Early experience after the “big bang” of 1990
In January 1990, Poland embarked on a bold program of economic reform designed to stabilize an economy whose situation was rapidly deteriorating and to move toward a market economy. The stabilization objectives of the program were highly ambitious in themselves, aiming to bring inflation down abruptly from near-hyperinflationary levels. The attempt to build a market economy had few historical parallels in its scope and rapidity. Combining these two objectives demanded considerable boldness.
Because Poland was the first socialist country to adopt such a radical program of stabilization and reform, its early experience is of particular interest to other countries contemplating market-oriented reforms, especially the former republics of the Soviet Union. Although even now the situation remains too fluid to permit an overall assessment, this article attempts to provide an account of the program and an explanation of the course of events during its fiscal year.
The Poland of 1989 was not a textbook case of a centrally planned economy. Although most productive activity remained in state hands, the private sector accounted for more than a quarter of economic activity, including most of agriculture. Reforms undertaken during the 1980s dismantled the structure of central planning and increased the autonomy of the state enterprises—leading to a situation that was “neither plan nor market,” that is, an economy in which enterprises were subject to neither the control of the central planner nor the discipline of the market. The increased economic efficiency that the authorities had hoped would result from the reforms did not materialize, and shortages of many goods and materials persisted.
In 1989, the Polish economy had reached a state of crisis. A “wage-price maneuver”—price increases accompanied by a smaller wage increase—early in the previous year had not only failed to correct economic imbalances as intended, but also triggered a wage-price spiral. By mid-1989, monthly inflation rates were close to double digits, labor unrest was mounting, the state budget deficit was burgeoning—the result of flagging tax revenues and expenditure overruns—and the external current account was deteriorating sharply. In the face of worsening food shortages, the government decided in August to liberalize prices of most food products. As a result, food prices more than doubled in a single month. External debt also remained a major problem. The debt, which had had to be rescheduled for the first time in April 1981, had accumulated through the 1980s, as interest was capitalized—reaching $40.8 billion, nearly five times Poland’s annual exports in convertible currencies, by the end of 1989.
The critical economic situation, together with electoral setbacks, led the communist government to embark on the Round Table discussions to determine the country’s political future. These talks, which began in April 1989, included representatives of Solidarity and other political parties. In September, the coalition government, in which Solidarity was accorded a major role, gained power; this government—the first in decades to enjoy broad popular support—had to devise a new set of economic policies. It decided to try to stabilize inflation quickly and, at the same time, begin a radical transformation to a market economy.
Early results of the program
The program that was adopted combined monetary and fiscal stringency with other measures’, the exchange rate was fixed as a nominal anchor; wage increases were limited to less than inflation; prices of many producer and consumer goods were freed, with substantial increases in administered prices, notably energy prices; the zloty was made convertible for trade in goods and nonfactor services; most trade restrictions were dismantled; and the authorities initiated a number of structural reforms, including the breakup of monopolies, privatization, and financial system modernization.
The early results of the program were nothing if not dramatic. Inflation was brought down successfully from the verge of hyperinflation, after an initial corrective price jump—80 percent in January 1990—but then lingered at levels around 5 percent monthly for most of the year. Measured real wages decreased sharply (see Charts 1 and 2). But what was more astonishing and a source of deep concern was the dramatic drop in measured output—by 30 percent in the first half of 1990 compared to the level a year earlier. Naturally such a situation begged an explanation, but, as discussed later, there were no clear or immediate answers on how this output decline should be interpreted. Two favorable developments in the program’s financial performance—the surprising improvements of the government budget and balance of payments—made it easier for the authorities to continue with the program: Both the external account and the budget swung from deficit into a sizable surplus (see Charts 3 and 4).
Chart 1Retail price inflation Chart 2Real wages Chart 3Balance of payments Chart 4Government budget balance
The transformation to a market economy also began. Shortages disappeared; instead, there was talk of firms “hitting the demand barrier.” Seventy percent of retail outlets were sold off to private individuals, as were most of the trucks used for road transport. There was also a surge in informal private trading activity. Street markets sprang up, offering consumers an ever-expanding range of products.
