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.
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
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
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?
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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