MACROECONOMICS OF TRANSITION
Boštjan Jazbec*
Faculty of Economics
University of Ljubljana
Slovenia
Abstract
Paper presents a survey of formal models of transition. The survey is selective, taking into
account only models that focus on macroeconomic stabilization and microeconomic
liberalization. The outcomes of macroeconomic stabilization and microeconomic
liberalization are measurable in economic terms, which allows one to contrast the models’
prescriptions with empirical work on transition economies. The models are presented and
explained by three distinguishing characteristics: general characteristics of the model, driving
mechanisms of the model, and policy implications drawn upon the model. The predictions
derived from the formal models of transition are contrasted with empirical findings indicating
that adverse initial conditions and the progress in structural reforms were the main driving
forces behind the initial output decline and recovery at later stages of the transition process.
Keywords: transition, stabilization, growth.
JEL: P20, P21, P27
MAKROEKONOMIJA PREHODA
Povzetek
Članek predstavlja pregled formalnih modelov prehoda. Pregled je selektiven, saj so
predstavljeni samo modeli, ki obravnavajo makroekonomsko stabilizacijo in
mikroekonomsko liberalizacijo. Posledice makroekonomske stabilizacije in mikroekonomske
liberalizacije so namreč neposredno merljive z ekonomskimi spremenljivkami. To mi
omogoči, da dejanske podatke iz držav v prehodu lahko primerjam z zaključki formalnih
modelov. Modeli so predstavljeni in razloženi na podlagi treh dejavnikov: splošne značilnosti
modela, ekonomskega mehanizma, ki poganja model, in priporočene ekonomske politike, ki
izhaja iz zaključkov modela. Poseben poudarek je na priporočilih ekonomske politike, ki jih
nato primerjam z zaključki empiričnih študij, ki so bile opravljene na podatkih za države v
prehodu. Zaključim, da so bili slabi začetni pogoji glavni vzrok za padec gospodarske
dejavnosti, strukturne reforme pa za njeno ponovno oživitev.
*
The research published in this paper is part of the World Bank, Europe and Central Asia Region, 1999
project on Macroeconomic Vulnerability in Transition Economies, task managed by Christof Rühl,
ECSPE.
I would like to thank Christof Rühl, Fabrizio Coricelli, Mojmir Mrak, and Ivan Ribnikar for their
comments and suggestions on earlier versions of this paper. All conclusions and remaining mistakes
are mine.
1. Introduction
At the time the transition began, there was little experience with the process of
economic transformation. Guidance and western expertise were drawn on general principles
and experiences from structural reforms in developing countries. The Latin American
countries served as a starting point in designing the programs of macroeconomic stabilization
although starting points in those countries were substantially different from the emerging
problems in transition economies. However, the facts on distinguishable characteristics of
transition economies were mainly learned while the transformation had already begun and
well before the evidence could be gathered.
What economists knew a priori about restructuring and transformation was that the
inflation stabilization was necessary for the resumption of growth. However, the striking
problem at the beginning of transition was the enormous fall in output ranging from 30 to 50
percent accompanied by a high inflationary environment. Although the transition
encompasses a wide horizon of institutional and political changes, macroeconomic
stabilization and restructuring of the ill-designed economies, it was the inflation and output
performance in the first days of transition that occupied economists across the world. An
extension of the problem and lack of experience of economic transformation from centrally
planned to market-oriented economies generated surprise on a great scale. All advise and help
to design the reforms had to be drawn on general economic principles or - somehow to a
lesser extent - lessons from structural reforms in developing countries. Although some
transition economies1 had undergone economic reforms during the old era of communism
(e.g. Yugoslavia), the transition process at the end of 1980s did not focus solely on the
economic restructuring of the economy, but also and at most on political reform aiming to
proliferate the democratic transformation of the society. However, as it was the case in some
transition economies, the macroeconomic stabilization proved to be the background for a
political reorganization and a smooth path to a sound democracy. If the initial macroeconomic
stabilization program conducted by the reformist party had failed, former communists would
have overtaken the governing of the economy. However, not all transition economies have
started with a new non-communist government. Accordingly, the economic policies aimed to
stabilize and restructure the economy have been implemented on different premises (Aslund,
Boone and Johnson, 1996).
1
There are 26 transition economies as classified by the European Bank for Reconstruction and
Development (EBRD).
1
While countries started the transition with different sets of starting positions either
regarding political environment or unfavorable macroeconomic conditions, they all have
experienced the common challenge of transforming their economies from a centrally planned
system to a market-oriented framework. This has transformed a rather different assessment of
structural changes across the region to a uniform process of transition that has taken place
during the last decade. Experiences with the transition process are different from country to
country in the region; however, they all share some common features that will be explored in
the paper.
The aim of this paper is to challenge the policy implications and predictions derived
from formal models on transition with empirical evidence observed in transition economies
after more than ten years since the process has started. In order to do so, a short review of
almost stylized facts on macroeconomics of transition is presented in Section 2. Particular
interest is paid to the design of macroeconomic stabilization and anti-inflationary policies in
transition economies. While experiences from Latin American episodes of high inflation were
of great use in designing the stabilization programs in transition economies, it is the specific
economic and political environment that distinguished the latter from the former. This issue is
explored in Section 3, where a selective survey of formal models on transition is presented.
The survey is selective in the sense that only models, which focus on macroeconomic
stabilization and microeconomic liberalization along the lines of Balcerowicz’s (1993)
definition of transition, are taken into account. The outcomes of macroeconomic stabilization
and microeconomic liberalization are measurable in economic terms, which allows us to
contrast the models’ prescriptions with actual data. Models are presented and explained by
three distinguishing characteristics: general characteristics of the model, driving mechanisms
of the model, and policy implications drawn from the model. The focus is on the policy
implications derived from the models. Section 4 outlines the survey of formal transition
models and compares the results with recent empirical studies. While in general, formal
models predicted well what has eventually happened in transition economies in terms of
output performance and resource reallocation, they ‘failed’ to recognize the extent of
structural changes that took place during the transition. One of the reasons for this ‘failure’
could be attached to a widely advocated gradual approach to the transition reforms proposed
by formal models. Section 5 presents concluding remarks.
2
2. Macroeconomic Stabilization in Transition Economies
Although some countries have tried to undertake early and radical stabilization and
liberalization and others have chosen to delay the implementation of these policies, the central
problem at the beginning of transition was the one of controlling inflation. The average rates
of inflation in Central and Eastern European countries are still well above the rates in their
Western European counterparts. From that perspective, the transition in Central and Eastern
Europe has not yet been finished. In theory, liberalization and privatization can take place
without price stabilization; however, in practice, the lack of the latter has proved to be fatal
for many transition economies. Consequently, price stabilization is, therefore, the necessary,
although not sufficient, condition for an effective transition from a centrally planned to a
market-oriented economy. A summary on stabilization programs and inflation rates before the
reforms began in transition economies is presented in Table 1. Despite significant differences
in economic structure and institutional framework, the inflation and stabilization experiences
of transition and market economies are similar in many respects. Monetary accommodation
and lack of financial discipline are crucial in sustaining inflation. However, the transition
economies have started the process of disinflation with inherited instabilities in the system.
Price liberalization and privatization fueled the inflationary spiral and almost endangered
economic and political reformation of previously centrally planned economies. The evidence
on transition economies confirms the overdetermination of prices and wages in these
economies (Sahay and Vegh, 1995). The source of inflation inertia has been usually linked to
the traditional factors of excessive money and wage growth, but also to an underlying natural
pressure for the real exchange rate appreciation and relative price adjustments.
An attempt to stabilize the inflationary economy requires the choice of nominal
anchors, which are a necessary condition for the stabilization in a sense that at least in the
long run, the chosen variables will converge to the predetermined rate of growth of the
anchors. The history of inflation stabilization tells us that either the nominal exchange rate or
the money supply is among the most effective nominal anchor to be used in inflation
stabilization throughout the world. The relevant additional anchors generally fall under money
or credit constraints, nominal interest rates, price and wage controls. In order to start with the
stabilization, the main causes of inflation have to be eliminated. If this is not so, even the best
stabilization policy is most likely to fail in an attempt to bring the economy on the path of
long-run growth and stability. Generally, two main causes of inflation can be identified:
3
1. Fiscal indetermination, which initiates money creation. Money supply is then driven by
the financing requirements of the government. However, it is not the budget deficit per se
that is the cause of inflationary money creation, but it is the reason why the government
budget is in deficit. The causes of budget deficits in transition economies can be traced
down to: particular institutional factors, as was the case in the former Soviet Union
(Johnson, 1994; Havrylyshyn, Miller, and Perudin, 1994); liberalization and privatization
of enterprises, which caused the lack of tax revenues (McKinnon, 1991); labor market
disequilibrium (Aghion and Blanchard, 1993); soft-budget constraints (Calvo, 1991); and
others. The stabilization of fiscal dominated inflation requires the elimination of the main
reasons for the budget deficit and the control over the money supply. Budina and van
Wijnbergen (1996) provide an empirical analysis of the fiscal roots of inflation for several
transition economies that were less successful with their anti-inflationary policies. The
main conclusion of this study is that the reasons behind high and persistent inflation rates
in transition economies are unsustainable fiscal deficits, including general government
and central banks as the main fiscal agents of the government in performing quasi-fiscal
activities. The persistent fiscal deficits have induced a sizeable foreign debt in many
countries, and consequently debt service difficulties. The rudimentary state of domestic
debt markets exacerbated the inflation rates since in many cases the only alternative left
to governments is to finance the deficits entirely through the money printing process.
Therefore, the size of the public sector deficit in many cases has directly fueled money
growth and inflation.
2. Balance of payments difficulties, which affect the exchange rate. The adverse balance of
payments developments force exchange rate depreciation, which in turn deteriorate
inflation and budgetary performance. In a setting of passive money, exchange rate
disturbances then cause inflation (Dornbusch, 1988). This phenomenon was particularly
important in explaining recent financial and macroeconomic turmoil in East Asia and,
recently, in Russia. The crisis usually occurs as the economy enters a recession2,
following a period of economic recovery that is fueled by rapid credit creation and heavy
capital inflows accompanied by appreciated domestic currency (Kaminsky and Reinhart,
1996).
The determinants of inflation could also traditionally be identified as various demandpull and cost-push factors that have successfully explained the temporal behavior of
inflationary processes. One the one hand, classic demand - pull factors include periodic
2
This was not exactly the case in Russia. However, it is believed that unfavorable movements in
Russian balance of payments (a surge in short-term capital flows mainly generated to finance the
budget deficit) triggered the crisis in 1998.
4
Table 1: Stabilization Programs in Transition Economies3
Albania
Armenia
August 1992
December 1994
Exchange
Regime
Adopted
Flexible
Flexible/Fixed5
Azerbaijan
Belarus
January 1995
November 1994
Flexible/Fixed3
Flexible/Fixed3
1651,0
2179,8
Bulgaria
Croatia
February 1991
October 1993
Flexible
Fixed
244,6
1902,8
Czech Republic
Estonia
January 1991
June 1992
Fixed
Fixed
45,5
1085,7
Georgia
Hungary
September 1994
March 1990
Flexible/Fixed3
Fixed
56476,2
26,0
Kazakhstan
Kyrgyzstan
Latvia
Lithuania
Macedonia, FYR
Moldova
Mongolia
Poland
January 1994
May 1993
June 1992
June 1992
January 1994
September 1993
October 1992
January 1990
Flexible/Fixed3
Flexible/Fixed3
Flexible/Fixed6
Flexible/Fixed4
Fixed
Flexible
Flexible
Fixed
2315,4
934,0
817,8
708,7
247,7
1089,7
281,6
1096,1
Romania
Russia
October 1993
April 1995
Flexible
Flexible/Fixed4
314,3
218,4
Slovak Republic
Slovenia
January 1991
February 1992
Fixed
Flexible
45,9
288,4
Tajikistan
Turkmenistan
February 1995
Not started before 1996
Flexible
Not applicable
73,0
1906,7
Ukraine
Uzbekistan
November 1994
November 1994
Flexible
Flexible
645,1
1555,1
Country
Stabilization
Program Date
Pre-Program
Inflation
(12-month)4
292,6
1884,5
Sources: De Melo, Denizer and Gelb (1996); and Aslund, Boone, and Johnson (1996).
3
Date of the most serious stabilization attempt.
Inflation in the twelve months previous to the month of the stabilization program. For Turkmenistan,
the figure is for the latest year available (1995).
5
As of 1995, these countries adopted a de-facto peg to the U.S. dollar.
6
The Latvian currency was pegged to the SDR in February 1994; Lithuania adopted a currency board in
April 1994. Russia announced an exchange rate corridor in July 1995. All three countries had flexible
exchange rate regimes prior to these dates.
4
5
episodes of money or credit growth expansion as well as the familiar pattern of monetization
of fiscal deficits. On the other hand, cost-push factors of inflation focus on wage growth in
excess of productivity and on structural supply shortages that tend to drive up price levels in
the short run. It is established as a stylized fact that the transition economies rather experience
both demand-pull and cost-push determination of inflation. Moreover, both groups of factors
seem to originate in fiscal imbalances characteristic to the transition process.
It is a question of what to do first: either to bring the inflation rate down by cutting
the money supply or to eliminate the main cause of inflation. The experience from the
successful stabilization episodes shows that these two issues usually go in step with each
other. It is believed that disinflating can be done quickly, but stabilizing takes longer. The
inflation rate may be brought down very abruptly, but lasting stabilization demands that
people both in and out of government modify patterns of behavior that have become
fundamental through prolonged experience with inflation (Heymann and Leijonhufvud,
1995).
The most important question when inflation stabilization takes place is whether
people will accept and believe in the stabilization program, and therefore change their
behavior, which is pertinent to inflationary environment. By choosing the right nominal
anchor, policymakers can command the credibility of the program. It is believed on the one
hand, that when the stabilization policy is fully credible, inflation falls instantaneously
without significant output costs. On the other hand, when the stabilization program is not
credible, the economy experiences relatively high output costs (Vegh, 1992). The choice of
the main nominal anchor greatly depends on several factors.
