Practitioners in Development Lecture Series PREM/DEC/WBI

18 November 2003, Washington

A Comment on Leszek Balcerowicz:Post-communist Transition in

Comparative Perspective

D. Mario NUTIUniversity of Rome La Sapienza, and CNEM,

London Business School

Leszek Balcerowicz has presented an exceptionally idealised vision of transition: – He neglects over forty years of economic reforms

– He ignores the deep and protracted transition recession, its true extent and its causes.

– He dismisses the outliers, like Belarus and Uzbekistan

– The faster and deeper are liberalisation, stabilisation and privatisation, the faster are recovery and growth.

– All is well in the best of all possible worlds.

Balcerowicz does not say anything at all abut his own role in the transition and in the associated recession in Poland – as Polish Finance Minister in 1989-91, then again in 1998-2000, and about his role as Governor of the National Bank of Poland, from end 2002 to date.

In particular, he makes no mention at all of monetary policy, interest rates, coordination of monetary and fiscal policy.

This Lecture Series is supposed to provide “a reality check”, by practitioners who would draw on “their experiences, their tragedies and triumphs” and would assess the validity of advice and actions of the Bretton Woods institutions (John Page, 22-10-2003).

Balcerowicz talks only of triumphs, and not even only his own. I look forward to his enlightening us with his experience.

In my comment I will try to qualify and supplement his vision, looking at “realised” or “really existing” transition, which is the critical label attached by Rudolf Bahro (1977) to Soviet-type socialism.

I will touch upon a limited range of points:

1. The legacy of the old system 2. The transition recession 3. The outliers: Belarus and Uzbekistan 4. The quality of economic policies 5. Examples of poor policies 6. Comparative governments in the same country 7. The performance of Central Bank Independence

1. The legacy of the old system

The old system described by Leszek Balcerowicz has very little in common with the system inherited by Minister Balcerowicz in 1989. To some extent the old system was worse than he portrays, in the dependance of state enterprises from sectoral Ministries, the segmentation of monetary circulation, overvalued and inconsistent exchange rates; symbolic interest rates and above all endemic excess demand, deeper and on a larger scale than illustrated by Balcerowicz.

But in many central eastern European economies there were many repeated attempts at radical reforms. In Poland they mushroomed in 1980-81, when at least seven alternative projects were publicly debated – one of which authored by Leszek Balcerowicz and his team at SGPiS.

In the system taken over by Balcerowicz in 1989, for instance: - The private sector was a third of GDP, not only in agriculture

and services but also in manufacturing; - Monetary circulation was unified and managed by the National

Bank, independent (1987) and surrounded by commercial banks; - Exporters retained foreign exchange earnings, could transfer

them to other firms, currency was auctioned by the central bank; - The former black market for foreign exchange had been

legalised (February 1989); -  A third of transactions took place at market clearing prices.

While these features did not add up to a new system they immensely facilitated the Polish transition. Comparative transition performance depends very significantly from the extent of previous reforms.

Depth of the transition recession

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I nflation in the Transition Economies

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2. The transition recession

By looking at the GDP level in 1989 and 2002, Balcerowicz loses sight of the time pattern of the transition recession in the intervening years, its depth and duration. (The same happens with his presentation of life expectancy data)

The depth of recession may have been distorted by the change in statistical procedures and conventions. According to Bob Mundell (1997) the transition recession was greater than that of 1929, as bad as that caused by the Black Death, which at least preserved living standards by reducing both population and income.

Balcerowicz for one did not expect it on the scale that it occurred (see his “My 800 days”).

Discussions have exaggerated the possible role of shock therapy or gradualism as a cause of recession – either way.  The shock of raising prices to market clearing levels at a stroke was absolutely essential – even to make the old system work. Many other things also had to be done instantaneously: legalising private property and enterprise, giving free access to foreign trade to all agents, eliminating quantitative trade restrictions, unifying exchange rates and allowing current account convertibility. All these changes can and should be done at a stroke.  Many other changes take time and must be allowed all the time they need: introducing legislation, establishing jurisprudence, setting up financial markets, establishing reputation and trust. It is pointless, indeed counter-productive, to pretend otherwise.

A choice between “shock therapy” or “gradualism” exists only in a handful of areas:

(1) trade liberalisation, (2) the elimination of subsidies, (3) privatisation, (4) capital account convertibility and, especially, (5) dis-inflation.

Here relative merits of speed and delay depend on the actual trade-offs between targets at a particular time and place, and on government preferences. Here gradualism may have net advantages. There were benefits from Polish slow dis-inflation, its late mass privatisation, its delay in capital account convertibility; Czechoslovak maintenance of price and wage subsidies. Conversely, Polish and Czechoslovak rush to liberalisation, soon reversed, only gave two unnecessary jolts to their economies.

Partly, the recession was caused by the disintegration of trade and currency areas: Comecon, the USSR, Czechoslovakia, Yugoslavia; to some extent this was self-inflicted.

Partly, the recession was caused by systemic vacuum, with the loss of planning institutions before the appearance of market ones, and the ensuing “disorganisation” and “chaos” (Blanchard, 2000).

Above all the recession was due to policy errors, by the wrong instruments or the wrong dosage of instruments and policies, in particular overshooting. Before considering the quality of policies, however, it is useful to look at two countries where both transition progress and transition recession were particularly mild.

3. The outliers: Belarus and Uzbekistan

Belarus and Uzbekistan are lagging behind very significantly in their progress towards a market economy and a pluralist democracy. Indeed they may be regarded as non-starters rather than laggards. Yet their economies have avoided much of the transition recession.

