table 9). However, i n recent years a shift to capital- and research-intensive industries has been observed, i n particular to

Transition i n Eastern Europe

51

Table 8 Share of imports after outward processing in total EC / E U imports from the CEE-6 1989 and 1993

Poland Czech Republic

1989

1993

9.0

18.5 12.3

5.5 a

Slovakia Hungary Romania Bulgaria

16.3 12.8 4.4

13.4 20.2 29.8 13.6

Note: Albania

3.8

24.8

a

1989 Czechoslovakia. Source: Own calculations.

Table 9 EC / E U imports from CEECs by commodity groups after outward processing 1989-1993 Mill. E C U CN-No. Total

Share in total imports (p.c.)

1989

1990

1991

1992

1993

1989

1990

1991

1992

1993

1,252

1,549

2,190

3,004

3,604

10.3

11.9

13.5

15.8

17.8

of which: 16

Meat, fish, crustaceans

11

26

22

39

40

11.7

20.9

14.8

26.2

29.8

42

Leather

22

32

35

40

28

28.6

34.2

30.5

30.9

24.1

61-66

Clothing, footwear

1,611 2,143

2,699

61.6

64.1

66.5

66.0

68.7

84

Machinery

47

51

107

106

81

8.3

7.0

10.6

9.2

6.7

85

Electrical engineering

33

44

115

235

284

8.4

8.7

18.6

27.3

23.0

87

Road vehicles

94

Furniture

891 1,127

51

42

44

93

60

14.0

13.4

9.0

10.4

5.6

152

160

130

139

167

26.5

27.1

16.4

13.7

13.9

Source: Own calculations.

machinery, electrical engineering and road vehicles. By and large, OPT i n these industries still concerns those types of goods where the products and production methods are standardized and where research work is not necessarily linked to production. Through OPT, CEECs have increasingly found their way into the sourcing networks of western producers of sophisticated goods. This indicates that they have been able to make some progress i n improving product quality according to the high quality requirements of their partners. CEECs, especially those sharing a common borderline w i t h western countries (Poland, the Czech Republic, Slovakia and Hungary) have tra4'

52

Klaus-Dieter Schmidt

ditionally participated i n OPT (Table 10). I n recent years, however, the Balkan states have been catching up. From all this we can conclude that OPT spreads internationally stepwise i n a double sense: on the one hand from "borderline countries" to more distant ones and on the other hand from labour-intensive productions to capital- and skill-intensive ones. Table 10 EC / E U imports after outward processing from selected CEECs 1989 and 1993 by commodity groups (Mill. ECU) Poland CN-No.

Czech SloRep. vakia

Hungary

Bulgaria

Romania

1993

1989

1993

1993

1989

1993

1989

1993

1989

1993

348 1,398

142

598

156

423

796

326

502

23

129 3

1989 Total

CSFR

of which: 16

Meat, fish, crustaceans

42

Leather

61-66

Clothing, footwear

11

34

0

0

0

0

0

0

3

0

5

10

3

5

1

13

8

1

3

0

2

269 1,106

57

290

121

314

589

226

455

22

114

84

Machinery

7

10

6

51

2

29

19

4

1

0

0

85

Electrical engineering

3

31

3

113

5

27

122

0

7

0

6

87

Road vehicles

2

14

40

21

15

8

8

0

3

0

0

94

Furniture

38

106

7

21

6

13

11

92

22

0

0

Source: Own calculations.

I n contrast to OPT and other forms of CWT, the integration of CEECs into world-wide production networks by F D I has developed less dynamically. Starting from an almost zero base, the number of registered projects skyrocketed - from about 2,500 i n 1989 to about 100,000 i n 1994 (Table 11). A minority of investors have made substantial investments. The majority is still testing the water but is hesitating to jump. Obviously, an equity involvement i n CEECs is considered as risky. Consequently, at the end of 1994 the cumulated total flow only amounted to about $ 25 billion. 3 For comparison: at the same time global F D I stocks reached nearly $ 500 b i l l i o n i n developing countries and approximately $ 2.3 t r i l l i o n world-wide (UNCTAD 1995). Moreover, w i t h respect to the recipient country foreign investors favour a few countries - Hungary, Poland, the Czech Republic and Slovakia. I n these countries alone, accumulated F D I flows accounted for 3 Inward F D I flows into CEECs have been estimated to $ 6.3 b i l l i o n i n 1994. CEECs' outward F D I was only $ 0.7 b i l l i o n i n 1994. For comparison: LDCs' F D I flows were $ 84 b i l l i o n resp. $ 33 b i l l i o n (UNCTAD 1995). I n 1994, inflows of F D I into CEECs were lower than inflows into Singapore.

53

Transition i n Eastern Europe

about half of total F D I attracted by CEECs. However, some successor states of the former Soviet Union (FSU) are becoming more and more attractive for western FDI. Especially the Ukraine and the Baltic states were able to raise their share i n total F D I projects significantly. A t the end of 1993, more than 10,000 joint ventures were registered i n these four countries, twice the number that existed i n Russia (5,200). Table 11 Registered projects and stocks of outward F D I a in transition countries 1990-1994 Stocks of F D I (mill. $)

Registrations (number)

Central Eastern Europe Albania Bulgaria ex Czechoslovakia Czech Republic Slovak Republic Hungary Poland Romania ex Yugoslavia Slovenia CIS Belorussia Kazakhstan Russian Federation Ukraine Baltic States Estonia Latvia Lithuania Total above Note: Developing countries 0 World 0

1994

1990

1993

15,640

77,500 85 1,500

140 1,600 -

5,700 2,800 1,500 3,900 -

-

12,300 3,250 18,500 14,300 23,500 -

2,400

b

93,00

1990 6,365 110 436 -

1,450 352 113 3,900 -

1993

1994

14,600 58 320

20,900 82 388

-

2,520 366 5,780 2,100 700

-

2,820 390 6,316

-

-

263

292 4,116

2,710 40 100 1,500 70

10,800 1,490

1,238 101

5,200 1,800

959 52

3,412 268 500 2,958 398

190 100 50 40

8,350 3,500 1,750 3,100

90 48 27 15

350 218 82 50

519 337 112 70

18,540

96,650

7,693

18,230

25,535

330 1,650

490 2,135

525 2,300

3,558 498

a

Cash basis; cumulated total, end of year. - b January-June. - c Bill. $. Source: UNCTAD; OECD; national statistics; own calculation.

Flows of F D I to CEECs had mainly come from all western developed market economies. The geographical pattern differs widely, but on aver-

54

Klaus-Dieter Schmidt

age German investors had dominated clearly: i n 1991 and 1992, they contributed more than two-fifths of reported F D I (Table 12). Recent statistics indicate, however, that even i n the Czech and i n the Slovak Republics, the predominance of its two western neighbouring nations Germany and Austria - is apparently becoming a matter of the past. Especially transnational companies (TNCs) headquartered i n the United States have now discovered the CEECs as a platform for international activities. Table 12 Top five outward F D I donor countries in selected recipient CEECs 1992/93 (ranking by amount stocks; percentage shares in brackets) Donor countries ranking Recipient countries Bulgaria

a

1st Greece ( - )

2nd Germany ( - )

3rd

5th

4th

Austria ( - )

Italy (-)

Russia ( - )

France (13)

Belgium (7)

Austria ( - )

Germany ( - )

USA

Netherlands ( - )

France ( - )

Germany ( - )

Austria ( - )

UK(-)

France ( - )

Germany (37) Sweden (8)

U S A (8)

Austria (7)

France (5)

Romania f

France ( - )

U S A (-)

Germany ( - )

Italy (-)

UK(-)

Estonia 6

Finland (51)

Russia 1 (22)

Sweden (11)

U S A (3)

Germany (3)

Russia

U S A (61)

Italy (6)

Ukraine11

Italy

U S A (-)

Czech R e p u b l i c 0

Germany (31) U S A (28)

Slovak Republic 0

Austria ( - )

Hungary0

U S A (-)

Poland 6

Η

Η

-

-

Germany ( - )

a 31 M a r c h 1993. - b 31 December 1993. - c 31 December 1992. 1 January 1992. - g 1 January 1993. - h 31 M a r c h 1993. - 1 CIS.

Sweden ( - ) d

1 August 1993. -

Germany (4) Spain ( - ) e

1 July 1992. -

Source: O E C D (1993).

There is no simple explanation for the different regional clusters of western F D I i n CEECs: geographic proximity as well as traditional economic and cultural links might be the main cause. The high share of French investment i n Romania or of Finland i n Estonia, e.g., may also be explained by language ties. Sometimes though, the ranking is still influenced by incidents such as large-scale engagements of single investors. E.g., i n the Czech Republic the lions' share of German and US-American F D I stems from the engagement of Volkswagen and Philip Morris. Although i t could be expected that CEECs are most attractive for i n vestors i n search of an engagement i n labour-intensive industries, these industries generally seem to provide only limited scope for outward FDI. There are at least two explanations for this: first, i n most labour-intensive industries, technologies are relatively simple; hence, the possibilities

f

Transition i n Eastern Europe

55

for foreign companies to internalize firm-specific advantages are quite limited. Consequently, i n these cases subcontracting is the dominant form of foreign investment. Second, the main interest of foreign companies is not or not only to take advantage of sweatshop labour. They look for a long-term commitment i n skill-intensive industries. This may explain why the structure of F D I i n CEECs differs significantly from the structure which is typical i n developing countries. Economists and policy makers i n CEECs often claim that the contribution of F D I to building up their country's new capital stock is relatively small. Indeed, at first glance, its impact appears to be disappointing if measured against the expectations and needs of these countries: on average, the invested capital at the end of 1993 amounted to about 1.5 percent of GDP. Only i n two countries, Hungary and - by a wide margin - the Czech Republic, accumulated F D I stocks reached a significantly higher level. However, historical experience of LDCs i n the 1970s and 1980s shows that net annual flows of F D I averaged only 0.4 percent of total investment over a twenty-year period. I n addition, only a few countries' inflows were persistently above the average (for example, Malaysia); most of the others were below (for instance, India); some countries' shares exhibited stability while others experienced significant changes from one year to another. Moreover, the presently small amount of inward FDI, especially largescale FDI, understates the long-term impact of western TNCs on restructuring of eastern companies and on l i n k i n g them into international production and sales networks. A n important share of F D I went into some key industries such as automotive production or electrical engineering. This type of F D I involves not only technology transfers to foreign affiliates but also spill-overs to related local suppliers, thus l i f t i n g the quality of these productions to international standards. Relationship between F D I and trade flows are of great importance for east-west integration. From a theoretical point of view, F D I and trade can be either complementary or substitutive to each other, depending, e.g., on industry characteristics, the degree of vertical and horizontal i n tegration among related firms and trade regime. W i t h respect to CEECs there is a greater plausibility that relations are complementary rather than substitutive: if differences i n factor endowment between the source country and the host country are large enough to attract FDI, then i t is likely that investments are much more geared towards production for export markets than for local markets. This was observed i n many LDCs,

56

Klaus-Dieter Schmidt

especially i n resource-intensive and labour-intensive industries (Hiemenz 1987). A t the same time, we can expect F D I to raise imports resulting from firm-specific inputs such as capital goods or intermediate goods for local processing. I n fact, a rough calculation suggests that F D I and trade i n CEECs are positively related: the shares of CEECs i n both OECD-countries' total stock of outward F D I and i n two-ways trade have been rising significantly i n recent years (Table 13). However, because of its small i n i t i a l basis, F D I has been rising faster than trade. Although i n general F D I can be expected to be regionally less concentrated than trade, 4 there is obviously a positive correlation between bilateral investment and trade i n tensities. This is evident for Poland, ex-Czechoslovakia and Hungary w h i c h share a common borderline w i t h two western countries, Germany and Austria. Despite increasing globalization, geographical nearness still seems to matter. Table 13 Share of CEECs in OECD-total outward stock in F D I a and in OECD-two-ways trade 1990 and 1993 (percent) Stock of F D I

Total of which: Poland ex Czechoslovakia Hungary Bulgaria Romania a

Two-ways trade

1990

1993

1990

1993

0.15

1.11

0.90

1.35

0.02 0.03 0.09 0.01 0.01

0.13 0.18 0.36 0.02 0.04

0.33 0.20 0.22 0.05 0.10

0.49 0.39 0.30 0.07 0.10

Cash basis; cumulated total, end of year.

Source: O E C D ; U N C T A D ; o w n calculations.

I n order to take a closer look at this issue, F D I and trade intensities for Germany w i t h respect to these three countries were calculated. The results indicate that the strongest German linkages are those w i t h its two neighbours Poland and ex-Czechoslovakia. This may reflect the 4 This can be explained by the fact that locational decisions of multinationals w i t h respect to F D I are influenced by a larger number of factors than those w i t h respect to trade.

Transition i n Eastern Europe

57

fact that transaction costs of F D I as well as transport costs of trade are increasing w i t h distance. Interestingly, F D I intensities are generally not significantly lower than trade intensities. This result needs further i n vestigation. Normally, one would expect that transaction costs of F D I are more important than transport costs of trade. The high barriers of trade, especially the discriminatory protection of the EC w i t h respect to "sensitive products", may have raised relative costs of trade and may be a possible explanation.

Poland

ex-Czechoslovakia

Hungary

Intensity ratio is defined as share of partner country in German FDI (trade) divided by the share of partner country in world-wide FDI (trade) excluding FDI (trade) with Germany. After logarithmic transformation an average level of bilateral intensity appears with the value of 0, positive (negative) values indicate stronger (weaker) linkages [UN 1993: 169].

Figure 1: Germany's F D I and trade intensities w i t h selected partner countries 1993 Source: Own calculations.

Apart from geographic proximity there is a further argument explaining this pattern: Poland, ex-Czechoslovakia and Hungary are also the leaders i n the transformation process. Similarly, i n developing countries, F D I and trade are concentrated i n some ten countries w h i c h provide a favourable location for foreign investors.

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Klaus-Dieter Schmidt 3.3 Wage differentials and migration

Economic theory suggests that a high degree of interregional labour mobility is necessary for smoothly operating i n an integrated w o r l d economy However, i n reality labour markets are highly segmented. Most countries all over the w o r l d try to prevent large-scale migratory flows. I n this respect the situation is quite similar wherever rich and poor countries share a common borderline - at the Rio Grande, at the Pearl River Delta or at the Oder and Neisse River. Nevertheless, the relatively small number of people from CEECs working legally and illegally i n west European countries remains puzzling. This fact cannot be sufficiently explained by tight immigration regulations. Experiences from other parts of the w o r l d suggest that large i m m i gration pressure may result i n illegal immigration if no official channels for legal migration are available. The main reason for small migration flows is that labour markets i n western Europe are highly segmented and regulated. I n the E U i t is difficult for immigrants from non-EUcountries to obtain even temporary or atypical work without having a permission for permanent residence. West European unions make all efforts to keep away foreign workers who might undermine their market power (see the recent development i n Germany where the government has initiated the so-called "Entsendegesetz", a law which is supposed to make foreign labour competition i n the building industry more difficult). Potential migration flows from CEECs to non-EU-countries were predicted to be i n a wide range between 5 m i l l i o n and 40 m i l l i o n over a decade (Bauer and Zimmermann 1995). Such figures are highly speculative and might be overrated. However, i t is probably fair to say that circumstances indicate some considerable potential for migration. Consequently, migration from the east to the west is a crucial point i n the process of CEECs' integration. The problem w i t h this story is that there is no easy answer to it. For an economist, international integration applies to the abolishment of any restrictions on labour mobility. However, no government i n the w o r l d (and no government i n CEECs which discourage migration, too) would be w i l l i n g to establish a laissez-faire regime allowing free labour mobil i t y As migration does include workers as well as asylum seekers i t deeply affects the balance of the social security systems. L o w interregional flows, however, do not necessarily hamper market integration. To a certain extent, labour markets are indirectly integrated

59

Transition i n Eastern Europe

by trade flows and by capital flows too. I n a strict Heckscher-Ohlin world, labour, capital investment and trade can be considered as perfect substitutes. A restrictive migration policy w i l l facilitate capital exports or / and imports of labour-intensive goods. The choice for E U countries is therefore either receiving large flows of immigrants on the one hand or losing a large number of working places on the other hand (Eichengreen 1993). No country can avoid both at the same time. Under these circumstances the only solution can be to remove barriers to free trade and to give CEECs f u l l access to international markets - as a substitute for closed labour markets.

4. Evaluation: competitiveness and exchange rates Undoubtedly, CEECs have proceeded towards international integration, especially i n expanding trade w i t h the west. Results of shift and share analysis reveals that on average 80 percent of the total increase i n E U imports from Poland, Hungary and ex-Czechoslovakia can be attributed to improved competitiveness (Havlik 1995, Werner 1995) (Table 14). Competitive gains result, first of all, from comparative cost advantages, especially low wages. I n this respect, CEECs have indeed improved their standing on international markets. Table 14 Decomposition of increment in CEE-4s' Exports 3 to the E U 1991 - 1994

Demand effect Structural effect Competition effect

ex Czechoslovakia

Hungary

Poland

8.0 2.9 89.1

18.3 6.7 75.0

12.7 4.7 82.7

a

Exports of manufactured goods excluding textiles and iron and steel. Source: Werner (1995).

On the other hand, the component measuring the structural effect of export increment is, although positive, relatively low. This is another unequivocal sign for the slow pace i n diversifying CEECs' exports. Moreover, all CEECs show a trend to concentrate their exports on similar product groups i n which they have gained relatively high market shares, such as iron and steel and non-ferrous metals, cement, petrochemicals, footwear, clothing, k n i t t i n g or wood products and furniture. These pro-

Klaus-Dieter Schmidt

60

duct groups are characterized by a high price elasticity rather than a high income elasticity I n this respect CEECs' export appears to be very vulnerable. Competitiveness, however, is a fuzzy concept. Everyone knows that the exchange rate plays a critical role i n reaching competitiveness. There is always an exchange rate which make a country's enterprises competitive i n international markets. I t is a matter of fact that all CEECs currencies have been undervalued vis-ä-vis purchasing power parity (PPP) (Figure 2). To a certain extent this may reflect the larger productivity gap between tradables and non-tradables i n CEECs compared to western industrialized countries. However, i t might also be a source for the observed "competitive strength" i n western export markets. Meanwhile, most CEECs have experienced a loss of strength i n exports due to a continuing decrease i n undervaluation. I t is likely that the currencies of some CEECs (especially those of Poland and Hungary) are already overvalued i n the sense that they are no longer compatible w i t h price competitiveness of the tradables' sector. Without further restructuring, export capacities i n CEECs w i l l hardly become competitive i n the long run.

Figure 2: CEFTA countries: evolution of ratios of official exchange rates to PPP rates 1990-1994 Source: Thießen (1995).

Transition i n Eastern Europe

61

5. Policy conclusions: which sort of integration? CEECs' integration into the w o r l d economy has undoubtedly made some progress. This has not only taken the form of trade reorientation, but also of new forms of foreign direct investment, subcontracting and co-operation agreements w i t h western enterprises. As a consequence, CEECs have started to become deeply involved i n the comprehensive process of globalizing production which characterizes the international economy. I n this process, enterprises' operations are becoming much more complex and pervasive than traditional arm's-length trade and traditional international investment, including both international production and sourcing. Nevertheless, CEECs still have a long way to go u n t i l they reach f u l l international integration. Economists have little difficulty praising the benefits of CEECs' international integration since trade and other forms of cross-border operations are usually a positive-sum game for the involved parties (Eaini and Portes 1995). I n this respect, rent seeking producer groups i n the east and west do not t h i n k the same. They are afraid that freer trade could damage their market position and, consequently, could displace investments and jobs. Recently A l a n Winters (1996) has warned that the honeymoon for trade liberalization w i t h Eastern Europe could already be over. The challenge w h i c h western countries as well as CEECs are facing is to design a framework for integration policy that can resist against the growing demand for protectionism and, moreover, that can keep liberalization going. This framework must include trade, capital and - as far as possible - migration flows. The crucial question is: what could be the right frame of such a design? The great majority of economists and policy makers i n the east and west favour close institutional ties between the CEECs and the EU. I t is argued that European Agreements (EAs) between the E U and the CEE-6 have accelerated liberalization of trade and capital flows. I n order to withstand protectionist pressure from their own lobby, CEECs should be given a strong institutional frame (Agarwal et al. 1995). However, i t seems debatable whether EAs really provide such a basis. EAs have three important shortcomings which might even aggravate integration: - They do not include all CEECs. Therefore, they economically and politically divide countries which share a common borderline and are "natural" trade partners (e.g. Poland and the Ukraine or the Baltic

62

Klaus-Dieter Schmidt

States and Russia). Furthermore, E U enlargement to the east including all CEECs which want to join is improbable for decades (Baldwin 1994; Baldwin and Flam 1994). The self-interest of EU-countries might prevent such a step for a long time (Daianu 1995). - They comprise some dangerous "political landmines" w i t h a delayed fuse of duration (Baldwin 1995) - agricultural trade, structural spending and migration which can go off at any time. F u l l EU-membership of CEECs might easily be vetoed by the lobby of farmers, depressed regions or workers i n the E U as well as i n CEECs. - They do not exclude contingent restriction such as anti-dumping, safeguard and anti-subsidy measures. I n this respect EAs are even more unfavourable for the CEECs than the Treaty of Rome is for E U members. Recent experiences i n western countries show that protectionist measures can be exactly tailored to produce that dose and form of protection which pressure groups are demanding. CEECs which strive for f u l l membership i n the EU, therefore, should carefully calculate not only the benefits but also the costs. The costs could easily become very high if, e.g., CEECs were forced to adopt the E U social or environmental standards. Moreover, benefits and costs of f u l l EU-membership should be compared to those of the relevant alternative, namely integration on a multilateral basis w i t h i n the GATT / WTO frame. To spell i t out: CEECs should avoid any k i n d of regional separation and discrimination. A free trade area from the Atlantic to the Pacific would bring enormous benefits for the more than 500 m i l l i o n people who live there - w i t h only marginal costs. Maybe this is still a v i sion for many years to come. However, international integration via l i b eralization is a stepwise process. What matters is sustainability, not the pace.

Abstract I n recent years, the integration of Central and East European Countries (CEECs) into the world economy has made some progress. This has not only taken the form of trade reorientation, but also of new forms of foreign direct investment, subcontracting and co-operation agreements w i t h western enterprises. The paper reviews the state of the art of research - i n order to identify the key issues. First it looks at the question of what would be the best economic and political path to integration, second it presents some facts and figures to describe the pattern of integration w i t h respect to commodity and factor markets, t h i r d i t eval-

Transition i n Eastern Europe

63

uates the recent results of integration and fourth i t discusses some policy conclusions.

References Agarwal, J. P., R. J. Langhammer, Μ. Lücke and P. Nunnenkamp (1995) "Export Expansion and Diversification i n Central and Eastern Europe: What Can Be Learnt from East and Southeast Asia", K i e l Discussion Paper 261, November. Baldwin, R. (1994) Towards an Integrated Europe, (London). - (1995) "Paths Towards an Integrated Europe: Problems and Prospects", i n R. Dobrinsky and M. Landesmann (eds), Transforming Economies and European Integration, Aldershot (UK) and Brookfield (US). Baldwin, R. and H. Flam (1994) "Enlargement of the European Union: The Economic Consequences for the East", CEPR Occasional Paper No. 16. Bauer, T. and K. F. Zimmermann (1995) "The Labour Market Effects of Migration", CEPR Discussion Papers No. 1235, August. Casson, M. (1995) The Organization of International Business. Studies i n the Economics of Trust, Aldershot (UK) and Brookfield (US). Collins, S. and D. Rodrik (1991) Eastern Europe and the Soviet Union i n the World Economy, Washington, D.C. Daianu, D. (1995) "Europe under a Double Challenge", i n R. Dobrinsky and M. Landesmann (eds), Transforming Economies and European Integration, Aidershot (UK) and Brookfield (US). Dobrinsky, R. (1995) "Economic Transformation and the Changing Pattern of European East-West Trade", i n R. Dobrinsky and M. Landesmann (eds), Transforming Economies and European Integration, Aldershot (UK) and Brookfield (US), pp. 86-115. Dobrinsky, R. and M. Landesmann (eds) (1995) Transforming Economies and European Integration, Aldershot (UK) and Brookfield (US). Drabék, Ζ. and A. Smith (1995) "Trade Performance and Trade Policy i n Central and Eastern Europe", CEPR Discussion Papers No. 1182, May. Eichengreen, B. (1993) "Thinking about Migration: Notes on European Migration Pressure at the Dawn of the Next Millenium", i n H. Siebert (ed), Migration. A Challenge for Europe, Symposium 1993, Tübingen. European Commission (1995) "Economic Interpenetration between the E U and Central and Eastern Europe", European Economy. Faint, R. and R. Portes (eds) (1995) Opportunities Outweigh Adjustment: The Political Economy of Trade w i t h Central Eastern Europe, London. - (eds) (1995) European Union Trade w i t h Eastern Europe: Adjustment and Opportunities, London.

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Gàcs, J. and G. Winckler (eds) (1994) International Trade Restructuring i n Eastern Europe, Heidelberg, Wien. Graziarli, G. (1995) "Threats and Opportunities for West European Industry Deriving from Trade Liberalization w i t h Central and Eastern Europe", i n R. Dobrinsky and M. Landesmann (eds), Transforming Economies and European Integration, Aldershot (UK) and Brookfield (US). Halpem, L. (1994) "Comparative Advantage and Likely Trade Pattern of the CEECs", CEPR Discussion Paper Series No. 1003, September. Havlik, P. (1995) "Trade Reorientation and Competitiveness i n CEECs", i n R. Dobrinsky and M. Landesmann (eds), Transforming Economies and European Integration, Aldershot (UK) and Brookfield (US). Hiemenz, U. (1987) "Foreign Direct Investment and Industrialization i n Developing Countries", Weltwirtschaftliches Archiv, 123. Klodt, Η. (1993) "Perspektiven des Ost-West-Handels: Die komparativen Vorteile der mittel- und osteuropäischen Länder", Die Weltwirtschaft, Heft 4. Krugman, P. (1995) "Growing World Trade. Causes and Consequences", Brooking Papers on Economic Activity, 1. Landesmann, Μ. (1995) "Projecting East-West Trade Integration", i n M.A. Landesmann and I.P. Székely (eds), Industrial Restructuring and Trade Performance i n Eastern Europe, Cambridge. - (1996) "Emerging Patterns of European Industrial Specialization: Implications for Trade Structures, F D I and Migration Flows, Executive Summary", mimeo. Landesmann, Μ. A. and I. P. Székely (eds) (1995a) Industrial Restructuring and Trade Reorientation i n Eastern Europe, Cambridge. - (1995b) "Industrial Change i n Central and Eastern European Economies", i n M.A. Landesmann and I.P Székely (eds), Industrial Restructuring and Trade Reorientation i n Eastern Europe, Cambridge, pp. 25-75. Lemoine, F. (1994) "CEEC Exports to the EC (1988-1993): Country Differentiation and Commodity Diversification", CEPII Document de Travail N° 94 - 15-décembre. Organization of Economic Co-operation and Development (OECD) (1993) "Foreign Direct Investment i n Central and Eastern Europe. Policies and Trends i n Fourteen Economies i n Transition", mimeo, Paris. Rollo, J. and A. Smith (1993) "The Political Economy of Eastern European Trade w i t h the European Community. Why So Sensitive?", Economic Policy, 16. Sheehy, J. (1995) "Economic Interpenetra tion between the European Union and Central and Eastern Europe", i n R. Dobrinsky and M. Landesmann (eds), Transforming Economies and European Integration, Aldershot (UK) and Brookfield (US). Thießen, U. (1995) "Competitiveness of Central-Eastern European Countries", Vierteljahreshefte für Wirtschaftsforschung, 2, 95.

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Traboldy H. and C. Berke (1996) "Veränderung der komparativen Vorteile Mittelund Osteuropas i m Transformationsprozeß", Vierteljahreshefte für Wirtschaftsforschung, 1. United Nations Conference on Trade and Development (UNCTAD) (1994, 1995) World Investment Report. Werner, K. (1995) "Wettbewerbsfortschritte der CEFTA-Länder i m Handel m i t der Europäischen Union", Institut für Wirtschaftsforschung Halle, Wirtschaft i m Wandel, 7. Winters , A. (ed) (1996) Foundation of an Open Economy: Trade Laws and Trade Institutions for Eastern Europe, London.

5 Konjunkturpolitik, Beiheft 45

Comment on: Klaus-Dieter Schmidt, Transition i n Eastern Europe: The Integration of Goods and Factor Markets into the W o r l d Economy By M a r k u s

Mende

Reviewing Mr. Schmidt's paper has been rewarding. The paper offers a comprehensive and meaningful set of data characterising Eastern Europe's state of integration into the world economy. On this sound basis the author then raises a number of highly important issues related to the future transition path of Eastern Europe. I n the following, I w i l l address these issues grouped under four main points. Firstly, Klaus-Dieter Schmidt compares the volume and direction of pre- and post-reform trade volumes. He concludes that for the former CMEA countries the sharp increase i n East-West trade has largely come at the expense of East-East trade. This apparent East European disintegration, however, calls for a closer look at the pre-1989 trade patterns. East European trade patterns not only suffered from strong trade diversion due to high external trade barriers against the rest of the world. Intra-CMEA was also heavily skewed towards the Soviet Union: i n 1985 Czechoslovakia, Poland and Hungary respectively settled 45 percent, 32 percent and 31 percent of their total external trade w i t h the Soviet U n ion 1 . On the other hand, bilateral trade shares between the CEEC-6 countries only averaged around 5 percent for the same year (Richter and Toth, 1996). Moreover, trade diversion arose from the administrative practice of trade balancing w i t h marginally desirable goods to avoid b i lateral trade deficits (Richter, 1994). Finally, intra-CMEA trade volumes were inflated since they were calculated i n highly overvalued transfer roubles (Brada, 1994). I n this sense the switch i n trade orientation is a sign that the CMEA countries have progressed i n terms of global market integration. Importantly, the paper questions the extent to which Eastern Europe has been integrated into the world economy. Klaus-Dieter Schmidt 1

5'

Average of import and export shares taken from I M F (1990).

68

Markus Mende: Comment

points to the low penetration of CEECs' imports i n the OECD and EU. On a first gross measure, the marginal role of the transition economies is underlined by the I M F (1995) i n its 1995 World Economic Outlook : i n dustrial countries, developing countries and transition economies 2 produce 54.6, 40.1. and 5.3 percent of world GDP respectively. However, given respective w o r l d trade shares of 70.2, 26.1. and 3.7 percent, the transition economies have a trade to GDP ratio of 0.7. Against a trade intensity of 1.29 for industrialised countries, this compares favourably to the trade to GDP ratio of 0.65 for developing countries as a whole. The low trade intensities of former CMEA members w i t h the rest of the w o r l d should thus not be attributed exclusively to lack of competitiveness. Rather, they are i n line w i t h the marginal total production volumes i n these countries. Finally, Eastern Europe's integration trough trade has picked up speed. While i n 1993 exports of the transition economies grew by an average 2 percent annually, i n 1994 the figure reached 12 percent, exceeding w o r l d export growth by 3 percent (The Economist, 1995A). Addressing the issue of comparative advantage, the author points to a specialisation of CEEC-6 exports towards labour-intensive, low value added goods, i.e. textiles, wooden manufactures, iron and steel etc.. I n the literature reviewed, this is interpreted as a downgrading of exports due to "patchy factor endowments" leading to inefficient utilisation of capabilities. Other data reviewed by Klaus-Dieter Schmidt indicate, a slow reduction i n export specialisation vis-à-vis the E U between 1988 and 1993. I n this light the current overall export specialisation appears to be a result of the massive trade orientation towards Western markets, thus revealing the CEEC-6's current comparative advantage under market conditions. This is not to say that the problem of export diversification does not deserve attention. On the other hand, the massive switch from internal non-competitive CMEA demand to external competitive Western demand deserves credit - particularly when considering the rather mixed results of I M F induced demand switching programs. The previous three points i n the realm of positive economics have given me the opportunity to interpret data on Eastern Europe reviewed by Klaus-Dieter Schmidt. From a different angle one obtains a slightly more encouraging view while generally agreeing w i t h the authors conclusions. However, on the issue of bilateral versus multi-lateral integration of Eastern Europe my opinion differs from the author's. Klaus-Die2

The I M F (1995) includes 28 countries covering Central and Eastern Europe, Russia plus the non-European states of the former Soviet Union.

Markus Mende: Comment

ter Schmidt criticises the single-minded determination of CEEC-6 policy makers to achieve integration through E U membership. He is concerned that this might eventually divide "natural" trading partners, e.g. Poland and Ukraine, and slow-down integration w i t h the non E U Western rest of the world. As i n all cases of applied public choice, the problem boils down to finding the best policy given exogenous constraints outside the control of policymakers. While multi-lateral integration is usually first-best, i n reality liberalisation and integration have frequently followed from bilateral and regional agreements that were successively expanded. Given the decisive influence of location and distance on trade flows (Hamilton and Winters, 1992), Paul Krugman has defined regional Free Trade Areas (FTAs) as "natural" and non-diverting (The Economist, 1995B). Indeed, the WTO regulations permit regional FTAs as stepping stones for wider liberalisation agreements as long as external barriers do not exceed multi-laterally agreed limits. A n I M F (1993, p. 112) study on regional trading arrangements concludes that "The consensus is that, overall, trade creation effects have been much greater than trade diversion effects". Moreover, for Spain and Portugal and more recently for Poland and the Czech Republic the E U has provided a concrete anchor for far-reaching economic reforms. Interestingly, liberalisation i n Poland and the Czech Republic as a result of strong ties to the E U proved complementary to further multi-lateral reforms as a pre-condition to OECD membership. On the other hand, i t is questionable whether a regional FTA comprising the CEEC-6 countries makes sense. Its members lack economic gravity relative to the E U or NAFTA, even if some or all CMEA countries join. Secondly, i t is unclear what benefits i n terms of informational externalities as discussed by Romer and Rivera-Batiz (1991) and Grossman and Helpman (1992) i n the spirit of new growth theory would accrue to members w i t h highly similar export products of low R & D i n tensity. Thirdly, the instability of some CMEA countries, particularly w i t h respect to market reforms, implies that a liberalisation anchor would not be a benefit of a new CMEA trading agreement. Finally, the failure of smaller FTAs among developing countries, e.g. the CACM 3 , ECOWAS 4 etc., augurs badly for integration efforts grouping countries w i t h similar economic structure and excluding the individual member's biggest trading partners (IMF, 1993). I n conclusion, concerted efforts by 3 4

Central American Common Market. Economic Community of West African States.

