IV Inflation Inertia, Credibility, and Disinflation
Author:
Mr. Peter Doyle
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Mr. Carlo Cottarelli
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Language:
English
Print Publication Date:
23 Aug 1999
Keywords:
OP; inflation environment; inflation stabilization; further disinflation; disinflation threshold; country; inflation inertia; disinflation effort; incomes policy; inflation expectation; Inflation; Disinflation; Baltics; Eastern Europe
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Abstract

The speed of disinflation and the apparent resilience of output in that context are remarkable features of transition economies' disinflation experience, and they are evident in the stabilizations of cases of extreme and more moderate inflation.

The speed of disinflation and the apparent resilience of output in that context are remarkable features of transition economies' disinflation experience, and they are evident in the stabilizations of cases of extreme and more moderate inflation.

This section will suggest that disinflation reflected the implementation of decisive financial policies that curtailed excessive monetary growth, and that the absence of evidence of output costs in this context reflected various combinations of low inflation inertia and policy credibility.8 In the highest inflation cases, inflation uncertainty was reflected in a shortening of the duration of nominal contracts, implying that aggregate price expectations were formed for relatively brief periods. This flexibility reduced output losses during decisive disinflation. In these cases, it was more important that financial policies were adjusted to eliminate the source of inflation than that they were adjusted credibly. But in the cases of less extreme inflation, where the duration of nominal contracts was largely unchanged, inflation inertia remained present. In these cases, policy credibility likely played a greater role in accounting for the low output costs associated with rapid disinflation.

The discussion attempts to identify the factors that facilitated the tightening of monetary policy needed to disinflate the economy, those that account for the evidence of limited output cost during inflation stabilization, and the extent to which these factors also explain the relatively slow disinflation in some countries, particularly during the poststabilization period. It addresses first the context in which disinflation occurred; second, the role played by fiscal policy; third, the role of credibility-enhancing devices; and last, the speed and sequencing of disinflation and structural reform. It concludes that fiscal consolidation and the decision of most authorities to disinflate rapidly were key to the success and the low output cost of these disinflations.

The Context for Disinflation

In many respects, the context for disinflation was more favorable than it might have appeared to be: inflation had not persisted for long; backward indexation was limited; the financial system, though fragile, turned out to be less susceptible to stress from disinflation than feared; and political economy factors favored disinflation in some countries. Further-more, while price liberalization and relative price adjustment initially boosted the price level, they subsequently facilitated disinflation efforts.

Where these circumstances did not hold, disinflation was slower. For example, widespread indexation was a problem in Poland and Slovenia, two of the slow disinflation cases identified in Section II. In Hungary—another slow disinflater—creeping inflation had persisted throughout the 1980s, possibly contributing to the stickiness of inflation expectations lamented by policymakers in that country (Suranyi and Vincze, 1998). Unresolved financial sector problems contributed to the inflation reversal in Albania and Bulgaria. And gradual administered price adjustments slowed down disinflation significantly in some countries (notably in Moldova and Ukraine).

Indexation

Backward indexation implies a lagged response of nominal wages to prices. This raises the output cost of disinflation, thereby reducing its credibility. Formal indexation, however, was exceptional in transition countries, possibly reflecting that while inflation had been violent, it had also been relatively brief, so that indexation had not had time to take root. As a result, even though wages and prices were frequently adjusted in the higher inflation cases, only six countries out of the sample of 25 transition economies ever used backward-looking indexation.9 And one of these (Croatia) abolished indexation at the start of the disinflation program. Even when indexation was present, it did not always increase inflation inertia. Where goods and factor prices were de facto indexed to the exchange rate, such as in Bulgaria, exchange rate stabilization fed directly into the stabilization of domestic prices.

The only two countries where indexation was pervasive are Poland and Slovenia. Both countries are part of the slow disinflation group, and there is evidence that indexation contributed to keeping these countries in the moderate inflation range for an extensive period (Pujol and Griffiths, 1998; and Ross, 1998).

Financial Fragility

The banking sector in all these economies was critically weak in the early stages of transition: two-tier systems and the associated legislative and accounting frameworks were generally in their infancy, and the banks were ill-prepared for a competitive environment, let alone one in which output, relative prices, and the price level were subject to major shocks.

While restructuring to address these problems would have facilitated disinflation by improving the strength, efficiency, and competitiveness of the financial system, it also seemed probable that disinflation would exacerbate financial fragility. This appeared likely to complicate disinflation efforts: the additional call on fiscal resources directly would challenge the fiscal consolidation; the additional calls on central bank refinance could undermine the monetary framework; the commitment to sustain disinflation might be weakened by concerns that increased interest rates could have indiscriminate effects, given poor credit assessment; and higher real interest rates could further undermine credit quality if solvent borrowers who expected to repay disproportionately stopped borrowing. Another potential danger, underscored by Cukierman (1992) with reference to nontransition economies, was that the monetary tightening associated with disinflation might be accompanied by lower bank interest rate spreads—owing to the longer maturity of lending rates than deposit rates.

Despite these difficulties, disinflations were rarely accompanied by up-front bank restructuring. In only two cases—the former Yugoslav Republic of Macedonia and Slovenia—were operations to buttress the banking system initiated at the same time as disinflation, and even in these cases, the measures taken began, rather than completed, the task. Furthermore, despite the manifest weakness of many financial systems, rarely were these concerns uppermost in the authorities' minds when weighing the risks and modalities of disinflation.

There were several reasons why financial fragility did not undermine monetary control and the credibility of disinflation. In some of the high-inflation cases, the financial system had shrunk in real terms prior to disinflation due to negative real interest rates. For example, in Georgia and Moldova in 1994, M2 was 3 percent of GDP and 12 percent of GDP, respectively, and even now in the Baltics, Russia, and other countries of the former Soviet Union overall, banking system claims on nongovernment agencies are roughly half the level relative to GDP of Organization for Economic Cooperation and Development (OECD) countries. This contained the fiscal and refinancing contingent liabilities posed by financial fragility. Furthermore, while a number of banks had profited from transactions predicated on the high-inflation environment, this source of income was rarely critical to their overall profitability. So the demise of that environment rarely affected the overall health of individual banks, or of the banking system.

Fast disinflation and the maintenance of banking spreads also diminished the risk that financial fragility would deepen. The potential sluggishness of lending rates with respect to deposit rates when monetary policy is tightened turned out to be unimportant. At times, the contractual basis for bank loans was sufficiently unclear that lending rates were rapidly adjustable in practice, though more often, banks had shifted to variable rate or short-term lending prior to disinflation. Furthermore, nominal interest rates started falling rapidly along with inflation. So even to the limited extent that lending rates were stickier than deposit rates, rapidly falling inflation allowed spreads to widen during disinflation.