This article is adapted from the author’s IMF Working Paper WP/91/70, “Inflation Stabilization and Economic Transformation in Poland: The First Year,” available from the author.
The early attempts at structural reform were encouraging, but also revealed the enormous practical and political difficulties in store. A privatization law emerged after prolonged parliamentary debate and compromise, setting the ground rules for privatization of enterprises by public share offering. An antimonopoly office was established and set to work addressing a broad agenda of breaking up the monopolies assembled by the central planners, as well as responding to complaints about monopolistic practices; its resources, however, were tiny in relation to its agenda. A program of financial sector modernization was begun, but the solvency of banks remained in doubt. Clearly, even with widespread agreement that the general direction of reforms should be toward a market economy, determining the details of these reforms would be a politically charged process, and one whose results were fraught with uncertainty.
The Polish economy changed direction around the middle of 1990. This was partly because there was mounting pressure to “reactivate the economy”: interest rates were cut, and an unlimited amount of credit was provided at preferential interest rates to finance the harvest; government expenditures that had been held back earlier in the year were resumed; and the wage control law was softened. In addition to these explicit policy changes, some automatic forces were at work. The wage control law, which stipulated a cumulative wage norm, permitted wages to recover some of the ground they had lost earlier in the year; the zloty appreciated in real terms, as the exchange rate remained fixed against the US dollar and inflation continued; and the budget, which early in the year was boosted by tax revenues accruing from temporarily high enterprise profits, began to weaken as this temporary boost ended.
As a result, inflation resurged, bouncing back from below 2 percent monthly in August 1990 to average 5.5 percent monthly over the fourth quarter. There was also a small increase in industrial output, which was about 4 percent higher in the second half of the year than in the first half. By the end of 1990, inflation stabilization was still incomplete, while the level of economic activity (as measured by real GDP) was an estimated 12 percent lower than the previous year.
The financial program
At the core of any successful stabilization program is a solution to the fiscal imbalance that is being financed through inflation. In Poland, fiscal adjustment was complicated by some particular features of the economy. To begin with—as is typical in socialist economies—the tax base consisted almost exclusively of the state enterprise sector: taxes and transfers from the state enterprises, including banks, amounted to about 90 percent of the revenues of the state budget. This meant that the profitability of the state enterprises was the key to fiscal balance. A second element was the enormous quasi-fiscal expenditure, namely the large implicit subsidies provided to enterprises by banks’ lending to them at negative real interest rates. Both fiscal and quasi-fiscal expenditures had to be financed by tax revenues and seignorage.
The logic of the financial plan for 1990 was as follows. There was a large cutback in government spending, particularly on subsidies. Interest rates were moved to levels projected to be positive in real terms, with the intention of eliminating the implicit interest subsidy. Revenue measures were carried out, with a view to increasing tax revenues from a given tax base. Another crucial element of the fiscal equation was the incomes policy—restraining wages would increase enterprise profitability and thus raise tax revenues. Together, the program was intended to bring the budget from a large deficit into approximate balance, while stopping the erosion of the real value of zloty money associated with seignorage.
In the event, the performance proved better than expected. Three circumstances played an important role. For one, the higher-than-expected initial inflation resulted in capital gains for the enterprises on their inventories, which led to higher tax revenues. A second element was interest rates: In January 1990, banks raised lending rates to as much as 55 percent monthly, compared with the National Bank’s refinance rate of 36 percent. Since deposit rates stayed much lower, the spread gave the banks huge (taxable) profits. A third surprise element was wage policy. As the wage control law limited wage increases to 30 percent of the increase in the cost of living in January 1990 (and 20 percent in February through April), the unexpectedly high initial inflation resulted in an unexpectedly steep drop in real wages. The extent to which this real wage decrease reduced workers’ real consumption possibilities is debatable, since shortages of consumer goods were eliminated at the same time. What is not disputed is that it helped raise the enterprises’ taxable profits.
