Introduction to Transition Economics

I. Economics of Transition• The demise of communism in Central and Eastern Europe (CEE)

ushered in a new phenomenon in economics, transition. – The break up of the Soviet Union in 1991 was, in a sense a twofold event.

• The country that was the USSR broke into successor states, such us the Russian federation and Ukraine.

• The Soviet Union lost its political control over many neighboring countries across CEE and the Baltic states.

• The econ transition brought increased political freedom but also econ and social depression.– The degree of econ and political freedom in the Soviet successor states was

quite low in the late 1980s. By the mid 1990s, these states enjoyed perhaps two-thirds of the political freedom of the developed, democratic nations of the world.

– The nations of the former SU and CEE entered a deep depression in the early 1990s. Econ growth started again in EE by 1994 and in Russia around 1998 and has increased rapidly since.

• This is an unprecedented process as no economy has ever moved from a comprehensively controlled economy to a market economy

•The Economist (March 24-30, 1990: 22) “Hundreds of books have been written on the transition from capitalism to communism but not the other way. There is no known recipe for unmaking an omelet.”

•The key problem is the difficult environment in which the new institutions must take root.

•In transition we are analyzing how one system transforms into another we need to understand what institutions are needed to become market economies.

•Transition has brought significant changes in the lives of the citizens•Rise in the standards of living•Demographic changes

•Transition is not the simple process

II. Why Study Transition?

1. Transition and development

• Transition is very different from development. Development is the process of turning a less complex organism into a more complex one. Transition can be likened to changing the organism from one type to another. Transition thus involves the study of the creation of markets; hence, it should be of interest to all economists.

• Institutions are precisely what transition economies lack.

2. Politics and Transition

• The end of communism is a political, as well as econ transformation.

• The collapse of communism led to political transformations as democracies replaced totalitarian political systems.

• developing democracy is thus as important in many countries as the creation of markets.

III. The Nature of TransitionTransition is the replacement of one ES with another ES.

1) The Evolutionary View• A central feature of transition is to build market-institutions—

legal system, private property, financial system, etc.

2) The Importance of the Historical Legacy• We are studying the transition from a particular system. The

historical legacy is crucial. The most important of these legacies is: – An industrial structure designed for a command economy; one that is

dominated by large industrial enterprises that are destructive of value (i.e., produce negative value added);

– The absence of property rights, dictatorship.

• Although transition economies share a common legacy, there are important differences.

3) Main explanatory forces in modeling transition are:• Initial conditions, prevailing at the onset of transition• Policy measures, chosen during transition (degree of liberalization)• Environmental factors-resource base, level of development

Initial Conditions:– Two waves of transition– Countries differ in the length of socialist period (Former Soviet republics,

some 70 years). – CEE were generally much smaller and homogeneous in many dimensions, &

were located in geographic proximity to West Europe– Soviet republics (Estonia, Latvia, Lithuania, Ukraine) vs separate members

of Warsaw Pact (e.g. Poland, Hungary) – Different per capita income – Differences in economic development-useful index is the percent of the labor

force in agriculture versus heavy industry– Different trade experience (countries had been largely isolated from world

competitive forces; Hungary and Poland more open economies)– Different resource bases– Degree of distortion in command economy:

• Deviations from market patterns of resource allocation– The plan was used to allocate resources.

• priority allocation based on ideology• Biases in favor of industry

– Soviet industrial enterprises were large, capital-intensive– Industry as a source of GDP is higher than in mkt economies

• Emphasis on investment at the expense of consumption • Allocation of labor distorted by rules against dismissal and state budgeting • Regional preferences for resource allocation (e.g. Soviet preference for

developing Siberia)• Foreign trade distorted by state trading organizations • Existence of large "shadow" economy

– Evidence suggests larger in Russia and FSU• Artificially high levels of employment• Countries had been largely isolated from world competitive forces.

Distortions growing out of economic isolation were:– distorted trade patterns– lack of foreign technological advances– isolation from democratic ideas– isolation from Western democratic institutions.

