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innesota gricultural conomist MINNESOTA EXTENSION SERVICE UN JVERSJTY OF MINNESOTA No. 670 Summer 1992 Economic Reform and Agricultural Trade in Central and Eastern Europe Harald von Witzke and Ben Senauer The last few years have witnessed the most significant political and economic changes in Europe since the end of World War II. As Central and Eastern European nations shed the remnants of Communist governance, they struggle with the process of adjusting to Western-style democracies with market-oriented economic systems. For many of these countries, restructuring agriculture is one of the crucial problems they face. For American and Minnesota agriculture, which are both exportoriented, the political, economic, and agricultural changes in Central and Eastern Europe could have major consequences. This paper addresses some of the central implications of the changes in Central and Eastern Europe for international agricultural trade and agricultural producers in this country. First, we discuss in general the factors that determine rapid economic recovery after a process of economic and political restructuring. Second, we analyze the current economic situation in Central and Eastern Europe and the state of economic and political reforms. Third, we discuss the prospects for agricultural production, consumption, and trade. We end with some conclusions which have implications for farmers in the United States and Minnesota. (See Refonn page 2) Economic Growth and Environmental Degradation: Win-Win or Lose-Lose? Terry Roe In recent decades, more people have been lifted out of poverty than at any period in history. Yet, approximately one-fifth of the world's population live in acute poverty with life expectancy for those born in 1990 in the range of 42 to 50 years. During this period the demand placed on the world's natural and environmental resources has grown immensely, giving new impetus to (See Growth page 6) Harald von Witzke is an associate professor and Director of tlte Celller for International Food and Agricultural Policy. Ben Senauer is a professor in tile Department of Agricultural and Applied Economics. Tern• Roe is a professor in tile Departmelll of Agricullliral and Applied Economics. (Refonn continued from page 1) The countries in Central and Eastern Europe differ significantly from one another with regard to their level of economic development, their cultural, economic, and political history, the speed and success of political and economic reform, and their internal political stability. Moreover, the future direction and success of reforms remain uncertain. The heterogeneity of this region makes generalizing about developments in this area extremely difficult. Determinants of Rapid Economic Recovery Having ousted the Communist governments and abolished the Socialist command and control economy, the next crucial step of reform in Central and Eastern Europe is to put pivotal institutions in place, such as banking and legal systems. These institutions would secure the continued development towards Western-style democracies and economies. What has evolved so far is promising, though there are exceptions such as the tragic ethnic disputes in the former Yugoslavia. The transformation to functioning market economies continues, despite the possibility of major frictions and setbacks. It is now generally accepted that a market economic system is superior to central planning. The people in these countries desire economic recovery and sustained growth and development. However, there are strong forces in the region for which a market economic system does not have much appeal. A popular argument is that Socialism had some features that are worth salvaging. Sometimes a "third way" between a market economy and central planning has been advocated. Knowledge and skill represent the ultimate engines of economic growth and development. They can be unleashed by a functioning market economic system. However, markets do not exist and do not function appropriately in a social vacuum. For markets to perform as suggested by simple models of perfect competition, they need to be embedded in an appropriate institutional framework that allows the market participants to exchange goods efficiently. This institutional framework must assure market participants that they will actually receive what they contracted for. It must also contain assurances that governments will abstain from direct market intervention for reasons other than removing market failures. Simply ridding markets of the regulations imposed under a system of central planning will not automatically lead to a functioning market economic system and is likely to result in a growing inequality of income and wealth which could destabilize these young and still rather vulnerable democracies in Central and Eastern Europe. Therefore, for economic reforms to be successful there needs to be a credible political commitment to put in place a market economic system. Deregulation of prices and markets needs to be paralleled by suitable institutional arrangements including a legal system. Reforming the legal system in and of itself is an enormous task, given that there are few lawyers trained in the principles of a legal system consistent with a market economy. Another problem is the definition of property rights consistent with a market economy. This, of course, is crucial for the reprivatization of capital goods and land. One of the major sources of economic growth in the post World War II period has been international trade. The countries which experienced the fastest rates of economic growth have been export oriented. Japan and Germany are examples. More recent examples include the East Asian tigers, such as Hong Kong, Singapore, South Korea, and 2 Taiwan which have open, marketoriented economies. The commitment to pursue market economic reforms must include the opening of their economies and a full participation in international trade. However, at early stages of economic reform and of opening the economies, the current account balance which reflects a country's exports and imports of goods and services tends to worsen dramatically. Many industries in Central and Eastern Europe have lost their traditional markets, but are not yet efficient enough to compete successfully in the world markets. At the same time, imports of goods from the industrialized market economies have increased. Obviously, economic reforms which result in the opening of the economy have to include the move towards