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Lecture 7. The strategy of
radical reform
Lecture outline
• Outcome of partial reforms
• Conditions at the beginning of radical
reforms
• Radical reform package
• Price liberalization, inflation and financial
stabilization
The outcome of partial reforms
•
•
•
•
•
•
Financial destabilization
Exacerbated shortages
Deterioration of “planning discipline”
Growth of the underground economy
Loss of confidence in the entire system
Did partial reforms fail?
Initial conditions for radical reforms
• The start of radical reforms (transition):
- China
1979
- Poland, Hungary,
1989-1990
Czech Republic
- Russia, Ukraine, Baltic Reps 1992
• Three categories of preconditions:
- structural factors;
- institutions;
- macroeconomic imbalance
Structural factors
• Economy "physical" structure (e.g., share
of heavy industry, services, agriculture),
which affect production possibilities and
characterizes the degree of its
“misdevelopment”
Institutions
•
•
•
•
•
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Small size of non-state sector
Weak entrepreneurial traditions
Prior development of market infrastructure
Degree of autonomy of state enterprises
Openness to world market
Administrative capacity of the state
Macroeconomic imbalance
• Budget deficit
• Inflation
• Foreign debt
Initial conditions of different
economies
Structural
problems
China 1979 Mild
Institutional Macroproblems
imbalance
Severe
Mild
China 1989 Mild
Mild
Medium
Czech R
Severe
Severe
Mild
Hungary
Medium
Mild
Medium
Poland
Medium
Mild
Severe
Russia
Severe
Severe
Severe
Radical reform package
•
•
•
•
Price liberalization and financial stabilization
Privatization
New legal and admin structure (new institutions)
Some of the more specific components of radical
reforms
– Radical reduction of government investments and subsidies to
firms
– Removal of direct controls over SOE’s
– New taxation system
– Monetary policy: tight credit
– Liberalization of foreign trade
– Social safety net
– Creation of privately owned banks
Price liberalization (PL)
• PL is paramount for market reforms because
markets don’t work without flexible prices
• PL is technically easy (the state simply stops
controlling prices)
• Why then is PL resisted by governments?
–
–
–
–
–
Fear of inflation
Adverse distributional effects
Rents generated by controlled prices
Flexible prices don’t work well without privatization
Monopoly
Inflation
• Monetary overhang
(Economy has too much money relative to
the value of consumer goods at official
prices)
• Does PL cause inflation in the presence of
monetary overhang?
• State-controlled prices vs. black market
prices
Inflation (CPI, % over previous
period)
Bulgaria
Poland
Russia
24
Czech
(Slovak)
10
251
93
123
26
80
1st year
334
57.7
586
2d year
91
10
70
296
(245)
1353
(2609)
940
Reform
Year -1
1st
month
Why was there inflation at the
beginning of transition?
• Free market prices rose much less than official
inflation rate (in Russia – 53% in January 92
compared to 245% inflation rate and 400% in
controlled prices)  pre-existing (repressed)
inflation was converted into open inflation
• Difficulties collecting budget revenues
• Nominal wages increased dramatically
• Indexation of savings
• EXPECTATIONS
Costs of inflation
• Anticipated inflation: opportunity cost of
holding money increases  flight from
domestic currency  frequent wage
payments; barter; dollarization; people
look for ways to benefit from inflation
rather than engage in productive activities
• Menu costs
• Makes it difficult to extract information
from prices
Cost of inflation (cont.)
• At high rates inflation is never anticipated
• Cost of unanticipated increase in inflation:
- redistributes wealth to borrowers from
lenders
- decreases real wages & may increase
GDP
- generates self-fulfilling expectations
- creates major uncertainty in the
economy, stifling investments
Fighting inflation
• Limiting government expenditure,
including subsidies to enterprises
• Increasing taxes
• Raising interest on government loans to
banks and other borrowers
Why does price liberalization take
place eventually?
• Recall objections to PL:
–
–
–
–
Fear of inflation
Adverse distributional consequences
Rents generated by price controls
Complementarity between PL and privatization and
demonopolization
These objections are overcome by both implicit PL that
takes place via informal economy and official inflation
Informal PL implies lower costs of official PL, but also
lower benefits of official PL
Effect of price liberalization
on output
• Production has to restructure in order to
reflect genuine demand
• Price liberalization implies that everybody
has to negotiate prices
• Negotiations in the presence of private
information may break down
• Failure of negotiations may result in the
lack of complementary inputs, reducing
production