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Markus Mende: Comment

the CEEC-6 countries to join the E U appear rational i n the absence of reasonable alternatives.

References Brada, J. C. (1994) Regional Integration versus Integration into the World Economy: The Choices for Central and Eastern Europe, The World Economy, 17, 603 618. Economist, The (1995A), Financial Indicators - Trade, A p r i l 8th, p. 127, London. - (1995B), Regionalism and Trade, September 16th, 27 - 33, London. Grossman, G. M. and Helpman, E. (1992), The Innovation and Growth i n the Global Economy M I T Press, Cambridge, Massachusetts. Hamilton, C.B.L. and Winters, L.A. Opening Up International Trade i n Eastern Europe, Economic Policy, 14,77-117. I M F (1991) Direction of Trade Statistics Yearbook, Washington, D.C. - (1993) World Economic Outlook, Washington, D.C.. - (1995) World Economic Outlook, October 1995, Washington, D.C. Romer, P. M. and Rivera-Batiz, L. A. International Trade w i t h Endogenous Technological Change, European Economic Review, 35, 971 - 1004. Richter, S. and Toth, L. G. (1996) Prospects for Economic Co-operation Among the Visegrad Group Countries, Russian and East European Finance and Trade, 32, 42 - 94.

Currency Substitution and Currency Controls: the Polish " B i g Bang" of 1990 By B a s v a n A a r l e 1

1. Introduction I n January 1990 the Polish government launched the so called Balcerowicz plan which aimed at restructuring the Polish economy into the direction of a modern market economy. From a structural perspective the Balcerowicz program contained guidelines regarding the privatization of the state sector, the liberalization of prices, trade and the financial sector and for restoring the convertibility of the Zloty. Besides these structural features the plan also proposed a set of measures to reduce the high inflation that existed and to stabilise output. A combination of fiscal consolidation, a unified fixed exchange rate, a reduction i n wage indexation and other restrictive incomes policies were expected to reduce inflation considerably. External aid from the IMF, World Bank and the EC and a considerable debt relief w i t h i n the Brady plan completed the Balcerowicz plan. The Balcerowicz program was carried out under supervision of the International Monetary Fund and its structure and results are already well documented, e.g. by Calvo and Coricelli (1992), Lane (1992a) and E b r i l l et al (1994). The Balcerowicz plan succeeded i n reducing inflation rates considerably and a gradual recovering of the real side of the economy, as can be seen i n Figure 1 which displays the annual rate of inflation (thick line, left scale) and the index of industrial production (thin line, right scale) i n Poland for the period 1986 - 1995: The graph reveals the sharp increase i n inflation at the end of 1989. After implementation of the Balcerowicz plan inflation started to decrease throughout 1990 and 1991. Figure 2 shows the amount of real 1 Correspondence to Bas van Aarle, Department of Applied Economics (5. 01. 34), University of Nijmegen, P.O. box 9108, 6500 H K Nijmegen, the Netherlands. I have benefited much from a large number of suggestions and comments from Harry Huizinga.

Bas van Aarle Inflation and output Poland 1987 - 1995

Figure 1: Inflation and output performance, Poland 1987 - 1995

Real currency, real narrow money and real FCD (in logs)

— real currency - - - real M l

— real FCD

Figure 2: Real currency, real narrow money and real FCD (in logs)

Currency Substitution and Currency Controls

73

currency i n circulation, real narrow money and real foreign currency deposits (FCD), all i n logarithms. These monetary aggregates display a structural break at the beginning of 1990 when real currency and real narrow money balances fall and real foreign currency deposits rise considerably. I n this paper we focus on the consequences of such a structural break i n real money balances on real seigniorage revenues of the government. This study relates the structural break i n real money demand to one important measure i n the Balcerowicz plan: the decision to restore convertibility of the Zloty and removal of the former strict currency controls. The removal of the currency controls enabled a strong increase i n currency substitution. Figure 3 displays the foreign currency deposits to currency (FCD / CU) and to narrow money (FCD / M l ) ratio. This ratio is often used as a proxy of the degree of currency substitution or "dollarisation" of the domestic economy 2 .

FCD / Currency and FCD / M l Ratios Poland 89.1 - 95.III

— FCD/CU - - - FCD/M1

Fugure 3: FCD / Currency and FCD / M l Ratios, Poland 1989 - 1995

2

See Sahay and Végh (1995) and van Aarle and Budina (1996) for more empirical evidence on currency substitution i n the economies i n transition.

74

Bas van Aarle

The liberalization of foreign exchange restriction between March 1989 and January 1990 is accompanied by a strong increase i n currency substitution i n Poland. Currency substitution entails a shift towards foreign money by domestic agents, both for transaction purposes and as a store of value. Currency substitution arises from currency viz. money demand that is sensitive to both domestic and foreign influences. I n particular, home and foreign interest rates influence currency substitution as they reflect the opportunity costs of holding domestic and foreign money, respectively. If real interest rates and foreign inflation are assumed to be small and constant, the opportunity costs of holding domestic and foreign money depends mainly on the domestic rate of inflation. Currency substitution i n the domestic country, then, is likely to increase w i t h a higher domestic inflation rate and to decrease w i t h a lower domestic rate of inflation. This "inflation driven" currency substitution stands central i n our analysis of the Polish experience w i t h reform. The part of currency substitution that was driven by increases i n foreign trade and other possible factors encounters less attention: i t comes i n as a constant. Currency substitution of a significant degree influences monetary equilibrium and public finance i n a small open economy. Currency substitution influences public finance since i t enables the domestic agents to circumvent the inflation tax imposed by the domestic government on holders of domestic money. When domestic money is held by foreign agents, an additional foreign source of seigniorage revenues is available. Via their influence on seigniorage revenues, currency substitution and currency controls affect the whole public finance. Moreover, currency substitution w i l l foster inflationary discipline which could provide an incentive for macroeconomic policy makers to avoid excessively inflationary policies, i n this manner contributing to a higher level of social welfare. Canzoneri and Diba (1992) compare the optimal rate of inflation if monetary authorities of two countries play seigniorage maximization games w i t h the optimal rate of inflation if both authorities seek to maximize social welfare i n their country. Optimal inflation rates i n both monetary policy games critically depend on the degree of currency substitution and i n welfare maximization games the optimal inflation rate also depends on the marginal distortion of ordinary taxation. A higher degree of currency substitution lowers the optimal rate of inflation i n both games as expected, while a higher marginal distortion from ordin-

75

Currency Substitution and Currency Controls

ary taxation increases the optimal rate of inflation i n the welfare maximization game. This paper seeks to extend the work of Canzoneri and Diba by considering the possibility that monetary authorities introduce currency controls i n an attempt to discourage currency substitution. Because of complexity the analysis is not cast i n a 2-country game as i n Canzoneri and Diba but i n a small country framework. The structure of this paper is as follows: chapter 2 introduces a macroeconomic model of a small open economy w i t h rational, maximizing agents i n which currency substitution is present. The effects of currency substitution on public finance are derived. I n chapter 3 the effects of introducing or removing currency controls are considered, chapter 4 applies the analytical results to the case of Poland. A conclusion summarizes the main results from this chapter. 2. A small open economy with currency substitution Consider a small open economy w i t h agents that hold both domestic and foreign money i n transactions and as a store of value. If we want to model the currency substitution that takes place we need to extend traditional money and allow domestic agents to hold both domestic and foreign money. For simplicity demand is modelled according to the moneyin-the-utility function approach which can be shown to be compatible w i t h a number of alternative money demand approaches. The representative domestic agent is assumed to maximize a concave intertemporal u t i l i t y function that has as its arguments real consumption 3 , c, domestic real money, m, and foreign real money, n:

(1)

'CC

U t i l i t y is maximized subject to the dynamic budget constraint which relates real asset accumulation, w, to real interest income, rvo , real labour income from an inelastic supply of one unit of labour, y, real taxes, r, real consumption and the inflation tax on both the holdings of domestic money, (r + π)πι and foreign money, (r + π*)η: (2) 3

w = rw + y - τ - c - (r + π)πι - (r + π*)π

Variables, except for inflation and interest rates, are expressed i n logarithms. For the sake of brevity, we ommit the time index t that pertains to any variable.

Bas van Aarle

76

Heal financial wealth of the individual consists of net foreign assets, /, w h i c h yields a real return r, which is assumed to be given and constant throughout the analysis, real domestic money and real foreign money: (3)

^

W =

Μ eN eF = __ + _ _ + _ _

=

m

+

n + /

i n which e denotes the exchange rate of domestic money against foreign money. We exclude ever growing foreign debt or asset accumulation and negative amounts of money: (4)

l i m / e x p ( - r t ) = 0 ra, η > 0 t—>oo

Solving the maximization problems of the representative agent yields implicit demand functions for consumption goods, domestic money and foreign money: (5a)

uc = A

(5b)

v m = A(r + π)

(5c)

v n = A(r + π*)

(5d)

λ = (δ - r) A

where A denotes the co-state variable associated w i t h real wealth. (5a) and (5d) are the standard static and dynamic optimality conditions concerning real consumption allocation. (5b) and (5c) reveal that demand for domestic and foreign money are determined by the u t i l i t y derived from l i q u i d i t y services, υ(ττι,η;σ), and the opportunity costs of both monies. Opportunity costs of both monies differ if there is any inflation differential between the domestic economy and the rest of the world. How much currency substitution is induced by an inflation differential depends critically on the value of σ which parametrizes currency substitution: i t measures the degree of substitutability between domestic and foreign money. A high σ implies that domestic and foreign money are poor substitutes, a low σ that they are good substitutes. When positive, both monies are substitutes of each other, when negative both monies are complements, σ summarizes the structural and institutional characteristics of the monetary system of the small open country, under study. Guidotti (1993) analyses the consequences of financial innovations that facilitate currency substitution i n the domestic country, inducing a

Currency Substitution and Currency Controls

77

decrease of σ. Financial innovations enable the representative agent to economise on real money balances, which make h i m better off. However a "secondary" effect is present, as indicated by de Grégorio (1991) if ordinary taxes, τ, are distortionary or carry collection costs: a decrease i n σ induces a decrease i n holdings of real domestic money and therefore a decrease i n real seigniorage revenues that has to be compensated by a rise i n distortionary ordinary taxes and which w i l l make society worse off. The exact magnitudes of both effects determine whether the economy is better off from a financial innovation or not. Assume that instant u t i l i t y u(c) + v(m i η; σ) has the following shape: u(c) + u(ra, η; σ) = c - 0.5(7 -m + ω-η)2

(6)

- 0.5σ[(7 - mf + (ω - η)2}

i n which 7 and ω are constants that reflect optimal holdings of domestic and foreign money respectively, σ is defined i n such a manner that -1/σ measures the change i n the relative amount of real domestic money balances of domestic agents, if the inflation differential is increased by 1%. - l / σ is therefore referred to as the elasticity of currency substitution i n the remainder, - l / σ = 0 and ω = 0 represents the case when no currency substitution occurs (n = 0). The first-order-conditions (3a),(3b) and (3c) can be combined to give m and η as a function of domestic and foreign inflation rates: v(7a)J

m = 71

(7b)

η = ω

r — (σ + 2)

(σ+ 1) 1 + —π Η—; —π ; σ(σ + 2) σ(σ + 2)

r

ν

}

1 (σ+!) * —+ — —π--^ f -π* (σ + 2) σ(σ + 2) σ(σ + 2)

A rise i n the domestic inflation rate induces a decrease i n the demand for domestic money and an increase i n the demand for foreign money, while a rise i n the foreign inflation rate has the opposite effects. 4 Holdings of both monies are non negative as long as inflation rates remain w i t h i n a certain range:

4

One could assume at this stage that domestic and foreign inflation rate are linked by relative purchasing power parity, implying that the expected rate of depreciation, è, is equal to the inflation differential, π - π*. As we are not convinced that PPP is a good approximation i n the case of Poland considered i n the empirical part, we stick to (7a) and (7b).

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Bas van Aarle

(8a) (8b)

σ(σ + 2) m > 0& π Ο ^ π > —σ(σ + 2)ω + στ + (σ + 1)π

If the domestic inflation rate exceeds the upper l i m i t of (8a) hyperinflation results: domestic agents seek to reduce their holdings of domestic real money to zero. 5 If inflation is lower than the lower l i m i t of (8b), domestic agents would actually prefer to have a negative amount of foreign currency which is not possible. Foreign demand for domestic money is assumed to be constant: (9)

m* = a

a > 0

This assumption makes i t possible to restrict computational complexi t y i n the remainder of the analysis considerably. This simplifying assumption can also be interpreted to represent a situation i n which foreign demand for domestic money is constant and not sensitive to relative interest rates: such a situation is present when the σ* i n the foreign equivalent of (1) goes to infinity. The parameters {σ, 7, ω, α} of the money demand system represent all factors that are not modelled but do affect demand for money: these parameters possibly change over time. A n increase i n ω could represent an increase i n currency substitution arising from an increase i n foreign trade and all other factors: an increase i n Poland's ω is likely to have taken place i n the period 1988 - 1991. The demand function for domestic money (7a) has the important property that an increase i n currency substitution possibilities, i.e. a decrease i n σ, raises the sensitivity of domestic money demand w i t h respect to the domestic and foreign rate of inflation. The government conducts monetary and fiscal policy subject to the dynamic gover nment budget constraint that relates the fiscal deficit, g - r , and real seigniorage revenues, s: (10)

5

g -

τ =

s =

ms

+

7rra s =

rh s

+

π(πι

+

τη*)

Unstable hyperinflationary processes, i n general, can only be ruled out when money is essential to agents, i.e. when v m(m = 0) = —oo. Money is essential if > 0, (Obstfeld and Rogoff (1983)). Essentiality of money is however not an attractive property. Money i n the present model is unessential, as can be seen by inspecting v m(0 , η; σ) and v n(m, 0; σ).

Currency Substitution and Currency Controls

79

where g denotes real government expenditures. 6 Real seigniorage revenues accrue to the monetary authorities because of their monopoly i n creating domestic (base) money. Seigniorage revenues i n (10) result from so-called "passive" seigniorage, m s , accruing from trend growth of real money balances i n a growing economy and so-called "active" seigniorage, nms, from the inflation tax. The total supply of money ms is equal to the amount of real domestic money held by domestic residents plus the amount held by foreign agents, ms = m + m*. Currency substitution, via its influence on the inflation tax, introduces a source of externalities: seigniorage revenues that domestic agents transfer to the foreign monetary authorities through currency substitution are rebated to foreign agents by the foreign monetary authorities, whereas the inflation tax on foreign holders of domestic money is rebated to domestic agents, together w i t h the inflation tax levied on domestic holders of domestic money. Because of the fact that part of the i n flation tax on domestic money can be shifted upon the shoulders of foreign agents, a rate of inflation larger than zero is optimal, even when ordinary taxes are non-distortionary. 7

2.1 Seigniorage maximization

Seigniorage revenues display the Laffer-curve characteristic: if the i n flation rate exceeds the rate that maximizes steady-state seigniorage revenues, seigniorage revenues decline if inflation is increased further. Steady-state real seigniorage revenues can be written as a quadratic function of the domestic inflation rate:

(11)

s = um = π 7 + ο. -

(σ + 2)

σ(σ + 2)

7Γ + -

σ(σ+1)

Figure 4 draws the seigniorage Laffer curve (11) i n the presence of currency substitution:

6 Lane (1992a) provides details on the different categories of taxes and expenditures and their relative importance i n Poland's public finance at the outset of reform. 7 This is the 'tax the foreigner' problem of Canzoneri (1989) and Canzoneri and Diba (1991) who show i n a 2-country game how non-cooperative seigniorage maximization games i n the presence of a seigniorage externality induce sub-optimal policies from a social welfare point of view.

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Bas van Aarle

Figure 4: The seigniorage Laffer curve

Currency substitution affects both the constant part, 7 + a - r/(a + 2), and the slope of the seigniorage Laffer curve. A n increase of a, 7 or π* or a decrease i n r imply a broadening of the base of the inflation tax. A decrease of σ implies that domestic and foreign money become better substitutes, i.e. —l/σ increases i n absolute value. The tax base of the inflation tax, therefore, becomes more elastic w i t h respect to changes i n the domestic rate of inflation. Together w i t h the decrease i n the constant of the seigniorage Laffer curve, this induces a flatter seigniorage Laffer curve that is rotated towards the origin. The inflation rate that maximizes real seigniorage revenues is found by differentiating (11) w i t h respect to π and setting the derivative equal to 0: (12)

ds — = 0

π=

1 2 ( σ + 1 )

[σ{σ + 2 ) ( 7 + a) - στ + π*]

If both monies are better substitutes, i.e. if σ is low, the optimal i n flation rate must be lower (provided that r and π* are small) as agents easily substitute between domestic and foreign money. I n other words, currency substitution imposes inflationary discipline on the domestic monetary authorities. I n Figure 4 we have indicated w i t h an arrow the inward rotation of the seigniorage Laffer curve caused by a decrease i n σ.

Currency Substitution and Currency Controls

81

2.2 Efficient taxation

I n Appendix A we consider efficient taxation as an alternative to seigniorage maximization by the government. The public finance view of inflation defines the optimal inflation rate by considering the inflation tax as part of the entire tax system. M a n k i w (1987) clearly states the problem of efficient taxation w i t h ordinary taxes and the inflation tax. Efficient taxation entails the minimization of the discounted social costs of financing a given amount of public expenditures. Efficient taxation requires (a) the equalization of the marginal excess burden of all forms of taxation i n one period (the static optimality condition), (b) the equalization of marginal costs of taxation over different periods (the dynamic optimality condition), a principle known as Barro's tax smoothing hypothesis. The inflation tax is distortionary i n that a higher rate of domestic i n flation induces agents to hold fewer domestic balances and to substitute away into foreign balances: according to (7a) households' demand for domestic money w i l l satiate only if the domestic rate of inflation is equal to zero. I n the presence of tax collection costs or any other distortion from ordinary taxes, a zero inflation rate is no longer optimal: efficient taxation requires positive inflation (tax) rates.

3. Currency controls U n t i l now i t has been assumed that the monetary authorities did not impose any restriction on currency substitution. I n this section we consider the consequences of imposing currency controls by the monetary authorities to discourage currency substitution. Since the use of foreign exchange restrictions is widespread i n reality, 8 i t seems interesting to i n corporate this possibility. Consider the following definition of a perfect currency control i n the home country 9 : (13)

η = 0

Vi

8 More institutional details on the use of foreign exchange restrictions can be found i n the IMF's Annual Report on Exchange Arrangements and Exchange Restrictions (1995). 9 I n reality, one would not expect monetary policymakers to be that effective i n imposing currency controls. A l e a k y ' currency control η — ν w i t h υ < 0, could be introduced instead of (13).

6 Konjunkturpolitik, Beiheft 45

82

Bas van Aarle

Assume that the use of domestic money by foreign agents is not restricted by either domestic or foreign monetary authorities: restricting the use of domestic money by foreign agents is not efficient from the point of view of the domestic monetary authority, since i t would imply giving up the source of foreign seigniorage revenues. W i t h a currency control, demand for domestic money by domestic agents changes since their money demand is the result of a different, more restricted, optimization program from which results:

(14)

raj? = 7 +

σ+1

σ+1

σ +1

Under a regime of currency controls, real domestic money balances held by domestic agents are non negative as long as the domestic nominal interest does not exceed a level of η/{σ + 1) + ω - r. If we compare (14), the "restricted" demand for domestic money by domestic agents, w i t h the "unrestricted" demand for domestic money by domestic agents, 77i£/, i n (7a), one finds:

(15)

1 mu - rriR = (σ+1)

OJ + σ+ 2

σ(σ + 2)(σ + 1)

π+σ(σ + 2)

A n (unanticipated) abolition of a currency control at time t induces a structural break i n demand for domestic money by domestic agents: the constant falls while the sensitivity w i t h respect to the domestic and foreign inflation rate increases. I n the next section we test whether such a structural break has been present i n Polish money demand at the removal of exchange restrictions i n January 1990. Seigniorage revenues i n the presence of currency controls amount to:

(16)

( ω s. Sr = nmRR = πV 7 + cH σ + 1:

r : σ+1

π \ σ+1/

The rate of inflation that maximizes steady-state seigniorage revenues if currency controls are imposed, is again found by differentiating real seigniorage revenues w i t h respect to the inflation rate and putting this derivative equal to zero: (17)

^

= 0 ^ π = ^ ± 1 ( 7 + α) + 2 ( ω - r)

Currency Substitution and Currency Controls

83

The removal of currency controls implies that the inflation rate that maximizes steady-state real seigniorage revenues becomes lower, since (18)

π υ

-π

κ

= -

^

[7 + α + 4(σ + 1)ω - (3σ + 4)r - π*]

is negative, provided that the real interest rate and the foreign rate of i n flation remain small, π υ denotes the seigniorage maximizing rate of i n flation if no currency control is imposed, according to (13), and 7tr denotes the seigniorage maximizing rate of inflation if a currency control was imposed, according to (17). A removal of currency controls induces a decrease i n the constant of the money demand function, a decrease i n the seigniorage maximizing rate of inflation and an increase of the sensitivity w i t h respect to the domestic inflation rate. Consequently, the seigniorage Laffer curve rotates towards the origin as we noted before i n Figure 4. This rotation implies a lower rate of inflation that maximizes steady state seigniorage revenues and lower seigniorage revenues for any rate of inflation. The change i n the seigniorage Laffer curve caused by a removal of currency controls is equal to: /.«χ

19 su-sR

/ = ir{m u-mR

r / ω π π* \ )= π 7T+/ m w , on ~ / . i w , on + / . o j ν σ+1 (σ + 1)(σ + 2) σ(σ+1)(σ + 2) σ(σ + 2)/

4. Empirical investigation of currency substitution and currency controls: the polish big bang of 1990 I n this section we test for a structural break i n Polish money demand as a consequence of the reform program launched i n January 1990. This comprehensive reform and disinflation program entailed amongst others a fixing of the Zloty against the dollar, a reduction i n the fiscal deficit, a restrictive income policy and the removal of currency controls. Evidence of the structural break i n money demand is then used to assess the i m pact of the reform on the seigniorage Laffer curve. Two interesting empirical studies on Polish money demand already exist. Lane (1992b) looks at money demand before the reform of 1990 when Poland was basically a planned economy. A theoretical model is constructed i n which Polish agents face a cash-in- advance constraint on domestic currency when buying i n official markets and a cash-in-advance constraint on foreign money when buying i n black markets. The 6:

84

Bas van Aarle

money demand functions from the model are then tested empirically. Using an Error-Correction Model a stable long-run money demand is found. Short-run adjustment of money demand is found to be fairly rapid, contradicting the notion that money i n a communist economy is passive. Chawluk and Cross (1994) find evidence that shortages had a significant influence on money demand of Polish agents. Higher shortages necessitated the Polish agents to hold larger precautionary cash-balances than they would otherwise. Fluctuations i n shortages therefore exerted a separate influence on money demand. A number of proxies for the degree of shortages are used to correct real money demand. A n interesting empirical implication from the theoretical part was the structural change i n the demand for real Polish money: a decline i n the intercept and an increase i n the elasticity of money demand w i t h respect to the domestic and foreign rate of inflation. Figure 2 indeed suggested that a structural break i n demand for real currency and the demand for narrow money occurred i n Poland at the end of 1989. We can test this theoretical implication by splitting the entire sample into two parts: the period before January 1990 when currency controls were i n force and the period after January 1990 when currency controls were not active, and test whether intercept and slopes of the money demand function changed around January 1990. I n order to test for a structural break i n the demand for money, we estimate a piecewise linear regression that combines i n one functional form (7a), (9), (14) and (15):

(20)

The dummy coefficients δ ο, δι and 62 measure the "regime switching" effects of a removal of currency controls on money demand as derived i n (15). The "reform" dummy D takes a value 0 for the first subsample and a value 1 for the second subsample. If 0 and /c"(r) > 0. The dynamic government budget constraint (10) then becomes: (A.l)

g - τ + k(t) = s = ms + πms = ms + π(πι + m*)

The tax collection costs imply that even lump-sum taxes, while not distortionary at the individual level, are costly from a macroeconomic perspective: collection can only take place at the sacrifice of real resources. Optimal taxation requires the government to choose that particular m i x of ordinary taxes and the inflation tax that maximizes social welfare, which is defined by (1). The optimal m i x of taxation is found when maximizing (1) subject to the dynamic government budget constraint (A.l), using (2), (6), (7a), (7b). The optimal taxation problem yields the

90

Bas van Aarle

following static efficiency condition regarding inflation and ordinary taxes: (A.2)

π=

σ Ζ + 2

1

σ +

[2σπ* + σ(σ + 2) 2 (α + «'(τ))]

2

According to (A.2), the government should rely more on the inflation tax if the foreign rate of inflation is high, if foreigners hold a high amount of domestic money or if ordinary taxes bear high marginal collection costs. Currency substitution as measured by a and σ influences the optimal rate of inflation: a higher a increases the optimal rate of i n flation whereas a lower σ drives down the optimal rate of i n f l a t i o n 1 0 . Maximization of social welfare i n the presence of currency controls is achieved when the ordinary taxes and the inflation tax are set such that: (A.3)

π = (σ + 1)(α + κ'(τ)) + ω

If a currency control is imposed, the optimal inflation rate is higher than without a control if σ is not too large, i.e. if both monies are good substitutes, and foreign inflation is low, as is clear when subtracting (A.3) from (A.2):

( Α

·4)

^

π Λ =

-

σ2

2σ Η- 2

+

^

~ω

+

+

i n which ttjj refers to the optimal interest rate when no currency control is imposed and ttr to the optimal rate of inflation if a currency control is imposed.

10

The partial derivatives of π w i t h respect to σ and a are dn da

+

σ 4 + 4σ 3 + ΙΟσ2 + 8 2 2σπ* + σ ( σ + 2 ) ( α + «'(τ))] σ 2 + 2σ + 2

σ2

2σ + 2 [ 2 π *

π _ da

+

( 3 σ

' +

8 σ

σ(σ + 2) 2 σ 2 + 2σ + 2

+ 4)

> 0

+

W)] >

0

Currency Substitution and Currency Controls

91

Abstract A small model is introduced to analyse the effect of currency substitution on public finance. A high degree of currency substitution lowers the scope for the inflation tax as domestic agents evade the inflation tax by substituting into foreign money. I t is shown how currency substitution affects the shape of the seigniorage Laffer curve. The monetary authorities could impose currency controls to counteract currency substitution. The effects of such controls are analysed w i t h the aid of the analytical model. I n the empirical part the removal of currency controls i n Poland i n 1990 is studied.

References van Aarle, B. and Budina, N. (1996), "Currency Substitution i n Eastern Europe", Journal of Policy Reform, vol. 1, pp. 279 - 298. Calvo, G. and Coricelli, F. (1992), Stabilizing a Previously Centrally Planned Economy: Poland i n 1990", Economic Policy, vol. 14, A p r i l 1992, pp. 176 - 226. Canzoneri, M. (1989), "Adverse Incentives i n the Taxation of Foreigners", Journal of International Economics, vol. 27, no.3, pp. 283 - 297. Canzoneri, M. and Diba, B. (1992), "The Inflation Discipline of Currency Substitution", European Economic Review, vol.36, no. 4, 827 - 845. Chawluk, A. and Cross, R. (1994), "Zloty and Dollar Balances i n Poland. 1965 1993", The Manchester School, vol. 62, Supplement 1994, pp. 41 - 66. Ebrill, L. et al. (1994), "Poland. The Path to a Market Economy", I M F Occasional Paper 113. Engle, R. and Granger ; C. (1986), "Co-integration and Error Correction: Representation, Estimation and Testing", Econometrica, vol. 55, no. , pp. 251 - 276. de Gregorio, J. (1991), "Welfare Costs of Inflation, Seigniorage, and Financial Innova tion", I M F Staff Papers, vol. 38, no. 4, pp. 675 - 704. Guidotti, P. (1993), "Currency Substitution and Financial Innovation", Journal of Money, Credit and Banking, vol. 25, no.l, pp. 109 - 124. I M F (1995), "Exchange Arrangements and Exchange Restrictions. Annual Report 1995", International Monetary Fund, Washington D.C. Lane (1992a), "Inflation Stabilization and Economic Transformation i n Poland: the First Year", Carnegie-Rochester Conference Series on Public Policy, vol. 36, July 1992, pp. 105 - 136. - (1992b), "Household Demand for Money i n Poland. Theory and Evidence", I M F Staff Papers, vol. 39, no. 4, pp. 825 - 854. Mankiw, G. (1987), "The Optimal Collection of Seigniorage. Theory and Evidence", Journal of Monetary Economics, vol. 20, no. 2, pp. 327 - 341.

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Obstfeld, Μ. and Rogoff, Κ. (1983), "Speculative Hyperinflations i n Maximizing Models: Can we Rule them out?", Journal of Political Economy, vol. 91, no. 4, pp. 675 - 687. Sahay, R. and Végh, C. (1995), "Dollarization i n Economies i n Transition: Evidence and Policy Issues", I M F Research Department Working Paper 95 / 8, International Monetary Fund, Washington D.C.

Debt Management and Inflation Stabilization i n Bulgaria By N i n a B u d i n a * and S w e d e r v a n

Wijnbergen1

1. Introduction Problems w i t h bringing inflation under control have been a hallmark of the adjustment experience of almost all countries i n transition. Some have had success (the Czech Republic, Slovenia, Albania, to a lesser extent Poland), some have failed spectacularly (the Ukraine, Russia) and many muddle through precariously (most Balkan countries). I n the absence of debt markets i n most countries, fiscal deficits broadly defined have been a direct input into the money creation that has fuelled inflation. Thus, assessing the consistency between fiscal and monetary policies is crucial i n understanding what is necessary to stabilize inflation i n the long run. The huge external debt burden is one of the major sources generating fiscal and inflationary pressures i n the Bulgarian economy and, therefore, debt-management policies must have an important place i n devising macroeconomic policy. Debt issue has been promoted using costly fiscal incentives, thus raising the cost of public debt substantially above recorded interest rates. L o w growth undermines seigniorage, pushing up inflationary pressure for any given deficit, which i n t u r n might jeopardise growth further; and so on. I n what follows we briefly describe the theoretical framework employed and discuss the inflationary financing of fiscal deficits. I n chapter 3, the model is put together and applied to assess the impact of domestic debt management policies * The first author thanks the European Commission for financial support through the ACE program. We are also indebted to Tcvetan Manchev from the Monetary Department of the Bulgarian National Bank for help w i t h data and information about regulatory changes. But the views expressed i n this paper are the responsibility of the authors only and are not endorsed by the Bulgarian National Bank or its officials. 1 The first author is from CERGE and the Tinbergen Institute, Keizersgracht 482, 1017 EG Amsterdam, the Netherlands. The second author is from University of Amsterdam, Roeterstraat 11, 1018 WB Amsterdam, the Netherlands, and LSE and CEPR.

94

Nina Budina and Sweder van Wijnbergen

on the inflation rate and fiscal deficits. Chapter 4 describes the Bulgarian foreign debt reduction deal and assesses its impact on the inflationfiscal deficits trade-off. Chapter 5 concludes.

2. Fiscal deficit and inflation in Bulgaria This paper uses a simple framework which links debt, deficit and i n flation w i t h an application to the Bulgarian economy focusing on the medium run consistency between fiscal policy, inflation, and debt management problems. I n the model the primary deficit is taken to be a policy parameter. Debt management is summarized by targets for the debt to GDP ratio for foreign and for domestic debt. Implicit i n this approach is the view that lenders w i l l impose such a constraint because potential tax revenues, the ultimate source from which debt w i l l need to be serviced, is obviously limited as a share of GDP. Base money growth, for any given inflation target, is endogenously determined by the path of the primary deficit, debt policy, the real rate of interest, the financial structure of the economy and the growth rate of GDP. The model is designed to indicate whether any given inflation target is consistent w i t h the other policy parameters and structural characteristics of the economy; alternatively, consistency can be imposed which yields the inflation rate consistent w i t h structural stability, other policy variables and the financial structure of the economy.

Inflation

and deficit financing

Table 2.1 summarises the results of using the model to assess potential revenues from seigniorage and the inflation tax. Seigniorage revenues (η + π)πι are derived as a function of the inflation rate, reserve requirements, l i q u i d i t y requirements and asset demands. 2 The monetary base m equals all interest free net public sector liabilities - i.e. currency i n circulation and commercial bank reserves held i n the central bank minus any claim the Central Bank has on the non-government sector.

2 See Ritu Anand and Sweder van Wijnbergen, "Inflation and the Financing of Government Expenditure: an Introductory Analysis w i t h an Application to Turkey", World Bank Economic Review, vol. 3, no. 1, pp. 17-38.