Firstly, on the cause of inflation in the economy. If inflation is initiated by an
imbalance in government budget and constant need of government to finance it by printing
money, it is most likely that a money-based stabilization program will be introduced. In so
doing, the central bank reduces the rate of money growth and thus eliminates the main cause
of inflation. On the other hand, balance of payments crises rather implicitly require exchangerate-based stabilization. By fixing a nominal exchange rate, the central bank reduces volatility
on the foreign exchange market and soothes the inflationary pressure on the economy.
And secondly, on the public perception of inflation. People realize relatively soon
their costs of inflation in everyday life. In order to protect their wealth held in money, they
figure out numerous ways to fight inflation. Transactions are processed faster, wages and
prices are indexed, people use foreign currencies to keep the real value of their money
balances stable, time span for bank credits is shortened, and so forth. The stabilization
6
program must cut this kind of behavior by persuading people that stabilization will be
successful. In this respect, the use of a nominal exchange rate as a nominal anchor in the
stabilization program has great advantage over the money-based stabilization policy. People
can check daily the exchange rate in the news. By so doing, they value the promise of
policymakers regarding the inflation stabilization. After a while, people either adapt their
behavior and expectations about inflation to the new circumstances or continue to work out
their fight with inflation. If the latter exists, the stabilization program has little chance for
success.
2.1. Exchange-Rate-Based versus Money-Based Stabilization Programs
Getting rid of high inflation has proved to be a long process. More often than not,
stabilization attempts have failed and inflation has come back with even more devastating
effects on the economy. With few exceptions, most major stabilization programs in highinflation countries (before the transition process in Central and Eastern Europe) have used the
exchange rate as the nominal anchor. In fact, during the past 30 years, there have been 13
major exchange-rate-based stabilization programs in Argentina, Brazil, Chile, Israel, Mexico,
and Uruguay. Rebelo and Vegh (1995) describe the stylized facts on these episodes with the
following nine points: slow convergence of the inflation rate to the devaluation rate; an initial
expansion in economic activity followed by later slowdown; real exchange rate appreciation;
an ambiguous response of real interest rates; a remonetization of the economy; a deterioration
of the trade and current account; a large fiscal adjustment in successful programs; and a boom
in the real estate market.
Despite some unfavorable effects of the exchange-rate-based stabilization programs,
it is believed that using the exchange rate as a nominal anchor produces a sudden end of high
inflation. Sargent (1982) attributes this sudden end of inflation to the re-establishment of a
credible intertemporal macroeconomic policy, mainly fiscal discipline and central bank
independence. This in turn increases the credibility of the stabilization program. Stopping the
exchange rate depreciation is, therefore, tantamount to ending inflation. On the other hand,
the money-based stabilization programs are mainly characterized by possible lack of
credibility, which the exchange-rate-based programs relatively easily achieve by reducing the
exchange rate depreciation and by providing visible effects of the stabilization7. Controlling
the money supply growth does not produce an immediate visible progression in slowing down
7
This is, of course, true only in a very short interval. People can observe the change of policy directly
in the newspapers by looking at current exchange rates. A clear signal of sharp shift in policy,
therefore, generates the credibility needed for the success of the stabilization.
7
the inflation rate. This is mainly due to a relatively rigid transmission mechanism of monetary
policy in high inflation economies, and the fact that the real money supply cannot change on
impact when the program is introduced (Calvo and Vegh, 1992).
Additionally, there is one more distinctive characteristic between the exchange-ratebased and money-based stabilization programs. It can be captured by the picturesque
expression “recession now versus recession later” (Calvo and Vegh, 1992). The evidence on
different stabilization programs in Latin America and Israel shows that the choice between
using the money supply as the nominal anchor or the exchange rate may imply choosing the
timing of the recession. Under the money-based program, recession usually takes place at the
beginning of stabilization, while in the case of the exchange-rate-based program, it occurs
later (Hoffmaister and Vegh, 1996). In this respect, the money-based program seems to be
better since the economy struggles with the recession at the beginning of stabilization. This
can be less harmful than recession at a later time, which may change people’s inflationary
expectation. Consequently, this can affect the success of the disinflationary program. Timing
of the contraction costs associated with reducing inflation, therefore, depends on which
nominal anchor is being used.
Although both programs exhibit an output loss, Fisher (1986) shows that the case of
exchange-rate stabilization is in general less costly. For the same drop in inflation rate, the fall
in the quantity of money is smaller under exchange-rate adjustment. The extent of recessions
is therefore smaller than in the case of the money-based program. Sargent (1982), on the other
hand, shows that a larger recession with monetary stabilization could, in principle, be avoided
if the reduction in the growth rate of money supply is coupled with one-at-a-time upward
adjustment in the level of the money stock. However, such monetary expansion would again
create a credibility problem.
Bruno (1991) further provides several quasi-practical advantages of choosing the
exchange rate over the money supply in the process of disinflation. Firstly, in an open
economy, tradable goods present a substantial part of the goods basket and thus of the
components of the price level. Stabilizing the exchange rate, therefore, provides a more
important and clearer signal to the rest of the economy than the indirect signal embodied in
the quantity of money. Secondly, the exchange rate is also used in setting the wages, which
again generates stability of the economy. And finally, the monetary targets are not stable,
especially during disinflation.
While inflation dynamics in transition economies can be described by the same basic
factors that are used in market economies, there are critical institutional and historical legacies
8
Table 2: Annual Output Growth in Transition Economies, 1989-1998.
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
Albania
9.8 -10.0 -28.0
9.6
9.4
8.6
9.1
-7.0
9.0
-7.2 -11.8 -52.3 -14.8
5.3
5.0
5.8
3.1
6.0
-0.7 -22.1 -23.1 -21.1 -13.2
1.3
5.8
6.7
-1.2
2.8
10.4
5.0
2.5 -10.9
-6.9
4.0
Armenia
14.2
Azerbaijan
-4.4 -11.7
Belarus
7.9
Bulgaria
-0.5
-9.1 -11.7
-7.3
-2.4
1.4
Croatia
-1.5
-8.5 -20.9
-9.7
-3.7
0.8
-1.5
6.0
6.5
4.2
1.4
-1.2 -14.2
-6.4
-0.9
2.6
4.8
3.9
1.0
-1.0
-3.6 -11.9 -21.6
-8.4
Czech Republic
-3.2
-7.2
-9.6 -10.7 -19.1 -10.2
Estonia
-1.1
3.0
4.0
4.0
11.4
5.0
Georgia
-4.8 -12.4 -20.6 -44.8 -25.4 -11.3
-5.0
10.5
11.0
9.0
2.9
1.7
1.3
4.4
4.6
-0.4 -18.8 -13.9 -12.0 -25.0
-8.9
0.5
2.0
1.0
1.3
7.1
6.5
4.0
Hungary
0.7
-3.5 -11.9
-3.0
-0.8
Kazakhstan
-0.4
Kyrgyzstan
3.0
Latvia
3.0
-2.3 -11.1 -35.2 -14.8
2.0
0.4
3.3
6.5
4.0
Lithuania
1.5
-5.0 -13.4
1.0
3.5
4.7
5.7
3.0
Macedonia, FYR
0.9
-9.7 -10.7 -21.1
-8.4
-8.2
-3.0
0.8
1.5
5.0
Moldova
8.8
-1.5 -18.0 -29.1
-1.2 -31.2
-3.1
-8.0
1.3
-2.0
Mongolia
4.2
-2.0
-9.2
-9.5
-3.0
2.1
6.3
2.4
4.0
3.5
Poland
0.2 -11.6
-7.0
2.6
3.8
6.0
6.5
6.1
6.9
5.2
-7.4 -12.9
-8.8
1.3
3.9
6.9
3.9
-6.6
-5.0
-4.0
-3.5
0.8
-5.0
Romania
-5.8
4.0
-5.0 -19.3 -16.1 -26.2
0.0 -18.4
Russia
3.0
-2.0 -12.9 -19.0 -12.0 -15.0
Slovak Republic
4.5
-0.4 -15.9
-6.7
-4.7
4.8
7.4
6.6
6.5
5.0
-5.4
1.3
5.5
Slovenia
-2.7
-4.7
-8.1
4.0
3.1
3.8
4.0
Tajikistan
-2.9
-1.6
-7.1 -29.0 -11.0 -21.5 -12.5
-4.4
1.7
3.0
Turkmenistan
-7.0
-2.3
-4.8
-8.0 -26.0
5.0
Ukraine
4.1
Uzbekistan
3.7
-5.3 -10.2 -20.0 -13.9
-3.6 -11.9 -17.0 -13.0 -21.8 -11.4 -10.0
4.3
-0.9 -11.0
-2.4
-3.5
-1.2
1.6
-3.2
0.0
2.4
2.0
Sources: EBRD Transition Report 1998; and IMF International Financial Statistics,
October 1999.
from the centrally planned era, which have affected the transition process. Calvo and Kumar
(1994) summarize four striking features of former centrally planned economies in the
transition to a market-based system. First, output in all transition economies has dramatically
9
declined (see Table 2). Some estimates range between 20 to 40 percent, although it seems that
this figure is even higher8. The decline in output has been accompanied by sharp increases in
unemployment. In some countries, the unemployment rate came to about 15 percent of the
work force (see Figure 1). Second, in the period after price liberalization, inflation sharply
increased. It should be noted that some countries entered the transition with very high
inflation rates (e.g. Yugoslavia and consequently all former Yugoslav republics). Third, in
most countries, large fiscal deficits have emerged as a result of the dramatic decline in tax
revenues, largely because of the steep drop in output. This fall in government revenue has not
been matched by an equal reduction in public spending. Governments in many countries have
continued subsidizing state-owned firms to prevent further output decline and rise in
unemployment. And fourth, there has been a huge initial deterioration of the external current
account and depreciation of the real exchange rate. Nonetheless, the real exchange rate of
most transition countries has appreciated significantly since the onset of the reforms,
adversely affecting the competitiveness of the exporting sectors (Krajnyak and Zettelmeyer,
1998).
Figure 1: Unemployment Rate in CEE and EU, 1990-1997
12,0
10,0
In Percent
8,0
CEE average
6,0
EU15
4,0
2,0
0,0
1990
1991
1992
1993
1994
1995
1996
1997*
Sources: EBRD Transition Reports 1997 and 1998.
Macroeconomic policies in transition economies have primarily focused on
containing the inflationary consequences of price liberalization and what was considered to be
a significant monetary overhang. Supply shortages and deteriorating real monetary balance
have accelerated the inflation rates across the region. To cut down the inflationary
expectations immediately, most transition economies have introduced exchange-rate-based
8
All data referred to the transition economies are from the EBRD Transition Reports of various issues,
if not otherwise stated.
10
stabilization programs. In so doing, the credibility of the stabilization programs across the
region was at least temporarily established. People were able to check daily the progress of
the stabilization by looking at current exchange rates. This effect was reflected in a relatively
successful stabilization of the velocity of money and stable money demand in a very short
period of time (Sachs, 1994). In addition, a few other factors were identified that appear to
have undermined the use of money as an anchor, especially in transition economies (Sahay
and Vegh, 1995):
1. Unpredictability in the velocity of money. In high-inflation countries, velocity is likely to
be subject to unpredictable shifts often magnified by a high degree of currency
substitution. The magnitude of the decline in velocity of money is difficult to predict,
especially in a transition economy. With greater demand for money, which is fueled by
lower inflationary expectations, velocity of money should fall. However, structural
changes in the economy might even increase the velocity despite successful inflation
stabilization. In this respect, the money target can be over- or under-estimated.
2. Lack of instruments of monetary control. Most transition economies enter the stabilization
with inadequately developed financial markets and monetary policy tools. Open policy
operations, as one of the most important policy instruments for controlling the money
supply, cannot be implemented effectively. Also, reserve requirements most often do not
provide a sound monetary policy tool because of the specific structure of the banking
system (for a broader analysis, see Johnson, 1994).
3. Currency substitution. People use foreign currency in high inflation economies in order to
retain their real value of wealth. Stable foreign currency substitutes inflationary money
that is still in use. As a consequence, the definition of broad money changes and monetary
policy loses its sharpness (see Rodriguez, 1993).
4. Targets on variables, such as foreign exchange reserves and real exchange rates may be
inconsistent with monetary targets. In an attempt to smooth out the exchange rate
fluctuations, interventions in the foreign exchange market are unavoidable. Such
interventions are most likely to be inflationary biased when targeting the money supply is
not an immediate goal of the stabilization program (Calvo, Reinhart, and Vegh, 1995).
When additional targets on nominal interest rates are set, monetary policy also loses its
tightness (Ribnikar, 1993).
11
2.2. Areas of Action for Successful Reform
Although the Central and Eastern European countries have adopted different
exchange rate regimes, they have all experienced real appreciation as well as large inflows of
capital in a relatively short time span (Halpern and Wyplosz, 1996; Krajnyak and
Zettelmeyer, 1998). Although capital inflows were not the most important issue at the
beginning of the transition, the relevance of the presence of foreign capital in transition
economies have become substantial just after the first shock of political and economic
transformation had slowly started to die out. Those economies that were fast in restructuring
and privatization of state and social entities where among the first to enjoy the positive effects
of fresh foreign capital. It is true that surge in foreign capital inflows was associated with new
problems in terms of pressures on external competitiveness; however, it seems that negative
effects of capital inflows were mainly offset by early growth recovery. In contrast, those
economies that were slow in adopting reform measures and mainly attracted foreign capital
into the government debt instruments (Russia and Ukraine) to finance their increasing budget
deficits have suffered from balance of payments and financial crises (Rühl, 1998).
According to Coricelli (1998), the choice of fundamental macroeconomic policy in
the design of a stabilization program was even more pronounced in transition economies with
special reflection on the importance of fiscal policy. Fiscal policy in transition economies
does not only entail the control over the budget deficit, but also involves the issue of reducing
the role of the government in the economy. However, to tackle inflationary pressure was not
the only area of action needed to bring transition economies on the right track of
transformation and restructuring toward market economies. The need for action in transition
economies was widely recognized in six areas (Fisher, Sahay, and Vegh, 1996):
*
macroeconomic stabilization;
*
price liberalization;
*
trade liberalization and current account convertibility;
*
enterprise reform (especially privatization);
*
creation of a safety net; and
development of the institutional and legal framework for a market economy,
including the creation of a market-based financial system.