This is not to say that financial instability played no role, or that it may not become a problem in the future. Banking difficulties occurred during the Baltic and Czech disinflations. And most countries had to recapitalize banks at some point, though these operations were generally financed by issuing bonds, rather than by printing money, softening their impact on inflation. In addition, as illustrated by Estonia in 1993, firm decisions were taken to restructure or close banks, rather than to recapitalize them. But in addition to these direct links between financial fragility and inflation, indirect links also played a role. In the Czech Republic, a combination of banking inefficiencies, reflected in large interest rate spreads, accompanied by confidence in the currency, may have induced both domestic disintermediation and capital inflows in the mid-1990s. In this way, financial fragility may have indirectly stoked inflationary pressures.

While fragility remains, there are risks of further calls on the budget and for central bank refinance, and the financial sector's contribution to flexibility and performance of the whole economy is diminished. Albania and Bulgaria show that, even though much-abused financial systems can survive a remarkably long time, they eventually collapse with serious implications for macroeconomic stability. Recent difficulties in a medium-sized regional bank in Croatia underline that strong inflation performers are not immune from these difficulties. And the exchange rate crisis in Russia in August 1998 reflected to some extent increases in liquidity to sustain the banking sector. While progress has been made in strengthening financial structures and supervision in most transition countries, significant risks remain (see Appendix II).

Political Economy

Social and political characteristics of the preinflation stabilization period may also account for the decisiveness of the disinflation effort and its credibility. In some Central and Eastern European countries and in the Baltic States, the perceived short-term costs of disinflation were seen as the price of national liberation. This muted the political backlash to “shock therapies,” and partly explains why determined reformers were often politically successful (Aslund, Boone, and Johnson, 1996). Moreover, when the old economic interest groups were discredited and disorganized, an opening for “extraordinary politics”—in the words of Poland's Finance Minister Balcerowicz (Bruno, 1996)—appeared, which eased the introduction of tough disinflation and reform programs, albeit sometimes only temporarily.

Such openings were, however, rarely apparent in most BRO countries (outside the Baltics), which partly explains why disinflation was often delayed there. Even in some Central and Eastern European countries, such as Bulgaria and Romania, it proved impossible to gather sufficient political support to implement sustained disinflation. In some cases, coalitions of various political interests may have delayed disinflation. Bruno (1996) notes that a high-inflation equilibrium can be generated when interest groups disagree on who should bear the brunt of the adjustment. In other cases, interest groups may have had an indirect interest in inflation, having privileged access to fiscal subsidies or transfers that generate it. Clearly, political instability and war played a key role in delaying disinflation in Armenia, Croatia, Georgia, and Tajikistan. Disagreement between the central bank and the government on the appropriate policy course or insufficient understanding of the economics of inflation—the view that inflation was caused by “speculators” rather than by financial policies—were also factors in some countries (notably, Belarus, Bulgaria, Tajikistan, Turkmenistan, Uzbekistan, and, initially, Ukraine).

By the mid-1990s, however, even in cases where political impediments to disinflation had been most severe, it had become apparent to most policymakers that inflation was a monetary phenomenon fueled by large fiscal and quasi-fiscal deficits. At the same time, the costs of inflation for vulnerable social groups (such as pensioners) were becoming apparent.10 These factors may have eventually strengthened the resolve to stabilize and the credibility of the disinflation programs subsequently implemented.

Relative Price Disequilibria

The environment for disinflation was complicated by the need for large relative price changes, given that relative prices were far from competitive equilibrium, combined in some cases with monopolistic pricing that emerged after price liberalization (IMF, 1997, pp. 108–11). A shock in relative prices, from either source, risks inducing inflation if there is downward price stickiness. If this pressure is accommodated to avoid an output loss, inflation will rise, with legal or de facto indexation delaying the disinflation process.

In transition economies, the inflationary pressure arising from relative price changes was exacerbated by the type of price shocks that accompanied the transition. Prior to the transition, some goods were largely underpriced while most were marginally overpriced (Pujol and Griffiths, 1998; and Coorey, Mecagni, and Offerdal, 1998). This pattern imparted an inflationary impulse because, while the few largely underpriced goods were rapidly repriced, the many overpriced goods were not cut (possibly reflecting microeconomic adjustment costs) and so were adjusted in real terms through inflation (Ball and Mankiw, 1994).

The role of relative price adjustments in inflation was particularly strong in the early phases of the transition when most prices were liberalized, but seems to have declined over time (Pujol and Griffiths, 1998; Coorey, Mecagni, and Offerdal, 1998; 1998; Krajnyák and Klingen, 1998; and Woźniak, 1998). This is because the relative price adjustment process appears to have been fairly rapid, partly reflecting limited indexation in most countries (Koen and De Masi, 1997). A key remaining inflationary impulse from relative price changes concerns administrative price adjustments.11 However, with price ceilings applied only to a limited number of products (energy, transportation, rents, and utilities), these have also declined in importance (Box 1).

Relative Prices and Inflation: A Look Ahead

Several years into the transition, goods price levels and structures remain distinct from industrial countries (Koen and De Masi, 1997). This does not necessarily mean, however, that a rapid convergence should be expected, as price levels and structures are generally correlated with GDP (Nuxoll, 1996). Market-determined prices are likely to converge to industrial country standards only in the long run. Thus, the main contribution of relative price changes to inflation in the near future is likely to come primarily from changes in administered prices.

The remaining inflationary potential from changes in administered prices depends on the share of administered prices in the CPI, how far they are below their market-determined level, and the response of other prices. In most cases, the share of administered prices in the baskets used to calculate the CPI is small, albeit possibly understated to the extent that the weights have not been fully adjusted as administered prices have been raised toward full cost coverage (Table 3). In only a few cases is removing all remaining price controls thought likely to add more than 10 percentage points to the CPI (Table 3).1 But in some low-inflation countries (such as the Czech Republic and Croatia), as well as in some moderate high-inflation countries (Belarus), administered price increases could put significant pressure on inflation developments.

Table 3.

Administered Price Changes

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Source: IMF staff estimates.

Includes energy and utility prices only. If the prices of basic consumer goods—including flour, sugar, bread, and so on—are also included, the weight of administered prices is at least 40 percent.

