Transcript Chapter 17

Chapter 17
Sequencing, Gradualism,
and the Political Economy of
Adjustment
© Pierre-Richard Agénor
The World Bank
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Stabilization and Structural Adjustment
The Order of Liberalization
Political Restraints and Economic Reforms
Shock Treatment or Gradual Approach
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Recent literature has focused on three issues:
 timing of reforms;
 sequencing of reforms;
 speed of reforms.
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Stabilization and Structural
Adjustment
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Policy complimentarity between macroeconomic
adjustments and structural adjustments man
argument in favor of shock therapy.
However, may also have conflicting effects.
Structural policies may have a longer time frame
than short-run macroeconomic policies.
Importance of interpreting and understanding price
signals supports stabilization objective proceeding
first.
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The Order of Liberalization
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Many distortions simultaneously present in an
economy.
First-best solution would be to remove all distortions
at once; never a realistic option in practice.
In reality, second-best solution must then be
optimized as a combination of,
 sequencing measures that are broad enough in
scope to ensure a first-best solution in the long run;
 minimizing adjustment costs.
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Liberalization of External Accounts

Sequencing trade and capital account liberalization:
 Many economists have argued to liberalize trade
prior to the capital accounts.
 Reason: capital inflows resulting from capital
account liberalization may cause real
appreciation while nascent trade liberalization
requires a real depreciation.
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Edwards and Van Wijnbergen (1986):
 Evaluated welfare effects of liberalization.
 Conclusion 1: liberalization can have ambiguous
effects on welfare because of three types of effects:
 direct effects, occur in the market and time period
in which the reform has taken place;
 intratemporal indirect effects, occur within the
period in which the reform occurs because of the
interaction between two or more distortions in
different markets;
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intertemporal indirect effects, result from the
inherently dynamic nature of liberalization policies.
They imply that a reform in one period may alter
the equilibrium in distorted markets in the next
period.
 Conclusion 2: current account should be opened
first.
Implication of uncertainty:
Conley and Maloney (1995):
 Considered a two-period model with uncertain
benefits to economic liberalization.
 Two-part liberalization program:
 current account liberalization in period 1;
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 complete opening of capital account.
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With uncertain benefits, agents base consumption
path on marginal productivity of capital in period 2.
Liberalization will thus lead to a surge in consumption,
a current account deficit, and an increase in foreign
borrowing by private agents.
Ex post potential for boom-bust cycles.
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Financial Reform and the Capital
Account
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Capital outflows: spurred by capital account
liberalization in the face of financial repression.
 Particularly large when credibility (sustainability) of
the structural reform not fully established.
 Many economists agree; capital account should
only be opened after financial market liberalization.
Prudential supervision and regulation of the
banking system concurrent with financial liberalization
vital.
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Sequencing Labor Market Reforms
Edwards (1989):
 Labor mobility needed to facilitate the reallocation
of resources across sectors. Labor reform should
precede trade reform.
 Wage formation and macroeconomic stability; tying
wages to future inflation rather than past inflation.
 Labor reforms be a contemporary to macroeconomic
reforms.
 However, difficult to introduce (Agénor, 1996).
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Political Constraints
and Economic Reforms
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New political economy analyzes economic policy
from both a normative and positive perspective.
Normative: issues related to the effect of institutions
on policy formation.
Positive: focusing on the types of policies that are
more likely to emerge from specific political and
institutional settings.
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Modeling Political Conflict
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Timing of economic reforms; recognition that reforms
generate winners and losers.
Short-run winners may differ from long-run gainers.
May lead to backtracking.
Assuming existence of a welfare-maximizing
benevolent social planner not realistic.
Policy choices reflect the resolution of conflicts of
interest between groups with different goals.
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Key question: How conflicts lead to delays in reform?
 Distributional conflict approach: based on
models of war of attrition. Each group uncertain
about other groups net benefits from reform and
their willingness to pay.
 Uncertain benefits approach: groups uncertain of
their own benefits, leading to a status quo bias.
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Benefits of Crisis
 Making delay of reform more costly can accelerate
implementation of stabilization program (Drazen
and Grilli, 1993).
 For example, episodes of hyperinflation more easy
to terminate that episodes of chronic inflation.
 Rodrik argued that this view suffers from two
problems:
 element of tautology, crisis as an extreme case of
policy failure;
 difficult to falsify, “crisis…not yet ‘severe
enough’”.
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Political Acceptability and
Sustainability
Wyplosz (1993):
 Uncertainty and the difficulty of sustaining reform
process.
Model illustrated:
 Consider economy with N identical workers faced
with possible reform.
 Reform calls for initial cut in labor force, by ,
followed by both a return to full employment in
period 2 and a gain in productivity.
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
Without reform,
Y0 : L N.

With reform, national income drops in period 1,
Y1 : (1-  )L N,
and rises in period 2,
Y2 : H N .
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Reform is efficient on aggregate level by inequality,
Y2
Y0
Y1 +
> Y0 +
1+r
1+r
(1)
Y0: national income without reform;
Y1: national income in period 1 with reform;
Y2: national income in period 2 with reform.
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Reform is efficient for laid off worker if,
L
H
L +
> 0+
1+r
1+r
(2)
L : wages (labor productivity) without reform.
H : with reform wages.
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Setting  = 1 / (1 + r) and rearranging (see pp. 62930), efficiency condition is given by,
+
<


H
L
1+
<

(4)
(4) ensures efficiency but does not ensure welfare.
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Welfare analysis
 Let (ch) be a utility function for consumption at period
h.
 Ex ante political acceptability given by,
E[(c1) + (c2)]  (1 + ) (c),
~
(5)
E: mathematical expectations operator.
: time preference factor.
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How government can create sufficient support?
 b: unemployment benefits.
 Suppose government and individuals are unable to
borrow against future income.
 In presence of b, (5) is rewritten as,

(1 - )v L b + v(b)
1-
{
}
(6)
 (1 + )v(L) - v(H)
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Two ex post conditions for political acceptability:
 For the losers,
v(b)  (1 + )v(L) - v(H)

For the winners,

v L b  (1 + )v(L) - v(H)
1-
{



}
Ex ante condition (6), a weighted average of ex post
conditions.
See Figure 17.1 for graphical solution.
See pg. 633 for discussion when government is 26
assumed able to borrow funds.
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Social Safety Net:
 Increasing recognition of importance alongside
adjustment program.
 Often include the following components:
 targeted subsidies and cash compensation;
 unemployment benefits, severance pay, and public
works schemes.
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Shock Treatment or Gradual Approach?
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Shock treatment argument based on
complementarities between policy instruments.
Arguments for gradualism:
 Preexisting distortions, which cannot be
removed at the time the reform program is
announced.
 Imperfect credibility, tantamount to a distortion in
the intertemporal price of tradable goods.
 Congestion externalities, may create too much
transitional unemployment (relative to the market
optimum) after a shock treatment (Gavin, 1996).
 Weak financial system.
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Political arguments
Pro-Shock:
 prevents interest groups from forming;
 reform administrations need to take advantage of
honeymoon window to execute reforms quickly.
Pro-Gradualism:
 may help to minimize adjustment costs and limit the
distributional burdens on particular groups in the
initial phases of reform.
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