full convertibility of the domestic currency. Also required is a central bank that is allowed to function independently of the government. In today's industrialized countries, monetary policies tend to be successful to the degree that the central bank is allowed to operate independent! y. The market mechanism can result in a distribution of income and wealth that is considered socially or politically undesirable. For market economic reform to be successful it is important to develop and implement a redistributive social welfare system, and a tax system that makes it possible to finance a social welfare system without distorting market incentives. Perhaps the biggest challenge for governments in Central and Eastern Europe is to constrain the political power of special-interest groups. These groups try to influence government decisions in favor of their clientele but to the detriment of overall economic prosperity and development. Right from the beginning, special interest groups formed, and they have begun to influence the course of economic and political reforms. One example is Poland, where farmers' interest groups have become increasingly successful in demanding protection from international competition. In our view, the undue influence of special interest groups can best be avoided if the government pursues a strategy which includes two elements. The first element is to develop and to have approved by the parliament an "Economic Constitution." The constitution must spell out the principles of a market economy with social, distributive, and fiscal policies consistent with this economic system. The second element is to move rapidly in implementing the economic constitution. Rapid implementation will make it difficult for interest groups to develop an effective organization for lobbying and these groups will tend to remain less influential. The Current Economic Situation The economic and political reforms in the countries of Central and Eastern Europe have progressed to different degrees and at different speeds. With very few exceptions the pace of reform has slowed down considerably. The old economic and political systems are disintegrating and the new market economic institutions are not yet in place to sustain rapid economic recovery. The economies are deteriorating and the economic situation in many Central and Eastern European countries has become worrisome. As shown in Figure I, economic activity continues to decline. The decline in output in 1991 averaged more than 10 percent for Central Europe. However, the official economic statistics may undercount the level of activity occurring in the emerging private sectors in some of these countries. In addition, inflation is a serious problem. The inflation rate varied from a low of 36 percent in Hungary to 550 percent in Figure 1. Growth of Gross Domestic Production in Central Europe, 1990-91 (percent change from previous year) Bulgaria Czechoslovakia Hungary Poland Romania Yugoslavia -30 -20 .1990 Bulgaria. Under-employment is widespread, and unemployment is climbing as inefficient state enterprises are restructured or become bankrupt and close. The current economic problems have been exacerbated by the collapse of the COMECON (Council of Mutual Economic Assistance) trade among former Soviet-bloc countries. This trade was conducted in "transferable rubles," which served as an accounting device. 3 -10 llllJ 0 10 1991, estimated The COMECON trade provided these countries a steady market for their goods, a market which tolerated poor product quality. They also depended on the Soviet Union for cheap oil imports. This has changed dramatically. The Russians now want hard currency for their oil at world market prices, and the COMECON market for Central European exports has vanished. The transformation from a centrally planned to a market economy is Figure 2. Per Capita Food Consumption in Central and Eastern Europe in Percent of EC-12 Consumption, 1984-87 140 120 EC = 100 100 80 60 40 20 0 Staple Foods Sugar Vegtable Oils & Seeds II Fruits & Vegtables Tropical Beverages D Central Europe Meat Dairy Products Calories USSR Source: United Nations. Food and Agriculture Organization, Trade Yearbook, (various issues). proving to be much more difficult than originally anticipated. The challenge is to carry out economic reform simultaneously with democratic reform of the political system. The first stage of the economic transition typically includes price liberalization with the removal of price controls and subsidies, allows market supply and demand to determine prices, establishes a freely convertible currency at a market determined exchange rate, and opens foreign trade from strict state control. This first stage has usually been successful. The second stage, however, appears far more difficult. It involves restructuring and privatizing large state-owned enterprises. Some 80 percent of industry is still in public hands in Poland, for example. Many of the industrial enterprises are so inefficient and produce goods of such poor quality that they actually are "value subtracting," rather than value adding. This simply means that if the inputs are priced at world market levels, they are worth more than the output can be sold for. Furthermore, people's attitudes are slow to change. For example, many still view nonlabor income as immoral. A backlash has set in as a reaction to the economic distress and inequities that the transformation process has brought. The November 199 I Polish elections can be seen as a vote against rapid economic reform. Agricultural Production, Consumption, and Trade Many people in the West remember pictures of long lines and empty shelves in food stores in Central and Eastern Europe under central plan4 ning. This created the impression of a food shortage and led to the conclusion that the region as a whole will be a net food importer for many years to come. This is supported by the fact that most of these countries were significant food importers under the Communist regime. However, the long lines and empty shelves camouflaged the relative abundance of food. In fact, overall per capita caloric intake in this region was not much different from that in Western Europe. As seen in Figure 2, the per capita consumption of staple foods, such as grain and potatoes, was even higher than in Western Europe (the 12 countries of the European Community), while consumption of vegetable oils, fruit, and tropical beverages were significantly lower. Meat and dairy consumption were only slightly below Western European standards, although