3 IMF-Supported Adjustment Programs in Central and Eastern Europe

Georg Winckler
Published Date:
September 1992
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Mark Allen

I. Introduction

This paper explores the relationship between stabilization, economic growth, and systemic reform in Central and Eastern Europe. It draws on the experience of the IMF in helping countries in the region design and implement adjustment and reform programs since the major political transformation of the last two years. The first part of the paper discusses some of the broad features of the adjustment programs adopted with Fund support in the region. It then goes on to analyze the initial results of the programs and some issues of program design. The final sections of the paper discuss some of the lessons that can be drawn from this unprecedented endeavor.

II. Adjustment Programs Being SupportedbytheIMF

Background to Stabilization Programs

The transformation of the political, social, and economic systems of the Central and East European countries that was set in motion by the revolutions of 1989 is among the most exciting processes of our time, creating intellectual and practical challenges of immense magnitude. The task of converting a series of centrally planned or administered industrial economies into market economies on the western model has never been undertaken before. This would in itself create fertile ground for new thinking about both economic theory and policy. The conversion, however, is occurring in the real world, where matters are complicated by the accompanying political and social upheaval and by the disruption of the previous external trading patterns of these countries. In the process of economic transformation, the IMF is playing a central role, through its provision of financial assistance, through the facilitation of international support packages, and through its technical assistance programs.

Role of the IMF

Basis for IMF Support

The Fund has responded both promptly and massively to the challenges of this transformation. Adjustment programs supported by the use of IMF resources are now in place in all the member countries in the region, although that with Yugoslavia is not currently operational (Table 1). Included are stand-by arrangements with Bulgaria, Czechoslovakia, Romania, and Yugoslavia, and three-year extended arrangements with Hungary and Poland. Financial support has also been provided by the Fund to most of these countries to cope with the additional costs of oil imports they now face. In addition, the Fund has provided exceptional amounts, by its standards, of technical assistance in the areas of macroeconomic policy formulation, financial sector reform, fiscal practices, and statistics. This assistance is being provided to help the countries become integrated in the multilateral world economic system, overcome and manage the disequilibria they face, cope with the tasks of systemic reform, and give assurances to the international community that the assistance it is prepared to provide will be applied rationally and productively.

The Adjustment Programs Themselves

The fundamental tasks of scrapping the old administered economy, creating a properly functioning modern market economy, and establishing stable internal and external financial conditions are common to all the countries of the region and their adjustment programs; nevertheless, the starting points of the countries differ, as do the governments’ views concerning the political and social trade-offs. Thus, while there are many points of similarity in the adjustment programs adopted, there are also substantial differences of approach and content.

All the countries involved are in the post-communist era, but their recent political histories differ in significant ways. This has led to differences in the nature of the social consensus concerning the content of the reform process and in the level of social acceptance of the reform process and the associated hardships. Nowhere, however, has the option of keeping the old economic structures in place been feasible, because the social and political revolution has destroyed much of the coercive basis on which that system rested.

Table 1.Recent IMF-Supported Programs In Central and Eastern Europe(In millions of SDRs)
CountryType of Arrangement(SDRs)(Percent of quota)Outstanding Loans, 3/31/91Dates
Source: International Monetary Fund, International Financial Statistics.

In addition, these programs were accompanied by drawings under the compensatory and contingency financing facility.

Source: International Monetary Fund, International Financial Statistics.

In addition, these programs were accompanied by drawings under the compensatory and contingency financing facility.

In the second half of 1989, the economies of the region also found themselves at different points in the process of introducing the elements of a market economy. In Hungary, market elements had gradually been introduced over a number of years, with considerable success. In Poland, attempts to introduce radical economic reform had not really taken root, but the planning system had largely broken down. Bulgaria and Czechoslovakia had neither of them undertaken fundamental economic reforms in recent years, while Romania remained a command economy. Yugoslavia was, and remains, somewhat sui generis, with the problems of reforming its self-management market economy differing significantly from the reform process elsewhere.

Similarly, the levels of internal and external disequilibria varied substantially among the countries. Externally, Poland and Bulgaria faced very severe external financing constraints with an inability to service their debts. Hungary too faced a difficult external position, as it was able to service its external debt and remain creditworthy only by dint of exceptional efforts. Yugoslavia had managed to strengthen its balance of payments considerably and to overcome its earlier debt-servicing difficulties by maintaining a competitive real exchange rate. For Czechoslovakia and Romania, the external position was much easier, as the former had largely refrained from borrowing, whereas the latter, through the sacrifices of the population, had repaid its indebtedness. With the broad exception of Yugoslavia, all the countries have also had to cope with the collapse of the Council for Mutual Economic Assistance (CMEA) trading system, on which in some cases a considerable part of the economy was dependent. This also involved a sharp deterioration in the terms of trade of most of the countries, which was compounded by the various shocks resulting from the crisis in the Middle East.

The levels of domestic disequilibria also varied widely, with Poland and Yugoslavia characterized by incipient hyperinflation, Bulgaria by growing shortages, and Romania by the need to cope with the level of deprivation inherited from the previous regime. On the other hand, macroeconomic imbalances in Hungary were relatively small, and there was little obvious disequilibrium in Czechoslovakia.

The speed and comprehensiveness of the adjustment effort has also varied between countries, largely as a function of the above factors. In Poland, Bulgaria, Romania, and Yugoslavia, the adjustment effort has been very concentrated, reflecting the need to stabilize the economies and prevent further deterioration. The pace of economic adjustment in east Germany has been the fastest of all. In Hungary, and, to a lesser extent, Czechoslovakia, adjustment has been more gradual as the initial imbalances were smaller. However, as discussed further below, there has not necessarily been much choice about the speed of the adjustment, and the internal logic of the reform process has dictated moving to a market economy as rapidly as possible.

Instruments of Macroeconomic Adjustment and Stabilization

The adjustment programs the Fund is supporting in Central and Eastern Europe have certain common elements, although they differ in detail according to the precise nature of the problems facing the country and the approach adopted by the authorities. The programs are all designed to ensure that the use of resources is compatible with the availability of resources, that internal and external equilibrium is attained, and that an incentive structure is established in which the broader programs of structural and systemic change can work effectively.

Balancing Claims on Resources

Balancing the supply of and demand for resources is a fundamental aspect of all IMF programs and underlies much of the Fund’s discussions with the authorities. Monetary, fiscal, and incomes policies are directed to creating a low-inflation environment with an equilibrated balance of payments in which systemic reform can work effectively and investment decisions can be taken with confidence.

Monetary policy in the Fund-supported programs in Central and Eastern Europe has been designed to bear down on inflation or to prevent its acceleration at a time when there is great uncertainty about the extent of repressed inflation and monetary overhang. By keeping inflation to a minimum and promoting positive real interest rates, the monetary programs are designed to establish confidence in the domestic currencies. In some programs this has also been aided by the use of a fixed but credible exchange rate as a nominal anchor to eliminate inflationary expectations. The tight monetary policies contained in the programs have meant that credit expansion has been restrained: the programs have also therefore tried to ensure that credit expansion is not pre-empted by the government or state enterprises, but is available in adequate amounts to support the emerging private sector.

Fiscal policy under the Fund-supported adjustment programs is designed to reduce the size and scope of the state and government sectors in the economy. The budget is progressively to hand over to the market its role as the central reallocator of resources, while it becomes more important as an instrument of macroeconomic management. In this process, the relative roles of the enterprises and the government are to be redefined. First, the programs involve a very substantial cut in the giving of subsidies by the government, thus serving both to reduce distortions in the price system and to put enterprises on notice that they are responsible for their own financial results, tightening financial discipline. Under the programs, the government is to refrain from ad hoc dealings with enterprises and the tailoring of levies and subventions to the particular circumstances of the enterprise that has taken place in the past. Instead, tax systems are being reformed along the general lines of those systems prevailing now in the developed market economies.

The enterprise sector is expected to take over the role of investor from the state, investment expenditures being in general very reduced at this point of the adjustment process. In turn, the budget takes over from the enterprises much of the social expenditure that they formerly conducted, including the provision of welfare facilities and housing. This shift in responsibilities, together with the rise in unemployment associated with the adjustment process, has necessitated the establishment of comprehensive social safety nets, to ensure that destitution does not emerge.

