Download Twenty-Five Years Later: Macroeconomic Aspects of Transition

Twenty-Five Years Later:
Macroeconomic Aspects of Transition
Charles Wyplosz
The Graduate Institute, Geneva, and CEPR
June 2014
I am grateful for useful comments to John Odling-Smee, Fabrizio Coricelli, other
conference participants and especially Anders Aslund who offered a number of
important suggestions
1. Introduction
When transition started, there were huge hopes and there were huge fears. Hopes of
democracy and of sharply increasing standards of living were combined with fears of
economic and social dislocation. Both happened, in varying proportions from one
country to another.1 The great wheel of transformation created winners and losers, but
the process was not random. In some countries, the winners were the better educated
and the younger, in others they were those better connected to the previous regime,
sometimes the less scrupulous. Older generations generally fared worst. This massive
reassignment of power and wealth was unavoidable because the old order collapsed
too fast for anyone to organize the new order. Yet, it could be successful despite
widespread hardship, or it could fail and lead to new forms of authoritarian regimes.
Both happened. This paper takes a broad-brush look at the macroeconomic outcomes
and tries to draw some general lessons.
When it started, the expectation had to be that transition would trigger a catch-up
process. Indeed, these countries emerged from a profoundly mismanaged economic
system. Most of them had large human, capital and natural resources. Most observers,
the author included, expected that within two decades, all of the transition countries
would have closed a significant part of the difference in standards of living with the
advanced economies. While acknowledging the limits of GDP measures, a good
starting point is to examine what happened to GDP per capita since the onset of
transition. A reasonable catch-up criterion is whether a country GDP capita has grown
faster than in mature economies. To that effect, Figure 1 compares the GDP per capita
of each of 28 transition countries relative to the Western Europe level in 2010 – latest
available observation – to the same measure in the initial pre-transition year. The
figure is sobering. The 16 countries (62.5%) that did close the gap appear above the
first diagonal. That means that the remaining 12 countries appear under the diagonal.
This includes 6 of the 12 CIS countries (excluding the Baltic States) and 6 of the 16
not-CIS countries (including the Baltic States). The list appears in Table 1.
Table 1. Who caught-up and who did not
Catching-up countries
Not catching-up countries
Not CIS
Albania, Bulgaria, Czech Rep.,
Bosnia, Croatia, Hungary,
Estonia, Latvia, Lithuania,
Macedonia, Romania, Serbia
Montenegro, Poland, Slovenia,
Slovakia
CIS
Armenia, Azerbaijan, Belarus,
Georgia, Kyrgystan, Moldova,
Kazakhstan, Turkmenistan,
Russia, Tajikistan, Ukraine
Uzbekistan
Note: Initial observation is 1989 for the non-CIS countries and 1991 for the CIS
countries.
Source: Bolt and van Zanden (2013)
1
Early reviews of the macroeconomic process are Blanchard (2003), Roland (2000), Svejnar (2001) or
Wyplosz (1999). Collective volumes include Blanchard et al. (1994), Pleskovic and Stiglitz (1999) or
Blejer and Skreb (eds) (2001). More recent assessments are Aslund (2007), Popov (2007) and Coricelli
and Maurel (2011).
1
< Insert Figure 1 >
Note: Initial observation is 1989 for the non-CIS countries and 1991 for the CIS
countries.
Source: Bolt and van Zanden (2013)
One could argue that Western Europe is not the proper comparator group given its
generally poor growth performance. If one chooses instead the whole world as the
comparator group, only two countries (Albania and Slovakia) are found to have
closed the gap. If we just look at whether the 2010 GDP per capita is higher than at
the onset of transition, we find that 5 countries fail this more than modest criterion
(Macedonia, Kyrgyzstan, Moldova, Tajikistan and Ukraine).
Most countries that did not catch up underwent wars or deep civil unrest. Some other
countries also went through severe unrest but still managed to achieve some degree of
catch-up. Those economies that appear above the diagonal have actually performed
very well. Most of the success stories are to be found in Central and Eastern Europe,
in the Baltic States and in some Asian CIS countries that are resource-rich.
The unmistakable conclusion is that the process has been enormously varied, which
should not really come as a surprise. Evidently, economic conditions were different à
the outset. In addition, geopolitical considerations had to play an important role,
including wars as an empire was breaking up. The paper examines some of these
aspects, with no hope of being exhaustive.
The next five sections examine the usual key macroeconomic variables: GDP per
capita, inflation, unemployment, public finances and the external balance. Section 7
offers a broad comparative interpretation of these developments. Section 8 concludes.
2. Economic growth
The time profiles of GDP per capita of selected countries are presented in Figure 2.
The countries are grouped in the four categories identified in Table 1. The starting
date is 1989 for the not-CIS countries and 1991 for the CIS countries. The quasiuniversal pattern is an initial drop in income (please note that the scales differ)
followed by a resumption of growth.
The figure shows that a substantial part of the economic performance summarized in
Table 1 is determined by the duration of the negative or zero growth period. Sharp
and long lasting depressions have left a long-lasting impact. A key example is Russia,
which lost 40% of its 1991 GDP per capita over a period of 7 years (ignoring a
decline in the previous “Glasnost” years). In contrast, income hardly declined in the
Czech Republic. Over time the impact of these original sins will vanish.