The reaction of nonadministered prices to changes in administered prices will depend, inter alia, on the degree of indexation, the overall credibility of the authorities, and, of course, the degree of monetary accommodation. In countries where the authorities' credibility is in doubt, an increase in administered prices may be regarded as signaling that inflation is accelerating, and lead to parallel increases in all prices. A case in point is Romania where in early 1997, the increase in some energy prices started a wave of general price increases. Conversely, the recent experience in Azerbaijan shows that even fairly large increases in administered prices can be absorbed with only a temporary rise in inflation.

Finally, there is evidence that after the initial impact of relative price changes on inflation, price liberalization is generally found to reduce inflation (Fischer, Sahay, and Végh, 1996; and Cottarelli, Griffiths, and Moghadam, 1998). This may be due to the fact that those countries that adjusted to administered prices more slowly through subsidies or price controls, such as Moldova, experienced larger fiscal or quasi-fiscal deficits, and due to the boost to supply-side flexibility that price liberalization engenders.

1 These estimates neither take into account the reaction of other prices nor the degree of monetary accommodation. More-over, the figures should be taken cum grano salis as, in many cases, it is difficult to evaluate what the market-determined price of certain products would be. Comparisons with industrial countries may be misleading for products (as services) that involve significant labor input. The case of rents is also complex: Zavoico (1995) argues that rents in transition countries may not need to incorporate amortization costs for a number of years, because currently there is an excess supply of houses.

Policy Response: Fiscal Policy

The early phase of the transition was accompanied by large fiscal imbalances in virtually all transition countries, as a result of falling revenues and rigid public expenditure. Government securities markets were virtually nonexistent and access to foreign finance was limited. So the emerging deficits had to be monetized when the potential for direct funding from the banking sector was exhausted. Of the Baltics, Russia, and other countries of the former Soviet Union, seven of 15 countries recorded seignorage in excess of 10 percent of GDP in 1993, when inflation was at or near its peak (Ghosh, 1997).

The development of a broader range of financing options for government alongside fiscal consolidation were key elements underlying the subsequent disinflations. The former reduced the pressure for monetization, given public deficits,12 and the latter reduced the risk of explosive paths for public debtto-GDP ratios (Buiter, 1997). This reduced inflationary pressures arising from the expectation of future monetization (Sargent and Wallace, 1981).

Government Securities Markets

By 1997, all transition economies (with the exception of Estonia, Tajikistan, and the former Yugoslav Republic of Macedonia) had introduced primary treasury bill markets—mostly based on auctions—with many of the Baltics, Russia, and other countries of the former Soviet Union joining the gruop in 1995–96 (table 4). In the most advanced transition economies (such as the Czech Republic, Hungary, and Poland), primary government securities markets are more fully developed, and secondary markets are also active, usually organized around a system of primary dealers. The Baltics, Russia, and other countries of the former Soviet Union are lagging behind. However, “moderate” or “substantial” progress had been achieved by 1997 in most of the Baltics, Russia, and other countries of the former Soviet Union (IMF, 1997).13 As a result, the share of fiscal deficits financed by issuing domestic government securities is now sizable in a number of transition economies (Table 4).

Table 4.

Development of Government Securities Markets

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Source: IMF staff estimates.

Fiscal Consolidation

Public finances strengthened significantly during 1993–97. The average fiscal deficit-to-GDP ratio fell from 13½ percent in 1992 to 3½ percent in 1997; the decline was faster in the Baltics, Russia, and other countries of the former Soviet Union, but it was sizable also in Central and Eastern European countries (Table 5). Quasi-fiscal deficits—whose importance for macroeconomic developments has been stressed several times (Mackenzie and Stella, 1996; and Buiter, 1997)—also abated (see below).

Table 5.

Overall and Primary General Government Balances, and Central Bank Financing to the Government1

(In percent of GDP)

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Source: IMF staff estimates.

For the countries that stabilized during 1993–97, shaded areas indicate periods in which inflation dropped below the stabilization threshold (see definition in Table 2).

The primary balance is calculated as the general government balance minus net interest payments. Primary balance calculations exclude interest receipts for Armenia, Azerbaijan, Belarus, Estonia, Kazakhstan, Kyrgyz Republic, Romania, Slovakia, and the Ukraine.

The higher overall deficit in 1995, the first stabilization year, is due to the payment of arrears related to government-guaranteed domestic loans.

About one-half of the deficit in Lithuania during 1993–96 was due to net lending.

A simple plot of inflation against the overall and primary fiscal balances of transition economies suggests that fiscal consolidation was closely related to the decline in inflation during 1993–97 (Figure 3).14 A closer look at individual country data (Tables 6 and 7) reveals five key features: (1) a sizable fiscal tightening—with a corresponding tightening of money creation through credit to the government—characterized most inflation stabilization cases, a key finding of earlier reviews of the transition experience (Bruno, 1992); (2) fiscal adjustment focused on expenditure cuts; (3) when fiscal adjustment did not accompany the inflation stabilization, the fiscal position was already strong; (4) inflation stabilization did not require a fiscal position that was solvent according to standard formulas; and (5) the link between fiscal tightening and disinflation is weaker in moderate inflation cases.

Table 6.

Fiscal and Inflation Developments

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Source: IMF staff estimates.

Quarter in which the 60 percent inflation threshold was broken (see Table 2).

Table 7.

General Government Revenue and Primary Expenditures in Transition Economies1

(In percent of GDP)

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Source: IMF staff estimates.

For the countries that stabilized during 1993–97, shaded areas indicate years in which inflation was below the stabilization threshold (as defined in Table 2).

The primary expenditure is calculated as the general government expenditure minus net interest payments. Primary balance calculations exclude interest receipts for Armenia, Azerbaijan, Belarus, Estonia, Kazakhstan, Kyrgyz Republic, Romania, Slovakia, and the Ukraine.

Figure 3.
Figure 3.

Transition Economies: Fiscal Performance Versus Inflation Performance, 1994–97

(In percent)

Source: IMF staff estimates.

Fiscal adjustment (typically up-front fiscal adjustment in the disinflation year or the year before) accompanied the drop in inflation in 13 of the 20 inflation stabilization cases observed during 1993–97 (Table 6). In two additional cases—Bulgaria (second disinflation) and Lithuania—the primary balance changed little, but quasi-fiscal losses were substantially reduced. In Lithuania, losses accruing as a result of arbitrage of interrepublican accounts after withdrawal from the ruble area were curtailed. In Bulgaria, quasi-fiscal losses accruing in both the financial and nonfmancial enterprise sectors as a result of wide-spread soft budget constraints were reduced under the first stabilization, albeit only to reemerge later, inducing a reversal of the associated disinflation gains. Quasi-fiscal deficits—particularly in the form of directed credit—were reduced also in countries that cut the general government deficits, especially in the Baltics, Russia, and other countries of the former Soviet Union (a case in point is Kazakhstan).