Debt Management and Inflation Stabilization i n Bulgaria

95

Table 2.1 Inflation tax and seigniorage at various inflation rates (percent of GDP) Inflation rate

D e m a n d for

Currency

Monetary Base

Inflation tax

Seigniorage revenue

Deposits Demand

Time

Savings

Foreign currency

0%

30.21%

31.54%

25.47%

38.80%

19.95%

39.71%

0.03%

0.58%

10%

24.22%

25.01%

24.80%

30.40%

19.56%

32.57%

3.00%

3.48%

64%

9.60%

9.47%

22.18%

10.96%

18.02%

15.11%

6.94%

7.21%

70%

8.82%

8.66%

21.95%

9.98%

17.89%

14.17%

6.96%

7.22%

122%

4.76%

4.53%

20.38%

5.05%

16.93%

9.22%

6.60%

6.79%

150%

3.61%

3.38%

19.71%

3.72%

16.52%

7.80%

6.32%

6.49%

This table presents the demand for currency, demand deposits, time deposits, savings deposits, and foreign currency deposits for various i n flation rates. These asset demands are derived by using the estimated demand functions 3 , as well as base year data for the inflation rate and different assets to GDP ratios. We then compute the demand for base money as a function of the reserve requirements for the correspondent commercial banks deposits. The next column presents the inflation tax revenue, while the final lists total revenue from seigniorage. The results indicate a very high sensitivity of the monetary base to inflation; demand falls increasingly rapidly w i t h rising inflation. Of course the increasing elasticity is a feature of the semi-logarithmic functional form used i n the estimation. But the increase is unusually rapid. As a consequence, the inflation tax is of course increasing w i t h the rise of inflation initially, but at a declining marginal rate, u n t i l the maximum is reached at 7.22 percent of GDP for a very low revenue maximizing rate of 70 percent per annum. This is indeed relatively low; studies i n L a t i n America tend to come up w i t h a revenue maximizing rate of 300 percent or higher. This result indicates the limited fiscal leeway the authorities i n Sofia have and explains at least partially why inflation has been so difficult to bring down. 3 See N. Budina and van Wijnbergen, S., "Fiscal deficits, Monetary reform and Inflation i n Transition Economies: the Case of Bulgaria", Tinbergen Institute Discussion paper TI4-96-5,1996.

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Nina Budina and Sweder van Wijnbergen

3. Domestic debt management and inflation stabilization I n the late 1980's and early 1990's the Bulgarian economy was thrown into a deep economic crisis. Large fiscal deficits financed mainly through direct Central Bank lending and the inability to carry out the huge foreign debt burden has fuelled the money p r i n t i n g process. Therefore, a foreign debt reduction deal, as well as creating auctions for government securities has provided an alternative to Central Bank financing and thus contributed to the overall stabilization. The bulk of issued government securities, however, are long term bonds which yield negative ex-post real interest rates (see Annex 1). These long term bonds were issued to cover the non-performing loans of the enterprises due to the switch to a policy of "hard budget constraints". The rest of the government securities were issued as short term treasury bills, w i t h maturity of up to 1 year which also yield negative ex-post real interest rates. One i m portant point bears mentioning, however, on measuring the cost of domestic debt. Treasury bills have an unusual tax treatment, i n that not just interest income, but also monies spent on purchasing the principal can be deducted from taxable income. This implies that a substantial part of the return is paid out i n the form of tax concessions. Thus, the corrected real interest is: m W

, 1 , _ (1 + i r a X l + r ) _ (1 + r T B ) ( 1 + π)(1 + τ) U + 'tb)-

n

= (1 + γτβ)(1 + Τ)

This implies that i t w i l l also affect the measure of operational deficit of that year; Therefore we have adjusted the deficit accordingly. Due to this unusual tax treatment of the issued treasury bills, and the necessity of short term funds for deficit financing, the treasury bills' secondary market has been booming since 1993 onwards. According to the B N B data, the share of TBills i n the total domestic debt (net of Central Bank financing) has increased from 8.07 i n 1993 to 32.33 percent i n 1994. Therefore, as i t w i l l be seen later, this unusual tax treatment is enormously increasing the cost of issuing new domestic debt which might put inflation stabilization i n danger. First, look at the implications for the current fiscal stance, using the actual data for 1994, but accounting for the impact of the tax concessions on the real interest rate on domestic debt. We have calculated the weighted average of the real interest rate on Long term bonds and TBills

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( a c c o u n t i n g f o r t a x concessions), u s i n g t h e i r shares i n t h e t o t a l d e b t as w e i g h t s . We also i m p o s e a c e i l i n g e q u a l t o t h e c u r r e n t (i.e. e n d of 1994) values o n t h e d o m e s t i c a n d f o r e i g n d e b t - t o - o u t p u t r a t i o s . I n t h e s i m u l a t i o n s , however, w e have a s s u m e d t h a t a l l t h e n e w d e b t c a r r y s u c h a h i g h cost (the r e a l i n t e r e s t o n T B i l l s ) because a t t h e m a r g i n t h e g o v e r n m e n t c a n o n l y r o l l - o v e r a l l t h e o l d d e b t at t h e m a r k e t i n t e r e s t rate.

Table 3.1 The financeable deficit, actual deficit and rdr for various inflation rates (percent of GDP) 4 Inflation rate

Financeable Deficit

Actual Deficit

Required Deficit Reduction

0%

-2.12%

-5.69%

-3.57%

10%

0.78%

-5.69%

-6.47%

64%

4.50%

-5.69%

-10.19%

70%

4.52%

-5.69%

-10.21%

122%

4.09%

-5.69%

-9.78%

150%

3.79%

-5.69%

-9.48%

T a b l e 3.1. is c o n s t r u c t e d for t h e actual

ex p o s t r e a l i n t e r e s t r a t e o n d o -

m e s t i c d e b t ( - 0 . 5 7 % , t h e w e i g h t e d average of t h e i n t e r e s t rates o n l o n g t e r m bonds and short t e r m treasury bills) a n d the a p p r o x i m a t e d real i n 4

We have used the rdr measure for required deficit reduction which is the difference between funding requirements and funding sources given the target debtoutput ratios: rdr = [d + rb + (r* + e)(b* - nfa*)e] - [nb + n(b* - nfa*)e + nm + ππι] r and r* stand for domestic and foreign real interest rates respectively, and e is the real exchange rate P/(EP*). Lower case variants of variables already defined as upper case indicate the corresponding ratios to GDP. For example b is the ratio of domestic debt to GDP, B/(PY). The first term between square brackets stands for the actual public sector deficit, inclusive of real interest payments on domestic and (net) foreign debt. The second term stands for the financeable deficit using the two constraints for the growth rate of the domestic and foreign debt (it should not grow faster than the growth of the real resources available for its servicing) plus the resources collected through the increase i n the monetary base (seigniorage). η is the real growth rate of the economy and π the target inflation rate, (η + π)πι equals the real value of the nominal increase i n base money, dM/P. 7 Konjunkturpolitik, Beiheft 45

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Nina Budina and Sweder van Wijnbergen

terest rate on foreign debt i n the base year 1994. We also assume continuation of the actual real exchange rate depreciation i n the base year, 5 percent. Finally we incorporate i n our deficit definition the consequences of the tax concessions granted to buyers of treasury paper that we discussed earlier. The table presents the financeable deficit, the actual real 1994 deficit, and the required deficit reduction (rdr) for various inflation rates. A minus sign for financeable and actual real deficits i n dicates a surplus, whereas a positive sign indicates a deficit. Figure 1 shows the change i n the required deficit reduction as a function of target inflation. On the face of it, all this looks rather good; if this was indeed Bulgaria's fiscal position, all but a zero inflation rate would have been consistent (with some to spare) w i t h the current fiscal stance. Of course if this was indeed the case, one would reasonably wonder why Bulgaria's actual inflation has been stubbornly refusing to come down. However, the actual situation is i n fact much worse. A t issue here is the fact that both the domestic and the foreign debt currently carry interest rates far below market rates. The assumption implicit i n the analysis so far, i.e., all due debt can be refinanced at that same (below market) rate, is patently unrealistic. I n fact, at least on domestic debt, the government may already be paying more than the records show: the low interest component consists of long term bonds issued to the banking system at below market rates. But since the losses of those banks i n the end come back to the government either via subsidies or renewed recapitalization expenses, what is saved on low interest rates is lost on higher subsidies needed. For medium term sustainability, an analysis assuming f u l l market rates on all debt is thus obviously called for. Figure 1 presents the impact of switching to market interest rate on foreign and domestic debt. The effects of a transition to market interest rate on foreign and domestic debt are presented step-by-step i n Table 3.2. The first column of the table presents the current situation. The second column calculates the effects of switching to market rates on all domestic debt, where we take the current cost of treasury b i l l financing as the indication of market rates. The final column presents the required deficit reduction under assumptions of a 29.8 percent market real interest rate on domestic debt and a 5 percent real interest rate on foreign debt. A comparison between the rdr's points at the hidden inconsistencies i n the economy. A t the 1994 inflation rate of 122 percent, the necessary adjustment rises from - 9.78

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The impact of switching to market rates on public sector debt on RDR

CM C\i Inflation rate

Figure 1

Table 3.2 Switching to market interest rates on public sector debt Inflation

Required Deficit Reduction r = -0.6%, r* = 1.17%

r= 29.8%, r* = 1.17%

r = 29.8%, r* = 5%

0%

-3.57%

5.11%

9.07%

10%

-6.47%

2.21%

6.18%

64%

-10.19%

-1.51%

2.45%

70%

-10.21%

-1.53%

2.44%

122%

-9.78%

-1.10%

2.86%

150%

-9.48%

-0.80%

3.16%

to - 1.10 percent, and i t reaches 2.86 percent of GDP under market interests on domestic and foreign debt. This comparison exhibits a medium term inconsistency between the current fiscal stance and even the current inflation rate, not to mention any plans of shooting for lower rates of inflation. The table indicates the severe resource constraints facing the economy once this transition takes place. I n the long run, the resultΊ

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ing monetization of the deficit could well result i n run-away inflation: the table indicates that there is no inflation rate for which the accounts w i l l balance without any additional measures. The impact of substituting

foreign borrowing by domestic debt issue

The next experiment consists of assessing the impact of substituting 10 percent of the foreign debt by a 10 percent increase i n the domestic debt issue. The underlying assumptions here are a 5 percent real interest rate on foreign debt and a 29.8 percent real interest rate on domestic debt. Such an experiment could come about if foreign debt is retired at face value, financed by issue of domestic debt (some proposals for debtequity swaps have this implication). The results of this simulation are presented i n Table 3.3 below. Table 3.3 Assessing the impact of foreign-to-domestic debt substitution Inflation rate

Required Deficit Reduction No foreign debt substitution

10% foreign debt substitution

0%

9.07%

12.32%

10%

6.18%

9.42%

64%

2.45%

5.70%

122%

2.86%

6.11%

150%

3.16%

6.41%

The first column represents the current situation under a real interest rate of 5 percent on foreign and 29.8 percent on domestic debt, whereas the second column presents the impact of a 10% foreign to domestic debt swap retiring on the rdr. For a 122 percent inflation rate i n 1994, this policy raises the amount of deficit reduction from 2.86 to 6.11 percent of GDP. Across the whole schedule this policy raises the amount of deficit reduction by about 3.5 percent. Debt restructuring that has, explicitly or implicitly, the same impact as this substitution experiment w i l l have very serious macroeconomic consequences.

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4. Foreign debt management and inflation stabilization Huge external debt burden inherited by the old regime is a major obstacle for achieving consistency between monetary and fiscal policy and therefore for inflation stabilization. Prior to the debt reduction deal concluded between Bulgarian government and the London Club, real foreign debt to GDP ratio amounted to 150 percent, whereas foreign debt to exports ratio amounted to 235 percent i n 1992. A t that moment, the country was not able to service its foreign debt obligations and i t has announced a memorandum on its foreign debt payments. This has completely cut off the international capital markets which i n presence of very restrictive credit policy (high nominal interest rates and imposed credit ceilings on the volume of commercial banks' credit) has caused a credit crunch and exacerbated the depression. Therefore, the access to the i n ternational capital markets and additional foreign lending were of crucial importance for carrying out the stabilization program and making the reform process irreversible.

4.1 Foreign debt reduction deal

The negotiations on Bulgarian foreign debt reduction were concluded i n March 1994. The reduction of the principal as well as the interest on foreign debt has been achieved through exchanging the liabilities for new instruments using US treasury bills and bonds as collateral. The subject of this agreement are all the Bulgarian Foreign Trade Bank (BFTB) debts i n foreign currency and the debts to foreign creditors guaranteed by BFTB, as of March 1990 when the moratorium on Bulgarian foreign debt had been announced 5 . The creditors of all the qualified debts have the following menu of options: i. cash buy back option; ii. front-loaded interest reduction bonds (FLIRB's) option; iii. discount bonds (DISCB's) option; and iv. interest arrears bonds (IAB's) option. Under the first option, cash buy back, the agreement was reached for the repurchase of 13 percent of the qualified foreign debt. Under the second option, the FLIRB's, the overall principal b i d is exchangeable one-to-one w i t h the overall loan principle. FLIRB's are issued i n two tranche at $ 250 000 par value w i t h maturity July 2012 and 5

See Alexandrov, S., Bulgarian Brady Bonds, Bank Review , Quarterly Journal of National Bank of Bulgaria, 1/1995, Sofia.

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are subject to a mandatory buy back to be made i n 21 semiannual instalments. The first buy back is due i n July 2002, and the last one - i n July 2012. Interest payments are due each January and July. 70 percent of the bonds issued under the first tranche were i n exchange for short term debts w i t h maturity of up to one year. The annual interest rates on the FLIRB's from the first tranche are as follows: Table 4.1 Annual interest rates on ranche A FLIRB's Maturity period

Annual interest rates

year 1-2

2%

year 3-4

2.25%

year 5

2.5%

year 6

2.75%

year 7

3%

years 8-18 (since 2002)

L I B O R + 13/16%

The second tranche consists of the FLIRB's exchanged for the remaining 30 percent of qualified short term debts which yield the above interest rates plus extra 0.5% per annum. Under the t h i r d option, DISCB's, the discount bonds are at $ 250 000 par value w i t h 50 percent discount from the total principal of the qualified debts. The DISCB's are issued i n two tranche: tranche A accounting for 70 percent of the short term qualified debts, and tranche B, accounting for the remaining 30 percent of the short term qualified debts. The DISCB's mature i n year 2024 and their coupon is 6-month LIBOR plus 13/16% per annum. DISCB's, issued i n tranche Β yield an extra 0.5% per annum. The DISCB's can yield an extra 0.5% per annum per 1% GDP growth rate between year 2 and year 1. This option has provided a debt reduction, accounting for $ 1.86 bn. Under the last option, IAB's are issued on the closing day of the Agreement at $ 250 000 par value and are used for a purchase of all adjusted interest arrears on the qualified debts or related to them which are exchanged for FLIRB's or DISCB's. The IAB's mature i n the year 2011 and are subject to buy back requirements. They yield an interest of 6-month

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LIBOR plus 13/16% per annum. Their principal and interest are not secured. There was a proposal for FLIRB's and DISCB's to be accepted i n debtequity swaps (one-to-one for DISCB's and for FLIRB's at a 50 percent discount. This proposal, however, was not embodied i n the Regulations concerning privatization through foreign debt conversion.

4.2 The impact of the foreign debt deal on inflation and fiscal deficits

We have discussed the impact of foreign debt reduction on the necessary fiscal adjustment (rdr measure) and inflation. We have proceeded i n a two-step fashion. First, we compare the rdr using the foreign debt to GDP ratio prior to the debt deal (144 percent) to the 1994 ratio (103.4 percent), by assuming that the Government pays the same ex-post real interest rate on the reduced foreign debt as well. This reduction accounts for the recently concluded Brady Deal, as well as for the new debt disbursed from the official creditors i n 1994. Second, we take into account that the deal has reduced the amount of debt outstanding but i t also i m plies a switch to market rates for what remains on the books. 6 The results of this experiment are presented i n Table 4.2. The table assesses the impact of foreign debt reduction plus a switch to actual market rates i n a two-step fashion. Table 4.2 Assessing the impact of foreign debt reduction Inflation rate

6

Required Deficit Reduction b*/y = 144% r = 29.8% r* = 1.7%

b*/y = 103.4% r = 29.8% r* = 1.17%

b*/y = 103.4% r = 29.8% r * = 5%

0%

7.61%

5.11%

9.07%

10%

4.72%

2.21%

6.18%

64%

0.99%

-1.51%

2.45%

70%

0.98%

-1.53%

2.44%

122%

1.40%

-1.10%

2.86%

150%

1.70%

-0.80%

3.16%

Most of the rescheduled debt actually carried market rates already but was simply not serviced.

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Comparison of the first and the t h i r d column shows the net gain from such a reduction. A t the actual 1994 inflation rate of 122 percent, foreign debt reduction by almost 40 percent w i l l achieve some reduction of the adjustment measures needed but not much because the real rate on foreign debt that is actually paid is so low: rdr falls from 1.40 to -1.10 percent of GDP. However, once we account for the fact that the remaining debt w i l l need to be financed at market rates, the picture changes radically: the gain from the foreign debt relief dissipates once market rates need to be paid over what remains. The net impact is i n fact a small increase i n required deficit reduction! For 1994 inflation reaches 2.86 percent. This result is shown i n the figure 2.

Figure 2

Of course there may also be side benefits to such a deal that may affect this result. I n particular, renewed capital market access may lead to renewed growth, which is after all the whole point of such an exercise. Therefore, the next experiment analyzes the implications of the restoration of the real output growth. A rise i n the real output growth rate from 1.4 to 4 percent w i l l first of all increase seigniorage revenue. Figure 3 presents the impact of a growth rate increase on the revenue from seigniorage. I t shifts the seigniorage curve upwards and therefore i n creases the financeable deficit for any given inflation.

Debt Management and Inflation Stabilization i n Bulgaria

105

The impact of higher output growth on the Seigniorage Revenue

sO Ο CO

vP TJCO

n=-2.4% 1993

-vO ο σ>

χΟ o^ CM CVJ T—

vO Ο in T—

n=1.4% 1994

>vO 0s Ο GO Ί—

sOs 0 Ο τ— CVJ

vO ο CVJ

—Δ— n=4% simulation

Figure 3

W i t h an inflation rate of 122 percent and 4 percent real output growth, seigniorage revenue w i l l increase from 6.8 to 7.15 percent of GDP. Second, higher growth rates w i l l allow more debt issue for given debt-output targets. Table 4.3 presents the impact of different growth rates on the required deficit reductions for various inflation rates. Otherwise the table maintains our base case assumptions of a 5 percent real interest rate on foreign debt, a 29.8 percent real interest rate on domestic debt and a 5 percent rate of real exchange rate depreciation. We also use the 1994 foreign debt to GDP ratio, which is 103.4% assuming that the growth rates would pick up i n response to such a debt relief package. Table 4.3 The impact of higher output growth Inflation rate

Required Deficit Reduction η = -2.4% (1993)

η = 1.4% (1994)

η = 4% (simulation)

0%

12.76%

9.07%

6.22%

50%

5.62%

2.61%

0.22%

70%

5.32%

2.44%

0.14%

122%

5.57%

2.86%

0.69%

150%

5.81%

3.16%

1.02%

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Nina Budina and Sweder van Wijnbergen

If the debt deal w i l l restore economic growth from -2.4 to 1.4 and further to say 4 percent, the model suggests that at a 122 percent inflation rate the amount of required deficit reduction w i l l decrease from 5.57 to 2.86 and further to 0.69 percent of GDP. This is lower than the pre-debt-deal base case, so if such a growth effect materialized the deal w i l l on balance improve the fiscal situation. There are already signs of recovery prospects, since the growth rate increased substantially from 4.2 to 1.4 percent from 1993 to 1994, and a substantial part of this growth could be attached to the concluded debt deal and the renewed access to the capital markets.

4.3 The impact of real exchange rate depreciation or raising the cost of foreign borrow

The cost of servicing the foreign debt depends of course on real exchange rate developments. I n this section we examine therefore the i m pact of varying the rate of real exchange rate depreciation on foreign debt servicing costs and thus on the financeable deficit and required deficit reduction. Table 4.4 The impact of real exchange rate depreciation Inflation rate

Required Deficit Reduction e = 5% (Base case)

e = 0%

e = 10%

0%

9.07%

3.90%

14.24%

10%

6.18%

1.01%

11.35%

64%

2.45%

-2.72%

7.62%

70%

2.44%

-2.73%

7.61%

122%

2.86%

-2.31%

8.03%

150%

3.16%

-2.01%

8.33%

We assume as base case the r u n w i t h f u l l market rates on all domestic and foreign debt. Table 4.4 shows the impact of varying the rate of real depreciation from 5 percent (the assumption i n the base case) to 0 and to 10 percent. I t is obvious from the table that a policy rule of pegging the real exchange rate w i l l decrease significantly the required surplus and consequently the required fiscal adjustment for all inflation rates. The

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rdr at 0 inflation is 14.2 percent at a 10 percent p.a. real depreciation, 9.1 percent at a depreciation rate of 5 percent, and 3.9 percent of GDP w i t h a pegged real exchange rate. Thus the capital losses on foreign debt associated w i t h real depreciation significantly complicate stabilization policy.

4.4 Debt, money creation and the trade-off between current and future inflation

I n this section we use the model to predict what the outcome would be if the government decides to close the gap between financeable and actual real deficits through debt accumulation rather than fiscal adjustment. We show the effects both for the current real growth rate of 1.4 percent and for a more optimistic assumption of 4 percent real GDP growth. Table 4.5 The implication of delayed adjustment Inflation rate

Required Deficit Reduction, η = 1.4%

Required Deficit Reduction, η = 4%

now

after 6 years

now

after 6 years

70%

2.44%

10.92%

0.14%

0.55%

122%

2.86%

12.83%

0.69%

2.73%

150%

3.16%

14.17%

1.02%

4.05%

The debt accumulation process crucially depend on the difference between the real interest rate and the real output growth rate. Whenever the real interest exceeds the growth rate, as i t does i n a big way i n the base year under consideration, delaying the necessary deficit reduction means a bigger adjustment problem later, as the table indicates. By the same token, the higher the growth rate, the slower the escalation of the debt burden measured as a percentage of GDP; compare the increase i n rdr i n the η = 1.4% columns w i t h the increase i n the n=4% columns i n Table 3.10.

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5. Conclusions Fiscal problems are widely recognized as the key factor behind persistent inflation i n Eastern Europe post-1989. But little has been said beyond these generalities. Deficits need to be cut back, but how far for any given inflation target? What is the implication of shifting financial structures, external debt management or exchange rate policy for this l i n k between deficits and inflation? We apply a simple framework for answering these questions to the case of Bulgaria; this is an interesting example i n its own right, because of the seemingly puzzling persistence of inflation i n the face of what at least i n our base year (1994) looked like a fiscal surplus. The analysis of domestic debt management policies shows that much of this puzzle disappears once the various tax concessions given to buyers of domestic debt instruments are taken into account; they do not show up i n that year's budget numbers but they hide the fact that the cost of domestic debt issue is extremely high. Further doubts about fiscal sustainability are raised by the recognition that most old debt was issued at rates far below current market rates. Analysing the consequences of refinancing all that at new market rates brought further inconsistencies to light. We also used the framework to assess the fiscal impact of the foreign debt reduction, due to the recently concluded Brady Deal for Bulgaria. The direct effects turned out to be modest; while the total amount of external debt was decreased by approximately 40 percent, what remains w i l l now need to be serviced at market terms; switching to market rates, which turns out to raise the fiscal burden of external debt substantially. However, there is a net positive effect if we l i n k the growth rate recovery to the package, if we compare the real GDP growth i n 1993 (-2.4 percent) and i n 1994 (1.4%) and simulate a further rise to 4%.The resulting i n crease i n seigniorage is just enough to restore a positive net fiscal impact of the package.

Abstract I n the absence of debt markets fiscal deficits broadly defined have been a direct input into money creation that has fuelled inflation. We have applied a simple integrated framework to assess consistency between fiscal and monetary policy for the Bulgarian economy. This framework is used to analyze the impact of debt management policies and external debt relief on the relation between fiscal deficits and sustainable inflation. We also discuss the impact of a transition to a mar-

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ket rate of interest on foreign and domestic debt, of a recovery of real output growth and delays i n fiscal adjustment.

References Anand, R. and van Wijnbergen , S. (1988), Inflation, External Debt and Financial Sector Reform: A Quantitative Approach to Consistent Fiscal Policy w i t h an Application to Turkey', NBER Working Paper No.2731. - (1989), 'Inflation and the Financing of Government Expenditure: an Introductory Analysis w i t h an Application to Turkey', The World Bank Economic Review, vol.3, No.l:17-38. Alexandrov, S. (1995), 'Bulgarian Brady Bonds', Bank Review, Quarterly journal 1/1995, Bulgarian National Bank, Sofia, Bulgaria. Algoskoufis, G. S. and Christodoulakis, N. M. (Sep. 1990), "Fiscal Deficits, Seigniorage and External Debt: The Case of Greece", CEPR Discussion Paper No.468. Angelov, I., Dulev, S., Iotzov, V., Houbenova-Delisivkova, T., and Konsulov, V. (1993), The Economy of Bulgaria u n t i l 1996, (Sofia: Bulgarian Academy of Science, Economic Institute). Budina, N. and van Wijnbergen, S. (1996), 'Fiscal deficits, Monetary reform and Inflation i n Transition economies: the case of Bulgaria', Tinbergen Institute Discussion paper T I 4-96-5. Buiter, W. H. (1985), A guide to public sector debt and deficits', Economic Policy, Nov 1985, N o . l . - (1990), International Macroeconomics, Cambridge University Press. - (June 1993), 'Public Debt i n the USA: How much, How bad and Who pays?', CEPR Discussion Paper No. 791. Bulgarian National Bank (1990, 1991, 1992, 1993, 1994,1995), Annual reports, Sofia. Miller, J. (1992), The Bulgarian Banking System, (SofiaBulgarian National Bank). Miller, J., and Petranov, S. (1996), Banking i n the Bulgarian Economy, (Sofia: Bulgarian National Bank), Bulgaria. Wijnbergen, S. (1990), 'External Debt, Inflation, and the Public Sector: Towards Fiscal Policy for Sustainable Growth', The World Bank Economic Review, vol.3, No.3:297- 320.

Government Deficits, Inflation, and Economic Transition By C l e m e n s F u e s t and B e r n d

Huber

1. Introduction Since the celebrated fall of the Iron Curtain and the end of the Cold War, significant progress has been made i n transforming the former socialist command economies into market oriented systems. Yet, even after more than six years of reform, the transition economies of Eastern Europe still struggle w i t h numerous difficulties and obstacles that seem to make the transformation more costly than was anticipated i n 1989, when optimists predicted that the first steps towards economic liberalisation would increase prosperity more or less instantaneously. I n the meantime, nearly all transition countries have gone through economic depressions that may well be compared to the great recession of 1929 to 1932. Somewhat ironically, the latest elections have brought parties w i t h communist roots to power i n almost all countries of Eastern Europe. Possibly, this is a desperate reaction of those parts of the population hit most strongly by inflation and unemployment. 1 I t was clear from the beginning of the reforms that the process of transformation would require considerable efforts i n the field of macroeconomic stabilisation. Restrictive monetary and fiscal policies were to set the stage for a macroeconomic environment that would allow the emerging private sector to take over the task of allocating resources, a function that had been performed so poorly by the central planning authorities i n the socialist system. However, although the worst part of the recession now seems to be overcome i n most transition countries, economic recovery is slow, and macroeconomic stabilisation is inhibited, above all, by growing financing needs of the public sector. The present paper has the purpose to examine some of the difficulties of macroeconomic stabilisation that are specific to the conditions of 1

For a retrospective of the period from 1989 to 1994, see United Nations (1995).

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transition. I n particular, we concentrate on the interaction between fiscal consolidation, inflation, and market oriented institutional reforms. I n the second chapter, we give a brief summary of the basic economic rationale behind macroeconomic stabilisation programs and consider the evolution of inflation rates and budget deficits i n the transition economies since the beginning of the reforms. The t h i r d chapter discusses the hazards associated w i t h policies that overemphasise the reduction of government budget deficits, without taking into account the effects on other policy areas, especially the restructuring of public enterprises and the financial sector, and monetary policy. Inchapter 4, we introduce a simple public finance model i n order to analyse the interaction between budget deficits and inflation, assuming that a given sequence of primary deficits has to be covered by monetary financing. This part of the analysis is meant to take into account that governments i n transition economies often face imperfect capital markets, which implies that the separation of monetary and fiscal policies, which is at the heart of macroeconomic stabilisation programs, is not feasible. The analysis reveals that building up well functioning financial markets may contribute more to the success of macroeconomic stabilisation and private sector development than strategies w i t h a narrow focus on the reduction of government budget deficits during the first years of transition.

2. The performance of fiscal and monetary policies in transition 2.1 Macroeconomic stabilisation and the budget deficit

Reform programs for former socialist economies usually put emphasis on macroeconomic stabilisation and consider the government budget deficit and the inflation rate as key indicators of success or failure i n economic policy during transformation. To a large extent, assistance programs, operated, for instance, by the World Bank, the International Monetary Fund (IMF) or the Group of Twenty-Four, have stipulated ambitious targets for monetary stabilisation and the reduction of budget deficits. 2 For fiscal policies, these programs require austerity i n public spending and efforts to b u i l d up tax systems that generate sufficient revenue. The aim of monetary stabilisation is often pursued by exchange rate pegging. 2

For a survey of the present economic situation of the reform countries, including external financing, see OECD (1995).

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I n principle, this type of stabilisation program conforms w i t h conventional wisdom concerning the role of monetary and fiscal policy i n a market oriented economy. Most economists would agree that monetary and fiscal policies should be separated, even if a certain interaction between the two unavoidably exists. I n general, monetary policy should be assigned to the target of price level stability rather than the financing of government expenditures. The latter is a matter of tax policy. If tax revenue is insufficient to finance public expenditures, the deficit should be covered by the issue of public debt. I n principle, i n the event of budget deficits that have to be considered as excessive according to whatever criterion, more restrictive fiscal policies should be conducted, one of the reasons being that public capital demand may induce higher interest rates and crowd out private investment unless Ricardian equivalence holds or the economy can attract foreign savings. I n transition economies, such a crowding out of the private sector would be considered as particularly harmful, because economic policies during transition have the very purpose of encouraging the development of the private economy. As mentioned i n chapter 1, macroeconomic stabilisation has taken more time than was expected on the eve of the reforms. 3 Table 1 shows that most reform countries of Eastern Europe have been unable to reconcile the early phase of transition of a market economy w i t h constant or declining budget deficits, the Czech Republic being a notable exception. On the other hand, by the fiscal policy standards of Western market economies, i t is far from clear whether the deficits have to be considered as constituting a hazard to macroeconomic stability. To be sure, i t is certainly inappropriate to assume that the capital markets i n the reform countries are able to finance deficits of a similar scale as i n Western countries without harmful effects on the rest of the economy. However, as w i l l become clear i n the next section, the numbers for government budget deficits i n transition economies may not be the best indicator for the assessment of fiscal policy. Therefore, the numbers below have to be interpreted cautiously. I n the field of monetary stabilisation, the hyperinflation of the first years after the beginning of the reforms seems to be under control i n most countries. The evolution of inflation rates is documented by table 2. Apparently, monetary stabilisation has been most difficult i n Bulgaria and Romania. This may not be considered as a surprise, because these 3 See United Nations (1995). 8 Konjunkturpolitik, Beiheft 45

114

Clemens Fuest and Bernd Huber Table 1 Budget balances in reform countries (in % of GDP)

Country

1990

1991

1992

1993

1994

1995

1996

Bulgaria Czechoslovakia Czech Republic Slovak Republic Hungary Poland Romania

-8,5

-3,0

-5,7

-11,4

-6,8

-5,0

-5,0

0,9

-1,0

-0,8

-

-

-

-

-

-5,0 -5,0 -1,0

-6,0 -6,0 -5,5

-

0,7

0,6

0,0

0,0

- 7,5 -6,0 -2,9 -0,7

-4,0 -8,0 -2,7 -4,0

-3,0 -6,0 -3,3 -2,5

-2,0 -4,0 -2,5 -2,5

-

-

-0,2 0,2 1,0

-

-

Source: 1990 - 92: O E C D (1993), 1993 - 96: O E C D (1995) (Forecasts for 1995 and 1996)

c o u n t r i e s are u s u a l l y c o n s i d e r e d as h a v i n g b e e n m o s t r e m o t e f r o m a n y t h i n g l i k e a m a r k e t o r i e n t e d system i n 1989. P o l a n d , i n c o n t r a s t , has succeeded i n c o n t r o l l i n g h y p e r i n f l a t i o n w i t h i n t h e f i r s t years of t r a n s i t i o n .

Table 2 The evolution of inflation rates (% change in average level of consumer prices over previous year) Country Bulgaria Czechoslovakia Czech Republic Slovak Republic Hungary Poland Romania

1990

1991

1992

1993

1994

1995

1996

26

334

71

64

125

60

30

10

58

10,8

-

-

-

-

-

-

-

-

28 585 4

35 70 165

23 43 210

Source: 1990 - 92: O E C D (1993), 1993 - 96: O E C D (1995) (Forecasts for 1995 and 1996)

-

23 22 35 295

-

10

9

8

13 19 32 137

10 27 23 45

8 16 18 35

Government Deficits, Inflation, and Economic Transition

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Still, whether or not the reduction of inflation rates since the early 1990s may be considered as an overall success is debatable. Even those countries who have been able to achieve relatively low infation rates, which means around 10 to 40%, such as the Czech and the Slovak Republic, Hungary or Poland, face enormous difficulties to bring inflation down further to one-digit rates. One of the reasons is of course that the monetary financing of public expenditures still plays an important role i n most transition economies. It therefore seems obvious to argue that further efforts should be made i n order to reduce budget deficits, which seem to be at the heart of the stabilisation problems. Yet, as w i l l become clear i n the next section, the conventional perspective on the problem of economic stabilisation sketched above tends to abstract from a number of policy problems specific to economies i n transition.

