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1. Roads to Growth: A Summary of Main Issues

Author(s):
Georg Winckler
Published Date:
September 1992
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Author(s)
Georg Winckler

Introduction

By mid-1991, the breakdown of the centralized regimes in the countries of Central and Eastern Europe seems to be complete. The old power structures have disappeared.

A vacuum of power has emerged, within which many small parties could mushroom into existence.1 The new parties are divided by ideology, ethnics, history, or mere personal rivalries. Because the old power structures have disappeared, the future course of the Central and East European countries will be fixed by parties that are capable not of seizing, but of creating, power by swiftly establishing strong popular support.

The issue of economic transition has to be seen within this political context. The old planning system is profoundly discredited. It could not generate economic growth in the last decades. All parties now favor the implementation of market economies based on the privatization of firms. Yet how will the transition look?

In all countries of Central and Eastern Europe, a deep recession has already set in. Output has declined considerably, and unemployment has reached unprecedented levels. All seminar participants agreed that the transition is full of “hardships and risks” (Jindra, p. 147). Calvo and Frenkel mention that the economic slowdown now exceeds that in Latin America where economists gathered experiences with economic stabilization efforts (Calvo and Frenkel, p. 112).

What are the political consequences of a transition with “hardships and risks”? Will (as Rosati fears, p. 106) governments be tempted to make excessive promises or create illusions, thus finally producing social unrest? Will there be a buildup of radical organizations exploiting the embarrassing fact of unemployment as happened in Europe in the 1930s?2

Note, in this context, Calvo-Frenkel’s and de Macedo’s point (p. 140) concerning the role of expectations when a new economic regime is implemented: A regime change can only succeed if economic agents believe that the new policy environment will endure. Otherwise, if agents do not believe, the ongoing reform may fail. Hence, widespread distrust in the success of economic transition may further destabilize politics.

Objections may be raised to this pessimistic scenario. A vacuum of power, even if it is accompanied by hardships and risks, does not necessarily lead to chaos or to authoritarian states. It could just be part of a Schumpeterian “creative destruction” of old institutions, leading to a “market democracy” (de Macedo) if the people so wish. In this respect note that Camdessus (p. 16) speaks about a “silent revolution,” referring to the worldwide acceptance of a set of general propositions concerning “good governance” and effective growth-oriented policies. Hence, one can still presume that the disrepute of the old system and the yearning for western market democracies will shape the future of Central and Eastern Europe.

However, such a future has two important implications for today. First, the west, by its policy and actions, must make sure that its values remain attractive. Second, in the countries of Central and Eastern Europe, institution building and systemic reform toward a market democracy must be seen as an integral part of the transition process. Market institutions do not spring into existence; they need to be organized. Otherwise the transition may go astray.

When assisting the transition process in countries of Central and Eastern Europe, the west, as well as international institutions such as the International Monetary Fund, has to discuss, again and again, whether and why the suggested policy approaches, conditionalities, and institutions ultimately build “roads to growth” (the title of this volume). As Camdessus emphasizes in his opening address, this seminar aimed at bringing together economists from the Fund and from countries in Central and Eastern Europe to discuss precisely these issues.

The book starts by analyzing the present economic situation in Central and East European countries as well as in the former German Democratic Republic (Part II). It proceeds by looking at the importance of human and real capital (Part III). Then the role of institutional reforms is studied (Part IV). Finally, representatives of international organizations (the World Bank, the IMF, and the Organization for Economic Cooperation and Development) discuss the international support for Central and Eastern Europe (Part V). Summaries of the discussion for Parts II-IV were prepared by Aurel Schubert and appear at the end of each part. The remainder of this introduction summarizes the main arguments of this book.

Present Economic Situationin Centraland East European Countries

“Extensive Growth” Versus “Intensive Growth”: The Economic Stagnation of the 1980s

In countries of Central and Eastern Europe, production per capita peaked in the mid- or late 1970s. During the 1980s, however, economic stagnation prevailed.

Allen (p. 31) explains this apparent shift of growth pattern by stating that the centrally planned economies in Central and Eastern Europe could handle the phase of “extensive growth” well. Yet these economies were not capable of generating “intensive growth” because they were unable to provide appropriate incentives. A prerequisite for such incentives is a hard budget constraint for economic agents, especially firms. In the old system firms did not have to face hard budget constraints.