Fiscal consolidation allowed a sharp contraction in central bank credit to the government. In the 20 inflation stabilization cases, the average flow of central bank credit to the government fell from 10.6 percent of GDP in 1992 to 0.7 percent of GDP in 1997 (Table 5), contributing significantly to the decline in the growth rate of money (see below).

In almost all the above cases, the adjustment consisted primarily of expenditure cuts. Only in Croatia, Latvia, and Uzbekistan did the revenue-to-GDP ratio rise significantly, and only temporarily in the latter case. In the former Yugoslav Republic of Macedonia, after an initial increase in the revenue ratio, both expenditure and revenue ratios started declining. In six countries (Armenia, Azerbaijan, Belarus, the Kyrgyz Republic, Russia, and Ukraine), revenue ratios declined during disinflation. The predominance of expenditure rather than revenue adjustment to close fiscal imbalances may have helped the disinflation directly, given that tax increases often produce a one-off increase in the price level, particularly indirect taxes (Suranyi and Vincze, 1998).

There are cases where fiscal strengthening did not accompany inflation stabilization. In Estonia, Latvia, and Turkmenistan, the fiscal position prior to stabilization was already fairly strong, and other factors underlay persistent inflation in that context. In Estonia, inflation was driven by price developments in Russia before June 1992, when an independent currency issued under a currency board was introduced. Thereafter, inflation fell sharply, but as Latvia also experienced later, the exchange rate peg was insufficient to eliminate inflation, despite the firm fiscal stance. In Turkmenistan, the reasons for the persistance of inflation are more difficult to assess, although they may have been related to the increasing scarcity of imported consumer goods until early 1997, when the central bank was allowed to sell foreign exchange on the market, relieving the shortage. In contrast to these cases, inflation in Tajikistan persisted in spite of the significant strengthening of the primary balance during 1996–98 because of political instability and civil war.

Inflation and Fiscal Deficits: Summary of Econometric Results

The relationship between inflation and fiscal deficits in transition economies has been explored through regression analysis in several papers (1996; Lougani and Sheets, Fischer, Sahay, and Végh, 1997; and Cottarelli, Griffiths, and Moghadam, 1998). All these papers find a significant statistical relationship between inflation and the fiscal deficit, which is robust to differences in the econometric specification and in the definition of the deficit.1 Moreover, these studies show that fiscal factors remain important even after controlling for other factors (such as the exchange regime, measures of the overall progress in reforming the economy, central bank independence, indexation, and relative price changes).

The estimate of the direct quantitative effect of fiscal deficits on inflation is, however, relatively low. In most of the specifications, a decline in the deficit-to-GDP ratio of 1 percentage point when inflation is, say, 100 percent involves a decline in inflation of only 5–8 percentage points. The effect is larger at high inflation levels, but smaller when inflation is low.2

This result may be explained in two ways. First, in a number of countries, disinflation did not require a reduction in the deficit either because the fiscal position was already sufficiently strong or because the main problem was related to quasi-fiscal deficits. As the regression results “average out” the experience of all countries during the sample period, the effect of deficit cuts estimated from regressions using changes in the variables (rather than levels) appears to be lower than in reality for those countries that had a fiscal problem. Second, the results indicate that fiscal adjustment should not be seen in isolation but rather as a component of a comprehensive package that enhances the credibility of disinflation through appropriate exchange rate policies, and other institutional devices (such as central bank independence). One element of a comprehensive package may be the development of government securities markets. Cottarelli, Griffiths, and Moghadam (1998) report that the relation between inflation and fiscal deficits is stronger in those countries without a developed government securities market, presumably reflecting the greater reliance of such countries on central bank finance for the government deficit.

1 In particular, Cottarelli, Griffiths, and Moghadam (1998) find that the relationship holds also after removing the effect of inflation on government interest payments, thus suggesting a line of causality that runs from fiscal deficits to inflation, and not vice versa. 2 This is due to the semilogarithmic specification of the relation between inflation and fiscal deficits, adopted in all papers. This specification seems to fit the data better than alternative specifications.

The only cases in which inflation stabilization succeeded while fiscal and quasi-fiscal deficits remained high were Romania and the Kyrgyz Republic. In the former case, the progress on inflation was ultimately reversed. In the latter case, there was a sharp temporary fiscal relaxation in 1995 associated with an election. But the inflationary impact of the fiscal position, both before and after this, was considerably less than is implied by the overall and primary fiscal balances. These reflect a large, import-intensive, and externally financed public investment program. Apart from 1995, domestic funding of the deficit remained about or below 2½ percent of GDP throughout the disinflation, and this shifted progressively from central bank to other sources of domestic finance. Thus, as with other cases, the Kyrgyz disinflation was underwritten by a firm fiscal position.

It is notable that inflation stabilization did not require fiscal solvency according to simple standard formulas. Such formulas identify the minimal primary balance necessary to avoid an explosive path for the debt-to-GDP ratio in terms of the initial debt level, the GDP growth rate, and the interest rate on debt (see formula in Table 8). By these standards, the fiscal position during most of the inflation stabilizations was insolvent, and still remained so in 1997.15 The simple assumptions that underlie the formulas, however, may be particularly inappropriate in transition economies. Transition economies have strong potential productivity growth and this is likely to contribute to future strengthened primary balances. In addition, some of these countries also implemented structural reforms that bolstered long-term fiscal sustainability, even if they had little immediate fiscal impact.16 This, and the fact that the Baltics and other countries of the former Soviet Union (excluding Russia) started the transition with negligible public debt and so could derive efficiency gains from added leverage, may explain why strict adherence to the standard formulas has not been necessary to support or sustain disinflation.17

Table 8.

Actual and Sustainable Primary Fiscal Balances

(In percent of GDP)

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Source: IMF staff calculations.

The sustainable primary balance is the primary balance that would allow stabilizing of the public debt-to-GDP ratio; it can be computed as

p = [ ( i - g ) / ( 1 + g ) ] d

where p is the primary balance-to-GDP ratio, i is the nominal interest rate on government debt, g is the nominal GDP growth rate, and d is the initial debt-to-GDP ratio. The figures in Table 8 have been based on a nominal GDP growth rate of 8 percent, and an interest rate-growth differential of 2 percentage points. Actual figures for end-1996 have been used for the debt-to-GDP ratio. It should be stressed that for countries with high debt/GDP ratios, stabilizing the debt-to-GDP ratio is unlikely to be sufficient to ensure long-run sustainability. Reducing vulnerability would require lowering the debt ratio and, therefore, stronger fiscal positions than indicated above.