2.2 The role of the budget deficit in economies in transition

The budget deficit is a meaningful policy guide if and only if the public and the private sectors of the economy can be sharply separated. This, however, cannot be taken for granted i n economies i n transition. For i n stance, i t is a well known fact that public enterprises i n centrally planned economies carried out a large number of tasks which, i n a market economy, should be performed by the government. Public enterprises supplied housing to their employees including their families, numerous social and medical services, professional training, schools and even carried out some forms of public investment. Moreover, they usually employed more staff than was required for efficient production. 4 The latter, of course, was a simple but costly way to avoid open unemployment. Next to the extensive role of public enterprises i n the completion of "public" functions, the banking systems i n most transtion economies still have important bad loans on their balance sheets today, mostly credits granted to public enterprises. I t is well known that many of these loans are unlikely to be repaid i n full, which means that they have to be taken over at least partially by the government if the banking systems are not to be destabilised. The absence of a clear separation between public and private sectors i n many former socialist reform countries gives rise to two difficulties.

4 See Tanzi (1993a), p. 697. 8*

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First, including public enterprises and contingent fiscal liabilities associated w i t h the restructuring of the banking system into the calculation of the budget deficit is much more important i n former socialist countries than i n Western market economies. Public enterprises are t y p i cally excluded from the budget but i n Western market economies they are less burdened w i t h the completion of government tasks. 5 I n principle, this is merely a statistical problem, but i t is well known that the i n troduction of appropriate accounting i n the public sector is difficult. For the time being, government budget deficits measured i n transition economies only report a part of the overall public sector deficits, and l i t tle information is available as to the true size of the deficits. Existing statistics on budget deficits therefore have to be interpreted w i t h caution, especially i n cross-country comparisons. Second, and this point is more important, i t is questionable whether i t is realistic to claim that budget deficits can be kept low during the first years of reform. I t is a fact that the transition from a centrally planned economy to a market system requires expenditure increases rather than reductions i n certain fields, while tax revenue typically declines. To a large extent, the revenue losses occur because old tax systems have to be dismantled more or less completely, the main reason being they would only operate i n a centrally planned system, w i t h administered prices and a one-tier banking system. 6 The introduction of entirely new tax systems including the creation of a working tax administration, on the other hand, is a time consuming task. Moreover, the restructuring of the economy is usually associated w i t h an economic downturn, further reducing tax revenue. Table 3 shows that, w i t h the exception of Poland, the share of general government revenue i n GDP has declined dramatically after 1989 i n most former socialist countries. Again, Bulgaria and Romania have been h i t most strongly by the shock. Note that i n the same period, all transition countries experienced sharp reductions i n GDP as well, which means that the decline of revenue i n absolute terms is even more dramatic than the figures seem to suggest. On the expenditure side of the budget, the transition to a market economy implies, among other things, that the government takes over tasks which, as mentioned above, used to be completed by public enterprises. 5

Even i n Western market economies, deficits are sometimes disguised if they occur i n public enterprises that carry out government tasks, such as the German railway company or the postal services. 6 See, for instance, Tanzi (1991).

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Table 3 The evolution of general government revenue in reform countries (in % of GDP) Country

1989

1990

1991

1992

1993

Bulgaria Czecho-slovakia Czech Republic Slovak Republik Hungary Poland Romania

59,8 69,5

51,6 61,1

42,3 55,0

38,3

37,4

-

-

59,6 41,4 51,0

-

-

58,0 42,8 39,8

-

-

56,1 41,5 39,4

-

-

49,5

48,5

50,9 57,8 43,9 37,6

48,1 54,1 45,5 30,8

Source: I M F (1994)

This leads to an increase i n public expenditures. Next to this, the restructuring of the economy normally entails a sharp increase i n unemployment. I n centrally planned economies, unemployment d i d not officially exist, which explains why there were no institutions providing unemployment benefits. W i t h the transition to a market economy, i t is unavoidable to b u i l d up at least a rudimentary social safety net, which further increases public expenditures. Of course, spending i n other areas of the economy can be reduced, such as subsidies to consumers and firms or military expenditures, but i t is unrealistic to assume that these spending cuts can be sufficient to close the rapidly widening gap between declining tax revenue and rising expenditures i n the policy areas mentioned above. Therefore, the I M F concludes: "Containing government deficits, . . h a s proved elusive i n all but a handful of countries, and i t is increasingly recognized that the transformation process itself has profound implications for government revenues and expenditures. The resulting deficits are, to some extent, a by-product of the transition process, and i n some cases have resulted from transferring previous quasifiscal activities to government budgets." 7

3. Budget Deficits and Market Oriented Reforms The argument of the preceding section should not be primarily interpreted as claiming that negotiations over assistance or general reform 7 I M F (1994), p. 9.

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programs should fix more generous targets for and apply more comprehensive measures of budget deficits. Our point is rather that a strategy trying to impose fiscal discipline combined w i t h tight monetary policy, while being justified i n its own right, may not be very promising under the conditions of transition. I n fact, putting too much emphasis on containing budget deficits may have unintended, but very harmful side effects. As has been pointed out by Tanzi (1993a), strict ceilings on budget deficits may create incentives for governments to take policy measures that inhibit transformation. This becomes clear when considering the effect of restricting budget deficits on the following policy problems specific to economies i n transition: a) The restructuring and privatization of public enterprises, b) the deregulation of financial markets and c) monetary stabilisation. a) The restructuring and privatisation of public enterprises I n a market economy, the government should restrict its activities to those areas where markets fail. 8 The privatisation of public enterprises is therefore an essential element of every meaningful transition program. However, if governments face strong pressure to contain government budget deficits, they may refrain from pursuing a consistent privatisation strategy for public enterprises. As has been mentioned above, these enterprises completed a number of "public" functions i n the socialist economy, and they have been very reluctant to give up these activities during transition. I n a market economy, under the conditions of competition, activities such as hoarding workers to avoid open unemployment and providing social services and education to employees have to be given up. Accordingly, privatisation and other market oriented reforms such as the admission of competition from foreign firms imply that these tasks - or at least the most essential functions - have to be completed by the government. This is of course associated w i t h an increase i n government expenditures. Whether the privatisation of public enterprises also generates revenue for the government depends on the method of privatisation. I n any case, privatisation receipts only occur once, and the additional burdens for the budget are more or less permanent. Moreover, the restructuring of 8 Of course, market failure is only a necessary condition for the desirability of government intervention. I t is not sufficient because government may fail too.

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the private sector also implies that government monopolies have to be dismantled. This implies that further revenue losses have to be expected i n cases where public enterprises provided revenue by exploiting monopolies. Politicians who have strong incentives to contain the government budget i n the short or medium term, measured as i n Western market economies, may therefore prefer to delay the privatisation of public enterprises and thus inhibit the process of transformation. From the point of view of overall efficiency, however, i t should be uncontroversial that i t would be preferable to report a larger government budget deficit, combined w i t h a quicker restructuring of the economy, rather than having these deficits disguised and huge efficiency costs due to the absence of necessary reform steps. For example, the OECD (1994) reports such inefficiencies i n the restructuring of public enterprises from Poland: "Restructuring policy seems to be generally driven by budgetary priorities, w i t h mixed results . . . the state is not a normal owner but i n effect a monopolist, leading to clear conflicts between forming holding companies under protected conditions or promoting competition. Industrial restructuring policy i n Poland i n key areas has represented an uneasy compromise between these two positions. Government decisions, ..., have avoided burdening the budget and the authorities w i t h the political cost of closing weak firms. The cost has been one of efficiency .. . " 9 . This clearly implies that containing government budget deficits irrespective of the factors that determine these deficits may be counterproductive. b) The deregulation of financial markets and the banking system I n market economies, financial markets have the essential function to mobilise savings and to channel them to the most efficient investments. Financial markets can only function if institutions for financial intermediation exist, such as equity and bond markets, mutual funds, specialised savings and loans organisations and pension funds, and, above all, a properly working banking system, w i t h commercial banks that operate under profit-making orientation. A t the beginning of the transition, many governments seem to have failed to realise the importance of reforming the financial sector. Right at the beginning of the transition, most countries did make a first essential step, which was to replace the old monobank structure w i t h a two-tier banking system. Subsequent re9 OECD (1994), p. 74.

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forms, however, i n particular the deregulation of capital markets and the privatisation of state-owned commercial banks have been delayed. 10 The urgent need for further reforms only became apparent when the old financial institutions turned out to be a major obstacle for both p r i vate sector development and fiscal consolidation. During the transition, the state-owned banks have continued to accumulate bad loans, mostly to state-owned enterprises. Basically, these loans have to be considered as fiscal subsidies. The banks themselves are able to finance these subsidies because they are refinanced by the central bank. Today, governments i n reform countries are well aware that i t is urgent a) to stop the recurrence of bad loans and b) to deal w i t h the stock of existing bad loans by a comprehensive financial restructuring program. 1 1 While the first problem requires, above all, reforms that change the i n centives of the bank managers, the second measure implies that the governments have to take over large contingent liabilities. Again, if governments have strong incentives to report low budget deficits, these necessary reform steps w i l l possibly be further delayed. For the efficiency of capital allocation, this delay has more or less disastrous consequences. The state-owned banks continue to accumulate bad loans and public enterprises w i t h weak corporate governance w i l l continue to have privileged access to credit, whereas profitable investments i n private firms are often inhibited by credit rationing. Moreover, as i t is extremely difficult to assess the real value of the assets held by the state-owned banks, depositors w i l l be discouraged from investing their savings via the banking system. 12 As i n the case of public enterprise restructuring, i t would be far more efficient if the government took over the contingent liabilities of the banking system immediately, making transparent the unavoidable costs of restructuring the financial sector. c) Monetary stabilisation Public expenditures that cannot be financed through tax revenue may either take the form of implicit subsidies, such as bank loans to public enterprises at concessional interest rates, somehow refinanced by the central bank, or they may be financed through direct monetary expan10 See United Nations (1995), p. 13. 11 Ibid. 12 See Tanzi (1993b).

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Government Deficits, Inflation, and Economic Transition

sion. As has been mentioned i n chapter 2.1., the separation of monetary and fiscal policies is a guiding principle for macroeconomic stabilisation efforts. Yet, if given primary deficits cannot be covered through the issue of debt, there is nothing governments can do apart from monetary financing. Table 4 gives estimates of the magnitude of inflation taxes i n the transition economies. Table 4 Inflation tax on domestic money balances (in % of GDP) Year

Bulgaria

Czech Republic

Hungary

Poland

Romania

1992 1993

6,3 5,4

3,2 5,6

3,2 3,4

2,9 2,4

9,2 5,6

Slovak Republic -

5,3

Source: U n i t e d Nations (1995)

I t is no surprise that the inflation tax typically plays a greater role i n East European countries compared to Western market economies, where estimates range between one and two per cent of GDP. Obviously, the i n flationary financing of public expenditures is another way to reduce budget deficits, provided that budget deficits are not measured as p r i mary deficits, excluding monetary financing. Pressures to reduce the government budget deficit therefore may well create incentives to resort to excessive monetary financing. Even if the budget deficit is measured net of direct monetary financing, i t is easy to let monetary financing appear as tax revenue. For instance, the ability of many state enterprises to pay taxes depends on the availability of credits at concessional rates. 1 3 However, the problem of inflation i n transition economies is more complex than one of choosing between monetary financing and explicit debt issue. The importance of the inflation tax i n transition economies raises the question of how economic transformation policies should take into account the fact that a certain amount of monetary financing of public expenditures seems to be unavoidable. I n the following section, we therefore take a closer look at the interaction between budget deficits and inflation. I t w i l l t u r n out that the interaction between these two key macroeconomic variables supports the view that the creation of an appropriate institutional framework for a market economy, including the separation of the public from the private sector and the deregulation of 13 I b i d . , p. 17.

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financial markets may contribute more to the success of the transition than trying to influence the path of budget deficits i n the early phase of reforms.

4. The problem of excessive inflation 4.1 Inflation and budget deficits

To understand the basic interaction of government deficits and inflation, i t is first helpful to consider the government budget constraint i n

(1). (1)

Gt-T t

+ UA t = M t-

Mt-i + A

m

- At

where Gt is government spending and T t is tax revenue. At denotes the outstanding government debt at the beginning of period t, i t is the nominal interest rate from t - 1 to t, and M t - M t~ ι denotes the revenue from money creation. Equation (1) tells us that the primary deficit Dt = Gt — T t and the interest payments must be financed by money creation or new debt issues. Now consider how primary deficits affect inflation. From (1), we obtain upon substitution the intertemporal goverment budget constraint i n (2). ^ (2)

Dt

^ +

_

f

M t-M t_!

+

The intertemporal constraint reveals that where the No-Ponzi-game condition is assumed to hold, primary deficits (and the outstanding government debt) must be eventually financed by money creation. Of course, this also means that inflation is excessive i n the sense that p r i mary deficits are inefficently high. Consequently, correcting primary deficits w i l l also lower inflation. However, as we have argued above, there are various obstacles to correcting public sector deficits i n reform countries. I n the present section, we w i l l therefore analyse the following problem: Suppose that a given sequence of primary deficits has to be financed through inflation tax revenue. What are the consequences for i n flation? Our main interest is the question whether the monetary financing of these deficits can create an additional inflationary bias and welfare losses i n reform countries. We study this question i n a simple public finance model. We show that the interaction of credibility problems and

Government Deficits, Inflation, and Economic Transition

123

capital market imperfections may result i n inflation which is too high, given the sequence of primary deficits. I n particular, our analysis makes clear that an underdeveloped market for government debt can be a key factor for excessive inflation. 4.2 The Model

I n this chapter, we use a simple public finance model to study the i n teraction of inflation and deficits. To begin w i t h , we first rewrite (2) i n real terms as

Σ°°

dt

.

. .

^rn t

- mt-\

K tm t-i

where d t = a 0 = pjf and r is the real interest rate. mt = ^ are real balances i n period t. nt is defined as ir t = Pt~p '~l a n ( * has the natural interpretation as the inflation tax rate. I n what follows, we assume that the sequence of primary deficits is given. We thus abstract from any potential benefits of correcting primary deficits. Instead, i n this section, we concentrate on the consequences of financing a given sequence of d t for the rate of inflation. To simplify the following analysis we also assume that there is no i n i t i a l debt outstanding (ao = 0) and that money demand is governed by the quantity theoretic relation mt = ky t where y t is real output. If y t is assumed, for simplicity, to be constant, real balances are constant over time and can be normalised to unity. The intertemporal constraint then becomes °°

(3)

V^

rj

(X)

*

έ ί ( 1 + τ·)
1, which has inherited debt obligations of B s _i, s from its predecessor. The problem of this government is OO

-J

-J

This program yields 7TS = π(1 + ns+j 14

bs-u)

=π

I n terms of equation (1), we thus have (1 + i t)A t

= Bf_

1>t .

Clemens Fuest and Bernd Huber

126

The government w i l l choose (if ö > 0) a higher i n f l a t i o n rate i n s t h a n i n a l l following periods where i t is o p t i m a l to have a constant i n f l a t i o n tax. The higher i n f l a t i o n i n s'reflects that, from the perspective of period s, the i n f l a t i o n t a x i n s yields an additional social benefit by reducing the real value of government obligations. However, this implies that a policy of constant i n f l a t i o n tax rates is not time-consistent, i.e. if the government i n 0 chooses a constant t a x rate, this policy w o u l d not be carried on by succeeding governments. Let us now consider the optimal time-consistent policy i n this situation. There are several ways to derive the o p t i m a l time-consistent outcome. Here, we w i l l use an approach used, e.g., i n Calvo/Guidotti (1992) w h i c h is based on the analysis of the necessary conditions for an o p t i m a l policy along an e q u i l i b r i u m p a t h . 1 5 The o p t i m a l time consistent p a t h of 7T t is denoted by [π^, π\...]. Time consistency requires that at each future date s i t is o p t i m a l to m a i n t a i n this policy. A t date s, the government has inherited debt obligations ö s _ i ) S . The government budget constraint i n period s is (5)

ds

+

(1 -

7T5)ÒS_1)S =

S+1

7TS Η

1+r

bSìS+1

Suppose that, u n t i l date s, i t has been o p t i m a l to follow the p a t h [πο, π \ . . . ] . Let us now check whether the government i n s w i l l also m a i n t a i n this policy. Consider the following perturbation of the e q u i l i b r i u m path. A t date s, the government changes the i n f l a t i o n tax by dn s. The budgetary consequences of this change are neutralised by an adjustment of 7ts+i. Of course, o p t i m a l i t y requires that the t o t a l welfare effect is zero. (6)


2

This also means that the optimal maturity structure is declining. If the government i n 0 chooses bot according to (15), this w i l l ensure that the government i n 1 w i l l choose nt = π for all dates t > 2. Since we have already seen that πχ = π is optimal (in (13)) this implies that the tax smoothing policy w i l l be time consistent. Notice that this policy is budgetarily feasible since, if botì t > 2, is determined by (15), an appropriate issue b 0 i , i.e. one-period debt ensures that (10) is maintained i n period 1. Obviously, we can use a similar argument i n all following periods. Thus, we can conclude that the tax smoothing policy is time consistent. This yields a surprising and, to some extent, counterintuitive conclusion. The use of long term nominal debt allows the government to

debt

Government Deficits, Inflation, and Economic Transition

131

achieve the tax smoothing solution as time consistent policy and to eliminate any inflationary bias. How can we explain this result? The main problem of nominal debt is that i t creates an incentive for surprise inflation. However, i n the presence of long term debt, the surprise inflation effect is ambiguous. Of course, higher current inflation lowers the real value of debt. Yet, for budgetary reasons, higher inflation today means lower inflation i n the future. However, this effect tends to lower nominal interest rates and this w i l l tend to raise the real value of long term debt. The trick behind the scheme outlined above is that i t balances these two effects such that i t is optimal to maintain n t = π. Our results differ from the existing theoretical time consistency literature. Persson / Persson / Svensson (1987) have shown that nominal debt could be used to achieve time consistency of the precommitment solution, i.e. the tax smoothing outcome. However, their model requires the government to be a net creditor. Several other papers (see, e.g., Obstfeld (1989), Calvo / Guidotti (1992)) have shown that the maturity structure plays an important role i n the optimal time consistent policy. Contrary to our argument, these papers state that i t is impossible to achieve the precommitment outcome as the optimal policy. One reason for our different results is that we have ignored the role of other taxes like, e.g., income taxes which present an additional source of time inconsistency problems i n these models. The key policy conclusion emerging from this part of the paper is that the development of domestic capital markets i n transformation countries may be an important factor which helps to eliminate the potential of excessive inflation discussed above. I n particular, the establishment of markets for longer term debt securities i n domestic currency can help to eliminate excessive inflation i n transformation countries.

5. Conclusions I n this paper, we have analysed the role of government deficits i n the reform process of transition countries. The conventional wisdom underlying the reform programs emphasises the role of restrictive monetary and fiscal policies as prerequisites of macroeconomic stabilisation and market oriented reform i n general. We have pointed out that a strict strategy of fiscal consolidation raises a number of policy problems specific to transition economies. I n particular, such a strategy may even ham9*

132

Clemens Fuest and Bernd Huber

per the reform process as governments slow down market oriented reforms i n order to conform w i t h negotiated or imposed deficit ceilings w i t h questionable economic content, the latter being primarily due to the fact that the accounting of government budget deficits suffers from the lack of a sharp separation between the public and the private sector. We have put particular emphasis on the interaction of government deficits and inflation. Using a simple, stylised public finance model, we have shown that the development of capital markets may be a key factor to avoid excessive inflation i n the reform countries. Even if a direct reduction of overall public sector deficits is impossible, or can only be achieved slowly, improving capital market institutions can help to m i t i gate the welfare costs of inflation associated w i t h the monetary financing of government deficits. Therefore, progress i n market oriented institutional reforms may be a more appropriate indicator for the assessment of reform policies than the path of reported government budget deficits.

Abstract This paper analyses the role of government deficits i n the reform process of transition countries. We show that a strict strategy of fiscal consolidation may create incentives for governments to slow down market-oriented reforms i n order to conform w i t h negotiated or imposed deficit ceilings. We then use a simple public finance model to analyse the interaction of government deficits and inflation. We show that the development of capital markets may be a key factor to avoid excessive inflation i n the reform countries. Even if a direct reduction of overall public sector deficits is impossible, improving capital market institutions can help to m i tigate the welfare costs of inflation associated w i t h the monetary financing of government deficits. Therefore, progress i n market-oriented institutional reforms may be a more appropriate indicator for the assessment of reform policies than the path of reported government budget deficits.

References Calvo, G. Α., and P. Guidotti (1992), Indexation and Maturity of Government Bonds: A n Exploratory Model, in: Dornbusch, R. and M. Draghi (eds.): Public Debt Management: Theory and History, Cambridge, pp 5 2 - 82. I M F (1994), World Economic Outlook, October 1994, Washington. Kopits, G. (1992), Fiscal Reforms i n the European Economies i n Transition, in: P. Marer and S. Zechini (eds.): The Transition to a Market Economy, Vol. 2, Paris: OECD, 359 - 390.

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Lucas, R.E. jr. and Ν. L. Stokey (1983), Optimal Fiscal and Monetary Policy i n an Economy without Capital; Journal of Monetary Economics 12, pp 55 - 93. Mankiw, N. G. (1987), The Optimal Collection of Seigniorage: Theory and Evidence; Journal of Monetary Economics 20, pp 327 - 341. Obstfeld, Μ. (1989), Dynamic Seigniorage Theory: A n Exploration, NBER Working Paper No. 2869, Cambridge. OECD (1993), Economic Outlook, No. 54, December 1993, Paris - (1994), Economic Survey, Poland, 1994, Paris. - (1995), Economic Outlook, No. 57, June 1995, Paris. Persson, Τ., M. Persson und L. E. O. Svensson (1987), Time Consistency of Fiscal and Monetary Policy, Econometrica 55, pp 1419 - 1431. Sargent, T. J. und Ν. Wallace (1981), Some Unpleasant Monetarist Arithmetic, Federal Reserve Bank of Minneapolis, Quarterly Review, pp 1 - 17. Tanzi, V. (1991), Fiscal Issues i n Economies i n Transition, in: V. Corbo, F. Coricelli, and J. Bossak (eds.): Reforming Central and Eastern European Economies: I n i t i al Results and Challenges, Washington: World Bank, pp 221 - 228. - (1993a), The Budget Deficit i n Transition: A Cautionary Note, I M F Staff Papers, 40 (3), pp 697 - 707. - (1993b), Financial Markets and Public Finance i n the Transformation Process, In: Vito Tanzi (ed.): Transition to Market: Studies i n Fiscal Reform, IMF, Washington, pp 1 - 28. - (1994), Reforming Public Finances i n Economies i n Transition, International Tax and Public Finance, 1, pp 149 - 163. United Nations (1995), Economic Survey of Europe i n 1994 - 1995.

Comment on: Clemens Fuest and Bernd Huber, Government deficits, inflation, and economic transition

By D i e t m a r

Wellisch

Let me first say that, as a non-specialist i n the field of economic transition from former socialist command and control economies to marketoriented economies, I have benefited very much from reading the paper, especially because i t provides a very instructive overview about current stabilization issues i n those countries. I w i l l proceed as follows. First of all, I w i l l discuss from my viewpoint the basic questions raised by both authors, and then I w i l l t u r n to a critical comment on the theoretical part of the paper (Chapter 4).

Content The first basic objective of the paper is to critically analyze the role that reported government deficits can play as an indicator of the progress i n the reform process of transition countries. While international institutions like the World Bank and the International Monetary Fund make their assistance programs dependent on the level of reported deficits, the authors conclude that government deficits may be a rather misleading guide for the progress of reforms. The basic reasons for this assertion are that: 1. Public enterprises were and are still predominant i n former socialist countries and they take on many tasks that are usually performed by governments i n market economies. Examples being numerous social and medical services, schools for their employees, and especially a higher working staff than is necessary w i t h the intention of avoiding open unemployment. To increase the efficiency i n those countries, i t is necessary to sell the public enterprises. While this leads to a one-time revenue effect, government expenditures increase permanently since the government has to overtake functions like the supply of social and medical ser-

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vices and has i n particular to finance unemployment benefits. If a too restrictive course of fiscal consolidation is required, this may postpone the necessary privatization efforts more or less indefinitely. 2. I n the course of transition, the tax system must be reformed leading to a drop i n tax revenues. Again, a too strict path of fiscal consolidation endangers necessary tax reforms. 3. State-owned banks have had bad loans on the eve of transition and have continued to accumulate bad loans during the transition, mostly granted to public enterprises. The stock of existing bad loans implies that the government has to take over large contingent liabilities i n order to establish a well-functioning two-tier banking system which is a necessary condition for an efficient allocation of private savings into i n vestment. If government have strong incentives to report low budget deficits, also these reform steps are delayed more or less indefinitely. 4. Any pressure to reduce the government deficits create incentives for monetary financing of government revenues. This increases the inflation rate and has adverse welfare effects. For all the reasons just mentioned, the necessary reform steps increase government expenditures while tax revenues rather fall due to the sharp rise i n unemployment during the period of transition. If a too restrictive course of fiscal consolidation is required, the necessary reform steps w i l l be called into question. The threat of high rates of inflation is at the core of the second basic aim of the paper, that is, to show w i t h i n a theoretical model that the establishment of well-functioning financial markets may contribute more to the success of the reform process (measured i n terms of welfare gains due to a constant path of inflation rates) than the requirement to report low levels of budget deficits. This is explained by showing that financial markets that allow for the use of long and short-term nominal debt issued by the government can help to overcome credibility problems that a government would otherwise face. As a consequence, the welfare losses due to inflationary finance of primary deficits are minimized. If financial markets are incomplete i n the sense that the government can only issue short-term debt, the government i n each period has incentives to devalue the outstanding debt by increasing prices. This leads to high i n flation rates at the beginning of the transition period as an optimal time-consistent equilibrium path. The coexistence of long and shortterm nominal debt balances the incentives of governments to inflate i n

Dietmar Wellisch: Comment

order to devalue the short-term debt and to deflate i n order to increase future inflation rates (so as to balance the intertemporal budget constraint) and thereby reduce the real value of long-term debt.

Comment M y basic critical comment concerns the theoretical model outlined i n chapter 4. The time-consistency problem is based on the fact that the government can use an inflationary tax to finance public funds and therefore devalue government bonds. The authors assume that private funds are supplied elastically and do not depend on saving decisions of private households. However, the size of savings depends on the net ret u r n to saving which, however, falls when the government uses the inflation tax. Consequently, taking the household side of the economy into account, i t is possible that public debt finance is restricted by the elasticity of saving decisions. This is not taken into account i n the paper, although i t is an important result i n the time-consistency literature.

Fiscal aspects of German unification: Who is stuck with the bill? By J o h a n n e s B r ö c k e r and B e r n d

Raffelhiischen

1. Introduction I n November 1989 East Germany opened the border to West Germany and, by that, two extremely different economies set forth to integrate into one. Half a year later, July 1st 1990, the deutschmark replaced the former East German currency, the mark. A l l of a sudden, one market for all but non-traded consumption goods developed. Restrictions on capital flows ceased to exist and people were allowed to move freely between both regions for the first time. Due to both a tremendous productivity gap and an inefficient public administration, the first years of transition reflect one of the worst regional depressions i n European history. Wages which rose to nearly 70 percent of the western level have induced an effective unemployment rate of approximately one t h i r d of the entire eastern labor force. I n addition, low employment brought along substantial problems i n financing the rather generous social security system of the West which was i n stalled successively but fairly fast i n the east. A t the same time, there has always been a peril of mass migration which could easily exceed the social integration capacity of the West. Most of the economic problems experienced i n the recent past still remain valid and for both the hindsight and the future perspective, the overall fiscal implications are straightforward. First, income compensations are needed i n order to ensure a socially acceptable transition to a market economy. Second, the government should continue to speed up the adjustment process by investing i n public infrastructure and subsidizing private investment i n the East. Presently, the public sector redistributes approximately 5 percent of the western GDP for both purposes on an annual basis. I n our analysis we refer to this overall east-west transfer as the burden of unification and

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investigate the intergenerational distribution between presently living and future generations of east and west Germans. The analysis is based on a dynamic general equilibrium model for two regions. The economy consists of West (1) and East (2) Germany which together represent a small open economy vis a vis the rest of the world. W i t h i n the regions any activity is undertaken by households and firms. W i t h respect to individual behavior we apply a neoclassical approach w i t h overlapping generations i n the tradition of Allais (1947), Samuelson (1958) and Diamond (1965). Investment involves installation costs as specified by Abel (1978) and Hayashi (1982). Hence, f i r m behavior is reflected by standard 'q'-theory. The paper is organized as follows. The microeconomic behavior of agents and firms, the policy instruments of the public sector and the aggregation procedure are described i n chapter 2. I n chapter 3 we outline the macroeconomic consequences of German unification. This enables us to calibrate the model and gives some hints on the transition process so far. Chapter 4 starts by specifying the western economy's steady state before unification. From that i n i t i a l perspective, we proceed by presenting the dynamic transition following the unification for alternative policy scenarios. I n chapter 5 we summarize our findings and give some brief conclusions.

2. The simulation model 2.1 Household

The numerical experiments are based on a perfect foresight cohort model. On entering the work force, every cohort lives for Τ — 50 periods. Hence, i n both regions there is a continuum of 50 overlapping generations. The entire population is stationary. I n each period t and i n each region r e {1,2} the youngest cohort U t _ x replaces the oldest L r t _ T . Every cohort i n itself consists of a continuum of heterogeneous individuals which decide how to allocate their life-cycle resources to the intertemporal consumption opportunities. Let us assume subsequently that an individual of the cohort entering the labor force at the point of time b has already decided, once and for all, upon his regional location r. Then the respective u t i l i t y is determined by a time separable, isoelastic function

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(1)

141

u(

where c£ represents a vector of all periodical consumption quantities [ c £ + 1 , . . . , cr b+T\. Consumption can be substituted intertemporally w i t h an elasticity of p. Hence, the lower we choose p, the smoother w i l l be the consumption profile. Note that agents work full-time during the first 40 years and fully retire the last ten periods of living. The structure of the u t i l i t y function exclusively affects the current account since we argue i n the context of an interest-taking small open economy. If regional savings fall short of (exceed) the respective capital demand, capital is simply i m ported from (exported to) the w o r l d capital market. Every agent of a cohort born at the point of time 6 living i n region r maximizes lifetime u t i l i t y under the budget constraint crb-pb 0) cancel out. 4 The efficiency aspects of alternate public policy options are discussed separately i n Bröcker (1992a) and Raffelhüschen (1992a,b). 10'

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As an opposite extreme, the second scenario requires a periodically balanced budget. I n every period a wage tax is raised i n order to meet all expenditures of the unification process. Only presently working cohorts are burdened by this tax-as-you-go (taygo) principle. W i t h respect to the public sector's budget constraint (12) there is neither debt service on bonds [(^)B t-i = 0] nor does the government issue new debt (B t = 0). The latter does not hold w i t h respect to the one-shot debt financed transfer of social security wealth. 5 While the Ponzi-scenario mainly reflects intergenerational redistribution, i t is clear that the taygo-scenario overwhelmingly emphasizes intragenerational redistribution. Since the Ponzi- as well as the taygo-scenario represent extreme solutions, we prefer to specify an optimal fiscal strategy as follows. To distribute the burden of unification i n an intertemporally well balanced way, all cohorts living at unification day and all future cohorts are taxed w i t h a constant rate over their respective rest-of-life. We calculate both the tax receipts and the unification burden i n terms of present values and balance the budget intertemporally i n the "fiscal-balance-rule (FBR) scenario". 6 The corresponding tax revenue is not sufficient to cover all expenditures i n the short and medium run. Similar to the Ponzi-scenario, public debt w i l l therefore accumulate i n the FBR-scenario too. However, the scale w i l l be much lower. I t is now possible to employ our system of difference equations to solve the i n i t i a l and final steady states as well as the dynamic transition path of the German unification. The i n i t i a l steady state exclusively represents West Germany before unification. I n period t = 0 former East Germany joins the West. A l l agents, however, have already decided upon consumption and investment before information about the unification became available. Therefore, the productive capital i n period t = 0 is fixed. This is not true for the other input factor, labor, since the eastern cohorts are allowed to migrate to the West. Both the newborns i n period t = 0(Lq 0 ) and the transition cohorts ( l | 0 ) , VZ > 0, revise their locational choice according to equations (5) and (6). After the unification period, only those eastern agents entering the labor force decide where to settle. I n those 5

The distribution of social security payments are neglected since we do not exp l i c i t l y model the paygo-system for both subregions. 6 As pointed out by Kotlikoff (1993), fiscal policies following the "fiscal balance rule" ensure both sustainability and an equal burden on subsequent generations i n the long run. I n our context, the burden is distributed according to a more specific scheme, that is, the payments are uniform w i t h respect to all presently l i v i n g and future generations i n terms of rest-of-life adjusted present values.

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periods, capital which flows into the East offers high returns on investment. This is due to the fact that installed capital is i n rather short supply i n the East. Both trajectories, the migration flows and the value of the firms, follow from equations (9) and (11). Wages and unemployment rates are given through equation (8) while equation (12) determines public debt necessary to finance the policies outlined earlier. Our numerical solution method is rather complex. We start w i t h the final steady state i n unified Germany. To solve for the saddle path we then integrate backwards over time to calculate the dynamic transition consistent w i t h the factor endowment inherited at unification i n both regions.