the quality was Table 1. Central European Production and Trade Balance (exports-imports) for Major Agricultural Commodities in 1991 * (In 1,000 tons) Wheat Coarse Grains Oilseeds Beef & Veal Sugar Pork Bulgaria 5,300 0 3,757 -100 465 -105 126 6 400 5 120 -340 Czechoslovakia 6,500 150 5,480 50 499 -65 391 46 894 40 700 0 Hungary 5,900 2,000 8,553 500 846 72 Ill 34 893 200 500 10 Poland 9,170 50 18,395 -50 I ,128 260 726 6 1,910 50 1,900 32 Romania 5,300 -500 11,520 -890 671 -400 230 -60 600 -20 560 -265 Yugoslavia 6,530 950 13,090 349 577 -282 301 -22 785 -22 900 20 TOTAL 38,700 2,650 60,795 -132 4,186 -520 1,885 10 5,482 253 4,680 -543 *T/iejirstjigure is production and tile second is tile trade balance (exports-imports). Source: U.S. Departmellt of Agriculture, Economic Research Service. Central and l::ast Europe Agriculture and Trade Report, April 1992. low. This consumption pattern was consistent with lines in front of food stores, because consumer food prices were highly subsidized and hence very low. Moreover, under the system of central planning, there were not many goods other than food which consumers could buy, and the opportunity cost of waiting in line was low. With economic reforms, consumer behavior has changed. Real household incomes have significantly declined, consumer food subsidies have been removed and food prices have risen sharply. Given the still relatively high response of food demand to income and price changes in these countries, this led to declining food consumption for nonstaples. Table 1 gives 1991 agricultural production and trade balance figures (exports-imports) for major crops. Growing conditions were favorable last year and consequently harvests were good. In general, the production and trade levels in 1991 were quite typical of patterns for the last four or five years. Hungary is the largest agricultural exporter, measured in value terms. In 1989, Hungary's agricultural exports were valued at $2.15 billion and imports at $857 million, for a trade balance of $1.29 billion. As shown in Table 1, pork products are a major contributor to Hungary's agricultural exports. Czechoslovakia exported agricultural products worth $718 million and with imports at $2.23 billion, the trade deficit was $1.52 billion. Besides oil crops and feed, some of Czechoslovakia's major imports are not shown in Table 1 and included cotton, wool, tobacco, coffee, and fruits and vegetables. Poland exported $1.29 billion and imported $1.78 billion, for a trade deficit of $492 million. 1 Unlike 1991, Poland had large wheat imports in 1989 and also imported oil crops and feed, cotton, wool, coffee, and tea. The agricultural input and output (processing and distribution) industries remain a major problem. These industries continue to be largely in the hands of large, inefficient stateowned enterprises. If they are to be competitive in the agricultural/food 1 U.S. Department of Agriculture, Economic Research Service, World Agriculture: Trends and Indicators, 1971-89, Statistical Bulletin No. 815. September /990. 5 product trade, these countries will have to have efficient farm input and agricultural/food processing and distribution systems. Not only will foreign trade suffer because of the inefficiencies of the output and input industries, but they will be hurt in their own domestic markets. As their markets are opened to Western goods, there is increased competition from imported food products which offer higher quality standards, more variety, more attractive and effective packaging, as well as persuasive advertising. Conclusions Agriculture in many Central and Eastern European countries has the potential to be rather productive. It will probably require an extended period of time, however, before many of these countries will emerge as major exporters of agricultural commodities. The infrastructure needed for efficient agricultural production, processing, storage, and transportation is currently in poor shape. The entrepreneurial and managerial skills necessary for efficient agriculture and agribusiness industries are scarce. Agriculture will become more competitive internationally only when the investments in managerial skill, agricultural research, infrastructure, and food processing industries begin to pay off. In the short run, export opportunities for agriculture in the United States and Minnesota will remain limited. Consumer income has declined and food prices have increased. Both have contributed to a considerable reduction in food consumption. Certainly, if some of these countries begin to experience sustained economic growth, there will be windows of export opportunity for agricultural producers nationwide, as well as for Minnesota farmers. Lowincome countries with rapidly growing economies are frequently characterized by a growing demand for agricultural imports. The next few years will be critical in the economic and political evolution of Central and Eastern Europe. A continuing economic decline could lead to increased political instability and should be of great concern to the United States and Western Europe. One of the most beneficial actions which could be taken to assist these countries concerns trade policy. The "Europe Agreements," signed in December 1991, will strengthen trade relations between Czechoslovakia, Hungary, Poland, and the European Community. However, the European Community gave minimal ground on agricultural products in these agreements, as well as on other goods such as textiles and steel, because Central and Eastern Europe are likely to become competitive in these areas. This is another example of the negative consequences of the protectionist agricultural policies of the European Community under the Common Agricultural Policy. Both the European Community and the United States would do well to refrain from disposing of their surplus agricultural commodities in Central and Easter Europe unless an actual food shortage occurs. It is clearly in our self-interest to have stable, prosperous, democratic countries develop in Central and Eastern Europe. Economic Growth and Environmental Degradation: Win-Win or Lose-Lose? (Continued from page 1) concerns about water pollution and water scarcity, air pollution, solid and hazardous wastes, soil degradation, deforestation, loss of biodiversity, and depletion of other natural resources. An emerging view is that poverty alleviation is not inimical to environmental degradation. Rather, the alleviation of poverty in developing countries will help to lessen many kinds of environmental degradation. Causes of Environmental Degradation Population Growth Between 1990 and 2030 the world's population will grow by 3.7 billion, according to estimates from the World Bank. Food production will need to double. Industrial output and energy use will probably triple world wide and increase fivefold in 6 developing countries. 