Chapter Twenty-One

1. Chapter Twenty-One Macroeconomics of Development and Transition

2. Introduction Development and the Macroeconomy Transition and the Macroeconomy Chapter Twenty-One Outline

3. Introduction • Two groups of economies that exhibit distinctive macroeconomic characteristics, encountering special macroeconomic situations as a result are: • developing economies • countries in transition from central planning

4. Introduction • Two reasons for interest from developed countries: • Many important trade and financial linkages exist between these groups and the industrialized countries; and • Emergence of 15 “new” economies from ex-Soviet Union :they need to establish sustainable and credible economic institutions.

5. Development and the Macroeconomy • Developing countries’ pre-reform macroeconomic characteristics: • Pervasive government involvement in the economy, with widespread government ownership of infrastructure, industry, and land. • Poorly developed financial institutions. • Government finance through money creation rather than taxes or domestic borrowing. • Fixed exchange rates, accompanied by capital controls or direct government control of FX transactions • Extensive foreign borrowing to cover current-account deficits.

6. Development and the Macroeconomy • Government ownership and control • Creates a variety of micro- and macroeconomic problems: • Low productivity, technological backwardness, and ignorance of customer preferences in state-owned enterprises. • Policy decisions hinge on political considerations. • These countries withdraw from international trade in an attempt to protect domestic industries.

7. Development and the Macroeconomy • Poorly-developed financial markets and institutions • Difficult to borrow by selling long-term bonds. • Due to poor policy records, bad reputations, and lack of credibility. • Widespread government ownership of industry precludes a stock market as a major means of raising private funds to finance investment.

8. Development and the Macroeconomy • Money-financed fiscal expenditures • They typically printed more money due to poor tax collection and inability to borrow from domestic population. • Produces inflation and “inflation tax.”

9. Development and the Macroeconomy • Government control over foreign exchange • These governments often used capital and foreign exchange controls as the means to keep domestic funds in the domestic economy rather than allowing them to escape as capital flight. • These means render the domestic currency non-convertible.

10. Development and the Macroeconomy • External debt • Reached crisis proportions in the 1980s. • Many governments forgot or ignored a basic rule for borrowing external funds: use the money to finance projects productive enough to bring economic return sufficient to repay the loan. Most projects failed for several reasons: • Projects chosen on political basis. • Funds supported grossly inefficient state-owned firms, military buildup, or unproductive “prestige projects” like national airlines or huge steel mills. • Economic conditions changed between the time the projects started and the time repayment came due. • Export revenues fell when primary-product prices plunged.

11. Development and the Macroeconomy • Reform • Almost every developing country, following decades of dismal economic performance, reformed their economies. • Stabilization reforms: refer to policy changes that aim to achieve macroeconomic stability. • Basic elements: cutting excessive government spending and reducing excessive money growth. • Structural reform or structural adjustment: refers to changes in the basic structure of the economy. • Reducing extent of government involvement in economy and increasing the role for markets.

12. Development and the Macroeconomy • Reform (cont.) • Panel (a) represents the typical macroeconomic situation in developing countries prior to reform. • Overly expansionary inefficiencies hold the LRAS to the left of its potential position. • This combination produces low levels of real output and rising prices. • Reform shifts the situation to one depicted in panel (b). • Macroeconomic stabilization stops the continual rightward shift of AD, and structural reform allows LRAS to move to right. • This new policy produces higher rates of real output and steady prices.

13. Figure 21.1: Macroeconomic Stabilization, Structural Reform, & Aggregate Demand/Supply Price LRAS Price LRAS 0 1 Level Level P 3 P 2 AD 3 P 1 A AD 2 P P 0 0 AD 1 AD AD 0 0 0 Q Real Q Real 0 1 Output Output (a) Pre-reform (b) Post-reform

14. Development and the Macroeconomy • Privatization and deregulation • Reduce role of government: many state-owned enterprises have now been privatized, or sold to private investors. • Privatization can be a slow and difficult process. • Asset valuations are a problem with new owners. • Efficiency improves after sale, but many employees are usually laid off – could create social unrest. • Foreign purchase of assets can generate domestic resentment.

