3 The Link Between Price Liberalization and Macroeconomic Management
- Richard Bart, Chorng-Huey Wong, and Alan Roe
- Published Date:
- September 1994
The topic I have been given is a complex one. It becomes even more complex when considered in light of the wide variety of countries represented at this seminar: Latin American, Asian, and African, as well as countries in transition to market economies. It is only fair for me to interpret my mandate in a way that has some relevance for all of you. Thus, I am going to present a general framework for discussing this issue, defining several initial conditions that apply to different types of countries and identifying the corresponding policy dilemmas.
Let me start with the definitions. Price liberalization can mean different things to different people. I will define it broadly as the elimination of any intervention that distorts relative prices, or, more specifically, as the elimination of any wedge between the signals prices convey to producers and consumers and true scarcity prices. Many distortions fit this definition, including price controls, mandatory procurement, restrictions on trade through tariffs or export quotas, and subsidized imports and credit.
Some of these interventions may generate excess demand, while others may not. Liberalization may take place in situations where official prices have been set at below market-clearing levels—as they were, for example, in the former Soviet Union—creating huge monetary overhangs. But liberalization will also eliminate distortions in markets that have been in equilibrium, reducing export or import taxes, for example.
Next, I will define the goals of effective macroeconomic management as low and stable inflation and a sustainable domestic and external debt. Achieving these goals calls for a sustainable fiscal deficit. Of course, I am referring to a sustainable fiscal deficit in terms of what the rest of society or the world is willing to finance. A country can have a high fiscal deficit, like Italy, but still be able to borrow—i.e., people are willing to lend to Italy at “moderate” real interest rates. So a deficit is sustainable or not according to how willing others are to provide financing for it.
Finally, and just as important, the fiscal deficit needs to be contained with measures that are equitable, efficient, and sustainable over the long run. In other words, the quality of the fiscal adjustment is fundamental. A generalized value-added tax (VAT) is more consistent with long-run efficiency than a tax system that relies solely on export taxes. And reducing expenditures by unduly curtailing real wages in the public sector is probably not sustainable; a better alternative is to reduce excessive public sector employment until the sector is lean and efficient, so that the remaining employees may be paid well.
Four Possible Cases
Using these definitions, I will discuss four initial sets of conditions, or situations (Chart 1).
Chart 1.Achieving Low Price Distortions and Low Fiscal Deficits (Situation 4)
Situation 1 includes countries such as India, Bangladesh, Pakistan, and Romania, which until recently have had rather severe price distortions but relatively low fiscal deficits and inflation levels. (Russia was also in this situation before 1992.) These distortions usually include taxes and quantitative restrictions on international trade, taxes on the use of labor, mandatory state orders, and quantitative allocation of credit.
Situation 2 includes economies with both strong distortions and severe fiscal disequilibria, such as Ukraine and Belarus today. Situation 3 includes economies with lower levels of distortions but still with large fiscal deficits and/or high levels of inflation (the result of high velocity). A good example is Brazil, which has a monthly inflation rate of over 30 percent but perhaps fewer distortions than Romania or Pakistan.
I will assume that all countries wish to move into Situation 4, in which major distortions have been removed and macroeconomic stability has been achieved. Countries such as Chile, Mexico, Thailand, Malaysia, and Korea are probably in Situation 4 today. What are the policy issues facing a country that wishes to move into this situation from each of the different initial conditions? In other words, what are the major trade-offs (if any) between price liberalization and fiscal balances when a country wishes to move toward Situation 4?
Distortions Are the Result of the Political Economy of Cross-Subsidization
The key hypothesis I now want to advance is that distortions are not the accidental or capricious results of policy interventions. In my view, long histories of price distortions reflect a balance among interest groups that permits some societal groups to be subsidized through implicit taxes on others. Most of the time the subsidized groups are politically vocal and highly concentrated. The groups taxed by such subsidization are usually less vocal and dispersed, and the tax per capita is smaller and less visual. And most important, such cross-subsidization does not go through the budget; it is nontransparent and hidden and hence less subject to scrutiny by parliament or public opinion. It is a fiscally cheap way of achieving a strategic, noneconomic objective.
