5. Transformation of Centrally Planned Economies: Credit Markets and Sustainable Growth

Georg Winckler
Published Date:
September 1992
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I. Introduction

The transformation of centrally planned economies (CPEs) into well-functioning market economies is likely to be lengthy and complex. During the transition period–when the economy is no longer a CPE, but has not yet become a fully developed market economy–it is referred to as being a “previously centrally planned economy” (PCPE). A major challenge facing policymakers in PCPEs is to reduce the disruptive effects of economic restructuring, and to resume sustainable growth.

Since the beginning of the 1990s most of the CPEs in Central and Eastern Europe have launched dramatic economic programs aimed at transforming their economies from a centrally planned system into a market system. Such programs have been adopted by Hungary and Yugoslavia and, more recently, by Bulgaria, Czechoslovakia, Poland, and Romania. In all of these economies the ultimate objective is a fundamental restructuring of the economy. However, the initial conditions prevailing in them have been diverse. For example, in Poland the economic transformation program started against the background of very high inflation and large foreign debt. Accordingly, the primary initial objective of economic policy in 1990 was price liberalization coupled with a dramatic reduction in inflation. In Czechoslovakia, on the other hand, the initial conditions were different: both inflation and external debt were relatively low. Accordingly, the primary initial objective of economic policy in 1991 has been preventing a flare-up of inflation associated with price liberalization while, at the same time, initiating a large-scale privatization program. In all cases, the objectives of macroeconomic stability are pursued through fiscal and monetary tightening. Experience with economic stabilization efforts in Latin America and elsewhere indicates that such tightening results in reduced public sector investment and higher real rates of interest. Even the more successful stabilization efforts have found it difficult to resume growth on a sustainable basis. The limited experience accumulated thus far in PCPEs appears to follow a similar pattern. In fact, the economic slowdown associated with the initial phases of the economic transformation process in PCPEs is much more pronounced than the one exhibited by other experiences. In most cases, the level of output is expected to fall by about 5-10 percentage points during the first year of the program. For example, in Poland the level of output is estimated to have declined by about 12 percent during 1990, real wages (in the socialized sector) are estimated to have fallen by about 30 percent, while measured unemployment rose dramatically.

The difficulties associated with the early phases of the transformation program reflect the combination of the collapsing central planning system and the unprecedented changes in the policy environment. The fundamental transformation induces large-scale dislocations as inefficient sectors are expected to go out of business, while other sectors are expected to expand in response to market incentives. In addition, faced by market prices and positive real interest rates, enterprises are likely to find their stock of inventories excessive. In the process of running down inventories, production declines (as firms sell from inventories rather than from new production) and the demand faced by inventory-producing firms falls.

This process of adjustment is always demanding. It is especially difficult under the circumstances prevailing in the PCPEs: the enterprise sector, facing a basic change in the “rules of the game” and saddled with an inappropriate mix and level of technical and managerial skills, is unprepared for the task. In addition, owing to the lack of access to well-functioning capital markets, even efficient enterprises may be forced out of business, thereby raising the social cost of the economic transformation. Against this background, two of the major questions are (i) what factors may aggravate the slowdown experienced in the early stages of the economic transformation process, and (ii) how to resume sustainable growth. In this paper we contribute to the discussion of these questions.

Section II focuses on the unique role that credit markets play in the economic transformation process. It highlights the nature of the distortions induced by the lack of efficient channels of financial intermediation that are especially pronounced in PCPEs. In this context, we identify the key factors that may result in suboptimal outcomes and discuss policy measures that can improve matters. In this regard, we pay special attention to the balance sheet positions of enterprises, as well as to the role of credibility. We also examine the question of the sequencing of policy measures, and the role of privatization. The main focus of the analysis is on improving the allocation of resources, and on clarifying the role that capital markets play in this regard. We show that well-functioning capital markets enhance the effectiveness of monetary policy and help to secure the benefits from price reform and trade liberalization. The improved functioning of capital markets contributes to a better allocation of physical capital and financial capital. While these forms of capital may contribute to enhance the level of economic activity, such an enhancement, in and of itself, does not yield sustained economic growth. Sustained growth requires a continuing improvement of technology, managerial know-how, the level of education, and, more generally, human capital.

In Section III we shift attention to the topic of sustainable economic growth. We develop a simple model that underscores the unique role that human capital plays in securing economic growth. The accumulation of human capital is the engine of growth. In our human-capital-led growth, the wage differential granted to skilled labor plays a central role in providing incentives to the accumulation of human capital.

In Section IV we apply the analysis to the special circumstances prevailing in PCPEs. We examine the various mechanisms through which monopolies, monetary overhang, and debt burden impede the attainment of a satisfactory level of sustainable growth. Section V contains concluding remarks, and an appendix discusses a micro-based growth model.

II. Credit Markets and Economic Transformation

In this section we identify key factors responsible for the difficulties in resuming growth during the transformation process. In this regard, we focus on the special role played by credit and financial markets, and argue that the imperfections prevailing in PCPEs could give rise to a “bad” equilibrium in which growth is low and the incentives to undertake efficient investments are stifled. We also argue that the alleviation of these imperfections should yield a distinctly superior “good” equilibrium.

Credit Markets: “Good” and “Bad” Equilibria

Credit and financial markets in PCPEs lack depth and breadth. The complex information system necessary to assess risk and creditworthiness is underdeveloped. This underdevelopment is inherited from the past, during which the economy was a CPE, and lacked incentives to accumulate such information. In the CPE, enterprises were subject to “soft” budget constraints, losses were automatically financed, and, in general, the government was viewed as a “lender of last resort” providing comprehensive insurance without charging the appropriate premium. This implicit insurance also often encouraged overextension of interenterprise credit.

The interdependence among the balance sheets of enterprises makes it very difficult to distinguish between enterprises that are efficient and viable and those that are inefficient and nonviable, thereby adding to the complexity of assessing creditworthiness of individual firms. The lack of information is especially pronounced, since the dramatic structural changes associated with the transformation process in PCPEs render the limited available information largely obsolete. Furthermore, in PCPEs policymakers are typically untested, the structure of property rights is not fully defined, and the private sector is unaccustomed to “market rules.” These factors contribute to the uncertainty about policy response, and about the behavior of economic agents. The overall uncertainty is likely to affect adversely the profitability of enterprises, to reduce the market value of installed capital, and, thus, to limit the capacity of enterprises to borrow against collateralized capital.

The imperfect information structure that makes it difficult to assess the creditworthiness of enterprises, superimposed on the complex web of interfirm credit that links the fortunes of efficient and inefficient enterprises, may result in a “bad” equilibrium in which socially profitable long-term investments are crowded out by less profitable short-term investments. Such a bad equilibrium could arise if potential lenders lack the confidence that other lenders will stand ready to extend credit to cover enterprises’ liquidity needs. This lack of confidence is more likely to prevail in situations in which information concerning the risk characteristics of specific enterprises is missing, or is not widely available to potential lenders.

In addition to the lack of information about specific firms, the PCPE exhibits a relatively high degree of economy-wide (systemic) risk owing to the large structural changes and the unpredictability of the policy response. The likelihood of systemic risk is enhanced in PCPEs because their capital markets are underdeveloped: risk that could be diversified in fully developed capital markets may remain undiversified. Furthermore, the network of interfirm credit increases the risk that firm-specific shocks are spread across enterprises and, thereby, are transformed into economy-wide shocks. All of these factors taken together contribute to shortening the planning horizon of lenders and borrowers in the PCPE and account for the tendency to undertake short-term rather than long-term investment projects (like infrastructure investment)–even though the latter might be more desirable from the social point of view. Thus, a bad equilibrium ensues.

Transforming Bad into Good Equilibria

The preceding discussion indicated that the fundamental reason for the emergence of a bad equilibrium is the underdevelopment of capital markets. Underdeveloped markets do not provide incentives for long-term investments, even though such investments are socially warranted. An important challenge facing policymakers is the creation of conditions under which the incentive system generates socially optimal investment patterns. Policies aimed at reducing the likelihood of a bad equilibrium would include measures that (i) improve the information system and the legal instruments available to lenders and investors, and that “clean” the balance sheets of enterprises and banks from “bad” debts, and (ii) enhance credibility.

Improved Information System and Legal Framework and Debt “Cleaning”

The improved information system would provide a better assessment of the creditworthiness of individual firms and thereby remove an important obstacle to lending. The development of a legal framework would provide the instruments for enforcing contracts and protecting property rights. It would, thereby, remove another important obstacle to lending. Furthermore, the protection provided by the legal system would encourage prospective lenders to engage in ventures that are socially desirable but that would be deemed too risky without the legal safety net. Put differently, the legal protection reduces the need for prospective lenders to engage in self-insurance by accumulating “excessive” (and socially costly) information.