In an environment of considerable uncertainty as to the level of inflation, and in the absence of a well-functioning labor market, the adjustment programs have all contained incomes policy measures. These have either been in the nature of national wage bargains to ensure that any necessary cut in real incomes takes place to the extent planned, or tax based to ensure that enterprises stay within the government’s guidelines, or some combination of the two. Such incomes policies have been considered necessary either to prevent wage growth in the state enterprise sector from generating inflation, or to ensure that rises in wages do not result in higher unemployment from labor pricing itself out of the market.

Reforming the System

While the adjustment programs are designed to create the environment in which the major systemic transformation can take place, there are a number of elements of immediate systemic reform that are essential to the adjustment process itself. These measures include correcting the incentive structure, opening the economy to the outside world, and hardening the financial constraints facing economic agents.

Both the price systems and the productive structures of the countries of Central and Eastern Europe have been severely distorted, and the recent adjustment programs have placed considerable stress on setting up an appropriate price structure as quickly as possible. This has involved the general liberalization of rules governing price setting and the ending of most price subsidies. Particularly important has been to make interest rates positive in real terms, thus helping to correct distortions in the price of money and credit.

Opening the economy has been viewed as essential in creating the correct structure of domestic prices, as well as responding to people’s long-suppressed appetite for foreign products and services. Domestic markets have been opened to imports of goods, quantitative restrictions have been largely eliminated, the state foreign trade monopoly abandoned, and uniform and low import tariffs introduced. In contrast to the policy sequencing adopted in Western Europe in the 1950s, current account currency convertibility, first for enterprises but also to a large extent for individuals, has been used as one of the primary measures to generate appropriate incentive patterns, rather than being the culmination of the process. This has required setting the exchange rate at an appropriately depreciated level and supporting it with adequate reserves and reserve lines of credit.

Finally, the programs have tried to harden the financial constraints facing enterprises. As already mentioned, subsidies and ad hoc adjustments of levies are being replaced with nondiscretionary tax systems. The creation of a commercial banking system is intended to ensure that credit decisions are made in a commercially sound fashion. Measures have also been taken in all countries to ensure that the high degree of monopoly in the economy does not give rise to abuses.

The raison d’être of these programs is the fundamental transformation of these economies into industrial market economies. Thus the stabilization and adjustment effort is accompanied by far-reaching measures of systemic and structural reform. These measures include privatization and the establishment of a properly functioning system of financial markets and institutions. They include a redefinition of the role of the state, the establishment of properly functioning social security systems, and the investment in infrastructure that is desperately needed. Programs to achieve this have already been launched in some of the countries, while others are in the earlier stages of planning. In all cases, the process will take a considerable length of time, and may only be substantially completed after a decade.

III. Some Resultsand Observations

Results of the Programs to Date

First Results

While the programs were being designed, it was not known how enterprises and other economic agents would respond to the new circumstances and incentive structures, and it was impossible to do precise estimation. In the event, the initial responsiveness of some economic agents proved to be large. Considerable adjustment is taking place throughout the region, and if there are areas where this progress is not as fast as hoped, in general the transformation of the economies and of everyday life is quite visible.

One sign of the responsiveness of the economy has been the strong initial improvement in the external positions of Poland and Hungary. While an immediate decline in the demand for imports has been an important element, enterprises have also shown dramatic improvements in their export performance on convertible currency markets. The rate of inflation was also brought down sharply in Poland, although not to the extent hoped, and in Hungary, where inflation was running at lower levels, there was some increase. Fiscal positions also improved, largely because of the cuts in subsidies, which in turn has improved the price structure in these countries. Finally, the programs have been successful in bringing about equilibrium on consumer goods markets and in increasing confidence in the domestic currency.

On the other hand, the problems of the transition process are also very clear, and it is increasingly apparent that stabilization may be a protracted and politically sensitive endeavor. In particular, production has fallen sharply and inflation is proving difficult to root out of the system. While the adjustment programs have been able to target nominal incomes, the targets have been achieved at lower output and higher price levels than hoped, or than probably would occur elsewhere. These two aspects of the adjustment programs are discussed in more detail below. It is also clear that it is taking time for fundamental change and restructuring to take place in state enterprises. In a situation where enormous and painful structural shifts are taking place, it is hard to maintain a strict stance of demand restraint, however vital it is for the financial stability that the transition process requires.

Collapse in Production

The extent of the collapse in production in the countries in the region has taken many observers by surprise, and the degree of the decline was certainly not predicted by most of those engaged in the reform process. The failure to appreciate the size of the problem in advance shows that in dealing with such a reform process, we have been entering uncharted waters. The substantial increase in unemployment that is occurring was predicted, but the implicit assumption was that it would occur as firms shed labor to become more efficient. This would have raised productivity and forestalled some of the fall in real incomes.

The Longer-Run Context. The collapse in production in the Central and East European countries in the last year needs to be put into the longer-run context. While official statistics showed continuing growth throughout most of the decade in most countries, the reported rates were low, and, if corrected for the probable true rate of price increase, probably negative. In any case, casual observation would indicate that production per capita and welfare throughout the region probably peaked in the mid- or late 1970s. These countries thus entered the current period of systemic change after a long period of stagnation. While it would be satisfying to blame this stagnation simply on the prevailing system of planning, the command economy did deliver impressive growth rates for a considerable period. What precisely, then, caused the slowdown?

The first explanation, which was noted by economists in the region already at the end of the 1950s, was that, while the system handled extensive growth effectively, it could not manage intensive growth well. As long as it could draw large resources of labor from relatively low-productivity areas such as agriculture and the handicrafts sector and equip such labor with modern industrial equipment, the system’s ability to mobilize resources allowed impressive growth in production. When such reserves ran out and the existing industrial labor force had to be equipped with newer, more productive equipment, the system found it difficult to cope. The reasons were widely discussed in the literature, and included the problems of creating appropriate incentive structures for managers to encourage innovation, improvement in product quality, exploiting the gains from trade, and cutting costs.

One underlying reason for the inability to squeeze improved returns from resources was the system’s excessive stress on the material, originating to some extent in Marx’s own materialist philosophy. One of the results was that it was difficult to deal with the concept of amortization. Once accumulation was embodied in a material asset, such as a machine, it was hard to accept that over time the material embodiment had become obsolete and should be scrapped, even though it was still working at or close to its design capacity. Emphasis was placed on the production of means of production (Stalin’s “Law of Planned Proportional Development”) rather than on the production of consumer goods as the final object of economic activity. As a result, large quantities of technically obsolete machines were kept in operation, holding back productivity levels and causing diminishing returns to investment. Another result of the idolization of the material was that the service sector was neglected, depriving these countries of a major source of growth.

Environmental sins thoughtlessly committed in the years of extensive growth began to catch up with the sinners in the 1970s and 1980s. Failure to take environmental consequences into account had led to declining health standards and falling life expectancy in some of the most important industrial areas, and to a decline in the quality of inputs. By the end of the 1980s, local environmental catastrophes had engendered social resistance, in some cases leading to the closing of plants.

Finally, growing macroeconomic imbalances affected production negatively. As the economies fell visibly further and further behind Western Europe, the governments tried to meet rising aspirations through borrowing or to buy off growing discontent with real wage increases unmatched with real production. In consequence, balances of payments deteriorated, involuntary savings increased, and parallel markets and repressed inflation grew. This in turn led to a further withdrawal of resources from the official sector and to further deterioration.

The Immediate Collapse. Against this background of stagnation, the further sharp declines in output associated with the adjustment process have been hard to bear (Table 2). What are the factors causing this drop?

First, all structural change is difficult. The IMF has found in its programs throughout the world that deep structural adjustment is almost invariably accompanied by a certain retrenchment in production. The greater the distortions in the economy, and the longer that inappropriate policies have been pursued, the more painful is the adjustment. As part of the adjustment process, people have to stop doing what they have become used to doing and have to look again at the economic effectiveness of their activities. The quicker they do this, the shorter and shallower is the recession. In the former socialist countries, it has proved particularly difficult for state enterprise managers to reorient their activities, since they may be ill equipped to take such decisions and highly uncertain as to their own and their enterprise’s future.