1 If this population increase and the associated consumption of resources yields environmental degradation at rates associated with historical levels, millions will die prematurely while others will suffer ill health. Natural resources will become relatively more scarce, threatening the sustainability of production levels and real incomes for a growing proportion of the world's population. Market Limitations Failure of the market to price resources according to their true scarcity is a major factor contributing to environmental degradation. Evidence strongly suggests that resources tend to be poorly managed and permitted to degradate when the market undervalues their true scarcity value. In this situation, incentives for the adoption of new technological practices, technical substitution, and investments to sustain productivity (which, in effect, save on the relatively more scarce environmental resources) are not sufficient to prevent degradation from occurring at a pace that is unnecessarily harmful. This failure of market prices to reflect the scarcity of natural resources can occur due to lack of property rights, when resources are subject to open access, and because of economic policies that, through subsidies and taxes, provide disincentives for their husbandry. When resource property rights are ill defined, individuals have incentives to extract marginal returns from resources to the point that is below their true scarcity value. Little or no incentive is provided to husband them or to reinvest in sustaining their productivity for the future since, to do so, would be to give up any remaining productivity to others without being compensated, or without the assurance of preserving productivity for the individual's own 1 World Development Report, 1992, p. 2. use. In countries where property rights are ill defined, soil erosion, salinization, and deforestation tends to be more severe than in other countries.2 The effects of gross soil loss on agricultural productivity are estimated to range from about 0.5 to 1.5 percent of the Gross Domestic Product (GDP) annually for regions in Costa Rica, Malawi, and Mexico where property rights are ill defined. With open access, individuals have unrestricted access to resources, such as fish, or unrestricted claims to tribal lands or lands set aside for an ethnic groups, as in the case of grazing lands in Morocco. Open access has given rise to overgrazing in many African countries, deforestation of tropical and dry forests and encroachment on land set aside for wild animals in Tanzania and Kenya. When species become extinct, an irreversible loss occurs with great uncertainties as to their impact on the balance of the ecosystem. The loss of forest ecosystems also means a decline in the capacity of forests to act as a carbon sink to absorb the high levels of carbon dioxide generated by the industrial-market economies. Even the earth's atmosphere is threatened. This resource, comprised of gases that provide protection from radiation and prevent global warming, unhealthy suspension of particulate matter, acid rain, etc., is subject to the same excessive use problems as those mentioned for land and other resources. Open access to the atmosphere has allowed the introduction of particulate matter and various gases believed to contribute to global warming and ozone depletion. A major source of greenhouse gas emissions is from fossil fuels. Flavin (1990), 3 estimates that four countries, the U.S., Japan, West Germany, and the United Kingdom account for more than 32.5 percent of the world's total carbon emissions from fossil fuels in 1987. The former Soviet Union and China alone accounted for another 29.2 percent of the world's total from this source. Since markets are unable to price atmospheric resources, regulations are required to restrict and control access. Without such regulation, individual firms and industries have little incentive to control the byproducts of production processes that degrade this resource. Consequences of Environmental Degradation Environmental degradation can be viewed in terms of its possible effects on current and future generations. While there is general agreement that natural resources such as unspoiled lakes, rivers, and forests contribute to human welfare, not all consequences of a depleted environment are obvious. Two possible effects of environmental degradation are especially noteworthy: (1) declining health and higher health costs and (2) lower productivity. Declining Health and Higher Health Costs Health care tends to be a "luxury" good in the sense that as income increases, individuals spend an increasing proportion of total disposable income on health. Based on data from 25 countries, a recent study4 estimated that health-care expenditures would rise by about 1.32 percent for every 1 percent increase in a country's GNP. Thus, as real economic growth occurs and individual disposable incomes grow, individuals are willing to spend a greater proportion of their rising incomes to offset those environmental factors that cause ill health. Though depletion of natural resources and environmental quality is known to have deleterious effects on human health, the "directness" with which this occurs is important to understanding key aspects of the poverty alleviation-environmental quality linkages. To clarify these linkages, Mohtadi and Roe (1992) 5 distinguish between embodied and disembodied effects. Embodied effects of environmental degradation are directly linked to individual consumption~ they include the unhealthy residues and contaminants on food, contaminated drinking water, unsanitary disposal of household wastes, and indoor air pollution caused by the use of wood, straw, or dung that is commonly used in cooking fires of the many lowincome households in developing countries. Disembodied effects on health come about from the total consumption and/or production of goods and services that are harmful to health. Examples are ozone depletion from the consumption and production of goods and services (air conditioning, refrigeration) that use chlorofluorocarbons (CFCs), sulfur dioxide and particulate matter6 from the burning of fossil fuels, toxic effects of effluent discharges from industrial processes that utilize heavy metals, and other hazardous wastes. Households can at least indirectly and partially compensate for embodied effects. Individuals may decrease their consumption of residueladen foods, substitute more expensive, possibly organically grown, foods and, through market forces, induce competition among firms to Molltadi, Hamid and Terry Roe (1992) "Endogenous Growth, Health and Environment: A General Equilibrium Approach," Working Paper, Economic 5 2 Developmelll Cemer, U11iversiry of Minnesota. World Development Report, 1992, pp: 55-60. 