Wyplosz (1999) and Kolodko (1999) especially emphasized the importance of
building the institutional arrangements, since there is danger of informal institutionalization
12
that fills the systemic vacuum. One cannot separate one area of action from the others.
However, sound macroeconomic stabilization is necessary for the success of all other reforms,
since it forces some state enterprises to contract as a consequence of the implementation of
hard-budget constraints and pushes people into a new private sector. In some respects,
economic reforms in transition economies can be compared to reforms introduced in Latin
American countries (Bruno, 1992). However, the extent of institutional reforms required in
transition economies was much greater and demanded the change of fundamental
characteristics of the institutional legacy of a socialist regime. Balcerowicz (1993) analyzes
the process of transition as consisting of three main components:
*
*
*
macroeconomic stabilization,
microeconomic liberalization, and
fundamental institutional restructuring.
Macroeconomic stabilization consists of restrictive fiscal and monetary policies,
coupled with restrictive income and adequate exchange rate policies aimed at macroeconomic
stabilization. Microeconomic liberalization represents the change in legal framework and
deregulation. It consists of policy measures such as the removal of restrictions on private
sector developments, price controls, foreign trade restrictions, and the introduction of
currency convertibility. The fundamental institutional restructuring includes financial sector
and enterprise restructuring; privatization; the reorganization of the state bureaucracy; and the
creation of new economic, political, and social institutions that promote the development and
growth of a democratic society. Even though macroeconomic stabilization and
microeconomic liberalization were relatively easy to introduce and implement, it is the
institutional restructuring which still after ten years of transition, is taking place in most
transition economies. Not surprisingly, the first two reform measures require literally no time
to prepare and fully implement, while the institutional building demands time not only in the
economic sense of the term, but mostly in the cultural and political segments of any society.
However, delayed and prolonged institutional restructuring may easily jeopardize the initial
effects of the macro- and microeconomic liberalization and transformation. The question of
what to do first again floats around with no distinctive and clear answer. Some authors
(Gligorov, 1994; Roland, 1994) point out that a more rapid approach to macro- and
microstabilization presupposes the existence of institutions that as a rule did not exist in
centrally planned economies. It is argued that a radical liberalization without a providing
institution would lead to chaos rather than creation of prosperity. Unfortunately, in some
cases, these predictions indeed proved to be correct. Nonetheless, a broader look at the
transition economies provides a better picture in terms of growth recovery and future
13
perspective. It is, however, true that most transition economies are still in a period of intensive
institutional building.
The reallocation of resources under the new rules of the game represents the core of
the transition process. Redundant workers from the socialist governed firms were either
employed in the new private sector or in restructured old firms. Unfortunately, many of them
joined the emerging pool of the unemployed. An essential part of the transition, therefore, is
to move resources from less productive to more productive uses. However, as it showed later,
moving workers from low productive employment to unemployment did not by itself increase
productivity, although a general perspective was often put forward that a large supply of
unemployed workers will create demand, partly by increased downward pressure on wages
(Stiglitz, 1999). The reallocation of resources and restructuring of unproductive enterprises
combined with stringent rules of inflation stabilization shaped most of the transition
economies at the early stages of ‘economic revolution’. Not all of them started their transition
process at the same time. However, all of them experienced almost identical performance of
inflation and output once they were put on track. The transition process was defined by
Kornai (1994), firstly, by a move from a sellers’ to a buyers’ market, and secondly, by an
enforcement of hard budget constraints. Later on, Blanchard (1997), in saying that the thrust
of transition lies in the reallocation of resources, enriched the characterization of a transition
process from old to new activities and restructuring within the surviving firms. Coricelli
(1998) summarized the process of transition mainly as a process of market creation. Stiglitz
(1999) adds to the point by concluding that the transition should be understood as a process of
building competition and institutionalization of private property. Both are required for a
market economy to work well. The main areas of action were recognized in inflation
stabilization, budget deficit control, price liberalization, current account convertibility, trade
and capital mobility, exchange rate regime, property rights, hard budget controls, and building
up the legal and institutional framework. The most important question disturbing the policymakers and their advisors was how to sequence the reforms and what the speed of reforms
should be. All the complementary changes in these fields of action needed to take place
without creating too many economic disturbances. Additionally, political support was needed
to be continuously maintained during the reform to avoid policy reversals. Two main
approaches of transition emerged: one group of policymakers was strongly for the big-bang
approach while the other group recommended gradualism in reforms. Both sides had many
arguments to support their views (Wyplosz, 1999).
14
The big-bang proponents were building their argument for the fast structural reforms
and macroeconomic stabilization on the questions of:
 Policy complementarity. New private sector - either emerging from scratch or by
restructuring the old state sector - needed the support from a well-designed economic
policy, legal institutions and political environment. To be fully effective, most measures
needed each other. The closing down state sector firms must be accompanied by an
effectively working private sector. An implementation of hard budget constraints has to be
accommodated by properly working financial markets. Macroeconomic stabilization is
built on the premises of tight monetary policy, which may fall short if government still
subsidizes loss-making firms. The right sequence of reform is blurred by the need of action
on such a grand scale of transformation as witnessed in transition economies at the
beginning of the 1990s.
 Policy uncertainty. The sequencing of reforms would most probably weaken the reforms,
which were introduced first. Even if the proper sequence of reforms was established, it
could have happened that the strength of some policies was weaker than optimal if there
was no clear picture of where the reforms were heading. For example, price liberalization
could have given the wrong signals to the economy if the certain threshold of economic
policy irreversibilities have been created.
 Political vacuum generated at the beginning of transition. Since transition is not only a
transformation of the economy toward new standards, it was important to take advantage
of a public support to reforms. Whatever reform is usually not welfare enchanting in the
short run. To wait for the right moment is dangerous for new political elite, which, in the
early days of transition, emerged from the public rebellion to the communist regime.
On the other side, gradualists were skeptical about measures that could place the
market economy at the existing institutional framework of previously centrally planned
economies. They believed that new institutional arrangements were of key importance for
successful transformation. Although they agreed that the liberalization and stabilization
measures could be radically introduced, the main thrust of their argument was based on the
institutional restructuring of the economies. Their arguments against the big-bang approach
are summarized as follows:
 Adjustment and political costs of transition. The time needed for the private sector creation
is longer than the time in which workers are being fired from the state sector. While the
latter can happen instantaneously, the former needs some time. The difference between
15
these two processes is costly both in economic and political terms. The sequencing of the
reform is important for the policymakers to retain the control over the transition process.
Economic costs of transition were mainly accounted for by the output fall without firm
reassurement of the growth revival. The political losers trying to recoup the power may
acknowledge quickly the economic uncertainty. The argument for gradualism in terms of
adjustment and political costs of transition was almost the same as the argument for the
big-bang approach. The striking difference was the point of perception of what might have
happened under the two different approaches.
 Time to build the New World (Murell, 1995). While some measures can be quickly put into
place, it takes time for others. It is the difference between evolutionary and revolutionary
processes. While economics is a social science, it may be favorable to acknowledge the
time needed for some measures to evolve in the economy. Putting everything into place at
once may jeopardize the transition process itself (Kolodko, 1999).
Looking back from a distance, both groups of arguments may be widely accepted
without too much resistance. However, the academic discourse at the beginning of transition
on the proper methods of structural and macroeconomic reforms was wrongly placed since
the unfavorable developments in transition economies were urging for immediate action.
However, the timing and intensity of reforms were mainly determined by the position of the
former communist elite after the outburst of political change. Aslund, Boone, and Johnson
(1996) look at the correlation between political regime and economic policies - aimed
especially at macroeconomic stabilization - and conclude that in these terms, transition
economies can be divided into five groups. The first group of countries, which include Poland
(1990)9, the Czech Republic and Slovak Republic (1991), Estonia (1992), Latvia (1992), and
Albania (1992), was initially ruled by liberal governments that enforced radical reforms in
order to stabilize and liberalize the economies. Inflation usually soared at the beginning of the
reform, but was then rapidly brought down to less than 50 percent. A second group of
countries has proceeded with less radical reforms enforced, however, also by non-socialist
governments: Hungary, Lithuania, Bulgaria, Russia, and Kyrgyzstan. With the exception of
Hungary, all these countries had higher inflation after two years of reform than the countries
from the first group, and none had inflation of less than 50 percent by 1994. In the third
group, there are countries where the former communists stayed in power and delayed the
reform. This was the case of Romania, Moldova, Belarus, Ukraine, Kazakhstan, Uzbekistan,
and Turkmenistan. Significant cuts in inflation rates were gained only in 1994 and 1995.
However, in some countries from this group (Belarus and Romania), the macro projections of
9
The take-off of the reform as determined by Aslund, Boone, and Johnson (1996).
16
increasing inflation have indeed materialized in recent years. The fourth group consists of
war-torn countries of the former Soviet Union: Georgia, Armenia, Azerbaijan, and Tajikistan,
which entered the transition with high inflation and remained there until 1995, when they
were able to cut down inflation from over 1000 percent at the beginning of transition in 1991.
The last group represents countries of former Yugoslavia that began the macroeconomic
stabilization already at the end of 1980s and entered the transition with relatively low rates of
inflation in comparison with other transition economies. Aslund, Boone, and Johnson (1996)
define the degree of reform by two criteria: how rapidly inflation was brought under control
and the change in the level of the liberalization index as measured by de Melo, Gelb, and
Denizer’s index (1996).
2.3. Additional Factors Determining Reforms
The question of political support and readiness on new social and political
environment to buttress transformation of the economy could also be one of the factors
determining whether transition countries have followed the radical rather than the gradual
approach to reform. De Melo, Gelb, and Denizer (1996) show that the close relationship
between economic liberalization and political freedom did not provide a very wide range of
options once the economy started to pursue the market-oriented reforms. Fast and determined
actions in terms of economic restructuring were necessary for the new political elite to stay in
power. The status quo was not a viable option. Also, the breakdown in the central planning
apparatus required rapid reforms in terms of macroeconomic policies. Otherwise, the
economy would quickly find itself in a chaotic environment that would jeopardize not only
further economic transformation but also new political climate, which started to show
promising results. Recent developments in the Slovak Republic and Croatia, where the
reforming political parties from the beginning of transition had almost blocked the transition
process and eventually had to step down, show that only fast and well-designed marketoriented reforms change business and political environment virtually overnight. If it is a
question of whether rapid or gradual reform depends on political climate in the economy, then
the answer broadly confirms and supports the more advanced and rapid reform. However, part
of the problem in assessing the performance of transition economies in light of different
reforms implemented across regions rises from confusing the means with the ends (Stiglitz,
1999). While stabilization and liberalization of the economies might account as a mark of
success, it is also true that macroeconomic improvement may be seen more like the means to
the more fundamental ends. As Stiglitz (1999) argues, it is not just the creation of market
17
economy that matters, but the improvement of the living standard and the establishment of the
foundations of sustainable, equitable, and democratic development.
Even if the political transition was the factor determining the policy of
macroeconomic stabilization (Balcerowicz and Gelb, 1994; Aslund, Boone, and Johnson,
1996), there were the initial macroeconomic conditions in transition economies that largely
contributed to the shape and extent of reforms at the beginning of transition. Transition
economies spanned a considerable range of development at the end of the 1980s. Generally
speaking, one could classify the initial conditions in transition economies into two groups (De
Melo et al., 1997).
 Macroeconomic distortions at the beginning of transition that take into account a measure
of unfamiliarity with the market process. Variables reflecting initial economic distortions
and institutional characteristics include the extent of repressed inflation, trade shares in
GDP, and exchange rate premium on the black market.
 Overall level of development that represents a measure of what the supply shocks would be
when prices are liberalized and free entry allowed. They include the income levels, degree
of urbanization, share of industry and services in GDP, and prior economic growth rates.
While these initial conditions were mainly recognized at the very beginning of the
transition process in each respective country, there was at least one further dynamic constraint
put on transition economies. Namely, the fiscal constraint to rapid reform that was mainly
associated with costs of closing or restructuring of state enterprises that needed to be offset by
revenues generated from new private businesses. If not, the budget balance would deteriorate
as reforms were implemented. The revenues from state enterprises would decline while the
unemployment benefits increased. The recognition of the extent of the fiscal constraint at the
beginning of transition (Chadha and Coricelli, 1997; Aghion and Blanchard, 1993) would
therefore significantly contribute to the decision of whether rapid or gradual approach to the
transition reforms would be implemented. There are indices indicating that the speed of
restructuring of state firms powerfully depended on fiscal constraints put on transition
economies (Commander and Tolstopiatenko, 1996).
Additionally, individuals, historical and cultural factors, external aid, demographic
structure, richness of natural resources, and geographical distance to market economies
played an important role in determining the reforms in transition economies. Few new
countries in the region emerged out of armed conflict that importantly contributed to the
18
structure of reforms. Country experiences point to significant diversity in restructuring rates
and private sector expansion. However, they also indicate that restructuring has tended to
move in phases, and has been greatly affected by the fiscal and political economy effects that
the transition itself has set in motion.
All these characteristics of the transition economies at the beginning of transition and
characteristics of the transition process itself determined the economic debate and policy
options relevant to tackle the problem, exceptional by its extent and confusion, which has
been produced. Once the political changes have taken place and political irreversibility has
been set up, the main argument in favor of transition has been to put these countries on the
path of sustainable growth. Armed with knowledge of standard economics and experience
from developing countries, scholars of economics started to produce models aiming to help
policymakers in transition economies. The main objective of most of the formal models on
transition was the interaction of output performance and labor reallocation, leaving aside the
recurring problem of inflation. It was correctly assumed that the macroeconomic stabilization
was the necessary condition for the revival of output growth. Most of the formal models of
transition focused mainly on the factors behind the U-shaped output performance that became
obvious two to three years after the initial reforms were implemented. That was also the
period when western economists realized that the standard economic instruments and policies
were not directly applicable to transition economies. Again, the extent of the economic
surprise required deeper analysis of the fundamental driving mechanisms in transition
economies. Lack of experience and uniformity of approach have produced much confusion
about the underlying economic structure of that environment. Giving the often-fragmentary
information on macroeconomic developments, there was no cornerstone upon which
economists and policymakers could rely on. Additionally, there were serious doubts on data
quality in transition economies, which greatly contributed to a blurred approach in the design
of macroeconomic stabilization programs. Fisher, Sahay, and Vegh (1996) classify two sets of
qualifications for which the output data were likely to be seriously biased.