Finding appropriate ways to clean the balance sheets of enterprises and banks from bad debts would delink the fortunes of enterprises that ought to go out of business from those that should continue operating. A major challenge is to achieve this objective without imposing excessive costs on the budget and without hampering the incentive structure. Care should be given to avoiding the moral hazard that cleaning operations may introduce to the capital market. In principle, the cleaning of books can be effected through either a cancellation or a socialization of debts.

Debt cancellation reduces the availability of working capital to creditor firms and carries with it the danger of choking good enterprises whose cash flow requirements depend critically on debt-service receipts. The government should consider, therefore, extending credits to such good firms. The identification of creditworthy, economically viable enterprises should be made simpler once the balance sheets have been cleaned. An additional difficulty with debt cancellation is that it may give rise to moral hazard problems. To avoid setting the precedent that interenterprise debts are not honored and are cancelable in what may seem to be an arbitrary manner, it is critical that this operation be viewed as a pure bookkeeping device. In fact, since in many cases the debtor and creditor enterprises are not privately owned (prior to the privatization program), the cancellation of interenterprise debts need not alter the distribution of income or wealth within the private sector. Indeed, it could be argued that such a cleaning operation is designed to avoid the moral hazard that might be present once the enterprises, whose balance sheets are heavily loaded with such debts, are privately owned.

Delinking the fortunes of debtor and creditor enterprises through debt socialization transforms the nature of debt and alters its risk characteristics without changing its magnitude. In socializing the debt, the government engages in debt-for-debt swaps in which government obligations (for example, treasury bills) are swapped for the claims that creditor firms and banks hold against other enterprises. In a sense, this operation serves to recapitalize creditor firms and banks by issuing government obligations in place of the nonperforming assets. At the same time, the liabilities of debtor firms to other enterprises and banks are transformed into liabilities to the government. By assuming the role of a financial intermediary, the government helps to delink the fortunes of the various enterprises. By servicing its own debt, the government ensures that the availability of working capital for the creditor enterprise does not depend upon the debtor enterprise’s capacity to pay. However, to secure its own capacity to pay when debtor enterprises get into debt-service difficulties, the government must have at its disposal a functional tax system capable of financing the debt-service obligations without resorting to inflationary finance. This underscores the urgency of an early development of an efficient tax system.

The development of an efficient tax system is a high-priority item on the structural reform agenda of most governments engaging in economic transformation. However, such development may need to be spread over a lengthy period. Therefore, consideration should be given to “financing” such contingent government debt-service obligations through external loans. However, to ensure that the need for such loans is temporary, it would be necessary to adopt tight conditionally; loans should be granted only if it is absolutely clear that the government undertakes concrete steps toward tax reform.

It could be argued, however, that the socialization of debt may also introduce moral hazard problems. For a precedent may be set that the government steps in to bail out firms in financial difficulties, thereby reducing the incentives for firms to run their affairs prudently. However, as indicated earlier, prior to privatization the various enterprises are, in fact, owned by the government, and therefore the socialization of debt amounts to making explicit what is already implicit. Indeed, one of the benefits of debt socialization prior to privatization is that it reduces the risk of moral hazard problems arising in the post-privatization stage.

Credibility Enhancement

To acquire credibility, policymakers must demonstrate that they are willing to introduce a fundamental change in the manner in which policy is conducted. The adoption of a transparent rule-based policy framework, rather than discretion, might reduce the perception of arbitrariness and, thereby, strengthen confidence in the policymaking process. The advantages of rules over discretion are particularly pronounced in PCPEs, where policymakers give a greater role to the market economy. However, since distortions are still abundant, the resulting structure of prices and other market signals reflect these distortions. There is therefore a great danger that the discretionary actions would be guided by the wrong signals.

The advantages of having simple policy rules are especially pronounced in PCPEs, since in most cases the new policymakers are untested. Furthermore, because discretion was the rule in the CPEs, a clear statement favoring rules over discretion could go a long way in signaling a basic change in the policy regime. The key challenge, however, is how to make such a statement credible.

Two elements of credibility are needed. First, the economic program must be credible. It should be feasible, stand the test of professional scrutiny, and reflect the experience and lessons gained from other episodes. Second, policy commitments must be credible. These commitments should not be susceptible to the “time inconsistency” problem, providing incentives to change policy direction in mid-course. Economic authorities make explicit or implicit pronouncements that influence the response of the private sector. In this sense, policymakers are the dominant player in the economic arena. The private sector shapes its economic behavior on the basis of expectations concerning the likely course of current and future policies. With the passage of time, the government, observing the behavior of the private sector, may be tempted to depart from the previously announced policy intentions that, in turn, have governed the private sector’s actions. This is the well-known time inconsistency problem that may hamper the credibility of policy commitments.

The two elements of credibility–of the economic program and of the policy commitments–are interdependent. For example, the likelihood that policy commitments may face time inconsistency problems increases, the higher is the credibility of the economic program: a credible economic program is likely to result in short-term hardships. It is likely therefore to generate political pressures and interest groups lobbying for midcourse changes, which may give rise to time inconsistency. This possibility in turn may already be anticipated by the private sector in the earlier stages of the economic transformation process, and incorporated into its behavior. If this occurs, then market participants may end up giving excessive attention to the near term while discounting heavily longer-term prospects–thus generating a bad equilibrium. To avoid such difficulties and enhance the likelihood that a good equilibrium ensues, policymakers may find it useful to “tie” their own hands and, thereby, send a strong signal that the advantages of being the dominant player will not be used.

It is useful to classify into four categories the methods by which the authorities can tie their own hands. First, the early steps of the new policy regime must entail policy actions that are sufficiently significant to provide a clear signal that a dramatic change in regime has occurred. Policy pronouncements accompanied by concrete actions indicating that the commitment of the government to the transformation process is “absolute” make a reversal of such process politically costly. The higher the political costs of policy reversals, the higher is the credibility of policy pronouncements. Once a credible signal is provided, it would influence materially the expectations of the private sector about the future course of the new policy regime. Indeed, in forming such expectations, the private sector is likely to reduce the weight given to past policy failures. Thus, the quick building of a track record imposes internal political constraints on the ability of the government to reverse course.

Second, the various branches of the policymaking apparatus can be designed so as to provide effective checks and balances to protect against time inconsistency problems. Examples are the establishment of a central bank that is legally independent, or a legal prohibition on central bank financing of government budget deficits, or a constitutional amendment legislating balanced budgets. Such mechanisms impose internal legal constraints on the ability of governments to abuse their dominant player role. Once in place, they contribute to the credibility of policy commitments.

Third, the credibility of policy commitments can also be enhanced if the government ties its hands by entering into international agreements of various sorts. Examples are exchange rate commitments, like those undertaken by countries joining the exchange rate mechanism (ERM) of the European Monetary System, or like those undertaken by countries joining the General Agreement on Tariffs and Trade (GATT). Each such arrangement imposes external legal constraints on the use of specific policy instruments: the exchange rate in the case of the ERM, and tariffs or quotas in the case of the GATT.

Fourth, credibility can be further enhanced if the government chooses to tie its hands by adopting an economic program supported by an international financial institution, like the International Monetary Fund or the World Bank. By receiving the endorsement of experts representing the international financial community, this course of action contributes to the credibility of the economic program. Furthermore, by making the financial support to the program conditional on the implementation of the prespecified policy measures, this form of tieing the hands imposes external economic and legal constraints, and contributes to the credibility of policy commitments.

These four methods by which the government can tie its hands are not mutually exclusive. In fact, governments may often find it useful to employ some or all of these methods simultaneously so as to reinforce each other and enhance credibility.

Sequencing and Safety Nets

Attaining the conditions conducive to a transformation of the bad equilibrium, characterized by short-planning horizons, to a good equilibrium, in which long-term commitments are undertaken, is not an easy task. Such a transformation necessitates fundamental and all-encompassing changes in incentives and in the structure of the economic system. It is unlikely to be effected overnight, since many of the economic distortions are deeply imbedded. Interest groups are well entrenched, the legal system protecting private ownership and property rights is not fully developed, managerial and technical know-how is limited, the banking system is underdeveloped, and the fiscal and monetary systems are ineffective. In addition, experience with the operation and with the rules of the game of a market economy is lacking, and policy credibility can only be earned over time.

Such difficulties have stimulated interest in the theoretical analysis of the optimal pace and sequence of economic reform measures. Experience suggests, however, that there is a great danger that a lengthy search for a perfect sequence of economic measures under conditions of fast-changing circumstances may result in the adoption of outdated and irrelevant policies. It may be preferable to adopt a timely, albeit somewhat imperfect, comprehensive reform program rather than to search the “perfect” fine-tuned sequence of policy actions. Indeed, simultaneously introduced measures of macroeconomic and structural reform are likely to reinforce each other, provide confidence and momentum, and reduce the risk that the process will be reversed. The enhanced confidence would lengthen the planning horizon of savers, investors, and enterprises, stimulate domestic and foreign investment, and contribute to the credibility of the transformation process.