The concept of extensive growth refers to growth of output owing to mere increases in inputs such as capital, labor, or natural resources. In contrast, intensive growth requires innovation, improvement of product quality, exploitation of gains from trade, as well as the incessant effort to reduce costs.

Allen’s observation on the growth pattern in countries of Central and Eastern Europe is consistent with the econometric results in the paper by Borensztein and Montiel (pp. 183–85). By using a Solowian output growth equation, originally derived for 75 countries, these authors estimate that most of the current stock of capital in countries of Central and Eastern Europe is not needed. Obviously, during the last years of planning, the economic agencies hoped that by increasing the existing capital stock, output would still grow. However, extending the phase of extensive growth was no longer possible.

A similar argument is stressed by Calvo and Frenkel and de Macedo (p. 139). They observe that the economies of countries of Central and Eastern Europe were “physical” ones run by “engineers,” lacking financial or human capital. As a consequence, intensive growth was not achieved.

Starting Point in 1989

As Allen’s paper points out, instead of providing conditions necessary for generating intensive growth, many, yet not all, governments in these countries tried to overcome the supply-determined growth problem by stimulating demand. Demand-side measures, such as higher wages, were adopted especially in countries such as Poland where governments had to cope with internal political unrest. Since this policy led to an undesired accumulation of monetary balances (monetary overhang), problems of repressed inflation emerged. To overcome supply constraints, some countries even chose to increase absorption by financing imports from abroad. As a consequence, in late 1989, countries such as Poland were not only threatened by an incipient hyperinflation, but came close to being unable to service foreign debts.

After the revolutions of 1989 had swept new governments into power, the various reform programs had to take into account the different macroeconomic starting points of those countries (Allen, pp. 24-26). However, with respect to systemic change or to microeconomic reallocation (elimination of monopolies, adjustment of internal price ratios to those of the world market) the programs were similar in all countries of Central and Eastern Europe.

For countries such as Czechoslovakia, which, at the end of 1989, was not troubled by macroeconomic stabilization problems, the question of sequencing and timing reform measures could be handled with care. In other countries, such as Poland, a quick and pragmatic solution for imminent macroeconomic problems was necessary. There was no option available to search for a “perfect” sequencing and timing of policy. Instead, areas of vulnerability had to be tackled by timely, albeit imperfect, comprehensive reforms. Comprehensiveness was needed to provide “confidence and momentum” (Calvo-Frenkel).

Lessons of German Unification

The paper by Siebert, Schmieding, and Nunnenkamp (pp. 62-96) discusses the German case. The German “experiment” could take place within a seemingly favorable environment: importing institutional infrastructure and political as well as economic stability from west Germany. In east Germany, there was greater freedom to conduct first-best policies. Yet the experiment fostered “unrealistic” expectations. An unrealistic exchange rate was chosen, real wages increased sharply (no wage control in enterprises, no effective control over management), soft budget constraints still prevailed (transfers of more than DM 120 billion from west to east Germany in 1991), and deviations from the Ordnungspolitik were accepted.

However, the sweeping trade liberalization between east and west Germany would have required “realistic” real rates (real exchange rate and real wage rate). Hence, the German example cannot be used as an argument against the “big bang” type of reform. Unrealistic expectations may have been encouraged for political reasons in order to speed up German unification.

Current Stagflation in Countries of Central and Eastern Europe

The sharp decline of industrial production is due to the dissolution of the Council for Mutual Economic Assistance (CMEA) and, only partly, to transitional problems. A realistic exchange rate may help to cushion the fall in production. The situation in these countries demonstrates that the recession is mainly supply, not demand determined.

Inflation originates mainly from increases in input prices, since prices in Central and East European countries are still mostly cost determined (Kolodko and Mujzel call this phenomenon “corrective inflation”). Three caveats have to be kept in mind when analyzing inflationary phenomena in these countries. First, when relative prices change, the industrial organization literature on monopolistic price behavior predicts an increase in absolute prices. Hence, inflation may be due to monopolistic structures, and their elimination may weaken inflation. Second, the measured inflation rates may overestimate the increase in the true cost of living, since substitution effects are neglected. As price ratios change in the wake of reform, substitution effects are of great importance. Third, since the old prices were accompanied by rationing, the new prices, even if higher, may improve the welfare of consumers. On the second and third issues, see Osband (1991).