< Insert Figure 2 >
Source: Bolt and van Zanden (2013)
2
Table 2 provides a synthesis of the time profiles. Looking at the not-CIS and CIS
countries separately, it is clear that the overall performance is indeed explained by the
duration of the decline period, the depth of the decline and the subsequent speed of
economic growth. Comparing the not-CIS and CIS countries shows that, on average,
the earlier countries underwent declines of shorter duration and lower depth, but also
that annual growth has been much higher in the latter once the depression ended.
Table 2. Average characteristics of the time profile
Source: See Table 1.
This observation suggests that the legacy was more severe in the CIS countries where
central planning had been developed deeper and longer. Indeed, average GDP per
capita of not-CIS countries initially was 42% of the Western European level, while it
stood at 30% in 1991 in the CIS countries. These two observations imply that initial
disorganization, as characterized by Blanchard (1999), was bound to be deeper and
longer lasting in the CIS countries, but also the potential for eventual catch-up would
be larger. It is quite remarkable that such a simple analysis goes such a long way
toward explaining the growth pattern observed over two decades.
3. Inflation
Before the transition, prices were tightly regulated. As is well known, they were set
according to the planners’ view of which goods “deserved” to be cheap and which
ones ought to be expensive. The ubiquitous existence of long lines in front of nondurable good shops and multi-year delays to acquire durable goods were prima facie
evidence of generalized excess demand (Kornai, 1980). The other side of rationing
was that most people were unable to spend their earnings as they wished, which
forced to save. After decades of rationing, accumulated savings were considerable.
Undoubtedly, people were eager to acquire goods, in particular imported goods
generally not available.
Freeing prices, therefore, had to lead to a surge of inflation. This, in turn, was bound
to erode the value of savings and thus further cut spending – beyond the
disorganization effect mentioned above – but not necessarily immediately. Indeed,
seeing inflation surge, consumers would see in their best interest to make durable
purchases. The signature of the establishment of free markets had to be an immediate
explosion of pent-up demand, in the face of unavoidably slow supply response,
3
including imports, due to disorganization. In addition, disorganization and slow
adjustment of formerly state-owned shops was bound to lead to the sudden emergence
of a black economy where prices would be free of any administrative influence that
could be moderating.
Examining the facts, however, is not straightforward because of data limitation. When
hyperinflation2 occurs, it is often the case that price collection breaks down. This was
the case in several transition countries, especially when economic and political
dislocation took place. Accordingly the evolution of group averages displayed in
Figure 3 must be complemented with further partial observations. The figure broadly
confirms the predicted scenario. The left-hand side chart shows that inflation rates in
excess of 1000% per annum were the norm, except in the catching-up countries of
Europe. It also shows that the surge was relatively short-lived (between 3 and 5
years), typically shorter than the recession. The right-hand chart, which uses a
different scale, shows that within 8 years or so, inflation rates in the European
countries stabilized around 5% while the CIS countries, especially several catching-up
ones, are still struggling to control price increases.
< Insert Figure 3 >
Note: The not-CIS group includes the Baltic States. Variable group composition due
to missing observations in the early years. First available observation: Albania: 1990;
Armenia: 1993; Azerbaijan: 1992; Belarus: 1992; Bosnia and Herzegovina:1997;
Bulgaria: 1989; Croatia: 1991; Czech Republic: 1994; Estonia: 1993; Georgia: 1993;
Hungary: 1989; Kazakhstan: 1993; Kyrgyzstan: 1993; Latvia: 1993; Lithuania: 1994;
Moldova: 1992; Montenegro: 2001; Poland: 1989; Romania: 1989; Russian
Federation: 1995; Serbia: 1995; Slovakia: 1994; Slovenia: 1993; Tajikistan: 1992;
FYROM: 1992; Turkmenistan: 1993; Ukraine: 1992; Uzbekistan: 1992.
Source: UN Economic Commission for Europe
This picture, however, does not reflect the early experience of former Yugoslavia and
the CIS countries, for which data are missing in general for the first two or three years
after the onset of transition. According to Hanke and Krus (2013), of the 56
hyperinflations ever documented, 26 occurred in transition countries.3 This stunning
observation, however, must be qualified. Out of these 26 episodes, 14 occurred
immediately after the dissolution of the USSR. In nearly all cases, the hyperinflation
episode lasted only one month. This does not mean that inflation was soon
vanquished. As shown in Figure 4, some CIS countries faced some further
hyperinflation episodes later on: Kazakhstan and Turkmenistan in 1993, the latter
again in 1996, and Armenia and Georgia in 1994. Outside the CIS, still according to
Hanke and Krus (2013), Poland had a brief hyperinflation episode in January 1990 as
did Bulgaria in 1991 and 1997. A true, lasting hyperinflation occurred in Serbia in
1992-93, with a peak rate that was the third largest ever in the world; this was the war
period, but before NATO attacks.
2
Hyperinflation is conventionally defined as an increase in the price level of more than 50% per
month.
3
I owe this remark to Anders Aslund.
4
<Insert Figure 4>
Source: Hanke and Krus (2012)
More details appear in Table 3, which displays national averages over two decade, as
well as the maximum rate reached in each county over the available sample period.
Half of the countries experienced at least one year of inflation above 100% and this
rate was exceeded for several years in many countries, including 6 years in Belarus
and Romania.
The early inflation figure for the catching up European countries (most of which
eventually joined the EU) is driven by one case (Croatia, which was at war) and
missing information for several others, including Serbia. Some countries managed to
control the surge; this is especially the case of Czechoslovakia and its two legacy
countries, which never underwent inflation much higher than10%.
Table 3. Inflation rates (% p.a.)
Note: See Figure 3.
Source: UN Economic Commission for Europe.
