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The economic transformation of Eastern Europe: the case of Poland - comment.

In a recent article for The American Economist, Jeffrey Sachs (1992) provides a review of Poland's economic reform and prospects for the future. In this article, Sachs argues that despite some shortcomings, the comprehensive economic reform package introduced in 1990 ". . . has had a profound beneficial effect on the Policy economy." Both economic theory and empirical evidence, however, suggest that this conclusion is too optimistic. This paper analyzes Sachs' statement in the light of Poland's economic performance during the first three years of transition to capitalism. It focuses on the real economic impact of privatization, free trade policy, and macroeconomic stabilization measures.

In the beginning of January, 1990, the Solidarity-controlled government introduced bold measures to reform the economy. Rather than introduce reforms gradually, the Polish government decided to opt for shock therapy and a rapid pace of market reforms. This program called for a free price system, drastic cuts in subsidies, a free trade policy, convertibility of currency based on a fixed rate of exchange, wage controls, a balanced budget, and elimination of "easy" credit to state enterprises.

Following the Polish example, similar measures have been adopted in many countries of Central and Eastern Europe. The governments of these countries and their economic advisors (both foreign and domestic) share the belief that market forces are powerful enough to do most of the necessary economic restructuring. It is also believed that private property is essential to the process of market development. Convertibility of currency and a free trade policy would allow these economies to replace the artificial price system, based on arbitrary decisions of the central planner, with world prices. This, according to Sachs and Lipton (1990), ". . .would immediately create domestic competition as well as a realistic structure of prices that would mimic that of Western Europe." Privatization, on the other hand, is necessary for the development of "a real competitive market." In short, if prices are freed, the economy privatized, free trade allowed, and subsidies to state enterprises eliminated, the price mechanism and real competition will automatically develop. This will cause the supply effect to emerge and an increase in production (from the same amount of economic resources) will take place. In addition, the price mechanism will generate a competitive environment in which efficient firms will prosper but unprofitable companies will have to cease their operations. The market, guided by an "invisible hand," will do much of the economic restructuring.

In his article, Sachs writes that "Poland has made it more than half-way through the reform process needed to transform itself into a market economy. The price system now works according to supply and demand; international trade is free, and as hoped, both exports and imports are rising, new private firms are forming and growing at a rapid rate." This all has happened indeed, but the cost has been incredibly high, perhaps too high to justify the "shock" approach advocated by Sachs. The first two years of economic reforms in Poland were characterized by a very deep recession.(1) As compared to 1989, GDP fell by almost 20 percent, industrial production by 35 percent, real wages by almost 25 percent, and the official unemployment rate increased from 0 to over 11 percent of the labor force.(2) Investment expenditure, which started to decline in 1989, fell by 10 percent in 1990 and by an additional 4 percent in 1991. The rate of inflation (CPI), which during the period of 1985-1988 was running at an average rate of 28.4 percent a year, reached hyperinflationary levels by the end of 1989; in 1990 the rate of inflation was 586 percent. In 1991, despite harsh anti-inflationary measures administered by the stabilization program, inflation was running at about 70 percent, which was two and a half times the average rate experienced in 1985-88.

These results could easily be anticipated on the grounds of economic theory. The response of the heavily monopolized state sector to the reform measures was a classical textbook example of monopoly reaction to freeing prices and the heavy taxation of inputs. Industrial output decreased while the price level increased. This decrease in industrial production did not result from a series of bankruptcies or massive plant closings, which to some extent could have been attributed to economic restructuring, but from a rational microeconomic response of enterprises to changing macroeconomic conditions. In fact, despite a decrease in 1991 profits, virtually no bankruptcies had occurred.(3) The average profit ratio for enterprises (measured as a ratio of profits to costs) was 29.9 percent in 1990 and 6.9 percent for 1991.

Although state monopolistic and oligopolistic firms faced a more competitive environment (more elastic demand curves as a result of competitive imports), they did not have to increase the level of output [ILLUSTRATION FOR FIGURE 1 OMITTED].(4) This could result from two causes. First, the economic stabilization program, by lifting price controls, allowed state monopolies to charge their equilibrium prices by reducing the quantities sold (movement from point A to B).(5) Second, in addition to a change in their demand structure, state enterprises had to face an extremely stiff progressive tax (with only minimal adjustment for inflation) levied on their wage fund and paid out of profits.(6) This tax significantly distorted the cost structure of state enterprises and increased variable costs of production, which shifted up both average and marginal costs. These two effects combined resulted in smaller quantities of output supplied by state monopolies despite higher prices for their products and increased competition from abroad. The market forces were too weak to affect the industry structure and to remove existing barriers to entry. Consequently, the new equilibrium point for the enterprise (C) shifted even further to the left.