15. Development and the Macroeconomy • Financial integration with world capital markets allows a more efficient capital-allocation process. • Government did it before. • Encourages domestic saving and creates domestic sources of funds for financing projects. • Fiscal consolidation and tax reform. • To reduce inflation, government expenditures that continue post-reform must be financed more through taxes and government borrowing, and less through money creation.

16. Development and the Macroeconomy • Currency convertibility • A country cannot enjoy the full gains from trade unless its currency is convertible. • Currency convertibility implies that the exchange rate, if fixed, cannot be set too far from equilibrium in the FX market. • Convertibility means that international traders and investors can demand that the central bank buy and sell FX at the pegged rate in amounts sufficient to cover the desired international trade and finance activities.

17. Development and the Macroeconomy • Currency convertibility (cont.) • Better to operate under a flexible regime. • Developing countries often hesitate to do this for two reasons: • Transactions in domestic currency might be so thin that the FX markets would not be competitive. • These countries like the price discipline inherent in a fixed system. • Economies of many of these countries are built around a few primary products – under a fixed system, a recession can severely reduce demand.

18. Development and the Macroeconomy • Investment finance and debt. • The debt crisis of the 1980s reminded debtors and creditors alike of the fundamental rules for sound debt management: • To avoid insolvency, an investment project must produce a rate of return sufficient to cover loan payments; • To avoid illiquidity crises, loan maturity and project maturity must match so that returns from the project come in time to make loan payments; and • Uncertainty regarding future economic events constrains the prudent amount of debt accumulation any country can undertake.

19. Development and the Macroeconomy • Lingering risks. • Some of the current concerns about developing countries’ macroeconomies differ between two groups of economies: • Those that cling to pre-reform characteristics and policy choices and remain relatively isolated from the world economy; and • Those that are “emerging” or reforming and integrating themselves into the world economy.

20. Five Principle Pre-Reform Macroeconomic Characteristics for Centrally-Planned Economies • 1. Extensive government ownership of productive assets; government control over all important aspects of economic activity, prices, and international trade; and government resource and capital allocation according to a centralized economic plan. • Until mid-1980s, 95+% of Soviet Union was under state control. • All firms faced a soft budget constraint: no threat of bankruptcy; more loans and credit always provided.

21. Five Principle Pre-Reform Macroeconomic Characteristics for Centrally-Planned Economies • 2. Overly industrialized economic structure, with underdeveloped financial and services sector. • Preferred very large scale state-owned enterprises that held monopoly positions. • Little or no incentive to produce high-quality goods or to adopt new technologies.

22. Five Principle Pre-Reform Macroeconomic Characteristics for Centrally-Planned Economies • 3. Government-set prices and capital-allocation procedures that encourage capital-goods production and discourage consumer-goods production, resulting in chronic shortages. • Workers often hoarded their cash wages (no goods to buy). • These hoarded funds, called monetary overhang, gave the government a further incentive to levy an inflation tax that eroded the funds’ potential purchasing power.

23. Five Principle Pre-Reform Macroeconomic Characteristics for Centrally-Planned Economies • 4. Extensive money finance of government expenditure, especially subsidies to large state-owned enterprises. • Tax systems were poorly developed. • Government found it difficult to borrow from world markets, so they printed more money.

24. Five Principle Pre-Reform Macroeconomic Characteristics for Centrally-Planned Economies • 5. Capital and exchange controls to maintain highly artificial fixed exchange rates. • Non-convertibility imposed bilateralism on trade: each pair of countries imported and exported about equal values of goods from one another, a pattern that eliminated many opportunities for mutually beneficial trade.

25. Transition and the Macroeconomy • Reform • So many are needed – political, legal, economic, and social. • Debate over the timing of the reforms: • Big-bang approach: attempt dramatic and immediate reforms on all margins simultaneously (Poland). • Gradualism approach: reform more slowly and take the different elements of reform one-by-one (China).

26. Transition and the Macroeconomy • Privatization represent the central task of structural reform. • Cumulative progress in privatization (Fig. 21.2 in the text): • The scale of the Progress Index progresses from 1 (very little private ownership for large-scale firms or little progress for small-scale firms) to 4+ (more than 50% of state-owned enterprise and farm assets in private ownership for large-scale firms and standards and performance typical of advanced industrial economies for small-scale firms).