All in all, the outcome is qualitatively as expected. Inflation surged at the outset of
transition, and then generally declined with numerous exceptions. The surge was
5
dramatic in nearly all CIS countries, including the Baltic States. It reflected an instant
flight from the Soviet ruble when people were trying to protect their accumulated
savings, mostly by buying hard currencies. As a result the exchange rate of the ruble
collapsed instantaneously. Hardly anything could have been done to avoid this surge,
except for capital controls. Such controls were indeed adopted in many countries but
they were largely ineffective given the dislocation under way. Those people who
could not convert their savings into hard currencies or durable goods saw their wealth
wiped out. Along with collapsing economic growth, in most countries, inflation made
the start of transition a most traumatic shock.
As new currencies were progressively introduced, the responsibility for price stability
shifted to national central banks. They were often inexperienced and hardly ever
independent from the political authorities. Since then, there have been a few
hyperinflation episodes, as previously indicated. Among them, after achieving a
monthly inflation rate of 242% in February 1997, Bulgaria adopted a currency board
arrangement for its exchange rate, in effect changing its currency into a clone of the
deutschmark first, and the euro next, and removing all political influence on its central
bank.
The natural suspicion is that high inflation was the consequence of large budget
deficits funded through money creation. Unfortunately, budget balance data are
generally not available for the first decade of transition. Over the period 2003-2013,
the correlation between inflation and budget deficits across the transitions countries is
rather low (0.44) and positive, which runs against the assumption that the mostly
modest inflation rates observed are driven my monetary financing of budget deficits.
Hyperinflation, on the other hand, is known to be driven by uncontrolled budget
deficits, which is most likely to be the driving force behind the few late episodes. As
argued above, the episodes that occurred immediately at the start of transition are
likely to reflect a flight from currency in a situation of acute dislocation.
Figure 3 shows that inflation has ceased to be a problem in most countries. Some have
achieved very low inflation rates. On others, mostly in the CIS countries and, to a
lesser extent in Hungary, inflation remains a live issue. In fact, the correlation across
countries between the two sub periods is (moderately) positive (19.4%), which
confirms the impression of long lasting characteristics, most likely institutional ones.
All not-CIS countries have now durably stabilized inflation, especially those that are
part of the EU. The situation is less stable among the CIS countries. Only two
countries (Belarus and Uzbekistan) exhibit in 2013 an inflation above 10% , and it is
above 5% in five others(Armenia, Kyrgyzstan, Russia, Serbia and Turkmenistan).
4. Exchange rates
4.1.
Monetary policy
So far, monetary policy has been considered only in its role regarding inflation.
Monetary policy, however, does not work mechanically in a vacuum. It operates
through the financial sector. Starting from the absence of financial intermediaries and
institutions, it takes time to build up a financial sector. In some countries, this was
done fast, in others it still remains unfinished business.4 As financial markets
4
See e.g. Berglof and Bolton (2001) and Bonin et al. (2003).
6
developed, monetary policy had to evolve. An interesting and important part of this
evolution is the choice of the exchange rate regime.
All transition countries started with artificial exchange rates, set according to central
planning pricing rules in the Soviet Union and in Comecon. It was clear at the outset
that market rates would eventually be unhinged from the legacy rates. Most currencies
were expected to depreciate in real terms to achieve external competitiveness for their
production and limit massive imports. Anyhow, given the widespread inflation surges
documented in Figure 3, nominal exchange rates had to depreciate deeply. The risk,
all along, was to trigger the classic vicious cycle where inflation and depreciation feed
each other. There was a trade off, though, as taming inflation and stabilizing the
exchange rate, could lead to a real appreciation, which stood to deepen the initial
recession. This is why the choice of the exchange rate was, and remains, crucial.
Adopting a fixed exchange rate is a way of harnessing monetary policy, but when
inflation is high overvaluation soon challenges the regime choice. Letting the
exchange rate float may reduce the risk of overvaluation but it requires a central bank
strong and independent enough to adopt a nominal anchor like an inflation target. In
both cases, the determination to hold the line is crucial. This is why intermediate
regimes are often adopted, including pegs that are often changed or managed floating.
The choice is well known but always challenging.
As they started with inexistent exchange markets, transition countries could not adopt
a flexible exchange rate. With inexperienced central banks, which therefore had no
credibility to start from, they needed to adopt a highly visible anchor. This called for a
fixed exchange rate regime. A very hard currency board could actually provide both
credibility and insurance that monetary policy would not be misused. However, as
they faced an inflation surge, these calculations were highly unpractical. One solution
was to start from a much-undervalued exchange rate to provide room for appreciation
without risking instant overvaluation and its crippling effects. But a large depreciation
would add fuel to the inflation fire. There simply was no choice that was robust and
feasible.
In the event, the transition countries adopted all the possible varieties of exchange rate
regimes, with some countries shifting their choices in rapid succession. A detailed
summary is provided in Table 4. Four regimes are considered, ranging from hard pegs
to free floating.5 The contrast between the CIS and other countries is stark. At the
outset, the not–CIS countries were mostly split between peggers and floaters and,
over time, moved to peggers, largely because a growing number of them joined the
Eurozone or adopted a currency board link to the euro. With the exception of Albania
and Poland, the Czech and Slovak Republics, the low inflation countries have adopted
a currency board arrangement vis à vis the DM first, then vis à vis the euro (Bosnia
and Herzegovina, Bulgaria, Estonia, Lithuania) or maintained de facto their exchange
rates reasonably fixed (Croatia, Latvia, Macedonia). Thus exchange rate based
monetary policies have been instrumental, but not always successful, in countries with
weak institutions. On the other hand, other countries achieved low inflation thanks to
solid monetary policy frameworks, including inflation targeting.