3. Macroeconomic aspects and public finance in transition When the German economic, monetary and social union was completed i n July 1990, living conditions i n both regions were extremely different. Despite large scale transfers of capital and technology during the last five years the major divergences still remain significant. Upon successful transformation from a centrally planned command economy to a decentralized market economy, the East w i l l eventually reach western standards of efficiency. 7 Subsequently, we want to specify the dynamic transition w i t h the help of a simulation technique. This is done on the basis of the observed macroeconomic development during the recent past which serves to calibrate the crucial parameters of the model. A t the starting point of the integration process, a tremendous gap concerning both labor productivity and per-capita output became apparent. Regarding the eastern productivity level the Bundesbank (1990, p. 15) estimated east-west ratios of one t h i r d while similar numbers apply for eastern per-capita output. I n the meantime, the typical J-curve effect concerning output and productivity is one of the worst regional depressions i n European history [Akerlof et al (1991)]. As late as 1992, both full-employment labor productivity and per-capita output caught up w i t h the pre-unification level and have presently reached about 50 percent of the western figures. I n contrast to this development, there was a remarkable increase i n real wages. While effec7 I n fact, this is the optimistic point of view. There may be macroeconomic constellations which produce a diverging development i n both regions as known from endogenous growth theory. Cf. Krugman (1991) and Bröcker (1992b).

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tive wages i n the beginning of 1990 corresponded to only 32 percent of the western standards, this figure rose to approximately 50 percent i n 1992. As seen from table 1, the gap decreased continuously. Presently, eastern wages measured over all sectors, range at about 68 percent of the western level. Additionally, most of the recent wage setting contracts ent a i l a step-by-step adjustment to the western wage level up to the year 1998 or earlier [Sachverständigenrat (1995, p. 109)]. These contracts, however, only reflect negotiations concerning m i n i m u m wages, i.e. the effective catching-up w i l l take a few more years. Table 1 Macroeconomic and fiscal aspects of unification

Wages, East-West Ratio

1990

1991

1992

1993

1994

1995

32

39

49

57

62

68

Eastern Unemployment, Percent of Workforce

16.3

30.4

36.7

32.1

29.2

25.7

Net Transfers* Percent of Western GDP

39 1.6

106 3.8

131 4.5

136 4.6

131 4.2

161 5.0

Public Debt* Percent of Western GDP

1049 43.2

1166 44.0

1332 47.3

1499 52.7

1645 55.3

2018 65.7

15.5 0.6

23.5 0.8

21.7 0.8

37.5 1.3

42.7 1.4

Additional Tax Receipts* Percent of Western GDP

-

1996 -

23.1 -

15.0 0.5

* Billion D M . Including federal, state, local level, social insurance, and off-budget authorities. Source: Sachverständigenrat (1995), Statistisches Bundesamt (1995-1995), Raffelhüschen (1994).

The increasing difference between the full-employment marginal product and the costs of labor induced massive unemployment. I n order to calculate the actual total unemployment, one must consider the official rates as well as those persons who are participating i n retraining and labor creation programs, the number of short-term employees, the exits from the labor force through early retirement, reduced female labor participation and out-migration of labor. Table 1 reports both open and hidden unemployment while neglecting the female exits from the labor force as well as labor migration. According to the adjusted quota, total unemployment rates rose from 16.4 percent i n 1990 to 36.7 percent i n 1992, decreased to a level of 25.7 percent i n the period 1993 - 1995, and is expected to range around 23 percent i n 1996 [Sachverständigenrat (1995, p. 9)]. Even these numbers have to be regarded as a fairly optimistic since one must also consider those workers of non-viable firms,

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which used to be held and subsidized by the Treuhandanstalt , as being employed under non-market conditions. I n combination w i t h the exits from the labor force, at least another 5 to 8 percentage points should be added to the actual unemployment rates during the first four years of transition. As mentioned above, the fact that registered unemployment increased much less than the decrease of employment was the permanently decreasing labor force. Among others, this is due to the migration flows which varied tremendously during the recent past. I n the first phase of the unification process, massive out-migration can be seen as a response to tremendous income disparities and rising unemployment rates which made i t highly attractive to move into "the golden west". Hence, from November 1989 to January 1992 more than 550,000 people, i.e. 3.3 percent of the entire population, left the East. Due to financial aid for the rising number of unemployed, the installation of wide labor creation programs and the fact that eastern wages approached the 50 percent level i n February 1992, more and more people were induced to stay i n the East. From 1992, the peril of mass-migration ceased to exist. The locational choice of eastern agents during the recent past reveals that i n the presence of a fairly broad coverage through the social insurance system, migration w i l l depend strongly on wage differentials w i t h a trigger differential of approximately 50 percent. 8 From the basic macroeconomic facts, stated above, i t is obvious that there is a dual problem w i t h respect to the fiscal implications of the integration process. First, a significant transfer to the East is necessary i n order to ensure a socially tolerable transition to a market economy. This involves a wide range of wage compensation for Easterners including benefits for the eastern unemployed, social security payments for those induced to retire early, wages for employees of artificial training firms etc. Hence, a variety of fiscal authorities would be affected. Among them, the unemployment insurance and social security system, both financed via a pay-as-you-go scheme, the federal budget and special task authorities. 9 Even if transfer measures can help to mitigate socially undue hardships i n the short run, they can not be the ultimo ratio i n the long run since an appropriate policy should encourage private investments and

8

Similar results are found i n Burda (1992) on the base of an option-valuemodel. 9 We do not specify the implication of the unification for all affected fiscal institutions i n detail. Instead, the interested reader is referred to Kitterer (1993).

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improve the public networks. As a second category of east-west transfers, investment subsidies as well as direct public investments i n the East ought to be part of a well balanced unification policy. The more i n vestment transfers increase labor productivity, the less wage compensations have to be paid. I n table 1 we also present the overall fiscal i m p l i cations of the German unification. I n sum, net public transfers redistributed between 106 and 161 b i l l i o n D M i n the period 1991 through 1995 annually i n order to speed up the technological catching-up process and i n order to achieve a socially balanced integration of the East. As a rule of thumb, about two thirds of these yearly transfers substituted for lacking labor income, one-fourth represented public investment, and the remainder provided for substantial investment subsidies for eastern firms [Sachverständigenrat (1992 - 1995), Bundesministerium für Finanzen (1992 - 1994)]. I n terms of western Gross Domestic Product, the net transfer from west to east seems to converge to a constant level of approximately 5 percent i n the medium term. As a consequence of both high east-west transfers and the reorganization of the eastern state budgets, the deficits of the public sector increased tremendously. I n fact, the debt to western GDP ratio rose from 44.0 percent i n 1991 to 65.7 percent i n 1995. During the same period, additional tax receipts did not exceed 1.4 percent of the western GDP. I n 1996, these additional tax revenues w i l l decrease tremendously while accounting for only 0.5 percent of the western GDP. Clearly, most of the net transfers were financed through deficits rather than through an increasing tax load. This is especially true for the early unification period but seems to hold also for the future since only i n 1994 and 1995, the additional receipts corresponded to more than 1 percent of western GDP.

4. The catching-up process Before presenting our results, the model's calibration has to be discussed. There are i n sum only seven parameters because the model is as highly stylized as possible. We assume that the economic conditions of unified Germany w i l l equal the West German standard of the 1980s i n the long run. Hence, some numerical values can be obtained by employing empirically significant parameter estimates from the literature. The remainder has to be calibrated. Estimates are required for the following figures:

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Elasticity of substitution between labor and capital σ: A value of σ = 0.8 is assumed according to the widely accepted conviction that this elasticity is smaller but close to one. The weight of capital in the production function a: I t is calibrated such that the capital income share equals 0.3 i n the steady state, roughly corresponding to long term pre-unification averages. Technical growth factor η: This parameter equals the steady state growth rate, which can realistically be assumed to be close to 2 percent per annum. Rate of capital depreciation δ: Following common practice we assume a depreciation rate of 4.5 percent per annum. Adjustment costs parameter ζ: This parameter controls the speed of convergence to the steady state. Hence, given an estimate of the rate of convergence, the ζ-parameter can be obtained as a function of this rate. We suggest a convergence rate of 8 percent per annum, resulting i n a ζparameter around 14. This rate sounds high as compared to Barro's 2percent law [Barro and Sala-i-Martin (1995)], but i t is less than Schalk's and Untiedt's (1995) estimated 12 percent for Germany, and i t fits well w i t h the catching up of east Germany observed u n t i l now. Intertemporal elasticity of substitution ρ: This parameter is calibrated such that supply equals demand i n the steady state, given a real interest rate of 4 percent, that is ρ = 0.7. Migration parameter β: The parameter is chosen i n order to match the low migration of the m i d 1990s. The parameter values imply a steady state interest rate of 4 percent. Assuming West Germany develops along a balanced current account, steady state has the consequence that this figure is also the w o r l d interest rate. A l l three scenarios, to be presented, display the dual public intervention described above as well as the adoption of the social security settings. A t unification day, eastern wages are assumed to equal 32 percent of the western level. I n the following five years eastern wages catch up according to the east-west ratios reported i n table 1. From 1995, where eastern wages correspond to 68 percent of the western level, the ratio continues to increase stepwise by 5 percentage points up to a level of 83 percent i n 1998. Thereafter, the east-west ratio is held constant u n t i l market forces are going to raise i t again as soon as f u l l employment w i l l

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be attained. This is our way to model the results of the bargaining process between labor unions and employers. Given the i n i t i a l east-west capital intensity ratio of close to 10 percent, 1 0 the marginal productivity under f u l l employment would be 26 percent i n the East as compared to the West. Hence, fixed m i n i m u m wages raise the unemployment rate to a level of 28 percent of the eastern labor force i n 1991 (figure 1). Both the estimate of the capital stock as well as the first years average productivity arising under the fixed wages come close to reality.

year Figure 1: Unemployment rate, east

Since wages continue to rise, unemployment accelerates to approximately 37 percent at the maximum i n 1993. A high eastern q-value (^1990 = 9-5) i n comparison to the western figure ( q j 9 9 0 = 2.0), induces high capital inflows, which offset the impact of significantly increased io For given eastern wage rates, East Germany's i n i t i a l capital stock is calibrated i n order to reproduce the observed unemployment i n 1991 and 1992.

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wages. Hence, as seen i n figure 2, the per capita GDP w i l l already rise during the first years of the transition. After eastern wages have i n creased to 83 percent of the western level i n 1998, unemployment starts to decrease from a fairly high level of 35 percent. Even when investment subsidies are no longer paid i n 2001, high investment w i l l continue to raise eastern per capita output significantly. I n 2004 the full-employment marginal productivity of labor reaches eastern wages and unemployment w i l l fully disappear. Another four years later, eastern average productivity, that is the east-west ratio of per capita GDP, catches up w i t h the western figures by 90 percent while the respective number i n 2018 hits the 95 percent level. According to our projections about 1.3 million people, i.e. close to 8 percent of all i n i t i a l Easterners, eventually leave the East during the unification process. I n reality, the net outflow amounted to 1.1 m i l l i o n up to the end of 1995. To a certain extent this loss also results from demographic repercussions since mainly young and fertile cohorts decide to move.

year Figure 2: Per capita GDP, east-west ratio

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Subsequently, we take a closer look at the fiscal implications of the three different scenarios. As regarding the Ponzi-strategy, where no new taxes are raised i n order to finance the burden of unification, public debt rises tremendously (figure 3). The plotted unification-induced public debt starts w i t h a value corresponding to the granted social security wealth of i n i t i a l eastern agents distributed according to the western asset-holding profiles over the life-cycle. Since eastern agents are assumed to receive 80 percent of the Westerners social security wealth - which again makes up roughly half of the entire wealth - the eastern asset holding corresponds to approximately 40 percent of the corresponding western figure. Furthermore, note that eastern assets at unification which amount to 30 percent of GDP expand the public portfolio. Taking together both components, we start w i t h an i n i t i a l debt ratio of 18 percent i n the Ponzi-scenario.

Ponzi

FBR

/

1985

1990

/

/ •

•

1995

•

2000

2005

2010

year

2015

Figure 3: Public debt ratio

2020

2025

2030

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157

Due to high and increasing unemployment as well as investment subsidies, the ratio exceeds the margin of 50 percent three years before subsidies cease to exist i n 2001. From 2004 onwards unemployment benefits do not enter the budget and solely interest payments add to the public debt while private external debt is going to get repaid. Already i n 2013, the public debt ratio exceeds the margin of 75 percent. I n the year 2028, one entire Gross Domestic Product would be necessary to repay exclusively the debt accumulated during the transition. U n t i l 2001 remarkable trade balance deficits - which are not repaid i n the future - help to fund for unification. Hence, the Ponzi-scenario is rather hypothetical since the public debt ratio increases ad infinitum. As opposed to the Ponzi-strategy the taygo-scenario involves no explicit public debt. Instead the budget is balanced periodically. Since our agents are not allowed to play the Ponzi game the current account deficit is lower and the repayments are higher as compared to the Ponzi-strategy. This is due to the fact that the entire public and private debt is paid instantaneously. As i n the Ponzi-scenario, trade is balanced i n the long run. Taxes needed to balance the budget rise enormously (figure 4). I n the first decade following unification additional tax revenues of 5.8 percent of labor income are necessary on an annual average. Note that this tax rate is to be added to existing taxes which are not taken into account i n our setting for the sake of simplicity. A t the maximum, i n 1994, the balanced budget tax rate amounts to 6.4 percent. After that year, the tax rate decreases gradually up to 2001. Thereafter, only unemployment benefits induce a fairly low level of surplus taxes and i n 2004, no additional taxes are necessary to balance the budget and the entire burden of unification is paid by those cohorts working during the first 14 years following unification. Since Germany is already one of the countries w i t h the highest direct taxation, e.g. average income tax amounts to roughly one third, such high tax increases are not to be recommended on either efficiency or equity reasons. As regarding efficiency, excessively high and volatile tax rates involve exorbitant excess burdens. As regarding equity, i t seems to be unfair to levy the burden of such a historical event on only such a small cohort window. That was the reason, why we specified the FBRscenario which burdens all existing and future cohorts equally. This fiscal policy option minimizes tax rate variability and maximizes intertemporal equity. I n our calculation the tax rate which - if lasting forever balances the budget intertemporally w i l l amount to 1.4 percent of labor

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income (figure 4). Note that this result depends partially on the assumption of a stationary population.

year Figure 4: Tax rates

As shown i n figure 3 the debt ratio increases steadily u n t i l the year 2004 because tax receipts fall short of the periodical expenditures during that period. Afterwards they just suffice to keep the ratio constant at a level of 49 percent of the GDP. Note that this figure estimates an increment of outstanding debt to be added to the pre-unification ratio of 45.2 percent. Future Germany would thus display a ratio similar to those currently found i n countries like Canada, the Netherlands or Greece. As regarding the trade balance results of the FBR-scenario, they range between the Ponzi- and the taygo-scenario i n the transition since FBRtaxes range between the higher taygo tax and the zero Ponzi tax. I n the long run interest is paid to the rest-of-the-world and leads to a balanced current account while the trade balance reveals lasting surpluses.

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159

One question remains to be answered: How close is the present stance of fiscal policy to our FBR-recommendations shown i n figure 3? As seen from a first glance on table 1, the unification burden as measured by west-east transfers is debt financed by approximately 100 percent. Obviously, the burden of unification is shifted into the future by a far higher degree as compared to the FBR-scenario. However, substantial debt takeovers as well as "normal" deficits must be taken into account. To compare our findings w i t h the intertemporal stance of the actual policy, i t is more instructive to focus on the tax revenues during the recent past. I n order to distribute the burden equally over all presently living and future cohorts our model suggests an increase i n additional taxes by 1.4 percent of labor income, which corresponds to approximately 1.2 percent of the western GDP. Indeed, taxes have also been raised i n reality. According to the official statistics, additional receipts from for example increased gasoline tax, the temporary income tax surcharge, value added taxes, insurance tax, tobacco tax, and property tax added up to roughly 0.8 percent of the Gross Domestic Product i n the period 1991 to 1993 on average. The figure is substantially lower compared to the necessary tax increment i n the FBR-scenario. As a rule of thumb, this result illustrates that present generations avoid paying for approximately one t h i r d of their share while shifting this on to future generations who would have to bear a significantly higher burden as compared to presently living generations if the policy of the early transition years had remained valid.11 Being aware of these intergenerational imbalances, however, a revised fiscal strategy has recently been launched. From January 1994 gasoline taxes have increased according to the Standortsicherungsgesetz and from January 1995 the solidarity surcharge on income taxes was re-introduced according to the Föderales Konsolidierungsprogramm. I n sum, the additional tax receipts i n 1994 and 1995 are projected to amount to 1.3 and 1.4 percent of the western GDP. Hence, our findings suggest that during 1994 and 1995, the stance of fiscal policy has distributed the burden of unification more equally while burdening future generations slightly less than presently living generations. However, beginning i n 1996, the recently launched income tax reform w i l l lead to revenue losses which reduce the net effect of overall tax increases to 0.5 percent of western GDP (table 1). It is obvious, that the bias towards shifting the bur11

This finding is i n line w i t h the Generational Accounting results found i n Gokhale, Raffelhüschen and Walliser (1995).

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den of unification to future generations w i l l again be substantial from 1996 onwards. On a 1991 to 1996 average, approximately 0.9 percent of the burden of unification was tax financed while the remainder increased public debt. This is i n contrast to our FBR-scenario which suggest a portion of 1.2 percent through levying additional taxes. 1 2 Overall, roughly one quarter of the annual burden is shifted to future generations i n addition to the fair amount. To make things even worse, our FBR-estimates, must be qualified as fairly optimistic. The well known frictions, including undefined property rights, lacking administrative efficiency etc. as well as the fact that the former state property could not be sold at its fundamental values [Sinn and Sinn (1992, pp. 106 - 124)] imply that our FBR-tax rate must be regarded as a lower bound. Hence, our findings strongly suggest that during the first years of the integration process, fiscal policy was far from being intergenerational balanced. Instead, the pressing problem of how to fund unification was faded out by shifting the major part of the burden into the future.

5. Summary This paper analyzed the dynamic transition following the unification i n Germany both via an examination of the effects occurred meanwhile and via a highly stylized numerical approach. According to the integration process of the eastern - former centrally planned - economy we developed an optimistic point of view. Even i n what Sinn and Sinn (1992, p. 152) called an high-wage-high-tech hypothesis where eastern labor is to be subsidized to a high extent, the optimistic viewpoint holds. If our model reflects reality fairly w e l l , 1 3 the eastern economy w i l l catch up w i t h the West w i t h i n the 1990s to a degree of roughly 80 percent.

12 Note that we do not simply suggest substantial tax increments i n order to induce a fair intergenerational distribution of the burden of unification. Of course, this would lead to an increasing public share i n the GDP which might not be acceptable for reasons of efficiency. As an alternative, an expenditure-cut-scenario could be modelled equivalently to the FBR-scenario, but is, however, plagued by the problem of specifying the intergenerational dimension of public expenditures. 13 We are aware that our model i n fact can only be regarded as a very rough back-of-an-envelope calculation. A l l problems concerning the institutional settings, e.g. the lack of defined property rights, the absence of an efficient administration etc., are neglected. Nevertheless, we consider our results as 'educated guesstimates'.

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W i t h respect t o t h e stance of f i s c a l policy, o u r results are f a i r l y o p t i m i s t i c . O u r f i n d i n g s suggest a ' f i s c a l - b a l a n c e - r u l e ' - s t r a t e g y t o d i s t r i b u t e t h e b u r d e n of u n i f i c a t i o n u n i f o r m l y over a l l e x i s t i n g a n d f u t u r e l i v i n g cohorts. T h i s w o u l d i n v o l v e s u r p l u s t a x revenues of 1.2 p e r c e n t of t h e w e s t e r n GDP. D u r i n g t h e f i r s t five years of t h e i n t e g r a t i o n process, taxes have i n c r e a s e d b y i n s u f f i c i e n t 0.9 p e r c e n t of t h e w e s t e r n G D P o n average w h i c h is e x p e c t e d t o decrease i n t h e m e d i u m f u t u r e . A s a consequence of t h i s policy, p u b l i c d e b t rose r e m a r k a b l y . T h e recent t a x a m e n d m e n t s , i n d i c a t e a c o n t i n u a t i o n of t h e t e n d e n c y t o l e v y t h e b u r d e n r e l a t i v e l y m o r e o n f u t u r e generations.

Abstract This paper examines fiscal policy options w i t h i n a dynamic general equilibrium model for unified Germany. I n a two-region setting w i t h overlapping cohorts we simulate the dynamic transition path of the eastern economy's catching-up process and exhibit the implications of levying the burden of unification either on presently living or future generations. International capital flows as well as interregional labor migration are thereby taken into account. Additionally, we derive a fiscal strategy which emphasizes intergenerational redistribution i n a well balanced manner.

References Abel, A. B. (1978) 'Investment and the value of capital', Research report, Federal Reserve Bank of Boston. Akerlof , G. Α.; Rose, A. K.; Yellen, J. L. and Hessenius , H. (1991) 'East Germany i n from the cold: The economic aftermath of currency union', Brookings papers for economic activity, no. 1. Allais , M. (1947) Economie et interèt (Paris: Imprimerle Nationale) Barro , R. J. and Sala-i-Martin, Hill).

Χ. (1995) Economic Growth (New York: McGraw

Bröcker, J. (1992a) 'Eastern Germany's catching-up: A dynamic simulation', m i meo, University of Kiel. - (1992b) 'Konvergenz und Divergenz: Myrdal und Kaldor aus neuer Perspektive', mimeo, University of Kiel. Bundesministerium für Finanzen (1992, 1993, 1994, 1995) Finanzbericht, 1992, 1993, 1994, 1995 (Bonn: BMF). 11 Konjunkturpolitik, Beiheft 45

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Burda , M. (1992) 'The determinants of East-West German migration - some first results', European Economic Review, vol.37, pp. 452 - 461. Deutsche Bundesbank (1990) Monatsberichte der Deutschen Bundesbank, Juli. Diamond , P. Α., (1965), 'National debt i n a neoclassical growth model', American Economic Review, vol.55, pp. 1126 - 1150. Gokhale, J.; Raffelhüschen , Β. and Walliser ; J. (1995) 'The Burden of German U n i fication: A Generational Accounting Approach', Finanzarchiv, vol.52, pp. 141 165. Hayashi, F. (1982) 'Tobin's marginal and average : a neoclassical interpretation', Econometrica, vol.50, pp. 213 - 224. Institut der deutschen Wirtschaft (1993) Informationsdienst des Instituts der deutschen Wirtschaft, 37. Kotlikoff, L. J. (1993) 'From deficit delusion to the fiscal balance rule: Looking for an economically meaningful way to assess fiscal policy', Journal of Economics, suppl.7, pp. 17 - 4 2 . Kitterer, W. (1993) 'Rechtfertigung und Risiken einer Finanzierung der deutschen Einheit durch Staats Verschuldung', in: Karl-Heinrich Hansmeyer (ed.), Finanzierungsprobleme der deutschen Einheit (Berlin: Duncker & Humblot), pp. 39 76. Krugman , P. (1991) 'Increasing returns and economic geography', Journal of Political Economy, vol.99, pp. 483 - 499. Raffelhüschen , Β. (1992a) 'Labor migration i n Europe: Experiences from Germany after unification', European Economic Review, vol.7, pp. 1453 - 1471. - (1992b) 'How to avoid major relocation of labor: The case of reunified Germany', Working paper of the Department of Economics, University of Bergen, no. 0692. - (1994) 'Migration i n Germany after unification', mimeo, University of Kiel. Sachverständigenrat zur Begutachtung der gesamtwirtschaftlichen Entwicklung (1992) Jahresgutachten, 1992 / 93, (1993) Jahresgutachten, 1993 / 94, (1995) Jahresgutachten, 1995 / 96 (Stuttgart: Metzler-Poeschel). Samuelson , P. A. (1958) 'An exact consumption-loan model w i t h or without the social contrivance of money', Journal of Political Economy, vol.66, pp. 467 - 482. Schalk, H.-J. and Untiedt, G. (1995) 'Unterschiedliche regionale Technologien und Konvergenzgeschwindigkeit i m neoklassischen Wachstumsmodell', Discussion paper of the IFO-Institut, Munich. Sinn , G. and Sinn , H.-W. (1992) Jumpstart - The economic unification of Germany (Cambridge: M I T Press). Statistisches Bundesamt (1992) Wirtschaft und Statistik, Heft 7, (1993) Wirtschaft und Statistik, Hefte 2 und 6, (1994) Wirtschaft und Statistik, Hefte 5 und 7, (1995) Wirtschaft und Statistik, Hefte 1 und 8.

Comment on: J. Bröcker and B. Raffelhüschen, Fiscal Aspects of German Unification: Who is Stuck w i t h the Bill?

By Frank D. Weiss

There is no doubt that this is a highly competent piece of work that is very useful for evaluating some fiscal aspects of German unification. I t w i l l be of obvious interest for tax planning and for the politics of burden sharing, particularly intertemporal burden sharing. M y only criticism of the paper is that i t takes too much as institutionally given, so that alternative policies are given much too short shrift. Alternative policies are taken by the paper to mean differently distributed intergenerational payment streams; different policies toward coping w i t h unification, which would result i n different "bills for unification", and different economic costs receive far too little attention. I t is central to note that the size of the " b i l l " being considered is most explicitly not the economic cost of unification. Rather, i t is the size of the transfer required to sustain a certain, very specific policy to cope w i t h unification. What is missing from the analysis on its own grounds is a consideration of the costs of the policy presently pursued. This would i n volve a calculation of the deadweight losses associated w i t h the present investment (physical capital) subsidy program as well as the deadweight losses resulting from the given tax system, both considered intertemporally. Now, doing all this extra work would require a different paper, probably a different model, so that i n a sense is an unfair demand. However, if I understand the model correctly, the economic cost of one policy measure or institutional constraint can be simulated fairly easily, and that is the distinguishing feature of German policy toward unificationkeeping the real wage well above market clearing levels. Additional simulations of income transfer measures might well be undertaken to gauge the overall fiscal impact as against the economic cost of such a policy. As i t stands, the paper measures the cost of a particular policy toward unification, and not the costs of unification. 11

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More on the paper's own grounds, the analysis of the intertemporal distribution of gains and losses, like another paper on the income distribution consequences of transition presented at this conference, is essentially arbitrary. I t is certainly worthwhile knowing (calculating) the various tax rates over time which are required to prevent a Ponzi scheme or t i l t the burden more to the present or more to the future; i t is quite another to deem equal intergenerational distribution of costs as the relevant standard, or implicitly, as the relevant goal. As one w i t has put it: "What have future generations ever done for me?" Before I t u r n to the issue of intergenerational equity, a few simple lessons from Public Finance can go quite a stretch to illuminate this matter. First, future generations i n East Germany w i l l have inherited a larger capital stock (measured i n efficiency units) than otherwise. Should they not be able to bear a higher burden easily? Second, future generations i n West Germany may well inherit a smaller capital stock, though this may be i n large measure attributable to the policy pursued rather than the fact of unification. Should they therefore bear a lesser burden? This logic suggests the distributional issue is not so much an intertemporal one, though i t is that, too, but an East-West one. Looked at i n this way, one can see that the group necessarily "taking the h i t " is present West Germans. Now, i t is inefficient to take a h i t all at once; i t is efficient to spread the costs over the future. I t is clear that future East Germans as well as future West Germans pay something, but this analysis does not make clear which side might reasonably be expected to bear a disproportionate share of the costs. This attempt to apply some simple lessons from public finance, though illuminating, reveals that an explicit treatment of the distributional issue cannot be avoided. A helpful analytic device, introduced by Harsanyi, and applied in extenso by Rawls, that might be used here is the "veil of ignorance", behind which self-interested individuals rationally reveal their preferences for distributional rules. While the device has great appeal, i t can be used to justify almost any k i n d of redistributional system, depending on how much information is available to the decision makers behind the veil, and what their degree of risk aversion is. What is a reasonable standard for us? Historically, whether a German became an East German or a West German had to do w i t h an accident of place of birth; the West Germans were lucky compared to the East Germans. This amounts to a simple insurance problem. I suggest assuming a usual degree of risk aversion, and the state of information about ίμΐΉΌ Soviet and western economic policy available i n 1945. Then one could ask what

Frank D. Weiss: Comment

a German living i n 1945 would have been w i l l i n g to pay to live i n the Western zones of occupation w i t h certainty. I n other words, how much would he have been w i l l i n g to pay for "East German" insurance? I suspect a lot. If so, a large West to East transfer is justified, some of course falling on future generations of Germans born i n the western part of the country. I don't wish to push my answer, which depends on information available i n 1945 rather than 1940, or 1960, but I do t h i n k such questions need to be, and can be, addressed explicitly. Similar Gedankenexperimente might fruitfully be undertaken for the alleged changes i n income distributions i n the other transition economies. A specific, technical aspect of the simulations which needs to be addressed is the great quantitative impact of one particular paramenter i n the model, the catch-up parameter. Obviously, the higher the rate of catch-up, the lower the fiscal transfers implied by present policies. The authors import the estimate propagated by Barro as "The Iron Law of Convergence"-the half-life of a given productivity gap is thirty five years. This parameter estimate is based on cross country and cross region convergence rates, holding constant everything i n sight. Now, no cross section regression of past convergence rates can be used to predict anything about future convergence of transition economies, unless historical catch up experience is on average like catch up conditions i n the transition economies, or if the places i n which i t has been similar are captured by corresponding empirical proxies. To my knowledge, neither is the case. Here, a sensitivity analysis really is called for, and an opinion about convergence rates should be ventured. This lack of relevance of cross country regessions, as they have been done, doesn't mean there are no historical analogies to developments i n Germany. I n part, there is an almost exact one. While the similarities between East Germany and Italy's Mezzogiorno have been widely noted, I wonder how well known i t is that i n two respects the analogy is exact. I n general, the Italian State, too, has always had a policy of support toward the South, that is from unification. But specifically, first, since just after the Second World War Italian policy toward the South has been one of capital subsidy accompanied by relatively generous unemployment benefits. This has lead to a widely commented upon increase i n (physical) capital intensity surely detrimental to employment and efficiency. The only respect i n which German policy is more appropriate than the Italian is that i t has been less selective. Second, since the early to m i d nineteen sixties, Italian labor law, like Ger-

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man labor law, has made i t difficult to vary the real wage by region-not impossible, just difficult. Since then, the Italian unemployment rate jumped upward once, and stayed up. Tellingly, most of that increase was concentrated i n the South. This policy, or better institution, is something the South has never recovered from. But like the problem for Italy as a whole, the problem for Germany as a whole is one of policy or institutions. A change i n institutions could reduce the size of the deadweight losses and the fiscal transfer i n both Italy and Germany.

Transition to Markets i n CEFTA Countries A Comparative Overview By A n t o n i n

Rusek

1. Introduction CEFTA 1 members are Poland, Hungary, Slovakia, Czech Republic and (from January 1996) Slovenia. Today's CEFTA is a rather loose association of countries ostensibly dedicated to fostering links among themselves via the promotion of mutual free trade. Some results were undoubtedly achieved. M u t u a l trade i n manufactures was largely liberalized and some - albeit meager - progress was reached i n financial liberalization. On the other side, the liberalization of agricultural trade became a rather intractable issue (so what else is new i n the contemporary world?). On balance the CEFTA as an organization remains rather dormant and its very existence sometimes surprises even some of those who consider themselves experts i n the post-Soviet economic and p o l i t i cal realities. This relative insignificance of CEFTA as an organization should not be surprising. The trade w i t h CEFTA partners constitutes only a small fraction of the overall international trade for each CEFTA member today (the mutual trade between the Czech Republic and Slovakia was an exception but even this seems to be disappearing rather fast). Except for Poland, all other CEFTA countries are small). 2 This does not make their internal markets especially attractive prospects for producers i n other member countries. Languages (except the Czech and Slovak) are sufficiently dissimilar to be mutually incomprehensible. This, aided by the persistent historically given national animosities, effectively eliminates any significant labor mobility between the member countries.

1 2

The acronym CEFTA stands for Central European Free Trade Association. Detailed statistical information is available from the author on request.

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Finally, the major obstacle to CEFTA's development into a functional regional economic organization are attitudes of member countries' governments. A l l of them consider CEFTA a sort of temporary arrangement, a stepping stone on their way to join the E U and NATO. Such an attitude may be naive and perhaps counterproductive as far as geopolitical realities i n the region are concerned, but i t certainly enjoys a widespread public support i n all member countries. 3 I t is therefore rather pointless to discuss the CEFTA as a regional economic organization i n such circumstances. Hence, the discussion i n this paper w i l l treat CEFTA countries as individual and distinct economic, political and social entities, albeit w i t h some rather significant common characteristics. The discussion of such a momentous event as the transition from cent r a l planning to markets i n five countries is, indeed, the topic for a book (or several books). I t cannot be comprehensively treated i n a rather short conference presentation as this one. The choices must be made. I decided to concentrate on the general "open macroeconomy" aspects of the transition process and the economic performance of the four original CEFTA countries (Poland, Hungary, Slovakia and the Czech Republic). The short term prospects of each individual country w i l l be assessed as well. The references to Slovenia w i l l be made when feasible. 4 The paper is organized as follows. Part 2 looks at the history of each CEFTA country, w i t h a special emphasis on the economic reforms i n the 1980's and the first phase of the transition, covering the period t i l l 1992. Part 3 assesses the performance of individual economies i n the 1992 1995 period. Part 4 then makes some educated guesses about the possible economic performance of the each individual CEFTA country i n the near future (next 2 - 3 years).