Most serious distortions are the result of such cross-subsidization. For example, many governments attempt to artificially lower the price of food to urban consumers by subsidizing food imports, imposing price controls, or setting procurement prices for agricultural products below world levels. These interventions obviously tax the agricultural sector. To partially compensate the sector, subsidized credit is made available to agricultural producers through state development banks or by government mandate through private banks. Such interventions introduce further distortions and corruption. Financial intermediation is being taxed, since other sectors now have to pay higher interest rates, and the room for bribes increases because such credit must be rationed. In fact, the most efficient way to subsidize consumers is to have a generalized food consumption subsidy, but that would constitute a heavy budgetary burden.
A concrete example of this problem exists in Russia today. The authorities keep domestic fuel prices artificially low by imposing severe export quotas on exports. These restrictions adversely affect oil exploration and output. A less distortive way to keep prices low for certain consumers would be to subsidize consumption directly—for example, by subsidizing the energy bill of schools, hospitals, and nursing homes. But again, this type of subsidy would be more expensive fiscally.
Another example involves social security systems. Most countries try to increase the lifetime real incomes of workers by putting together a social security system financed by payroll taxes. Such taxes are not a distortion if workers place a value on the eventual benefits equal to 100 percent of these contributions. However, if workers value the benefits at less than 100 percent, this way of financing the social security system becomes a tax on the use of labor. A much more efficient way of achieving the same end is to finance social security directly from the budget. But this method is more expensive fiscally, since including social security in the budget will of course require additional overall taxation.
A very important conclusion can be derived from such examples: achieving a noneconomic or strategic objective without generating distortions will be costly to the budget. Distortions can be seen as attempts to achieve such objectives without having to recur to the budget, usually by implicitly taxing another sector of the economy. Hence, for a given subsidization objective, a trade-off exists between economic efficiency and the fiscal cost of achieving an objective. Such trade-offs have profound implications and represent a major link between attempts to liberalize the economy and efforts to reduce fiscal deficits.
If price distortions are the result of cross-subsidization, then price liberalization will adversely affect public finances—unless the pressures for subsidization are curtailed. Consequently, governments will have to manage the political economy of subsidy reduction as prices are liberalized—a major task that involves changing public opinion and building a consensus. And this task is not easy when, as a result of a long history of subsidization, the majority of the middle class views subsidies as acquired rights or entitlements.
Many countries, particularly in Latin America, have managed subsidy reduction well. Their main strategy has been to move to more targeted subsidies, focusing on the most vulnerable groups of the population. These subsidies are more affordable fiscally, since they involve schemes such as food coupons and vouchers for the neediest, school feeding programs, and low-cost heating for hospitals and schools, thereby avoiding a general subsidization of food, fuel, or essential services.
Let us now explore the dilemmas faced by countries wishing to move into Situation 4. Economies starting from Situation 1 may face a deterioration of fiscal accounts if price liberalization is not accompanied by reduced subsidization objectives and/or additional fiscal resources. Otherwise, there is the danger that price liberalization may move the economy from Situation 1 to Situation 3. This danger is even more significant if the economy is starting from Situation 2, with an already high fiscal deficit. For this reason, the government must make minimum progress on public finances before accelerating price liberalization, and the movement from Situation 2 to Situation 4 may have to go through Situation 1 (see path in Chart 1).
In both situations, it is important to exploit—at the beginning of the liberalization process—all complementarities between price liberalization and fiscal revenues. In order to increase revenues in the short run, quantitative restrictions on exports and imports can initially be replaced by export and import taxes and then lowered as the fiscal situation improves. Prices should be liberalized quickly in markets with excess demand (i.e., black markets and those with queuing) to increase transparency without necessarily raising costs to consumers. Targeted subsidies can replace general subsidization and may be accompanied by public opinion campaigns that stress both the need to protect the neediest and the high cost of maintaining entitlements for the middle class. Eliminating exemptions and improving the enforcement of tax collection by radically increasing penalties for tax evasion should raise revenues quickly.
It is important that a country starting from Situation 3 not be allowed to slide back into Situation 2 through the use of price controls to repress inflation, or the transition to Situation 4 will be even more difficult. Moving from Situation 3 to Situation 4 involves making a major effort to change public opinion. Public expenditures and general subsidies will have to be reduced by moving to targeted approaches with lower fiscal costs. These initiatives will also reduce the pressure (or the temptation) to use the price mechanism as the vehicle of subsidization. Chile and Mexico during the last five years are good examples of such approaches.