5
The definition of exchange rate regimes, as well as their properties, is highly controversial; for a
recent review see Rose (2011). This means that the foregoing discussion needs to be considered with a
grain of salt.
7
With almost no history of independent central banking, the CIS countries started off
by pegging, as expected, but then deserted in mass this regime toward one variety or
another of float as they underwent massive inflation surges. By 2007, only Armenia
had adopted pure floating. Among the peggers, Ukraine has been forced to devalue
repeatedly, often within IMF programs, as uncontrolled inflation kept undermining
external competitiveness.
Table 4. De facto exchange rate regimes (Number of countries)
Note: data for Bosnia start in 1995, for Croatia and Uzbekistan in 2002. The Baltic
States are classified as not-CIS countries.
Source: IMF.
Summarizing, the most preferred regime (38% of all country-year observations) has
been managed floats, where the central bank makes a limited commitment. It has
supported a large share of the high (10% to 50%) inflation and a few of above 1000%
episodes. The second most popular regime (34% of the observations) has been the
fixed exchange rate regime. This is what is found in many of the low inflation cases
(less than 10%) but it also characterizes a few of the above 1000% inflation cases,
which means that the regime soon had to be abandoned. Free floating corresponds to
25% of the observations.
Thus, the ex ante agnosticism is well borne out by subsequent developments. Like all
other countries, the transition countries faced, and still do, complex tradeoffs. The real
issue is how to anchor monetary policy to achieve long run price stability. Initially,
the absence of well-functioning financial markets argued strongly for a fixed
exchange rate, which inflation surges immediately undermined. Over the last decade,
strong domestic politico-economic institutions argued for a large degree of exchange
8
flexibility. Weak institutions, in particular limited central bank independence, favor a
fixed exchange rate, if only because it promptly reveals the consequences of monetary
and fiscal policy laxity.
4.2.
Real exchange rates
A key principle is that, over the long run, real exchange rates are driven by real
forces: international competitiveness, external indebtedness and the presence of
natural resources. In the short run, real exchange rates are driven by nominal
exchange rate movements. It follows that real exchange rates fluctuate around their
long-run equilibrium level, which can itself change over time. In fact, catching-up
countries are expected to display a real appreciation trend; this is predicted by the
Balassa-Samuelson hypothesis (Halpern and Wyplosz, 1997; Coricelli et al., 2001).
In an ideal world, the real exchange rate would simply be equal to its equilibrium
level. For catching-up and transition countries, this would mean a smooth path of
continuous appreciation. The world is not ideal, however. Even freely floating
exchange rates exhibit fluctuations around their trends, responding to policy actions
and various domestic and international disturbances. Fixed exchange rates, tend to
become overvalued when inflation is higher than abroad. This calls for recurrent
devaluations, which are often accompanied by speculative attacks and result in
undervaluations. Looking at real exchange rate fluctuations around their trends
provides a good summary of a key aspect of monetary policy.
Figure 5 displays the evolution of the (unweighted) average of the deviation of
national real effective exchange rates from their sample means (1989-2013 for the
not-CIS countries, 1992-2013 for the CIS countries) in the four country groups
previously identified. Using sample means is a way of avoiding to estimate the
equilibrium real exchange rate, always a delicate exercise. Over a long enough
sample, the presumption must be that the sample mean is close to the equilibrium
level, if it is constant. As noted above, however, equilibrium real exchange rates are
expected to be appreciating over time in transition countire, which must be kept in
mind when interpreting the chart.
The general pattern for all country groups involves a sharp initial devaluation
followed by an appreciation trend, as expected. The sharp initial fall, which ranges
from 40 to 80% – huge movements by any standard – are a further signal of economic
dislocation. For most citizens, this was the fist traumatic event that they met in the
transition process. The loss of value of their currencies acted as a powerful symbol,
but it was not merely symbolic. It meant a massive loss in purchasing power over
foreign imported goods, precisely those that they were longing for and believed that
they could finally access to. It also meant that those who had put their savings in hard
currencies – legally or not – enjoyed an immediate windfall gain of considerable
proportion. This was perhaps the first encounter with large income and wealth
inequalities.
It is interesting to observe that the not-CIS catching-up countries promptly absorbed
the initial fall. From 1992 onwards (with exceptions like Bulgaria), their real
exchange rates started to appreciate quite smoothly. This meant either that inflation
was tamed in the fixed exchange rate countries, or that floating exchange rates were
absorbing inflation differential, as in the ideal case. Elsewhere, the initial real
9
depreciation was followed by large overvaluations as one form or another of nominal
exchange rate rigidity prevented the absorption of large inflation rate differentials. It
took about a decade for these countries (on average) to adopt adequate monetary
policies, which then led to limited fluctuations around the appreciating trend that
reflected the catching-up process.
<Insert Figure 5>
Note: Each country REER is computed as a percent difference from its sample
average (1989-2013 for the not CIS countries, 1992-2013 for the CIS countries). The
group measures are unweighted average of these deviations.
Source: Darvas (2012).
The association of overall economic performance (whether countries are catching up
or not) with the evolution of the real exchange rate over the first decade is unlikely to
be fortuitous. This is the period when time was lost and not yet made up for. The real
exchange rate gyrations correspond to the ineffective use of monetary to trade off
inflation control, the search for a nominal anchor and, most likely, political pressure
to finance budget deficits.