'Falvin, C. ( 1990) "Slowing Global Warming," In State of the World, L. Browned., N.Y.: W. W. Norton. Gertler, Paul and Facques van der Gaag ( 1990). Tile Willingness to Pay for Medical Care, John Hopkins University Press, Tables 2-3, p. I I. 4 7 Sulfur dioxide levels have beenli11ked to death rates from bro11chitis while suspended particulate matter has been traced to eye and lung damage. 6 supply goods and services that are healthier. Subject to such market forces, firms are likely to be more willing to invest in water purification equipment and better household technology for food preparation, heating and waste disposal. Still, the market is not likely to totally solve the problem. After households adjust their consumption patterns to account for ill-health effects, welfare could be further increased by engaging in collective action. Collective action may take the form of a neighborhood or national association whose main purpose is to influence political choice on environmental matters. An association of this type can attempt to resolve unsanitary waste disposal, influence state and national government to establish grades and standards for residue and contaminant sensitive foods, impose taxes on the use of pesticides, construct municipal waste disposal systems, etc. In the case of disembodied effects, the consumption level of a single individual, and in many cases of a single firm, will have only a negligible effect on the environment and therefore on health. Thus, the individual will have no incentive to decrease consumption or place pressure on domestic firms to, for example, install pollution-abating equipment. Since the individual's own level of consumption has no effect on health, collective action is needed to pressure local, state, federal, and perhaps international agencies (particularly if the source of degradation is from activity in another country) to impose conditions that will mitigate the ill effects on health. But what incentives are there for individuals to incur the costs of forming coalitions to get this process started? If individual costs. are high, then deep personal commitment exercised through political leadership or environmental organizations will likely be required to induce governmental action in lieu of an environmental crisis. Lower Productivity The environmental problems which cause resource productivity problems in developing countries differ from those in the wealthier countries. Low-income countries rely on agriculture and fisheries, which accounted for about 30 percent of their GDP in 1990 (World Bank Tables). Given their level of economic and institutional development, as a group, land and fishery degradation tends to be their most immediate and threatening source of real income decline from environmental factors. Loss in human productivity from the environmental effects on health are also large. Developing countries also face potential declines in agricultural productivity from greenhouse gases and acid rain in some regions. One of the major resource degradation problems faced by wealthier countries is that of degradation of primary resources (minerals, fossil fuels, timber) in developing countries, because these resources comprise important industrial-country imports. Developing-country investments in maintaining ecological diversity and forests, both as a resource and carbon sink, do yield benefits for the developing countries, but yield proportionally larger benefits for the developed countries. Further, policies to arrest natural resource and environmental degradation typically increase production costs. Rising costs imply that incomes of some individuals may fall. If incomes fall, some individuals may be made worse off, but this is not the case from a global perspective. Instead, well-designed policies that alleviate the effects of degradation on health and the decline in resource productivity are likely to increase the affordability for individuals and countries to invest in mitigating further degradation. Since the benefits and costs of policies designed to redress environmental degradation may fall on individuals, firms, regions, countries or perhaps generations in disproportionate ways, 8 compensatory schemes that compensate the losers at the expense of the gainers may need to be implemented. Environmental degradation should not be simply viewed as increasing the costs of producing goods and services and, therefore, decreasing a country's competitive advantage in world markets. Instead, health and environmental amenities should be viewed as consumption goods that the market, by itself, fails to provide at socially optimal levels. Addressing environmental degradation can increase the supply of these "goods," with the net result that society benefits. Obstacles to Economic Development: Inward-Oriented Policies Many of the world's economies, including those which formerly were centrally planned, are moving in the direction of policy reform. Most, however, have a great distance left to go and many still pursue policies that can be described as "inward oriented." To better illustrate the implications of policy reform on economic growth and the environment, it is useful to briefly discuss the characteristics of a typical inward-oriented economy, many of which can be found in the studies cited. Countries pursuing inwardoriented policies typically protect their import-competing industrial sector from foreign competition. To accomplish this they tax the export sectors and pursue capital market policies that invariably entail overvalued real currency exchange rates, low and often negative real interest rates, and fiscal deficits that are frequently financed by money creation. Since agriculture is an export sector in many developing countries, rural households tend to bear the burden of these policies. Protection of the industrial sector generally gives rise to concentrated, often single-firm or state-enterprise industries, that cannot attain economies of scale