Another reason for the decline in output has been a sharp cut in demand at the outset of the program. At the start of the adjustment process, particularly in those countries where the reform has taken the form of a “big bang,” individual consumers are worried about the impact of the reform process on their incomes, are not yet in a position to assess their own equilibrium financial positions, and have been saving as a precautionary measure, reducing their current purchases. Thus the flood of imports that many expected to follow the virtual elimination of border and currency restrictions in Poland and the massive spending spree that many thought would follow the currency conversion in the former German Democratic Republic just did not occur. But citizens of the two countries have also been cautious about spending their limited resources on the domestic goods that they would happily have bought in the past.

Table 2.Decline in Output(In percent)
GNPIndustrial Production
East Germany12.0-20.0-28
Source: IMF staff estimates.

Net material product.

Generalized system of preferences.

Source: IMF staff estimates.

Net material product.

Generalized system of preferences.

The decline in demand for final goods has worked its way back through the economy. Just as final consumers have found it no longer necessary to hold large precautionary stocks, producers have found themselves able to economize on their holdings of stocks of inputs, as supply became more certain. On the other hand, with customers becoming more discriminating, and in the face of reduced demand for their products, producers have found themselves with unexpectedly high levels of output stocks. This shift from a pattern of holding stocks of inputs as a precaution against disruptions in supply to holding stocks of outputs so that customers’ demands may be met is one of the fundamental parts of the process of transition from a supply-constrained to a demand-constrained economy. As it occurs, it inevitably causes output losses as firms run up against the barrier of demand for their products. This process is probably not yet complete, as producers are still not in a position to ensure the steady availability of supplies as happens in established market economies.

Faced with radically changed economic conditions, many producers have responded slowly or appear to have decided to sit the process out, hoping for the sort of government assistance that would have been available in the past, rather than actively searching for new markets or restructuring their production processes. This has posed a challenge to the governments, which need to convince the enterprises that there is no alternative to adjustment. The extent to which enterprises have been able to react in this fashion depends on the hardness of the budget constraint facing them. As enterprises found it more difficult to sell their products, they reacted in Poland at least by putting labor on shorter hours or vacation, paid or unpaid, thereby contributing to the sharp fall in real incomes at the start of the adjustment process. They seem to have been able to survive a sharply reduced level of production by increasing the amount of unpaid bills, living off accumulated surpluses, postponing maintenance, and distributing in wages a part of the valuation gains resulting from the impact of inflation on the value of inventories. Some, if not all, of these techniques reduced the net worth of the enterprise and involved the diversion of net worth to current consumption. This has been possible because of the difficulty of the owner, the state, in exercising effective control over its assets.

The uncertainty connected with the reform process, the inefficiency of the emerging banking system, and the tightness of the government’s budgetary position have had very pronounced effects upon investment activity. This has clearly reduced the demand for investment goods.

Part of the decline in output can be attributed to the breakdown or elimination of plan discipline, a factor that was already apparent before 1989. While the planned economy did not work well, its elimination has made the coordination of economic activity more difficult during the period when the market itself is not yet functioning efficiently as a mechanism for economic coordination. This is presumably just a temporary phenomenon, until new systems of wholesale trade and contract orders can arise. In any case, the sort of social control that plan discipline involved is not compatible with the new political and social systems emerging in these countries.

The change in trading arrangements among the CMEA member countries has also been a major factor in causing the decline in production, and the full effects of this are being felt in 1991. The change in the pricing system, particularly for raw materials imported from the U.S.S.R., has led to a sharp adverse terms of trade shift for most of the countries of the region. The introduction of convertible currency payments has sharply increased the competition facing Central and East European producers on each other’s markets. The integration of these economies was effected through the planning mechanism that has now been abandoned, leaving producers without their accustomed distribution system in partner countries. Then the level of effective demand on these partner country markets has been greatly reduced, and in some cases there is considerable disruption: nor is it clear how soon this demand will revive. Nevertheless, it is important that these countries keep their markets open to the products of the others during the transition process, as there could be considerable efficiency gains from trade, particularly because of the similarity of the inherited production structures of these countries.

While production has clearly been declining in the socialized industries, the overall decline in production may be much less than the statistics show. Statistical systems are still geared largely to reporting by large enterprises and do not pick up much of the burgeoning private economic activity. Of course, the latter starts from a low base, and is clearly overwhelmed by the relative size of the socialized sector. However, those data that are available together with casual observation seem to indicate considerable dynamism in this sector. Not only is the statistical apparatus less well oriented toward this sector, but the sector probably tries to avoid contact with the state to the extent possible, making it difficult to pick up even indirect information about its output. This sector has long been part of the black, underground economy, and the habits associated with this die hard.

The fall in production that is occurring has been large, and neither can nor should be explained away. But positive features balance it. First, consumption in those countries that are furthest advanced on the reform path has become much more efficient. Goods are available, attitudes toward customers are changing, and the waste of human resources in queuing has ended. Thus the reduction in welfare is probably considerably less than the reduction in output. Second, it is important that pressure be kept on enterprises if they are to adjust. It is by having to search for markets and having to cut costs that enterprises will become efficient and responsive. Finally, the decline in production that has been occurring is not an endless process: these economies are not in some sort of free fall. Enterprises are finding markets, some are clearly adapting, and there seems to be a floor to the fall in production.

What Can Be Done to Limit the Fall in Production? The sharp fall in production that is occurring in Central and Eastern Europe seems to be happening regardless of whether the governments have adopted strong adjustment programs or tried to avoid and postpone adjustment altogether. This would seem to indicate that the causes of the fall lie rather deeper than macroeconomic demand management policies. If this is so, the issue for governments becomes how to manage the process so as to ensure that the resulting production structure is more efficient and a better basis for long-run growth.

East Germany is in some ways the extreme case of what is happening in the rest of Central and Eastern Europe. The east German economy is subject to the full force of competition from Western Europe, with no protection, either through the tariff system or through the exchange rate. Real wages are rapidly finding their way to west German levels, and very little east German industry can compete. This is resulting in the almost total destruction of east German industry (although this may rapidly be replaced by new investment), and in a very steep rise in unemployment. This is occurring despite transfers for social welfare programs and capital investment on a scale much greater than the rest of Central and Eastern Europe can hope for. It is clear that in the east German case, there is no shortage of demand in general, just of demand for the sort of products that east Germany produces. Thus the injection of demand into the economy, as is already happening through the transfer payments, would find its way primarily into the balance of payments and into the prices of nontradables, since the price of tradables is already largely determined on the west German market. If the market was more protected, the injection of demand might have some effect on production. However, the experience of Poland in the middle of 1990 shows that such additional demand pressures may first find their way into the price level and the balance of payments.

Adjustment in the face of such a distorted production structure is bound to entail output losses. If output includes the production of items with negative value added, cutting production can actually increase national income. The opening of the economies of the region to foreign goods reflects in large part the wish of consumers to have access to the goods that have been so scarce for the last forty years. The main instruments at the authorities’ disposal to control output loss are the exchange rate and wage policy, which can allow domestic industry to remain profitable for a time and can keep real wage costs competitive. The availability of these instruments is one reason why output losses elsewhere in the region have not been as sharp as in east Germany.

Beyond the general protection given by a competitive exchange rate, governments may choose to give special protection and assistance to particular industries. This, however, poses a number of problems. First, the state has not shown itself in the past a particularly good judge of comparative advantage, and is unlikely to be able to pick the winners today. Individually tailored protection is more likely to be directed to those industries that can make the loudest noise. Protection can also be justified in terms of giving industry time to adjust, rather than forcing the adjustment to take place virtually instantaneously. In all countries, protected infant industries have a tendency to go senile before they grow up. The evidence is mixed about the willingness or ability of Central and East European management to adjust, even given time: for example, despite the looming problems of trade with the U.S.S.R. for the last year and a half, enterprises dependent on that market have generally done little to protect themselves.

Gradualism—to give enterprises time to adjust—can reduce output losses and smooth the transition, but only if the government’s insistence on ultimate adjustment is credible. In the past, the government has always tailored its policies to accommodate the more severely affected enterprises. As discussed below, establishing credibly that economic units have to adapt to the requirements of the market rather than expect assistance from the government is the central task of the reform process. In practice, direct action now to reduce such losses is likely to postpone the achievement of policy credibility, and thus result in greater losses over a longer period.