There is a widespread critique that the stabilization programs in Central and East European countries, assisted by the IMF, caused the current recession. Since, in some cases, quick and pragmatic solutions had to be found, there may be problems of overshooting, as mentioned by Mujzel (p. 54), Rosati (p. 103), and Kolodko (p. 197). However, it is worth noting that in two previously centrally planned countries, the former German Democratic Republic and the Soviet Union, the economic situation seems to be worse, indicating that the speed of reform without IMF assistance was either too fast (the former) or too slow (the latter). Besides, even if these programs did cause a decline in output, one would have to acknowledge that other problems were solved: hyperinflation could be prevented, as in Poland (an inflation rate of 30 percent a month in the last quarter of 1989), see Allen, p. 30; and further indebtedness could be avoided (Hungary and Poland had positive current accounts in 1990). Therefore, tradeoffs in economic policy (see the discussions on the Phillips curve) must be taken into account.

Given the disrepute of the old regime, it may be that there was a political interest also in getting rid of the old power elite by challenging firms with really hard budget constraints. Perhaps this is one reason why Calvo and Frenkel’s proposal of cancellation of firms’ debt was not supported by seminar contributors from Central and East European countries. The combination of lower inflation and higher unemployment was, perhaps for political reasons, preferred.

In addition, it may be of interest for those not supporting the reform path adopted to dramatize the recession. Two controversial issues may be mentioned in this context: How big was the reduction in real income in Poland in fact (see, however, Sachs and Lipton, 1991)? Why complain about a decline in industrial production if a reallocation of resources from industry to the service sector is desired, for example, for generating “intensive growth” or for preserving the environment?

Overcoming “Bad” Equilibria: The Roleof Humanand Real Capital

The economies of Central and Eastern Europe were “physical” ones run by “engineers.” Roads to growth, therefore, should stress the role of human and financial factors. A production structure increasingly based on human capital should be envisaged. This is the main point of Calvo and Frenkel, pp. 125-34, and de Macedo, pp. 138-40.

The “Cleaning” of Balance Sheets and Problem of Credibility

There are many reasons why “bad” equilibria in the underdeveloped capital markets of Central and Eastern Europe may emerge: the information structure is imperfect, the degree of systemic risk is high, etc. Two remedies are suggested by Calvo and Frenkel, pp.115-20:

  • (1)The “cleaning” of the books, that is, the cancellation or socialization of debts of firms, makes privatization more feasible. Efficient firms might otherwise be insolvent. Cleaning removes one element of systemic risk, since much of the debt is of the intra-governmental type resulting from the old pricing system. Such cleaning is done in Germany via the Treuhand, and in Czechoslovakia, reportedly, bad loans are dumped on a specific state bank.
  • Yet there are problems when debts are cancelled: “moral hazard” may arise. Hence, as Calvo and Frenkel insist, the cleaning of books should be a pure and a one-time bookkeeping device prior to privatization; it must be implemented unexpectedly. In addition, to avoid a financial crisis, creditor firms or banks should be compensated (debt-for-debt swaps).
  • (2)Credibility is established by adopting simple and transparent rule-based policies (see, however, east Germany, where the rules imported from west Germany were too complicated, Siebert, Schmieding, and Nunnenkamp, p. 84). The reform must be durable. Perverse effects may arise if a policy action is not credible for economic or political reasons.

Human Capital

The accumulation of human capital requires an incentive to invest in education, which calls for a relatively high (feasible) wage rate for skilled work. Consequently, distorted wage structures should be removed. A higher (more feasible) wage rate may emerge if monopolies or inefficient transaction structures (caused by a monetary overhang) are removed.

Should government policies foster the incentives to invest in education by providing a specific tax structure? As the literature in economics suggests, the accumulation of human capital has positive external effects (see the endogenous growth models), and therefore subsidies may be justified. Because the positive external effects of education are not limited by national boundaries, an international policy approach may be attractive.

Real Capital

According to Borensztein and Montiel, the bad news with real capital is that, judged from output results in many countries, most of the existing capital stock in Central and East European countries is inefficient. But this implies good news: the marginal productivity of capital is high, and therefore, the investment necessary to obtain a satisfactory growth rate does not have to exceed normal levels. For example, an investment ratio of 22 percent of GDP (lower than it was in the past) may be sufficient to resume a high rate of growth.