Many times price distortions are simply the result of using price interventions to subsidize certain groups by taxing others. This cross-subsidization escapes the transparency and scrutiny of an explicit budget process. Price liberalization will therefore have to be accompanied by strong efforts to reduce the pressures for subsidization. Otherwise, such subsidization will ultimately be financed through the budget and will significantly worsen the macroeconomic situation.
This analysis has important implications. Price liberalization should, early on, be accompanied by measures to improve public finances. In addition, the government must move to more targeted approaches to budgetary subsidies, focusing on the most vulnerable groups. To convince the middle classes to accept cuts in general subsidies that have come to be considered entitlements, governments will have to confront a difficult political agenda.
In my view, there is no direct link between price liberalization and macroeconomic stabilization. I am going to illustrate my contention by looking at the recent experience of Russia. In January 1992, Russia experienced large-scale price liberalization, which resulted in a jump in the absolute price level that was very large not only by historical standards but also by the standards of other countries in transition from a command economy (Chart 1).1 Since then, Russia has experienced high inflation. Yet there is no reason to conclude that there is a link between the two facts and certainly no reason to conclude that price liberalization was responsible for the current level of inflation in Russia.
Chart 1.Russian Federation: Money, Inflation, and the Exchange Rate, January 1992–March 1993
Sources: Central Bank of Russia; and IMF staff estimates.
1 Lagged by one quarter.
2 Urban CPI through December 1992, expanded CPI thereafter.
Prices in Russia began rising in 1991, but for the sake of historical curiosity, let me remind you that this episode was not the country’s first experience with high inflation. In 1921–23, during Lenin’s New Economic Policy, the monthly rate of price increase averaged almost 50 percent for several months; in January 1924 (the month Lenin died), prices actually surged by 300 percent. Monetary reform followed, and inflation went down sharply. Later on, during the decades of central planning, prices in state stores remained constant or rose very little. There were some exceptions. First, in some markets prices did rise at times; second, there was occasionally some “cooking of the books” by certain firms, along with practices such as claiming that a new or modified product differed fundamentally from an earlier, similar one in order to justify a higher price. But in general, state-controlled prices did not change greatly.
In the mid-1980s, a growing gap developed between nominal incomes and actual physical production that was reflected in a corresponding gap between free market prices and official, controlled prices in the state stores. The mirror image of this gap was a forced accumulation of savings by the population, the so-called monetary overhang. Toward the end of the Gorbachev era, the system came under increasing pressure: as the gap between income and production widened, shortages increased, queues grew longer, the disparity between free agricultural market prices and prices in state stores continued to grow, and it became increasingly clear that a more uniform approach to price liberalization was necessary. In 1991, controlled prices were administratively increased (an adjustment of industrial producer prices in early January was followed in March and April by adjustments to consumer prices), but this rise did not constitute genuine price liberalization.
In spite of these adjustments—large by historical standards—the gap between official and market prices continued to widen. In the fall of 1991, Russian President Boris Yeltsin decided that the situation was unsustainable and that comprehensive price liberalization must take place. Once it became obvious that liberalization would in fact occur, households and enterprises began speculating in anticipation of price increases. Households hoarded foods and other consumer goods in their closets, and enterprise managers stocked up on raw materials and producer goods. As a result, so many goods disappeared from the market so rapidly that by the end of the year, the situation had become extremely serious.
On January 2, 1992, comprehensive price liberalization did take place. Some 80–90 percent of price controls were eliminated entirely, with the notable exceptions of those on oil, electricity, and natural gas. Prices for a few other products, including bread, milk, baby formulas, and vegetable oils, were liberalized in March.
There was a huge increase in Russian consumer prices, as well as an even higher one in producer prices, immediately after prices were freed. But the increases were basically a one-time event, the result of prices shifting from one equilibrium level to another. Naturally, the increase in market retail prices was considerably smaller than it was in state stores: the disequilibrium in those markets was considerably lower, since prices had been allowed to rise somewhat over time.