In practice, however, there may be cases in which the prevailing socioeconomic conditions do not generate the political support necessary for the adoption of a rapid, comprehensive, and all-inclusive reform. In such cases, the buildup of credibility becomes more difficult. Frequently, choices need to be made as to the appropriate pace and sequence of reform measures. In this regard, there is no blueprint. Indeed, the optimal pace and sequence of reform measures depends on circumstances that differ across countries. These circumstances reflect diversities of historical backgrounds, economic, legal, and political institutions, entrepreneurial traditions, as well as attitudes toward the role of markets and incentives. Such disparate circumstances imply that the economic reform programs of different countries may differ in their areas of vulnerability. Countries may differ in their sensitivity to the level of employment, prices of foodstuffs, income distribution, real wages, and the like. Such differences in sensitivities may reflect themselves in the choice of the sequencing of reform measures, as well as in the characteristics of safety nets.

In choosing among alternative safety nets, one should be aware that there is no way to protect all segments of society. A comprehensive reform program must involve sacrifices by a substantial share of the population. Furthermore, in designing the mechanism through which the safety net is effected, one should avoid as much as possible the introduction of new distortions. In this regard, the safety nets should not interfere with the incentives to work, save, and invest, nor should they tamper with monetary and exchange rate policies. Likewise, in adopting indexation rules, the benefits from real wage protection should be weighed against the cost of stimulating inflation. In general, safety nets should be allowed for in the budget and effected through income transfers.

Privatization and “Liquidity Overhang”

Programs of economic transformation frequently encompass the privatization of public enterprises. The beneficial effects of privatization on the efficiency of resource allocation may be significant if the privatization of state enterprises and the housing sector provides incentives for higher productivity and better maintenance of the capital stock.

The benefits from privatization are especially pronounced in PCPEs, where domestic capital markets are in their infancy: markets are underdeveloped, segmented, and lack the know-how necessary for their effectiveness. In this regard the opening of the economy to foreign investment can be highly beneficial. In addition to providing financial and managerial capital, privatization programs that encourage direct foreign participation can be useful in providing access to international capital markets. Foreign investors bring with them know-how, contacts, and information. Their presence and active participation yield the added benefit of improving the functioning of domestic capital markets.

Many of the PCPEs find themselves saddled with excess liquidity (“liquidity overhang”) inherited from the previous regime. Constrained by the absence of conventional financial instruments and the underdeveloped capital markets, the PCPE has limited means by which the liquidity overhang can be absorbed. In this regard, a privatization program has been considered a vehicle through which the excess liquidity is absorbed as the authorities engage in open market sales of state property. Thus, in addition to the efficiency gain associated with private ownership, the privatization program also aims at reducing liquidity overhang.

To reap the benefits from privatization, it is important to recognize some of the obstacles that must be overcome. The difficulties in designing an effective privatization program are well known.2 They include the problems of establishing a “fair” market price for an enterprise without the help of a well-functioning marketplace, developing the legal infrastructure necessary for the effective use of entrepreneurial drive, developing domestic credit and financial markets necessary for intermediation, the redistribution of rents, and the potential for corruption. In addition to these and other difficulties associated with the “incidence of the tax,” privatization has profound implications on the budget. On the one hand, sales of state enterprises generate (nonrecurring) revenue (such revenue cannot be spent, however, as otherwise a new liquidity overhang would be generated); on the other, the transfer of income producing assets to the private sector results in a (recurring) loss of future revenue. To make up for this lost revenue the government needs to find a new source of recurring income.

In searching for such a new source, the government will be tempted to levy new (previously unannounced) taxes on the enterprises just sold to the private sector (again, the time inconsistency problem). Such a strategy would, however, be counterproductive. In setting their bids for state enterprises, potential buyers will take into account the possibility that the government will be tempted to raise taxes. Such anticipationstend, therefore, to lower the market price of state enterprises, reduce the proceeds from privatization, and leave the liquidity overhang problem unsolved. To prevent the erosion of privatization proceeds, the government must provide reliable and believable signals that such “surprise” taxes will not be levied. To produce such credible signals, the government must demonstrate its capacity and unequivocal commitment to tap new sources of tax revenue. These new sources of tax revenue must cover the entire loss of recurrent revenue induced by the privatization program. Thus, for a privatization program to be implemented effectively the government must levy new taxes on entities other than the newly privatized enterprises.

The discussion above indicates that to be fully effective and to yield the benefits that private ownership entails, a privatization program aiming at reducing the liquidity overhang must be accompanied by increased tax collection. Without such increased tax revenue, a privatization may result in medium-term budget deficits and a rise in public debt. These considerations underscore the urgency and early development of an effective tax system.

Recognizing that the potential benefits from privatization can be enormous, many of the PCPEs launching economic transformation programs have placed privatization high on their reform agendas. The unique feature of the early 1990s is that privatization efforts have been launched (or are being contemplated) simultaneously in all of the reforming economies in Eastern Europe, as well as in several Latin American economies. This coincidence introduces a systemic dimension to privatization. With this added dimension, the success of a privatization program in any given country depends not only on the policy environment adopted in that country, but also on (i) the availability of global savings, (ii) the effectiveness of instruments of intermediation that can be used to channel domestic and foreign savings into productive investments, and (iii) the policy environment and economic prospects prevailing in other economies that are also engaged in similar transformation efforts, and are competing for the same pool of resources.

While it could be argued that privatization, in and of itself, does not require new financial resources–as it just transfers ownership from one owner (the government) to another (the private sector)—there is a presumption that a successful privatization increases the global demand for world savings. Effective privatization requires expertise, managerial know-how, contacts with markets, and access to foreign capital. In the short run, these resources are scarce and global competition is likely to bid up their prices. Furthermore, successful widespread privatization is likely to increase future growth prospects and, thereby, stimulate investment demand, put further pressures on world capital markets, and drive up rates of interest. To succeed in the competition for the scarce resources, the credibility of the economic program and of policy commitments must be in place. In addition, incentives should be given to investment in human capital, reflecting the social returns to such investment. Investment in human capital improves the managerial know-how and technical skills, and provides for an environment that stimulates foreign investment, attracts both physical capital and financial capital, and discourages capital flight. We return to discuss the role of human capital in sustaining growth in Section III.

Capital Markets, Price Reform, Monetary Policy, and Trade Liberalization

The removal of subsidies, the freeing-up of prices, and the dismantling of administered pricing machinery is likely to generate a significant rise in the aggregate price level, especially during the early stages of the price reform program. Coupled with the tightened credit control and the segmentation of the underdeveloped domestic credit markets, such developments may have profound negative supply-side effects. For, as noted earlier, under such circumstances the ability of enterprises to resort to alternative sources of finance to offset the rise in input prices, and the consequent fall in working capital, is limited. Great care should therefore be given to ensuring that good enterprises can replenish their eroded working capital so as to maintain their productive activities during the price reform period. The foregoing discussion provides an added reason for an early development of domestic capital markets: the benefits from price liberalization would be enhanced by the operation of such markets.

An early development of domestic capital markets also enhances the effectiveness of monetary policy. By its nature, monetary policy has aggregate effects on the economy. These effects impact on good and bad firms alike. Well-functioning credit markets, however, facilitate a separation between good and bad firms. While good firms can mitigate the contractionary effects of monetary policy by relying on other sources of finance, bad firms cannot. The latter do not have access to capital markets and, therefore, they must either cease operations or restructure. Accordingly, the instrument of monetary policy (which is inherently unrefined) can yield socially desirable outcomes if it operates in an environment of well-functioning capital markets. In addition, the restructuring of capital markets should enhance the incentive effects of monetary and credit policy. Once enterprises are aware that they cannot borrow automatically to cover losses, that access to credit markets is limited, and that credits can only be obtained by good firms, it is likely that they will respond more promptly and effectively to signals conveyed by monetary and credit policies.

The benefits from trade liberalization also depend on the quality of capital markets. Trade liberalization provides the economy with the right price signals. Exposure to world prices helps to demonopolize the economy, enhance competition, and improve the allocation of resources. However, in adjusting to the removal of protection, even good and economically viable firms may require credit. The adoption of hard budget constraints eliminates the automatic financing of enterprises’ deficits by the government. Without sufficient access to capital markets such good firms may be forced out of business, thereby reducing the benefits from trade liberalization. Moreover, in attempting to protect themselves, the good but endangered enterprises may be tempted to join the bad and economically nonviable enterprises in lobbying against trade liberalization, thereby reducing the likelihood that liberalization will be adopted. Furthermore, for trade liberalization to succeed in providing the “discipline” of world prices, unconstrained imports and exports should be permitted. Accordingly, a significant degree of current account convertibility should be adopted. To enable the introduction of such convertibility, the financial system needs to be functional. These considerations imply that the benefits from, and support for, trade liberalization can be significantly enhanced by an early development of domestic capital markets.