At the core of any successful stabilization program is a solution to the fiscal imbalance that is being financed through inflation. In Poland, fiscal adjustment was complicated by some particular features of the economy.
The unexpected budget surplus of the first few months of 1990 could not last, however. The extraordinary capital gains on inventories were a one-time event, which ended as inflation was brought down. The spreads between banks’ lending and deposit rates shrank as the overall level of interest rates fell with inflation, and as households shifted a larger fraction of their money holdings out of foreign currency deposits into zloty-denominated deposits bearing higher interest rates. Wages also recovered strongly, rising 42 percent in real terms in the second half of 1990, and this lowered enterprises’ profits. In the second half of 1990, the state budget recorded a slight deficit.
The output collapse
During 1990, the most widely quoted economic figure in Poland perhaps was the decline in output sold by state enterprises—about 30 percent in early 1990 relative to the same period a year earlier. Opinions on how to interpret this output decline differed widely—ranging from the view that it signaled an economic catastrophe to the view that most of the output eliminated was essentially “scrap.” The alternative interpretations imply divergent views on what lessons should be drawn.
Measurement problems. It is widely agreed that these output figures cannot be taken at face value. To begin with, January 1990 saw a move from a shortage economy to an economy in which markets were clearing. Many goods of poor quality or unsuitable specification that could be sold in a shortage economy, due to spillovers of unsatisfied consumer demand, could no longer be sold once the shortages were eliminated. For some products, value added may actually have been negative, because of their poor quality and the wasteful use of energy and other inputs in their production. Eliminating output of such products would actually be beneficial. Moreover, the official output statistics cited included only the state enterprises, an important omission at a time when the private sector was growing by leaps and bounds.
Demand side contraction. Many economists, while accepting that the output decline was not as large as officially recorded, have recognized that there was some decline and have sought to explain it. To begin with, disinflation generally results in some decline in output. This effect is often attributed to a demand-side contraction, given price stickiness and sluggish expectations; price stickiness might have been particularly important in the Polish context due to nonprofit-maximizing behavior by state enterprises, while the adjustment of expectations might have been delayed by the public’s (understandable) lack of complete credence in the success of the stabilization program. For these reasons, a reduction in the rate of monetary expansion did not immediately result in a proportional reduction in the inflation rate, but in some persistence of inflation and in some temporary decline in real output. This view would also be consistent with the observed improvement of the trade balance and with the temporary decline in money, and therefore credit, in real terms.
Credit crunch. An alternative way of viewing Poland’s output contraction is the idea of a “credit crunch.” Some economists have argued that the real contraction in credit in early 1990, resulting from tight control of nominal credit expansion together with the large price increases, was so severe that it impaired enterprises’ ability to continue financing their productive activities. This is a supply side explanation, in contrast to the view that a demand-side contraction was at work. Real bank credit did fall sharply in the early months of 1990, continuing a trend from the latter part of 1989; this largely reflected the usual effect of inflation in demonetizing the economy.
Another way of viewing the same developments, however, is that inflation was erasing enterprises’ debts in real terms; the resulting capital gains, augmenting enterprises’ own resources, partly offset the decrease in the real credit. The decline in credit in early 1990 may also have been from an artificially high level that reflected enterprises’ borrowing to purchase materials in anticipation of price increases. Moreover, over 1990 as a whole, credit actually increased in real terms, but the drop in output persisted. Therefore, although credit may have played an important role in the 1990 developments, it is hard to believe that the real contraction of credit in January 1990 was the main factor responsible for the output decline.
Monopoly power. Other authors have focused on the role of monopoly power in the state enterprise sector, arguing that freeing prices enabled enterprises to exercise their market power, cutting output and raising prices. This argument should not be driven too far, however. Enterprises producing tradable goods but having a domestic monopoly would not cut back their production, but only channel more of their total output into exports. Moreover, in cases where prices had initially been fixed below the market-clearing level, so that there were shortages, even a monopolist’s response might be to increase both price and output. Finally, it should be noted that the freeing of prices in Poland was not an abrupt move in January 1990, but a stepwise process—in contrast to the decline in output, which was abrupt.