The January 1992 price increase was huge, even when considered in light of the experiences of East European countries. Taken together, the initial rise in 1991 and the increase in January 1992 pushed up consumer prices in Russia by almost 300 percent. In similar episodes of price liberalization, consumer prices rose by less than 150 percent in Bulgaria and less than 100 percent in Poland, while increases in Czechoslovakia and Romania were considerably smaller. The same was true for producer prices. There were relatively large jumps in producer prices in Romania, but in all the East European countries, the increases were considerably smaller than they were in the Russian Federation.
Why was the increase so large in Russia, especially when compared with developments in East European countries? One simple explanation is that the monetary overhang—or, equivalently, the absolute price disequilibrium accumulated over the years—was much larger in Russia than it was in any of the East European countries. Even in Poland, where the overhang was estimated to be relatively large, prices had been liberalized considerably over the years. When Poland implemented its main round of price liberalization in 1989, 50 percent of agricultural and food prices, even for processed foods, had already been freed.
A second possible hypothesis for the jump in prices holds that the Russian authorities made a mistake in announcing a three- to fivefold price increase beforehand. The theory is that producers, having had no experience with markets, did not know how prices would behave after liberalization was announced and so took the government’s predictions as guides in raising prices. Thus, prices went up threefold to fivefold as soon as the announcement was made. It is very hard to verify this theory. There is some evidence of overshooting in certain prices in the period immediately after liberalization, a fact that could lend the explanation some veracity. For example, the price of beef in several Russian cities showed a huge initial increase, followed by an absolute decline. This behavior is consistent with the hypothesis that price setters could not identify the appropriate price level. The moral of the story, if it is true, is that price hikes should not be announced beforehand. Instead, the market should be left to find its own equilibrium.
Another important aspect of Russia’s experience is the wide geographic dispersion of prices. In part, this dispersion resulted from an initial lack of arbitrage in the period following price liberalization, and the differentials may, in many cases, have been reduced by arbitrage later on. In addition, local governments were given permission to set their own price controls on basic goods, provided that any subsidies were paid for out of the local budget. Rich oblasts with surpluses in their accounts found it relatively easy to be politically amiable by keeping prices low at the expense of taxpayers in general, while poor oblasts could not do so, explaining some of the price differentials.
What happens when prices differ from region to region or from city to city—when eggs, for example, cost twice as much in one region as in another? People will, of course, go to the place where the price is lower and buy eggs there. In effect, an arbitrage mechanism is set in motion, and eggs begin to disappear from the area where the price is lower. What was the reaction of the local authorities in Russia? Sometimes, it was to abandon the price controls, but often, unfortunately, it was to impose export controls. For this reason, some regions within Russia have been able to maintain price controls in spite of liberalization at the federal level by trying to suppress arbitrage, thus leading to a segmented market. Over time, of course, smuggling diminishes the effectiveness of the export barriers, and price controls become increasingly difficult to maintain.
After the initial surge in prices that followed price liberalization, the inflation rate came down, bottoming out at around 7 percent per month in June and July 1992. It then accelerated in the summer of 1992, averaging around 20 percent per month through the end of 1993. By that time, however, price decontrol was no longer a factor. The rise in inflation resulted primarily from a shift toward an expansionary monetary policy by the Central Bank of Russia (CBR) in the summer of 1992.
In Russia (as anywhere else), the ultimate cause of inflation is excessive expansion of money. It is not the speculators; it is not the monopolists; it is not the labor unions asking for wage increases; it is certainly not price liberalization. The rate of inflation cannot rise, and it cannot continue to rise, unless it is accompanied by excessive monetary expansion. As the upper panel of Chart 1 shows, there is a high correlation between the lagged value of the money supply (in this case ruble M2, or broad money excluding foreign currency deposits) and consumer price inflation in Russia.
Of course, to say that monetary expansion is the direct cause of inflation is to give only part of the story. The other part involves the reasons why countries have excessive rates of monetary expansion in the first place. There must be a set of social and political factors that makes an excessive rate of monetary expansion politically unavoidable, or at least that makes it seem politically unavoidable, and perhaps even desirable, to the authorities. In Russia there were, I believe, three fundamental factors. The first was the CBR’s expansion of credit in order to finance the government’s budget deficit. The second was the CBR’s expansion of credit to commercial banks in Russia to be on-lent to enterprises in Russia. The third was the CBR’s extension of credit to other central banks in the ruble area. These three sources of credit expansion were, in turn, the fundamental factors behind monetary expansion in Russia. I do not put the blame on the CBR alone, for its policy was in part explained by the need to finance the government’s budget deficit—something that was not under the control of the Central Bank.