III. Human Capital and Sustainable Economic Growth

In this section we present a simple model of economic growth. The model is designed to highlight key determinants of growth, with special reference to the characteristics of PCPEs. To highlight the critical importance of skills and technical know-how, we pay special attention to the role of human capital. Earlier theories of economic growth–classical and neoclassical–have emphasized the role of capital formation as the key factor governing economic development. In many of the traditional formulations the rate of growth of population (labor force) is given exogenously, and it ultimately constrains the rate of capital formation and, thereby, growth. More recent formulations have recognized that the rate of growth itself should be viewed as an economic variable which is determined endogenously.3 The model we develop belongs to this latter group. To facilitate the exposition and to gain insight into the analytical framework, we start with a formulation of the basic growth model representing a perfect-competition-nondistortion paradigm. The model is then employed to examine some implications of special characteristics of PCPEs.

The Basic Growth Model

The production function is assumed to be of the fixed-proportions variety in which output is produced by inputs of physical capital, K, and human capital, H. The fixed-proportions assumption is introduced to simplify the exposition and to highlight the close link between human capital and output. Thus, the level of output is limited by the minimum value of the two inputs. Accordingly,

where Y denotes output and α denotes the output-input coefficient-representing factor productivity. The units of measurement are chosen so as to ensure equality between the output-input coefficients pertaining to the two forms of capital.

In developing the simple growth model, it is convenient to start with the perfect-competition-nondistortion paradigm. If we denote the competitive wage rate by W and the competitive rental rate on physical capital by R (both measured in terms of units of output), then the cost of producing a unit of output is (W+R)/α. Under perfect competition, marginal cost equals the price, it follows that in the present case in which marginal and average costs are equal to each other,

From equation (2), the competitive wage rate can be written as

Equation (3) reflects the zero-profit condition prevailing under perfect competition. Accordingly, the wage rate equals output per unit of input net of the rental on physical capital. The relation portrayed by equation (3) is the familiar “factor-price frontier.”

We turn to an analysis of growth. In our frictionless model physical capital is assumed to be perfectly mobile across countries. Accordingly, with uninhibited trade the stock of physical capital located in the economy will always be adjusted to the prevailing stock of human capital, and the rental rate, R, will be equalized to the world rental rate, R*. In contrast, human capital, by its nature, can only be accumulated gradually. This gradual accumulation reflects the technological constraints on the speed by which education, training, and know-how are built up, or, if human capital is accumulated through migration, the gradual adjustment reflects adjustment and moving costs. The accumulation of human capital is assumed to respond to the economic incentives reflected by the prospects of higher earnings. To simplify, we assume that there exists a “base wage rate,” W*, at which there is no incentive to accumulate human capital. If the prevailing wage, W, exceeds W*, then the rate of growth of human capital, H˙/H, is proportional to the difference between these two wage rates. Specifically,

where θ stands for the speed of adjustment.

Substituting equation (3) in equation (4), and recalling that with uninhibited trade R = R*, yields

Equation (5) is the fundamental relation underlying our model of human-capital-led growth. The assumption that physical capital can be traded internationally without any barriers implies that the accumulation of human capital is always accompanied by an equiproportional accumulation of physical capital so as to ensure that human capital is fully utilized. The properties of the production function imply, in turn, that output also grows at the same percentage rate. Hence, the right-hand side of equation (5) also denotes the rate of growth of output. As is evident from equation (1) a higher factor productivity, α, is associated with a higher level of output. In addition, as indicated by equation (5), the higher factor productivity is also associated with a faster growth rate. This latter relationship is the key implication of our human-capital-led growth model.

While factor productivity affects both the level and the rate of growth of output, the international rental rate, R*, and the base wage rate, W*, impact only on the rate of growth of output. Specifically, a higher international rental rate, or a higher base wage rate lower the rate of growth, since, by reducing the wage differential, W–W*, they diminish the incentive to accumulate human capital. As an example, a deterioration of the terms of trade in an economy dependent on foreign physical capital would be equivalent to a rise in the world rental rate, R*, and thereby would lower the rate of growth. This reduction is brought about through a fall in the real wage, which in turn reduces the incentive to accumulate human capital.

The foregoing analysis is summarized in Chart 1. In panel I the downward-sloping solid line portrays the factor price frontier specified in equation (3). Owing to our normalization of units, its slope is unity (in absolute terms), and its intercept with the two axes is the factor productivity coefficient, α. Panel II depicts equation (4) portraying the positive association between the rate of growth and the real wage. As shown, the slope of the schedule signifies the speed of adjustment of human capital accumulation, θ. Consider the initial situation in which the international rental rate on physical capital is R0*. As shown by point A in panel I, the real wage associated with this rental rate is W0. Since W0 exceeds the base wage W*, the resulting wage differential induces an accumulation of human capital. As shown by point B in panel II, the common rate of growth of human capital, physical capital, and output associated with this wage differential is λ0. A rise in the international rental rate from R0* to R1* lowers the real wage from W0 to W1 (point Aʹ in panel I), lowers the wage differential, and induces a fall in the rate of growth from λ0 to λ1, (point Bʹ in panel II).

Chart 1 can also be used to analyze the consequences of a once-and-for-all technological progress that raises the factor-productivity coefficient from α to αʹ > α. This rise in factor productivity induces a rightward displacement of the factor-price frontier in panel I to the position indicated by the dashed schedule. If the international rental rate remains unchanged at R0* (that is, if the rise in factor productivity is localized rather than being spread internationally), then the domestic wage rises to W2 (point Aʹʹ in panel I). The higher wage increases the incentives for human capital accumulation, and raises the rate of growth to λ 2 in panel II (point Bʹʹ in panel II).

Chart 1.Rentals, Wages, and the Rate of Growth

Sustainable Growth in PCPEs

The basic model developed above pertains to the perfect-competition-nondistortion paradigm. We consider next several modifications designed to adapt the model to circumstances prevailing in PCPEs. As indicated earlier, the transformation of PCPEs is a long one. It may last many years. Therefore, the characteristics of PCPEs impact on the economic system for a period that goes beyond the early stages of the transformation process. They also impact on the secular evolution of the economy. Therefore, it is appropriate to examine how these characteristics influence the rate of growth of the economy. In what follows, we employ the model to deal with these issues. We focus on the implications of monopolistic price behavior, monetary overhang, debt burden, lack of credibility of policymaking, and underdeveloped financial markets on the growth prospects of the PCPE.


One of the key features of PCPEs is the noncompetitive organization of markets. Specifically, most sectors are highly monopolized, and production is concentrated in a few large enterprises. The monopolistic behavior of enterprises results in pricing strategies that introduce a wedge between price and marginal cost. Defining the ratio of the price to the marginal cost by ξ, we may note that a higher value of ξ represents a stronger monopoly power of enterprises. The formulation of the basic model assumed perfect competition; that is, ξ was assumed to equal unity. With monopolistic pricing, the relation between price and cost is shown in equation (2ʹ):

Equation (2ʹ) is the monopolistic analog to the case of perfect competition shown in equation (2). Proceeding in an analogous manner as in the case of perfect competition, the rate-of-growth equation (5) becomes

As is evident, the introduction of monopolistic pricing reduces the effective factor productivity coefficient from α to α/ξ. This reduction lowers the real wage, which, in turn, reduces incentives for human capital accumulation and, thereby, lowers the rate of growth of output. In terms of Chart 1, the introduction of monopolistic pricing is equivalent to a technological retrogression that displaces the factor price frontier from the dashed to the solid line in panel I, and lowers the rate of growth shown in panel II.

The foregoing analysis implies that the introduction of a more competitive structure into the highly monopolized PCPEs has a long-lasting payoff. The benefits from breaking the monopolistic structure go beyond a once-and-for-all improvement in economic performance. Rather, by accelerating the rate of growth of output, the benefits are amplified and are spread into the medium term. In practice, it may be very difficult to introduce competitive structures into an economy in which monopolies are deeply embedded in the economic system. Faced with the danger of losing their monopoly power, pressure groups are bound to get organized and to exercise their leverage so as to protect their own monopolies from the competitive tide. As implied by our earlier analysis of credibility, an effective way to prevent the cementation of such pressures and to build up credibility is to act promptly. A prompt introduction of competition can be effected through exposing the economy to the competitive pressures prevailing in world markets. Thus, the adoption of trade liberalization during the early phases of the transformation process would facilitate the introduction of competition and the breakup of monopolies.

Before concluding this discussion, it is noteworthy that while trade liberalization may be a potent force in the breakup of monopolies, the adoption of a fully competitive system may require further incentives. Such incentives might be provided through a privatization program, at the end of which the ownership of the broken monopolies would be transferred to the private sector which, by its nature, is more prone to respond to incentives and behave competitively. However, as emphasized by the discussion in Section II, many of the benefits derived from trade liberalization and privatization programs may be elusive unless capital markets are sufficiently developed to support such programs.

Monetary Overhang

One of the features of PCPEs, especially in the early phases of their transformation process, is the presence of a sizable “monetary overhang.” This overhang has accumulated over the years during which governments in the centrally planned economies have financed their budget deficits through monetary creation. Large enterprises have enjoyed “soft” budget constraints: losses were automatically financed through credit creation. At the same time, the shortages of goods were not allowed to result in an open inflation, which was suppressed by the administered-pricing strategy of governments.