The link between disinflation and fiscal adjustment is less clear at moderate inflation levels, however. In the Czech Republic, inflation remained moderate despite declining primary surpluses during 1993–96. Conversely, the drop in inflation in Slovenia during 1993–97, in the Slovak Republic during 1994–96, and in Poland during 1993–97 was not accompanied by a fiscal strengthening. Various factors may account for this. Moderate inflation countries are also relatively fast reformers with more developed government securities markets. This alleviates the monetary impact of fiscal deficits as illustrated by the case of Hungary, where large deficits in 1993–94 led to only a limited rise in inflation. In addition, once fiscal sustainability is achieved, disinflation may become a problem of expectation coordination (Blanchard, 1998). In this environment, a fiscal expansion that casts doubts on fiscal sustainability or that leads to overheating should be avoided, but a fiscal tightening may not be necessary. The results of more fomal research into the relationship between fiscal balances, government securities markets, and inflation, at different inflation levels, are outlined in Box 2.

These findings have implications for fiscal policy in sustaining the progress toward low inflation. Fiscal consolidation, having been so central to laying the groundwork for inflation stabilization, will remain essential to sustain disinflation. Those countries that already have a strong underlying fiscal position, implying that inflation is an expectational problem, should maintain this strong fiscal stance. Whether a fiscal tightening will be necessary to disinflate further will depend on its contribution to reducing aggregate demand pressures. In many cases, however, the priority will be structural fiscal reform, including second-generation reforms aimed at fostering economic growth and medium-term fiscal credibility. Key issues will be the structure and level of taxation, social spending, and social transfers. Progress in these areas can benefit disinflation not only by strengthening the fiscal balances, but also by spurring productivity growth.

Policy Response: Credibility-Enhancing Devices

Various monetary frameworks, external agents, and incomes policies were adopted to bolster credibility. This section describes and discusses these devices and assesses their contribution to disinflation.

Monetary Frameworks

A striking feature of the 1993–97 inflation stabilizations is the limited use of formal exchange rate or monetary targets. Though both monetary aggregates and exchange rates did stabilize during and after inflation stabilization (Table 9), the announcement of targets for these variables played a limited role: no country announced monetary targets (although several IMF-supported programs included indicative targets on base money) and, perhaps surprisingly, few announced exchange rate targets when initiating disinflation.

Table 9.

Broad Money Growth and Depreciation Rates in Transition Economies1

(End of period, in percent)

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Source: IMF staff estimates.

The depreciation rates are computed vis-à-vis the U.S. dollar. For the countries that stabilized during 1993–97, shaded areas indicate years inflation was below the stabilization threshold (as defined in Table 2).

The depreciation rates refer to the official exchange rate.

The absence of publicly announced monetary targets, other than rules directly implied by the exchange rate regime as in the case of currency boards, reflects structural change and uncertainty. Reform in the financial sector—particularly the advent of substitutes for bank deposits for household savings and innovations in payment systems—was substantial. This compounded the lack of knowledge of money demand and the prospect that disinflation itself would induce a strong, though unpredictable, recovery in real money demand. In this context, money targets appeared to be unworkable as signals for inflation expectation formation.18

Exchange rate targets—the most obvious substitute for monetary targets—were initially adopted only by a handful of countries (Tables 10 and 11). They subsequently became more common: by 1997, the share of floaters had dropped to little more than one-half, and was thus close to the share of floaters in nontransition developing countries in the mid-1990s (Cottarelli and Giannini, 1997). Note that, in the most recent period (1995–97), the increase in the number of pegs reflects the increased popularity of broad band pegs. Former floaters, such as Russia and the Ukraine, as well as former narrow band pegs, such as Poland and the Slovak Republic, have shifted to this intermediate regime.19 In contrast, only the Czech Republic has crossed the whole spectrum from a peg to a managed float.

Table 10.

Number of Peggers and Floaters1

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Source: IMF staff reports.

In this table, the exchange regime of the countries that had not yet introduced their own currency is the exchange regime of the preexisting currency.

Table 11.

Exchange Rate Regime in Transition Countries

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Source: IMF staff reports. Notes: The exchange rate is regarded as floating in the absence of major exchange rate intervention; managed float means that some intervention takes place but the exchange rate is not regarded as the main monetary anchor; exchange regimes in which the exchange rate peg is frequently revised (as in Hungary before March 1995) are also classified as managed float; pegged exchange rates are formal pegs or regimes in which the authorities have, at least in some periods, announced their commitment to a certain exchange rate target and the exchange rate is regarded as pegged by most market participants. The term “crawling peg” refers to regimes in which the rate of exchange rate depreciation is preannounced. For the countries that stabilized during 1993–97, shaded areas indicate the years in which inflation was below the stabilization threshold (as defined in Table 2).

As of July 1,1997.

In 1992–93, the exchange rate was repeatedly devalued (being formally floated between May and October 1993). In October 1993, an exchange rate floor (maximum depreciation) was announced; after a brief period of appreciation, the exchange rate stabilized.

As of February 28, 1996.

As of May 27, 1997.

As of March 15,1995.

As of May 1995.

As of November 22, 1993.

During the first quarter of 1994, the exchange rate was pegged to the U.S. dollar; in April and May 1994, it was pegged to the ruble.

The Georgian coupon was introduced in April 1993, and the lari was introduced in September 1995.

As of February 1994.

As of April 1994.

As of November 1993.

As of July 1995.

National currency introduced in May 1995.

National currency introduced on November I, 1993.

National currency introduced in March 1993.

As of October 1994.

Among the successful inflation stabilizations between 1993–97, only Bulgaria (in 1997), Lithuania, Estonia, and the former Yugoslav Republic of Macedonia formally pegged throughout, though Russia adopted a broad band a few months after the beginning of its disinflation program.20 Croatia announced an exchange rate floor against the deutsche mark and allowed the nominal exchange rate to appreciate initially, although most now consider that it is operating a de facto peg. Even in the four disinflations that occurred without a fiscal tightening, where weaknesses in the nominal anchor framework might have been thought to have been sustaining inflation, only Estonia used a formal exchange rate anchor to stabilize expectations. Latvia, Turkmenistan, and Ukraine formally floated (in the latter two cases, throughout).