As regards the second factor, the Supreme Soviet and, in some cases, government ministries were pressuring the CBR to extend credits to specific regions, such as the far Northern Territories; to specific sectors, such as agriculture; and to certain enterprises. The CBR may not have resisted these pressures with great determination, but the fact remains that it did not always take the initiative in issuing domestic credit but acted because of pressure from political forces.
The third factor—the extension of credit to the other central banks in the former Soviet Union—stemmed from the fact that after the Gosbank system disintegrated, the 15 new countries established their own central banks, all eager to issue domestic credit to their governments, banks, and enterprises. To issue such credit, some of the new central banks created their own parallel currencies (like Ukraine’s coupons); most of them relied on credits from the CBR that were, in effect, interest free. For a while, the CBR simply extended credit automatically, and while some countries, such as Armenia, were rather conservative in their own emission of credit, some, like Ukraine, were quite generous—at times, more generous than Russia itself. Since the new countries shared a common currency area (the ruble area) excess inflation in one country, say Ukraine, fed through all the other countries in the area, including Russia. This situation has changed over time as the Baltic countries, Ukraine, the Kyrgyz Republic, and others have introduced their own currencies.
What are some of the important effects of the high inflation Russia has been experiencing? One is that the ruble has depreciated in foreign exchange markets. Since July 1992, when market unification took place and convertibility was introduced, there has been a negative correlation between ruble M2 and the exchange rate of the ruble in relation to the dollar (see bottom panel of Chart 1). The other, related consequence is that real interest rates have turned sharply negative. Last week the interbank rate in Moscow was 164 percent per annum for maturities of about three months, compared with an inflation rate of around 1,000 percent per annum. These figures help to explain why people are interested in investing their money elsewhere: the interest rate differential between assets denominated in rubles and assets denominated in major foreign currencies is not sufficient to cover the inflation differential, which people interpret as an indication of the future depreciation of the ruble.
This problem leads directly to the issue of capital flight, which was estimated at anywhere between $6 billion and $15 billion in 1992. While the sum cannot be measured exactly, there is ample anecdotal evidence that some large Russian enterprises have substantial bank accounts abroad. As capital flows out, the Central Bank’s ability to transfer real resources through monetary expansion (the seignorage) diminishes, and financing a given budget deficit requires increasingly high inflation. Finally, those members of the Russian population whose nominal incomes are not strictly linked to inflation experience a continued decline in real income, and those enterprises that do not have privileged access to subsidized credits are put at a great disadvantage.
What I will try to do today is to describe some of the experiences of Latin American countries that pertain to the subject at hand. In discussing the relevance of price liberalization in macroeconomic management, I would say that both Marcelo Selowsky and Ernesto Hernández-Catá are correct in their assessments. The process of price liberalization can be viewed from a monetary perspective—that is, in terms of the monetary overhang—but it can also be looked at as a phenomenon that affects a country’s macroeconomic performance, primarily through the fiscal deficit, as the experience of Latin America shows. For instance, price distortions reflect taxes, subsidies, or price controls on public goods and services. These distortions, in general, feed first the fiscal deficit, resulting in more credit creation, and then the monetary aggregates, where they manifest themselves in rising inflation and a deteriorating balance of payments.
Certainly, in talking about price liberalization, it is necessary to look at all types of prices, including interest and exchange rates. Also important, as Mr. Selowsky noted, are the price distortions associated with covert cross-subsidization. In these cases, it is frequently difficult to identify fiscal or inflationary problems, because one group of economic agents—say, manufacturers—is taxed heavily through price controls, while another group—consumers—is subsidized heavily through low interest rates, low energy prices, and the like.