Saddled with the monetary overhang, the various transactions in the economy became inefficient, as individuals spent excessive time and resources in “chasing” the missing goods and standing in queues, rather than engaging themselves in socially productive activities. Such behavior disrupted the production process as workers and managers had to divide their attention between their jobs and shopping activities. Furthermore, the shortages reduced the ability to exchange money for goods, eroded the liquidity and “moneyness” of money, and encouraged costly barter transactions.

To illustrate the consequences of liquidity overhang in terms of our model, we observe, in the light of our previous discussion, that the overhang disrupts production and acts like a technological retrogression. Put differently, it reduces the effective factor productivity coefficient. Thus, as is evident from the production function in equation (1), liquidity overhang reduces the level of output. In addition, and in analogy with our previous discussion of monopoly, the liquidity overhang lowers the real wage in equation (5), reduces the incentive for human capital accumulation, and lowers growth.

The above analysis implies that the elimination of monetary overhang raises both the level, as well as the rate of growth, of output. In addition to yielding these gains, an early elimination of the monetary overhang would enhance the benefits obtained from other reforms, such as trade liberalization and the adoption of currency convertibility. As indicated earlier, the opening of the economy to world market prices stimulates competition and provides the most reliable guide for production decisions in the uncharted territory of decentralized decision making. In addition, the opening to free trade provides consumers with goods they never had before (in terms of quantity or quality). These benefits may be jeopardized if, upon the adoption of trade liberalization, the monetary overhang has not yet been eliminated. If the monetary overhang is still in place, the newly acquired access to world markets would unleash the previously constrained demand pressures that in turn may result in a substantial loss of international reserves, balance of payments difficulties, and/or unsustainable pressures on the exchange rate.

Liquidity overhang can be reduced by various methods. In a previous paper (Calvo and Frenkel, 1991), we examined in detail these methods. For the present purposes, it is sufficient to note that they include (1) an increase in the attractiveness of domestic monetary assets through a rise in the deposit rate of interest; (2) an appropriate rise in the price level; and (3) a reduction in the outstanding stock of monetary assets. The latter, in turn, can be brought about through a monetary reform or through a substantial sale of public sector assets (that is, through privatization, as discussed in Section II).

Debt Burden

Many of the PCPEs carry out their transformation efforts while having a sizable debt burden. Such debt has been accumulated in the past when the rules governing economic policies and behavior were those prevailing in CPEs. As a result, the resources obtained through external borrowing have frequently been used inefficiently. The purpose of the economic transformation toward a market economy is to improve the allocation of resources, and thereby contribute to growth. A major difficulty faced by the debt-ridden PCPEs is how to mobilize the resources needed to service the debt, while at the same time ensuring that sufficient resources are allocated to productive investment. This general issue has been widely discussed in connection with the developing countries’ debt problem.4 In these discussions special emphasis was given to the adverse effects of “debt overhang” on investment. Debt was seen to retard investment through its effect on expected taxation. Specifically, governments with large debt-service commitments are likely to impose higher taxes, which reduce the private rate of return on investment. In addition to affecting the rate of return directly, the likelihood that such taxes might be imposed at some future date increases the degree of uncertainty in the economic system, and may reduce further the incentives to invest.

The adverse investment effect of debt overhang may be especially acute in PCPEs. Frequently in such economies, the tax system is underdeveloped, and accounting practices are obsolete and not designed for a decentralized economic system. In addition, as discussed earlier, policymakers do not always possess the experience of dealing with such an economy, nor do they have the track record necessary to lend credibility to policy announcements. Furthermore, in most cases the economic transformation is associated with a political transformation. It is occasionally argued that the new political regime need not stand behind debts incurred by the ousted old regime. All these factors taken together may result in a strongly negative relation between the level of investment undertaken by the PCPE and the size of its inherited debt.

To examine the implications of debt overhang on the rate of growth of output, we use the model developed in Section III. To illustrate the effects of debt overhang within the context of the model, we assume that in supplying capital to the debt-ridden country, capital owners attempt to offset expected taxes by raising rental charges. Accordingly, unless the accumulated debt has been used productively (that is, unless there is no debt-overhang problem), it is likely that the higher the amount of debt that the PCPE has inherited, the larger becomes the need for new taxes and the higher become the rental charges. In addition to compensating for higher expected taxes, rental charges may also rise to compensate capital owners for the heightened degree of uncertainty concerning the modes by which the government will raise revenues in attempting to service its debt. In terms of Chart 1, such a rise in the rental rate results in a lower wage rate, as illustrated by the move from point A to point in panel I. The lower wage rate, in turn, reduces the incentive to accumulate human capital and results in a lower growth rate, as illustrated by the move from point B to point Bʹ in panel II.

IV. Concluding Remarks

In this paper we have discussed the problem of transforming a centrally planned economy into a market economy displaying sustainable growth. We focused on problems encountered during the initial stages, when imperfect domestic credit markets play a prominent role, and on problems that may arise afterwards, when credit markets function adequately but growth is limited by the development of domestic human capital. We argued that the first stages of the process are highly critical, because wrong policies may place the economy in a bad equilibrium in which growth could be seriously jeopardized. We further argued that to prevent the emergence of such a bad equilibrium, it is essential to clean the books–of both firms and banks–of nonperforming loans, and to achieve credibility of program and policy commitments. It is essential that cleaning the books be done prior to privatization. As long as the various entities are owned by the public sector, such an operation entails a bookkeeping exercise, with a minimal degree of moral hazard.

All this is a fairly tall order. Cleaning the books, for example, is an operation that requires a firm hand and a firm commitment if repetition of the operation after a short period is to be avoided. In the absence of these requirements, slippages are likely to occur and credit market behavior is likely to be distorted. These difficulties may actually lead policymakers to dismiss cleaning the books as impractical or politically dangerous. While not underestimating the importance of these considerations˙, we would emphasize that by failing to set the appropriate “initial conditions,” for fear of a political backlash, for example, the policymaker might implicitly be opting for the more frustrating alternative of prolonged stagnation.

Credit markets are also essential for the efficient management of monetary and trade policy. We showed that with segmented credit markets, stabilization policies relying on domestic credit targets may have undesirable effects on economic activity. Trade liberalization may also be impaired, because inadequate credit markets may hamper the associated economic transformation process, and may even lead good firms to lobby against trade liberalization.

Graduating into a workable market-oriented economy is only the first step toward sustainable growth. In the final analysis, output levels are constrained by the skills with which physical capital is run and maintained, and by the ability to absorb and develop new technology. Human capital is at the heart of all of that, and its development is thus essential for growth. The accumulation of human capital, however, responds to incentives. Attractive wages and good schooling and working conditions are all conducive to the development of human capital. This paper focused on the wage element, and discussed the effects of several obstacles faced by economies in transition. Some of these obstacles, like monopolistic structures and a monetary overhang, can be tackled by internal reforms. Some others, like heavy international debt, can be tackled only with international support. Strong and consistent policymaking is thus required for the growth process to succeed. Market forces have to be unleashed, but the watchful eye of a consistent and persistent policymaker will always be necessary.


In this appendix we sketch out a micro-based model, which yields similar qualitative results to the ones obtained in terms of the ad hoc model discussed in Section III.

Consider an economy that produces (internationally tradable) output by means of physical capital, K, and human capital, H. The production function is given by equation (1) above. Physical capital is perfectly mobile. The international relative price of output (per unit of time) and physical capital is unity.

The accumulation of human capital requires the use of output and is not (instantaneously) internationally mobile. For simplicity, we assume that the output cost of a flow of human capital H˙ is given by ξ(H˙/H)H, where ξ(•) is twice continuously differentiable and strictly convex.

Let r denote the (constant) international rental on physical capital. Thus, given the constancy of the relative price of physical capital with respect to output, r also stands for the international own rate of interest on output and physical capital (which is usually called the “real” interest rate). Therefore, the present value added associated with output production at home, V, is given by the following expression:

The two terms in the right-hand side of equation (Al), (α - r)H, is output minus the cost of capital (= rK = rH, since, by equation (1), we assume K = H). Thus, for each point in time, the integrand in equation (Al) gives the net value added (at international prices) of production activities, discounted to the present at the rate r.

Letting z = H˙/H, equation (A1) can be written in the following, more useful, form:

We assume that the path of z (that is, the growth rate of human capital) is chosen so as to maximize net value added, V, given the initial stock of human capital, H0. Implementation of this solution maximizes social welfare. Furthermore, if, as in the present setup, there are no distortions or economies of scale, one can show that the market economy will be able to generate the social optimum.

The strong stationarity of the above optimization problem immediately reveals that the optimal solution must exhibit constancy of z.