Why the initial conditions matter? • As markets are introduced, we expect allocation patterns to revert

to more “normal” patterns that resemble long-term market outcomes. The more serious the distortions are, the greater the distance that an economy must travel to reach market dimensions, therefore the more difficult the transition process will be.

Can the effects of initial conditions and thus distortions be measured?

• To measure a country’s “initial condition” an “initial condition” index developed by European Bank of Reconstruction and Development (EBRD) is used –the index is “derived from factor analysis and represents a weighted average of measures of the level of development, trade dependence on CMEA (Council for Mutual econ Assistance), macroeconomic disequilibria, distance to the EU, natural resource endowments, market memory and state capacity.”

Common Features of transition economies at the beginning of transition

• Dominated by state ownership prior to transition; – small private sector share—FSU <10%, CEE <20%.

• Foreign trade was controlled by the state

• High level of secondary school enrollment; unlike developing countries, transition econ invested rather highly in education.

• A critical feature of transition is the decline in output—since 1990 typical pattern is the ‘J curve’, the pattern of severe economic collapse followed by recovery;

• The significant increase in inflation accompanied liberalization in transition economies.

4. Transition Policies

a) Important question about transition is the speed of transition —should the economy be transformed rapidly, or should there be a more gradual adjustment to the new system.

– Big bang (shock therapy)• strategy that involves moving quickly to eliminate the old order and to

replace it with new organizational and policy arrangements, i.e. markets; transition policies could be implemented rapidly.

• all at once and painful

– causes immediate, sharp economic collapse

– get it over with before it can be undone

» The window of opportunity for reform must be exploited

• It was often thought that markets would naturally emerge from decentralization as the state exited from its former dominant role.

• Poland, other Central European countries (Hungary, Czech, Slovenia, Slovakia) chose the big band strategy

– slow and steady (gradual or evolutionary approach)-- emphasizes complexity of organizations; process of learning and adaptation required.

• This approach drew on the analogy of how mkts and related organizational arrangements and policies emerged in Western industrialized economies, typically over extended periods of time.

• spread out and less painful

– avoids collapse, in principle

– takes longer

• The gradual approach believe that institutional change is path-dependent. Organizations are viewed as complex hierarchies within which participants pursue objectives while guided by incentives but subject to bounded rationality. “Bounded rationality” refers to the limits of information; the limits faced by decision makers and personal limitations (inadequate education).

• Hierarchy is an architecture in which there are superiors and subordinates. To an economist the hierarchical structure of an organization implies the principal-agent problem.

• Organizational change is sequential, path-dependent and evolutionary through a process of organizational learning and adaptation.

b) Important question in transition is also the sequencing of specific reforms —the order in which reforms should be introduced.

– where to begin (in what sectors?); where to privatize;• liberalization of prices (when?, some or all?); safety net

– Importance of sequencing and complementarities, e.g. financial markets must be developed as firms are privatized and required to raise capital.

– The notion of gradual reform implies that there is a proper sequence in which reforms must be implemented. Some reforms must be first, whereas the notion of big bang is that all, or at least several, components, must be implemented at once.

– Major steps necessary for the transition to a market economy:• Privatization• Creation of property rights• Price liberalization• External liberalization• Hardening budget constraint• Creation of financial markets

– Some of the steps in transition are mutually dependant, e.g. privatization and price liberalization. Some aspects of transition are most dependant on successful implementation of other steps, e.g. external liberalization and price liberalization.

c) Transition stages:

• To decide on a particular transition strategy, it was necessary to stabilize the economy and try to limit the decline of econ activity.

• The legislative base of transition began to evolve early 1990’s.

• Implementing of new policies toward market institutions, arrangements and outcomes.