nor compete in international markets. Owing to their marginal profitability, these industries seldom are required to conform to even modest industrial market economy standards for effluent and other byproduct discharges. Further, they often make inefficient use of natural resources as measured by energy per unit value of output,7 timber harvested relative to tree population per square mile, and so on. Since food is a wage good in many of these economies, political pressures exist to maintain low nominal prices for food which induce lower nominal wages, a benefit to marginally profitable enterprises, but higher real wages, a benefit to urban households. A common result is lower farm-gate prices which eventually leads to economic stagnation of the rural sector. The country studies directed by Krueger et. al 8 found that in 16 developing countries during the 1980-84 period, farmers received farm gate prices for export crops that averaged 40 percent below the price they would have received had economic policy not been biased against them. Since these policies lead to stagnation of the rural economy, governments often subsidize farm inputs and take over agricultural marketing functions. This is done to increase farm prices while holding retail prices unchanged, thus absorbing the costs of marketing services in the federal budget. In Egypt during the 1980s, for example, farm-gate prices for wheat, in bread equivalents, often exceeded the retail price of bread. For example, countries ranking highest in carbon emissions per unit of GNP in 1987 are China, Egypt, India, Mexico, and Poland, while Japan, Italy and France rank among those with the lowest levels of carbon emissions per unit of GNP (Flavin, 1990). 7 Over-valued real currency exchange rates, low and often negative real interest rates, inflation, and fiscal deficits that are frequently financed by money creation, typify the macroeconomic consequences of these policies. These consequences tend to further contribute to declining competitiveness in international markets, the pushing of resources into the non-internationally traded goods sector of the economy, and declines in domestic capital formation because asset holders seek to shelter their liquid assets in other countries. The majority of the world's most poverty-stricken population live in countries pursuing these inward-oriented policies. Win-Win Strategies: Economic DevelopmentEnvironmental Preservation If countries instead choose to pursue policies that are more strongly associated with economic growth, then incomes can be expected to rise. Rising incomes make it possible for individuals to at least partially compensate for the embodied effects of environmental degradation on health. Hence, unhealthy residues and contaminants on food, contaminated drinking water, unsanitary disposal of household wastes, and indoor air pollution should be among the environmental factors that are the most likely to improve. Increased affordability should also induce individuals to place more political pressure on local and federal governments to pursue policies and engage in treaties that seek to mitigate the ill-health effects from the production and consumption of ozone-depleting gases, sulfur dioxide and particulate-matter suspension, and the toxic effects of effluent •op. cit., p. 262. 9 discharges from industrial process. For example, a recent study was done using time series data for more than 21 cities in 13 countries. The empirical results clearly find that sulfur dioxide levels tend to decline when per capita incomes reach somewhere in the $4,000 to $5,000 range, and that suspended particles found in a given volume of air monotonically decreases as GDP per capita increases.9 In recent years, the studies of numerous countries and syntheses of these studies have led to a better understanding of some of the fundamental factors associated with economic growth. 10 The findings are not surprising. Essentially, they suggest that the keys to economic growth lie in the amelioration of market failures, technological change, and capital accumulation. These keys must be broadly defined to include the human capital of men and women and must include the efficient allocation of resources to meet final demand. Foreign trade policy is also important because it influences the degree to which international markets for final goods and services, information, and technology interact. This interaction is needed to yield a growth path along which patterns of production, investment, and capacity creation are determined. Three lessons are contained in these findings. One, governments should pursue stable macroeconomic 9 Grossman, Gene and Alan Krueger, (1991) Environmental Impacts of a North American Free Trade Agreement Discussion Papers in Economics, Woodrow Wilson School, Princeton University. 10 Refinery prices for various grades offuels in Egypt during 1985-1990 averaged 36 perce111 of world market prices. Many state-owned and operated firms received energy subsidies beyond these alreadv low prices; Holt, Robert and Terrv Roe, (1991) ·"The Political Economy of Reform: Egypt in the 1980s, "forthcoming in The Political Economy Structural Adjustment, Anne Krueger and Robert Bates, eds.. Basil Blackwell publishers. policies. In these policies, trade balances should be attributable to structural factors, such as the propensity of households to save. Capital inflows should be explained by returns on investment. Two, governments need to establish fiscal policies in which deficits are financed by savings and restricted to business cycles, as opposed to fundamental deficits of the type experienced by the U.S. during the last decade. Finally, governments should select policy instruments to effect income transfers among societal groups that have minimal impact on producers' resource-allocation decisions. Otherwise, resources tend not to be allocated to their most profitable alternative and the economy suffers a loss in economic efficiency. Briefly, there are five additional routes through which policy reform to achieve economic growth can also resolve environmental degradation. First, inward-oriented policies that tax the rural sector almost always give rise to the under-valuation of the rural sector's sector-specific assets, such as land, forests, and natural resources that a country exports. When resources are undervalued, individuals tend to excessively exploit them and to under invest in their maintenance. Hence, reform that reflects the true scarcity of these resources in market prices should result