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“Comparative Transitions: A Critical Review” CNEM-LBS, 11-12 June 2004 THE QUALITY OF MACROECONOMIC POLICIES IN THE TRANSITION Grzegorz W. KOLODKO, TIGER Institute, WSPiZ, Warsaw D. Mario NUTI, University of Rome and London Business School 1 The main proposition of our paper is that poor policy quality, especially of macroeconomic policies, has contributed greatly to the cost of post-communist transition and offers the most satisfactory explanation of differential performance. 2 Definitions Traditional literature on the transition characterises policy quality from the speed and degree of implementation of the main prescriptions of the Washington Consensus: - macroeconomic stabilisation - price and foreign trade liberalisation, - privatisation (the “good policies”, Balcerowicz, 2003); OR from the EBRD indices of Transition Progress: private sector share of GDP, small and large scale privatisation, governance and enterprise restructuring; price liberalisation, trade and exchange rate system, competition policy; banking reform and interest rate liberalisation, securities markets and non-bank financial institutions; infrastructure; 3 OR the cumulative summation of these indices over time, e.g. the Cumulative Liberalisation Index (CLI) used by Fischer and Sahay (2000). Critics, in turn, simply tend to juxtapose gradualism to shock therapy within the same basic approach. We, instead, call for a greater consideration of policy quality, judged from: the consistency or targets, the choice and intensity of qualitative and quantitative policy instruments and packages, their sequencing and speed, the coordination of policies delegated to different agencies. 4 Within this framework we will be considering: 1. The false dilemma between shock therapy and gradualism 2. Overshooting stabilisation programmes 3. Real interest rates 4. Other examples of poor policies 5. Comparative national governments 6. Central Bank Independence in the transition 7. Fiscal-monetary policy co-ordination 5 1. Shock Therapy versus Gradualism The alternative between shock therapy and gradualism is a narrow dilemma. Regardless of transition there can be no doubt that the shock of raising prices to market clearing levels was absolutely essential – even if one wanted to make the old system work. In principle prices could be raised right to equilibrium (to avoid speculative behaviour) at a stroke, or gradually over the spectrum of commodities as in the relaxation of war-time price controls, or via a dual track system as in China. In practice the generalized and endemic shortages of socialist economies could only be tackled at once. 6 In the transition a number of other things also could and should be done instantaneously and simultaneously, such as legalising private property and enterprise, giving free access to trade to all economic agents without bureaucratic obstacles such as licences or registration, eliminating quantitative trade restrictions, unifying exchange rates and allowing current account convertibility. All these changes can be done by decree, literally from one day to the next, and there is no point in waiting. At the other end of the spectrum there are a number of things that take time and must be allowed all the time they need: introducing legislation, establishing jurisprudence, setting up financial markets, establishing reputation and trust. It is pointless, indeed counter-productive, to pretend otherwise. 7 A choice between “shock therapy” or “gradualism” exists only in a handful of areas: (1) trade liberalisation, (2) the elimination of subsidies, (3) privatisation, (4) capital account convertibility and, especially, (5) dis-inflation. Here relative merits of speed and delay depend on the actual trade-offs between targets at a particular time and place, and on government preferences. Gradualism may have net advantages. There were benefits from Polish slow disinflation, its late mass privatisation, its delay in capital account convertibility; or from Czechoslovak maintenance of price and wage subsidies. Conversely, Polish and Czechoslovak rush to liberalisation, soon reversed, only gave two unnecessary jolts to their economies. 8 2. Overshooting stabilisation programmes In 1990-91 undoubtedly the Polish stabilisation plan overshot, and so did many of the plans that took it as a blueprint. On 1-11990 the exchange rate was set at the rate prevailing in the free segment of a dual market, obviously higher than the equilibrium rate in a unified market. This was inflationary. Nominal monetary targets, based on an under-estimated prospective inflation, led to an unintended credit crunch. Real wages, indexed with very low elasticity with respect to prices, took the brunt of adjustment; they collapsed and so depressed consumption demand. Investment was out of the question. Inflationary paper profits boosted tax revenues, generating an unintended budget surplus. An unintended current account surplus was generated by recession and excessive devaluation, building up foreign reserves that had to be expensively sterilised. 