Lecture 7. The strategy of radical reform

Lecture outline Outcome of partial reforms Conditions at the beginning of radical reforms Radical reform package Price liberalization, inflation and financial stabilization

The outcome of partial reforms Financial destabilization Exacerbated shortages Deterioration of “planning discipline” Growth of the underground economy Loss of confidence in the entire system Did partial reforms fail?

Initial conditions for radical reforms The start of radical reforms (transition): - China Poland, Hungary, Czech Republic - Russia, Ukraine, Baltic Reps1992 Three categories of preconditions: - structural factors; - institutions; - macroeconomic imbalance

Structural factors Economy "physical" structure (e.g., share of heavy industry, services, agriculture), which affect production possibilities and characterizes the degree of its “misdevelopment”

Institutions Small size of non-state sector Weak entrepreneurial traditions Prior development of market infrastructure Degree of autonomy of state enterprises Openness to world market Administrative capacity of the state

Macroeconomic imbalance Budget deficit Inflation Foreign debt

Initial conditions of different economies Structural problems Institutional problems Macro- imbalance China 1979MildSevereMild China 1989Mild Medium Czech RSevere Mild HungaryMediumMildMedium PolandMediumMildSevere RussiaSevere

Radical reform package Price liberalization and financial stabilization Privatization New legal and admin structure (new institutions) Some of the more specific components of radical reforms –Radical reduction of government investments and subsidies to firms –Removal of direct controls over SOE’s –New taxation system –Monetary policy: tight credit –Liberalization of foreign trade –Social safety net –Creation of privately owned banks

Price liberalization (PL) PL is paramount for market reforms because markets don’t work without flexible prices PL is technically easy (the state simply stops controlling prices) Why then is PL resisted by governments? –Fear of inflation –Adverse distributional effects –Rents generated by controlled prices –Flexible prices don’t work well without privatization –Monopoly

Inflation Monetary overhang (Economy has too much money relative to the value of consumer goods at official prices) Does PL cause inflation in the presence of monetary overhang? State-controlled prices vs. black market prices

Inflation (CPI, % over previous period) BulgariaCzech (Slovak) PolandRussia Reform Year st month (245) 1 st year (2609) 2d year

Why was there inflation at the beginning of transition? Free market prices rose much less than official inflation rate (in Russia – 53% in January 92 compared to 245% inflation rate and 400% in controlled prices)  pre-existing (repressed) inflation was converted into open inflation Difficulties collecting budget revenues Nominal wages increased dramatically Indexation of savings EXPECTATIONS

Costs of inflation Anticipated inflation: opportunity cost of holding money increases  flight from domestic currency  frequent wage payments; barter; dollarization; people look for ways to benefit from inflation rather than engage in productive activities Menu costs Makes it difficult to extract information from prices

Cost of inflation (cont.) At high rates inflation is never anticipated Cost of unanticipated increase in inflation: - redistributes wealth to borrowers from lenders - decreases real wages & may increase GDP - generates self-fulfilling expectations - creates major uncertainty in the economy, stifling investments

Fighting inflation Limiting government expenditure, including subsidies to enterprises Increasing taxes Raising interest on government loans to banks and other borrowers

Why does price liberalization take place eventually? Recall objections to PL: –Fear of inflation –Adverse distributional consequences –Rents generated by price controls –Complementarity between PL and privatization and demonopolization These objections are overcome by both implicit PL that takes place via informal economy and official inflation Informal PL implies lower costs of official PL, but also lower benefits of official PL

Effect of price liberalization on output Production has to restructure in order to reflect genuine demand Price liberalization implies that everybody has to negotiate prices Negotiations in the presence of private information may break down Failure of negotiations may result in the lack of complementary inputs, reducing production