Thus, at optimum, equation (A2) takes the following simpler form:

The optimum growth problem now consists of maximizing V, as given by equation (A3), with respect to z. The optimal value of z, z*, is, by definition, the equilibrium growth rate. It is easy to verify that, as in the text, the equilibrium rate of growth increases with factor productivity, α, that is, ∂z*/∂α >0. The model can be easily adapted to yield the other implications of the model in the text of the paper.


    BorenszteinEduardo andManmohanS. Kumar“Proposals for Privatization in Eastern Europe,”Staff PapersInternational Monetary FundVol. 38 (June1991) pp. 300326.

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    CalvoGuillermoA. andJacob A.Frenkel“From Centrally Planned to Market Economy: The Road from CPE to PCPE,”Staff PapersInternational Monetary FundVol. 38 (June1991) pp. 26899.

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    ChadhaBankim“Wages, Profitability, and Growth in a Small Open Economy,”Staff PapersInternational Monetary FundVol.38 (March1991) pp. 5982.

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    FrenkelJacobA.Michael P.Dooley andPeterWickhameds.Analytical Issues in Debt (Washington: International Monetary Fund1989).

    FrydmanRoman andAndrzejRapaczynski“Markets and Institutions in Large-Scale Privatization,”in Reforming Central and Eastern European Economiesed. byVittorioCorboFabrizioCoricelli andJanBossack (Washington: World Bank1991) pp. 25374.

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    LiptonDavid andJeffreySachs“Creating a Market Economy in Eastern Europe: The Case of Poland,”Brookings Papers on Economic Activity: 1 (1990) The Brookings Institution (Washington) pp. 75147.

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    LucasRobertE.Jr.“On the Mechanics of Economic Development,”journal of Monetary EconomicsVol.22 (July1988) pp. 342.

    RomerPaulM.“Increasing Returns and Long-Run Growth,”Journal of Political EconomyVol.94 (October1986) pp. 100237.

1The views expressed in this paper are the authors’ and do not necessarily reflect those of the International Monetary Fund.
2Examples of recent analysis of issues arising in privatization efforts in PCPEs are Frydman and Rapaczynski (1991) and Lipton and Sachs (1990). For an examination of these and other privatization schemes, see Borensztein and Kumar (1991).
3Examples of this literature are Chadha (1991), Lucas (1988), and Romer (1986).
4For a recent selection of studies on the debt problem, see Frenkel, Dooley, and Wickham(1989).


Jorge Braga de Macedo1

There is a growing literature that applies the insights of economic theory to the historic transformations taking place in Central and Eastern Europe and in the Soviet Union. Propelled by the desire to set up multiparty democracy, the former Soviet satellites began in mid-1989 to reject the system of central planning and of so-called socialist integration in the Council for Mutual Economic Assistance (CMEA). The transformation of a centrally planned economy (CPE) into a market democracy is so profound that an intermediate phase is inevitable. This is what Guillermo Calvo and Jacob Frenkel have been calling “previously centrally planned economies” (PCPEs). In another paper, which partly overlaps this one, the authors spoke of a “road from CPE to PCPE.” The question now is whether this road leads to growth and–more important–to sustainable growth. Moreover, does the answer depend on external assistance?

Financial and Human Capital

The “road from CPE to PCPE” involves financial development. Calvo and Frenkel (1991) say that “the special circumstances prevailing in these economies include lack of depth and breadth of financial markets and a complex network of interenterprise debt. The critical dependence of firms on working capital and the lack of an information system necessary to assess risk and creditworthiness and, more generally, to distinguish between good and bad firms complicate the conduct and effectiveness of credit policy” (p. 295).2

Financial development is taken up again in Section II of “Transformation of Centrally Planned Economies.” The transformation of a “bad” equilibrium (“in which socially profitable long-term investments are crowded out by less profitable short-term investments”) into a “good” equilibrium (“in which long-term commitments are undertaken”) is seen to depend on the credibility of the reform program. Credibility, in turn, hinges on the acceptance by the transforming economy and on the polity of internal and external political and legal constraints. As argued below, this acceptance is one of the conditions for enduring reform. In addition, however, Calvo and Frenkel emphasize that “incentives should be given to investment in human capital, reflecting the social returns to such investment” (italics in original).

Section III of “Transformation of Centrally Planned Economies” is precisely devoted to illustrating the role of human capital in sustaining economic growth in a PCPE. An endogenous growth model is presented, based on the combination of a downward-sloping factor price frontier in wage-rental space with a human capital accumulation equation (implying a positive association between the rate of growth and the real wage). Greater competition, which is equivalent to a higher factor productivity, shifts the wage/rental ratio and is associated with a higher growth rate. The same is true for the elimination of the “liquidity overhang” that is common in a PCPE. Conversely, a rise in the rental rate is brought about by an excessive debt burden, because capital holders try to offset expected taxes in this way. This lowers the wage rate and therefore the rate of growth.

Unfortunately, given that the paper was presented in a seminar on “Roads to Growth,” the paper ends without discussing ways to restore growth. The conclusions in Section IV reiterate the central message of this paper and the previous one by the same authors: financial and human capital are crucial for sustainable growth in a PCPE. Adapting a popular song of the seventies, one might say that the Calvo-Frenkel message for a PCPE is “let’s forget physical.” This is a message that the Commission of the European Communities (EC) has stressed repeatedly when presenting the report on the Soviet Union–because its immense size makes the physical bias of central planning even more formidable than in the smaller ex-partners in the CMEA. It is comforting to see the emphasis shared and supported by the elegant model contained in the appendix and summarized graphically in the text.3

Law, Trade, and Expectations

Another way of conveying the same basic message is to stress the crucial role of expectations in economic transformation. A physical economy is likely to be stuck in a bad equilibrium because the absence of a market for future consumption isolates it in time, and makes reform programs more subject to reversals, which in turn induces a widespread “reform fatigue” on the population. This skepticism about the possibility of bringing about a change in an economic regime is by no means a characteristic unique to Central and East European economies. It has been observed in many semi-industrialized economies, including the poorer member states of the European Community.

Economic agents will not change their behavior if they do not believe that the policy environment has also changed irreversibly. Calvo himself showed–in his contribution to the Díaz Festschrift that he coedited (Calvo and others, 1989)–that a move to free trade that is thought to be temporary will be welfare worsening. The presence of reform fatigue in a physical economy is therefore a vicious circle, because expectations of a reversal of reform go against accumulating the financial and human capital called for by the initial conditions. Conversely, a credible reform program has a bootstrapping quality that puts the physical economy on a growth path of financial development and human capital accumulation. Self-fulfilling expectations make reforms enduring if they are based on the rule of law, free trade, and if they are monitored by conditional assistance. Coming back to the slogan of development in the sixties, “trade not aid,” a slogan for the nineties, “law, trade, and (conditional) aid,” might be suggested.4

Self-fulfilling expectations are held under certain initial conditions, however. For these initial conditions to sustain an enduring reform path, the move to a market democracy must be perceived as irreversible. This is called a regime change, and it has been observed in some newly integrating countries of the EC, such as Spain or Portugal, whereas it has not taken place in others, such as Greece. Assuming that economic and monetary union (EMU) is beneficial for the Community as a whole, such a regime change is seen as a condition for positive spatial effects, especially in peripheral nations or regions.5 A regime change is defined for a given population and therefore rules out substantial mobility of labor and of voters (including the main thrust of the so-called economic constitution). In the case of the former German Democratic Republic, both the effective mobility of labor–which was a legal right formerly constrained by physical force–and voting rights were granted with unification, so that the economic constitution immediately became that of the Federal Republic of Germany.

The economic constitution is part of the constitutional system, which determines the rule of law in society, by accepting solutions reached by voting. However, when the new economic constitution is to be determined by majority rule, there is a great deal more uncertainty about the timing and sequencing of reforms, and even about the appropriate level of public goods and therefore of taxes. Since public goods are often mixed with private goods, the “free-rider problem” may inhibit private enterprise until the new regime has sufficient legitimacy. The internal legal constraints cited in the Calvo-Frenkel paper–such as an independent central bank and a constitutionally guaranteed balanced budget–require democratic legitimacy to serve as anchors to long-term expectations. Otherwise, these constraints will be resisted by the population because the distribution of the gains will not be clear to the voters. The “status quo bias” in trade liberalization is actually a reflection of the tendency for politics to dampen the force of economic interactions.6

How to Sustain a Regime Change

If the economic constitution is anti-market, then constitutional reform can be an important delay to regime change, even in a multiparty democracy. In Portugal, widespread nationalizations were enshrined in a Soviet-inspired constitution from 1976 to 1989, delaying both stabilization and liberalization beyond Community membership in 1986.7 If the need for enduring reforms is understood, then the authors’ suspicion of gradualism is exaggerated. As long as the anchor of long-term expectations remains that of a market democracy, gradualism need not make reforms less enduring; it will rather lessen the status quo bias. In addition to the theoretical demonstration of this point by Dewatripont and Roland (1991), the argument of noncredibility of temporary reform can be used against excessive reliance on shock therapy. What is required is a sustained regime change based on enduring reforms.