First, at a conceptual level, the prices at which the output was measured at the
beginning of transition were wrong. It was not unusual that goods were not available at any
price. Services were largely underpriced, which consequently resulted in wrong relative
prices. The same was true for the official exchange rates that were highly undervalued
(Halpern and Wyplosz, 1996; Kraynjak and Zettelmeyer, 1998). Price and trade liberalization
disrupted the pre-transition equilibrium price levels and presumably led to an overestimated
decline of output.
19
Second, there was a serious measurement problem since many of the newly
constituted countries in the region did not have well-developed statistical services. By
inadequately capturing newly emerging activities, the output decline was overstated.
Additionally, the measurement problems related to output data also apply to inflation. It is
suspected that the price indices were likely to be biased upward (Osband, 1991).
Suspicion on overestimation of initial output decline led to the re-estimation of GDP
based on the electric power consumption, a good proxy for output in most developed market
economies (Dobozi and Pohl, 1995; Hernandez-Cata, 1997). Cumulative changes in real GDP
and power consumption differed on average about 10 percentage points for all transition
economies. The gap was smaller for Central and Eastern Europe than for the former Soviet
Union. Hernandez-Cata (1997) concludes that, on average, almost two-thirds of the gap
between changes in real GDP and changes in power consumption reflect under-recording of
output.
Overall, the performance of transition economies since their reforms began in the
early 1990s share many common features despite different approaches to the transition
process and country specific problems (wars in some parts of the region; financial crises that
few countries experienced later in transition; and political turmoil that was mainly caused by
unsatisfactory macroeconomic performance in some countries). Inflation was broadly
suppressed; output growth generally successfully started to show signs of recovery; despite an
initial increase in the pool of the unemployed, unemployment rates do not significantly differ
from those in the European Union; real exchange rates feature trend appreciation; most
countries in the region experienced a surge in capital inflows and deterioration of the current
account; and the state lost its overwhelming role in the economies. There are these common
features, which demand an explanation in terms of economic analysis and theory that emerged
at the outset of the transition process. In the next section, a few formal models of transition
are summarized. Their conclusions are contrasted along empirical evidence that now, after
more than ten years into the transition process, has started to clarify the picture of what has
really happened in the region. The following exercise is instructive in the sense that although
both groups - formal models on the one hand and empirical studies on the other - share the
same object of analysis, their conclusions are rather different. While formal models
emphasize the importance of initial conditions and the sequence of reforms in guiding the
economies toward new market mechanisms, empirical studies show that those countries
which were fast enough in implementation of macroeconomic stabilization programs and
microeconomic liberalization are better off in terms of output recovery, reallocation of
resources, and sound economic performance. Generally speaking, one could conclude that the
main difference between formal models of transition and recent empirical studies is nested in
20
the question of whether there should be a gradual or a big-bang approach to the transition
process. It is important to note that transition economies are still far from completing
transition, especially in terms of institutional building required to maintain the level of
economic performance in terms of sustained economic growth experienced in developed
economies. For this reason, the formal models of transition present long-run theoretical
framework aimed to explain the perspective of transition economies considering the
unfavorable initial conditions countries faced at the beginning of their process. On the other
hand, empirical studies mainly serve as a policy-oriented tool aimed to help policymakers
design an appropriate economic policy in order to maintain the first signs of economic
recovery in transition economies. Comparison is, therefore, biased in that mainly
macroeconomic performance is taken into account when formal models are contrasted with
empirical studies. Again, formal models of transition offer a much broader perspective on the
transition process, as it is usually empirically possible to test and confirm.
3. Formal Models of Transition
The literature on transition economies has been constantly growing since the start of
transition in 1989, when Poland introduced its big-bang stabilization and reform program on
January 1, 1990. Given the goal of moving to a market-oriented economy, one would expect
that there should be no disagreement over the general proposition on macroeconomic
stabilization and structural reforms needed to bring those countries to the world market
standards. Although the goal of transition was uniformly accepted, the main dispute was
frequently cast in terms of the speed of transition and the sequence of reforms. Consequently,
the literature on this subject presents a large number of difficult problems with many
alternative proposals each with their pros and cons. At the most general level, the literature on
transition economies can be divided between an early formal theoretical work and recent
growing number of empirical studies on transition economies. This classification naturally
emerges from the fact that serious empirical work was not possible at the dawn of transition
due to lack of consistent data. Both groups of studies should nonetheless convey the same
message. However, the differences on certain aspects of transition are surprising. Generally, it
seems that the formal models of transition are primarily concerned with the question of
whether policymakers should start transition with a big-bang approach or not. Mostly they
focus on the interaction between output performance and unemployment development. Rarely
is the institutional framework in transition economies an issue in models of transition. Using
these building blocks, the formal transition models generally conclude that the radical reforms
at the beginning of transition would result in higher unemployment, slow down the private
21
sector development, and prevent a proper institutional development. Gradual reform and
macroeconomic stabilization may overcome these problems and result in an output growth
that is not only higher, but also obtained earlier in the transition process. Empirical tests on
transition progress and developments measured mainly by the output performance, growth
potentials, and disinflation processes in the last ten years reject the view incorporated in the
formal models on transition. Some specific transition country studies fall somewhere in
between. The literature on macroeconomic stabilization and economic transformation can
therefore be classified into one of the following three groups (Aslund, Boone and Johnson,
1996). First, policy prescription work that favors complete stabilization and carries out all
other reforms with as much intensity as possible. Second, a group presenting formal models
that argues that the radical reforms are too costly and a slower approach is preferable. And
finally, individual country studies, which in general conclude that radical policy has important
advantages, but slower reform can also have positive results.
3.1. Common Legacy of Transition Economies
The extent to which transition can be considered a common process witnessed in
Central and Eastern Europe depends on the relative strength of the common legacy of
communism versus country specific factors (De Melo et al., 1997). Transition countries
differed substantially in their initial conditions, which include the level of income and wealth,
the nature and extent of economic distortions, and the level of institutional development.
However, they also had a strong common legacy that can be characterized by four features (de
Melo, Gelb, and Denizer, 1996).
First, macroeconomic balance by direct control. Financial flows were the passive
outcome of central directives that regulated credit and incomes. Financing of enterprises was
set by a credit plan, taking into account investment targets, and implemented through the
mono-bank financial sector. Surpluses were accumulated in large enterprises and were
transferred to the budget to finance subsidies and transfers as well as direct expenditures.
Given fixed prices and consumption targets, wage control was the critical factor for the
balance between output and demand. In the years prior to the collapse of the old regime, wage
increases exceeded the ability of the economy to provide consumer goods, resulting in
involuntary accumulation of financial assets, or repressed inflation.
Second, coordination through plans. Economic activity was based on the central plan
with quantitative output targets specified in physical units. Heavy industry was accorded
22
priority over consumer goods, and service sectors were accorded low priority in the allocation
of resources. The matching of income and expenditures with physical targets was achieved
through coordinated, economy-wide plans, such as the central plan for material products, the
manpower plan, the credit plan, and the investment plan. These practices were softened in
‘market socialist’ countries, but even there, discretionary ex post interventions by central
authorities largely offset market forces.
Third, little private ownership. With limited exceptions, property rights were
exercised by the state, and private ownership was not allowed. The lack of a profit motive,
arising from the absence of private ownership adversely affected efficiency, and the
prevalence of planned allocations meant that socialist economies had relatively few small
firms.
And fourth, distorted relative prices. Prices played an accounting role and were set in
accordance with the central plan. Implicit prices of essentials including housing, energy,
transportation, education, and medical care were kept low, and land prices were essentially
zero. Implicit trade margins were low, and prices of final goods failed to reflect differences in
distribution costs.
Dewatripont and Roland (1996) summarize the objectives of the transition in the four
points. First, it was necessary to improve allocative efficiency by correcting the distortion of
socialism. Mainly, the introduction of flexible relative prices and the creation of a competitive
market environment open to the world was believed to set the market-oriented framework for
previously centrally planned economies. Second, not surprisingly, macroeconomic stability
was required to advance the reforms in terms of a correct functioning of the price system.
Third, privatization on a large scale was needed to provide better incentives for firms to
respond to market signals. And fourth, the creation of government institutions adequate to
function in a new environment, that is, to exhibit political stability and protect private
property rights was needed.
At the outset of transition, these features reflect the systemic changes and
consequences that again share common roots in most if not all transition economies. De Melo,
Gelb, and Denizer (1996) summarize the features of a post-liberalization period of transition
by three characteristic developments in transition economies.
First, macroeconomic destabilization. Initial price liberalization typically leads to
subsequent price increases, especially if it is undertaken under conditions of repressed
inflation particular to transition economies. The immediate challenge for macroeconomic
23
policy is then to slow the rate of price increases and reverse inflationary expectations. This
requires introducing hard-budget constraints on enterprises while introducing well-targeted
social expenditures, including unemployment benefits. But inflationary pressures may persist
if and when the government’s traditional tax base is eroded due to output losses, further
pressure on state enterprises’ revenues due to their loss of a monopoly position, and
difficulties in imposing payments discipline through a previously passive financial system.
Second, output declines from disruptions in the coordinating mechanism. The sudden
abolition of planning in a complex, highly interdependent economy can impair economic
coordination, affecting both useful and unwanted production pending the establishment of a
new, efficient system of market coordination. The resulting increases in transition costs can
be imagined as a negative supply shock to an economy-wide production function that is
specified to include coordination activities as an intermediate sector. How serious output
declines actually are would depend on the degree of interdependence within the economy, the
extent to which the planning system was disrupted, and the speed at which the new, marketbased coordinating system develops. In some countries, where plan coordination began to
deteriorate prior to price liberalization, costs may occur over many years.
Third, output gains from private ownership and private sector growth. Efficiency
gains come from the legalization of private ownership, which creates incentives to maximize
returns; the establishment and enforcement of a legal framework to support private activities;
and the facilitation of private entry. Smaller firms would produce much of the increased
private sector output. In the long run, the movement from inefficient plan to efficient market
should be equivalent to a positive supply shock, raising the efficiency of resource allocation
and creating a burst of economic growth.
And fourth, microeconomic and sectoral reallocations. Microeconomic and sectoral
reallocations occur in response to price changes resulting from liberalization and cuts in
subsidies, as well as to changes in demand. Previously repressed sectors, notable energy and
services, should expand and offset declines in industry. Expansion of previously repressed
non-tradable goods sectors, including real estate, occur despite large devaluations in exchange
rates, which normally favor tradable goods. Developments in the labor market would reflect
the changes in the composition of sectoral output, and especially the growth of small private
trade and transport activities.
24
3.2. Survey of Eight Formal Models
The following survey is selective in the sense that only models that focus on
macroeconomic stabilization and microeconomic liberalization along the lines of
Balcerowicz’s (1993) definition of the transition are taken into account. The outcomes of
macroeconomic stabilization and microeconomic liberalization are measurable in economic
terms, which allows contrasting the models’ prescriptions with actual data. Models are
presented and explained by three distinguishing characteristics: general characteristics of the
model, driving mechanisms of the model, and policy implications drawn upon the model. The
focus is on the policy implications derived from the models. The predictions derived from the
formal models of transition are then compared with empirical work on transition economies.
Results are contrasted along the following:
1. How well did formal models predict what has really happened in transition economies
concerning the macroeconomic performance in the region?
2. Did formal models help in designing an economic policy in transition economies?
Obviously, one would like to ask how far has transition proceeded according to model
predictions? The satisfactory answer to this question, however, will most probably never be
found because it crucially depends on the measures one takes into account when trying to
assess the transition process. If unemployment rates in transition economies represent that
kind of a measure, then transition is over (see Table 11). According to the models, transition
is over when most of the economy is privatized or restructured. Taking into account that the
most successful reformers have privatized almost 90 percent of their economies, while the
majority of transition economies lag behind this figure than for most countries in the region,
transition is far from the end. Moreover, Havrylyshyn and McGettigan (1999) in their survey
on privatization experiences in transition economies show that the center of transition should
be new private enterprises rather than privatized old entities, although they conclude that even
privatized old sectors are associated with better enterprise performance. Bearing this in mind,
privatization is therefore only one of the mechanisms to reach the goal of a large private
sector. As studies show, the other mechanism that is more important for the sustainable
growth processes in transition economies is allowing and promoting entry of new firms.
Having established this stylized fact, Havrylyshyn and McGettigan (1999) go further and ask
what is the relative efficacy of, on the one hand, fostering an appropriate market environment,
and on the other, implementing an effective privatization program? Since the method of
25
privatization heavily depends on the progress in institutional restructuring in transition
economies, it is rather straightforward to conclude that an appropriate market environment is
a pre-condition for a successful privatization program. However, as an appropriate market
environment generally comprises four elements: macroeconomic stability, hard budget
constraints, competitive markets, and adequate property rights, it is again difficult to asses the
progress of transition only on the measure of the extent of privatization reform. The Russian
experience is a natural candidate to support this conclusion (Moers, 1999). For this reason,
one cannot define in a clear-cut way the end of transition regardless of the model
prescriptions.