The role of different exchange regimes in disinflation remains under dispute. Bruno (1992) concluded that exchange rate anchors had played a key role in the early disinflation cases, and is supported by econometric evidence for that period (Fischer, Sahay, and Végh, 1996; and Cottarelli, Griffiths, and Moghadam, 1998). However, others, focusing on more recent disinflations, have argued that formal exchange rate anchors were not critical for disinflation (1995; Budina and van Wijnbergen, 1997; Begg, 1998; and Gomulka, 1998). Indeed, in two-thirds of the inflation stabilization cases observed during 1993–97, the exchange rate was formally floating (Table 11).21

The popularity of exchange rate floats during the later inflation stabilization episodes is striking, particularly in light of the role pegs were thought capable of playing as “launching vehicles” for new fiat monies lacking an initial credibility endowment (Selgin, 1994), their high visibility and direct effect on prices through imported inflation, despite the absence of sensible monetary anchors as alternatives. Most of these countries followed what in essence were discretionary monetary frameworks, or informal inflation targeting regimes.22

Not only has evidence of successful inflation stabilization with formally floating exchange rates mounted, but there is no clear evidence that these episodes have involved a higher sacrifice ratio. In-deed, if anything, the converse appears to be the case. The ratio between percentage change in output and percentage change in inflation during the disinflation year and in the following year is larger for countries with a pegged exchange rate than in the group of floaters, and this pattern is apparent even allowing for other determinants of growth (Christoffersen and Doyle, 1998).

There are various possible accounts of the declining frequency of formal pegs during disinflation in transition: that the disinflations after 1993 tended to confront more extreme inflations with less inflation inertia and so the credibility-enhancing role of formal pegs was less important; that informal pegging was both relatively frequent and proved to be a close substitute for formal pegs even in these higher disinflation cases; and that there were a number of practical “entry and exit” issues that qualified the general case for formal exchange rate pegs during disinflation.

Clearly, the inflation stabilizations after 1993 included a greater number of cases of extreme inflation than earlier (Table 1). Accordingly, the credibility-enhancing role of formal pegs may have been less important to effective disinflation than in earlier cases because inflation inertia was more limited. Thus, to the extent that sustained exchange rate stability signified the elimination of the excess monetary growth at the root of these later inflations, it may have been more important that the exchange rate was stabilized than that this was achieved by means of a credibility-enhancing formal exchange rate commitment.

It is more difficult to assess the role of informal pegging—that is, exchange rate stabilization through intervention or adjustment in monetary instruments in the context of a formally floating regime. The stability of the nominal exchange rate in several transition economies with formally floating exchange rates after the inflation stabilization was notable, including for example, in Armenia and the Kyrgyz Republic in 1995 during their disinflations, and in Georgia from 1995 through 1997. However, while the exchange rate was closely monitored in all countries, it appears that only in relatively few cases, such as Moldova, Slovenia, and occasionally Kazakhstan, were intervention and monetary instruments focused on informal exchange rate targets as part of the policy framework underlying disinflation. And even acknowledging such cases, it remains remarkable that so few countries adopted formal exchange rate targets.

The declining incidence of formal pegs also reflects concerns about entry and exit issues (Gomulka, 1998; Begg, 1998; and IMF, 1997, pp. 114–15). On the entry side, many countries in the post-1993 period began their disinflations with low international reserves, and so may not have been able to operate pegs credibly at sensible exchange rates. The mirror image of this problem, on the exit side, was the risk for a country of entering the exchange rate peg at a substantially undervalued exchange rate. Pegging at such rates might have slowed inflation from its extremely high levels initially. But thereafter, it could have implied ongoing inflation above partner country levels to correct the real exchange rate, compounding similar pressures for this arising from relatively rapid productivity growth in the tradable sector (the Balassa-Samuelson effect).23 And pegs, in the context of moderate inflation, might also induce large short-term capital inflows.

These difficulties with pegs as nominal anchors for disinflation took a particular form in a number of the BRO countries in the mid-1990s. Disinflation using pegs normally requires that the peg is set against a low inflation hard currency, such as the deutsche mark or the dollar, or a hard currency basket. However, the fact that Russia was a major trading partner for the Baltics and for the countries of the former Soviet Union created a dilemma for this approach to setting a peg in those countries. To eliminate shocks to competitiveness and inflation arising from changes in the real exchange rate of the ruble, the latter would need to be included among the currencies defining the peg. But this would have weakened the ex ante credibility of the peg as a nominal anchor because the ruble was so vulnerable. Hence, the uncertain prospects for the ruble in the mid-1990s qualified the merits of hard currency pegs as nominal anchors for the disinflation efforts elsewhere in the BRO countries.

The various difficulties with pegs are illustrated in the experience of transition countries that stabilized inflation both before and after 1993. After initial successes, advanced pegging reformers, notably the Czech Republic, Estonia, Hungary, Latvia, Lithuania, and Poland have made slow progress toward low inflation while they have retained their pegs. The inflationary pressures arising from an undervalued peg are illustrated by the kroon, the level of which at the outset of disinflation implied wages in Estonia of about one-seventh of those in Poland. Latvia is also thought to have pegged too low, despite its initial float (Hansson, 1997), and inflation above industrial country levels was slow to correct this undervaluation (Richards and Tersman, 1995). The recovery of the ruble between 1994–96 in real terms may have delayed the correction of the Latvian undervaluation further. In other cases (notably Hungary and Poland), rates of crawl in 1996–97 may have come to imply floors rather than ceilings on inflation because the authorities were unwilling to use the rate of crawl as an active disinflation tool, given the uncertainty about the real equilibrium exchange rate and their past exposure to external shocks. Difficulties in managing capital flows—most clear in the case of the Czech Republic up to 1997—may partly account for the recent trend toward broad band pegs.

The advantages of discretionary monetary frame-works are illustrated by Albania, Azerbaijan, and Georgia, and for some months after the start of their disinflations, Croatia and Russia. In these cases, rapid disinflation was accompanied by nominal appreciation of the exchange rate, correcting an initial undervaluation. In all these cases, appreciation boosted the disinflating effects of lower import prices compared to a peg, facilitating an even faster disinflation.24 Moreover, in some countries, the nominal exchange rate appreciation, after years of continuous depreciation, signaled a clear break with the past, with a dramatic impact in inflation expectations (Ŝkreb, 1998).

It should be recognized that a nominal appreciation of the exchange rate involves some risks. Unless prices and wages adjust rapidly to changes in the nominal exchange rate, a nominal appreciation will lead to a real appreciation. As noted, a real appreciation may be consistent with fundamentals in transition economies characterized by high productivity growth, or in case of an initial undervaluation. But whether this is the case or not in practice is a judgment call, involving a wide margin of uncertainty, particularly taking into account dynamic factors. In practice, it may be difficult for the authorities to assess whether a real appreciation following a nominal appreciation reflects sluggishness in wage and price adjustment, with a negative impact at least in the short run on the external accounts, rather than an equilibrium appreciation. These considerations may be more important at moderate inflation levels, at which wage and price stickiness may be stronger. In-deed, the authorities of some moderate inflation countries have justified their reluctance to abandon exchange rate crawling pegs with the risks arising from such a move for external equilibrium (Section III).