27. Figure 21.2: Transitional Economies’ Progress in Privatization, 2001 Country Albania Armenia Azerbaijan Belarus Bosnia and Herzegovina Bulgaria Croatia Czech Republic Estonia FR Yugoslavia FYR Macedonia Georgia Hungary Kazakhstan Kyrgyzstan Small-scale privatization Large-scale privatization 4 1 2 3 Progress index

28. Figure 21.2: Transitional Economies’ Progress in Privatization, 2001 Country Latvia Small-scale privatization Lithuania Moldova Poland Large-scale privatization Romania Russian Federation Slovak Republic Slovenia Tajikistan Turkmenistan Ukraine Uzbekistan 1 2 3 4 Progress Index

29. Transition and the Macroeconomy • Governance and restructuring • Central planning produces an economy in which supplies of and demands for various goods and resources do not match; results in: • Over-industrialization • Queues for consumer goods • Existence of large monetary overhangs • Sectoral restructuring occurs when market-determined prices begin to allocate resources so that the economy produces those goods that consumers and firms want.

30. Transition and the Macroeconomy • Governance and restructuring (cont.) • Figure 21.3 reports the transitional economies’ progress in governance and restructuring. • Scale of Progress Index ranges from 1 (soft budget constraints, few other reforms to promote corporate governance) to 4+ (standards and performance typical of advanced industrial economies).

31. Figure 21.3: Transitional Economies’ Progress in Governance and Restructuring, 2001 Country Albania Armenia Azerbaijan Belarus Bosnia and Herzegovina Bulgaria Croatia Czech Republic Estonia FR Yugoslavia FYR Macedonia Georgia Hungary Kazakhstan Kyrgyzstan 1 2 3 4 Progress Index

32. Figure 21.3: Transitional Economies’ Progress in Governance and Restructuring, 2001 Country Latvia Lithuania Moldova Poland Romania Russian Federation Slovak Republic Slovenia Tajikistan Turkmenistan Ukraine Uzbekistan 1 2 3 4 Progress Index

33. Transition and the Macroeconomy • Governance and restructuring (cont.) • Other piece of restructuring that involves designing policies to foster competitive markets. • Figure 21.4 documents this area – the Progress Index ranges from 1 (no competition legislation and institutions) to 4+ (standards and performance typical of advanced industrial economies; unrestricted entry to most markets).

34. Figure 21.4: Transitional Economies’ Progress in Competition Policy, 2001 Country Albania Armenia Azerbaijan Belarus Bosnia and Herzegovina Bulgaria Croatia Czech Republic Estonia FR Yugoslavia FYR Macedonia Georgia Hungary Kazakhstan Kyrgyzstan 1 2 3 4 Progress index

35. Figure 21.4: Transitional Economies’ Progress in Competition Policy, 2001 Country Latvia Lithuania Moldova Poland Romania Russian Federation Slovak Republic Slovenia Tajikistan Turkmenistan Ukraine Uzbekistan 1 2 3 4 Progress index

36. Transition and the Macroeconomy • Price liberalization • Privatization cannot occur without large doses of price liberalization. • Private investors will be hesitant to purchase enterprises that produce goods whose prices are held down by government price controls. • Figure 21.5 reports the price liberalization progress for the economies in transition. • Scale of Progress Index ranges from 1 (most prices formally controlled by government) to 4+ (standards and performance typical of advanced industrial economies).

37. Figure 21.5: Transitional Economies’ Progress in Price Liberalization, 2001 Country Albania Armenia Azerbaijan Belarus Bosnia and Herzegovina Bulgaria Croatia Czech Republic Estonia FR Yugoslavia FYR Macedonia Georgia Hungary Kazakhstan Kyrgyzstan 1 2 3 4 Progress index

38. Figure 21.5: Transitional Economies’ Progress in Price Liberalization, 2001 Country Latvia Lithuania Moldova Poland Romania Russian Federation Slovak Republic Slovenia Tajikistan Turkmenistan Ukraine Uzbekistan 1 2 3 4 Progress index

39. Transition and the Macroeconomy • Fiscal consolidation • Extensive control of the economy translates into extensive government expenditures. • Must reduce government expenditures. • Must shift from money finance of expenditures to taxes and government borrowing. • Whole process of fiscal consolidation involves not only changes in policy makers’ day-to-day behavior, but changes in fundamental structure of policy making institutions. • Figure 21.6 illustrates 2000 government budget balances as a percent of GDP.