5. Unemployment
As is well known, there was supposed to be no unemployment in the centrally
planned economies. Equally well known is that significant numbers of workers were
employed without any real job and that work intensity was limited in many firms,
sometimes leading to second jobs in the underground economy. Part of the transition
challenge was to raise productivity, which required inter alia the elimination of
redundancies. Eventually, growth would provide workers with productive jobs but,
early on, unemployment was expected to jump. Then, over time, the unemployment
rate would move towards its equilibrium level, which would be largely driven by the
quality of labor market institutions. Hopefully, therefore, initial high rates of
unemployment would decline as transition takes hold.
This is not what happened if one judges by the group averages exhibited in Figure 6.
Unemployment generally increased initially, as expected, but did not quite go down
afterwards. In fact it has risen steadily in the not-catching up European countries.
Interestingly, the unemployment rates are lowest in the CIS countries, and at very
similar levels, independently of whether we look at the group of catching up countries
or at the group of not-catching up countries. This suggests that labor market
institutions do not play a crucial role in determining the growth outcome in the CIS
countries. In contrast, labor market institutions are likely to play some role in the notCIS countries since unemployment rates in the catching up countries have long been
lower than those in the not-catching up countries.
<Insert Figure 6>
Note: Early years not available for most countries.
Source: UN Economic Commission for Europe.
10
As always, averages may be misleading. The situation in 2011 – the most recent year
when most data is available – is documented in Table 5. Some rates are suspiciously
low (Belarus, Tajikistan). For the now-EU former transition countries, most rates are
“classic European” in the 7-10% range. They were much higher in the Baltic
countries as these countries were then in the midst of severe fiscal consolidations in
2011; since then the rates have gone down significantly. In the CIS, the situation is
very diverse from one country to another, an indication of equally diverse evolutions.
Table 5. Unemployment rates in 2011
Source: UN Economic Commission for Europe
6. Public deficits and debts
The states that emerged, sometimes gradually and dramatically, from the collapse of
the old order started with different public debt levels. At one end of the spectrum (see
Figure 7), Romania had virtually no debt, the result of aggressive policies by the
Ceaucescu regime. Neighboring Bulgaria, at the other end of the spectrum, had a debt
of 170% of GDP in 1992. Russia, which assumed the public debt of the Soviet Union,
started off at 116% of its GDP. Highly indebted Poland (62% of GDP at end 1989)
benefitted in 1991 from a unique 50% reduction from the Paris Club of official
creditors. Hungary could have possibly obtained a similar treatment but refused to do
so.
<Insert Figure 7>
Note: Due to data availability, the initial year, indicated in bracket, does not coincide
with the onset of transition.
Source: IMF
11
Independently of the size of inherited indebtedness, the early years were to be
extremely challenging. To start with, a legacy from the previous regime was a large
public sector, arguably inefficient. Public spending included subsidies to state-owned
firms, extensive social expenditures and a vast bureaucracy. As famously known,
transition countries had a public sector and a level of transfers similar to those found
in developed countries, but they were poor. Thus large spending cuts were needed but
at the same time, public infrastructure was famously dilapidated and massive
investment was needed. This investment was bound to raise aggregate productivity
and therefore likely to eventually pay for itself. The whole composition of public
expenditures had therefore to be turned around, with an overall reduction toward
levels commensurate with the state of development.
No one could underestimate the extreme political difficulties of the required
undertaking. Cutting subsidies to firms and the ranks of the civil service meant going
against entrenched interest groups. Trimming social spending would hurt the weaker
part of the population, the sick, the elderly and the unemployed, who were the least
well prepared to seize on the opportunities opened by the transition process. At the
same time, keeping subsidies in place would stunt the transformation process and
prevent incomes from rising and reaching the broad population. This was a make-orbreak undertaking.
On the revenue side, the economic dislocation and initial recession had to severely
reduce tax revenues. In fact the tax system had to be overhauled for the system
inherited from the command economy was woefully incompatible with a market
economy. This involved redesigning the whole range of taxes and building up an
adequate tax collection administration. Even under the best of circumstances, such a
massive undertaking requires years. Meanwhile tax income was bound to decline,
quite possibly sharply.
Absent financing considerations, therefore, the likely path of budget would involve
initial deficits, possibly large ones given the infrastructure needs and the initial
welfare costs in the wake of the transition shock. Eventually, budgets should return to
balance or to what would be needed to bring the public debt to a sustainable level.
Financing considerations, however, had to be crucial. Most transition countries did
not have market access at the outset. Most of them applied for external support, either
through the IMF (where a new department was created to deal with the CIS
countries), or through the EBRD (specially created for the purpose), often both.6 Debt
reduction in the largely indebted countries was naturally promoted by these
organizations and, anyway, was a requirement for gaining market access. Indeed, ten
years later, all large public debts had been slashed, sometimes as the result of very
high inflation as documented above. Thus public policies were far too constrained in
moth countries to resemble the desirable path. It must be noted that the European
countries benefitted from loans and grants from the EU as they moved toward
membership. Once members, they were eligible to various structural and regional
funds.
6
In passing, it may be noted that the IMF’s European II department was closed down in 2003, marking
the end of the transition phase. The EBRD, which its second director promised to close down when the
transition phase would be over, still exists, having expanded its outreach to North Africa.