If on the other hand, the growth performance in recent years is the measure that
would constitute the answer on the progress of transition, then most economies are on the safe
track of positive growth rates and well out of the pool of transition countries. Fisher, Sahay,
and Vegh (1996, 1998) show that the growth process in transition economies is driven first by
the transition process itself, and second, by the typical long-run growth process of market
economies once stabilization and structural transformation are achieved. However, looking at
the transition process only through the prism of macroeconomic performance would be
misplaced since transition is not only an economic problem but mainly a sociological issue
that would probably take much longer to be thoroughly understood. Stiglitz (1999) concludes
that reform models of transition based on conventional neoclassical economics are bound to
under-estimate the consequences of informational problems, opportunistic behavior, and
human fallibility. For these reasons, the question of how far the transition has proceeded
according to model predictions would be too ambitious to raise. In what follows, models are
presented along the lines of macroeconomic performance in the last decade of transition
rather than trying to extract the extent of institutional reformation the models mostly
presuppose as a necessary condition for any kind of macroeconomic stabilization and
restructuring. In so doing, the question on the end of transition is disguised by
macroeconomic figures, which in most cases may easily lead to ill-argued conclusions at the
end of the transition process.
The formal models of transition can, however, be classified into three main groups.
The first group represents models that analyze transition in a framework that deviates from
the general equilibrium approach. Special attention is paid to labor market dynamics once the
transition process has started. This group of models is represented by works of Burda (1992);
Aghion and Blanchard (1993); Chadha, Coricelli, and Krajnyak (1993), and Chadha and
Coricelli (1997). Models in the second group take the general equilibrium approach, but
employ special technologies to model the transition process. The labor market is perfectly
competitive and the driving mechanism of transition is defined through decisions on
26
intertemporal income allocation between consumption and investment. Works of Castanheira
and Roland (1996a, 1996b) represent models in this group. The third group of formal models
of transition presents extensions of both classes of models in the first two groups. These
models either introduce sophisticated match-searching mechanism in the labor market
(Atkeson and Kehoe, 1997; Garibaldi and Brixiova, 1997), or extend the analysis of the
effects of fiscal policy on the transition process (Commander and Tolstopiatenko, 1996).
Aizenman and Isard (1996) focus on the relationship between the degree of political support
for the transition process and the speed at which the state sector shrinks. Despite different
approaches to modeling of the transition process, formal models in general support the
sequencing of structural reforms and gradual transition in order to avoid unsuccessful
transition outcome. As shown later, these conclusions are in contrast with empirical studies on
the transition process, which emphasize fast and radical reforms to avoid transition
depression.
3.2.1 Models that Deviate from General Equilibrium
Table 3
General
Characteristics
Burda (1992)
Unemployment is necessary to facilitate the emergence of a new private
sector and to force the acquisition of human skills by workers. The
emergence of unemployment offsets a growing imbalance in bargaining
power between workers and managers. It represents a disciplining
device, which raises effort and productivity levels on the one hand, and
controls the growth of real wages on the other hand.
A two-sector economy with the state sector constantly shedding a labor
and private sector hires according to the matching function, which
captures the process by which jobs and workers come into contact with
each other and employment relationships are formed within some
interval. The ratio between vacancies and unemployment represents the
state of tightness in the labor market.
The model consists of two relationships. Both are spanned in a
vacancies-unemployment plane. The first depicts the negative
relationship between vacancies and unemployment when the change in
unemployment (difference between separation rate from the state sector
27
and hiring to the private sector) is constant. The second relationship
presents the supply of vacancies, which is derived from an equilibrium
condition, which states that the marginal cost of posting a vacancy must
equal the expected discounted profit.
The unemployment and vacancy rates are a function of the model’s
underlying parameters, which are institutional by nature: the bargaining
power of workers, mandated severance benefits, rate of separation, and
the efficiency of the matching function.
Budget constraints require that total unemployment benefits are equal to
the taxes collected from operating firms.
Driving Mechanism
The matching function implies that the growth of the private sector
requires time. It depends on the efficiency with which workers and
firms can be put together. Moreover, it crucially depends on the
availability of labor resources, which requires a certain unemployment
pool.
At the beginning of transition, an unambiguous increase in
unemployment and decline of vacancies is observed. This shock lessens
the market tightness and initiates the private sector employment.
However, if the speed of closing of the state sector is too high, the tax
burden levied on the emerging new sector prevents it from hiring new
workers. The model implicitly defines the equilibrium rate of
unemployment, which makes the transition possible. Again, transition is
explained in two phases. The first phase requires a creation of
unemployment workers through a process of reallocation, while the
second phase explains the interactions between the growth of private
sector and unemployment along the balanced transition path, which is
defined as a state where the separation rate is equal to private sector
hiring.
The end of transition implies the depletion of the state sector with all
workers employed in private firms.
Policy Implications
Maximizing the present value of social output in the economy subject to
the labor market condition and employment creation of the private
28
sector finds the optimal policy for the social planner. The economy
consists of a large state sector and negligible private sector.
Productivity of the state sector is always lower than the productivity of
the private sector.
The optimal policy is depicted by an initial jump in unemployment to
its long-run level, followed by a gradual reduction in state employment
at the rate of private job creation. If the marginal cost of unemployment
is rising rapidly, the optimal unemployment rate may be too low, and
consequently, the growth of the private sector is slower.
Having institutional factors as the collective bargaining, unemployment
insurance and severance regulations may have profound effects on the
speed and nature of transition; it may be advisable to hold back on these
until the private sector has grown to its appropriate size. In other words,
it is important that initial flow to the unemployment pool is not
exaggerated since otherwise private job employment may never take
off. The policy implications are rather similar to the model of Aghion
and Blanchard (1993) as both models bear surprisingly a lot of
methodological and conceptual similarities.
Table 4
Aghion and Blanchard (1993)
General
Characteristics
Two-sector model where all workers are employed in the state sector at
the beginning of transition. A closure or restructuring of all state firms
defines the end of transition.
Balanced budget constraint plays an important role in transition
dynamics. Through this fiscal channel, unemployment may have an
adverse effect on the growth of the private sector since higher
unemployment at given unemployment benefits implies higher taxes,
which may mitigate the private job creation.
State Sector
Workers set wages higher than the marginal productivity of labor,
29
reflecting the appropriation of quasi rents. Payroll taxes are assumed to
be the same in both sectors.
Private Sector
Efficiency considerations set wages in the private sector at a higher
level than in state firms. The important characteristic of wage
determination process is that wages depend on the exit rate from
unemployment rather than the level of unemployment per se.
Unemployment
Unemployment increases on impact due to product market shocks and
institutional disruption at the beginning of transition. There are two
flows to unemployment thereafter: one is a direct flow because of state
firms’ closure and the other is because of restructuring. Only private
sector hires new workers from the unemployment pool. Private job
creation depends on profit per worker, which is defined as a difference
between the average product of labor (which is higher in private sector)
and wages net of taxes. Once employed in the private sector, workers
cannot lose their job.
Fiscal Policy
Taxes are equally levied on state and private firms to finance
unemployment benefits. This implies that higher unemployment, given
unemployment benefits, leads to higher payroll taxes. Furthermore,
higher unemployment decreases private job creation.
Driving Mechanism
There is an equilibrium level of unemployment that makes the transition
possible. If the initial increase of unemployment is less than the
equilibrium level of unemployment, which is defined as a level at which
the flows into the unemployment pool (closure and restructuring) are
equal to the flows out of unemployment (private job creation), there
must be a discrete increase in unemployment until the equilibrium level
is met. On the other hand, if initial increase of unemployment is larger
than the equilibrium level, there should be no restructuring of state
firms until private sector growth has reduced unemployment level to the
equilibrium one. The driving mechanism of the transition, therefore,
crucially depends on the difference between the expected value of being
in an unrestructured state firm and the expected value of being either
30
unemployed or being employed in a private (restructured) firm. For
restructuring to occur, the expected value after restructuring must be
greater than or equal to the value absent restructuring.
Two factors are, therefore, important in shaping the dynamics of
transition. First, the higher the initial shock to unemployment, the
stronger and longer the opposition to restructuring. The transition is
prolonged. And second, the strength of private sector employment
creation determines the initial phase of no restructuring at the beginning
of transition and the speed of transition on the balanced path (constant
unemployment) thereafter.
Policy Implications
In a case when probability (or rate) of closing the state sector is
exogenous – workers do not the have power to oppose the restructuring
- the government can set the economy on a balanced path of transition
by announcing that the rate of closure of the state sector will slow down
if unemployment gets too high. Therefore, the flexibility in the speed of
restructuring makes transition more flexible although such a policy is
more likely to suffer from problems of credibility and time consistency.
In a more realistic case when the government cannot explicitly choose
the speed of privatization and restructuring, the decision to restructure is
fully levied on state workers. It is, therefore, assumed that restructuring
comes with privatization. This implies that wages in restructured firms
are set in the same way as in the rest of the private sector.
However, the scope for policy intervention in this case crucially
depends on whether or not the economy is already on the equilibrium
transition path (whether or not the unemployment has reached its
equilibrium level, which remains constant until the state sector
vanishes).
Policy variables in a case of endogenous restructuring include
unemployment benefits (fiscal policy) and the privatization program,
which determines the extent of rent appropriation by state workers or
the proportion of workers that remain in the firm after restructuring.
The effects both policies have on the equilibrium level of
unemployment and the speed of restructuring is, however, different.
31
If the initial unemployment level is larger that the equilibrium level,
then an increase in unemployment benefits (tight fiscal policy) may or
may not lead (this depends on ‘not-too-high initial unemployment’) to
higher equilibrium unemployment, higher wages, and consequently to
lower private job creation. The effect of higher unemployment benefits
on the equilibrium level of unemployment and the speed of transition is
thus ambiguous.
On the balanced transition path, generous privatization rules decrease
private wages, increase the speed of transition, and increase
unemployment. However, off the balanced path, privatization rules have
no impact on private employment creation, although higher
unemployment may imply that it takes less time for restructuring to
occur.
Table 5
General
Characteristics
Chadha, Coricelli, and Krajnyak (1993);
Chadha and Coricelli (1997)
Two-sector economy with productivity differential between sectors.
Productivity differential depends on the level of human capital
employed in production. The level of physical capital and other factors
of production are assumed to be constant and normalized to unity.
Workers can be either employed in one of the sectors or unemployed.
Employment is a function of the difference between human capital
growth in the private and state sectors.
State Sector
Labor-managed firms maximize employment and wages subject to zero
profit constraint. State sector output is subsidized (taxed). The optimal
level of private sector employment depends positively on the level of
unemployment rate and subsidy (tax) adjusted to the relative price of
private sector goods, and negatively on the level of private sector
human capital. The effect of unemployment benefits on the optimal
32
level of private sector employment is not clear.
Private Sector
Private firms make decisions about employment and wages based on
profit-maximization considerations. Worker effort in private sector is
endogenously determined by an efficiency-wage mechanism reflecting
the differential of the real private sector wage over the level of
unemployment benefits, and the level of overall unemployment.
Equilibrium real private wages are, therefore, a function of the
unemployment rate for any given level of unemployment benefits. The
optimal employment level of the private sector depends positively on
the unemployment rate and the level of human capital, and negatively
on the level of unemployment benefits.
Unemployment
Equilibrium on the labor market determines the equilibrium
unemployment in the economy at each point in time as a difference
between constant labor force and employment in the state and private
sectors.
Fiscal Policy
Government operates under soft-budget constraints. Any budgetary
balance could be financed.
Driving Mechanism
An increase in the value of human capital from initial low values at the
beginning of transition increases the equilibrium level of
unemployment. At certain level of acquired human capital in the
economy, every further increase reduces the number of unemployed
workers until all workers in the economy are employed in the private
sector. This defines the end of transition.
The driving mechanism underlying the transition process is the growth
of human capital or total factor productivity. Two cases are
distinguished. First, the growth of human capital is determined
exogenously. And second, the human capital growth is endogenous
derived from the learning-by-doing process. In both cases, human
capital growth in the private sector is assumed to be higher than in the
state sector.
33
Exogenous Growth
As human capital in the private sector grows faster than in the state
sector, employment in the latter shrinks continuously, while
employment in the private sector expands continuously until all labor is
employed in the private sector. However, at the beginning of transition,
the state sector sheds labor faster than the private sector is able to
expand. Since, on the one hand, employment in the private sector
depends positively on the level of human capital and an unemployment
rate, and on the other hand, employment in the state sector is an
increasing function of the level of unemployment, but a decreasing
function of the level of human capital, there must be a point in time
after which unemployment in the economy starts to fall. The transition
is over when all labor is specialized in private sector good.
Endogenous Growth
If the relative higher growth of the human capital in the private sector is
defined through the learning-by-doing mechanism, there exists the
critical level of human capital in the economy, which determines the
path of transition. If the value of the initial human capital were less than
the critical value, the economy would never specialize in the production
of private good. Transition would never occur.
Policy Implications
The level of unemployment benefits, possible subsidies, and the relative
price of the state sector good define the initial level of unemployment.
The higher the unemployment benefits are, the higher is the initial
unemployment rate. Moreover, the higher the unemployment is at each
unit of human capital. The higher the subsidies and the relative price of
the sector good are, the lower is the initial unemployment rate.
Exogenous Growth
Declines in the state sector subsidies (an increase of taxes) increase the
unemployment rate at each level of human capital. State sector
employment is lower, and the share of labor employed in private sector
is higher. Therefore, a decline in the state sector subsidies increases the
speed of transition.
If the government offers an exogenous subsidy to the private sector for
each unit of labor it hires, then labor costs in the private sector will be
34
lower, which leads to higher private job creation. Private sector
employment is higher at each point during the transition as a result of
an increase in the employment subsidy. However, an employment
subsidy to the private sector will also affect the state sector’s
employment decision. At lower values of human capital, the state sector
will shed labor even faster than the private sector will absorb it. This
will result in an increase in unemployment for each value of human
capital at the beginning of transition. An increase in employment
opportunity increases the outflow of workers from the state sector.
However, at later stages of transition, the speed of private sector job
creation is higher resulting in lower levels of unemployment.
Endogenous Growth
Any policy, which succeeds in reducing the critical level of human
capital necessary for attaining a self-sustained path toward
restructuring, increases the set of initial conditions necessary for a
balanced and successful transition.