This is all the more important as the credibility of a regime change makes it less vulnerable to temporary departures from the path of “enduring reform.” Just as a temporary move to free trade was welfare reducing in Calvo and others (1989), a temporary move away from an enduring reform toward a market democracy will not be credible. To that extent, it may not be associated with a reversal of the whole reform process.8 This is most visible when the reform path is determined by external legal constraints. When there are exceptional circumstances, derogation clauses apply, such as those associated with the General Agreement on Tariffs and Trade (GATT) or indeed the exchange rate mechanism (ERM) of the European Monetary System. If the policy commitment remains, such temporary derogations do not undermine the reform effort, and may indeed prevent a reversal under crisis circumstances.

The role of external legal constraints such as the GATT or the ERM can also be fulfilled without an explicit international agreement, as long as they have the same effect on determining the “enduring reform” path. In this connection, external economic and legal constraints such as the ones implied by IMF or World Bank conditionality come readily to mind. The role of these constraints in promoting the effectiveness of assistance is indeed a crucial one, for ineffective assistance is less likely to be sustained by the donor countries. Since the EC was given the mandate of coordinating assistance to Central and Eastern Europe, the problem of the effectiveness of assistance has become central to the so-called Group of Twenty-Four operations.

European Community Conditionality

The conditionality of Group of Twenty-Four assistance is, in other words, a means of ensuring that an enduring reform path to a market democracy is followed by each recipient country. In spite of this deeper concept of conditionality, the Group of Twenty-Four setup is one in which multilateral surveillance of budgetary and monetary development was not agreed. It will be recalled that with the Community Convergence Decision of 1990, member states agreed on this. As a consequence, a procedure of political and economic conditionality was devised, which sought to keep the reform process moving toward a market democracy by providing the expectation of market access through association agreements and eventual membership. This “tailor-made” conditionality introduces added political, economic, and legal constraints to the adjustment programs agreed upon with the IMF and has indeed been complementary to standard IMF performance clauses. The closest analogue to this process is the conditionality package applied in the Community loan to Greece in February 1991.

In effect, the option of conditional assistance by the Group of Twenty-Four two years ago was an innovation in Community practice. The intellectual basis for the innovation was an adaptation of the Community support framework to the grants provided to developing regions within the Community. In the context of structural interventions, which were being discussed at the same time, the problem was that they could not be inconsistent with the multilateral surveillance set up in the transition toward EMU. This consistency applies to additionality requirements as well as to the broad lines of microeconomic and macroeconomic policy. It is the essence of the partnership implied in such interventions.

But both partnership and conditionality pertain to compatibility of incentives between donors and recipients. A country eligible for assistance in a recurrent program is subject to pressure to adjust so as to enhance the effectiveness of assistance and ensure its future availability. Explicit conditions help monitor the adjustment process, given a common set of objectives and an agreement about the instruments. The broader the agreement, the more conditionality will turn into partnership. The nature of sanctions for noncompliance changes accordingly. In the tightest of partnerships, some sanctions lose credibility, because they will not be carried out. For example, a partner may not credibly threaten not to bail out another partner, unless the sanctions can be independently enforced.9

The argument for conditional aid is based on the credibility of the sanction of discontinuing such assistance. It is therefore very general and should not be confused with the tied and untied nature of assistance. In particular, the conditions needed to ensure the effectiveness of aid will typically be presented by the recipient country itself as part of a multiannual reform strategy. Noncompliance with the reform program can imply sanctions in the budgetary surveillance procedures, such as fines or withdrawal of credits by the Community. Once again, the credibility of such sanctions varies with the degree of partnership involved, and may therefore be complicated by differences in preferences between the principal and its agent, or between the partner and the enforcer.

The Community’s medium-term policy objectives (energy, environment, trans-European networks, sensitive sectors, etc.) for the region are relevant to several policy issues. They should be taken into consideration when specific admissibility or selectivity criteria are attached to the release of certain types of the Community’s project-related aid for restructuring. The same applies to the loans for structural purposes of the European Investment Bank (EIB) (and the European Bank for Reconstruction and Development (EBRD)).

A good example of an objective of this additional conditionality is to ensure a continuing effort to mobilize private sector finance (including borrowing from commercial banks and international capital markets) so that official inflows of capital are not misdirected to financing private sector outflows. In addition to market access, privatization is also prominent in the success of such efforts. The reason for this is that both privatization and market access help balance government finances and bring about competition. The appropriate mix between trade promotion and the breakup of the tutelage system may become an important element of the additional conditionality.10

There could be operational advantages if the framework used to decide this mix were consistent with the one used to decide on the appropriate mix between adjustment and financing, because compatibility of incentives among donor institutions (in particular between the EC and the IMF) must be preserved. Even though the risk of appearing to differ from the Fund is to be avoided at all costs, it would be inappropriate to present the issue as the Commission becoming an agent and the Fund behaving as principal.

In addition, if market access–through the European agreements or other means–becomes a stronger anchor for reform, the EC, by making it more enduring, will be able to influence IMF conditionality. The usefulness of complementarity between different institutions (such as the Fund, the World Bank, the Community, the OECD, the EIB, and the EBRD) will be judged by the scope for taking into account not only policy options specific to each country but also regionwide problems, like the collapse of trade and payments relations within the CMEA. This involves dealing with relations among recipient countries and between them and the Soviet Union without endangering market reform. Tailor-made operations would avoid cross-conditionality and would recognize the individual circumstances of each country. While the same has traditionally been true of association agreements (and even of enlargements such as the last one, involving Portugal and Spain), more needs to be done on a regionwide basis.

The experience of newly integrating countries in the EC shows how reform needs to be enduring even when an irreversible regime change has taken place. EC country surveillance procedures may actually be adapted to the kind of regime change we have seen in the former CMEA countries. If so, these procedures might be used to support multiannual structural adjustment strategies in countries receiving Group of Twenty-Four assistance. There is no guarantee that the conditionality underlying these multiannual strategies will be effective, but it can be said that such strategies provide the best signal that it takes a long time to go from central planning to market democracy. To come back to popular songs, the message is not only to “forget physical” but also to “take the long way home.”

Vladimír Jindra

After consuming most of what the previous generations had accumulated, Czechoslovakia under communist rule lived off its substance, at the expense of its future. While wages were paid for most of this time, the consumer goods to absorb them remained in short supply. What was produced did not meet customers’ demands and had to be exported without obtaining a proper return. Modernization of worn-out machinery was postponed, as were structural changes, and infrastructure, housing repair, and ecological investments were neglected. The future of generations to come was burdened with a mortgage that they will have to redeem in the future. Unless this debt is fully paid, it will be difficult to restore equilibrium, to bring about dynamic and effective growth, and to earn enough through exports to pay for imports of raw materials and power and of new technical equipment, or to avoid further environmental damage.

Therefore, at this point in our history, we have resolved to take the path toward a modern, open market economy. While the path may be full of hardships and risks, we must take it immediately and confidently. Although it may prove painful for the population, the Government has decided on a radical approach rather than a gradualist one, which might only deprive the Government of credibility.

In the transition from a centrally planned to a market economy, priority should be given to restoring equilibrium rather than to promoting economic growth. More important than growth are the conversion of the economy into a functioning market mechanism and the introduction of structural changes that will eliminate the power-and raw-material-intensive sectors. Therefore the Government decided that the first task of macroeconomic policy was to establish an economic environment in which the unavoidable disturbances caused by the transition to a market economy would not bring about further deterioration of global disequilibrium. Any prolongation of the growth that leads to “production for production’s sake,” to stockpiling, and to increasing frozen assets in insolvent foreign countries is illogical, since it does not improve the people’s standard of living. A reasonable decline in output and hence in employment is inevitable during the transition and is fully justified. The conversion of hidden inflation–in the form of shortages and poor-quality products, etc.—into open inflation is also justified. It has been concluded that in the present situation the inflationary overhang from the past cannot be cured by supply-side measures, as any expansion of production or of imports would eventually disappear in the “black holes” of accumulated purchasing power. The only way out is the restrictive macro-economic policy that creates an economic environment in which the unavoidable changes and disturbances that accompany correction of the price structure would not result in growing global disequilibrium, galloping inflation, or undue expansion of foreign debt. What has to be done now is to combat inflation and restore equilibrium, subordinating all other goals such as economic growth, full employment, and balance of payments equilibrium to this goal, at least in the early stages of transformation.

Influential lobbies exist, of course, in Czechoslovakia, which oppose this official concept. According to them, restriction equals collapse, while subsidies equal economic growth. In other words, they subscribe to the concept of growth, expansion, and promotion of development programs. Market pressure should be for a specific period of time, to be replaced by a selective policy of the center combined with a parallel pressure on the liquidation of nonviable enterprises. The increased competitiveness that would gradually develop would be achieved without waste and more economically. They advocate higher rates of economic growth, lower taxation, higher budgetary incomes from higher profits, and expansion of exports and imports: in their terminology, “active adaptation rather than restriction; to suppress inflation, boost supply, raise the dynamics of selective economic growth!”