12
Figure 8 displays the evolution of public spending for the four groups identified in
Table 1. It confirms that initial spending ratios were excessively high. They were
brought down over a period of ten years so, especially in the CIS countries where
financing considerations often played a considerable role. In the early years, quite
often, expenditures were not officially reduced but governments resorted to various
forms of non-payments or sequestration, which contributed to the disorganization
process.7 In many instances, this was a question of government survival in front of
collapsing tax revenues.
The figure also shows that the catching up countries, both in Europe and in the CIS,
have succeeded in permanently reducing public expenditures by some 20% of GDP,
on average. In contrast, there was a relapse among the not-catching up countries,
especially in the CIS. This most likely reflects deep institutional failures, as discussed
in Section Error! Reference source not found..
<Insert Figure 8>
Notes: Early years data are subject to large errors. Averages for country groups
include varying composition in the early period.
Source: World Economic Outlook, IMF, and Transition Report 1995, EBRD, for the
early years.
The result was large initial budget deficits. In the early years, nearly all transition
countries depended critically on emergency international assistance. IMF programs
invariably called for deficit reductions through a combination of expenditure cuts and
tax reforms. In a few cases, desperate governments resorted to monetary financing,
leading even to hyperinflation as noted in Section 3. Elsewhere, runaway deficits
have occasionally led to outright financial crises, the case of Russia in 1998 being a
prominent example. In 1996-7, Bulgaria underwent both a financial crisis and
hyperinflation.
Over time, as deficits were brought under control, most transition countries gained
market access. This meant an end to rising public indebtedness. Figure 9 documents
the current situation by comparing public debts with their initial levels as displayed in
Figure 7. It shows that the countries that started out with very large debts have
achieved a lasting reduction. For the initially low public debt countries, the situation
is highly contrasted. By and large, public debts in the CIS countries are now lower
than they were initially, the exceptions being politically-troubled Belarus and Ukraine
as well as Armenia and Kyrgyzstan. In Europe, only five countries have public debts
lower now than initially, all of which started with debts in excess of 50% of GDP.
The European countries thus display a regression to the mean, which is what would
have been seen desirable at the outset. Governments with borrowing space did borrow
while those burdened by large legacy debts had to bring them down.
7
This is one reason why early data are not reliable.
13
As noted previously, tax systems had to be completely overhauled. In addition to
introducing VAT and modern corporate taxation, a number of countries have
innovated income taxation by adopting flat taxes. As documented in Turley and Luke
(2011), 14 out of the 28 transition countries have adopted this system: the three Baltic
States in 1994-7; Russia in 2001; Slovakia and Ukraine in 2004; Georgia and
Romania in 2005; Macedonia, Kyrgyzstan and Montenegro in 2007; Albania,
Bulgaria and the Czech Republic in 2008. This simplified approach was well adapted
to the complicated situation of transition countries. It is controversial, though, an issue
not pursued further here.
<Insert Figure 9>
Notes: Due to data availability, the initial year, indicated in bracket, does not coincide
with the onset of transition. For the exact date, see Figure 7. The Baltic States are
classified as not-CIS.
Source: IMF
All in all, budgetary issues were crucial and overwhelming at the outset. In the initial
years, the outcome has been predictably chaotic. In many countries, it has a decade or
more to stabilize the situation. Where reforms lagged, protracted inflation (Table 3)
indicates that deficit financing through money creation has been the variable of
adjustment. On the other hand, the requirements of EU membership have provided
many European transition countries with the incentive to speed up the process of
fiscal stabilization.
7. Current accounts
There was no obvious prediction concerning external balances at the outset of the
transition process. All countries inherited from the previous regimes antiquated
production means and largely obsolete products. Specialization was largely artificial,
as mandated by central planning for the whole Soviet Bloc. This meant limited
possibilities of exporting to market economies and, over time, to the former Soviet
Bloc. In addition, previously accumulated forced savings could be mobilized to fulfill
pent-up demand for western goods after decades of relative isolation, in line with the
permanent income hypothesis. These characteristics would predict a burst of deficits,
which could be financed by external borrowing for those countries that started off
with limited external debt and no private debts. On the other hand, the initial deep
recessions would severely limit spending and therefore imports. Finally, the behavior
of exchange rates would also affect the external balance (see Section 4. ). These
considerations ignore the fact that many CIS countries are rich in natural resources,
which would eventually lead to exports while leaving them open to price fluctuations.
In the longer run, the natural prediction would be of current deficits as the countries
catch up and therefore need considerable private and public investments, in excess of
14
domestic savings.8 This would require access to international financial markets and
therefore sufficient improvements in domestic banking and markets.
In the event, the evolution of current accounts has been very varied across countries
and no general pattern emerges. A stylized – and somewhat arbitrary – classification
is presented in Table 6. It shows that deficits have been the rule, the exception being
Russia owing to its enormous natural resources, and Slovenia and Ukraine where the
current account has fluctuated near balance. All other countries have experienced
continuous current deficits – some with occasional but rare surpluses – since the
beginning of transition, as predicted by the catch-up view. Nine countries are even
classified as continuously undergoing very large deficits. Indeed, deficits above 20%
of GDP represent 5% of all country-year observations (half of all observations for
Montenegro and nearly 25% for Azerbaijan). Over the last few years, several
countries have managed to break their long streak of deficits. This is the case of the
Baltic States where a severe fiscal consolidation has been implemented following a
decade or so of break-neck growth fueled by domestic demand, as predicted by the
permanent income hypothesis.
Table 6. Current accounts patterns (1990-2012)
8
Of course, a lasting puzzle is why many emerging market countries operate current account surpluses.