Some Issues in Program Design

The adjustment programs described above were designed under even more uncertain conditions than is usual. The unprecedented nature of the task of transforming an administered industrial economy into a market economy meant that few guidelines were available for policymakers. The basic parameters underlying macroeconomic policy were inevitably based largely on guesses. The size of the monetary overhang in particular, and the response of both consumers and producers to the opening of markets were unknown. Basic statistics describing the economy are poor and not a very helpful guide to policy. The external environment, and in particular the future of trade among the countries of the region and with the U.S.S.R., remain very uncertain. By early 1991, however, some hindsight is available to allow preliminary judgments to be made about the policies adopted in the first programs.

Monetary Policy

The Monetary Overhang

The principal issue in the design of monetary policy has been to estimate the extent of the monetary overhang and the effect on spending and on the price level of the liberalization of markets. Problems in estimating the extent of the monetary overhang are reflected in the difficulty in assessing the initial jump in prices expected to follow price liberalization and in choosing the correct level for the exchange rate.

In those countries such as Hungary and Yugoslavia where domestic prices have been allowed for some time to reflect supply and demand conditions, such an overhang was judged not to exist. In Poland, where unofficial markets had been widespread on which both domestic and imported goods were available at prices several times the official price, the existence of an overhang depended on whether prices were measured at official or unofficial prices. Widespread monetary overhangs were thought to exist in Bulgaria and Romania, while in Czechoslovakia, the data indicated little overhang if any. In general, though, programs seemed to have underestimated the size of the initial jump in prices.

It is worth recalling that a serious concern of policymakers was that the opening up of markets, with currency convertibility and largely unrestricted imports, would lead to a rapid consumption boom, as consumers, long starved of foreign consumer goods, immediately spent their holdings of money on imports. This was a major fear before the introduction of the deutsche mark in east Germany and before the big bang in Poland on January 1, 1990. In fact, a spending spree of the magnitude feared did not emerge, although foreign goods became widely available on the market. Instead, uncertain of the future, and apprehensive about their future income levels, people in both Poland and east Germany strove to build up or maintain their holdings of money. There was, however, a shift in demand from domestic to imported products, which made it harder for domestic producers to sell their output.

Concern about the impact of liberalization of prices and of exchange and trade controls on the balance of payments lay behind the establishment of a stabilization fund in Poland and the mobilization of support in other cases through the Group of Twenty-Four mechanism. Such external assistance has been mobilized in conjunction with IMF support to ensure that liberalization can take place without running into an external financing constraint.

The Exchange Rate. A related issue is the use of exchange rate policy in these programs. In all cases, the exchange rate was expected to provide a sufficient competitive margin to allow the balance of payments to be strengthened. From that point, however, some programs have regarded a fixed exchange rate as a vital nominal anchor to combat inflationary expectations, while others have concentrated on its use to ensure continued strengthening of the balance of payments. The use of the exchange rate as a nominal anchor has been important in Poland, Yugoslavia, and Czechoslovakia; in the first two, the main task of macroeconomic stabilization was to break the momentum of inflation. In Hungary, a rather more flexible exchange rate policy has been followed, while in Bulgaria and Romania, because of the extremely tight external financial position and the considerable uncertainties, a floating exchange rate policy was adopted.

Using the exchange rate as a nominal anchor requires that the government convince economic agents that it has the desire and the will to defend the exchange rate. If the exchange rate is fixed at a level that gives considerable competitive margin to domestic producers, as turned out in Poland, its initial impact in stabilizing price expectations may be relatively small, since, although imported goods prices are largely frozen by the exchange rate, there is considerable room for the prices of domestic producers to rise. When price rises of domestic products reach the point that their competitiveness is in doubt, the government may face a test of strength with domestic producers calling for a change in the rate. Then the establishment of credibility requires permitting firms to suffer in order to force them to cut costs to remain competitive. Since firms, particularly in the export sphere, may be used to the government adjusting the exchange rate or otherwise ensuring the profitability of export production, it may require considerable strength of purpose on the government’s part to resist doing so again. Nevertheless, this determination to keep the exchange rate fixed can be part of the process of hardening the financial constraints facing enterprises and of forcing them to make the cuts in costs and to raise productivity as is required for these economies to progress.

Problems in Monetary Control. A further issue is the conduct of monetary policy in the absence of developed financial markets. In most cases, commercial banks have only just been spun off from the central bank, on which they often rely for their accounting capabilities. They have a staff that is untrained in techniques of credit analysis (and would be trying to do such analysis in very difficult conditions), have had little experience in modern banking, and are used to acting as an executing agency rather than as economic principals. The banks inherit a portfolio of assets for which they do not feel responsible and which may be of dubious quality. The payments and accounting systems are archaic. There is also little real competition between financial institutions as yet. Bank supervision remains in a rudimentary stage.

These conditions complicate the conduct of monetary policy by the central bank. The virtual absence of money and other financial markets makes the use of indirect instruments of control more difficult and means that there is a lack of feedback to the authorities about monetary conditions. Nor can the monetary authorities be sure that tighter financial conditions will result in credit being rationed to the most efficient users. It has therefore not been possible for the central banks to rely on using the refinancing rate and other indirect instruments as the main means of ensuring control over credit expansion. Some countries have had to put direct controls on credit expansion by individual state-owned banks or to apply moral suasion to this end. They have also sought in this way to ensure that an adequate part of any credit expansion is directed toward the emergent private sector. While this may be necessary to secure stable financial conditions in the immediate future, it does not help to promote a competitive and efficient banking system in the longer run. The IMF has therefore attached considerable importance to providing technical assistance to allow the proper functioning of money and other financial markets and to ensure that proper payments, accounting, and bank supervision systems are put in place as soon as possible.

Wage Policy

It is not surprising that wage policy has emerged as one of the most difficult areas of post-socialist macroeconomic policy. Freedom of wage bargaining seems to most people a reasonable quid pro quo for freedom of price determination. When the new governments rest on the support of labor movements, attempts to control wage levels can seem like betrayal, particularly at a time when living standards appear to be falling and aspirations for the good life are growing.

But wage growth has had to be moderated for two reasons. First, the adjustment process has required that the growth in consumption be limited or even that consumption be cut to strengthen the balance of payments, raise domestic savings, and improve the macroeconomic balance. Second, moderation in real wage policy can limit the rate at which employers shed labor. In this context, while wages are not the only cause, the sharp rise in unemployment in east Germany must be a salutary example to the rest of the region.

Governments have thus tried to engineer a cut in real incomes as measured by the official price deflator in most countries in the region. This has often been done in agreement with the unions. In Poland, the actual cut in real incomes that emerged was considerably larger than expected (mainly because the initial price adjustment was larger), although subsequent nominal wage growth has since restored much of the unexpected loss. Partly in response, unions in other countries have sought assurances from the government that losses in real incomes will be kept close to the agreed level.

Most countries have freed wage formation in the private sector, which has sometimes led to a considerable exodus of the more marketable employees from the state sector. However, state enterprises in particular, and those facing a relatively weak budget constraint in general, cannot be relied upon to resist pressures for higher wages, which in turn can be expected to feed rapidly into the price level and the balance of payments. Some countries have tried to refrain from direct controls by relying on draconian excess wage taxes for increases beyond some (usually enterprise-specific) norm. Others have set strict limits on the wage bill paid by individual state enterprises. These mechanisms, while necessary, are not very efficient. Not only do they inhibit an enterprise from taking responsibility for its wage levels, they encourage creative accounting to get round the rules set by the center. Thus they can be expected to be effective only in the short run.

In the longer run, there is no substitute for the development of a harder budget constraint at the enterprise level, which can be assisted by privatization, but also depends on making funds difficult for enterprises to obtain. Unless a policy of wage restraint receives the convinced backing of powerful unions, tight credit policy may turn out to be a more effective way of ensuring that adjustment programs are not thrown off track by excessive wage pressures.

Fiscal Policy

Fiscal policy in the adjustment programs has generally been tight, with very large reductions targeted in the fiscal deficit as a share of GDP. In Poland, the fiscal target was even exceeded by a considerable margin in the first part of 1990. This reduction in the deficit has been a major factor in promoting macroeconomic balance and in ensuring that there was room for credit expansion to the rest of the economy. The reduction in the deficits has largely been achieved through the cut in subsidy payments and from revenues generated by the surprisingly high profitability of enterprises.