The disinflations achieved under discretionary monetary regimes—similar to informal inflation targeting—are notable given the cautious assessment given to more fully fledged inflation targeting regimes in developing countries (Masson, Savastano, and Sharma, 1997). The low inertia in the initial inflation being stabilized—a key difference with respect to Latin American disinflation episodes—the drawbacks of monetary and exchange rate targets in the transition context, the focus on fiscal consolidation, and the credibility gained from increased central bank independence and the adoption of IMF-supported programs may account for these successes. In most cases, however, the performance of discretionary monetary frameworks has yet to stand the test of time.

Credibility Through Delegation

Central bank independence and IMF-supported programs featured in many of the inflation stabilizations, and may have buttressed financial discipline and the credibility of the disinflation programs. During 1993–97, most transition economies enhanced the legal independence of their central banks (Knight, 1997; and Radzyner and Riesinger, 1997)—price stability is now the main mandated objective of central banks in most transition economies; and ceilings on central bank credit to the government have been tightened, with many coun-tries having prohibited any credit to the government (Table 12). There has also been significant progress in extending the terms of central bank governors, the rules for their appointment and revocation, as well as in strengthening the financial independence of the central bank.

Table 12.

Developments in Central Bank Legislation

article image
Source: IMF staff estimates.

Thepercentage declined sharply starting in 1998.

A new draft is in preparation.

A new central bank law was submitted to Parliament in 1997, but was later withdrawn. The draft was regarded to weaken the independence of the central bank.

A survey of IMF desk economists used in Cottarelli, Griffiths, and Moghadam (1998) provides a summary indicator of this trend. Desk economists were asked to rate central bank independence in terms of control on monetary policy instruments, constraints on credit to the government, statutory mandate, and ability of the government to dismiss the central bank governor. On a 1–10 scale (10 being the maximum degree of central bank independence), the average rating of CEE transition economies moved from 4.7 in 1993 to 5.3 in 1996. The average in the Baltics, Russia, and other countries of the former Soviet Union (excluding those with currency boards) also improved from 4.7 to 8.4 in the same period.25 Further progress was made in 1997 and in 1998 in several countries, including Albania, Hungary, Kazakhstan, the Kyrgyz Republic, and Poland. However, attempts—unsuccessful so far—have been made to weaken the central bank law in the Slovak Republic. Moreover, central bank credit to the government—possibly the most important indicator of central bank independence—remains unrestricted in a number of the Baltics, Russia, and other countries of the former Soviet Union (Table 12).

Some econometric studies shed some light on the importance of central bank independence in transition (Cottarelli, Griffiths, and Moghadam, 1998; and Lougani and Sheets, 1997). Controlling for other factors, inflation is lower in countries with more in-dependent central banks. Cukierman, Miller, and Neyapti (1998) find that central bank independence is unrelated to inflation during the early stages of liberalization, but it reduces inflation for sufficiently high levels of liberalization.

With only three exceptions—Croatia, Slovenia, and Turkmenistan—the inflation stabilizations of 1993–97 took place in the presence of IMF-supported programs; in seven cases, under the Systemic Transformation Facility, but more frequently under other IMF arrangements. And even in these three cases, the authorities maintained a dialogue with the IMF. The incidence of IMF-supported programs suggests that they were regarded as an important component of the disinflation effort throughout the transition area. However, with almost all countries following IMF-supported programs, it is virtually impossible to conduct statistical tests of the marginal impact of IMF-assistance on shaping appropriate policies or strengthening the credibility of those policies.

Incomes Policies

Some countries also employed incomes policies, though their contribution to disinflation is disputed. Though they featured in various forms in many initial disinflations, it is difficult to identify their contribution to real or nominal wage adjustments or inflation, after controlling for other influences on these variables (Morsink, 1995).

The approaches ranged from excess wage taxes (Belarus, Estonia, Latvia, Poland, Romania, and Slovakia) through formal wage guidelines or controls for the public and private sectors (as in Croatia, Hungary, Lithuania, and the former Yugoslav Republic of Macedonia) to wage limits applied only in the public sector with the aim of influencing private wage setting by example (Albania and Moldova). Several countries, however, did not use any form of incomes policy, including many of the disinflations of 1994–95 in the Baltics, Russia, and other countries of the former Soviet Union (Azerbaijan, Georgia, Kazakhstan, the Kyrgyz Republic, and Russia). Even in countries where incomes policy was present, it is not regarded as one of the main factors behind disinflation, in some cases because of substantial noncompliance. Incomes policy is regarded to have played an important role only in a handful of Central and Eastern European countries (Albania, Bulgaria, Croatia, and the former Yugoslav Republic of Macedonia).

Blanchard (1998) suggests that incomes policies may not have affected inflation expectations in the transition context because they were often used to secure sizable shifts in income distribution that transition required. Wage growth was set at a level significantly below what inflation turned out to be, in this way leading to a sharp drop in real wages. While this adjustment was inevitable, it undermined the subsequent use of incomes policy as a tool of fast disinflation. A case in point is Hungary, in which a tight wage policy in 1995–96 resulted in a sharp contraction of real wages (inflation being sustained by the exchange rate depreciation in early 1995 and needed increases in administered prices). This undermined the credibility of incomes policy in 1997, and partly explains the lack of progress in inflation during that year. Finally, the resulting shifts in the distribution of income secured by the incomes policies weakened tax revenues in cases where the taxation of labor was more onerous or effective than the taxation of nonlabor income. Concern with the consequent loss of revenue may at times have qualified the authorities' commitment to incomes policies. This was particularly apparent in Poland in 1990–91, where this incentive was compounded by tax receipts derived from the excess wage tax.

Policy Response: Sequencing and Speed

The final characteristic of the policies that appears to have contributed to the absence of evidence of output costs arising from disinflation concerns the sequencing of disinflation relative to structural reform and its intended speed.

Much theoretical reasoning about the relative sequencing of disinflation and structural reform was predicated on moderate inflation, and much of it advocated structural reform first, as a condition to enhance the credibility of disinflation. Blanchard (1998) suggests that disinflation is easier when it is purely a matter of inflation coordination, and is not accompanied by structural changes in relative prices and wages. Szapáry (1998) notes that inflation, in the presence of money illusion, may be needed to implement structural relative price changes, such as a redistribution from wages to profits. The findings of Berg and others (1998) on the differential impact of inflation on the public and private sector suggests that inflation should fall as the private sector expands. Kornai (1998) emphasizes that the behavior of unreformed economies is highly uncertain. So structural reform should precede disinflation, both to render macroeconomic developments during disinflation more predictable and to provide an offsetting underlying growth stimulus to any recessionary trend during disinflation.