40. Figure 21.6: Government Balances in the Transitional Economies, 2000 (% of GDP) Albania Armenia Azerbaijan Belarus Bosnia and Herzegovina Bulgaria Croatia Czech Republic Estonia FR Yugoslavia FYR Macedonia Georgia Hungary Kazakhstan Kyrgyzstan -10 -8 -6 -4 -2 0 2 General government budget (% of GDP)

41. Figure 21.6(cont.): Government Balances in the Transitional Economies, 2000 (% of GDP) Latvia Lithuania Moldova Poland Romania Russian Federation Slovak Republic Slovenia Tajikistan Turkmenistan Ukraine Uzbekistan -10 -8 -6 -4 -2 0 2 General government budget (% of GDP)

42. Transition and the Macroeconomy • Financial integration • A system of central planning with its artificial prices requires isolation from world markets, where demand and supply determine prices. • Removing capital controls allows domestic residents to invest abroad and allows foreign investors to invest in the domestic economy. • Figure 21.7 shows that reform of banks and non-bank financial institutions has proceeded slowly.

43. Figure 21.7: Transitional Economies’ Progress in Bank and Non-Bank Financial Reform, 2001 Country Albania Armenia Azerbaijan Belarus Bosnia and Herzegovina Bulgaria Croatia Czech Republic Estonia FR Yugoslavia FYR Macedonia Georgia Hungary Kazakhstan Kyrgyzstan Securities markets and non-bank financial institutions Banking reform and interest-rate liberalization 1 2 3 4 Progress Index

44. Figure 21.7: Transitional Economies’ Progress in Bank and Non-Bank Financial Reform, 2001 Country Latvia Lithuania Securities markets and non-bank financial institutions Moldova Poland Romania Banking reform and interest-rate liberalization Russian Federation Slovak Republic Slovenia Tajikistan Turkmenistan Ukraine Uzbekistan 1 2 3 4 Progress Index

45. Transition and the Macroeconomy • Financial integration (cont.) • Most transitional economies have made significant progress in reforming their foreign-exchange systems and in liberalizing international trade. • Figure 21.8 indicates which countries have made progress on this front.

46. Figure 21.8: Transitional Economies’ Progress in Trade and Foreign-Exchange Reform, 2001 Country Albania Armenia Azerbaijan Belarus Bosnia and Herzegovina Bulgaria Croatia Czech Republic Estonia FR Yugoslavia FYR Macedonia Georgia Hungary Kazakhstan Kyrgyzstan 1 2 3 4 Progress index

47. Figure 21.8 (cont.): Transitional Economies’ Progress in Trade and Foreign-Exchange Reform, 2001 Country Latvia Lithuania Moldova Poland Romania Russian Federation Slovak Republic Slovenia Tajikistan Turkmenistan Ukraine Uzbekistan 1 2 3 4 Progress index

48. Transition and the Macroeconomy • Transition prospects • Differ substantially depending on the degree of their economic problems. • Russia inherited a more complete set of economic institutions than did the other Soviet republics. • Generally speaking, most countries’ macroeconomic stabilization efforts have thus far been more sustained and successful than their structural reforms. • By 1994, early reformers had positive real GDP growth. • By 1995, small private capital flows into the transitional economies had begun (Czech Republic, Slovakia, Hungary, and Baltics).

49. Note for Case 2: Ownership Matters • One benefit of privatization is the revenue it generates for governments. • Figure 21.9 summarizes the revenue effect for a sample of transitional economies between 1990 and 1998. • Privatization created a one-time inflow of funds to government coffers. • Revenues came primarily from privatization of infrastructure industries, as in Figure 21.10.

50. Figure 21.9: Privatization Revenues by Sector, 1990-1998