9 Disorganisation was rampant, and recession set in. The initial tasks confronting the Polish government were daunting; they were navigating in uncharted waters. But without hindsight it was clear that their programme would have overshot. Imagine an alternative scenario: prices are freed to marketclearing level, but wages are also freed, or a lower and affordable real wage is indexed at 100% instead of the entire current level being indexed at only 10% of inflation. Money targets are kept constant in real terms; the zloty floated – and thus initially devalued much less than it was; money interest rates are adjusted more frequently, rising and falling with inflation but more slowly, without targeting intermittently a positive real rate. Under this set of policies overshooting, if any, would have been less severe. Frequently over-shooting takes the form of excessively high interest rates. 10 3. Real interest rates Targeting positive real interest rates is not supported by any known economic theory. They are supposed to encourage savings but – outside the hyper-inflationary zone – savings may or may not be promoted by high real rates. An ageing population, for instance, like any “target-saver” might save more at lower rates. In any case real interest rates in the transition have been highly variable and occasionally exceedingly high. In the next figure they go off the scale, being taken to extremes in Russia in 1994. In Poland in 2000-2003 real interest rates were maintained above 6% for inflation rates below target and below Eurozone inflation. Note that the rates in the figure are calculated deflating money rates at current inflation, and therefore are under-estimated at times of de-celerating inflation as in most of the period considered. 11 Real Interest Rates 100 Ukraine 50 Russian Federation Poland 0 Czech Republic -50 Hungary 2001 1999 1997 1995 1993 1991 1989 -100 12 High interest rates are recessionary through their impact on both investment and international competitiveness (through stronger exchange rates). In Russia they encouraged the de-monetisation of the economy (through barter, payment arrears, money substitutes). 13 4. Other examples of poor policies Non-sustainable combinations of high interest rates, overvalued exchange rates and low targets for government deficits: these are the ingredients of the Russian financial crisis of August 1998, and other instances such as the Czech koruna crisis of 1997. Exchange rates boosted by high interest rate policies undermine their own credibility by adverse impact on the trade balance and the cost of servicing government debt. Setting limits to the government deficit calculated on a cash basis instead of accruals gives an incentive to the government to postpone expenditure rather than restrain it; together with high interest rates it was a major factor in the de-monetisation of the Russian economy, through arrears in the payment of wages and salaries, pensions and government purchases from enterprises also caught in the chain and 14 responding with their own arrears including tax arrears. Paradoxically, excessive real interest rates, non-sustainable packages of interest/fiscal and exchange rate policies, and cash limits for government deficits – are all enshrined in IMF and World Bank policies. Another form of poor quality is that of policy reversals. Beside the protectionist involution of many countries after initial overenthusiastic and unilateral trade liberalisation – already mentioned – reversals have occurred, for instance, in the macroeconomic stance adopted in Russia in 1992 by the government in January-April and undone by the Central Bank in the second half of 1992 with the restoration of enterprise liquidity through large scale. In Poland in 1995 the exchange rate was forced down along the ceiling of the band around the crawling peg only to be pushed up intermittently by the market. 15 5. Comparative governments performance in the same country The analysys of comparative transitions should include the comparison of policies followed by different governments in the same country over time. See for instance Poland’s economic performance in 1989-93, under Balcerowicz Mk-I and the whole first legislature, in the period 1994-97 of Grzegorz Kolodko’s “Strategy for Poland”, and the 19982001 “cooling” period of Balcerowicz Mk-II, returned to government and then President of the National Bank of Poland (2001-). 