Nevertheless, pressure on state budgets is clearly growing. The need to finance social safety nets to cover growing numbers of unemployed, the evident need for public investment to rehabilitate decaying infrastructure, and pressure to support social groups that feel disadvantaged from the adjustment process can be expected to grow. Furthermore, the extent of contingent government liabilities resulting from both past and present policies is as yet unknown and may turn out to be large.

On the revenue side, problems of a collapsing tax base are beginning to emerge. As the adjustment process continues and pressure on state enterprises continues, their financial position is worsening, and it is this sector that generates the bulk of tax revenue. The profitability of state enterprises has also been affected by the difficulties in trade with former CMEA partners and possibly by an increasing tendency of managers to hide assets from the authorities. At the same time, it is hard to collect taxes on the population and the rapidly expanding private sector. It is clearly necessary to push ahead as rapidly as possible with the widening of the tax base, through the introduction of broad-based consumption taxes, such as the value-added tax, a personal income tax, and taxes on the profits of private sector activity. At the same time the customs and tax administrations need to be strengthened as a matter of priority.

Problems in Systemic Reform

Stabilization and Systemic Reform

It is clear that stabilization and systemic reform have to be pursued simultaneously. Without stabilization, democratic support for the governments of the region will be undermined, and the aspirations of the population for higher living standards will be translated into continuing inflationary pressures. Without stabilization, internal and external confidence in the economies of the region will not be restored, and the capital flows necessary to support the resumption of growth will not occur. Without stabilization, resources will not be effectively channeled into productive investment. Without stabilization, the financial sector that a developed economy requires will not be able to emerge.

The immaturity of the free market institutions in these economies, however, contributes to the problems of stabilization. Poorly developed financial markets inhibit the direction of credit to the more productive users, hindering the development of new suppliers. The labor market remains underdeveloped, making the regulation of wages and employment more disorderly. The extent of monopoly in the economies limits the extent of free price formation in some important sectors. The response pattern of management in state enterprises makes the system more prone to inflation, and has led to larger output cuts than would be expected elsewhere. These factors are related to the softness of the budget constraint. In view of this, practice has now shown that there are some areas where controls have to be kept in place for a time, until market control mechanisms have developed.

One such area is the state enterprise sector. This is rather paradoxical, since the main thrust of the economic reform discussion in Central and Eastern Europe for many years was the need to take the hand of bureaucracy off the enterprise sector and to allow management freedom to take commercial decisions. However, unless management is to be given the rights of ownership, and this is difficult with competing claims from the population in general and the work force in particular, management cannot be relied upon automatically to exercise control over the enterprise’s assets in the interest of the state. Indeed, in the more freewheeling economies that are now emerging, the dangers of the improper disposal of assets by management, either for their own benefit or for that of the work force, are likely to be more serious. The market can only be expected to tighten the budget constraint for state-owned enterprises to a limited extent. It is thus necessary to ensure that these enterprises meet financial targets and that they do not pre-empt the available credit in the economy. Nevertheless, problems of effective control of state enterprises are also widespread in market economies. With an extensive state sector inevitably remaining for many years in the economies of Central and Eastern Europe, the need to maintain strict control by the owner will also persist.

A second area where the market cannot be expected to operate efficiently from the start, and yet cannot be allowed to stumble, is that of monetary policy. An adequately functioning financial system is something of a public good, and the authorities cannot afford to let it collapse at the start of the reform process. The monetary authorities could try to control credit through interest rate policy and manipulation of reserve requirements, but the existing banks are unlikely to be sufficiently flexible to respond efficiently to such instruments. While competition between banks would help ensure that the use of these monetary policy instruments had a predictable effect on the volume of credit, in the absence of effective bank supervision, banks might be tempted into excessively risky operations. Since the main banks are either owned by the state or would probably not be allowed to fail, such risky behavior could create considerable liabilities for the government.

It has thus been found necessary to rely on the use of moral suasion and direct credit controls until such time as money and credit markets can become better developed. Banks also tend to prefer their established clients, primarily the existing state enterprises, either because they find it less trouble to deal with them or because they consider them more creditworthy and less likely to fail. As part of the adjustment programs, moral suasion has been applied to the banks to ensure that sufficient credit was made available to the emerging private sector.

A final area where it has not been possible to let market forces work fully is that of wages, discussed more fully above. Until enterprise management can be relied upon to resist wage pressures sufficiently, there seems no alternative to some form of wage controls for the state enterprise sector at least.

Hardening the Budget Constraint

When Kornai characterized the primary difference among modern economic systems in terms of hard or soft budget constraints, he gave us a very fruitful way of thinking about the problems of economic reform. The issue of tightening the budget constraint on economic agents is fundamental to the process under way in these economies. The term provides a useful shorthand to describe what is in reality a very painful process. It involves making people feel that they are subject primarily to the forces of the market, and that they can no longer appeal to the state for help or relief, except in a few well-specified areas.

Marx wrote about market fetishism, by which he meant that, in a market economy, the market itself was seen to be an impersonal, but living, force to which individuals felt themselves subject. He saw his work in part as the destruction of the mystique of the market, tearing away the veil to reveal that market forces were really a front for some people doing things to other people. In this at least, the economic systems that were put in place in Central and Eastern Europe and elsewhere in his name were a success, in that people saw clearly that domestic economic forces were largely the result of people doing things to other people. The task is now to put the veil back in place, and to convince people that the costs of conscious intervention to right individual economic problems are outweighed by the losses in economic efficiency and dynamism that such intervention entails. While this point has been largely accepted politically, its application in individual cases, letting firms go bankrupt and people be put out of work as a result of impersonal market forces, is very painful and calls into being strong lobbies and pressure groups that can have powerful voices in the newly emerging political systems.

Without a hard budget constraint, economic theory gives us no reason to believe that the market will allocate resources correctly. In more practical terms, we are now seeing the introduction of measures in the region which, if introduced in a market economy, would lead to very rapid adjustment by economic agents. In Central and Eastern Europe we find that the response patterns of enterprises, particularly those in the state sector, are both slower and different from those we would expect. This takes the form of the absence of bankruptcies, the accumulation of unpaid bills, and continued automaticity in granting credits by the banks. It takes the form of an unwillingness by firms to shed labor or to make difficult changes in production processes to raise productivity or to find new products for new markets. It contributes to the unfavorable trade-off between prices and output, with enterprises preferring to raise prices and reduce output, rather than maintaining output and cutting costs. It manifests itself in the increasing voice of the workers inside the enterprises and, in the absence of countervailing forces, contributes to the wage pressures that are now being felt.

The adjustment programs in place in Central and Eastern Europe have included a number of measures to strengthen the budget constraint. The first has been to open up the economies to foreign competition, by liberalizing border restrictions and barriers to the entry of new competitors on the domestic market. Governments have also taken steps to reduce the degree of monopolization in the economies and to ensure that monopoly power is not abused. The second has been a very sharp cut in subsidies, both price subsidies and subsidies to individual enterprises. Governments have told enterprises that they cannot in the future be expected to be bailed out by the government if they get into financial difficulties: but the problem remains for governments how to make this threat credible. Another measure to tighten the budget constraint has been to tighten credit policy, with the aim of having credit decisions made only on a commercial basis: however, problems in the banking system can prevent the full implementation of this goal.

The measures that have been taken have changed these economies from supply- to demand-constrained economies. Enterprises throughout the region are now aware that they face a demand barrier that did not exist before. In these circumstances, there are inevitably pressures on the government to ease that barrier before it puts some enterprises out of business. In addition, enterprises see foreign markets as a source of demand, and put pressure on the government to keep the exchange rate sufficiently depreciated to guarantee their profit levels on exports. These pressures create a major challenge to governments throughout the region: once enterprises feel the budget constraint biting, they press the authorities, not just for individual but also macroeconomic relief. To give way to such pressure will show enterprises that the market is not such a hard taskmaster, and the government will again accommodate them. This will postpone again the hardening of the budget constraint, and make it that much more difficult for the authorities to gain credibility for their policies. On the other hand, failure to give relief will inevitably result in business failures which in turn will be blamed on the government.