In spite of Sachs' optimism, the list of positive developments in 1990 was relatively short: elimination of lines of customers queuing in front the stores to purchase scarce goods, a balanced budget, and a $3.8 billion foreign trade surplus. In 1991, despite high expectations, the performance of the Polish economy was quite disappointing. For example, it was assumed that in 1991 the rate of real GDP growth would exceed 12%. Instead, the level of GDP fell by 7.6%. Meanwhile, economic recession had a negative effect on the state budget and foreign trade. Both recorded deficits in 1991. The government also expected that an inflow of foreign capital could help revive and modernize the economy. Unfortunately, the amount of foreign direct investment in 1990 and 1991 was only a small fraction of what was projected.(7)

The economic slowdown continued in 1992. Although further decreases in GDP and industrial production have been halted, the overall economic results for 1992 indicate that the economy was still in recession. According to official statistics for 1992 released by the Central Statistical Office (GUS), GDP increased by 1.0 percent, industrial output increased by 2.6 percent, while the unemployment rate soared to 13.6 percent. Real wages in 1992 declined for the third year in a row, this time by 2.7 percent. Inflation in 1992 was still high at 43 percent. Although there were some signs of recovery in 1993 with estimated GDP growth of 3-4 percent, it is too early to tell whether this increase (after a 19 percent decline in output in 1990-91) signals the beginning of robust economic growth since several key economic indicators showed considerable weakness. For example, the unemployment rate had increased steadily to almost 16 percent at the end of 1993, and the rate of inflation of 38 percent was the highest in Central Europe. Despite the acute shortage of housing, residential construction in 1992 was 30 percent lower than in 1988 and falling further. In 1993, the number of housing starts, which includes apartments and single family homes, decreased by an additional 40 percent from the 1992 level.(8)

With a shrinking economy, government revenues (despite levying new stiff income and corporate taxes) fell short of projections resulting in a budget deficit in of 6.1 percent 1992. The budget deficit is expected to remain at 5 to 6 percent in 1993 despite more new taxes including the value-added and border tax which were introduced in July 1993. The deficit reflects the growing cost of a vast system of social benefits, which include free medical care, paid maternity leave, public schools and college education, social security, pension plans, and most recently, unemployment benefits. In the 1992 budget these components accounted for over 56 percent of government expenditures, while in 1993 their share exceeded 60 percent. The deficit also reflects the growing financial cost of privatization. Despite a widespread notion that private ownership leads to an improvement in economic efficiency and profitability (and hence larger tax receipts for the state), the gross rate of return in the private sector was much lower than in the state sector. Although some of that could be explained by tax fraud and illegal accounting practices, higher profitability of state enterprises (3.0 percent vs. 0.0 percent in 1992 and 4.6 percent vs. 1.8 percent in 1993) resulted mainly from lower production costs.(9)

The impact of these macroeconomic stabilization policies can be illustrated on a simple AD-AS diagram [ILLUSTRATION FOR FIGURE 2 OMITTED]. In 1989, the economy experienced repressed inflation (point A). Repressed inflation resulted from the full employment level of output [Y.sub.0] falling short of the macroeconomic equilibrium determined by the intersection of [AD.sub.0] and [AS.sub.0]. The official average price level was [P.sub.0], which reflected government price controls being in effect in early 1989. The long-run supply curve (LRAS) illustrates the constrained level of output, which is typical to socialist planned economies plagued by persistent bottlenecks and imbalances of inputs.

Although the macroeconomic measures, such as freeing prices, included in the reform package were quite successful in reducing demand-pull inflation, they also affected the supply side of the economy by decreasing output in the dominant state sector which responded negatively to taxation of inputs, freeing prices, and cutting subsidies (point B). The decrease in the short-run aggregate supply was magnified by significant external effects, such as the collapse of the Eastern European trading block (CMEA).