Since in Central and Eastern Europe the marginal rates of factor substitution within and among firms were not equalized, mobile factors may bring about efficiency gains, which make the good news even better. Yet prerequisites exist for obtaining factor mobility (for example, in the housing sector).

Although an investment ratio of 22 percent does not seem high, investments with sunk costs, when combined with such uncertainty as exists in Central and Eastern Europe, can cause potential investors to be extremely passive: the option value of waiting may be too high (see Obstfeld, p. 189). Again, that is bad news. Investment subsidies for overcoming this high option value of waiting may run into a problem of time consistency or may negatively affect the accumulation of human capital.

Saving and Foreign Debt

Factors that may influence savings behavior include the role of the monetary overhang, changes in the structure of the financial system, or the implications of privatization. Privatization may, in the non-Ricardian case (of people getting richer), reduce savings; see Obstfeld, p. 191.

A successful reform that brings about a strong investment demand has to attract foreign savings. A reduction of foreign debt can resolve uncertainty and thus foster investment, yet this forgiveness may also create problems of moral hazard.

Institutional Reformsin Laborand Capital Markets

The decentralization of decision making does not necessarily release the productive energies thwarted by central planning. It can instead release the force of special interests. Institutional reforms are necessary to balance these special interests, especially in labor (see Commander, Coricelli, and stähr, pp. 207-40) and capital markets (see Frydman and Rapaczynski, pp. 255-85); otherwise a government desiring to demonstrate its commitment to a more passive role is faced with the task of maintaining direct controls.

The Importance of Wage Bargaining Mechanisms

In Central and Eastern Europe many firms are now controlled by workers. Within a policy game with two players, the bargaining between the government and such firms about the enforcement of a hard budget constraint can be explained. If the worker-controlled firm understands that the government ultimately wants to maintain the level of employment (despite announcements to the contrary), this will result in the government offering subsidies to the firm, which undermines the credibility of the reform program.

Another problem concerning worker-controlled firms may arise if the firm is likely to be privatized. Then it may be rational for the workers to “eat up” the existing capital if they have no assurance of long-term employment.

In any of these cases the government is called on to interfere in the decisions of the worker-controlled firms, for example, by imposing wage constraints.

The Privatization Issue

Privatization does not spontaneously create institutions that guarantee a routinized, structured control system over the internal coordination process within firms. Pathological cases may occur: the old bureaucratic structure keeps control of the enterprise; foreign investors may be totally absent (and with them the inflow of foreign managerial skills, foreign savings, and foreign control); investors or owners may remain passive and refrain from controlling the managers; or serious problems of the principal agents type may arise.

Although agreement was widespread that these cases were pathological and should be avoided, less consensus existed on whether the remedy should be by a specially designed “constitutional” approach (as suggested principally by Frydman and Rapaczynski, and specifically planned in Czechoslovakia), be left to the self-correcting forces of the markets (however thin), or be solved by gradual privatization as in Hungary.

International Support for Central and Eastern Europe

There was widespread agreement that the support of international organizations is important in its financial dimension. However, technical assistance on various aspects of institution building and systemic reform is equally important. The role of technical assistance stresses the main argument of this book: “Roads to Growth” cover political as well as economic issues, with macroeconomic stabilization being only a part of it. The creation of human capital and the building of institutions of a market democracy will be equally significant in whether Central and Eastern Europe can resume growth on a sustainable basis.

References

    OsbandKent“Index Number Biases During Price Liberalization,”IMF Working PaperWP 91/76 (Washington: International Monetary FundAugust1991).

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    SachsJeffrey andDavidLipton“Shock Therapy and Real Incomes,”Financial TimesJanuary291991.

1Take the case of Czechoslovakia, where nearly one hundred political parties have been founded since the end of 1989. Not one of them, according to opinion polls, would receive more than 20 percent of the votes.
2In east Germany economic illusions were already created; see Siebert, Schmieding, and Nunnenkamp, and Lipschitz’s allusion to “politics-and-prayer.” Some, like Mujzel, insist on an anti-recession policy so that the political foundation of economic transformation does not get eroded (p. 54).

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