An increase in a rate of subsidy to the state and private sector in general
increases unemployment for any level of human capital. Consequently,
the relative critical level of human capital is reduced. The economy
increases the possibility of attaining the long-run equilibrium with all
labor employed in the private sector. Although the effects of granted
subsidies to the state and private sectors are the same, the model
considerations prefer subsidies to the private sector alone.
Generally, any policies that aim at reducing the level of unemployment
would slow down the restructuring process. Moreover, in a case of
endogenous growth of human capital, the eventual outcome of
restructuring critically depends on the initial level of unemployment
and consequently on the relative critical level of human capital. Policies
that reduce unemployment may jeopardize the final outcome of
restructuring, though reducing the social costs of transition.
On the other hand, if growth of human capital is exogenous, any policy,
which alters the speed of transition or the extent of transformation at a
point in time, has no long-run impact. The transition is always possible.
35
Extensions of the model (1997) provide the role for active fiscal policy.
For each level of exogenous budget balance target, there is a high-tax
and high-unemployment equilibrium and a low-tax and lowunemployment equilibrium. An improvement in the budget balance at
any point in time during the restructuring process requires a lowering of
tax rates on the state sector. However, the speed of transition is lower as
a result of this decline since wages in the private sector are higher due
to lower unemployment. Thus, the private sector employment is lower
at each point in time during the transition.
By maintaining employment in the state sector at a higher level, a
policy of lower tax rates (higher subsidies) on the state sector succeeds
in reducing the budgetary costs of transition, but slows down the speed
of the transition process. Again, if the growth rate of human capital is
exogenous, this tax manipulation does not have a long-run effect.
However, in a case where the process of skill accumulation is
endogenous, the extent of transformation at any point in time takes on a
critical importance in determining whether or not restructuring actually
takes place. Maintaining state sector employment may make transition
impossible since lowering taxation of the state sector increases the
critical level of human capital in the private sector needed to initiate the
restructuring process.
Although the effect of an increase in unemployment benefits on
unemployment is ambiguous, there is an increase in the critical level of
human capital, which may jeopardize the successful transition. An
implication of this is that at the beginning of transition, low
unemployment benefits may be an effective way to speed up
restructuring.
36
3.2.2 General Equilibrium Models
Table 6
Castanheira and Roland (1996a, 1996b)
General
Characteristics
This model focuses on the process of capital accumulation generated
inside a transition economy to finance economy-wide restructuring. A
general equilibrium closed-economy model encompasses the
consumption and investment decisions of a representative agent, the
capital, labor and goods markets. There are two sectors with firms in the
private and state sectors. Firms differ in their productivity, which is
embodied in the capital they use. State firm productivity is always
lower than private firm productivity.
The process of transition starts in a fully state-owned economy and ends
when the old socialist capital has been either fully restructured by
private owners or replaced by new private capital.
The production function is endogenously determined as it depends on
the dynamics of the shrinking of the state sector and growth of the
private sector, which is also affected by the endogenous scrapping of
state-owned firms. Capital is endogenously supplied through
households’ savings decisions.
Labor market is perfectly competitive and without frictions (1996a).
Transition is defined by an optimal speed of closure of the state sector.
The optimal speed of closure is the result of the social welfare
maximization. The government can pursue an objective different from
social welfare.
Driving Mechanism
The mechanism that drives the model is the restructuring of state firms
through decisions on income allocation between consumption and
investment. The optimal speed of transition is found by choosing the
rate of restructuring of the state sector that maximizes the intertemporal
utility of the representative agent, subject to constraints on investment
and labor.
37
If scrapping of the state assets is too slow relative to the optimal path,
too few resources are left to new enterprises. This discourages
investment and reduces the speed of transition. If, however, the state
sector is subject to hard budget constraints and workers are perfectly
mobile, the optimal speed of transition is still achieved. Only in the case
of subsidizing wages in the state sector and soft budget constraint, too
slow a closure of the state sector may be inefficient.
On the other hand, if the state sector is closed too fast, the speed of
transition may be reduced as a contraction of output reduces total
savings. Excess closure of state firms at the beginning of transition
leads to higher welfare losses compared to excess closure at later
periods of the transition process.
The benchmark model simulations – the model does not have a closed
form - depicts the process of transition that ends in finite time with a
symmetry between the evolution of the private sector and the closure of
state firms. An interesting observation is that output never declines
along the optimal path. During transition, growth rates of income,
consumption, and savings decline. Simulations of the model show that
in spite of a monotonic fall in the savings rate, investment can increase
at the beginning of transition.
Policy Implications
The government can choose exogenously a path of closure of state
firms, which then influences investment decisions of the private sector
through changes in economic conditions.
The effects of exogenously determined paths of transition different from
the optimal one depend on the timing of policy implementation and on
whether state firms have hard-budget constraint and pay wages equal to
or less than marginal productivity.
If the state sector is constrained by hard-budget constraints, then the
speed of restructuring that is slower than the socially optimum one does
not have adverse consequences on welfare and the speed of transition.
This result is a consequence of a frictionless labor market. If, on the
other hand, the state sector has soft-budget constraints, then the private
sector must pay higher wages to attract workers from the state sector.
38
This discourages investment and slows down transition.
With two effects at stake, the income and substitution effects,
respectively, the relative size of these two effects determines the effects
of a too-high rate of closure of the state sector. If the income effect of
output contraction dominates the substitution effect of higher
investment, the pace of transition is slowed down due to a higher speed
of closure of the state sector. The length of transition then depends on
the extent of the initial higher rate of closure of the state sector.
However, if closure of the state sector is accelerated at later stages of
transition, the restructuring may progress at a higher pace, and
eventually speeds up transition. Again, welfare losses are smaller when
hard budget constraints are viable. A too-high or too-low speed of
restructuring may be translated to bigger or slower productivity shocks,
respectively. It is believed that negative productivity shocks at the
beginning of transition prolong the transition process, whereas shocks at
later stages may in fact even speed up the transition since the least
productive state firms may already be restructured by then.
If policymakers have an influence on the timing of productivity shocks
through the sequencing of reform, it is better to avoid adverse
productivity shocks too early in transition.
When assumption on perfect labor market is abandoned (1996b), wage
rigidities slow down transition and create unemployment. Government
can, through subsidies to the state sector, replicate the optimal transition
path. Therefore, in the case of sticky wages, unemployment is
inefficiently created in the absence of subsidies to the state sector, and
the level of unemployment can only increase in the case of an adverse
productivity shock.
39
3.2.3. Extensions
Table 7
Commander and Tolstopiatenko (1996)
General
Characteristics
Two-sector general equilibrium model with three different labor market
states. Workers can be either employed in one of the two sectors or
unemployed. Capital is constant and normalized to one.
State Sector
State firms are governed by zero profit condition. Equivalently, one can
look at the state firms as highly unionized entities, which care for
employment and wages. Wages are set equal to average product. They
are subject to taxation (subsidies). Taxes (payroll taxes) in the state
sector are assumed to be different from the tax rates levied in the private
sector.
Workers can lose their job either because the state firm is closed at an
exogenous rate or because part of the workers becomes redundant in a
process of restructuring. The probability of the state firm to restructure
is equivalent to the probability of moving from the state to the private
sector. Total employment decline equals all outflows from the state
sector.
Private Sector
Private firms pay efficiency wages. They depend on the labor market
conditions reflecting the constant mark-up of the value of being
employed in the private sector over the value of being employed in a
state firm.
Workers in the private sector lose their job at some exogenous rate.
Private jobs are created on the basis of retained profits in the private
firm.
Unemployment
At the beginning of transition, all workers are employed in the state
sector.
40
In response to product market shocks and institutional disruption, part
of the state workers loses their jobs. Unemployment then follows the
difference between total firing from state and private sector and private
job creation.
Unemployed workers receive unemployment benefits. Only once can
unemployed workers find a new job only in the private sector or they
remain unemployed.
Driving Mechanism
Workers have a choice to restructure by weighing up the values of
staying employed in the state sector, getting a new job in the private
sector (restructured firm) or becoming unemployed. A decision to
restructure requires the expected value of getting a new job in the
private sector (restructuring) or would becoming unemployed be a
better value than the value of staying in a state firm.
The restructuring takes place only if the probability of the closure of
state firms exceeds some critical value, which depends on the private
sector hiring rate and the difference between state wages and
unemployment benefits. The lower is the private sector hiring rate, the
higher must be the probability of closure in order to make state sector
workers choose to restructure. The smaller is the difference between the
state wages and unemployment benefits, the higher is an incentive to
restructure for any value of the hiring rate.
Policy Implications
Different values of payroll taxes in the state and private sector affect the
dynamics of private employment and the speed of restructuring. Low
tax compliance by the private sector can stimulate its own growth,
while rising the effective taxation of the state sector. However, at low
probabilities of closure or restructuring, the tax ratio between taxes
levied on private and state sector does not matter very much. It is only
the case of high probabilities of closure and restructuring when a lower
tax burden on the private sector speeds up the private employment,
lowers the unemployment peak relative to the unemployment levels
attained under the higher tax burden for the private sector, and results in
a faster overall pace of transition.
A low tax burden on the private sector can drive unemployment up
41
rapidly, through raising the probability of closure and restructuring of
the state sector, and can also speed up transition.
Table 8
Atkeson and Kehoe (1997)
General
Characteristics
The transition model, which emphasizes that the processes of matching
workers to new activities takes time and involves uncertainty is partial
in the sense that it does not explicitly define the end of transition.
The main conclusion of the model is that social insurance can slow
transition, entail involuntary unemployment, and have an impact on the
steady state level of output. An implementation of a generous social
insurance scheme may exert moral hazard and incentive problems for
less productive workers.
The transition process is modeled contingent upon two different
interpretations offered to explain the reallocation of labor during the
transition. The first encompasses the tax reform, which reduces taxes on
the private activities, which were at such a high rates at the outset of
transition that it was optimal for workers to work in the state sector. The
second interpretation is the one where opening up the economy to the
trade in goods at world prices changes the incentives for the workers
who were previously engaged in activities that had low productivity
when productivity was measured at world prices. The effect of social
insurance for the workers who search for new jobs, however, depends
on whether workers can borrow and lend on the international market.
Driving Mechanism
An economy lasts for two periods, has a continuum of agents, and two
sectors. Workers from the less-productive sector either work or look for
a job in the other sector during the first period. During the second
period, workers can either find a good match with an activity in that
sector or they fail to find a good match. Those workers who fail to find
a good match can still be at least as productive as if they did not search
for a new job, but less productive if they would find a better job. The
two sectors, therefore, require task-specific skilled labor.
42
The government provides social insurance through taxes and subsidies.
However, only those who search are subject to taxation if they find a
good match. Those workers who get engaged in a bad match receive
transfers. Workers who work during both periods are tax exempted.
Policy Implications
Adding social insurance in a closed economy may slow down the
transition if workers have a large precautionary demand for saving and
are not too risk averse; otherwise, adding social insurance may even
speed up the transition.
If workers can freely borrow and lend in international markets, then
adding social insurance cannot decrease the search for new jobs in
equilibrium.
If extended to the infinite horizon, the model’s conclusions again
depend on the elasticity of intertemporal substitution. If workers are not
too risk averse, adding social insurance may slow down the transition.
However, if some workers are too risk averse to search for a more
productive job, then adding social insurance schemes may attract more
workers to move to the more productive sector. Consequently, the
steady state level of output is higher.
Additionally, if only workers who exert an effort to find a good match
in a more productive sector, then an introduction of the optimal
insurance scheme may involve forced layoffs and involuntary
unemployment. Consequently, the steady state level of output is lower.
Table 9
Aizenman and Isard (1996)
General
Characteristics
A framework that emphasizes the relationship between the degree of
political support for the transformation effort and the speed at which the
state sector shrinks.
The hypothesis that the economic transformation may be more rapidly
achieved when the collapse of the state sector is restrained is supported
43
by the fact that the transition process in not only an economic issue but
also an important political process in which the managerial power of
running state firms is shifted from old élites to reformers. Consequently,
the political defeat of proreform governments can greatly slow the
overall speed of transition. In this sense, success in reforming
macroeconomic policy asks for a gradual development of reforms that
contract the state sector.
In a static model, private capital formation depends on public
infrastructure investment. Private savers and investors base their ex ante
decisions on the assumption of macroeconomic stability where the latter
is characterized in terms of the fiscal balance. Expenditures on
infrastructure must be financed from taxes on the private sector, fiscal
surpluses from the state sector, and official external grants and loans.
There are three groups of economic participants: state sector workers,
private sector workers, and private investors. Each of these three groups
is assumed to have some political power, which depends on the amount
of its income changes during the transition process.
Workers are heterogeneous and distinguished by the amount of labor
and effort they provide to the old state enterprise sector and the
emerging private sector. While the productivity of the state sector
depends only on the labor provided to it, the productivity of the private
sector depends, in addition to labor productivity, on both the stock of
capital and the stock of public goods. It is only the private sector that
invests.
Workers decide whether to supply labor or exert effort on the basis of
factor payments for labor and effort. The amount of unemployment
benefits to those unemployed is equal to wages earned in the state
sector.
There is a fixed fraction of total labor force, which is locked in with the
state sector. Other workers make decisions on whether to stay in the old
sector or move to the new one based on their individual skills.
Entrepreneurs - on the other hand - make decisions on whether to invest
in productive capital at home or in portfolio investment abroad based on
an exogenously given real interest rate.
44
The model shows that greater heterogeneity of workers increases the
importance of political economy factors. An increase in output is
necessary and sufficient to sustain political support for the reform
whenever labor is homogenous.
In the absence of well-developed institutions for compensating losers
from the reform process, a laissez-faire strategy can be politically
unsustainable if it leads to a rapid collapse of the state sector.
Driving Mechanism
The transition process splits the population into three groups with
different sources of income: workers in the old state sector, workers in
the private sector, and those who invest their savings and earn a return
on private-sector capital. Due to higher productivity of private sector,
which arises by allowing heterogeneous labor to pursue their
comparative advantages, workers want to work in the private sector.
However, not all can find new jobs. Moreover, workers who remain in
the old state sector can be even worse off after the reform.