in their better husbandry. Second, policy reform that increases the profitability of previously taxed firms should also increase their willingness to accept and pursue policies that save on natural and environmental resources while the previously protected and marginally profitable firms should either decrease their scale of economic activity or shut down. Since many of the marginally profitable and protected firms typically receive large subsidies, particularly for energy, 11 forcing them to incur the true cost of environmental resources should yield significant environmental savings while at the same time contribute to the more efficient use of other resources. Third, relative to inward-oriented policies, policy reform tends to open up an economy to international markets for information and technology that, by substituting for the old technology, can save on the use of environmental resources. As noted below for the case of Mexico, reform often encourages economic activity that uses a country's most abundant resources, such as labor. It turns out that many of these types of economic activities do not use abundant energy and other environmental resources, and hence, opening up the economy tends to save on these resources. Further, when international companies enter the economy, they tend to utilize modern technology that often employs more modern methods for saving environmental resources than would otherwise be available. In Argentina, an IBM subsidiary recycles three-quarters of the waste it generates because it could not find local disposal facilities. Similarly, in Nigeria, Chevron uses only waterbased lubricating fluids in its drilling operations for the same reasons. 12 Further evidence in this regard is provided by Grossman and Krueger, op. cit. They find that the maquiladora plants (firms that are permitted to locate close to the American side of the border in 11 These include a 17-coumry study discussed by Cordell, Max ( 1990 "Macro Economic Policy and Growth: Some Lessons of Experience," 1n Proceed- ings of the World Bank Annual Conference on Development Economics, pp. 59-84, another 21- country sludy direcJed by La/ and Myint and discussed by La/, Deepak ( 1990) The Political Economy of Poverty, Equity and Growth in 21 Developing Countries: A summary of Findings. Paper prepared for the American Economics Association Meetings, Washington. D.C., and still another 18-countrv studv directed and discussed bv Krueger, Anne, M: Sch;.if and A. Valdes, ( 1988) . "Agriculturallncemives in Developing Countries," The World Bank Economic Review, 2:255-271. 12 Economist, Vol. 323, May 30-June 5, page 11. 10 Mexico) appear to have located along the Mexican-American border for reasons of lower wages and not for reasons of avoiding U.S. environmental restrictions. Fourth, policy reform that decreases fiscal deficits, and broadens a country's tax base by decreasing its reliance on foreign trade taxes is not only good for economic development, it is also good for the environment. Conversely, when governments incur large fiscal deficits and have large and cumbersome bureaucracies that are heavily engaged in carrying on activities that can be better performed by the market, environmental degradation often results. In such circumstances, the expenditures to monitor and control environmental degradation will be less than is socially profitable in a benefit-to-cost context. The opportunity cost for governments in inwardoriented economies to incur larger deficits and to engage in additional planning and management activities required for environmental management tends to be too burdensome to address environmental problems to the degree they should otherwise be addressed. Fifth, policy reform and investments in public goods, particularly in education for both men and women, will tend to reduce environmental degradation associateJ with relatively large numbers of low income households in rural areas. Removing the mentioned taxes on the rural economy and opening the urban industrial economy to foreign competition and capital inflows will in the longer term tend to induce a migration from the rural to the urban sector of the economy. Typically, protection of the domestic industrial sector from foreign competition does not permit an economy to efficiently use what is often its most abundant resource, cheap labor. While labor migrates to urban sectors in an economy pursuing inward-oriented policies, labor still gets locked into the rural economy where it often subsists on small farms using traditional technologies. This situation often forces labor to meet urgent short-term needs by mining natural resources, e.g., farming land on hill sides that are easily eroded, over grazing, and excessive cutting of trees for firewood. Poverty also prevents them from reinvesting in the natural resources they are forced to mine. 13 Low-income households in which women are relatively uneducated typically have larger families than higher income households where both parents are educated. Research suggests that low income households, particularly in rural areas, have larger families because of the need for family labor, relatively high infant mortality, and the need to help secure an income stream in old age. 14 As an economy grows and real wages rise, households choose to have fewer children and to invest more in each child in terms of health, education and so on. Investments in the education of women tend to make them more aware of family-planning choices and induce them to seek employment outside the home, thus increasing incentives to reduce family size. Recent evidence from a cross-section of countries shows that where no women are enrolled in secondary education, the average woman has seven children, but where 40 percent of all women have had a secondary education, the average drops to three children. Hence, public investment in education is not only desirable for economic development and equality among the sexes, it is also a way to dampen population growth and population induced pressures on the environment. "See Uma Le/e and Sleven W. Slone, Populalior. Pressure, the Environment and Agricultural Intensification: Variations on the Boserup Hypothesis, Madia Discussion Paper 4, The World Bank, 1989 for a discussion oflhese issues. 