Just one comment on that: how could a selective structural policy by the Government determine which industries should be stimulated and which should be suppressed unless the market indicates which are effective and which are not? State structural policy can serve only as an exception that proves the rule, giving to viable enterprises the temporal protection that is necessary for their adaptation; the nonviable ones should by no means be protected. Liberalized prices should become the yardstick of effectiveness, indicating which enterprises should be allowed to die, and which rescued. In the light of experience so far, this growth-oriented concept would restore voluntaristic redistribution, with most of the money being wasted on conserving obsolete structures and inefficient management and with the pressure from above withering away in time anyway.

I think that the conflict between these two concepts is misleading and is to be attributed to the inability of some scholars to distinguish between a short-term and a long-term approach. The growth-promoting policy needs time, and a number of requirements have to be met first (such as a competitive environment based on private ownership, a solid banking network, and a capital market). Without these, a growth-promoting policy would, under Czechoslovak conditions, lead only to waste and inefficiency. Whereas growth is regarded as the ultimate goal by both schools, the short-term goal emphasized in the official concept is a restrictive macroeconomic policy that would dampen the inflationary spiral. At the same time, nonviable structures that are artificially financed must be eliminated.

Obviously the exponents of these two schools of thought have different views on practically every step toward reform, its timing, and its intensity. Now that price liberalization has been launched, the criticism is that it should have taken place only after privatization, the breakup of monopolies, and the introduction of competition. The small-minded Czech or Slovak monopolist would rather cut the volume of his output than bring down the price unless forced to by his competitor. The Government is also criticized for having failed to liberalize, along with the prices of consumer goods, the retail prices of gas, coal, and urban transport: if that had been done, the consumer goods and food prices would not have risen as much as they did and would have hit the demand barrier much earlier than the present, when the consumer can afford to pay for overpriced food and consumer goods while still saving on heat and local transport. The Government is also blamed for having allegedly phased out foreign competition, which would compel local producers to reduce their prices in order to survive, and that producers have been protected through excessive devaluation and a 20 percent import surcharge that discourages the would-be importer.

Another important reform step effected in January 1991 was the introduction of current account convertibility. Everybody accepts it as an indispensable step toward foreign trade liberalization, but some question the intensity of the initial devaluation (US$1 = Kčs 28). The excessively high prices of imported inputs will in their opinion spread throughout the economy, spur inflation, and lead to the closing of many enterprises unable to pay high import prices. The exporters, on the other hand, will enrich themselves without any merit; they will be inclined to export raw materials and discriminate against domestic customers. Instead of opening up the economy to the world immediately and drastically, it should have been done gradually by encouraging export industries and raising the general industrial potential and should have opened up only when local products became competitive on world markets. In the meantime dual foreign exchange rates should have been used–one for the regulated foreign exchange market and one (the free exchange rate) for foreign exchange auctions–which would fluctuate according to the demand for and supply of foreign currencies.

Although everybody favored privatization, again views differed on the approach to be adopted. The official school, which ultimately gained the upper hand, emphasized an immediate transformation of state-owned property into private property. Because of the lack of domestic capital, an egalitarian distribution of investment vouchers among citizens at a token price had to be employed, whereas the supporters of a more standard method wanted to give shares in privatized enterprises to those who could pay for them now or in the future or to distribute them only among employees of the specific enterprise, who, in this way, would become concerned about the future prosperity of their enterprise. An indispensable condition for privatization is the clarification of property rights. No wonder that the fiercest debates were conducted over the return of the property to its former owners from whom it had been confiscated–how far back to go, the form of restitution (whether in nature, or in money, or in investment vouchers), at what price, whether to the owner, or even to his heirs, etc.

Another problem was wages. There is a consensus that wages must be kept on a leash, or an inflationary spiral is inevitable. An agreement was reached that wages should lag behind price increases, that in real terms wages should not drop by more than 10 percent over the whole year, that there should be a social safety net, and that the minimum wage should be raised somewhat, but the claims that the price hike should be more generously compensated were decisively rejected.

In line with the stabilization concept, the Government embarked for 1990 and particularly for 1991 on an anti-inflationary fiscal policy accompanied by a restrictive monetary policy. For 1990 a moderate state budget surplus was planned (Kčs 5 billion) and for 1991 a surplus of Kčs 8 billion, that is, 1 percent of GDP. In 1990 only Kčs 8.5 billion of new credits was pumped into the economy–an increase of 1.5 percent over 1989. With an eye to rising prices, more money must be pumped into the economy during 1991 to prevent massive bankruptcies, but the rate of credit expansion will be well below the rate of inflation and the price surge. Against an expected price increase of 30 percent, credit should rise by only 20 percent. What is more, during the first three months of 1991, when prices were supposed to skyrocket (following price liberalization), the increase in credit should not be more than 7 percent compared with the yearend figure, thus preventing the temporary price hike from turning into an inflationary spiral. This credit policy is on the one hand anti-inflationary and on the other it should be more flexible and better harmonized with real economic processes.

A tight monetary restraint will not only be imposed on the economy, but at the same time demand for money will be discouraged by raising its price. During 1990 the discount rate was raised four times—from the original rate of 4 percent up to the present 10 percent–and the intention is to adjust it further as the restrictive policy requires. To encourage the savings habits of households (the savings rate dropped from 4 percent to 1.5 percent), and deposits by enterprises (a decline of Kčs 34.6 billion), the interest rate on deposits was raised substantially. As far as households are concerned, the deposit rates on medium-term deposits should be slightly above the discount rate. The rates are differentiated according to the duration of the deposit and the length of the cancellation period. Higher rates on deposits raised, in turn, the interest rates on loans. Higher interest rates on loans should discourage enterprises from excessive investment in fixed assets and stockpiling. Because of inadequate competition among commercial banks, the central bank set a ceiling on lending rates (14 percent above the discount rate), meaning that today the maximum lending rate is 24 percent. The high interest rates are particularly painful for private entrepreneurs and fledgling private companies. They are mostly charged a preferential rate of 18 percent, which, however, is still discouraging.

It is expected that the economy will go through three stages. The first stage will be marked by a steep price jump that is expected to stop once prices hit against the barrier of domestic demand, which will force producers to adjust their prices to new market conditions. The liquidation of some nonviable firms is also to be expected during this initial stage. The second stage can be described as the stage of adaptation. During this stage sales will go down, forcing the producers to rationalize their production, change their programs, and reduce prices. Bankruptcies will be more frequent, and investment volume and employment levels will go down. By this time, the economic policy should start supporting the most efficient producers. The third stage will be marked by a revival of economic growth and the growth of supply. This is supposed to take place in the mid-nineties, when GDP formation should reach its 1989 level. This time, of course, the structure of production will be entirely different (that is, competitive on world markets).

This program assumes that inputs of material will be maintained at the present level or only slightly below the 1990 level (13 million tons of oil are needed; 2 billion cubic meters of gas less than 1990 imports; and the supply of electric power should not drop below 10 percent of present supply). Three fourths of exports will go toward paying for all those imports. The “emergency scenario,” prepared in the event that the Soviet economy totally collapses and oil imports drop below 11 million tons, foresees a re-examination or even a slowdown of the reform steps as well as a reintroduction of some administrative regulations. National income is expected to decline by more than 10 percent, owing to scarcity of power and raw materials and a negative balance of payments development. The scenario counts on the possibility that under the pressure of powerful producers’ lobbies, the threat of strikes, etc., the tight fiscal and monetary policy will be eased and the strict wage policy somewhat liberalized. The third scenario, described as catastrophic, assumes an even larger shrinkage of inputs of power and raw materials than the emergency scenario. As a result, resolute administrative regulation is inevitable, particularly the administrative allocation of scarce resources and the shutdown of factories consuming large amounts of material and power. Such “war economy” measures would probably bring the economic reform process to a halt for a long time. Let us hope that there will be no need to resort to them.


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1The views expressed in this paper were first contained in a comment to L. Brainard at a seminar on Transformation of Planned Economics, organized by the Organization for Economic Cooperation and Development (OECD) and the World Bank (Paris, June 20, 1990), and in Macedo (1990).
2This is of course quite common in semi-industrialized economies and has been stressed by McKinnon in Ranis and Schultz (1988) and by Branson in Bliss and Macedo (1990).
3The report on the Soviet Union is in Commission of the European Communities (1990c).
4This is the conclusion to Macedo (1990).
5Commission of the European Communities (1990b), especially Chapter 9. The political economy of regime change is analyzed in Macedo (forthcoming).
8This point was clarified during a conversation with Ekaterina Angelova of the Bulgarian Central Bank about the applicability of the agreement in Calvo’s “Incredible Reforms” (Calvo and others, 1989) to the Bulgarian situation.
10The tutelage system and privatization are analyzed in Commission of the European Communities (1990a) and (1991).

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