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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;
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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
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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.
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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.
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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
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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
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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.
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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
20
14
10
8
Overcooling
Shock “therapy”
7,0
5,2
6
3,8
4
%
Reform of Public
Finance*
Strategy for Poland
12
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
2
1,9
-4
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
18
2003 2004 2005 2006
8
6
4
-7,0
2
0
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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:
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- 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;
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- 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.
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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.
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