16 Under Balcerowicz Mk-I unemployment rose from a negligible level to a peak of 16.9% in 1994 due to the government policies of 1993. Under Kolodko unemployment fell by a million to 9.8% and GDP rose by 28% (corresponding to almost the entire increase of 29% that occurred in 1989-2001). In September 1997 during the electoral campaign Balcerowicz produced a three-page document dubbed by the press “The Second Balcerowicz Plan”. He criticised the government for having a too low growth rate and proposed to raise it so as to double GDP in the following ten years. (The rate was 7.5% in the second quarter of 1997, already higher than the 7.2% necessary to double GDP in 10 years). Back in government, Balcerowicz Mk-II adopted a policy of cooling (zachlodzenie), indeed overcooling (przechlodzenie) the economy down to 3% in the second quarter of 2000 when he stepped down as Minister of Finance, though he acquiesced to a budget deficit increase under Solidarity pressures. 17 Growth deceleration continued under the influence of high interest rates and strong exchange rates adopted by Balcerowicz Mk-III (as Governor of the National Bank of Poland), over-fulfilling the target of inflation reduction and raising unemployment (from 9.8% under the previous government back up to over 17%. Income growth acceleration resumed when Kolodko Mk-II took over again as Finance Minister (2002-2003), with his policies of financial restructuring and debt reduction of enterprises; institutional developments; more active public policy especially in investment; reform of public finances. Unfortunately the latest fiscal incontinence of the Polish government has gone some way towards justifying ex-post the deflationary stance of NBP. Identical relative performance applies to investment and GDP growth. 18 Investment in Poland in 1990-2004 (in %; fixed prices) 21.9 97 2.5 94 95 98 99 -6.8 -8.8 91 2.7 93 5.0 2.9 92 12.2 14.5 20.6 16.9 96 9.2 2.3 90 -4.4 -10.6 25.0 20.0 15.0 10.0 5.0 0.0 -5.0 -10.0 -15.0 2000 2001 2002 2003 2004 19 GDP dynamics and unemployment rate in Poland in 1990–2007 (* 2004-06 – forecast from PNFR – Program of Public Finance Reform) 16 14 20 10 8 6 % Reform of Public Finance* Strategy for Poland 12 Overcooling Shock “therapy” 7,0 5,2 3,8 4 2 6,0 16 6,8 4,8 6,0 4,9 5,4 4,1 4,0 3,5 2,6 1,0 0,6 1,9 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 I half 2002 -10 -12 -11,6 half 2002 -6 -8 II 14 12 10% 0 -2 -4 18 2003 2004 2005 2006 8 6 4 -7,0 2 0 20 6. Central Bank Independence in the transition CBI is a fairly recent invention, dating from the 1980s. It is the child of rational expectations theory and the vertical Phillips Curve, and concerns for the credibility of monetary policy (see Kydland-Prescott 1977 on time inconsistency of discretionary monetary policies, Barro-Grossman 1983 on reputation building, Rogoff 1985 on the conservative independent central banker). Transition economies have implemented – also due to international pressure – the German model rather than the milder British, Japanese or even US model of CBI, and in an even stronger version (Alex Cukierman et al., 2002). This model has not always performed well in the transition: 21 - some central bank governors look independent but are not (Belarus) - other central bank governors are truly independent from the government but are not exactly politically independent technicians; - some independent central bankers have pursued policies manifestly contrary to the pursuit of price stability: (Russia 1992); - real interest rates have been pushed to inordinately high levels (Russia 1994, Poland, etc.), as we have already seen, with respect to the requirements of domestic and external balance; 22 - Inflation targets have been treated not as something to hit but to overfulfil, as if they were central planning targets, and without adjusting accordingly nominal interest rates (Poland 2002, unlike the Czech Central Bank in identical conditions). 23 7. Fiscal–monetary policy co-ordination An independent Central Bank is confronted by an equally independent government: this raises the most important issue of fiscal-monetary coordination. It is well known that failure to coordinate leads to higher fiscal deficits, higher interest rates and stronger exchange rates than would prevail in case of coordination, thus adversely affecting output, net exports and therefore employment. A particular issue of such fiscal-monetary coordination in Poland in 2003 has been the possible mobilisation of $7bn reserves (out of a total of about $32bn) or about 3.5% of GDP, representing profits (half actually realised) from the purchase of foreign currency at exchange rates stronger than the current rate. 24 CONCLUSION There are many ways to skin a cat – and to run a transition economy. The adoption of simplistic hyper-liberal prescriptions such as shock therapy in all policy areas, “privatise, privatise, privatise!”, central bank independence etcetera, ignoring the wide and complex range of policy alternatives and the possible and likely ways in which things can go wrong, can be and has been in the transition a costly undertaking. Differential performance of transition economies cannot be explained satisfactorily without facing the direct and sideeffects of widespread poor policies. 25