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MAY 1994





This paper contains the text of a guest lecture delivered by Dr Gomulka to

the Nordic Finance Committee at its meeting in Lillehammer, Norway, on 21 January 1994 at the invitation of Kjell Storvik, Deputy Governor of the Central Bank of Norway and the Chair of the meeting. The Committee is composed of top representatives of Central Banks and Finance Ministries of the five Nordic countries: Denmark, Finland, Iceland, Norway and Sweden.

This paper was produced as part of the Centre's Programme on Post-Communist Reform



Stanislaw Gomulka Page Reform strategy 1 1.

The output collapse has been inevitable 3 2.

3. Money has been the key nominal anchor 4

4. The exchange rate policy 5

5. The public finance crisis and the fiscal policy 5

6. Mr Klaus' Ten Commandments 6

7. A closer look at Russia 9

8. The special case of Poland 11 Endnote 13 References 14 I wish to acknowledge helpful comments by Audun Gronn of the Norges Bank and by Peter Boone and Mark Schaffer of the London School of Economics. The Centre for Economic Performance is financed by the Economic and Social Research Council.



Stanislaw Gomulka * My primary purpose is to comment on the experiences so far by the formerly communist countries in transforming their economies with a view to proposing lessons for policy-making. Although my familiarity is greatest with the Polish experience I shall make use of the empirical evidence, both economic and political, from the whole area of Central and Eastern Europe and the Former Soviet Union (FSU), particularly Russia.

I begin with a few general observations about the choice of reform strategy. This I follow with a discussion of the output collapse and the conduct of macroeconomic policies. The Ten Commandments of Mr Klaus provide me with a further opportunity to comment on policies.

Finally, I shall take a closer look at Russia and comment briefly on developments in Poland.

1. Reform Strategy The change of economic system now under way in Central and Eastern Europe and the FSU requires, of course, major structural shifts in terms of institutions, ownership, modes of interpersonal behaviour, attitudes to work and laws. Some institutions have to be cut in size or closed down, others expanded or created. These institutional changes are superimposed on large changes in the pattern of prices and foreign trade relations, both of which imply major shifts in the required composition of output. In particular, exports to the former Council for Mutual Economic Assistance (CMEA) area and the shares of industry in GDP have to fall and did fall dramatically. On the other hand, the share of trade and financial services should increase and are increasing sharply.

In terms of institutions, skills, prices and products, there is therefore a large distance between the initial point where a post-communist economy finds itself just before the reforms and the end point of its intended transition. Reform strategy is about the speed and sequence of reforms to effect the transition.

A policy designer, in proposing a broad reform strategy and specific policies, has also to take into account particular economic circumstances as well as political constraints. These circumstances relate above all to the sizes of internal and external disequilibria and the possible extent of external assistance.

The strategy has therefore five major components: microliberalisation, macro-stabilisation, structural changes, safety nets and external assistance. Of these the first three are crucial components of any reform package. External assistance is typically small and of limited impact even though it may be useful for political reasons to exaggerate its significance by both donors and recipients.

The inherited circumstances fall into two categories, common and country-specific. The common part dominates and ensures that the reform policies and transition paths exhibit some basic similarities among countries. Nevertheless, the variation in country-specific circumstances is substantial enough to have a major impact on the choice of overall reform strategy as well as specific policies.

The similarities are possibly greatest with respect to rapid microliberalisation and some important structural changes, notably rapid reorientation of foreign trade and privatisation. Somewhat unexpectedly, the greatest differences have emerged in the area of macroeconomic policy.

Three broad reform strategies may be distinguished: the so called shock therapy, managed shock and gradual. The true shock therapy was applied only in East Germany where Western prices were imposed from one day to the next. Although subsidies remained in place, the instant monetary union meant that local producers were offered no protection against West German products. Moreover, real wages for political reasons were increased sharply. The outcome is well known: drastic collapse of industrial output, massive unemployment and external assistance of some $100 billion per year. Although this strategy offers the potential for a fast reallocation of resources, it is far too costly in the short and medium term to be of interest to any other post-communist country. At the other end of the spectrum is the truly gradual strategy. This has been pursued successfully only by China since the late 1970s. The strategy had been tried also in Central Europe, especially in Hungary and Poland, but with insufficient vigour and poor results. In conditions of severe economic and 2 political crisis, virtually the only choice open for the FSU and Central Europe was therefore a form of managed shock. A strong form of it was adopted by Poland, Latvia, Estonia and Czecho-Slovakia and a more gradual variant in most other transition economies, particularly Russia.

2. The Output Collapse Has Been Inevitable Unusually large output declines during the initial phase of transition are probably the socially gravest and the most politically dangerous economic phenomenon. The critics of radical reforms have tended to associate these declines with, in their view, excessively restrictive macroeconomic policies. However, it is now clear and this is possibly the key lesson from the cumulative experience of transition countries during the last four years, that the output declines have little to do with the conduct of macroeconomic policy. It would appear that, given the large weight and commonality of inherited economic problems (and the fast speed with which the transition has taken place), the recessions inevitably have to be deep and fairly long everywhere.