5. The framework of transition—traditionally the econ literature on transition is translated into 4 major dimensions:

a) Microeconomics of transition, which includes the process of – creation of markets and associated price signals

• product markets– Mkts in which firms sell products and services to hhlds

• factor markets– Mkts in which resources( capital, land, labor) are sold to firms

• Prices must be allowed to fluctuate in response to changes in dd and ss. The rewards and penalties of the price system must be allowed to encourage and motivate decision-makers

– Privatization• Countries have used different schemes in order to privatize SOE

– The establishment of property rights– The process of privatization and development of factor and product markets—

involves changing the nature of property rights. – A major difficulty in the privatization of enterprises in the transition economies

has been:• the existence of large state subsidies in many instances• the problem of valuing enterprise assets• the absence of well-developed capital markets

– Restructuring is frequently defined as changes which take place in an enterprise after formal privatization has been completed to achieve efficiency objective.

b) The development of the macro economy (both institutions and policies).

• creation of monetary-financial system• financial markets (regulatory agencies)

• central bank/monetary authority (monetary policy)

• The macroeconomics of transition focuses on the state budgetary process• revenues and expenditures

• tax structure

• budgetary process

The process through which gov’t expenditures are determined and allocated

• Most economists have argued that stabilization is important, especially during the initial stages of the transition, ending the decline of the economies. Rather that focusing on longer term issues such as econ growth, in this context stabilization can refer to monetary health of the economy, e.g. inflationary pressures.

• Normalization refers to the development of financial markets for financial

intermediaries and the budgetary process and the banking system.– These issues in transition are especially important b/c financial institutions had

limited influence on resource allocation before.

c) International trade and finance policies

• elimination of state trade monopoly

• Introduction of convertibility of currency and the implementation of an exchange regime capable of sustaining a reasonable foreign & domestic balance.

d) Safety-net issues—the concept of a safety net refers to changes in pensions, medical benefits, benefits for the elderly, unemployed etc

6. The Legal System must be broadly obeyed and generate a climate of trust. The legal system creates private property and defines the rules of econ transactions.

a) Property law must be developed—set of rights• rights to income from the use of property• rights of transferability (sell, rent)• rights of control (exercise of decision making)

b) Contract law—framework within which parties can legally enter into contractual relationships– protection of vulnerable parties (consumers, tenants)

c) Bankruptcy law• controls how businesses can close down and distribute their assets and pay

their liabilitiesd) Anti-monopoly laws—prevent anti-competitive practices e) Securities law—regulates sale of stocks and bonds to public

– regulatory body to prevent fraud and ensure full disclosuref) Intellectual property law—patents, trademarks, copyrightsg) Labor laws—defines rights and obligations of employers and employees

7. Assessing transition patterns-growth index models

To understand how we might assess the patterns of performance exhibited by different transition econ, we will use two illustrative approaches for transition economies.

a) Simple model of transition economy• Let’s assume that the performance of transition economies is determined by

just one variable: liberalization (Lib) (typical index to capture systematic change)

Gri=f(Libi)

Gri—an index of growth, 1989-1999, 1989=100

Libi—an index of liberalization is compounded from consideration of price liberalization (ending price controls) and trade and foreign exchange liberalization (current account convertibility, end of export control and taxes)

Rather than estimating, Scatter diagram

• Greater liberalization—higher positive number

b) More complex model of transition economy

• Gri=f(ICi, Libi, Envi)

• ICi—an index measuring initial conditions

• Envi—a measure of environmental factors

• Econometrically estimate this relation:– Expect better IC (less distortions) would make the transition easier

(positive relation)

– Expect positive relation with Liberalization

– Less clear

Therefore, transition experiences differ according to:

• the level of economic development

• environmental factors

• distortions left behind

8. Problems of specification and estimation• specification• endogenity• time lags• selecting the dependent variables

9. Empirical evidence• debate about what dependent variable or measure of the

outcome of performance is appropriate (growth, unemployment rate, inflation)

• attempt to capture the impacts of systematic change-the typical index to capture systematic change has been liberalization

• serious econometric issues• data in transition –measurement problems

– different data series from west– changes in basic indicators– qualitative differences– “non standardized” components—shadow economy