By assuming that private investors are no better off under the reform
regime than in the absence of reform, the transition is politically
feasible if the value of political influence function is positive. The
political influence function measures the changes in income of the three
groups of population. A set of politically feasible outcomes can be
defined as a range of factor payments in the state and private sectors,
respectively, conditional on various exogenous and predetermined
parameters (taxes, level of public infrastructure, foreign interest rates,
external grants and loans, etc.).
The equilibrium outcome of the transition process - rather once-and-forall change in economic and institutional conditions - must be both
economically and politically feasible. The feasibility of the transition
change therefore requires a critical threshold of public infrastructure
investment associated with a critical threshold for an external
assistance. In the absence of any external assistance, macroeconomic
stability would require that the state sector closure, and consequently
the loss of political support, be matched or exceeded by tax revenue
from the private sector. However, higher taxes would decrease private
sector workers’ support for the transition process.
45
Further complication is possible if the initial stock of public
infrastructure is too primitive to provide attractive opportunities for
building up the private capital stock.
Policy Implications
After reform is launched, the policymaker has a two-control variable:
the tax levied on the private sector and the amount of investment in
infrastructure. For a given pair of this policy instrument, market forces
lead to a unique combination of the rewards to workers in the state and
private sectors. Therefore, the choice of the two instruments must lead
to an aggregate level and distribution of income that has greater
political support than in the absence of transition.
The sustainability of the transition depends critically on the
development of the private sector. This in turn requires a critical
threshold of public infrastructure investment, which one may in general
interpret as a well-defined and transparent legal environment for private
activities, communications and transportation services, and so forth. An
inadequate investment in public goods at the beginning of transition
may mitigate the transition process through lower political support of
different groups of workers, and may even lead to defeat it.
More importantly, the external technical and financial aid in the short
run may not only be feasible for the transition reform to progress, but
even necessary in order to generate a critical threshold of public good.
Accordingly, foreign assistance should be made conditional on
compliance with political and macroeconomic developments in the
economy.
Table 10
Garibaldi and Brixiova (1997)
General
Characteristics
A dynamic matching model in which the state sector endogenously
sheds labor and private job creation takes time. The model examines the
effects of various labor market institutions, such as the unemployment
insurance system and the minimum wage, on the speed of transition and
the dynamics of unemployment and real private sector wages.
46
There are two types of jobs in the economy, low productivity jobs in the
state sector and high productivity jobs in the private sector. Throughout
the transition, only creation of private sector jobs is possible.
Consequently, private sector jobs can either be filled and producing, or
vacant, while state sector jobs are only filled and producing. Workers
can spend their unit of time working and producing, or being
unemployed and searching for jobs. If state sector workers want to
move to the private sector, they have to experience an unemployment
spell, and therefore, the on-the-job search is ruled out.
Although workers are homogenous in quality, have identical riskneutral preferences in consumption, and are endowed with one flow unit
of time, the value of their labor product in the state sector is
heterogeneous and it changes over time. However, the most productive
state sector job is still less productive than the homogenous and timeinvariant private sector job. Also, private sector jobs are subject to
exogenous catastrophic events, which lead to job destruction.
At each point in time, a job-worker pair splits a surplus from a match
given by the sum of the respective value functions of filled jobs, net of
the respective outside options. Although the state sector firms do not
hire new workers, and consequently do not open vacancies, state sector
employees share the surplus from the job with other state sector
employees. The surplus from the job is an increasing function of the
productivity.
The restructuring and privatization of the state sector firms are
neglected as well as the role of the government in the economy.
Driving Mechanism
State sector firms are subject to adverse business conditions and
endogenously select a value of the labor product at which the
continuation of production is no longer profitable. Once an adverse
productivity shock hits a state sector job, the value of its labor product
will be permanently lower, but the residual value of future streams of
production may still be positive. When the present value of the job turns
negative, the job is immediately destroyed and the worker switches to
unemployment.
47
Therefore, the state sector job is kept running as long as the
productivity of the job is at least as high as a reservation productivity
index. When the productivity falls below that index, the job is
destroyed.
The productivity level at which jobs in the state sector are destroyed
drives the dynamics of aggregate labor market variables
(unemployment, employment in the private and state sectors, and real
wages). Thus, different values of productivity shock and productivity
values would affect job destruction in the state sector, and the speed of
transition.
The transition process is completed when the share of the state sector
jobs converges to a predetermined proportion (assumed zero for
simplicity).
Policy Implications
Effects of three different labor market institutions on the aggregate
labor market dynamics are examined.
Unemployment Benefits
The level of unemployment benefits affects both job creation in the
private sector and job destruction in the state sector. A higher
unemployment benefit through an increase of the value of an outside
option to the unemployed workers reduces the surplus of the private
sector job and consequently reduces the private job creation and
increases an equilibrium unemployment. Additionally, an increase of
unemployment benefits speeds up the transition by raising the
productivity level at which state sector jobs are destroyed.
However, the dynamics of unemployment is also affected by different
values of unemployment benefits. Higher unemployment compensation
produces higher unemployment levels throughout the transition to the
equilibrium since the incentive to hold on to low productivity jobs in
the state sector is relatively low and state sector jobs decline faster.
The average real wages remain relatively high during the transition with
high unemployment benefits.
48
An extension of the model helps one to analyze the effect of payroll
taxes levied on jobs in the private sector. On the one hand, higher taxes
in the private sector increase steady state unemployment. However, on
the other hand, they increase the surplus in state sector jobs and reduce
the impact of higher unemployment benefits on job destruction in the
state sector. Consequently, the speed of transition is slowed down.
If taxes are levied entirely on state sector jobs, the qualitative
implications of the model are the same as in the case of higher
unemployment benefits.
Minimum Wages
When minimum wages are set higher than the negotiated wages in the
state sector, then the increase in unemployment at the early stages of
transition is higher and the fall in real wages is lower. The relatively
high minimum wages increase job destruction in the state sector by an
increase in the reservation productivity index. This speeds up the
transition process.
Firing Tax
If the state sector incurs costs when closing down a job, then the
incentives to hold on to low productivity jobs increase. Consequently,
higher firing costs reduce job destruction in the state sector, reduce the
increase in unemployment at early stages of the transition, and increase
the fall in real wages. The qualitative effects of higher firing costs are
similar to the effects of higher unemployment benefits with one
difference.
To answer the first question of how well formal models predicted what has really
happened in transition economies concerning the macroeconomic performance in the region,
one has to look at the driving mechanisms of the models. Generally, driving mechanisms –
although different among models - would be reflected in the development and performance of
output and unemployment. A common feature of the formal models of transition is a peculiar
pattern of output performance in the early years of transition. Sharp output decline and slow
recovery was not due to any cyclical component of the economy but rather to systemic factors
particular to centrally planned economies. This fact is the cornerstone of formal models on
49
transition. Based on output performance, the ability of a model to predict the transition
process is assessed. All models share this characteristic development of output in the early
years of transition. In this respect, transition models are different from “standard” growth
models, which focus on growth determinants only once the economy is set on a positive
growth track. Formal models, therefore, mimic the actual output decline and slow recovery.
Moreover, unemployment increased in all transition economies, which is another common
feature and conclusion of the models presented above. In this respect, one could say that
formal models indeed depicted the macroeconomic performance in the region. However, to
answer the question on whether they helped in designing an economic policy in transition
economies, one has to be more careful. First, any model would help to understand the reality
as long as one takes into account that models provide only a simplified reflection of the
world. In this respect, all models helped to understand the thrust of the transition process.
However, one cannot say that one model performed better than another, since the features of
the economy that are crucial to one model are often unimportant to others. And second, the
models presented above are generally not subject to rigorous econometric testing because of
the period models emerged. Chronologically, those models emerged in the first years of
transition when few data were available and econometric work was almost impossible to be
performed. It is commonly accepted that the transition process will only be better understood
when more data are available. Ten years’ perspective still does not provide a long-enough
time series that would ensure consistent econometric work. To look at the transition process,
one has to distinguish between sub-periods defined broadly as the decline or negative growth
period (for most transition economies period, during 1990-93), and the recovery or positive
growth period (from 1994 onward) (Berg et al., 1999). As more time passes, the number of
observations increases and therefore provides a much longer period of positive growth
observations (Havrylyshyn, Izvorski, and van Rooden, 1998).
Nonetheless, formal models do share a common point of stressing that the proper
sequence of reforms and gradual approach to reforms is better than the once-and-for-all
implementation of stabilization and restructuring programs. As shown in the next section,
empirical studies broadly refute this conclusion by showing that countries which adopted
some kind of big-bang approach in macroeconomic stabilization and microeconomic
liberalization are better off after almost a decade of the transition process. From this
standpoint, formal models predicted that the transition process in the sense of output
performance and unemployment development would last longer than it actually has.
Accordingly, unemployment rates should be higher in transition economies than in developed
countries. Table 11 presents average unemployment rates in transition economies and 15
members of the European Union. Unemployment has indeed increased since the beginning of
transition as predicted by models; however, it has never reached levels implied by the models.
50
Table 11: Average Unemployment Rates in Transition Economies and in EU15
Transition
economies
EU15
1990
1991
1992
1993
1994
1995
1996
1997
3.00
4.94
7.37
8.84
8.53
8.67
9.32
9.34
8.10
8.40
9.10
10.80
11.10
10.70
10.90
10.70
Sources: EBRD Transition Reports 1997 and 1998; and IMF International Financial Statistics
Yearbook, 1998.
Once again, it could be misleading to look only at the aggregate figures of
macroeconomic variables, since the thrust of the transition process is in the structural
changes, which go beyond a simple process of resource reallocation from a contracting state
sector to an expanding private sector. The percentage change in the ratio between labor
employed in services and labor employed in industry in the period from the beginning of
reform to 1998 presented in Table 12 shows that there was indeed a substantial change in the
distribution of employment as predicted in formal models. The group of Central and Eastern
Europe (CEE) consists of Bulgaria, Croatia, the Czech Republic, Hungary, Poland, Romania,
the Slovak Republic, and Slovenia. The Baltic countries are Estonia, Latvia, and Lithuania.
Table 12: Percentage Change in the Ratio Between Labor Employed in Services and Industry
in Transition Economies
(Start of Reform10 – 1998)
CEE11
Baltics
FSU
Start of Reform - 1998
55 %
33 %
39%
First Five Years of Transition
30 %
39%
39 %
Source: Author’s calculations.
10
As defined in Fisher, Sahay, and Vegh (1998).
While the CEE countries experienced the largest labor reallocation during the transition process, they
began with transition earlier than the Baltics and FSU countries. In the first five years of the transition
process, the difference is less substantial as shown in the second line in Table 12. If Bulgaria and
Romania are excluded from the CEE countries, the ratio between labor employed in services and
industry increased only by 47 % during transition. Moreover, if changes in the labor employment in the
agriculture sector are accounted for, the differences in the labor ratio changes among transition
economies almost vanish.
11
51
The countries of the former Soviet Union (FSU) are represented by Armenia, Azerbaijan,
Belarus, Kazakhstan, Kyrgyzstan, Ukraine, and Uzbekistan.
One of the distinctive features of the previously centrally planned economies was the
degree of over-industrialization. The extent of the state sector can be approximated by the
industry sector while services are mainly provided by the private sector. With the abolition of
the central plan, the structure of demand changed dramatically against the production of
industrial goods. Consequently, the labor market followed structural and institutional changes
in the economies. Formal models heavily elaborated on this issue, although the extent of the
problem was slightly exaggerated in the sense that transition economies would experience
much higher rates of unemployment, as they eventually have. Nonetheless, the intrinsic
dynamics in the labor markets mimic the models’ predictions. The reason why formal models
correctly predict the structural change, but fail to determine the extent of the problem, may lie
in the approach to reforms they generally propose. Once again, the common feature of most
models is that the gradual approach to the reforms is better than the big-bang implementation
of a macroeconomic stabilization plan. And the arguments for the former have roots exactly
in the implied behavior of the output and unemployment which when they reach a critical
level may jeopardize the progress of transition. Fortunately, this black scenario did not occur
in the region with the exception of a few countries where mainly political reasons were the
factor of delay and the reorientation of reforms. If it is true that a delay in reforms protracted
economic growth in late and slow reformers, then formal models wrongly supported the
gradual and sequenced approach to the structural changes needed in transition economies.
4. Review of Empirical Studies on Transition
Sharp output decline, disruption of traditional trade and financial links, and the
abandonment of central plan lines of production have characterized the early years of
transition. The initial developments in real sectors were generally followed by attempts to
maintain production and employment at previous levels by running large fiscal and quasifiscal deficits, resulting in high rates of inflation and further collapses of output. One of the
main sources of inflation in newly emerged countries was the introduction of their own
currencies. After this common experience, most countries engaged in comprehensive
stabilization and reform programs. Although countries that implemented such programs
generally succeeded in bringing down inflation to low levels, the success in achieving
sustained growth has been more varied (Havrylyshyn, Izvorski and van Rooden, 1998).
Figure 2 documents output behavior in different groups of transition economies. Despite a
52
Figure 2: Growth in Transition Economies
140
120
Index (1991=100)
100
CEE
80
Baltics
FSU
60
40
20
0
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
Source: EBRD Transition Reports 1997 and 1998; and Havrylyshyn et al. (1999).
common legacy of planning, transition economies started out their transformation under
different circumstances. There were substantial differences in terms of the initial levels of
development, macroeconomic distortions, integration into the trading system of socialist
countries, and the extent of prior reforms (de Melo et al., 1997).
While theoretical literature on transition from a planned to a market economy has
focused on the particular trade-off that arises from a systemic transformation, the aim of all
applied policy analysis is to provide an advice to policymakers. The interplay between
empirical and theoretical research in achieving this task is an important element in developing
such useful advice. In the analysis of transition economies, this interplay has been made
difficult by methodological issues. First, standard econometric techniques cannot easily be
applied to the transition economies where at most ten years of history is available. Second,
even if long time series were available, transition is by its very definition a rapid and
simultaneous institutional change where empirical research proved hard to disentangle
different shocks to the economic system at a certain time. Moreover, transition is believed to
involve specific features in terms of the non-linear paths of the main economic aggregates and
peculiar intertemporal issues (Coricelli, 1998). Christoffersen and Doyle (1998) study
possible non-linearities in the relationship between inflation and growth in transition
economies using panel data on 22 transition economies. They find that inflation is associated
with weaker output only above a certain threshold. The identified threshold for transition
economies is found to be about 13 percent: inflation above that level reduces output growth,
while no significant effect on the growth is apparent if inflation is below that level.