3 Attitudes of some local politicians toward CEFTA are outright paranoid. For example the Czech Republic's Prime Minister V. Klaus accuses E U of fostering CEFTA as the way of delaying Czech Republic's joining of E U - see his 'performance' i n the World Economic Forum meeting i n Davos, Switzerland, i n January 1996. 4 I t should be remembered that Slovenia was the first of former Yugoslav republics to gain its freedom i n June 1991. However, its economy was strongly affected by Serbian aggression against Croatia and Bosnia-Herzegovina.

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2. History: economic reforms and the initial transition policies 2.1 The socialist past

A l l CEFTA countries 5 constituted the westernmost part of the former Soviet Empire - formally independent 6 but firmly under the tutelage of Moscow's rulers. Historically - i.e. culturally, politically and economically - they are heirs of the Austro-Hungarian Empire, w i t h strong Germanic influences i n Poland. What i t means is that those countries are not quite western being separated from Atlantic cultures by the barrier of modern Austria and Germany. But they are certainly not Eastern (in the sense of being culturally orthodox) or Moslem either. The aspirations of the people are and always were oriented toward the west. 7 Communism, the ultimate product of Russian soul and the pinnacle of orthodox culture, was obviously alien to such a milieu. Contrary to common perceptions and popular opinions, Eastern Europe was one of the socially and politically most unstable areas of the w o r l d during the dominance of Soviet Empire. The chain of revolts, uprisings, strikes and more mundane reform efforts is the most striking characteristic of the epoch between 1953 and 1989. The sources of resentment and resistance were both cultural and economic. A n imposition of communism was accompanied by the wave of terror intended to severe any connections the new local ruling elites might preserve w i t h population and by the mandatory intellectual gobbledygook stemming from orthodox traditions and totally incomprehensible to normal men. Simultaneously, i t included large economic dislocations, hardships and a general decline i n the living standard. Such a dynamic was very painful for those Poles, Czechs and Slovaks who considered themselves victors of the W.W.II and who could now only observe (and even that w i t h great difficulties) their standard of living falling more and more behind their recent enemies. The situation of an inherent political instability and an incipient popular revolt forced East European rulers to seek ways how to alleviate at least some of the economic regression and social alienation. The pro5 Because this part deals only w i t h the period before 1992 - 93, references w i l l be made to Czechoslovakia unless the context requires otherwise. 6 Ex post this appeared to be an advantage i n the transition. 7 'Easternized' behavior is still quite common i n Prague, less so i n Warsaw, Budapest or Laibach. But these are the legacies of a recent past, not to be confused w i t h general aspirations.

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cesses of economic reforms of central planning started i n the Eastern Europe quite early - i n Hungary i n 1954, i n Poland i n 1956 and i n Czechoslovakia i n 1957. The stated goals of these reforms were to i m prove the efficiency of the resource allocation and utilization via introduction of some market and/or quasi-market elements into the mechanism of central planning. However, the reform efforts i n all countries were always constrained by the perceived need to preserve the basic tenets of socialism as defined by Moscow - i.e. the full political and power control by a Communist Party, the effective state ownership of almost all resources and the dominant role of a political and economic center i n the resource allocation. The interplay of popular aspirations, domestic political powerplays and Moscow's political struggles made for a fascinating but often confused picture of the dynamics of political and social reforms i n what today are CEFTA countries. Periods of "successes" were followed by periods of "retrenchments" or "retreats". A n d at least twice the reform effort resulted i n the catastrophe - when Soviets occupied Hungary i n 1956 and Czechoslovakia i n 1968. I n such circumstances the reform process was not only uneven i n individual countries, but among the countries as well, often going i n different directions i n different countries during the same time. The result, of course, was that when a real opportunity struck by the end of 1989, the countries under consideration i n this paper (Poland, Hungary and Czechoslovakia) differed substantially from one another. Hungary was perhaps the most advanced i n the reform process. By the time the Hungarian late communist regime was swept away i n the March 1990 elections, 1/3 of domestic prices were already free and another 1/3 were effectively free - w i t h only loosely binding upper limits on the rates of change. The foreign trade was re-oriented toward the West (with only about 30% of the total w i t h COMECON partners) and the foreign exchange was essentially available on demand for the most of current account transactions. The small scale private sector and joint ventures were booming. The major Hungarian problems were foreign debt and gradually rising inflation. Both problems were consequences of rising domestic budget imbalances - reflecting the efforts of late communist governments to ease their stranglehold on the control of resources w i t h out being quite w i l l i n g to pay the necessary price i n the form of an i n come redistribution.

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Poland was also well advanced i n the reform process, but the Polish situation was different. Attempts to improve the economy and living standards by massive borrowing and import of capital goods i n the early 1970's failed, but left behind a significant debt burden. A failing economy generated almost a permanent conflict between the people (represented by the Solidarity union from 1980) and the Polish late communist rulers. I n this environment the Polish government gradually traded their control over economic resources for the continuing political and power dominance of the Communist Party (the sine qua non thought necessary to keep Moscow's armies i n Russia). The major phenomena representing this trade-off were: a) the decentralization of the state economic organization which reduced the role of planning and increased the role of i n dustrial ministries (which often represented interests of firms they were supposed to manage rather than interests of government); and b) the rise of power and influence of workers' councils i n individual enterprises. 8 But at the same time the debt service situation required growing transfers of domestic resources abroad. The Polish government solved its dilemma by a classical way - running budget deficits financed by an inflation tax. But accelerating inflation i n the essentially price controlled environment and i n the economy w i t h the strong self-management elements on the enterprise level has especially insidious impacts. 9 Because of this the Polish society i n the late 1980's become ungovernable and the Polish economy was collapsing. Czechoslovakia, i n contrast to both Hungary and Poland, was still the essentially centrally planned economy i n 1989. The Czech reform effort culminating i n the brilliant year of 1968 challenged the w o r l d of socialist orthodoxy (and much more) i n the way never seen before or after. However, the Warsaw Pact attack and the subsequent occupation of the country was almost a death knell. A l l reform effort was effectively quenched and the country went into the "winter sleep" w i t h a good chance never 8 There are reasons to t h i n k that Polish late-communist government accepted workers councils i n enterprises i n the hope that the workers dissatisfaction w i l l be directed toward their local managers - and hence that the nationwide Solidarity movement aimed against the socialist system w i l l be weakened. If so, this policy backfired. 9 A n inflation process i n the environment of controlled prices means that goods are disappearing from official markets where prices are controlled and appear i n black markets where uncontrolled prices skyrocket. Strong elements of workers self-management then make i t much easier for workers to relax the labor effort and discipline and to increase their nominal wages. Both are i n fact needed if workers are to be able to keep i n step w i t h increasingly black market economy. The macroeconomic consequences of such a dynamic are obvious.

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to wake up again. Economically speaking the situation meant that the Czechoslovak communist government maintained the f u l l control over the country resources and their allocation, including the f u l l operational control over productive facilities. This survival of central planning meant that a) the economy preserved a strong orientation on its COMECON partners; b) the capital base was becoming increasingly obsolete - and this was only strengthened by an effort of ruling communist party structures to maintain consumption (in the interest of social peace) at the expense of capital formation; and c) the domestic price system was determined by government w i t h interests of central planning i n mind. That is, the existing system of relative prices looked more like the table of random numbers rather than anything else.

2.2 The beginning of the transition processes

The present day consensus as far as the transition from central planning (or more precisely from the late socialist economic system) to markets is concerned stipulates four basic steps which must be undertaken simultaneously at the beginning. I.e. the first phase of the transition process consists of: 1) Domestic price liberalization - needed i n order to restore microeconomic equilibria and to provide the newly emerging markets w i t h a market based signaling system (i.e. the relative prices reflecting supply and demand). 2) Foreign trade liberalization including a market clearing exchange rate regime. This is needed to provide desirable foreign competition to newly autonomous (see below) domestic producers. But perhaps more importantly i t provides a sort of anchor to the emerging domestic relative price system at times of an enormous uncertainty and when everybody just started to learn. 3) The fiscal reform - governments must take control of their revenues and expenditures. 4) A n enterprise autonomy as the first step towards enterprise independence. This includes the measures attempting to re-enforce a hard budget constraint like wage controls, a liberalization of rules for a new private business creation, removing restrictions on operations of existing private businesses etc. From 1989 onwards all CEFTA countries implemented policies defined by steps 1) to 4) above. Of course, due to different starting conditions po-

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licies actually implemented may seem different - but i n fact all the countries discussed here followed the same pattern, had very similar goals and achieved very similar results by 1992. Poland acted first and seemingly i n the very radical way. But as noted above by 1989 the Polish economy was disintegrating. The quick action was the absolute necessity. Three months after i t took office i n September of 1990, the new Solidarity government implemented all four steps specified above immediately and simultaneously from the January 1, 1990 - hence a "big bang" strategy. I t worked. 1 0 Price and foreign trade liberalizations, coupled w i t h a predictable near equilibrium exchange rate regime quickly wiped out the black market economy and together w i t h the newly established freedom of enterprise restored incentives to work and save. A radical reduction of the black market economy improved the government tax base. This together w i t h reduced government expenditures reduced budget deficits and hence the need to rely on the inflation tax i n financing public sector. Finally, the punitive wage tax helped to harden the budget constraint for many companies still strongly influenced by workers' councils. By 1992 Polish retail inflation was down to about 45%, the current account was balanced and the economy experienced its first actual growth from the 1970's. On the other side the budget deficit still hovered around 6% of GDP and the unemployment reached almost 13%. Finally, the attempts to officially privatize the extensive state sector failed. However, the unofficial (and probably somewhat illegal) transfer of state assets into private hands - which started probably i n the last year of communist regime - continued, contributing to the rapid growth of new private businesses. The share of the private sector i n Polish GDP reached about 70% i n 1992. Hungary was chronologically the second country switching from "economic reforms" of socialism to a transition to markets. However, the Hungarian starting position was different. When the new conservative government took office i n A p r i l 1990, domestic prices and foreign trade were liberalized to a significant degree. Hence additional measures i n these areas were perceived more as a gradual acceleration of the existing 10

Not ideally. The inflation was higher and persisted longer than predicted by architects of the Polish stabilization program and their I M F advisors. Similarly both the output decline and the rise i n unemployment exceeded original expectations. But an 'overoptimism' is almost a structural characteristic of all stabilization programs.

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trend than a radical new approach. The same can be said about the measures related to the step 4) above. I n contrast to Poland and especially to Czechoslovakia (see below), Hungarian large enterprises were autonomous and the private sector dominated among small businesses. What the new Hungarian government failed to do was to take control over its own finances. Even i n 1992 government expenditures exceeded government revenues by almost 7% of GDP. One surmises that this phenomenon may be the consequence of the fact that i n 1990 Hungary was the "most reformed" of all former COMECON countries. Price and foreign trade liberalizations, even when accelerated, d i d not produce the same k i n d of the inflationary shock as i n Poland and Czechoslovakia. Thus no policies of an aggregate demand containment were deemed necessary. On the contrary, because aggregate demand for Hungarian goods was falling due to the COMECON disintegration - leading to a declining GDP and a rising unemployment - any further steps i n this direction were considered undesirable. Moreover, the high level of government expenditures relative to revenues was partially related to the needs of the official debt service. Finally, even i n the 1990- 1992 period (and i n fact t i l l today) Hungary maintained an excessively high share of personal consumption i n GDP (officially reported around 70%). This is somewhat puzzling and difficult to explain. I t h i n k i t is related to two things. First, a personal consumption was strongly encouraged i n the days of reform "goulash" socialism. A n d what is once learned . . . A n d second, i t is alleged that most of the Hungarian privatization took place via so called spontaneous (i.e. the i l legal, but condoned) appropriations of formerly state owned assets by private individuals. If this was so then indeed the demand for private savings w i l l be relatively low and a private consumption w i l l be correspondingly high. Czechoslovakia is the only country i n our sample which started its transition toward markets straight from a centrally planned economy. Moreover, i t can be argued that the country was pushed into changes by the fact that the w o r l d of "real socialism" was collapsing all around i t i n the late 1980's. That perhaps explains an excessive caution and a rather bookish approach to the transition process on the side of Prague authorities. More than a year elapsed between the formation of the non-communist government i n Czechoslovakia i n December of 1989 and the commencement of a transition process i n January 1991.

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For the first two years the Czechoslovak transition process followed the blueprint outlined above i n steps 1) - 4). The rationale for such an approach is easy to see. The central planning distorted both the price structure and the composition of aggregate demand. Hence, both domestic and foreign liberalizations were absolutely necessary starting points for any process aimed at the creation of a market economy. Czechoslovak communist governments maintained a tight and effective control of resources during the 1970's and 1980's so that the maintenance of the fiscal discipline during the first phase of the transition was not a big problem. Shifting to an enterprise autonomy and especially opening up the space for a creation of new businesses proved to be immensely popular. This is understandable i n the view of a legacy of central planning which left enormous gaps i n the economic structure of the country - especially i n areas of consumer oriented and information services. The major problem of the Czechoslovak transformation process appeared to be its differentiated impact on the different parts of the country. Such phenomenon probably existed i n all transformation countries. But Czechoslovak misfortune laid i n the fact that an impact differentiation line roughly coincided w i t h the ethnic division of the country between Czech and Slovaks. 1 1 The resulting strain was too much and i n January 1993 the country disintegrated into the independent Czech and Slovak Republics. But by then the first phase of the transition was essentially completed not only i n these two new countries but i n Poland and Hungary as well. Given the just described varieties of transition processes and experiences the results were remarkably similar. A l l countries experienced about 20% decline i n the overall economic activity, reached about 2 years after the commencement of the transition processes themselves. (Transition, February 1996.) After an i n i t i a l spike the inflation declined and stabilized approximately between 10% and 30%. Unemployment gradually increased and stabilized between 10 - 15% (except i n the Czech Republic where i t remained notoriously low at about 3%).

11

To too many people it appeared that the poorer and economically weaker Slovakia carried the brunt of transformation costs. I n 1992 (the last year of the common Czechoslovak state) the unemployment i n Slovakia was about 4 times as high as i n Bohemia and Moravia (i.e. i n what is today called the Czech Republic). The major reason for such differences were different industrial structures. Slovakia being more to the East had a disproportionate part of armaments and other COMECON oriented industries. A n d those were early victims of transition processes.

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Finally, what is perhaps the most important is that by 1992 all countries discussed here (i.e. the Poland, Hungary, Slovakia and the Czech Republic) ceased to be socialist economies and became market economies. Primitive perhaps, w i t h a lot of modern market institutions either still missing or non-functional but market economies nevertheless. A n d i t is perhaps from this point - i.e. 1992 - when the effort to b u i l t modern market economies i n CEFTA countries really began. The next part w i l l look at results of this effort up to date.

3. Toward modern market economies: 1992 - 1995 The second phase of a transition towards a market economy consists of steps i n the following areas: 5) The creation of the basic institution of a market economy - i.e. the private sector. 6) The process of building a functioning financial sector, legal system and decentralized and coordinated state administration. 7) A deep reform of the educational system. 8) The introduction of policies aimed at a social stabilization and the restoration of an economic growth. The list may not be exhaustive but i t consists of basic mutually dependent measures necessary for the newly created market economies to flourish and grow. 5) is obviously the key, but i n some sense the most problematic step. The majority of productive assets i n socialist economies were formally owned by the state. Effectively (i.e. as far as the actual exercises of ownership functions were concerned) the state ownership survived intact only i n Czechoslovakia. I n Hungary i t was diluted i n favor of management (but sometimes i n favor of workers as well) by the cumulative effect of 1980's reforms. A n d i n Poland the effective state ownership of productive assets ceased to exist by the m i d to late 1980's, being replaced by a "social ownership" dominated by workers councils. Such significant differences i n forms of effective ownership of productive assets by the end of a socialist era had a deep impact on the process of the formation of private sector i n the individual countries and, by i m plication, on their economic performance i n the 1992 - 1995 period. The Czechoslovak situation was easiest and the most manageable. U n disputed effective state ownership enabled the new non-communist state

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to dispose of productive assets i n an orderly and organized way. First, the small shops and enterprises were transferred to a private ownership (via auctions) between 1990 and 1992. Then the larger state companies were commercialized - i.e. transformed into joint stock companies - and their shares were distributed among the population at large via the so called "voucher privatization" scheme. This process started i n the late 1991 and continued i n the Czech Republic t i l l the beginning of 1995. By 1995 about 70% of the Czech Republic's GDP was produced by the p r i vate sector. Slovakia, however, interrupted the process of "voucher p r i vatization" after its first wave (spring 1994) so that only about 50% of Slovak GDP was produced by the private sector i n 1995. One extraordinarily important remark should be made here. I n 1990 an average Czechoslovak citizen (i.e. either Czech or Slovak) owned zero assets. By the end of 1994 an average Czech owned $ 30.000 and average Slovak somewhat less - at least on the paper. This journey "from rags to riches" via state handout had a profound impact on the individual savings and consumption behavior and hence on the economic dynamic of the country, especially i n the Czech Republic. I n this context the Slovak interruption of "voucher privatization" had rather unexpected consequences (see below). 1 2 I n Hungary most of small businesses were created before 1990. Large enterprises were at that time controlled by their management which used this position to transfer most of productive assets under their de facto control into their de iure ownership - the process called "spontaneous" privatization. No formal privatization plan like the one i n Czechoslovakia was undertaken and none was probably seriously contemplated. The government privatization agency was created but its work was effectively limited to organizing foreign interests i n Hungarian state owned assets. Despite the enormous visible differences i n their approach to privatization the Czechs and Hungarians had one thing i n common. Most assets "accumulated" by the private sector after 1990 came as a result of transfers from the state sector. A n d i n Hungary, as i n the Czech Republic this k i n d of creation of the private sector had a significant impact on the p r i vate savings and consumption behavior w i t h negative consequences for an economic dynamic. Curiously enough, the share of the private sector 12 I t may be argued that most of wealth transferred to individuals via 'voucher privatization' has only a paper value. Perhaps. But as long as it is perceived to be real it has real behavioral consequences.

12 Konjunkturpolitik, Beiheft 45

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i n Hungarian GDP i n 1995 was around 70% - approximately the same as i n the Czech Republic. When the Polish transition to markets commenced the most productive assets outside agriculture were formally state owned. Practically, however, those assets were controlled by workers councils. A n d as i t turned out this control was probably the main obstacle to any organized privatization of formally state owned assets i n Poland. Many plans were suggested, some even approved by the Polish Parliament, but none was ever implemented. Of course, a noninsignificant amount of spontaneous p r i vatization took place i n Poland. But having i n general only a limited access to state owned assets the only way for most Poles to acquire private wealth was to save out of a current income. A n d Poles d i d save, creating a vigorous private sector i n the process. A n d curiously again, the share of private sector i n Polish GDP is about 70% - very similar to shares i n Hungary and the Czech Republic. There is an interesting (and for some somewhat unexpected) affinity between the GDP growth, private savings and the methods of creating a private sector i n CEFTA countries. 1 3 Poland has the consistently highest GDP growth rate and the highest rate of private savings. But its organized privatization process bogged down. The second highest growth rate and second highest savings rate belongs to Slovakia - the country where the official privatization process was interrupted i n 1994 and so far i t was not resumed. The last two places i n both categories (of GDP growth and the rate of private savings) belong to the Czech Republic and Hungary. Both are the countries where the bulk of the existing private sector was created by the transfer of formerly state owned assets into private hands. Moreover, the Czech privatization program is often taunted as both highly organized and highly successful. But this result should not be surprising. The standard microeconomic theory postulates an inverse relationship between an individual's wealth and his rate of saving out of a current income. I t is therefore not surprising that if an individual believes that his real wealth suddenly increased (say due to redistribution of state owned assets via voucher privatization) his saving rate w i l l decline. But lower saving rate means i n the East European circumstances lower domestic savings, hence lower domestic investments and lower GDP growth. 1 4 13 See footnote 2. 14 The relationship between domestic saving, domestic investment and growth is still not well understood, leading to a large gap between the implications of

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To m a k e progress i n t h e v e r y i m p o r t a n t areas l i s t e d above as 6) a n d 7), a d d i t i o n a l resources are needed. I n t h e l o n g e r r u n those m a y b e o b t a i n e d o n l y v i a e c o n o m i c g r o w t h i n t h e r e a s o n a b l y s t a b l e society - hence t h e i m p o r t a n c e of step 8). Because a l l C E F T A c o u n t r i e s e x c e p t P o l a n d are s m a l l o p e n economies t h e g r o w t h o r i e n t e d p o l i c i e s s h o u l d t a k e i n t o a c count b o t h domestic a n d i n t e r n a t i o n a l constraints. Obviously, the disc u s s i o n of e c o n o m i c p o l i c i e s i n 4 c o u n t r i e s over 4 years r e q u i r e s m o r e space t h a n is a v a i l a b l e here. For t h i s reason a n d because those p o l i c i e s c h a n g e d v e r y o f t e n w e w i l l c o n c e n t r a t e o n t h e e v a l u a t i o n of results. On the b r o a d socio-political plane, the stability i n CEFTA countries w a s a c h i e v e d b y 1992 - 9 3 . 1 5 P o l a n d , H u n g a r y a n d S l o v a k i a w e n t t h r o u g h successful a n d o r d e r l y transitions f r o m center-right to center-left w i t h o u t noticeable social u p economic theory and reality Theoretically (Kindleberger, 1989, Modigliani 1986) saving and investment must equal worldwide but not necessarily i n each individual country. Investment opportunities i n country A may exceed domestic saving leading to a capital inflow and current account deficits. But investment generates an economic growth i n A and via lifecycle hypothesis an increase i n A's saving rate. This not only eliminates the gap between between domestic saving and investment - and hence current account deficits - over time but generates enough domestic savings to cope w i t h an accumulated past debt. The implications for economic forecasts and policy are as follows. The current account deficits generated by the i n i t i a l surplus of domestic private investments over domestic private savings are not a problem. On the contrary, such deficits signal stronger growth i n the future which w i l l then correct current imbalances. Theoretical conclusions are, however, at odds w i t h empirical observations. Studies of Feldstein and Bacchetta (1991), M c K i b b i n (1993) and L a i (1993) conclusively showed that i n the real world, domestic savings are closely correlated w i t h both domestic investments and domestic growth. Those relationships are especially strong for the semideveloped newly industrializing countries - the ones most similar to CEFTA members. Together w i t h the study of Carroll and Summers (1991) (the study shows the close correlation between the growth of income and consumption i n the extensive sample of countries i n all income groups) this empirical research indicates that current account deficits stemming from the excess of domestic private investments over domestic private savings are not solved by the induced economic growth. Hence current account deficits do matter and their growth require policy action (indeed, the w o r l d financial markets always knew this.) The reason for this discrepancy between the theory and reality is attributed to a limited capital mobility due to uncertainty stemming from asymmetric information, differential treatment of domestic and foreign investors, political risks, tendency of firms to rely on the investment financing from retained profits etc. But whatever the reason the empirical research strongly suggests that especially i n countries similar to CEFTA members domestic investments and hence economic growth are constrained by the availability of domestic savings. A n d because this is an empirical discussion I decided to go w i t h empirical findings regarding the relationship between domestic saving, domestic investment and growth. 15 This is especially true i n comparison w i t h other successor states of former Soviet empire. 12*

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heavals. On the economic front similar results were achieved. Economic decline i n the region bottomed out i n 1992 and the positive economic growth resumed by 1994 i n all countries. After 1992 unemployment stabilized (or mildly declined) across the region. Inflation showed a stabil i t y or a mildly declining trend as well. Real wages (and hence presumably private incomes) stabilized too - except i n the Czech Republic where the real wages skyrocketed by about 10% i n 1995. The economic and socio-political stability is undoubtedly a success to be cherished - but the future requires economic growth. A n d i n this area the performance of CEFTA countries i n the 1992 - 95 period was mixed and somewhat surprising. These countries can be divided i n two groups - performers and laggards. But the membership i n those two groups is rather unexpected. Performers are Poland and Slovakia whereas the Czech Republic and Hungary are lagging behind. The previous analysis identified one key to this distinction: Domestic private savings and domestic private investments are higher i n "performing" countries - and this difference was attributed to the ways i n which the b u l k of today's private sector was created i n individual countries. 1 6 But not only that. Both Poland and Slovakia significantly reduced the weight of government sector i n their respective economies both i n the areas of government expenditures and budget deficits (see the relevant country tables). I n addition both performing countries maintained a stable real exchange r a t e 1 7 , stable or surplus trade balances and current accounts and stable or rising share of exports i n GDP. The laggards' problems are more complicated. I n the Hungarian case, the low domestic private savings and investments are clearly the cause of a low rate of growth. The government managed to reduce its expenditure to about 30% of GDP and budget deficit to about 2% of GDP i n 1995. As a result the current account deficit declined by about 40%. But the p r i vate consumption i n 1995 remained only slightly below its 1992 level, 16 I t is important to remember that Slovakia is to a large degree a special case. A n entirely new country created i n 1993 i t had to use its meager resources to b u i l d essential nationhood and statehood infrastructure 'from scratch'. This more than anything else accounts for 'bad numbers' i n 1993 and the beginning of 1994. The turnaround achieved i n the second half of 1994 and i n 1995 is simply amazing. The Slovak economic performance is perhaps the most pleasant surprise and certainly the best kept secret i n the region. 17 The major trading partner for Slovakia was the Czech Republic - hence the most important exchange rate was the one between the Slovak (Sk) and Czech (Kc) crowns. The comparison of relevant numbers clearly indicates that Slovak crown slightly depreciated i n real terms relative to Czech crown.

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trade gap still exceeds 8% of GDP and private investments increased only marginally - barely enough to offset the declining government expenditures. The real exchange rate, after some depreciation, appreciated slightly between 1993 and 1995. I t appears that the Hungarian government faces two major structural problems - both of them defying short term policy solutions (especially now when the privatization process is effectively over). First, the private consumption is relatively very high - as a percentage of GDP i t is much higher compared to other CEFTA countries. Second, the Hungarian economy displays a rather strong propensity to import. The first problem means that even a strong reduction i n government expenditure does not enable the tax reduction needed to increase private savings without endangering the current account balance. A n d the second means that any acceleration increases the trade deficit and threatens again the current account balance. Without solving those two problems Hungary is likely to remain trapped i n the low growth - low investments equilibrium. The Czech problem is the low level of private savings. But besides that the Czech Republic has a relatively high domestic consumption and the highest public expenditure i n the region as a % of GDP. Balanced budget policy then implies very high domestic taxation. I n such a situation any acceleration of a private investment activity must be financed from abroad - hence the need for capital inflows facilitated by a fixed nominal exchange rate policy (with 23% real appreciation) of the Czech crown between 1992 and 1995. The overall Czech economic activity remained rather stagnant t i l l the later part of 1994. Private investments being very low the problem of their financing d i d not exist. However, the acceleration of investment demand from the end of 1994 showed the domestic private savings - i.e. the financing of domestic private investments - to be the Achilles heel of Czech economy. Almost a half of Czech private i n vestments i n 1995 was financed from abroad, compared to less than 25% i n 1994. The current account deficit, zero i n 1994 - is now about 5% of GDP and growing. A n d the trade deficit, helped by the real appreciation of currency and by more than 10% increase i n real wages, more than quadrupled i n 1995, reaching about 9% of GDP. I n contrast to Hungary, Czech problems appear to be more the problems of policy rather than of an underlying structure. Reduction of taxes and public expenditures to about 30% of GDP (by about 6% of GDP) is certainly possible given experiences of other CEFTA countries. Such reduction would increase domestic private savings and hence i m -

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prove the current account and to some degree the trade balance. The shift i n the exchange rate policy toward the real exchange rate stabilization via a crawling peg would certainly somewhat increase domestic i n flation. But, like i n Poland and Slovakia, i t would improve the trade balance and by l i m i t i n g capital inflows the current account as well. Finally, a higher inflation would most likely reduce an explosive growth of real wages which is today a major danger to international competitiveness and to growth i n the future.

4. Future prospects The analysis i n the previous part and the information provided i n the country tables (albeit perhaps incomplete) indicate that the patterns of economic activity which emerged among the CEFTA countries i n the last two years are likely to continue (with perhaps one exception) i n the near future. Poland, Slovakia and most likely Slovenia 1 8 w i l l remain "performing" countries whereas the Czech Republic and Hungary w i l l struggle or perhaps worse. Poland, the best performer i n Eastern Europe, is a large country. Its significant domestic markets w i l l shelter i t at least partially from a possible European economic downturn (note that the share of Polish exports i n GDP is relatively small at 20%). Two years of the center-left government showed that its policies are not detrimental to private savings and investments. Moreover the same government demonstrated its ability to maintain a stable real exchange rate, stable real wages and what is very important i n Poland a stable income distribution. I n addition i t showed the ability to reduce the government share i n the utilization of resources and to stabilize inflation at a 20 - 30% annual rate. 1 9 Finally, the centerleft government managed to improve its relationships w i t h Poland's

18 Slovenia was not discussed i n our prior analysis. I t became CEFTA member only i n January 1996 and its economy was strongly effected by Balkan war. But recent information indicate that Slovenian economic growth accelerates. 19 Historical experiences show that a 20 - 30% annual inflation rate is common to almost all successful semideveloped states. There may be two basic reasons for this phenomenon, a) the inflation process transfers the real income from low savers (wage and salary recipients) to high savers (recipients of profits). A n d b) the inflation rate i n the above mentioned range facilitates significant changes i n relative prices i n the environment of a general downward price stickiness. Such a relative price flexibility is indeed needed to enable radical structural changes which accompany growth i n many semideveloped economies.

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eastern neighbors - the fact that may be important if an economic performance i n those countries improves. 2 0 If Poland manages to maintain its present policies i n the near future (and there is no reason why i t should not) then its rate of growth i n the next 2 - 3 years should be i n the 6 - 8 % range, w i t h slowly declining unemployment, stable inflation and a more or less balanced current account. Major future dangers are on the political side. On the domestic side the government may be tempted to reduce inflation and unemployment i n more radical way before the next elections. The technique used would most likely be the simultaneous real appreciation of currency (via so called "active" crawling peg) and domestic fiscal expansion. Such steps would work for a while, but eventually they would end up i n a balance of payments crisis requiring restrictive policies (a scenario somewhat similar to the Hungarian situation today). The second set of problems may come from the political instability further East. Whereas i t is useful to keep this possibility i n m i n d the discussion of its actual likelihood today seems to be premature. Slovakia is the second CEFTA country performing well today and likely to perform i n the future - w i t h performance parameters similar to those of Poland. But i n order to maintain its position Slovakia needs some policy adjustments. The required structural changes may need more flexible relative prices. This would imply an inflation rate and thus the monetary policy closer to Poland and Hungary rather than to the Czech Republic. Moreover, as a small country Slovakia depends heavily on exports (over 50% of GDP). A n d w i t h its export markets shifting away from the Czech Republic, Slovakia w i l l have to pay a close attention to its real exchange rate to avoid crippling current account imbalances. This may require a shift to the crawling peg regime aimed at the maintenance of a real exchange rate. The failure to make these adjustments may not, however, be the only source of problems for the Slovak economy. W i t h elections due i n 1998 the government may be tempted to adopt a similar populist measures as mentioned above i n the case of Poland - and w i t h similar results. I n addition the opening up to the East and Balkans which Slovaks rather successfully conducted i n the last two years could be a double-edged sword. Very beneficial if Eastern and Balkan economies grow but a domestic structural burden (similar to the collapse of COMECON) otherwise. 20 R. Lyard of CEPR recently forecasted Russian GDP growth for 1996 to be up to 10%.

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Hungarian problems and their likely impact on the near term future of the Hungarian economy were mentioned i n part 3. Overcoming structural shortcomings (a high private consumption and a high propensity to import) requires more or less restrictive demand policies to be applied for an extended period of time. The good news for Hungary are that the crisis of 1993 - 94 is probably over and the economy is on its path to recovery, albeit rather slowly. The bad news are that present policies i.e. stabilizing the real aggregate demand, a real exchange rate and real wages and accepting the inflation rate high enough to permit domestic relative price changes - w i l l result i n relatively low growth and high unemployment i n the near future. But the major danger for Hungary lies i n the abandonment of existing policies i n favor of "growth oriented measures" before the next elections. Whoever would w i n i n such circumstances w i l l be subsequently forced to adopt a stabilization plan much harsher i n its consequences compared to existing conditions. The case of the Czech Republic seems to be a most complicated one. Its growth performance i n 1992 - 94 period was effectively the worst i n the region. 2 1 I n 1995 the Czech economic growth accelerated but data has become so muddled and uncertain that one hesitates even to mention them. 2 2 But the economic growth, albeit rather sluggish by Polish and Slovak standards, is not the major Czech problem. I n 1995 the Czech Republic experienced a major buildup of both trade and current account deficits. Those were financed by capital inflows fueled by expectations of continued nominal interest rate differentials at a stable nominal exchange rate (or alternatively by expectations of the real exchange rate appreciation given the approximate parity of real interest rates). As a consequence of these capital inflows the Czech international indebtedness (measured as a net foreign assets position of the country) increased. A t the same time the real appreciation of the Czech currency resulted i n the declining Czech ability to service its rising debt i n the long run - i.e. i n the declining export to GDP ratio. A n d this decline i n the interna21

See footnote 13 regarding Slovakia's 1993 results. For example: The official data (obtained from the PlanEcon Report no. 5 - 6, March 18, 1996) indicate that the increase of the real GDP i n 1995 was 21.2 b i l lions Kc, whereas the increase i n inventories was 31.1 billions Kc. Or the latest announcement reported the nominal GDP for the 1Q 1996 as 287.1 b i l l i o n Kc, which compared w i t h the previously reported nominal GDP for the 1Q 1995 281 billions Kc and by applying officially announced 9% WPI inflation would imply a decline of the real Czech GDP i n the 1Q of 1996 by about 6.5%. Those numbers are obviously unrealistic but they indicate the state of Czech statistics. 22

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tional competitiveness was only exacerbated by the explosive growth of domestic real wages - by about 10% i n 1995 alone. I n 1996 these developments are likely to continue. Some Czech analysts predict that the trade deficit i n 1996 w i l l reach about 12% of GDP and the current account deficit about 8% of GDP. I n addition, the CNB (Czech National Bank - the central bank of the Czech Republic) seems to be seriously contemplating a nominal revaluation of the crown (the Czech currency) i n order to arrest the inflationary money supply buildup stemming from the accumulation of foreign exchange reserves i n the Czech banking system. This looks almost like a prescription for a "Mexican" type of crisis. One time nominal revaluation w i l l not necessarily generate a devaluation (or nominal depreciation) expectations given the intent of such revaluation and the recent Czech exchange rate history. The underlying Czech inflation (around 10% annually) as well as a nominal interest rate differential are structural and therefore unlikely to be reduced soon. I n such a situation, capital inflows - albeit perhaps dented around the time of revaluation - w i l l still continue and country's international indebtedness w i l l still keep rising. But a nominal revaluation accompanied by a continuing inflation differential means an accelerated real appreciation, leading to a declining export to GDP ratio and hence to a declining ability to service country's rising debt. Eventually this debt w i l l be evaluated by markets as unserviceable and capital flows w i l l be reversed. A n unfinanciable current account gap w i l l develop forcing a rapid nominal depreciation i n effort to obtain a real depreciation. However, i n the small open economy like the Czech Republic a nominal depreciation means almost immediate domestic inflation acceleration via rising prices of imports. Hence the real depreciation w i l l be very difficult to achieve. A contraction of the real domestic aggregate demand (i.e. the domestic GDP) may be necessary to restore the balance of payments equilibrium. I n the Czech Republic this would happen almost automatically due to a collapse of domestic investment activities of which about a half is financed by capital inflows today. Given the present set of Czech economic policies the question relevant to this hypothetical scenario is not if but when. M y guess would be the late 1997, but things have their own way of happening. Czechs entered the political cycle i n 1996. Parliamentary elections are scheduled for May/June and full Senate elections for November. I t is therefore unlikely that required policy changes w i l l be made before the beginning of 1997. But then i t may be too late.

