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Economic reform in Eastern Europe and the U.S.S.R.

Economic Reform in Eastern Europe and the U.S.S.R.

Stanley Fischer

The NBER's research on economic reform in Eastern Europe and the U.S.S.R. is part of its overall project on "The Economics of National Security." Research Associate Olivier J. Blanchard of MIT directs the work on the macroeconomics of stabilization, while Research Associates Kenneth A. Froot of MIT and Jeffrey D. Sachs of Harvard oversee the research on the structural elements of economic reform.

There are no historical examples of economic reform as broad and rapid as what is now envisaged in Eastern Europe. In analyzing the reform processes there and in the Soviet Union, we have had to draw on both theory and the partial reform experiences of other economies. The extent to which simple theory - for example, supply and demand analysis, and intermediate macroeconomics - can illuminate the experiences of the formerly socialist East European economies is impressive. The precedents come from reform attempts in the developing countries, from the reform programs in China, Hungary, and Yugoslavia, and from the industrialized economies, including Britain with its privatization program. However, there is always the question of whether different methods are needed for systemwide reform - such as the privatization of all industry - than for more modest reforms that have been attempted within a market economy.

Now, roughly two years after serious systemwide reforms became a realistic prospect, the early and tentative lessons are beginning to come in.

The Problem

The problem in all the reforming countries is how to transform into a modern western market economy an economy with massive, and sometimes near total, state ownership, which relies to a considerable extent on central planning and pursues international trade on a quasi-barter basis at prices that differ grossly from those in the rest of the world. The social cost must be as low as possible. While there has been much discussion of which is the best western model, the formerly socialist economies have a way to go before having to choose the West German, or the U.S., or some other model.

The reforming economies started from different points. Some, such as Hungary and Yugoslavia, were significantly decentralized; the extent of public ownership differed; and some, such as Poland and the Soviet Union, had developed massive macroeconomic imbalances, visible in large budget deficits and inflation. These differences affect their reform strategies.

The Challenge

Two years ago, the reform process posed several key policy and intellectual challenges: 1) How to shift from a severely distorted price system to a reasonably rational one. 2) How to create functioning markets to replace the planning system. 3) How to privatize. 4) Would it be possible to use the usual macroeconomic methods to stabilize socialist economies? 5) Does reform have to await the creation of a viable banking system? 6) How rapidly can reforms take place?

Tentative Answers

Price Reform

The rational price system for a country that wants to integrate into the world economy is world (relative) prices. World prices can be imported through a convertible currency, with low and uniform tariffs. With current account convertibility, imports are available at world prices, and exporters can earn world prices for their products. Then, given the exchange rate, international competition forces domestic producers to sell at world prices and, by allowing domestic producers to sell abroad, ensures that goods will not be sold in the domestic market below world prices.

Thus, price reform does not require an elaborate process of decontrol in which economic policymakers try to guide prices to the proper levels - the process can be left to the international markets. The early evidence also suggests that price reform can take place rapidly. Convertibility can be put in place at the start of the reform process, as it was in Poland, at an exchange rate that is consistent with balance-of-payments equilibrium. And, most domestic prices also can be freed up at the start of the reform program.

Of course, there are some qualifications. Not all goods are traded internationally. In those cases, domestic prices can be expected to reach rational levels through competition. Public utilities and other quasi-natural monopolies usually have regulated prices, even in market economies. Finally, for certain basic inputs whose prices are far from world levels, such as energy in most of the reforming economies, a very rapid transition to world prices could produce widespread bankruptcies, thereby complicating the reform process. Moving the prices of such goods to world levels gradually, over a sufficiently short period (say two to three years) that there is no question that the shift will take place, might soften the shock.

The Creation of Markets

Markets are not created independently of price reform. They emerge as prices that are freed to move and guide the allocation of resources. Privatization of transportation (for example, by selling state-owned trucks) and retail trade is likely to contribute to the efficiency of the markets through which food and other commodities are sold.

Ownership Transformation

Privatization is at the heart of the transformation process. A similar basic strategy is being followed in all countries: to privatize the smallest firms, such as restaurants and small retail shops, very rapidly, typically through sale or lease to employees, but to proceed more slowly with larger firms. In most countries, small- and medium-scale enterprises are being privatized on a pragmatic and eclectic basis, with current employees proposing schemes that are approved by a state property agency. These may involve sales to foreigners, or to the employees, or to any other purchaser.

There are two approaches to the privatization of the largest industrial firms, which account for over half of industrial output. There are 500 such firms in Poland, and 5000 in the Soviet Union. Voucher schemes, which will make it possible for citizens to buy shares in firms or in mutual funds, are being implemented in Poland and Czechoslovakia. The vouchers are distributed to citizens, who then can use them to buy shares. An alternative approach is being followed in Hungary, where the view is that property should not be given away. Accordingly, all firms will be sold for money, rather than vouchers. This has the advantage of raising revenue, either for firms or the state; the voucher schemes, when implemented, will result in large-scale and rapid change of ownership.

Macroeconomic Stabilization

Before the stabilization programs in Eastern Europe, it was sometimes argued that the labor-managed firms would not react in the usual way to tightening fiscal and monetary policy. However, balanced budgets and tight credit do reduce demand and can slow inflation. Because money markets are absent, though, direct credit targets for individual banks are needed to control the overall growth of credit.

Macroeconomic stabilization generally has involved three additional elements. First, a fixed exchange rate provides a nominal anchor for the price level. Second, because unemployment was unknown in the socialist economies, an emergency social safety net has been put in place to deal with workers who become unemployed during the reform process. Third, because worker-owners may permit excessive wage increases, countries have imposed taxes on wage increases above some norm. There is a trade-off between the needs of stabilization and those of the efficient allocation of labor, which has to await privatization anyway.

The Role of Banks

Most banks in the reforming economies are bankrupt. Bankrupt and near-bankrupt banks tend to take excessive risks, so balance sheets will need restructuring before banks will be able to finance industry successfully. Restructuring is a time-consuming process, particularly where the economy is in a state of flux. Therefore, the question of how firms are to be financed in the interim arises. New, well-capitalized banks, including foreign banks, could contribute to the financing of industry; so could separate, private sector departments within existing banks. The implementation of reform does not have to await the development of a viable banking system, but the absence of banks and financing will make the process more difficult.

The reforming countries all are fascinated by the development of stock exchanges and other more sophisticated financial markets. While stock exchanges will have a role in privatization schemes, they cannot be expected to play a big part in allocating resources until more information about emerging firms becomes available.

The Speed of Reform

In Eastern Europe, especially in Poland, changes have been put in place remarkably rapidly. The implementation of the reforms that have already been put in place will take many years. But one recent lesson is that rapid decisions on reform on several broad fronts can be taken, and put into law, far more quickly than was generally believed two years ago.

While it is still too early to appraise the costs of the reform process, it is essential in considering those costs to ask, "Compared to what?" The choice to reform has been made; the next choice is the pace of reform. The appropriate question is whether gradual and partial reforms would have been less costly than rapid, comprehensive reforms. We do not know the answer definitively, but the evidence points increasingly in the direction of more rapid and comprehensive reforms.
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Title Annotation:National Bureau of Economic Research's Annual Research Conference - I
Author:Fischer, Stanley
Publication:NBER Reporter
Date:Jun 22, 1991
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