The virtual absence of bankruptcies in the new post-socialist economies has been noted by many observers. When a medium-sized industrial market economy can expect to see several thousands of bankruptcies a year, even when the economy is not in recession, the virtual absence of bankruptcies in the economies of Central and Eastern Europe during a ferocious contraction of economic activity is remarkable. Explanations in terms of macroeconomic conditions, such as the various cushions the enterprises have on which they can survive, or the high profit levels stemming from unorthodox accounting practices, are unconvincing in the face of such a situation. The reason for this has to be found in the incomplete reform of the economic system.

Bankruptcy refers both to a company or individual seeking protection from its creditors and to an orderly distribution of the assets of a company among its creditors. What appears to be missing in most of the countries of the region is a precondition for this, that is, a legal system that effectively enforces contracts. Until a creditor, whether a voluntary or involuntary creditor, is able to go to the courts and enforce a judgment against a debtor, it seems impossible to reach the ultimate stage in the process—bankruptcy—when the debtor has insufficient assets to meet the claims. At present the courts in the region either do not regard the enforcement of contract as being their job, are afraid of the political consequences of enforcing contracts, or do not possess the means to do so. The absence of effective contract enforcement is a major obstacle to the development of normal business relationships and the hardening of the budget constraint.

If the courts were more assiduous about enforcing contracts, what would be the effect? The most important is that banks and commercial creditors would be able to prevent the accumulation of capitalized interest, involuntary loan rollovers, and unwanted interenterprise credit, all of which at the moment complicate the conduct of monetary policy and make credit restraint bite hardest on the weaker and less-established sectors of the economy. The absence of an ability to pursue claims through the courts makes it difficult for banks to evaluate their portfolios or to take proper credit decisions. The banks still in general prefer cozy relations with their old clients to actively seeking out new clients. If contracts were better enforceable and the banks themselves were subject to financial discipline, credit restraint would be more effective in forcing enterprises to adjust, and those bankruptcies that took place could be credibly attributed to the functioning of the market and the inability or unwillingness of those involved to adjust, rather than being blamed on the actions of the authorities.

Instead of an orderly bankruptcy that protects the interests of creditors and thus helps preserve capital, the economies are facing a series of disorderly bankruptcies. Enterprises facing increasingly difficult financial conditions, unwilling or unable to adjust, and without an owner interested in preserving capital, may face gradual decline. To maintain wage payments, the enterprise will sell whatever assets are moveable and seek to borrow where it can, including through failing to pay suppliers. This process may go on until there are just no liquid assets left, no money in the till, and no supplier willing to provide goods on credit. At this point the doors may be closed, leaving a derelict factory, and a lot of debts, including back wages to a now unemployed work force.

Hardening the budget constraint requires making sure that the owner of each asset in the economy is able to exert his ownership rights to the fullest possible extent. This is one of the strongest arguments for rapid privatization, since it is virtually impossible for the state to exercise effectively its ownership rights over the assets of state companies when they are so numerous. Instead, what is being witnessed now is a struggle between management and workers over the disposal and use of state assets. With other claimants on those assets—other creditors such as banks and suppliers—unable to press their claims, those effectively in control of those assets have a temptation to run them down when pressures mount. Only if management and work force believe that such a consumption of an enterprise’s substance would reduce the gains to them from privatization would they refrain.

Insofar as privatization creates an owner interested and able to get the maximum return from his assets, it can harden the effectiveness of the budget constraint on other units. But it is not a panacea. Large private firms can wield political clout and press the government to accommodate them in its policies. Furthermore, with much political capital tied up in the privatization process, governments are going to find it difficult to stand by with folded arms when newly privatized companies go bankrupt, putting people out of work and destroying the newly invested capital of part of the population. This is necessary if the government is to gain policy credibility and if the belief is to spread that it is the market, not the government, that determines economic success and failure. This will not be an easy task for the emerging democracies to cope with.

The urgency of privatization may also create pressures for an easing of financial market conditions to allow greater use of credit to purchase equity. There may also emerge a lobby arguing that financial conditions must be liberalized for the private sector to thrive. However, unless stable financial conditions are assured, the privatization process is likely to be more difficult in the longer run, as the uncertainty attached to the future stream of earnings will be greater.

Riding the Tiger

The similarities of the adjustment and reform programs in Central and Eastern Europe reflect not just a shared diagnosis of the problem and a common vision of the goal, but also the rather limited options facing the authorities in the region. The process of political and social change that has been unleashed makes impossible the use of the instruments of economic control that were applied in the past. Political liberalization makes it impossible to enforce the discipline required for a planned economy. Individual people demand more autonomy both in their personal and working lives. The imposition of strict border controls conflicts with the human freedoms that have been won. Much of the economic liberalization that has taken place reflects an unstoppable demand for more freedom in everyday life as well as the goals of the new leadership.

In these circumstances, what is the scope for governments to control the process, and how should they do so? Is there scope for the process of change to be slowed and the degree of pain in the adjustment process reduced? The principal option here seems to be the use of the exchange rate to ensure that domestic production remains competitive and that real wages are kept within bounds. However, by making things more comfortable for domestic producers, it reduces the pressure to take the painful microeconomic adjustment measures that are needed if productivity is to be raised, and tends to prolong the inflationary tendencies already inherent in the system. The alternative approach would allow a measure of protection and subsidy to many sectors of the domestic economy. This would postpone the adjustment of the output mix of the economy and would require larger amounts of external support. It might cost less, but only if enterprises could be relied upon to realize that any support was temporary and that they should make themselves able, as soon as possible, to do without it.

Governments are certainly going to be tempted to control the process of adjustment, and a range of instruments is available. Border restrictions, trade licenses, price controls, and intervention purchases to support the agricultural market can all be used in response to particular problems of adjustment. But governments are also considering seriously the question of the extent to which the use of such measures is consistent with the development of an economy where market forces are the basic constraint on economic activity. These temptations need to be resisted as they will prolong distortions and hinder growth for a considerable time. More rapid structural change, rather than prolonging the life of old structures, is the key to the rapid take-off of which these economies are capable.

After the revolutions of 1989, macroeconomic management has come into its own in the region. This is an area where the IMF has much experience and a lot to offer. It may be somewhat frustrating for policymakers, since the financial tools available are relatively blunt and general, compared with the specificity of the economic interventions to which they are accustomed. Managing an emerging market economy by using macroeconomic instruments does require courage: the government is blamed by many for the pain of the adjustment process, and maintaining the necessary policies requires political will. Pressures for the early relaxation of macroeconomic adjustment policies are not a peculiarly Central or East European phenomenon, but responding to them is particularly dangerous at a time when financial discipline is the key to hardening the budget constraint and thus successfully pursuing a historically unprecedented economic reform. Fortunately, this danger is fully appreciated by the governments of the region, and they can count on the financial and technical assistance of the IMF as they meet this challenge.


Jan Mujzel

I have read Mark Allen’s paper with great interest and enjoyment. I think that it is a methodologically successful and convincing attempt to sum up the first experiences of transformation in Central and Eastern Europe. The author has concentrated on Hungary, Poland, Czechoslovakia, and east Germany, but, for obvious reasons, the relatively richer Polish experiences have become the main basis of his reflections and conclusions.

Mr. Allen’s presentation touches on many topics. It encompasses the whole range of the solution, in my view: stabilization as well as systemic issues, including issues related to the reconstruction of ownership relations. Of particular importance here and throwing a new light on understanding the logistics of transformation are the analyses of currency exchange rates, the breakdown of production, and the significance and forms of strengthening budgetary constraints in socialized enterprises.

I have decided to confine my remarks to one issue—the breakdown of production and the ensuing conclusions for stabilization policy and the entire transformation policy. I may view this issue too narrowly—from the point of view of current reality and needs in Poland—but only in this sphere do I feel fairly competent. The “Polish lessons” may turn out to be helpful also in a broader context, but the subject would require additional information and analysis.