Other factors. Another potentially important factor is the collapse of trading arrangements in Eastern Europe and the disruptions in other countries in the region. In 1990, their impact on Polish exports was offset by various subsidies, so the volume of exports to countries actually rose by 15 percent from 1989 to 1990, but in 1991 these developments had a strong negative effect on the Polish economy. The decline in output was also prolonged by the need for myriad adjustments, at the microeconomic level, from a shortage economy to one in which the “demand barrier,” as well as the risks associated with the possibility of bankruptcy, are relevant.
Debate continues on which of these explanations of the output decline carries the most weight. These explanations have important implications for whether the program should have been designed differently, and thus for whether other countries should avoid similar policies. The credit crunch explanation suggests that credit was so tight as actually to hinder the stabilization of inflation; the monopoly explanation suggests that inflation stabilization should perhaps have been postponed until vigorous measures to break up monopolies had been undertaken. Some output decline is to be expected from disinflation in any country, though, and in Poland, this might have been exacerbated by the unusual rigidities of the existing economic system. In addition, economic and social adjustment costs are inevitable with such a major economic transition and some decline in measured output would result simply from eliminating shortages. A more gradual stabilization might have reduced the output decline somewhat, but might also have prolonged the high inflation: a rapid approach to stabilization may have been needed to create the perception of a genuine change in policy regime and break the cycle of inflationary expectations. Faster progress with structural reforms, however, could help reverse the output decline, by creating a framework in which new economic activity can emerge.
The achievements of the first year of the program were considerable. They included a substantial reduction in inflation and the end of shortages; the correction of budgetary imbalances; the convertibility of the zloty for trade purposes and substantial liberalization of trade; rapid expansion of private sector activity; substantial progress in demonopolization and small-scale privatization (notably in retailing, road transport, and food processing); and early steps toward the privatization of large state enterprises. These achievements seem modest only in relation to the program’s extremely ambitious goals and to the immense tasks that lie ahead. By the end of 1990, there were continuing sources of anxiety, notably the persistence of inflation; the severity of the output decline in the socialized sector; the emergence of unemployment, which reached 8 percent of the workforce excluding private agriculture by the end of the year; the transitory nature of some factors that had aided fiscal adjustment; and emerging signs of popular impatience with the program.
The events of 1991 have heightened fears about the successful continuation of the program. The disruptions in the Soviet economy and the breakdown of trading arrangements in Eastern Europe led to a slump in the sheltered sector of the economy that had specialized in selling to the Soviet market. This also had larger than expected spillover effects on other sectors of the economy. The decline in the economy’s GDP over the two years 1989-91 reached an estimated 20 percent. Enterprises also turned out to be less profitable than had been apparent, with the ending of the transitory factors that had increased their profits; many teetered on the edge of bankruptcy, and the revenues of the state Treasury fell off sharply. The reform program began to falter—notably, the plan for mass privatization of 400 enterprises was delayed as the authorities feared that many of the enterprises were not viable and sought to avoid the social consequences of mass shutdowns of newly privatized firms.
In the wake of the shocks affecting the fiscal position, it was difficult to reach agreement on a new plan of fiscal adjustment toward an agreed target path, and this in turn made it impossible to maintain other aspects of the stabilization program. In early 1992, the Government faced a dilemma between calls to stimulate the economy through increased spending and concerns that the resulting budget deficits would re-activate inflation.
The road ahead is a long and uncertain one. Even the progress that has been made so far is in jeopardy. Given the shocks that have occurred, a resurgence of high inflation is possible; there is also pressure to slow down the pace of reform, and in some instances to reverse it. Maintaining the momentum toward a market economy, without renewed inflation, will require political cohesion, as well as considerable patience.
Timothy D. Lane