14 See T. Paul Schullz. "Educalion lnveslmenls and Relurns," in The Handbook of Development Economics, Vol. 1, Chenerv and Srinivasan, eds., Norlh Holland, 1988, pp: J43-630 for a review of I his lilera/ure. We have given little attention to policy instruments and design of institutional structures to ameliorate market failures except to note that as individuals become more wealthy they are likely to be more willing to encourage governments to address these failures. Still, it is a challenge to design and implement policies to resolve the market's limitations, especially its inability to deter environmental degradation. These failures are especially evident in the areas of disembodied health effects and open access. This challenge includes building institutions to establish and clarify property rights, providing information on the environmental causes and effects of economic activity, and channeling of collective action to focus on the sources of degradation. A balance is needed between the institutional capacity to manage, monitor, and enforce policy instruments and a tendency for these instruments to cause unintentional consequences on economic incentives. Since this aspect of economic policy tends to be more dependent on cultural characteristics of society, the form of government, and the stage of economic and institutional development, the particular approach to resolve market failures, as is already evident in many countries, will need to be tailored to the specific country. Hence, conditional on the ability of governments to pursue policy reform and their ability to resolve problems of market failures, there appears to be considerable grounds for optimism. Win-win development strategies are very possible, and may be indispensable. That is, if we do not pursue win-win strategies we may well default to lose-lose. Winwin strategies do not imply that the productivity of all environmental resources nor all amenities and ill health effects will be ameliorated. As Summers states "We can help our descendants as much by improving infrastructure as by preserving rain forests, as much by educating children as by leaving oil in the ground, as much by enlarging our scientific knowledge as by reducing carbon dioxide in the air." 15 In other words, the degradation or even exhaustion of a resource is not necessarily inconsistent with the welfare of present and future generations nor with the socially efficient allocation of resources. Trade-Offs Between Wealthy and Poor Countries Many health and resource productivity benefits from environmental policies in developing countries accrue to the wealthy countries, and some of the potential ill health and resource productivity problems facing developing countries have their origin in the economies of wealthy countries. The implication is clear: wealthy countries should compensate the poorer countries. Three points should be kept in mind: First, health is a luxury good and wealthy countries are willing to pay more for the ill effects of the environmental degradation on health than are poor countries. An opportunity exists for both wealthy and poor countries to gain from trading in goods that have environmental implications to health. For example, poor countries can often export healthy goods, e.g., organically grown food, to earn foreign exchange which can be allocated to the purchase of new technology produced in wealthy countries. Second, foreign aid to encourage economic growth in poor countries has ~esirable environmental consequences for wealthy countries. Since environmental degradation crosses national boundaries, the development of new technologies that conserve environmental resources serves their 15 Economist, 11 Vol. 323, May 30-June 5, p. 65. interests as well as the interests of wealthy nations. Furthermore, since the economies of poor countries tend to be adversely affected when the economies of wealthy countries are mismanaged, economic growth in wealthy countries is actually to the advantage of poor countries. Finally, the world's wealthy economies must be the ones to take the initiative. They have the major capacity to influence world opinion, to take initiative in fostering treaties, and to assure treaty compliance. Thus, the key responsibility must lie with the world's wealthier nations to form new world institutions that are in the best interest of both the wealthy and poor nations. Environmental degradation affects health, a luxury good, and the productivity of a variety of resources in complex, and occasionally, irreversible ways. As income growth occurs, individuals tend to be willing to pay proportionately more to resolve environmental effects on health. Hence, one major difference between low- and high-income countries is that the embodied health effects of degradation tend to be more immediate and harmful to individuals in poor countries than to individuals in wealthy countries. Many of the harmful effects of disembodied factors are the result of economic activities associated with wealthy nations. For example, ozone depletion can largely be attributed to sulfur dioxide emissions, particulate matter suspension, and toxic effects from effluent discharges. Yet poor nations, as well as wealthy ones, accrue many of the ill health effects of these activities. Because these effects are difficult to resolve by individual actions through the market, governments are required to address them. nesota gric~ltural onom1st No. 670 Summer 1992 W.B. Sundquist .. Managing Editor Rich Sherman ... Production Editor Prepared by the Minnesota Extension Service and the Department of Agricultural and Applied Economics. Views expressed are those of the authors, not necessarily those of the sponsoring institutions. Address comments or suggestions to Professor W.B. Sundquist, Department of Agricultural and Applied Economics, 1994 Buford Avenue, University of Minnesota, St. Paul, MN 55108. Please send all address changes for Minnesota Agricultural Economist to Louise Letnes, 232 Classroom Office Building, 1994 Buford Ave., University of Minnesota, St. Paul, MN 55108-6040. Produced by the Educational Development System, Minnesota Extension Service. The University of Minnesota, including the Minnesota Extension Service, is committed to the policy that all persons shall have equal access to its programs, facilities, and employment without regard to race, color, creed, religion, national origin, sex, age, marital status, disability, public assistance status, veteran status, or sexual orientation. Printed on recycled paper with agribased inks. Beth Walter Honadle Program Leader and Professor Community Resources UNIVERSITY OF MINNESOTA DEPT. OF AGRICULTURAL AND APPLIED ECONOMICS 232 CLASSROOM OFFICE BLDG 1994 BUFORD AVE SAINT PAUL MN 55108-6040 NONPROFIT ORG. U.S. POSTAGE PAID MPLS., MN PERMIT NO. 155