Mr. Hernández-Catá mentioned another significant point, which I want to emphasize: a distinction must be made in the process of price liberalization between the one-time impact of a price adjustment and continuous inflation. The Dominican Republic offers a good example of the difference between the two. Before 1990, domestic oil prices were half those in the world market. These low domestic oil prices aggravated public sector deficit problems, which in turn put pressure on consumer prices and the balance of payments. The authorities decided to correct domestic oil prices by raising them threefold to match world levels. When these adjustments were introduced, the rate of price increases which had been running at 30-40 percent annually, jumped to over 100 percent. The year after the corrective price adjustments were made, the fiscal situation improved, and the absence of credit creation—a result of the reduced public sector deficit—helped lower inflation to 4 percent per year. The Dominican Republic’s experience is a good example of a marked one-time increase in prices that quickly reverses itself as macroeconomic imbalances are corrected. Of course, this kind of sharp reduction in inflation depends on certain factors—for instance, the absence of indexation. In a country like Brazil, which has widespread indexation, seeking to correct relative prices can affect the level of wages and a number of other prices. These increases can, in turn, affect both credit and money growth, as well as inflation, if the underlying situation is not corrected.
With indexation in place, the fundamentals of an adjustment program will work, but because of the built-in rigidity in relative prices, the move to a lower inflation plateau will be much more difficult. Accordingly, the adjustment may initially have a greater impact on output and employment than on inflation, at least in the short run. Looking at effective price liberalization in countries of the Western Hemisphere, I can draw the following conclusion: in order to be effective, price liberalization must be accompanied by a consistent macroeconomic program and aided by a process of de-indexation.
My discussion thus far illustrates Latin American countries’ experience with adjustment programs and price liberalization over the last decade. In the early 1980s, these countries confronted a difficult situation: their external debt levels were high; their terms of trade were weakening; foreign financing, plentiful during the earlier oil boom, had dwindled; and real interest rates had increased. In these circumstances, many of the structural problems that the Latin American and Caribbean countries faced became more evident. Since then, there have been significant efforts in the region to improve macroeconomic policies and correct existing structural problems. Overall, the experience has been favorable, but the process of adjustment is not complete. Although some external observers may suggest that the region has few remaining problems, a closer look shows that numerous issues have not been resolved. Admittedly, many countries have brought inflation under control, liberalized their price structures, and improved their foreign reserve positions. However, external debt remains high, savings are still low, and the rate of growth has failed to increase sufficiently.
Some country experiences are worth mentioning, including that of Chile, where the process of price liberalization started around 20 years ago, when price distortions were widespread. Chile moved to a system that was intended to bring about macroeconomic stability, reduce price controls and subsidies for goods and services, and promote the liberalization of external trade. This multipronged approach has resulted in an economic performance that is possibly the region’s strongest, combining sustained growth, healthy public finances, and relatively high levels of saving and investment. Chile’s experience illustrates the need for a broad strategy that not only restores healthy public finances and corrects price distortions but fosters overall structural reform as well as macroeconomic adjustment.
Another country that has moved ahead in its structural and macroeconomic reforms is Mexico. Initially, Mexico undertook a process of macroeconomic adjustment, but it quickly became evident that fiscal adjustment alone would not solve the country’s problems. Fiscal reform was begun in 1982 with policies aimed at correcting the large public sector deficits. In 1986, the government broadened its strategy to encompass structural reforms, including privatizing large parts of the state sector, liberalizing external trade, opening up the financial system by allowing greater flexibility in interest rates, and eliminating the domestic transportation monopoly that had significantly increased the cost of transportation within regions and for exports. Like Chile, Mexico moved to modify its social security system, in part through privatization, resulting in a significant increase in savings.
While Chile and Mexico are the region’s best-known examples of successful economic reform, other countries have also modified their policies significantly to encourage adjustment and reform. For example, Bolivia’s inflation rate had reached 23,000 percent in 1985. One interesting aspect of this hyperinflation was that as part of the adjustment process, the authorities moved to adjust the fiscal and monetary accounts and liberalize prices. In response, inflation fell rapidly after a short period, providing another illustration of Mr. Hernández-Catá’s statement that adjustment is often followed by a sharp increase in prices and, shortly thereafter, by a sharp decline in inflation.
Peru has also liberalized prices in recent years, but at the same time the government has cut the public sector deficit and allowed the exchange rate to float. In this context, inflation, which was running at the rate of 3,000 percent a year in the late 1980s, has declined to around 40 percent—still high, but well within the realm of the reasonable.