15
Note: A star identifies catching up countries.
Source: World Economic Outlook Database, IMF
A different way of organizing available information is to look at the Net Foreign
Assets (NFA) positions as estimated and updated by Lane and Milesi-Ferretti (2007).
This is the balance between private and public assets and liabilities vis a vis the rest of
the world. Its evolution reflects cumulated current accounts as well as changes in the
values of these assets and liabilities. When they are computed in national currency, as
they are when given in proportion of domestic GDP, NFA estimates also include the
effects of exchange rate movements. Figure 10 compares the positions initially (the
first available observation) and in 2011, the last year currently available. Observations
above the 45o line indicate an increase (less indebtedness) in the NFA position. As
suggested by Table 6, there is no regression to the mean. Only two of the 14 listed
European countries improved their positions: postwar highly indebted Serbia and,
marginally, Albania. On the other hand, 5 of the 13 CIS countries saw their NFA
position increase, all of them resource-rich (Azerbaijan, Russia, Tajikistan,
Turkmenistan and Uzbekistan). In addition to Tajikistan, which remains heavily
indebted (NFA is – 61% of GDP), all the other transition countries display negative
NFA positions as of 2011. There is nothing fundamentally wrong with negative NFA
positions, except maybe for the most highly indebted countries (Bulgaria, Croatia and
Georgia, with positions at close to or above 90% of GDP).
<Insert Figure 10>
Note: The Baltic States are classified as not-CIS.
Source: Update of Lane and Milesi-Ferretti (2007).
8. Speed of Reforms: an Old Controversy:
In the early transition years, a heated debate concerned “shock therapy”. In contrast
with a gradualist approach (see e.g. Coricelli and Milesi-Ferretti (1993), Roland,
2000), a number of economists (see e.g. Balcerowicz (1994), Sachs, 1996) argued that
taking just one big step was preferable to moving slowly. The debate is well
summarized in Popov (2000) and reviewed in Aslund (2007). It involves a wide array
of trade-offs, hence the inherent controversial nature of any firm conclusion. A
sketchy summary of this rich debate is as follows.
One economic issue is how quickly prices should be freed and trade be reoriented. An
immediate freeing of prices and trade sends clear signals to producers, including
incumbent ones, which allows them to invest wisely. On the other hand, adequate
financial and human resources may be insufficient to promptly replace obsolete firms,
so that old firms disappear long before new ones emerge. In brief, the existence of
16
substantial and quickly rising adjustment costs justifies gradualism while the
maintenance of outdated incentives at best block inevitable adjustments and quite
possibly encourage investment in obsolete firms and products, which shock therapy
avoids.
Another economic issue is the need to conduct appropriate macroeconomic policies at
a time of dislocation. The shock view is that too much is unknown and too few
technical resources are available to fine tune policies. The best that can be done under
the circumstances is to rely on very simple, universal, and well understood principles,
in the full knowledge that they do not apply fully, but are less prone to major mistakes
than more subtle and untested approaches. The gradualist view is that smaller initial
shocks require less active macroeconomic policies and therefore lead to fewer
mistakes.
However, many other non-economic arguments were, explicitly or not, weighing in.
The legal environment too had to change to establish commercial law, property rights,
labor relations, etc. The gradualists pointed to the scale of the required undertaking
while the shock therapists argued that the old legal environment could not lead to the
new economic order. More broadly, the question was how to deal with existing
institutions, including the administration and the financial system. The gradualists
observed that the ability to manage sharp changes was extraordinarily limited while
the shock therapists advocated the rapid adoption of institutions as they exist in the
market institutions, including relying in foreign banks.
An even broader issue is purely political. The collapse of the Soviet Bloc was of a
revolutionary nature. Whether it was triggered by civil unrest or whether the old
regimes collapsed because it happened elsewhere, this was everywhere a sudden
political regime change. In the not-CIS countries as well as in Russia, the previous
elites where instantly sidelined while the new elites had to emerge, creating a
temporary vacuum. This changeover obviously involved massive economic interests.
Those on the losing side were bound to at least try to limit their losses, taking
advantage of the vacuum. They were in favor of gradualism. The new authorities had
to quickly assert their authority and to thwart attempts by the outgoing elites to
recover what they could, possibly even to return to power. This was one important
reason for the adoption of shock therapy. Indeed, in most CIS countries, with the
notable exception of Russia and to a lesser extent of Ukraine, the old elites took over.
They were gradualists by definition as their central aim was to limit the changes.
A sizeable literature has focused on the transitional recession. As reviewed in Popov
(2000), the evidence of the strategy choice on the depth and duration of the recession
is unclear. One has to take into account other aspects than the strategic decision,
including the starting situation (specialization, industrial structure, political turmoil,
etc.), to account for the different recession patterns. In addition, gradualism or shock
therapy were not black-and white strategies and one cannot easily classify most
countries as having pursued one or the other strategy.
This assessment is confirmed by Figure 11, which plots the duration and depth of the
initial recession against a measure of the liberalization that occurred during the first
17
three years of transition.9 The shock therapy countries appear on the right side of each
chart while those towards the left can be characterized as gradualist (one country,
Bosnia and Herzegovina actually backtracked according to the average EBRD index).