With the launching of the Polish economy on the road to radical transformation (that is, from the beginning of 1990), the decline in economic activity—which has generally been referred to as recession—has no doubt become a fundamental problem. First of all, this decline has turned out to be a serious one, incomparably greater than the Government’s predictions had indicated. In 1990, the gross national product was lower by 12 percent, according to official data, compared with the previous year. Industrial production dropped by 23 percent; unemployment—a hitherto unknown phenomenon—rose by the end of the year to over 1.1 million, that is, 2.3 percent of those employed outside private agriculture and 6.1 percent of the total number of working people. In the first quarter of 1991, the recessionary trend persisted. Second, the deep recession, while not the only one, became the major source of the high social costs involved in transformation. In 1990, the average real wage decreased by 32 percent, compared with the previous year, and in March 1991 it was 13.5 percent lower than in December 1990. The consumption level per capita decreased in the first three quarters of 1990 by 27 percent in relation to the corresponding period of 1989 in worker families and among the retired and pensioners, and by 23 percent in peasant and worker-peasant families. To a certain extent, this decrease was compensated by the benefits stemming from market balance and opportunities for private enterprise. Nevertheless, support for the Government’s economic policy by numerous social groups was dangerously eroded. Third, to a large degree as a result of the recession, investment in 1990 decreased by about 8 percent, compared with 1989, which had anyway been unfavorable. In the decapitalized economy, the 18 percent decrease in outlays for machinery and other equipment was particularly severe. Fourth, the persistent recession became a threat to the stabilization so far achieved. In the fourth quarter of 1990 and in the first quarter of 1991, there were considerable deficits, of 10-11 percent, in the state budget, which led to mounting difficulties and tensions. As in 1990, the trade balance was also negative in the first quarter of 1991.

The recession has been generated by internal as well as external factors. The first includes already existing and corrective inflation (the latter evoked by stabilization decisions) and restructuring. Stifling high levels of inflation, necessary to create an efficient market mechanism, required a restrictive monetary and fiscal policy on a scale that almost inevitably led to the decline in economic activity. Restructuring, which was to have transformed the inefficient post-communist economy into a modern economy capable of competing in foreign markets and of raising the standard of living of society, can only be destruction with simultaneous creation. The relation between these processes determines the recession-inducing nature of restructuring. Today both of these processes are in their initial stages in Poland. External factors include recession before transformation was begun and unfavorable changes in economic relations outside Poland, including the loss of the traditional sources of supply and sales markets owing to the disintegration of the Council for Mutual Economic Assistance (CMEA).

Perhaps, in conditions that are favorable in every respect and with the optimal intensity, sequence, and form of the stabilization and systemic policy, transformation would not have had to be accompanied by recession. At present, however, this is only a theory, not confirmed by any experience. At the beginning of transformation, there were unusually favorable political conditions in Poland, but also particularly unfavorable economic circumstances—high inflation and devastation in most markets, declining production, decapitalization, technological and organizational backwardness, an alarming situation in the natural environment, and a high foreign debt. What was feasible in such circumstances was not avoidance of recession but rational minimization as regards its depth and duration.

In the light of these facts and contingencies, could the recession in the Polish economy in 1990-91 be considered minimized? Or, to put it another way, did the Solidarity-led governments succeed in carrying out transformation at the lowest possible cost? I think that an unmistakably affirmative answer would not be justified.

No doubt, in the transformation process there are changes that if resolutely and immediately implemented (even as shock treatment) in the first phase determine the success of the entire operation. These most certainly include the removal of high inflationary overhang; liberalization of prices and bringing equilibrium to markets; balancing the state budget; internal convertibility of at least domestic currency; removal of monopolist structures and positions; and transformation of ownership, including a radical change in the model of state enterprises, or their commercialization. And there are also changes that, even if they are necessary and desirable from a certain perspective, may be implemented gradually, more gently, making transformation relatively smoother, less painful, and therefore more effective. I think that these changes consist of devaluation, which already stabilizes the exchange rate considerably in the first phase; elimination of price subsidies that are in excess of the undisputed needs of budgetary equilibrium; and the lowering or cancellation of import tariffs, often beyond the degree of freedom of trade in the highly developed market economies. The controversial nature of the transformation policy so far has meant that by agreeing to delays in changes in the first group has excessively forced changes in the second group.

There were also certain significant imperfections in execution, such as the overregulated conditions of foreign investments, the manner of taxing wage raises, or the system of development credits, unadapted to the still high rate of inflation.

In effect, the substantial and undisputed successes of transformation were accompanied and continue to be accompanied by negative phenomena that could have been avoided, and by threats. Corrective inflation and then recession turned out to be not only excessive, but also not effective enough. This excess is evident from the unexpected surpluses in the budget and the trade balance in 1990, and also by the role of the “overshooting” exchange rate as an inflation-inducing factor for at least a year instead of as an anti-inflationary anchor and source of pressure for efficiency on domestic manufacturers. And the high rate of inflation that was maintained along with the very modest progress in efficient restructuring of the socialized sector have to be regarded as an expression of limited effectiveness. Presumably, in such an important and unprecedented operation, with the unusual accumulation of tasks, the lack of experience, and the scale of uncertainties, it was difficult to avoid conceptual errors and mistakes in implementation. But this is an entirely different matter.

The evaluations mentioned above are the natural starting point for considering as priority tasks the fight against inflation and the guiding of the economy onto the path of efficient growth. In my view, this is justified by economic as well as political considerations. Economic premises consist not only of resources of the work force and the means of production. They also consist of institutional changes already attained in the course of transformation in ownership relations, the market environment, the financial infrastructure, and capital, technological, and organizational options that accompany foreign credits and direct investments. Political considerations are even more obvious. Nobody really knows what are the limits of society’s endurance of sacrifice and suffering caused by the recession. Many facts, however, indicate that we are dangerously close to this boundary. Underestimation of the problem of recession may simply disturb the political foundations of transformation.

The approach to a resolute anti-recession policy—if it is to serve transformation and not lead it astray—must fulfill two principal conditions: it must not initiate the inflationary spiral that runs out of control, that is, it must not allow for price increases beyond a certain relatively low ceiling; and it must not weaken the pressure for efficiency and restructuring, expressed inter alia in the change in microeconomic behavior and in the elimination of those that cannot adapt to the requirements of a market economy.

Many economists in Poland and abroad believe that fulfilment of these conditions is unfeasible at present. They say that the hard principle of sequence applies here, in which anti-recession policy, and the increase in aggregate demand associated with it, cannot bring success without prior reconstruction of ownership relations, organizational arrangements, technical structures, and the entire regulatory system. If this sequence is disturbed, the anti-recession policy causes not so much an increase in production and income as a development of the inflationary spiral, the halting of efficiency restructuring, and the cancellation of opportunities for a nonnegative trade balance. To confirm the above position, they refer to the latest Polish experience—the failure of the anti-recession policy attempted in the second half of 1990.

I do not share this position. I feel that the real conditions and limitations existing in transformation are interpreted too rigidly and thus in an oversimplified manner. Nearly one and a half years after the commencement of transformation, serious, carefully prepared anti-recession action is not only urgently needed, but—in my opinion—is also possible on account of the considerable probability of success. Naturally, this action can be noninflationary only if monetary policy remains responsible and careful, supported by a strict income (wage) constraint and ready for speedy correction if inflation runs out of control. An important integral part of the action would also have to be reorientation in developing pressures for restructuring efficiency. Pressures generated by recession would have to be replaced by competitive pressures. This would become feasible with a resolute anti-monopolist policy more than with the hitherto dynamic emergence of new private domestic and foreign enterprises, the expansion of all enterprises that are already efficient, and the unweakened pressure of imports. I do not think that these pressures would be weaker or less effective, especially if we assume that the manner of reacting to these pressures of microagents changes at the same time.

György Surányi

Mr. Mark Allen’s paper is a very comprehensive summary of the Fund’s key role in the region of the former centrally planned economies (FCPEs). The adjustment processes these countries have started and the promises of success are inseparable from the assistance of the IMF. It is hard to find details of Mr. Allen’s paper with which I would disagree; rather, my comments supplement his paper, based on the lessons that can be drawn from developments in Hungary during the recent, historic period.

The transition from the “hard” or “classic” centrally planned to a market economy started with the side-effects of the old system’s reforms—although this was not the objective of the policy. It began in the early eighties in Hungary, when the first building blocks of the legal framework of a market economy were formed and the opportunity was given to citizens to learn entrepreneurial behavior: this framework provided most of the social basis for the changes in Hungary over the last two years.

