ECONOMICS OF TRANSITION LECTURES ON TRANSITION I

1. ECONOMICS OF TRANSITION LECTURES ON TRANSITION I

2. I. Reasons for collapse of CSS: • Development strategy focuses on heavy industry: • High investment rates into heavy industry => 1)wage fund, i.e. part of output of economy going to wages, is low; 2) industry producing consumer goods is neglected => shortages persistent: • Workers get low wages AND even this low income they are unable to spend. 3) CPS => Those who are able to buy rationed consumer goods, get shoddy goods. • => The collapse may be explained by tremendous incentive problemat the micro level.

3. II. Legacies of central planning Some stylized facts of initial conditions of transition economies (TE’s). • Disequilibrium at the aggregate level: supply constrained economy, i.e. firms can sell all the output they produce => important consequences within firms, marketing is not a priority but has to become one as the economy becomes demand constrained. Incentive structure of managers has to change. Disequilibrium also implies monetary overhang (i.e. stock of forced savings) => will translate into corrective inflation when prices will be liberalized.

4. Some stylized facts of initial conditions of transition economies (TE’s) cont. • Socialist economies are internationally based on the principle of division of labour within CMEA, so they predominantly allocate resources according to what overall plan says, they DO NOT allocate resources in an efficient way at all if we think about relative world prices => opening these economies to world markets (trade liberalization, i.e. slashing of tariffs) will make a lot of these firms unviable unless they rapidly restructure, i.e. use resources in a way that reflects relative prices rationally (energy is a particularly good example). Also => to ensure a rational use of resources one needs to open up these economies.

5. Some stylized facts of initial conditions of transition economies (TE’s) cont. • Government budget: Tax revenues: based predominantly on turnover tax of SOE firms. With the decline of revenues of SOE firms after transition, tax revenues fall. Expenditure side: lots of non-targeted subsidies, with rise in open unemployment and bridging schemes expenditures could/did rise, so government deficits are pre-programmed once transition starts.

6. Some stylized facts of initial conditions of transition economies (TE’s) cont. • No banking sector. It needs to be developed => At the macro level this means that initially government can only monetize deficits, it cannot raise internal financing (with foreign debt high external borrowing is also difficult/impossible). At the micro level, there is (certainly in the early stages of transition) no mechanisms to allocate external funds to investment projects by firms => lack or embryonic nature of banking sector retards growth and job creation.

7. Some stylized facts of initial conditions of transition economies (TE’s) cont. • CPS has a very different “social security” system from a Western economy. Virtually no unemployment (better, no OPEN unemployment) exists. Apart from pensions, all other benefits that workers have are given to them by firms (typically life-long job at one firm with all benefits provided from firms - “social assets”). In a western economy, firms are in the business (roughly speaking) to make profits; they don’t provide predominantly benefits to workers (although there are some elements of this in western firm – worker relationships). In the west, labour markets are relatively efficient (in the sense that they remunerate skills in demand with relatively higher wages and in the sense that they in equilibrium over the medium to long run, i.e. skills demanded ≈ skills supplied). The state provides a safety net for those workers who are permanently or temporarily at a disadvantage in the labour market.

8. Some stylized facts of initial conditions of transition economies (TE’s) cont. =>Social safety nets have to be builtup once transition starts to effectively and in a targeted way alleviate poverty and help temporarily non-employed, where both poverty and non-employment are, at least in part, brought on by reform. No open unemployment before => labour offices (“employment service” in Russia) that previously helped firms to find workers (under CPS excess demand for workers exists) now have to do several tasks: a. administer Unemployment Benefits (UB); b. help workers find work (“job brokerage”) and c. administer ALMP (active labour market policies). A huge achievement is that TE’s in Central Europe have very rapidly built these offices along these lines from scratch.

9. Some stylized facts of initial conditions of transition economies (TE’s) cont. • Sectoral distribution of employment is skewed towards industry and strongly against services (the consequence of development strategy that emphasizes industry, in particular heavy industry and sees consumption as a residual). Also size distribution of firms is skewed towards large (very large) firms that are often vertically integrated. In the West small and medium firms are often responsible for most new job creation.