Theoretical arguments favoring the reverse sequencing in a moderate inflation context are relatively few. They include that structural measures take so long that postponed disinflation risks entrenching inflation expectations (Cottarelli and Szapáry, 1998). Burton and Fischer (1998) add that the timing of disinflation should, in part, be opportunistic. It should exploit favorable supply shocks and political openings when they occur, rather than necessarily waiting for structural reforms or other desirable preconditions to be in place.

In practice, inflation stabilization in the Central and Eastern European countries was accompanied by a burst of structural reform, a pattern not evident in the Baltics, Russia, and other countries of the former Soviet Union (Figure 1). Nevertheless, by the third year of stabilization, both country groups had made similar structural progress. These patterns rarely reflected a sophisticated choice. Structural reforms inevitably take time, and particularly in the Baltics, Russia, and other countries of the former Soviet Union, inflation was so extreme that it clearly had to be addressed first. This may partly explain why political or technical trade-offs between disinflation and structural reform were apparent in only a few countries. For successful stabilizers such as Armenia, Croatia, and Ukraine, the precedence given to disinflation reflected its urgency, not that structural reform was sacrificed to disinflation or that disinflation was substituted for structural reform. In Hungary, however, the authorities argued that simultaneous disinflation and structural reform would have been politically impossible (Suranyi and Vincze, 1998): as inflation was moderate, precedence was given to structural reform. The political difficulty of implementing structural reform and aggressive disinflation at the same time has also been stressed in the case of Romania.

While comprehensive structural reform was not a precondition for inflation stabilization in most cases, minimal progress may have been necessary, notably the establishment of a “hard-budget constraint” environment and the associated termination of inter-enterprise and tax arrears. The failure of some disinflation attempts, such as the first two attempts in Russia as well as other BRO countries was in part due to the absence of such an environment.

Disinflation Reversals in 1993–97: Albania, Bulgaria, and Romania

Albania, Bulgaria, and Romania stand out as cases where substantial disinflation was reversed.1 In 1995, Albania had reduced 12-month inflation to 6 percent, and Bulgaria and Romania had reduced inflation to below 35 percent. But by the end of 1997, inflation had increased to 40 percent, 580 percent, and 150 percent, respectively.

Albania made substantial progress between 1993–95, with forceful privatization, large cuts in public employment, rapid disinflation, and strong output growth. Though electoral pressures were reflected in a deteriorating fiscal position in 1996, and some increase in inflation, the emergence and rapid growth of pyramid schemes operating on an unprecedented scale ultimately led to the financial crisis and public disorder of early 1997, and to the resurgence of inflation. Problems in Bulgaria were more long-standing. Structural reform was intermittent and uneven since 1990. Combined with political instability, this bolstered the rent-seeking culture, undermined fiscal policy, and culminated in economic crises in 1994, 1996, and in hyperinflation in early 1997. Stop-go policy has been only slightly less marked in Romania. The political commitment to the agricultural and energy sectors has pervaded all aspects of policy, from privatization and price liberalization to the exchange rate, undermining all initiatives to implement sustained structural and fiscal reform.

Chronic financial fragility, revealed in the collapses of banks and pyramid schemes, is a common feature of all three cases. And, while all three cases illustrate how long even much abused financial sectors can survive, they also demonstrate how costly delayed financial sector reform can ultimately turn out to be. Financial fragility also reflected other underlying structural weaknesses. In Bulgaria, widespread soft-budget constraints in industry undermined disinflation. In Romania, inflation largely reflected support of energy and farming, with weaknesses in the banking sector being less directly important. However, central bank support to two banks at the end of 1997 led to a significant monetary relaxation. The immediate cause of the surge of inflation in Albania was civil disorder, but the root cause of this was inadequate control of unlicensed deposit takers.

Fiscal indiscipline also undermined disinflation. In 1997, large quasi-fiscal deficits persisted after the disinflation. The ratio of the overall fiscal deficit to GDP in Albania has remained in double digits since 1992. And while Bulgaria's primary fiscal balance recorded strong surpluses prior to the reemergence of inflation, heavy quasi-fiscal losses accruing in the financial sector persisted.

1 Uzbekistan also experienced a resurgence of inflation in 1997, from a low point for 12-month inflation of 42 percent in October 1996, to a subsequent high of 82 percent in August 1997, as policies were relaxed following a poor agricultural harvest. However, thus far, this resurgence is not on the same scale as that of the Central and Eastern European countries discussed here.

Structural reform that is insufficiently comprehensive, for example, one that fails to develop effective corporate governance structures, is likely, however, to weaken the chances of maintaining price stability in the long run. As noted in Section III, strong reformers have a lower incentive to inflate and have enjoyed lower inflation. Moreover, it is significant that structural weaknesses—in public enterprises, in the financial system, and in governance structures—were behind the major episodes of inflation reversal during 1993–97 (Albania and Bulgaria after the first disinflation, and Romania; see Box 3). This suggests that those countries of the Baltics, Russia, and other countries of the former Soviet Union that stabilized inflation recently but that have not made more progress on structural reform than those countries that have experienced reversals may have difficulties in sustaining disinflation over time, unless wide-ranging reform is accelerated.

Having decided to stabilize first, most countries attempted to stabilize quickly. This likely helped credibility, given the high inflation context. As discussed above, when inflation has little inertia, as it generally has at high rates, the short-run output costs of rapid disinflation are usually lower. So a gradual approach risks signaling some lack of intent about disinflation, which undermines credibility. Bulgaria and Romania illustrate this difficulty, while the experience in Azerbaijan, Croatia, and the former Yugoslav Republic of Macedonia is suggestive of how successful such rapid disinflations could have been in these cases. But when inflation has some inertia, as more commonly occurs at less extreme rates, rapid disinflation may be more likely to incur short-run output losses. For this reason, a gradual approach is less likely to suggest a lack of commitment to disinflation because it may reflect appropriate concerns about output. This pattern does not mean that all rapid disinflations of high inflation and gradual disinflations of moderate inflation are credible, nor that the reverse pairings are always noncredible: the Czechoslovak experience in 1991 shows that rapid stabilization of moderately high inflation is possible. But the pattern suggests that gradual stabilization of high inflation and rapid stabilization of moderate inflation may have inherent credibility problems.

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