In 1991, the government attempted to further reduce inflation by continuing a tight fiscal policy and by committing to a balanced budget. However, the unexpected rise in budget deficits and aggregate consumption in 1991, as well as an easy monetary policy caused aggregate demand to shift from [AD.sub.1] to [AD.sub.2].(10) As a result, the inflationary gap has widened, which kept the annual inflation rate in a 40-50 percent range. In the period 1989-91, the economy moved from repressed inflation (point A) to even higher inflation coupled with a period of severe recession (point C).

Instead of reviving the economy and increasing the supply of consumer goods, the economic stabilization program squeezed both aggregate supply and aggregate demand by reducing the level of real personal income.(11) An increase in consumption spending in 1991 and in 1992, which was financed mainly from savings, borrowings, and transfer payments, failed to stimulate the economy. Instead, it was satisfied almost entirely by imports of consumer goods. Consequently, the distorted economic structure inherited from the old command system and characterized by repressed inflation and under-production of consumer goods has been insulated from the impact of economic reform; quantities of goods supplied decreased not increased, while existing shortages have been filled by foreign imports.(12)

Jeffrey Sachs is correct in stating that liberalization and privatization have created a large number of new enterprises (about 290 thousand in 1991 and 220 thousand in 1992), but a great majority of this increase took place in retail trade. This has also been the area where the largest amount of private wealth was accumulated. Almost all of it came from profiteering of a speculative nature, however. Fortunes have been made by trading in liquor, cigarettes, foreign currencies, and automobiles, which often involved evasion of taxes and custom duties.(13) Most of this money has been spent on consumption of luxury goods imported from abroad, and very little was directed toward new capital formation. The accumulation of wealth by this means did almost nothing to support domestic production.

Another negative aspect of the reform process ignored by Sachs is related to the exchange rate policy. It is true that opening markets to free trade and deep devaluation of the currency caused Polish exports to surge in 1990-91. However, convertibility of currency based on the fixed nominal rate of exchange, which continued until mid-1991 despite hyperinflation, dramatically reduced the amount of domestic financial capital.

The fixed nominal exchange rate advocated by foreign experts caused the purchasing power of the Polish zloty to appreciate about eight times with respect to the U.S. dollar and other major currencies. By exchanging foreign currencies to zloty, depositing money in Polish banks, and later converting this money back to foreign currencies, foreign investors could obtain real interest rates on bank deposits 10-20 times higher than anywhere in the world. Interest payments alone drained over $2.4 billion from currency reserves. This loss of capital was much higher than the inflow of foreign direct investment during the same period. Rapid appreciation of Polish currency quickly reversed export expansion and flooded the country in 1991-93 with cheap imports, which further destabilized the Polish economy.(14) This Polish version of "Dutch disease" is another textbook example of the lack of effectiveness of the stabilization measures.

Although economic reforms were initially embraced with enthusiasm by the Polish society, it now seems that the early euphoria has been retained only by those who advocated the so-called shock therapy approach. It was originally expected that the restrictive fiscal policy could cause a short-term recession (12-18 months) but the fast progress in privatization, inflow of foreign capital, and freeing of prices was to be able to generate positive supply effects. However, none of these elements happened either in 1991 or 1992. The inflow of foreign investment was several times less than expected. Privatization of the state sector instead of increasing economic efficiency and revenues to the government, put additional financial strain on the budget. Also, the supply effect did not materialize primarily due to the fact that the macroeconomic policy measures implemented in Poland did little to stablize the economy.

In his paper, Jeffrey Sachs argues that reforms need patience because they will produce positive results only if they are given enough time to work. This seems strange since the major argument for the shock treatment was that this strategy would generate positive economic results faster than a gradual approach. Given the economic effects of the first four years of rapid changes this argument is questionable. The main problem with the current policies is that they have failed to take into account several constraints which are the consequence of the communist legacy. Among these constraints are: a highly concentrated and outmoded industrial structure, lack of developed financial infrastructure, absence of a sound banking system, specific social infrastructure (i.e., people with their behavior, habits, and work ethic), and a vast net of costly social programs.

These constraints are different from those typical of developing nations and, therefore, should be addressed with a different set of proposed solutions. In the case of Poland and other countries of the region, these problems should be confronted by a comprehensive transition-period policy which focuses upon the following priorities: economic growth, stimulation of investments, economic education of the society, a new approach to privatization, and a clear economic role of government.(15) The purpose of the new economic policy should be to immediately stabilize the economy and secure growth of domestic production and consumption, and at the same time, to gradually remove the barriers to competitive solutions.