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To conclude: The economic perspectives of CEFTA countries i n the near future are mixed but not necessarily bad. A l l depends on policies implemented. Poland and Slovakia are i n better positions than Hungary and the Czech Republic. But this ranking does not have to last forever.

Abstract By the end of 1995 all CEFTA countries (Poland, Hungary, Slovakia, Slovenia, Czech Republic) successfully transformed themselves from late socialist to essentially market economies. Their future prospects, however, are uneven. High domestic private savings and investment coupled w i t h reductions of public expenditure as a share i n GDP and stable real exchange rates indicate good growth prospects i n Poland, Slovakia and Slovenia. Low domestic private savings, high share of public expenditures i n GDP and strongly overvalued real exchange rate cast Czech Republic as a prime candidate for crisis. Hungary is i n the middle.

References Amsden, Alice H. (1994) The Market Meets Its Match, (Cambridge, Mass.: Harvard University Press). Carroll , Christopher D. and Summers , Lawrence H.(1991) "Consumption Growth Parallels Income Growth: Some New Evidence," i n National Saving and Economic Performance, ed. by B. Douglas Bernheim and John B. Shoven (Chicago: University of Chicago Press ). Feldstein, Martin and Bacchetta, Phillippe (1991) "National Saving and International Investment," i n National Saving and Economic Performance, ed. by B. Douglas Bernheim and John B. Shoven (Chicago: The University of Chicago Press ). Kindleberger, Charles (1989) International Capital Movements, (Cambridge, U K : Cambridge University Press ). Kornai , Janos (1995) Highways and Byways, (Cambridge, Mass.: M I T Press). Lai, Deepak (1993) "World Savings and Growth i n Developing Countries," i n World Saving, Prosperity and Growth, ed. by Mario Baldassari, L u i g i Paganetto and Edmund S. Phelps (New York: St. Martin Press ). Lazear , Edward P. ed. (1995) Economic Transition i n Eastern Europe and Russia , (Stanford, CA: Hoover Institution Press) McKibbin, Warwick J. (1993) "Savings and Growth i n an Interdependent World," i n World Saving, Prosperity and Growth, ed. by Mario Baldassari, L u i g i Paganetto and Edmund S. Phelps (New York: St.Martin's Press).

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Modigliani, Franco (1986) "Life Cycle, Individual Thrift, and the Wealth of Nations," American Economic Review, Vol. 76, No. 2, June 1986, pp. 297 - 313. Thiessen, Ulrich (1994) Aspects of Transition to Market Economies i n Eastern Europe, (Vermont: Ashgate Publishing Co.). Zon, Hans van (1994) Alternative Scenarios for Central Europe, (Brussels: Commission of EU). OECD Short Term Economic Indicators - Transition Economies , various issues 1995, 1996. PlanEcon Reports, various issues, 1994, 1995, 1996, (Washington D.C.: PlanEcon Inc.). Transition - The Newsletter for Reforming Economies, various issues 1994, 1995, 1996. (Washington D.C. : World Bank).

Comment on: A n t o n i n Rusek, Transition to Markets i n CEFTA Counties By H u b e r t

Grabisch

This topic includes two dimensions: a more economic and a more political one. The first relates to the question of why the Czech Republic and Hungary show rather disappointing economic performance after having done so well i n transforming their countries; and why, on the other hand, Poland and Slovakia report a surprisingly good performance although they get bad marks concerning privatization, liberalization and political stability. To answer these questions is a task for economic analysis. 1 The second dimension relates to the influences the CEFTA framework has on the course of macroeconomic events and on the future perspectives of the CEFTA countries. Unfortunately, Prof. Rusek d i d not provide us w i t h adequate or satisfying answers. I shall start by commenting on the course of macroeconomic events i n the CEFTA countries.

The course of macroeconomic events in the CEFTA countries The crucial point i n understanding the macroeconomic processes going on i n the CEFTA countries is the role of private savings. Prof. Rusek suggests that under East European circumstances a lower savings rate means lower domestic savings, hence lower domestic investment and lower GDP growth. This is his pivotal tool for analysing achievements and delays i n macroeconomic performance. I t h i n k that this view represents a misunderstanding of the role savings play i n an economy. From a micro point of view, an individual's high savings rate is a prerequisite for his or her wealth. Higher savings mean less consumption and more investment i n monetary or real assets. The issue, however, is completely different from a macroeconomic point of view. The well known paradox of thrift states that an increase i n the savings rate di1

I do not want to refer to the boring debate on the quality of statistics.

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minishes the absolute amount of domestic private savings. 2 A higher propensity to save means less private consumption, thus less effective demand, output and income which is the basis of savings. I n the macro w o r l d of economics i t is not savings which determines investment but i n vestment which determines savings; firms do not decide on their profits (firms' savings) but on their investments. Investments generate income and agents decide what to save and what to consume. I n this way, the equality of investments and savings is restored ex post. If investments were realized only on the basis of savings from past incomes, the West German economic miracle would not have happened. I t is important to know what happened to the different elements of savings i n the CEFTA countries, i.e. investment i n the enterprise sector, the budget deficit and net exports. Table 1 provides a picture of fixed capital formation i n the CEFTA countries. While Poland, Slovakia and Slovenia recorded an acceleration of investment growth after 1992, investment i n the Czech Republic and Hungary suffered a weakening i n 1995 which contributed to the prolongation of stagnation. What were the reasons? Table 1 Fixed capital formation (in %, against previous year) 1991

1992

1993

1994

1995*

Czech Republic Hungary

-32.5 -12.1

16.6 -1.2

8.0 2.7

17.0 10.4

11.2 0.0

Poland Slovakia Slovenia

-4.1 -27.3 -14.8

0.7 9.2 -14.9

2.3 13.1 15.0

7.1 2.1 18.3

18.6 8.2 15.5

Country

* Estimate Source: N a t i o n a l statistics; own calculations

(1) Investments depend on income (the accelerator) and thus on expectations about private consumption and foreign demand. The difference between changes i n real wages and retail trade turnover may serve as a proxy for changes i n the savings behaviour of households (Table 2). I n the Czech Republic, the (average) private savings rate increased despite higher real wages which indicated a decreasing propensity to consume. 2 Cf. Blinder / Beaumol, 1988.

Hubert Grabisch: Comment

This factor may have more than compensated the positive effect of i n creased wealth from voucher privatization on autonomous consumer spending. I n Hungary the savings rate increased, but real wages and the retail trade turnover declined. I n Poland and Slovakia, both real wages and retail trade turnover increased, and the savings rate declined. I n Slovenia, the real wage increase was strong enough to ensure higher p r i vate consumption and a small increase i n the savings rate. Thus, we have a simple explanation why i n the latter three countries economic growth was higher than i n the former two countries: private consumption went up and investment followed. This explanation is quite the opposite to Prof. Rusek's explanation.

Table 2 Changes in real wages, real retail trade turnover and estimated (real) private savings (in %, against previous year) Country

Real wages 1993

1994

Growth differential

Retail trade turnover

1995*

1993

1994

1995*

1993

1994

1995*

-2.1 2.8

5.5 -6.3

4.0 -7.5

6.2 -6.7

-0.3 11.5

3.0 -3.6

7.0 9.9 3.3

2.1 7.3 5.2

9.8 - 9 . 9 7.7 -15.3 3.9 13.1

-1.6 -2.5 0.8

-6.8 -2.3 1.0

Czech Republic Hungary

4.1 -3.9

5.2 7.0 5.2 - 1 1 . 1

Poland Slovakia Slovenia

-2.9 -5.4 16.4

0.5 4.8 6.0

5.5 5.4 4.9

* Estimate Sources: N a t i o n a l statistics; o w n calculations

(2) Investments also depend on interest rates, though to a lesser extent. If the market shrinks, the expected profit margins must be very high to attract more investment. However, profit margins i n the CEFTA countries were squeezed by high interest rates, which raised the opportunity cost of investment i n fixed capital. Firms i n CEFTA countries preferred to invest i n monetary assets or increasingly tried to finance investments abroad - a sign of high credit demand and high interest rates. This was the case mainly i n Hungary and the Czech Republic, but less i n Poland, Slovakia and Slovenia. Besides changes i n the average propensity to save, two important elements of domestic savings decreased significantly during transition i n all CEFTA countries: the budget deficit and net exports.

192

Hubert Grabisch: Comment Table 3 Budget deficits (in % of GDP)

Country Czech Republic Hungary Poland Slovakia Slovenia

1991

1992

1993

1994

1995*

2.1 4.6

0.2 6.7

-0.1 5.6

-1.0 7.4

-1.6 3.9

3.8 3.6 -2.6

6.0 2.8 -0.3

2.8 6.3 -0.3

2.7 5.3 0.3

2.7 1.3 0.9

* Estimate Source: N a t i o n a l statistics; o w n calculations

A look at budget deficits shows that four countries reduced them between 1991 and 1995, and one - Slovenia - turned from surplus to deficit. The increasing Czech budget surplus obviously dampened growth i n 1994 and 1995.3 The same was true for Hungary i n 1995. The reduction of the deficit was even stronger if one only considers the primary budget. A large part of budgetary expenditures are interest payments on public debt, which are not demand-effective. The Hungarian government had to impose strict controls on the salaries and wages of public servants and employees i n still state owned companies i n order to consolidate the budget - one reason why real wages fell by 11% i n 1995. A similar look at the course taken by net exports i n recent years reveals another source for differing economic performance: during that period, i n which the other countries moved from recession to recovery, the Czech Republic and Hungary registered a deterioration of their net exports (Table 4). Despite partly strong devaluations the competitiveness of goods on foreign markets was insufficient to compensate for losses i n domestic demand. Both countries opened their economies more than the other countries. The strong deterioration of Poland's net export position i n 1995 was less a result of shrinking competitiveness than of soaring domestic demand chiefly for capital goods.

3 I t should be mentioned that the Czech Republic's budget surplus was mainly achieved by the split from Slovakia. The Czech Republic was a net payer of transfers to Slovakia. As a net payer i t also had a net surplus i n trade. Hence, the cut of transfers to Slovakia immediately caused a loss i n output.

Hubert Grabisch: Comment Table 4 Net exports of commodities and services (in % of GDP) Country

1991

1992

1993

1994

1995*

Czech Republic Hungary

6.8 -2.7

0.4 -1.1

1.8 -7.5

-0.3 -9.4

-7.0 -5.5

0.4

-0.6

12.2

9.1

1.0 -6.0 3.1

1.0 6.1 5.0

-5.1 0.0 2.8

Poland Slovakia Slovenia * Estimate.

Sources: N a t i o n a l statistics; o w n calculations.

From this very brief general survey of past developments we may draw some conclusions about the remainder of this decade. The most pressing problem for all countries are high nominal and real interest rates which directly harm the propensity to invest i n fixed assets and which also indirectly hurt net exports. A high nominal interest rate differential between domestic and foreign investment attracts foreign short-term capital if the nominal exchange rate is more or less stable. This applies to at least three of the CEFTA countries which received huge short-term capital inflows i n 1995: Poland, Hungary and the Czech Republic. Their central banks tried to neutralize the impact on the money base by higher interest rates and other means. Neutralization means that interest rates remain high and play the role of a disincentive to fixed capital formation. I t also means that there is pressure for real appreciation harming the competitiveness of the country's industry. A d ditionally, short money forces the Hungarian government to achieve a primary budget surplus. The crucial point is how to combine a relaxed monetary policy w i t h efforts to balance foreign trade and hold down inflation. A combination of three measures seems acceptable: (1) Monetary policy should utilize the existing room of manoeuvre provided by the increase i n international reserves and by declining inflation to cut interest rates. This would avert speculative short-term capital and weaken pressure on the exchange rate. (2) Monetary policy should be supported by a restrictive income policy coupling nominal wage increases w i t h productivity improvements. This would mainly be a task for the Czech government which is confronted w i t h an unemployment rate indicating nearly full employment (by OECD standards). 13 Konjunkturpolitik, Beiheft 45

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The CEFTA countries have not yet achieved currency stability. I n all of them inflation ranges between 8% and 30% per year. There is, however, little evidence for the presence of demand-pull inflation caused by relaxed monetary policies. I n all CEFTA countries inflation tends to go down despite increasing domestic demand. On the other hand, stubborn inflation is fuelled by cost and fiscal factors: - i n all countries, wage increases i n nominal terms exceeded productivity improvements; - i n Hungary, fiscal consolidation efforts included higher administrative fees for services and higher prices for energy, etc. This contributed to increasing the inflation rate i n 1995. A lower interest rate would remove much of the burden of public debt on the Hungarian budget and help to prevent further price increases. (3) The CEFTA countries should reconsider the question of joining various international organizations later. The price, the Czech Republic, Poland and Hungary w i l l pay for becoming OECD members this year w i l l be a further deterioration of their trade balances. They w i l l have to suspend the border taxes and non-tariff trade barriers introduced two or three years ago to stabilize their external equilibria. I n summary, the main problem for recovery i n the CEFTA countries lies i n their trade balance. Some countries - Poland and Hungary - are heavily indebted; strong recovery fuelled by domestic demand could cause a narrowing of their access to foreign financial markets. Other countries - the Czech Republic, the Slovak Republic and Slovenia - have no debt problem, but a real appreciation of their currencies could have the same effect: higher trade deficits without higher GDP growth. This could i n t u r n provoke doubts about the reliability of their exchange rate and stabilization policies.

The role of CEFTA I do not agree w i t h Prof. Rusek's belief that CEFTA cannot play any important role i n improving the economic performance of its member countries. On the contrary: CEFTA may provide some opportunities for alleviating their growth problems. The CEFTA countries are all at a similar level of economic development. Removal of trade restrictions among them may support the development of more balanced trade. If they form a larger common market, this w i l l make them more attractive

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195

to Western firms as places of production and not just as targets for sales. This point seems to be crucial: foreign direct investment by the West is still marginal, but could increase and help to improve productivity and other growth conditions. I t is true that after the dissolution of the COMECON, trade between its former member countries broke down. CEFTA was established i n December 1992 after difficult negotiations. It is true also that some governments of the original CEFTA member countries were quite reluctant to enter into some new k i n d of economic and perhaps political cooperation very shortly after the breakdown of the unloved COMECON. Especially the Czech government intended to direct its trade mainly towards the EU. But soon i t became clear that regional economic cooperation is a means of gaining admission to the EU. A t the CEFTA summit i n Brno i n September 1995 i t was decided to admit new members - a sign of the role CEFTA may play i n the coming years. Indeed, many countries i n Central and Eastern Europe are eager to become members of the group. Slovenia joined CEFTA on 1 January 1996, while Bulgaria, Romania and Lithuania have officially applied for membership later i n 1996 or 1997. Even the Czech government has changed its position: Mr. Klaus seems to have gathered that regional economic cooperation may be favourable. What contributes to the importance of this organization? - Most CEFTA countries are included i n the OECD's Partner i n Transition programme (PIT) preparing them for OECD membership (the Czech Republic became an OECD member i n January 1996, Hungary is to follow i n May and Poland i n the second half of the year). OECD membership requires the elimination of all non-tariff trade barriers and balance-of-payments liberalization. - Countries applying for OECD membership must have concluded an association agreement w i t h the EU; this means, i n other words, a country asking successfully for membership i n the E U must be a member of CEFTA. It was not accidental that the CEFTA treaty was signed i n December 1992, immediately before trade liberalization w i t h the EU. The CEFTA treaty means that trade among its member countries is treated i n a similar way to their trade w i t h the EU. I t was also not by accident that the CEFTA summit held at Brno i n September 1995 decided to speed up the originally agreed tariff reductions on imports i n analogy to a similar decision taken at the 1993 E U Copenhagen summit on the faster reduction of import tariffs of associated countries. The E U has 13:

196

Hubert Grabisch: Comment

been conveying the idea that success w i t h more advanced forms of regional cooperation w i l l be taken as evidence of " E U maturity". Stronger i n tra-regional trade is considered as a valuable tool to repair most of the damage done by the collapse of the COMECON. 4 Without CEFTA, bilateral agreements w i t h the E U would remain a torso. Free trade w i t h the Czech Republic and Poland, but not between Poland and the Czech Republic, for example, would lower their attractiveness for E U investors and the competitiveness of their exports. For E U investors the markets of individual CEFTA countries would simply be too small, while CEFTA exports would suffer because the E U rules of origin would not allow them to use the most profitable inputs of the region. The E U honoured the establishment of CEFTA by adopting the so called cumulative rule of origin which eliminates tariffs on goods containing inputs imported from other CEFTA countries.

References Blinder, Alan and Beaumol, William: Macroeconomics, 4th edition, New York 1988. Gabrisch, Hubert: Stabilisierungspolitik i n post-sozialistischen Ländern. In: Wirtschaft i m Systemschock, Berlin 1994, pp 185 - 198. - Polen 1995 / 96 - Droht eine Rückkehr der Inflation? In: IWH-Forschungsreihe No. 2 / 1996, Halle 1996. Inotai, Andräs and Sass Magdolna: Economic integration of the Visegräd countries: Facts and Scenarios. Institute for World Economics, Working Paers No. 33, Budapest 1994. Richter, Sändor and Tóth, Laszló G.: Perspectives for economic cooperation among the Visegräd Group countries. Wien, WIIW, 1994.

4

Cf. Inotai und Sass 1994, p. 5.

Stabilization and Economic Reform i n Russia, Ukraine and Belarus By D a n i e l G r o s * and A n d r z e j

Gonciarz**

1. Introduction Following decades of central planning and systematic repression of market forces under the Soviet regime, dismantling of the old economic order started essentially w i t h the formal beginning of the independence of the former republics of the Soviet Union (FSU) at the end of 1991. Although the policies implemented were far from uniform, progress i n transition has been slow i n almost all successor countries (except the Baltics). Consequently, the full complement of economic policies needed to establish a new institutional framework and to solidify a market system have not yet been implemented i n these former republics. This is also the case for three former Slavic republics: Russia, Ukraine and Belarus (Rub) which d i d not implement a 'big bang' solution, but rather muddled through and their stabilization has so far proved to be elusive. Russia is by far the largest successor economy and is clearly ahead of the other CIS countries i n market-oriented reform. Ukraine, the second biggest, started a serious transformation process only i n late 1994, while Belarus remains behind on most indicators even today. This raises the question of the extent to which the slow reform shows up i n the results achieved by those three countries and to what extent these results differ from the those recorded by other Central European countries like Poland, and Estonia. The purpose of this paper is to shed some light on the causes and consequences of the sluggish reform process. I n what follows, the experiences of economic transformation i n the * Centre for European Policy Studies (CEPS), Place du Congrès 1, B-1000 Brussels and Johann Wolfgang Goethe Universität, Mertonstr. 17 - 25, 60054 Frankfurt am Main. * * Johann Wolfgang Goethe Universität, Mertonstr. 17 - 25, 60054 Frankfurt am Main, e-mail: [email protected], [email protected] .

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three big Slavic former republics, Russia, Ukraine and Belarus w i l l be analyzed and compared. These countries count for most of the CIS and their problems are rather typical for all successors of the Soviet Union. We take Poland and Estonia as comparative countries. Poland is also a Slavic country just across the border where progress i n market oriented transformation is evident and one might argue that i t is, or should be a model for new neighbors. Estonia clearly shows what can be achieved by an extremely tough reform program even w i t h a Soviet style economy at the start. We begin i n chapter 2 by showing the i n i t i a l imbalances resulting from price distortions i n the former Soviet Union. We then present reform progress so far i n chapter 3. This is followed by an examination, i n chapter 4, of three facets of external liberalization: foreign trade regime, trade performance and foreign currency market. I n chapter 5 we focus on stabilization i n progress. I n our conclusions we briefly discuss the role of foreign trade i n the process of transformation to a market economy.

2. Structural distortions at the start I n order to have a base for an assessment of the transition strategies i t is necessary to look at the scale of the distortions at the outset of the reforms. The new countries i n the FSU inherited serious i n i t i a l imbalances as a result of highly distorted prices. The most serious distortion was perhaps that the prices for fuels and raw materials were well below the w o r l d market level. During the Soviet period this disequilibrium was covered by internal transfers inside the Union. Implicit transfers were provided by the net exporting republics of underpriced goods and net importing of overpriced goods (investment goods). Underpriced fuels and metals accounted for almost 80% of these implicit subsidies. As substantial net importers of energy, Ukraine, Belarus and the Baltic countries (e.g. Estonia) were traditionally the main beneficiaries of such transfers. I n 1990 estimated net receipts for Belarus amounted to almost 9% of GDP and for Ukraine to 3.6% (see Table 1). The second, but much less important, source of transfers for the republics were net contributions to or receipts from the Union's budget. I n 1989 Russia and Belarus as well as Estonia were net contributors to the Union's budget; 0.4, 0.1 and 0.2% of their GDP respectively. I n the same

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year Ukraine's net benefits from that fiscal transfers accounted for 0.3% of GDP [Orlowski (1992), p. 11]. Table 1 Implicit transfers in 1990 (in million of current rubles) Transfers through:

Receipts through:

Underpriced exports of oil and gas

Overpriced imports

Overpriced exports

Net transfers

Underpriced imports of oil and gas

as % of GDP (NMP)

-15811

-13867

4071

3166

-22441

3,7

Ukraine

-430

-3500

2780

6979

5829

-3,6

Belarus

-1564

-1281

2745

3699

3599

-8,9

Estonia

0

-239

948

287

996

-12,1

Russia

Source: Dabrowski and Antczak (1995), p. 11.

After the dissolution of the Soviet Union i t was widely predicted that countries like Belarus and Estonia would have a tough time surviving without deliveries of cheap energy whereas Russia would gain a lot. However, they adopted different strategies, Belarus (and Ukraine) tried to mitigate their problems through special arrangements w i t h exporting countries, i.e. mainly Russia, by securing the supply of fuel at prices below the international level. It is worth noting that relying on special agreements was a part of general strategy i n most CIS countries. They were looking for a solution of their problems through intergovernmental barter. Estonia was an exception and, on the contrary, tried from the start of the reform to abandon all old economic links resulting from the former planned economy system. I n principle, the move to world prices i n 1991 for CMEA trade (and to convertible currency payments) should have had the same effects for Poland (and other CMEA member countries). Estimations from this period suggest that Poland would have suffered a deterioration i n the terms of trade of about 23% and a deterioration i n the trade balance of $ 1.5 b i l lion, about 1.5% of GDP [Kenen (1991), p. 251]. S t i l l much less than i n case of Ukraine and Belarus.

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3. Trice liberalization . . . but what else?' During last five years the three countries have all achieved at least one goal, namely price liberalization. Under the EBRD rating they all obtain a good score on this item (vote of '3'). Price reform is an indispensable element of any reform program and the liberalization of prices i n Russia had an enormous impact over time. However, price reform, while necessary, is not enough on its own to create a stable market economy. I n Russia, price reform came early (i.e. i n 1992) but even i n Belarus and U k raine, where i t took much longer, i t was essentially completed by 1994. Price reform is 'easy' because i t can be achieved by the stroke of a pen, but the other elements needed to create a market economy are more difficult because they require concrete and sustained action by the government. This is especially true for stabilization. I t is exactly i n this area that the three Slavic countries d i d not make much progress u n t i l very recently. The incompleteness of the i n i t i a l reforms i n three countries under consideration can be illustrated through some concrete examples: 1. The development of a new private sector and the privatization process were (and to some extent still are) held up by the continuing uncertainty about the question concerning private ownership of land. 2. The distinction between cash and non-cash money, clearly a relict of the Soviet period was maintained for several years. U n t i l then, firms could convert their bank accounts into cash only for certain approved purposes (chiefly to pay wages). De facto the distinction between cash and non-cash could not be maintained tightly since after a while, specialized "financial services" firms that offered to convert cash into noncash and vice versa developed. This example shows how incomplete reforms favour the emergence of a semi-legal sector. 3. 'Soft budget constraints' continued de facto for large state owned enterprises which periodically stopped paying each other and were later bailed out by their respective Central Banks. 4. Privatization had a very slow start. I n Poland small scale privatization (shops and artisans) had been privatized w i t h i n half a year but i n Russia (the fastest privatizer) i t took two years to achieve the same result. I n the other two Slavic countries, even after four years, this has not been achieved. Large scale privatization is quite advanced i n Russia (but very slowly under way i n the other two). A t this point i t is not yet possible to say whether the transfer of ownership titles to managers and

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workers, the essence of privatization i n Russia i n 1993/94, w i l l lead to large scale restructuring and adjustment. One could argue that i t was simply not possible to create a working market infrastructure i n these countries i n 1992/93. However, their governments made the same mistake, namely, they failed to increase energy prices close to w o r l d market levels. Wholesale (e.g. crude oil and gas) and retail (e.g. electricity and petrol) prices of energy were almost i n variably kept u n t i l 1994/95 as a fraction (between 20 and 50%) of the world market level. The failure to increase energy prices was the main reason why foreign trade liberalization was at best, partial and why stabilization was delayed by two years. These two issues are discussed separately below, but before turning to them i t is useful to provide a brief i l lustration of the importance of energy (and the lack of adjustment). Energy and raw materials (chiefly minerals) continue to provide not only two thirds of Russian exports but, one could argue that energy constitutes the economy of Rub. I n 1994 energy consumption accounted for 40% of the Russian GDP and 160% of that of Ukraine. This shows that the price system was still so distorted that the rest of the economy contributed very little to the international market value of the output of Rub. The standard objection to these k i n d of numbers is that the currencies are 'undervalued' and that the 'true' value of their GDP is higher. However, this objection misses the central point that the currencies are undervalued because energy prices are distorted. Comparing the value of energy consumption to GDP evaluated at market exchange rates is legitimate because the purpose is not to measure how well people live, but to see how much of an input that is easily tradable internationally is used to produce value added at international prices. If energy prices go up, the real exchange rate would also go up, as was the case i n Russia. Has the situation at least improved? Here the picture is mixed. 4. Lack of adjustment in energy sector As mentioned above, at the outset of the reforms Belarus and Ukraine were living above their means because of the underpricing of energy. Ukraine and Belarus, as independent states, could no longer rely on resource transfers from abroad. Both countries have few domestic energy sources but a very high energy intensity, both i n production and i n household sector. This would have required extensive adjustment i n energy sector.

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But adjustment to higher market prices for energy was not immediate since Ukraine and Belarus progressively moved to the w o r l d price level only i n 1994. I t should be noted that this process was encouraged and supported through international financial organizations, especially the I M F and the World Bank. As of 1995, the border price of Russian gas for Ukraine was below the w o r l d prices only because of an offset for the gas transit exported from Russia to Western Europe through the territory of this country. As of March 1995, domestic industrial users were also charged at the world prices. The increase i n prices for energy w i l l take some more time to have effects. A t present energy prices are 'quasiprices', i.e. few households and enterprises are actually paying them (on time). Most of the inter-enterprises debt that still exists i n Rub is due i n the energy sector. This indicates that the 'closer to w o r l d market prices' that exist since 1995 might still be only quasi-prices. As a result, there are still few incentives to reduce energy consumption. Consequently, i n spite of urgent need, neither general nor sectoral restructuring processes materialized. Table 2 shows that real output declined by more than power consumption. Table 2 Growth in power consumption and real GDP 1990

1992

1994

Cumulative 1989- 94

Russia

Power consumption GDP

-0.4 -4.0

-6.2 -19.0

-8.5 -15.0

-21.1 -49.4

Ukraine

Power consumption GDP

1.0 -3.4

-6.2 -17.0

-11.7 -23.0

-24.6 -54.9

Belarus

Power consumption GDP

1.3 -3.0

-10.3 -9.6

-11.8 -21.5

-27.6 -39.9

Estonia

Power consumption GDP

-0.5 -8.1

-15.2 -14.2

6.1 6.0

-21.1 -30.6

Poland

Power consumption GDP

-8.1 -11.6

-2.6 2.6

0.8 5.0

-10.1 -8.7

Source: E B R D , Transition Report 1995, p. 182.

Interestingly, although cumulative decline i n power consumption i n 1989 - 1994 was the same for Russia and Estonia (-21%), real GDP almost halved i n the same period i n Russia, but i n Estonia declined by only one third. Between 1991 and 1994, Ukrainian gas consumption declined

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by 22%, notably less than GDP (- 45%). I n Ukraine, energy accounts for around 40% of total imports and energy use per unit of GDP is one of the highest i n the world. The situation i n the energy sector reflects delayed adjustment i n all sectors. Enterprises w i t h continued access to cheap inputs and financial support were protected from the pressure of import competition, thus they have little incentive to adjust their use of inputs (and thereby freeing up exports) or to change their production profile. What has been the outcome so far? Exaggerating a bit one could say that Belarus and Ukraine are barely surviving whereas Estonia is doing nicely but this is difficult to document. Official data on GDP per capita, especially evaluated at PPP are always suspect, but i n the case of Belarus, the results are even more difficult to believe than usual. 1 Hence i t might be more appropriate to look at average wages which can be measured w i t h more accuracy. Table 3 shows that the difference i n wages between Russia and other CIS countries can be explained quite easily by considering the production of Russian oil and gas (about 800 m i l l i o n tons of oil equivalent per annum) which is worth about 60 b i l l i o n US $ on the world market, or not much more than $ 800 annually for the more than 70 m i l l i o n strong Russian workforce.

Table 3 Monthly income and average gross wages, 1990 - 1995 a

Russia Belarus Ukraine Estonia Poland

1989

1993

Income p.c. (dollars)

PPP dollars

100 96 102 130

467 530 336 572 418

1992

1993

1994

1995

i n dollars 28 28 24 47 215

63 23 15 83 221

96 25 30 138 241

106 48 290

a

For 1992 - 1995 average gross wages in domestic currency divided by market exchange rates per U S dollar. Source: E B R D Transition Report 1995, W I I W Database.

1 Although considerably reduced, the estimations for 1994 still give more than 5.000 US$ which is only slightly less than the level of Poland or Russia. See World Bank Atlas 1996, p. 18.

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This alone is more than the difference i n annual wages. But Estonia's radical reforms were apparently worth as much as Russian oil and gas. Average wages i n Estonia continue to be almost 30% higher than i n Russia, as i n 1990, when Estonia received cheap energy. As shown by Sachs and Warner (1995) a lot of natural resources can be bad for growth whereas openness to trade is good for growth.

5. External liberalization To be able to judge the strategy's effects (or rather the non-strategy's effects) i n the three FSU countries i t is necessary to ask some questions about the effects of external liberalization and foreign trade reform, which we believe, do not yet have a satisfactory answer. I n what follows, we look first at development i n trade liberalization and then at trade performance. I t should be noted that there is still much uncertainty w i t h trade statistics for FSU countries. Official customs statistics fail to record a significant proportion of imports, especially of consumer goods. However, even if the accuracy of this statistic is limited, i t w i l l reflect the general tendencies properly.

5.1 Liberalization of international trade

F u l l external liberalization can i n principle also be achieved by the stroke of a pen. However, this was not the case i n these countries for quite some time. I n most evaluations of the Russian reforms i t is stressed that imports were almost completely liberalized i n the sense that i n January 1992 quantitative restrictions were abolished and only i n July a flat import tariff of 5% was levied. 2 However, as shown i n Gros and Steinherr (1995) the Russian trade policy was not really liberal if one takes into account the distortions on the export side. The regime that was retained for exports of raw materials and energy had to be restrictive because domestic prices of these goods had not been 2 The import tariff rate was later increased to 15% (in September 1993) but this d i d not change the overall liberalization of imports that lasted u n t i l the rouble begun to strengthen i n late 1993 so that import competition became a serious threat i n a number of sectors. A t that point a number of high tariffs on goods that competed w i t h Russian products were introduced. After the next general revision (in July 1994) the average level remained the same, but the degree of differentiation increased even more.