They are neither a statistical delusion as suggested by Balcerowicz, nor a desirable alternative, but are a feasible version of command economy – as long as they avoid endemic shortages and have access to cheap natural resources, whether through production (Uzbekistan) or gift (from Russia in Belarus). But either one or the other will not be sustainable, Belarus if oil prices increase (as Russia is beginning to do), Uzbekistan if they fall.

4. The quality of policies

Leszek Balcerowicz mentions the quality of policies, by which he means whether or not a country has liberalised, stabilised and privatised, according to some quantitative index.

This approach neglects two major factors in explaining comparative performance: the choice of instruments and their quantitative strength.

For instance, what matters is not the share of privatised state enterprises, but the mode of privatisation, the revenue collected, the impact on distribution, implications for governance, for the injections of new capital, management and technology.

5. Examples of poor policies

Poor policies are exemplified first of all by over-shooting, as in both of Balcerowicz’s terms as Minister of Finance; and in his inflation targeting while Governor of the National Bank of Poland.Other examples are:- Excessively high interest rates (Russia 1994, Poland to date)- Non sustainable exchange rate policies (Czech Republic 1997, Russia 1998)- cash limits on government budgets (Russia mid-1990s) - over enthusiastic trade liberalisation and its reversals (Poland in 1990-93, Czechoslovakia.- Neglect of implications of alternative modes of privatisationIn all these areas the Bretton Woods institutions also bear some responsibility.

Real Interest Rates

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In mid-February 1990 I visited Warsaw on an official mission for the European Commission, where I was an economic adviser on eastern European affairs. I told Leszek Balcerowicz that he had overshot. He was running an unintended budgetary surplus, a much tighter monetary policy than announced, a balance of payments surplus due to excessive devaluation, foreign reserves were being built up and had to be expensively sterilised. Balcerowicz admitted it, but claimed that there was nothing he could do because if he changed anything he would lose credibility and the public would believe that stabilisation and reform were being scrapped.  The tasks confronting Balcerowicz and his team at the beginning of transition and stabilisation were daunting; they were navigating in uncharted waters. But one does not need hindsight to see that the original programme would have overshot.

On 1-1-1990 the exchange rate was fixed at the former free rate, clearly higher than in a unified foreign exchange market. This was inflationary. Money targets were fixed in nominal terms embodying an under-estimated prospective inflation, thus leading to an unintended credit crunch. Real wages, indexed with extremely low elasticities with respect to prices, took the brunt of macroeconomic adjustment; they collapsed and so depressed demand. Investment was out of the question. Disorganisation was rampant, and recession set in.

Imagine an alternative scenario, in which not only prices but also wages are freed, or a lower and affordable real wage is indexed at 100% instead of the entire current level being indexed at only 10% of inflation. Money targets are constant in real terms; the exchange rate is floated – and thus devalued significantly less.

Money interest rates are adjusted more frequently, rising and falling with inflation but more slowly, without targeting intermittently a positive real rate. Under this set of policies overshooting, if any, would have been less severe.

6. Comparative governments in the same country

Comparative transition analysis should include the comparison of policies by different governments in the same country. See for instance Poland’s economic performance in 1989-93, under Balcerowicz Mk-I and the whole first legislature, the period 1994-97 of Grzegorz Kolodko’s “Strategy for Poland”, and the 1998-2001 “cooling” period of Balcerowicz Mk-II .

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7. Central Bank Independence in the transition

CBI is a fairly recent invention, dating from the 1980s. It is the child of rational expectations theory and the vertical Phillips Curve, and concern for the credibility of monetary policy (see Kindland-Prescott 1977 on time inconsistency of discretionary monetary policies, Barro-Grossman 1983 on reputation building, Rogoff 1985 on the conservative independent central banker)..

Transition economies have implemented – also due to international pressure – the German model rather than the milder British, Japanese or even US model of CBI, and in an even stronger version (Alex Cukiererman et al., 2002). This model has not always performed well in the transition:

- some central bank governors look independent but are not (Belarus)     - other central bank governors are truly independent from the government but are not exactly politically independent technicians; Leszek Balcerowicz was the leader of Freedom Union, a political party defeated in parliamentary elections  - some independent central bankers have pursued policies manifestly contrary to the pursuit of price stability: (Russia 1992);

 - real interest rates have been pushed to inordinately high levels (Russia 1994, Poland, etc.), with respect to the requirements of domestic and external balance;

- Inflation targets have been treated not as something to hit but to overfulfill, as if they were central planning targets, and without adjusting accordingly nominal interest rates (compare the Czech and the Polish central banks in 2002) - The most important issue is that of fiscal-monetary coordination. Failure to coordinate leads to higher fiscal deficits, higher interest rates and stronger exchange rates, thus adversely affecting output, exports and therefore employment.  - A particular issue of such fiscal-monetary coordination in Poland in 2003 is the possible mobilisation of $7bn reserves (out of a total of about $32bn) or about 3.5% of GDP, representing unrealised profits from the purchase of foreign currency at exchange rates stronger than the current rate.

CONCLUSION President George Bush senior said, on the transition (after Yogi Berre):  “No-one said it was going to be easy… and no-one was right”. Actually, some people were more right than others. There were different ways of navigating the previously uncharted waters of the transition. Some were or would have been better than others. We knew it or should have known it then without the benefit of hindsight, we should know it now. I look forward to the contribution that undoubtedly Balcerowicz can make to our understanding.