The first observation is that it would be arbitrary to separate the transition countries
into two distinct groups. The second observation is that the recession tended to be
shorter the stronger was the liberalization change during the first three years. The
third observation is that the recession tended to be less deep for fast reforming
countries. Both observations are tenuous, though; the corresponding correlation
coefficients are -0.25 and 0.22. Yet, if any conclusion can be drawn from this
comparison, it is that “shock therapy” led to a shorter and shallower initial recession
than gradualism. An alternative conclusion, backed by the regression analysis
presented in Popov (2000), and in the literature quoted there, is that the speed of
liberalization did not produce much of a difference.10
<Insert Figure 11>
Note: The horizontal axis is the change in the average of EBRD’s six liberalization
indices, which range from 1 (economy not free) to 5 (free economy) three years after
the start of transition: from 1989 to 1992 for the not-CIS countries and from 1991 to
1994 for the US countries. Duration and depth measures are presented in Table 2.
Sources: EBRD and Bolt and van Zanden (2013).
A separate question is whether the scale of liberalization has had an impact on longterm growth. To that effect, Figure 12 relates average per capita GDP growth over the
period 2000-2010 to the change in the liberalization index between the onset of
transition to 2010, computed as a percentage of the index initial value. The
relationship is positive, but hardly so, with a correlation coefficient of 0.065, which is
too low to be significant.
<Insert Figure 12>
Note: The horizontal axis displays the percent change of the average of the
liberalization index from 1989 (not-CIS) or 1991 (CIS) until 2000. The vertical axis
displays the average growth rate of GDP per capita over 2000-2010. Azerbaijan, an
outlier with a growth rate of 26%, is excluded from the sample.
Sources: EBRD and Bolt and van Zanden (2013).
Now that the dust has settled, what is left of the controversy? It is probably fair to
recognize that the debate was sharper than justified. Given the many trade-offs
involved, it always was unlikely that a simple, clear-cut answer would emerge as the
9
Looking at the first 5 years provides similar figures.
10
An important issue is causality. It is possible that the speed of reforms was driven, at least in part, by
the recession. This issue as been studied at length, see the literature review in Popov (2000).
18
universally right one. Each strategy involved not quantifiable benefits and costs. With
hindsight, these pros and the cons were finely balanced, at least from a purely
economic viewpoint. But transition never was only an economic problem. Political
aspects were paramount and the choice of a strategy did matter.
With few exceptions, the CIS countries adopted a gradualist strategy. These countries
today are often non-democratic, and many of them are in the non-catching up group.
Many of them still suffer from endemic inflation and the road so far has been market
by recurrent inflation surges and financial crises. It is hard not to speculate what
would their economic and political situation would be today had they erred on the
side of shock therapy. On the other hand, Russia serves as a counter-example.
Arguably a shock therapy country, even if actual reforms have been limited in the
early years, the poor economic experience of the 1990s has led to an economic and
political backlash. Of course, a crucial aspect has been the evolution of primary
commodity prices, most notably oil and gas. Had they been at the comfortable levels
reached in the 2000s, they might well have provided the governments of the 1990s
with the resources that they crucially lacked and the crisis of 1998 might have been
avoided. We do not know the answer to this question and this, again, makes it
impossible to pass a strong judgment.
Another important aspect of the debate is that the not-CIS countries decided early on
to join the European Union. This decision framed policies throughout the transition
years. The policies requested for eventual membership were precisely those that the
shock-therapists wanted to adopt. In some cases, these policies were implemented
gradually, but this does not provide an argument for gradualism. Indeed, one central
part of the shock therapy approach was to limit uncertainty on the big issues: the
eventual aim of transition, the commitment to free and open markets, the rule of law
and the form of legal institutions. Once the principle of EU membership was adopted,
and widely shared by the population, key aspects of shock therapy were established,
even if implementation was gradual.
9. Conclusions
Since 1989, life has radically changed for hundreds of millions of people, mostly for
the better. Except for China’s own transformation, it is difficult to find in the history
of mankind an economic experiment of that scale, speed – just one generation – and
complexity.
Macroeconomics was just one aspect of the economic process; privatization and trade
opening were other crucial elements. Beyond the unavoidable controversies,
macroeconomic principles have fared well. The key issues were clearly identified, the
policy responses were known and the mistakes were detected in real time.
Perhaps the most important lessons concerns which parts of macroeconomic
knowledge have been the most valuable. The issues were often complex and a
tendency was to meet them with sophisticated economic reasoning. We know,
however, that complexity takes us to areas where knowledge is imperfect and where
disagreements soon surface. In the end, sticking to simple principles proved to be the
winning strategy. To be sure, some advanced knowledge could have helped in some
instances, but gaps in this knowledge could also have led to severe errors. The most
19
successful policymakers are those who stuck to those simple principles that have long
been recognized as approximately right in all circumstances. This includes the role of
monetary policy in driving inflation and the dangers of monetary financing of budget
deficits, as well the theory of financial crises.
20
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22
Figure 1. GDP per capita initially and in 2010 (% of Western Europe)
Figure 2. GDP per capita (1990 US dollars)
Not CIS catching-up countries
Not CIS not catching-up countries
CIS catching-up countries
CIS not catching-up countries
23
Figure 3. Inflation rates (% per year)
Figure 4. Hyperinflation episodes
(Monthly inflation in the peak month)
24
Figure 5. Real Effective Exchange Rates
Figure 6. Unemployment rates
25
Figure 7. Initial gross public debts (% of GDP)
Figure 8. Public expenditures (% of GDP)
26
Figure 9. Public debts: initially and in 2013 (% of GDP)
Figure 10. NFA positions: initially and in 2011 (% of GDP)
27
Figure 11. Liberalization effects on recession duration and depth
Figure 12. Long term growth effect of liberalization until 2000
28