The range of measured GDP falls is nevertheless quite wide, from about 17% in Poland to about 50% in parts of Central Europe and the FSU. The recession appears to be deeper whenever; the initial price distortions are larger, the price liberalisation is faster, the private sector is smaller, the defence sector is larger and the intra-CMEA trade accounts for a larger proportion of GDP. Price liberalization contributes to recession by virtue of the fact that it leads to prices increasing much faster than wages and other income. This results in large falls of real purchasing power. The falls, however, are necessary in order to eliminate the forced buying of goods (forced substitution) so that the market mechanism can begin to function. Price liberalization results also in changed relative prices which require large changes in the entire product composition of the supply side. Owing to the presence of various rigidities, substantial resources become permanently useless or idle until redeployed and/or improved to produce the goods which, under new prices and new trade links, are in demand and profitable.

The immediate implication of this interpretation of output falls is that post-reform sustainable supplies should form J-curve patterns. The further implication is that macroeconomic policies of the authorities must 3 not attempt to regain the earlier levels of real aggregate demand. That demand must be allowed to fall to the level of much reduced aggregate supply. In other words, the essentially structural causes of these recessions imply that they cannot be reversed in a Keynesian way through an expansion of nominal aggregate demand. By far the dominant, if not the only, effects of any such expansion are higher prices and/or higher net imports.

The experience also shows that the needed supply-side adjustments take place much faster in the private sector than in the state sector.

Consequently, the size of the private sector at the start of the transition appears to be the single most important factor influencing the size of initial output fall and the speed of subsequent recovery.

3. Money Has Been the Key Nominal Anchor In most countries of Central and Eastern Europe it was assumed that stabilization of the liberalised prices must be based on the standard International Monetary Fund (IMF) approach with an important role for nominal anchors assigned to a tough incomes policy and a fixed exchange rate, in addition to a restrictive monetary policy. However, the money supply has emerged to be by far the dominant nominal anchor with the exchange rate and the incomes policy playing no role or only supportive roles. With respect to the exchange rate there were good reasons, such as low levels of international reserves and poor credibility of macroeconomic policies, why large up-front devaluations were necessary. But the immediate consequence of such devaluations was that large gaps opened up between domestic and world prices for tradables, so that, initially, world prices offered little discipline on domestic prices. The other potential anchor, an incomes policy, was intended to help to achieve a given inflation rate with a less restrictive monetary policy and hence a possibly smaller recession. However, given the large risks and uncertainties, it has proved difficult to coordinate the anchor role of the two policies, incomes and monetary. In Poland in 1990 and Czecho-Slovakia in 1991, for instance, monetary policies were initially so restrictive that incomes policies were not binding in most enterprises. In the FSU the authorities took the view that a really restrictive incomes policy could not be implemented for political reasons. Moreover, in Russia the politically dependent Central 4 Bank became excessively concerned with the level of economic activity, typically the domain of governments. A wage-price inflationary spiral was the consequence.

In the pursuit of a proper monetary policy, the experience has been that credit limits can be used successfully by the Central Bank, especially in the initial few years of the transition. Consequently, the real interest rates need not be positive to begin with but they should not be strongly negative as they have been in most of the FSU. However, the rates may have to be strongly positive in the intermediate stage of transition when credit limits are lifted and the real exchange rate has had time to appreciate.

In that stage the interest rate becomes the key policy instrument to protect international reserves, induce savings and restrain wage inflation.

4. The Exchange Rate Policy A large upfront devaluation at a unified rate has proved to be an effective policy during the vital initial phase to protect domestic producers and to replenish international reserves. Consequently, internal convertibility was achieved in many countries and has been successfully maintained. However, it is important not to overburden the exchange rate with its role as a nominal anchor in the later stages of transition. The Polish experience suggests that the policy of a pre-announced crawling peg is a very good follow-up, provided the switch to it from the fixed rate regime is not unduly delayed.

5. The Public Finance Crisis and the Fiscal Policy In all transition countries, with the notable exception of Hungary, budget deficits are financed almost wholly by bank credit. Moreover, the velocity of money circulation tends to be high, especially in those countries which are experiencing or have recently experienced a hyperinflation. The combination of the two features is that budget deficits are highly inflationary. An independent role for Central Banks and their monetary policies is fairly limited. Yet all transition countries, with the notable exception so far of the Czech Republic, appear to suffer from a crisis of public finance. Therefore the political will and administrative ability to control a budget deficit effectively determines the success or failure of a stabilisation programme. Some countries, notably Hungary and Poland, 5 have already accumulated a large public debt. In these countries the rapidly rising cost of servicing the debt and above all the high and rising social transfers are the two categories of public expenditures which together are emerging as posing the greatest threat to macroeconomic stability.

6. Mr Klaus' Ten Commandments In his address to the Group of Thirty at its Spring 1993 Plenary meeting in Vienna, Mr Klaus, the present Prime Minister of the Czech Republic, summarised his experiences as a major reformer in the form of Ten Commandments for what he calls profound, fundamental, structural reforms. Let me remind you of these Commandments and comment on

them. They are as follows:

Reforms in post-communist countries are the outcome of a (i) complex social and political process and therefore cannot be pre-planned or socially-engineered by any one person or centre.

–  –  –

Dramatic actions are required to impose a restrictive (iv) macroeconomic policy, liberalise prices and foreign trade, and establish a process for privatisation.

(v) Restrictive macroeconomic policy must be sustained.

(vi) The price shock resulting from price liberalisation must be vigorously defended and survived.

(vii) Economic restructuring requires comprehensive privatisation.

(viii) Transformation costs must be widely shared.

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