10. Some stylized facts of initial conditions of transition economies (TE’s) cont. • Most of physical capital in the economy is owned by the state => privatization of virtually the entire stock is required. This is not easy for many reasons. Among them are: - Sheer size of the task; - Valuation problems (issue of sequencing) - Privatization schemes and corporate governance issues: - Selling vs give aways (corrective inflation has wiped out savings, so selling the stock domestically is difficult. To foreigners - ideologically impossible (the main exception – Hungary)).

11. Some stylized facts of initial conditions of transition economies (TE’s) cont. Question: why is it necessary to privatize? Empirically - in western countries private firms in general are more efficient than firms run by the state. Theoretically – if there is a private claimant of the residual, i.e. π, of a firm’s activity, this claimant makes sure that resources are used in the most efficient possible way, i.e. that π is maximized. In the west a claimant of the residual can be: - a manager – owner - share owners in the equity market (Anglo-Saxon model) - banks as majority holders of a firm’s equity (German model) Whichever way, we have efficient corporate governance.

12. Some stylized facts of initial conditions of transition economies (TE’s) cont. Political economy viewpoint. Privatization is also an irreversibility issue; fast privatization ensures that it will be virtually impossible to go back to the old economic regime.

13. Some stylized facts of initial conditions of transition economies (TE’s) cont. • Most countries have high foreign debt (government and private western creditors) => IMF, WB have leverage in pushing for reforms. Most countries have little FDI in the early stages of transition (the only exception is Hungary that had already opened up before 1989) => little foreign capital helping in restructuring.

14. Some stylized facts of initial conditions of transition economies (TE’s) cont. • Last but not least. Soft budget constraint is pervasive throughout CPS => generates management behaviour that does not economize with resources => imposition of hard budget constraint seems to be one of the most pressing problems of reformers.

15. t III. Introduction to Transition • Taxonomy of economic reform I Price liberalization Trade liberalization Macro stabilization Privatization Social safety net and income support for unemployed Tax reform Creating a banking system Systemic reforms: Reforming the labour market Generating a business friendly environment that also encourages competition Generating a commercial law structure Define BB (Poland) vs Gradualism (Hungary) using taxonomy I

16. Taxonomy of economic reform II 1. Consistent reformers. 2. Inconsistent but substantial reformers. 3. Laggards (countries that lag behind).

17. Ad. 1 CR, Hungary, Poland Main Reasons: · Collective memory of “bourgeois”, pre-communist times unlike in CIS. · Own government for the first time in 50 years, initially given a blank cheque by population (Balzerowich can pursue his reform policies for years). CPS governments are perceived as satellite governments imposed by Moscow. · Top bureaucracy is united in reform stance · EU accession requires reform.

18. Ad. 2 Russia Gaidar and his “window of opportunity” slashing expenditures on military-industrial complex. Main problems with consistent reforms: · Reformers surrounded withinbureaucracy by enemies of reform; also no attempt whatsoever to sell reform to the public; BB approach trying to move on several fronts at might also have been ill-conceived given the lack of support: it might have been better to move on one front only and then having some success getting support for further reforms. · No collective memory of capitalist/market based economy (socialism more than 70 years) · Soviet government “own government” for a large part of population (certainly in Russia) => new governments don’t get a blank cheque like in Poland, CR etc.

19. Ad. 3 Ukraine as a laggard After independence, Aug 1991, several years no reforms whatsoever. Reasons: · “Moscow” syndrome: no one gives order anymore from Moscow. · Western Ukraine (mainly Ukrainian) is confronted with Eastern Ukraine (mainly Russian) ð these factions block each other

20. GDP(indexed to 100 at the beginning of reform) 100 “U – shaped” output curve Time (0 – start of reforms) 0 t One piece of evidence w/r to taxonomy II (NB: the large positive growth rates in Russia and Ukraine since 1999 are not taken into consideration in the graphs) 1)

21. GDP 100 2 3 t One piece of evidence w/r to taxonomy II cont. 2), 3)

22. General implication for poverty: Increase in poverty is much stronger and more persistent in CIS (starting at any rate from a much lower per capita income than Visegrad countries) than in CE. Poverty in CE like in the West affects above all the unemployed, in CIS most employed workers are impoverished after the collapse of the old system. =>Reform is harder to pursuein CIS than in CE as benefits of reforms are not clear