Havrylyshyn, Izvorski, and van Rooden (1998) arrive at similar conclusions, except that the
level of inflation at which inflation begins to have a significant adverse effect on growth is
53
found to be in the range of 20 to 30 percent. The fact that several tests on correlation between
disinflation and growth do not yield the same cut-off point suggests that the relationship
between inflation and growth is a non-linear one. Moreover, there is evidence that the
inflation threshold may fall over time as structural reform proceeds and that fast reformers
have lower inflation rates (Fisher, Sahay, and Vegh, 1996). Given these binding constraints
on available observations, empirical research in the early years of transition has tended to
concentrate on anecdotal case study evidence rather than full-fledged empirical analysis.
Nonetheless, commonly accepted stylized facts on output performance in transition
economies can be summarized as follows (Hernandez-Cata, 1999). First, in its early stages,
the process of liberalization and macroeconomic stabilization results in a large fall in output
in almost every country in the region. Second, the fall in output tends to be particularly steep
in those countries where the liberalization effort was relatively strong. Third, after some time,
the countries where liberalization was strong show at an early stage the highest rates of output
growth, or the smallest cumulative declines in output. Fourth, there has been considerable
under-utilization of industrial capacity in the early stages of transition. And finally, although
price liberalization initially results in a burst of inflation, over the medium run, there is a
negative correlation between growth and inflation and also between liberalization and
inflation. Cotarelli and Doyle (1999) review a range of policies implemented in transition
economies contributing to the disinflation and factors that were particular to those economies.
They conclude that moderate and low inflation brought about through disinflation stimulated
growth. This conclusion is in contrast with an established negative correlation between
disinflation and economic growth usually measured by the sacrifice ratio (Barro and Sala-iMartin, 1994). However, it points to the complications that were particularly apparent in the
period of deep structural changes affecting potential output (Cotarelli and Doyle, 1999). First,
the drop in output may have been due to the collapse of central planning rather than to
disinflation. And second, the recovery may have been due to the effect of structural change
rather than to the stabilized inflation environment. Nonetheless, the estimated threshold above
which inflation involves significant output costs appears to be close to industrial country
inflation rates and provides the relevant benchmark for the most advanced transition
economies (Ghosh and Phillips, 1998).
54
4.1. Growth Patterns
From such a core concept of transition, there follow some implications for growth
that differentiate the transition economies from market economies and that provide the basis
for empirical analysis of determinants of recovery in transition (Havrylyshyn, Izvorski and
van Rooden, 1998). First, there is a necessary output decline due to new market and hard
budget constraint. This point is well documented in theoretical models of transition presented
above. Second, growth of either restructured or new sectors will not occur until new
incentives are in place and made credible. In other words, the sooner reforms achieve a hard
budget and liberal price environment, the sooner reallocation and restructuring of the old and
the creation of new production can begin. Third, the proximate mechanisms in the early
recovery period are most likely a variety of efficiency improvements rather than an expansion
of factor inputs, either investment or labor. There is a consensus in the general growth
literature that investment is a major engine of growth in the medium to long run. However, in
transition economies with substantial inherited inefficiencies as well as under-utilized
capacity, the short-run role of new investment is likely to be relatively less important, at least
for the initial recovery (Fisher, Sahay and Vegh, 1996; Blanchard, 1997).
While the prevailing doctrine on economic growth in the 1950s and 1960s attributed
growth to the expansion of factor inputs and exogenous technological progress, the data
appeared to invalidate the central proposition of this approach that national per capita incomes
will converge in the long run. Retaining interest in the growth puzzle helped the emergence of
the endogenous growth theory (Romer, 1990; Barro and Sala-i-Martin, 1994; Aghion and
Howitt, 1998), which emphasized the extension of a previous approach by inclusion of
technical progress based on increasing returns to scale, research and development activities,
imperfect competition, human capital, and government policies. The role of the latter was
initially focused narrowly on economic measures such as macroeconomic stability, openness
of the economy, and degree of price distortion. Later, property rights policies were added
(Olson, 1996). Numerous empirical studies (see Barro and Sala-i-Martin, 1994; Aghion and
Howitt, 1998) based on this synthesized model seeking to explain the observed wide
differences in growth patterns across countries and over time have distinguished three main
categories of factors believed to be important in explaining growth performance in market
economies. Not surprisingly, factor input expansions remained to be important in explaining
growth developments across countries. Additionally, the key conclusions from the
endogenous growth theory emphasize the following groups of growth variables and indicators
(Havrylyshyn, Izvorski and van Rooden, 1998). First, initial conditions are important in
explaining cross-country differences in growth. Most studies have found that per capita
55
growth is inversely related to the initial level of output, and once other factors are accounted
for, poor countries tend to grow faster than rich ones. Further, greater availability of resources
does not necessarily ensure growth, while unfavorable geographic circumstances can hinder
it12. Second, good economic policy represented by macroeconomic stability and nondistortive interventions has a strong effect on growth. Thus, reducing inflation to certain
thresholds seems to be a necessary condition for achieving sustained growth. Policies that
lower or distort the rate of return on private capital, such as high taxes, exchange or import
controls, and price regulations are likely to reduce the growth performance of the economy.
And third, the legal, political, and institutional framework is very important. The growth is
higher with better institutional quality, political stability, government credibility, and other
indicators of a market environment.
Review of earlier empirical studies on growth in transition economies broadly
supports the evidence from developed market economies. However, there is one major
distinctive characteristic of transition economies, which places them in different theoretical
and empirical context when discussing growth. While most models and studies on growth
emphasize the role of investment in explaining growth performance, it is the transition
economies where investment to GDP ratio fell significantly from the outset of transition. In
less than 20 transition economies that experienced positive growth rate in recent years, the
ratio of investment to GDP fell from levels of 30 percent or more to nearly 20 percent or even
lower. It is therefore not surprising that empirical studies on transition economies ignore the
long-term factors such as investment, and focus on efficiency-improving factors such as
macro policies, structural reforms, and property rights climate (Havrylyshyn, Izvorski and van
Rooden, 1998). The notable exception is work by Fisher, Sahay, and Vegh (1996, 1998), who
look at the transition output performance only once economies are set on the positive growth
rate patterns. The further along a country is in the transition process, the less the weight on the
factors that determine the transitional growth rate, and the greater the weight on the standard
determinants of growth. It is believed that recovery from transition depressions is likely to be
based on vast reallocation and efficient improvements rather than the conventional factor
inputs or technology determinants of growth (Havrylyshyn and van Rooden, 2000).
12
Zettelmeyer (1998) rejects this view in the case of Uzbekistan. He concludes that early growth of the
Uzbek GDP can mainly be accounted for by cotton exports.
56
4. 2. Concluding Remarks on Empirical Studies
The main remarks on the empirical studies on transition economies can be
summarized as follows. Probably the least controversial conclusion is that stabilization is a
necessary, though not sufficient, condition for output recovery. Second, more reforms are
associated with better growth performance (Hernandez-Cata, 1999). This point contrasts most
of the conclusions from the theoretical models of transition which emphasize that a gradual
pace of reforms might lead to a slower decline of output earlier and a faster recovery later.
Empirical studies generally conclude that fast and early reforms result in early and strong
recovery. Third, initial conditions and other factors specific to countries, such as wars, do
matter a great deal in explaining the growth performance of transition economies. And finally,
the market-enhancing nature of institutions, such as the legislation, corruption, and tax burden
increase growth performance. Although most empirical studies confirm the role of initial
conditions in explaining the cross-sectional variation in growth, Berg et al. (1999) in one of
the most extensive empirical studies on transition economies to date, reduce the importance of
the effect of initial conditions on economic growth. They explain the difference between the
best and worst performing transition economies by differences in structural reforms rather
than initial conditions. In so doing, they again question the conclusions derived from the
formal models of transition. Nonetheless, their findings confirm the role of fiscal policy in
effecting the economic growth, which is a rather unique result since most other studies
neglect the explicit fiscal variables in explaining growth performance in transition economies.
In this respect, Berg et al. (1999) support the argument put forward in formal models of
transition (in particular, Chadha and Coricelli, 1997) that fiscal constraints affect the speed of
transition. However, beyond potential model mis-specifications, the usual caveats on data
availability and measurement apply and should be taken into account when results are
interpreted. In fact, growth in empirical studies appears to be negatively affected by the level
of contemporaneous reform policies. In turn, this negative effect is quickly compensated if
reforms continue. On balance, growth is affected by the accumulated stock of reforms, which
more than offset the initial output loss (Havrylyshyn, Izvorski, and van Rooden, 1998).
Moreover, looking only at the large output losses at the beginning of transition, empirical
studies confirm that the output losses have been more associated with the transition process,
due to disorganization or adverse initial conditions, and not due to tight stabilization policies
(Fisher and Sahay, 2000). As concluded in the survey on formal models of transition, initial
output losses were - in contrast to most empirical studies13 - mainly explained by the effects
13
Christoffersen and Doyle (1998), for example, show that output losses appeared to be explained
solely by rapid disinflation and the pegged exchange rate. However, their view seems to be isolated
from other empirical studies.
57
of the intensive stabilization policies rather than the particular structure of the economy and
remedies to improve it.
5. Conclusions
This paper has attempted to bring together two strands of literature on transition
economies. An early formal work on transition economies has been contrasted by recent
growing empirical work. The aims of the paper are ambitious in a sense that chronologically
one has to take into account a different level of knowledge on structural changes that have
happened once the ‘iron curtain’ separating East from West came down. While formal models
of transition mainly emerged in the first years of the transition process, most scholars on
transition were not aware of the extent and significance of the transition, which we still have
an opportunity to observe daily. From this standpoint, it would not be fair to judge the formal
models on transition only on their ability to correctly predict what has eventually happened in
the region. The survey on formal models of transition, therefore, tries to establish the view
that economists have at the beginning of the process, which has undoubtedly changed the
lives of millions of people and was exceptional in purely statistical and - even more sociological aspects of the transition from centrally planned to market economies.
Models were presented and explained by three distinguishing characteristics: general
characteristics of the model, driving mechanisms of the model, and policy implications drawn
from the model. The focus was on policy implications derived from the models. The
predictions derived from the formal models of transition were then compared with empirical
work on transition economies trying to find answers to the following two questions. First,
how well did formal models predict what has really happened in transition economies
concerning the macroeconomic performance in the region? And second, did formal models
help in designing an economic policy in transition economies?
Questions were broad enough to fit into the conclusions of the formal models which
took different aspects of transition as their starting point in explaining the restructuring and
transformation process in transition economies. Results from this exercise fall into two
categories. First, formal models on average predicted well what has happened with an output
performance and resource reallocation despite different structures and variables, which were
important in the mechanisms of driving forces of transition. The extent of the output decline
and the levels of unemployment were, however, pessimistically exaggerated, fortunately, as
one would say. The reason for this fortunate mis-prediction may originate from the approach
58
to reforms that formal models generally supported and advised. And this is the second
common characteristic of formal models, which emerged from the survey. Namely, formal
models implicitly favored a gradual and properly sequenced approach to the design and
implementation of reform programs in transition economies. Why they favor gradual to fast
and deep restructuring is another question; however, empirical studies found that the main
reason for faster recovery - in spite of greater initial output decline - is in fact early and
thorough implementation of the reform package. Contrary to the conclusions of formal
models, empirical studies show that radical reforms do not result in higher unemployment,
slow down private sector development, and prevent institutional restructuring. Additionally,
initial conditions at the beginning of transition play only a minor role in explaining the
differences in performance among transition economies (Berg et al., 1999), while formal
models stress the importance of their effect on output performance during transition.
However, it is important to notify that those who advocated rapid reforms in transition
economies mainly based their arguments not only on the economics - and related output fall
in cases when actions were taken quickly - but especially on political economy grounds
(Fisher and Sahay, 2000).
The political connotation of the transition process is mainly ignored in most empirical
studies. It seems that the points of controversy on appropriate transition strategies mainly
emerge within the pool of political economy arguments that favored the rapid approach to
reforms in countries with powerful old elite and overall structure of the economy. However,
the only argument one can provide in defense for rapid reforms on the one hand and gradual
approach on the other should be based on macroeconomic performance in countries, which
took different approaches. As observed, economies with political consistency in design of
reforms perform better. Whether they had to introduce reforms more rapidly than others does
not really matter. What matters, however, is the stance of initial conditions in reforming
countries, which mainly determined the pace of transition. Rapid policy action was possible in
some areas of reform (inflation stabilization, price and trade liberalization, and small-scale
privatization), but in others it was clear that reforms would take longer. As Fisher and Sahay
(2000) tentatively conclude, the controversies over shock treatment are mainly relative to
macroeconomic stabilization and the pace at which privatization could be attempted. To a
lesser extent, the controversies emerge over the pace of price and trade liberalization. Both
debates on sequencing and shock therapy are, therefore, closely related and mainly based on
the argument that some reforms are preconditions for others. Looking at transition ex ante, the
arguments for sequencing may be correct. However, by taking an ex post view, it seems that
rapid reforms produced better results. Again, one has to take into account distinguishing
characteristics of initial conditions across transition economies when talking about design and
implementation of reforms at the beginning of transition. Since transition encompasses more
59
than a narrow economic concept of resource reallocation and output performance, the results
of empirical studies should be taken into account cautiously. While most macroeconomic
variables are relatively easy to quantify, transitional characteristics of institutional changes are
difficult to incorporate in econometric analysis since data on them are not directly observable.
For this reason, formal models on transition take a broader look at the transition rather than
empirical studies and, therefore, predict empirically unpredictable performance of transition
economies, which we observe daily.
60
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