The transition period, which could last at least 15-20 years, is required to allow time to create basic market institutions, establish and enforce corporate laws, and develop antitrust legislation. While this may appear quite long by American "immediate results" standards, it is short in comparison to the time it has taken these institutions to become a part of the fabric of life in any of the Western economies Poland would seek to emulate. The transition policies must concentrate on effectively removing the constraints to a free market system rather than promoting quick market solutions which are incapable of producing positive results without such a broad and firm foundation.

Notes

1. Economic data concerning Poland's economic performance in 1990-92 are drawn from Zajicek and Heisler (1993).

2. It can be argued, however, that the unemployment rate of 0% in 1989 reflected the ideological commitment of the communists to full employment without a consideration to economic realities.

3. According to the Central Planning Office only 18 state enterprises, about 0.2% of their total number, started the bankruptcy proceedings in 1990 and 1991.

4. As a result of a more competitive environment (free trade policy), the new flatter demand curve [D.sub.1] represents a decrease in demand for domestically produced goods caused by foreign imports.

5. Although, as a result of output quotas and price limits set by the plan, the actual quantity produced by an enterprise could be less than [Q.sub.0] (i.e., to the left of point A), the level of output of many state-owned enterprises in the late 1980s was no longer controlled by the plan.

6. Private enterprises were exempt from this tax.

7. According to official government statistics, the net amount of foreign direct investments in Poland in 1990-91 was $127 million (Statistical Yearbook 1993, p. 156).

8. Sources: Statistical Yearbook 1993, p. LXXIX, and Statistical Bulletin, December 1993, p. 97.

9. According to Statistical Bulletin, December 1993, p. 27.

10. Easy monetary policy is a primary cause of inflation in Poland. In 1990-92, the stock of money increased 14.3 times while the level of consumer prices increased 16.6 times. The current monetary policy conducted by the National Bank of Poland is quite inconsistent. To stimulate the economy, the bank is committed to maintain a real rate of growth of money supply and, at the same time, it attempts to target interest rates to fight inflation.

11. Real personal income fell by 15% in 1990 and increased by 6% in 1991. This increase in PI in 1991 was attributed to a large (30%) increase in government transfer payments. Statistical Yearbook 1993, p. 197.

12. There are several reasons which could explain a large increase in demand for consumer durables in Poland during the recent period of severe economic recession. One could be an attempt to follow Western consumption patterns by the society which has always been fascinated with the West but deprived of consumer goods for a long period of time. The other one is a shift in consumer portfolio to durable assets as a result of galloping inflation and a sharp decrease in purchasing power of zloty- and dollar-denominated savings.

13. Many articles on this subject could be found in Polish newspapers. One of them named "The Giants of Polish Business" appeared in a popular weekly, Polityka, 4.10.93.

14. Net exports decreased from $3.8 billion in 1990, to -$0.8 billion in 1991, -$2.7 billion in 1992, and almost -$2.8 billion in the first six months of 1993 (Statistical Bulletin, December 1993, p. 117).

15. See Zajicek (1994), for a more detailed discussion of the constraints and proposed solutions.

References

Sachs, Jeffrey, "The Economic Transformation of Eastern Europe: The Case of Poland," The American Economist 36, (Fall 1992), 3-11.

Sachs, Jeffrey and Lipton David, "Poland's Economic Reform," Foreign Affairs (Summer 1990), 47-66.

Zajicek, Edward K., "Can Capitalism Be Built through Shortcuts? Lessons from Poland's Economic Reform," paper presented at the 1993 International Workshop on Post Keynesian Economics, Knoxville, TN. A revised version of this paper appeared in Employment, Growth and Finance, Paul Davidson and Jan A. Kregel, eds., Edward Elgar Publishing Ltd., 1994, 217-233.

Zajicek, Edward K., and Heisler James B., "Privatization or Partition: Economic Reforms in Poland and the Privatization Dilemma," International Journal of Politics, Culture and Society," Vol. 7, 1993, 19-42.

Edward K. Zajicek and James B. Heisler, Department of Economics and Business Administration, Hope College, Holland, MI 49422.
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Title Annotation:comment on article by Jeffrey Sachs, The American Economist, vol. 36, Fall 1992, p. 3
Author:Zajicek, Edward K.; Heisler, James B.
Publication:American Economist
Date:Mar 22, 1995
Words:3376
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