Argentina is operating under a different type of exchange rate regime, maintaining a fixed exchange rate while seeking to improve its public finances and liberalize prices, and inflation has fallen sharply. Additionally, Dominica, the Dominican Republic, El Salvador, Grenada, Guyana, and Jamaica have lowered their high inflation rates, in part by dismantling widespread controls.
In general, Latin America’s experience has a bottom line. In broad terms, successful structural reform has gone hand in hand with macroeconomic adjustment. If price distortions remain, the market will not accept the macroeconomic solutions offered as permanent and will act accordingly. Macroeconomic programs alone can be sustained for a year or two, as they were in the 1970s and 1980s in some Latin American countries, but only a program aimed at achieving both structural reform (including the liberalization of prices) and macroeconomic adjustment can create a stable macroeconomic situation conducive to sustainable economic growth.
Summary of Discussion
There was general agreement with Marcelo Selowsky’s basic propositions about the fiscal preconditions necessary for price liberalization. Participants also expressed the view that the problems facing Russia are unique, in that the authorities are trying to reconcile a reform of the price structure with macroeconomic stabilization. In particular, it was pointed out that if high inflation occurs during the reform transition, the available instruments of economic policy are not adequate to deal with it. For this reason, some participants argued that transition economies like Russia must live with high inflation for a time. Structural adjustment, while absolutely essential, is fiscally expensive.
Participants felt that Selowsky’s fiscal preconditions may not be achievable, although they are logical and necessary. For example, it may be possible to force bankruptcy on as many as 100 financially distressed enterprises, but it is impossible to force it on 20,000 or more. Hence, enterprise subsidies or directed credits must continue. In the same vein, although one poorly functioning bank can be penalized, all the banks in a banking system cannot be disciplined. In short, the inadequacies and inefficiencies in transitional institutions will have to be accepted for a time, so that inflation is unlikely to be corrected quickly or easily.
Another issue raised in the context of the East European transition economies was trade liberalization, which many felt had not been actual liberalization, at least not in the accepted sense of the term. Much of the technical infrastructure for conducting trade with countries other than those in the Council for Mutual Economic Assistance area is missing, for example, and competition from Western imports does not follow naturally and easily from the removal of the formal barriers to trade. It was suggested that a variety of special programs may be needed to reinforce the effects of trade liberalization in some countries.
This line of argument attracted some support, although the speakers from the IMF also noted that reform decisions are always politically difficult and that this rather pessimistic view of Russia should not be used as a reason to limit reform efforts. It was accepted that certain social benefits and payments to enterprises need to continue during the transition period. However, participants disputed the idea that because these payments must continue, inflationary financing is inevitable or even possible. It was pointed out that the “high-inflation approach” to adjustment can only generate inflation tax revenues for a relatively short period of time. After that, people will rapidly find alternative assets for holding wealth, and the base for the inflation tax will erode rapidly. The consensus was that there is no alternative to combining liberalization with an aggressive assault on inflation.
In relation to the Latin American countries, considerable interest was expressed about the management of the large capital inflows some of these countries are currently experiencing. Claudio Loser explained that these favorable flows are not miracles but the result of hard work and greatly improved fundamentals. In most cases, they represent a vote of confidence in the reform programs the countries concerned have carried out. IMF staff expressed the view that a balance needs to be found between the benefits of the additional foreign savings—some of which represent the repatriation of earlier capital flight—and the inflationary problems attendant upon these flows. Thus, countries benefiting from these flows should allow their economies to adjust to them and not try to control them or neutralize their impact through, for example, sterilization. Such efforts often cause unnecessarily high interest rates and central bank losses.
Finally, there was some discussion of the role of independent central banks in controlling inflation and the apparent difficulty of reducing inflation from “moderate” to very low levels. One commentator noted that many countries seem able to get rates down to about 20 percent but that the next step in inflation reduction—to single-digit levels or even close to zero—seems to be very difficult. There was some sympathy for the view that social and political tolerance of inflation in a country is an important factor in this context and that this tolerance may also explain the support fully independent central banks, such as the Bundesbank, are able to command. Apart from this factor, achieving the last degree of inflation reduction seems to depend on sound fiscal and monetary policies and, in some cases, on eliminating indexation arrangements.