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liberalized. The government evidently feared that most of the large i n dustrial enterprises would go bankrupt if they had to pay w o r l d market prices for energy and other raw material inputs. The reasons for this decision are not important for this section. What matters is that these products accounted for about 75% of all Russian exports and this raises the question of whether one can still speak of trade liberalization if most exports are subject to restrictions. Trade i n energy and other raw materials must certainly have been restricted for some time given that internal prices were only about 30 - 50% of world market prices u n t i l well into 1994. However, this seems to have changed very recently i n Russia. By the end of 1995 export taxes were eliminated for ferrous metals and petroleum products, but the export tax on oil (20 Ecus per tonne) was still under debate at the beginning of 1996. There is a basic, but not widely appreciated, theorem from international economics, the 'Lerner symmetry theorem' [Lerner (1936)]. This theorem states simply that an export tariff is equivalent to an import tariff. This equivalence of export and import taxes can easily be understood if one regards foreign trade as using exports to pay for imports. I n the case of a domestic sales tax i t does not matter whether the tax is paid by the seller or the buyer, similarly i n international trade i t does not matter whether i t is the Russian importer or the Russian exporter that pays the tax. The Russian government's claim of the most liberal trade regime i n the w o r l d was thus somewhat disingenuous. If correction of price deformation and resultant market distortions lead to a protectionist response then the exporters w i l l be adversely affected twice, first by the decline i n the terms of trade, and then by the p u l l of resources into import-competing industries. From the national welfare point of view, the distortion costs of protection w i l l be added to the unavoidable loss resulting from the terms of trade deterioration. I t can be shown that the policy of keeping the domestic prices of oil and gas to a fraction of the w o r l d market price was extremely costly i n standard welfare terms. Welfare triangles can amount to a considerable fraction of GDP when distortions are large. A preliminary estimate puts the static welfare costs of Russian export restraints i n 1993 at 25% of their GDP [Gros (1994), p. 57]. Belarus and Ukraine provide, i n a sense, a mirror image of Russia. They wanted to obtain cheap energy through preferential agreements and i n t u r n had to promise to apply export restrictions similar to Russia's. Their trade policy was thus also very restrictive. I n contrast,

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Estonia did not ask for a special deal on energy and was thus able to put into place a really liberal regime. Far-reaching liberalization of foreign trade was the key element i n i n itiating Polish transition. From the start of the reform, the country operated w i t h an open market as tariffs were low. As i n Estonia the currency's undervaluation provided uniform temporary protection during adjustment. A transparent and liberalized trade regime created incentives to reorient trade to the convertible currency area. Polish and Estonian exports benefited also from generous market access conditions guaranteed by the main Western countries: free trade agreement w i t h EFTA since 1992 and GSP treatment i n the E U and Austria since 1992 [Hansen and Sorsa (1994), p. 116.]. But even the most generous conditions for access to foreign markets cannot substitute for consistent and stable macroeconmic and foreign trade policy (Agrival et al. (1995), p. 40.). Russia never had any serious problems of market access.

5.2 Export performance

'The proof of the pudding is i n the eating.' The proof of a substantial liberalization of foreign trade is the actual behavior of exports and i m ports. A l l of the Central European countries increased their exports to the West by between 30 and 40% i n the two years following the start of serious reforms. This export boom was helped by a substantial nominal devaluation and the opening of major export markets, such as the EU. Privatization cannot have been the main reason since most of the exports came from enterprises that were at the time still state owned. This shows that even the managers of SOE were not b l i n d to the profit opportunities that arose when wages were about $ 100 per month, as initially i n Poland. 3 The experience of Rub seems to have been again different. Unfortunately, however, i t is very difficult to document their trade performance over the last years. 4 Konovalov (1994) reports that official Russian statis3 The export boom went hand i n hand w i t h a boom of imports from industrialized countries. As foreign financing became more widely available imports increased by more than exports and most Central European countries developed a trade deficit. But this development has nothing to do w i t h the overall expansion of trade generated by trade liberalization. 4 A first problem is that no reliable statistics exist at all for the former Soviet republics foreign trade before 1992 because i t was simply part of Soviet Union trade. A second problem is that during 1992 the trade data collection system i n

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tics which actually show a collapse of exports from $ 80 b i l l i o n i n 1990 to about $ 40 b i l l i o n i n 1992. However, these numbers cannot be accepted because the most reliable source that exists, namely western i m port statistics, show totally different figures. Using this source (which has its own problems) one can at least compare the Russian experience after 1992 to that of Poland. On this basis, Gros and Steinherr (1995) show that although the devaluation of the rouble was even stronger than that of the Zloty, and although the average wage expressed i n US dollars was even lower i n Russia (below $ 30 per month during 1992, compared to over 100 i n Poland), Russian exports of industrial products d i d not increase significantly i n 1992. More recent figures show that some adjustment seems to have started. Reliable recent figures are difficult to come by. Table 4 uses the most easily available source: E U import statistics. But even this data on imports of industrial goods of the E U from these countries must still be viewed w i t h caution since during 1993 E U customs officers still had to learn about all the new countries i n the FSU. Table 4 shows that i n 1994 Russian exports of industrial goods to the E U increased by over 40%, about as much as those of Poland i n 1990 (the first post-reform year). Belarus and Ukraine also report large increases i n exports of industrial goods i n 1994 and 1995, albeit from a very low base. This suggests that the relative stabilization achieved plus the i n crease i n energy prices which makes trade liberalization possible is now producing effects. Estonia is, as usual, way ahead. I t is interesting to note that the increase i n exports went hand i n hand w i t h an increase i n dollar wages. This suggests that domestic supply side effects are much more important than competitiveness considerations. The usual argument that these countries could not increase their exports because they were producing the 'wrong products' is thus not true. Given the right incentives managers w i l l find ways to increase their sales on the w o r l d market even if initially they do not have the 'right' products.

the new countries worked only partially and many Western import statistics lumped all former republics together. Russian trade statistics for the FSU period have been reconstituted, but are extremely unliable because they show that exports i n 1990 were close to $ 80 b i l l i o n whereas the I M F Directions of Trade Statistics show that the rest of the w o r l d declared imports from the entire FSU of only $ 50 billion.

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Daniel Gros and Andrzej Gonciarz Table 4 Exports and wages of rub, Estonia and Poland Year before reform

Russia (FSU) Wage ($ / month) Exports ($bn) Total To EU12 Ind.Production to EU12 Belarus

Ukraine

Estonia

Poland

Wage ($ / month) Exports ($bn) Total To EU12 b Ind.Production to EU12 Wage ($ / month) Exports ($bn) Total To EU12 Ind.Production to EU12 Wage ($ / month) Exports ($bn) Total To EU12 b Ind.Production to EU12 Wage ($ / month) Exports ($bn) Total To EU12 Ind.Production to EU12

Year of reform 3

Year following reform

42

28

63

44.5 18.6 7.3

42.4 17.4 3.1

43.4 16.1 4.9

28

23

25

3.5 0.2 0.1

2.8 0.3 0.3

2.5 0.6 0.5

24

15

30

11.3 0.8 0.3

12.8 1.1 0.6

11.8 1.4 1.1

47

83

2.8

0.5 0.1 0.1

0.8 0.2 0.2

155

108

167

13.5 4.8 3.0

16.2 6.3 4.1

14.3 7.9 5.6

a Year of reform for Russia and Estonia is 1992, for U k r a i n e and Belarus 1993, and 1990 for Poland. b As recorded by D O T S Y 1995.

Source: E B R D Transition Report 1995, D O T S Y 1995, Eurostat.

D i d trade liberalization at least lead to a quick redirection of trade away from the 'bad' trade w i t h the socialist economies and LDCs that that did not pay for their imports of Soviet weaponry, towards 'good' trade w i t h western economies based on market principles? Gros and Steinherr (1995) show that this started much earlier than widely believed. For the FSU the share of CMEA had already fallen by one half (from about 40 to 20% of overall exports) i n 1991. I n Russia the share of CMEA countries even increased slightly i n 1992 and that of the western market economies fell somewhat. This is another indication that the year 1992 did not bring a radical liberalization of foreign trade i n Russia.

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But what about intra-FSU trade? Predictions based on the gravity model [see Gros and Steinherr (1995)] suggest that i n the long r u n countries like Belarus and Ukraine should export less than one fourth of their total exports to FSU countries. For Russia the share of trade w i t h other former republics should be even lower since Russia itself is the largest market i n the FSU. This would imply a huge change from the past since FSU data imply that prior to 1992 intra-FSU trade was several times larger than foreign trade for all republics except Russia. Table 5 The re-distribution of trade Old system 1988

Russia Belarus Ukraine Estonia Poland* a b

New system 1994

intra / extra FSU

extra FSU (% of GNP)

intra / extra FSU

extra FSU (% of GDP) b

1.4 6.4 3.9 6.3

9 7 7 8 19

0.3 1.4 1.5 0.8

5 18 20 29 20

total exports. G D P converted at market rates.

Source: Gros / Steinherr (1995), Belarus Economic Trends, O E C D , Short Term Economic Indicators.

This re-direction of trade flows has apparently started i n the sense that since 1994, for Belarus and Ukraine exports to FSU countries are now only slightly larger than those to non-FSU countries. By contrast, the opposite is true for Estonia, which has again shown a quicker adjustment on this account (see Table 5). For Russia the share of FSU i n all exports has already reached 20%. The FSU data also suggest that the ratio foreign (non-FSU) trade to GDP was similar for almost all former republics, between 7 and 9% of GNP. This has also changed considerably. The last column of Table 5 shows that for Estonia, exports to non-FSU countries account for 30% of GDP. For Belarus the corresponding figure was 18%. However, the numbers do not reflect properly the strength of foreign sector, because for Belarus and Ukraine, GDP expressed i n dollars gives low figures due to undervalued exchange rates.

14 Konjunkturpolitik, Beiheft 45

210

Daniel Gros and Andrzej Gonciarz 5.3 The foreign exchange market

More progress was made on the issue of convertibility, which can also be achieved by the stroke of the pen (as long as the exchange rate is not fixed) since all the government has to do is to allow anybody to buy or sell foreign currency without restrictions. F u l l current account converti b i l i t y was achieved i n Russia by 1992 but only later i n Belarus and Ukraine. Given the laxity of controls one could even argue that de facto convertibility extended also to capital account transactions. A large degree of capital account convertibility was officially permitted when, i n the summer of 1993, non-residents were allowed to open ruble accounts which they could use also for investment purposes. I n order to make convertibility operative a foreign exchange market must exist on which enterprises can buy and sell foreign exchange. Such a market can i n principle be created rather quickly. Somebody, e.g. the central bank, just convenes regularly potential buyers and sellers of foreign exchange and organizes an auction mechanism to find a price at which supply and demand meet. This is already done on a regular basis i n Moscow since January 1992 but only much later i n Minsk and Kiev. How did these markets perform? I t has often been observed that the volume of transactions that went through the official auctions was rather small if compared to recorded foreign trade. For example, i n 1992 the total turnover on the Moscow Interbank Currency Exchange was much less than Russia's exports. I t has therefore often be argued that this market was not representative; or not 'efficient'. However, does not seem to have been the case i n Rub. How does one measure market efficiency? A crude measure of the (weak form of) efficiency of any asset market can be obtained by regressing the change i n the (log of the) exchange rate on a constant and its own past. Denoting the log of the exchange rate by stand the change i n the exchange rate by ds t = st - st-1, the equation to estimate is thus : (1)

ds t = constant + ßds t~\ + disturbance

The constant measures the expected rate of depreciation. The coefficient on the lagged change i n the exchange rate measures to what extent information on past prices can be used to make profits. Thus weak form efficiency implies that the coefficient, β, should not be significant and that there should be no autocorrelation i n the error terms. If these conditions are not satisfied, any trader could use information on past prices to

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211

predict future exchange rates. For example; if there were a negative autocorrelation i n the errors i n the sense that a unexpectedly large depreciation was, on average, followed by an appreciation (a 'correction' i n market jargon) any trader w i t h access to the foreign exchange market could make profits by buying rubles whenever a large depreciation occurred and sell these rubles when the correction arrived. The sign and significance level of the constant has no particular i m p l i cations for market efficiency; i t just shows to what extent the ruble depreciates, on average per week. However, i n the absence of capital controls, the intercept should reflect the difference between domestic and international interest rates. The magnitude of the constant can thus be used to see whether there are capital controls. Formal tests of market efficiency indicate that the foreign exchange markets i n Russia was efficient almost from the start [see De Nicola and Gros (1994)]. Efficiency means i n this context that the exchange rate did not follow any predictable pattern. This indicates that the price for foreign exchange that is set by a small market is not necessarily wrong. Tests for Ukraine for the period u n t i l October 1995, i.e. one year after the exchange system was substantially liberalized are not so conclusive as for Russia. 5 However, the same k i n d of weak market efficiency was confirmed for the following period. The foreign currency market i n Belarus is subject to more strict regulations and controls on currency transactions were even tightened as the pegging of the exchange rate since the beginning of 1995 led to heavy depletion of foreign currency reserves. The exporters are still obliged to sell all their foreign currency earnings. Establishing an efficient foreign exchange market was the one part of the reform plans that worked at least i n Russia and Ukraine.

6. Macroeconomic destabilization The approximate cause of high inflation is almost everywhere the same: a large public sector deficit that is monetized. Rub are no exception to this rule, but the way i n which the deficit arose was somewhat different i n the sense that the official fiscal deficit often remained mod5 U n t i l October 1994, Ukraine maintained a system of multiple exchange rates, comprising an official exchange rate set by the authorities and a market rate set at a foreign currency auction. 14*

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erate. The official budget numbers do not indicate any severe problems for the i n i t i a l reform period since they report, for Russia, deficits of about 4 to 7% of GDP for 1992 and 1993. Belarus also reports rather small deficits for the first years of independence. These deficits are not large by any standard and i t is therefore, at first sight, difficult to explain why inflation was so high i n Rub. Table 6 Reported fiscal deficits (% of GDP)

Russia a

1992

1993

1994

1995

-10.4

-2.9

-6.9

-5.7

b

-1.6

-8.3

-1.5

-2.4

Ukraine 0

-12.2

-6.5

-10.5

-7.9

Estonia b

0.5

-1.4

-0.9

-1.0

-6.9

-3.4

-3.0

-3.2

Belarus

Poland a a b c

State budget balance. General government incl. state, local government a n d extra-budgetary funds. General government excl. extra-budgetary funds.

Source: E B R D Transition Report 1995, U k r a i n i a n Economic Trends, Belarus Economic Trends.

However, when one looks at the high rates of monetary expansion that went hand i n hand w i t h the very high inflation rates one sees immediately that the public sector must have had a strong need for additional revenues. For example i n Russia, cash i n circulation increased i n 1992 about tenfold, from 184 to 1 716 b i l l i o n rubles, the increase of 1 532 b i l lion rubles was equivalent to 8.5% of GDP; or close to the total revenue from direct taxes. On top of the seigniorage from cash holdings the central bank also profited from the reserves of commercial banks that constitute the remainder of the monetary base. The increase i n the reserves held by commercial banks w i t h the Central Bank amounted to another 2 100 billion rubles; equivalent to 13% of GDP so that the total seigniorage revenue for that year was about 21% of GDP. I n 1993 seigniorage remained very large at about 12% of GDP. Table 7 shows that Belarus and Ukraine used seigniorage even more. The contrast w i t h Estonia and Poland is again striking.

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Table 7 Cash-flow seigniorage as percentage of GDP 1991 Russia

1992 19.0

1993

1994

1995 7.6

10.8

10.6

Belarus

20.1

19.7

Ukraine

48.9

24.7

9.2

1.5

2.5

4.0

1.2

2.0

10.3

3.2

4.0

3.6

Estonia Poland Hungary

6.9 3.5

Note: Seigniorage is the increase i n the money base divided by GDP. Source: Gros and Vandille (1994).

These numbers should be compared to those of other high inflation countries. The average revenues from seigniorage over a large number of (generally high inflation) countries was found to be about 3 % of GDP [see Fischer (1982)]. Or, to take a more concrete example, one could compare Russia to Brazil i n 1991. I n Brazil, the consumer price level i n creased by a factor of about 7 between 1990 and 1991; close to the Russian value for 1992. Over the same period the increase i n cash i n circulation (the cash component of seigniorage) amounted to 1.6% of GDP, and the increase i n the overall monetary base (i.e. total seigniorage revenue) was equal to 3.7% of GDP. 6 The main difference w i t h respect to Russia is that i n L a t i n America a (market based) financial system has had decades to adapt to a high inflation environment whereas the Russian financial system was barely operational i n 1992 / 93. However, seigniorage i n Russia was large even if compared to other transforming economies [see Gros and Vandille (1994)]. The importance of seigniorage i n Russia can also be seen from the fact that the printing press turned out to be the most important source of revenues for the public sector. I n 1992 seigniorage was more important than the sum of indirect and direct taxes obtained by the government. For Ukraine seigniorage was the main source of revenues during 1992 and 1993 but its level was reduced i n 1994 and especially i n 1995 as a result of a tighter monetary policy. I n Belarus, during the first half of 1995, seigniorage still ran at level 20% of GDP, similar to previous years. 7 6 Cash i n circulation end of 1991 (3672) minus the stock end of 1990 (989) divided by GDP (164991). The monetary base increased to 8166 from 1995. A l l figures i n billions of cruzeiros.

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The basic message is thus that destabilization stifled the private sector and led to a colossal redistribution of income from households towards the financial elite (the small part of the population that was able to dominate the financial sector and obtain huge amounts of cheap credit). The notion that inflation is bad for growth can actually be demonstrated quite easily. Brenton et al (1996) looked at the performance of the 10 Central and Eastern European Countries and 15 FSU republics i n 1994 and found that there is a significant correlation between change i n real GDP and the rate of monthly inflation. This adverse effect of delayed stabilization on growth was restated for the sample including Rub. Table 8 contains the regression results w i t h pooled cross-section and time-series data for the period 1991 - 1995 for Rub and for comparison also for Poland and Estonia. This is further evidence that decline i n GDP was indeed significantly correlated w i t h the rate of price increase. I n this respect transition economies are not different than those w i t h more established market principles: a first prerequisite for resuming economic growth is more stability. Table 8 Regressions for annual changes in real GDP (t-stat in parenthesis) Rub 1+1 / (1+av. monthly inflation) Intercept

Adj. R

2

Poland and Estonia

100.29

62.16

(3.25)

(4.59)

-120.49

-78.17

(-3.64)

(-4.63)

0.41

0.69

S.E.

4.76

4.46

Durbin-Watson statistic

2.19

2.61

7 One should note that the concept of seigniorage used so far measures how much revenue the government can obtain by creating its own liabilities, i.e. the monetary base. This is not the same as the loss of real purchasing power that is borne by the holders of money. Their loss is equal to the inflation rate times the amount of money, corrected for any interest payments they might receive. This loss is also called the inflation tax. The inflation tax goes to the issuers of the assets on which no interest is paid.

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7. Conclusions: consequences of non-reforming This paper shows that disappointing performance i n Russia, Ukraine and Belarus (Rub) accompanied by instability has stemmed from a strategy which intended to postpone stabilization and the confrontation w i t h foreign competition. The differences i n i n i t i a l conditions and economic structures (compared w i t h their counterparts i n Central Europe and Baltics) were not so profound that they could account for the difference i n performance since 1992. The main difference is that reforms i n Rub were more domestically oriented. Halfway between opening and protection, accompanied by slow progress i n other institutional reforms resulted i n 'muddling through'. Liberalization was delayed for almost three years by the perceived need to impose export controls i n order to protect domestic markets. I n Russia this was perceived to be necessary to l i m i t bankruptcies i n heavy energy using industries. I n Ukraine and Belarus the delay i n foreign trade adjustment can be seen as a by-product of a strategy aiming to seek special agreements w i t h Russia to obtain cheap imports of energy and another raw materials to protect heavy industry. The necessary structural changes were retarded for two reasons. The enterprises were not exposed to the pressure of foreign competition. A n overregulated and frequently modified environment for foreign trade activities created substantial economic uncertainty and a tendency to follow mainly shortterm (or rent-seeking) strategies. Another by-product of an economic and administrative uncertainty i n trade regulation, taxation and payment system is the widespread use of barter (and related) arrangements i n intra-FSU trade. Although i n the end a gradual adjustment i n prices of inputs to the world market level d i d occur, the policy which was intended as a protection for the economy from immediate pressure to undertake structural adjustment brought rather opposite effects. The output decline was not mitigated and the trade performance was initially rather bad. Why did Russia and other CIS countries also prefer direct intervention i n foreign trade? The reform strategies i n the FSU countries still seem to be commanded by the old way of thinking that exports are a necessary evil to be tolerated because they are needed to pay for imports. There is less confidence that through implementing a more outward-oriented strategy, foreign trade could became an engine of growth. Comparison w i t h Poland and Estonia i n this paper and more general analysis of Brenton et al. (1996) show that the degree to which the trade

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Daniel Gros and Andrzej Gonciarz

constraints of the centrally planned system were lifted was the main factor behind subsequent export expansion and recovery of output. The Polish trade record show that expansion occurred i n all branches almost equally (including those enterprises which were still state owned). E x port remained high also after i n i t i a l real maxi-devaluation was reversed. This suggests that tight budget constraints are more important for exports than an undervalued exchange rate. A t the moment, the main challenge for all three countries is to consolidate macroeconomic stabilization so that, together w i t h further progress i n restructuring, the basis is laid for resumption of economic growth. Stabilization and opening are necessary conditions for recovery, but many other tasks remain: to deepen the structural adjustment progress w i t h privatization, to discover the investment opportunities and to restructure the enterprises and to redefine the role and responsibilities of the state i n the economy. U n t i l these countries learn from their own experience of the last four years and from successful transitions i n other countries who could piece together their own transition strategy, their economies w i l l continue to sputter.

Abstract This paper shows that the disappointing performance i n three Slavic former republics of the Soviet Union, Russia, Ukraine and Belarus accompanied by instability has stemmed from a strategy which intended to postpone stabilization and the confrontation w i t h foreign competition. The failure to increase energy prices was the main reason why foreign trade liberalization i n these countries was at best partial and why stabilization was delayed by two years. Comparison w i t h Estonia and Poland shows that the differences i n i n i t i a l conditions and economic structures were not so profound that they could account for the difference i n performance since 1992.

References Agrival , J. P., Langhammer ; R., Lücke , Μ. and Nunnenkamp , P. (1995) "Export E x pansion and Diversification i n Central and Eastern Europe: What Can be Learnt from East and Southeast Asia?", K i e l Discussion Paper No. 261, November. Brenton, P., Gros , D. and Vandille, G. (1996) "Output Decline and Recovery i n the Transition Economies: Causes and Social Consequences", Brussels, CEPS Working Document No. 100.

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Dabrowski, M. and Antczak, R. (1995) "Economic Transformation i n Russia, Ukraine and Belarus i n Comparative Perspective", Warsaw, CASE Studies and Analyses No. 50. European Bank for Reconstruction and Development (EBRD), Transition Report 1995, London. Fischer , S. (1982) "Seigniorage and the Case for a National Money", Journal of Political Economy, vol. 90, no. 2, pp. 295 - 313. Gros , D. (1994) "Comment on Russian Trade Policy", i n Trade i n the New Independent States Michalopoulos, C and Tarr, D. G. (eds), The World Bank, Washington, D.C., pp. 52 - 57. Gros, D. and Steinherr ; A. (1995) Winds of Changes: Economic Transition i n Central and Eastern Europe, (London: Longman). Gros, D. and Vandille, G. (1994) "Seigniorage i n Economies i n Transition", Brussels, CEPS Working Paper. Hansen, J. and Sorsa, P. (1994) "Estonia: A Shining Star from the Baltics", i n Trade i n the New Independent States Michalopoulos, C and Tarr, D. G. (eds), The World Bank, Washington, D.C., pp. 115 - 132. Konovalov, V. (1994) "Russian Trade Policy", i n Trade i n the New Independent States Michalopoulos, C and Tarr, D. G. (eds), The World Bank, Washington, D.C., pp. 2 9 - 5 1 . Kennen, P. (1991) "Transitional Arrangements for Trade and Payments among the CMEA Countries, I M F Staff Papers, vol. 38,no. 2, pp. 235 - 267 Lerner, A. P. (1936) "The Symmetry Between Import and Export Taxes", Economica, August, pp. 306 - 313. De Nicola, C. and Gros , D. (1995) "The Efficiency of Emerging Foreign Exchange Markets: the Case the Ruble / Dollar Rate", i n International Trade Issues of the Russian Federation Gacs, J. and Peck, J. (eds), Laxenburg. Orlowski, L. (1992) "Direct Transfers between the Former Soviet Union Central Budget and the Republics, K i e l Discussion Paper. Sachs, J. and Warner, A. M. (1995) "Natural Resources Abundance and Economic Growth", Cambridge, M A , NBER Working Paper No.5398, December.

Comment on: Daniel Gros and Andrzej Gonciarz, Stabilization and Economic Reform i n Russia, Ukraine and Belarus By R o l f J. L a n g h a m m e r

The paper reports on work i n progress on explaining characteristics of the transformation process i n Russia and two other former Soviet Union republics, Belarus and Ukraine. The latter can be labelled satellite economies because of their asymmetries i n mutual economic links (dependence on energy supply from Russia; no equivalent of Russia on the two economies' supply). I n addition to what the title of the paper promises, Gros and Gonciarz (G & G) confront transformation experiences i n these three CIS states w i t h those of Poland and Estonia as "control groups" for small open, EU-oriented resource-poor transition countries. I n my comments, I w i l l concentrate on six points. 1. G & G convincingly exhibit the overwhelming importance of resource abundance and distorted energy prices as a structural impediment to a reform path which was followed by the Visegrad and Baltic countries. I would have liked to see G & G arguing that this impediment which has also plagued many resource-rich countries i n the developing world had not only allocational but also distributional implications: i t burdened the entire transformation process w i t h a legacy of income i n equality and rent seeking activities which d i d not emerge as a result of transformation and growth but existed from the moment when the old system was dismissed. I n particular, the income distribution was affected. Functionally, factors of production i n resource industries were privileged; regionally, resource-rich institutional sub-entities (republics, oblasts) enjoyed a strong positive reversal i n their terms of trade relative to the entities w i t h an obsolete industrial capital stock; sectorally, Dutch disease phenomena discouraged fresh resources to flow i n the non-resource sector, and finally the personal income distribution became extremely uneven between those having access to resource rents and those which were excluded from this source of income generation. The "muddling through" i n transformation which distinguishes Russia and its two

220

Rolf J. Langhammer: Comment

economic satellites from Poland and Estonia has been the outcome of efforts to avoid rent erosion. Also the continuous resistance of Russia to dismantle export barriers, especially export taxes on energy, can be explained by the political economy of rent seeking. Even the offer of external donors to compensate Russia for domestic rent erosion by granting international rents failed, for a long time, to induce the Russian government to erode resource rents. The importance of rents i n CIS transformation can be extended to tax resistance, the exemption of large parts of the economy from tax collection, to the micro-level of huge intercompany arrears and to the monetary side (seigniorage). What has not been discussed by G & G is why Russia (if not for political reasons) continues to pay rents to the two neighbouring countries i n terms of accepting poor assets for delivering energy. The economic rationale of still granting Ukraine and especially Belarus soft budgets i n spite of Russian indust r i a l imports diverted from the satellites to external sources has not become clear to me after reading the G & G paper. 2. Strong insufficiencies i n institution building are a second element of CIS transformation which I would have liked to see more deeply discussed. G & G correctly describe the i n i t i a l institutional reforms as i n complete (and i n Belarus perhaps even not yet initiated at all). But I would go much further by arguing that i t is still the public sector which dominates the Russian economy and that large scale privatization is by no means "quite advanced". Here, Russia simply cannot stand the comparison to the non-CIS transformation countries. Void i n institutional infrastructure has discouraged domestic savings mobilisation and u n t i l 1996 has refrained growth rates i n private capital formation from becoming positive i n non-resource sectors. The uncertainty premium i n real interest rates remains extraordinarily high. Given these shortcomings, i t is naive to expect a rapid change to the better after the president i a l elections as concerns the recorded economy. The unrecorded economy w i l l continue to grow, potential surplus sectors like agriculture (see the Chinese success after 1978) w i l l stagnate and real exchange rate appreciation w i l l squeeze the manufacturing sector further, jointly w i t h fierce competition from imports. 3. G & G are right i n questioning the assertion of Russia operating an open liberal trade policy. Lerner's symmetry theorem gives the adequate theoretical clue for doubting its validity. Yet, the equivalence of export and import tariffs only holds for uniform tariffs which do not exist i n Russia. Furthermore, export and import tariffs have different exchange

Rolf J. Langhammer: Comment

rate implications: while an export tax leads to exchange rate depreciation, an import tariff tends to appreciate the exchange rate. Hence, under the Russian conditions, the export tax should have contributed to offset trends toward an appreciating ruble and should have encouraged non-resource exports. Meanwhile, export tariff dismantling has gradually weakened this countervailing effect. Overall, the static welfare costs of Russian export restrictions gauged by G & G as i n the range of one quarter of GDP can be expected to have declined since 1993. 4. Expecting Russian non-traditional exports to rise parallel to export tariff dismantling coincides w i t h the observation i n Table 4 that Russian exports of industrial goods to the E U increased i n 1994 (and beyond). Yet, this must not obscure the fact that these exports are still largely Ricardo goods (fertilizers, non-ferrous metals) so that competitiveness is determined by resource availability rather than unskilled labour abundance . Resource intensity explains why i n spite of rising dollar wages Russian resource-based industrial exports have remained fairly immune against exchange rate appreciation. Price elasticities of demand for these products are known to be low. I n my view, this does not lend support to overly optimistic conclusions for rapid recovery of non-traditional exports. 5. Gravity models based on mass and distance factors have their merits i n producing reasonable yardsticks for judging on actual regional patterns of trade. Yet,in the case of Belarus and Russia, there are institutional signals which suggest higher actual export orientation of Belarus on the Russian market than predicted by the model which does not account for such signals. These are, for instance, the customs union between Russia and Belarus or the so-called "zero-option" of February 1996. Under the latter option Russia has given up claims on Belarus for technical credits and gas arrears of Belarus while Belarus " p a i d " by giving up claims on its deposits i n Russian branches of Vnesheconombank, arrears for nuclear material extracted from arms, and hosting Russian military troops i n its country. 6. The interesting tests on efficiency of foreign exchange markets should be linked to different strategies of exchange rate targeting. I t could be that a crawling peg as introduced i n 1996 allows the exchange rate to follow a more predictable path than i n the past and invite speculators to test the credibility of targeting the exchange rate. Overall, the paper presents an insightful and concise discussion of the many stumbling blocks and inconsistencies i n the CIS transformation

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which did not exist i n the Visegrad and Baltic economies. Hence, the latter are not best candidates for a control group. I conclude from G & G that notorious optimists like Richard Layard and others w i l l still have to wait for quite some time before such catching-up processes can be observed as i n the Western neighbours of the CIS states.

Autorenverzeichnis Dr. Bas van Aarle, Tilburg University, Post Box 10953, NL-5000 L E Tilburg Prof. Dr. Ulrich Blum, Technische Universität Dresden, Mommsenstraße 13, 01062 Dresden Prof. Dr. Johannes Bröcker, Technische Universität Dresden, Mommsenstraße 13, 01062 Dresden Nina Budina, Ph.D.cand., Tinbergen Institute Amsterdam, Keizersgracht 482, NL-1017 EG Amsterdam Dr. Clemens Fuest, Staatswirtschaftliches Institut, Ludwig-Maximilians-Universität, Ludwigstraße 28/IIIVG, 80539 München Dr. Hubert Gabrisch, Institut für Wirtschaftsforschimg, Delitzscher Straße 117, 06120 Halle Dipl.-Vw. Andrzej Gonciarz, Johann Wolfgang Goethe-Universität, Mertonstraße 17 - 25, 60325 Frankfurt / Main Prof. Dr. Daniel Gros, Center of European Policy Studies, Rue Ducale 33, B-1000 Brussels Prof. Dr. Bernd Huber, Staatswirtschaftliches Institut, Ludwig-Maximilians-Universität, Ludwigstraße 27/III VG, 80539 München Dr. Henning Klodt, Institut für Weltwirtschaft an der Universität Kiel, Düsternbrooker Weg 120, 24105 K i e l Dr. Rolf J. Langhammer, Institut für Weltwirtschaft an der Universität Kiel, Düsternbrooker Weg 120, 24105 K i e l Markus Mende (Msc.), Technische Universität Dresden, Mommsenstraße 13, 01062 Dresden Prof. Dr. Bernd Raffelhüschen, Albert-Ludwigs-Universitt Freiburg, Europaplatz 1, 78098 Freiburg Prof. Dr. Antonin Rusek, Susquehanna University, Department of Economics, Selinsgroove, Pennsylvania 17870-1001, U.S.A. Prof. Dr. Friedrich L. Seil, Technische Universität Dresden, Mommsenstraße 13, 01062 Dresden

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Dipl.-Vw. Klaus-Dieter Schmidt, Institut für Weltwirtschaft an der Universität Kiel, Düsternbrooker Weg 120, 24105 Kiel Prof. Dr. Frank D. Weiss, The Bologna Center, John Hopkins University, Via Belmeloro 11,1-40126 Bologna Prof. Dr. Dietmar Wellisch, Technische Universität Dresden, Mommsenstraße 13, 01062 Dresden Prof. Dr. Sweder van Wijnbergen, University of Amsterdam, Roeterstraat 11, N L 1018 WB Amsterdam