One of the most important messages of this transformation process in the Central and East European region is that the opportunities, the speed, and the choice of a successful economic policy in this region depend on the following factors:

  • To what extent is the institutional framework of a market economy built up.
  • Are there shortages in certain markets and to which extent.
  • How open is the economy.
  • What is the policy with respect to privatization.
  • What is the degree of freedom of economic policy.
  • Are the government and economic policy legitimate in the eyes of the public.

The ranking of these elements corresponds to the importance of the role they can play. Hungary is an example to illustrate these factors in detail.

Institutionsofa Market Economy

The legal framework of entrepreneurship began to be formulated and implemented in Hungary in 1981. It is a rare example of how the legal system can influence the progress of a country, since at that time it did not reflect the already existing and articulated needs and interests. In the case of Hungary the framework was established bearing in mind future needs and social interests.

The Partnership Regulation offered the opportunity of starting small private businesses, either independently or in association with the public sector. Entrepreneurial behavior and the concept of self-management—which is the prerequisite for change in the political and economic system—thus has roots in history. The Association Law, which is dated 1988, defined the framework of the modern limited and nonlimited liability business associations. The Law of Transformation was passed in 1989, containing guidelines for privatization and regulating the manner in which state enterprises can convert to business associations.

The two-tier banking system was implemented on January 1, 1987, following the establishment of three commercial banks and a central bank (the National Bank) by splitting up the former Hungarian National Bank. Since then the banking sector has flourished, and financial services are improving rapidly as the private and partly state-owned banks are being granted additional licenses. At the end of 1990 there were 13 Hungarian and 8 joint venture commercial banks in addition to 9 investment banks, 5 insurance companies, and 250 savings and loan banks. Among the new services that banks provide are the issue of credit cards, the holding of hard currency deposits, and the financing of foreign trade and trade-related services in hard currencies.

The financial market began to be built up in 1982, when the first corporate bonds were issued to the private sector. Since 1988, short-term treasury bills have been applied as a means of effective open market operations, and an interbank money market is also operating. In May 1990, the Hungarian stock exchange was the first among the former centrally planned economies to reopen. At the end of 1990 the market value of the companies listed on the stock exchange was Ft 23.2 billion.

Limited convertibility of the Hungarian forint has already been achieved, albeit limited in the sense of the type of transaction and the economic agent.

Joint ventures have reached almost complete convertibility. Profit and also the invested capital can be repatriated, and currency deposits can be held in addition to all the rights of any domestic company. Domestically owned enterprises can freely gain access to hard currency for their current account transactions. The National Bank has the obligation to provide the foreign currency required for trade and trade-related services, supplementing trade liberalization. On the one hand private households are allowed to obtain only a very limited amount of foreign currency, but on the other, they can hold currency deposits without any restrictions.

The role of the budget has been under parliamentary control since the free elections in 1990 and has resulted, for example, in a 3 percent decline in central government expenditure to GDP. The new Act on Budgetary Framework is now being prepared, which is going to define the liabilities and the financing of the Central Government in accordance with the new requirements. The Act on the Central Bank, which would guarantee the independence of monetary policy, should pass Parliament soon.

Subsidies have been cut and prices liberalized. In 1990 already 90 percent of domestic prices were free of subsidy and other distortions, which resulted in a decline of the central government consumer price subsidies from 2.5 percent of GDP to 1.8 percent in 1990 and to a planned 1.2 percent in 1991. Production and price subsidies of general government totaled 9 percent of GDP in 1989 and 7.2 percent in 1990. When production subsidies are diminished, the resulting market prices provide the correct signals for the economy.

The normative tax system is the main form of regulation. A value-added tax and personal income tax system was introduced on January 1, 1988. The enterprise profit tax has been in effect since 1989 and with gradual correction the system is approaching the standards of the European Community (EC).

Consequencesof Shortages

The black market has played a minor role in the last decades, and it has never been the framework for obtaining primary consumer goods. Since the sixties the variety and the magnitude of consumer goods available in the legal market were sufficient for the improved living standards in Hungary. Small retail shops and small foreign trade companies have improved the supplies in the legal market. The black market has been limited to the foreign exchange market. The gap between the official and the black market foreign exchange rate has decreased from an average of about 40 percent in 1989 to an average of 15 percent in 1990, with sometimes even a discount on the black market.

Domestic money has been the means of exchange in Hungary and has not had to face any serious attack by a foreign currency. This trust in domestic money is mostly due to the relative development of the domestic money and goods markets.

The monetary overhang has not reached a size that would have a serious inflationary effect after the lifting of price controls and the widening of the economy. Private and public savings are not forced but voluntary.

Some market integraton is still in evidence even after the shock of the collapse of the Council for Mutual Economic Assistance (CMEA). The system showed great flexibility by being able to change the pattern of trade. In 1989 42 percent of Hungarian exports were to the CMEA countries and 25 percent to EC member countries. In 1990 30 percent went to the CMEA and 35 percent to the EC countries, while the total of both imports and exports increased—creating more ties to international markets. Another very favorable change occurred in exported goods. Among the nonagricultural goods exported, the ratio of the industrialized countries increased from 57 percent to 70 percent during the last year.

Opennessofthe Economy

Trade liberalization is almost complete. Ninety percent of imported goods (in volume terms) are free of licenses and restraints, and all companies have free access to foreign exchange to finance international trade and trade-related services. Foreign direct capital investment in Hungary amounts to $1 billion, which is more than in any other FCPE.

International legal relations have been improving rapidly during recent times. There has been a long-lasting relationship with the IMF and the GATT. Hungary recently became a member of the Council of Europe and a member of the Organization for Economic Cooperation and Development.


The legal framework of privatization consists of two laws. The Law of Transformation was passed in 1989; the Law of State Property Agency is dated 1990. The privatization process, which is historically unique with regard to the magnitude and the circumstances, was successful in the first year: 10 percent of the total of Hungarian firms were privatized (2,000 companies). Partly owing to the very limited domestic private savings, only 7 percent of nonagricultural assets were affected by this process.

Socially, privatization is in general well accepted; neither the resulting unemployment, nor the increasing gap between social groups endangers the process. The tension that is created is mostly regional, as the least developed regions are facing the most serious problems brought on by the structural and ownership changes.

The private sector existed before privatization, creating a very favorable basis for society to benefit from the new situation. Since 1981, entrepreneurial behavior has been widely learned in Hungary. Privatization of the public sector and the flourishing private enterprises resulted in an estimated 25 percent share of GDP in 1990, while 15 percent of total nonagricultural assets is privately owned, showing the well-known efficiency gain of private ownership, even when the business is only starting up.

Degreeof Freedomof Economic Policy

The degree of freedom of economic policy is rather limited. The size of the budget in 1990 was mostly predetermined, because no new law on the budgetary framework had yet been passed. (It is now being prepared.) No major liabilities have been lifted from the Central Government, and new responsibilities arose from the need for a strong social safety net and for speeding up the structural changes in the economy. The strong incentive to limit the role of the Central Government led to an increase in total nominal expenditure of 8 percent, which is a decline in the share of GDP from 34 percent to 31 percent. The general government nominal expenditure ratio to GDP declined from 63.3 percent to 60.7 percent.

The high inflation rate, which is mostly due to exogenous factors, is limiting the range of sustainable economic policies. Many factors contribute to the rapid structural adjustment—the main source of the high inflation rate. The first is the collapse of the CMEA, and thereby the sudden loss of the main foreign market. It was accompanied by a deterioration of almost 10 percent in the terms of trade. The liberalization of imports, the shift in the markets to more expensive ones, and the enormous price increase in imports from the U.S.S.R. resulted in primary inflation. Nonperforming loans to the U.S.S.R. have accumulated, to a total amount recently of $1.8 billion, which is an extreme burden for a small economy.

Debt service was 12.5 percent of GDP in 1990. In terms of trade it was 53.5 percent of the goods exported—a slight improvement over the 57 percent of the previous year.

Acceptanceof Economic Policy

The main reason for this public acceptance in Hungary is that the May 1990 elections were the first free elections after 31 years. A medium-term public policy program was developed and announced by the Minister of Finance, a person who is highly accepted not only by the profession but also by the public.


The role of the IMF in the adjustment process is crucial. All the FPCEs differ from each other in many of the respects described above. This can provide a basis for different behavior on the part of the IMF in judging the criteria for the success of these countries and in monitoring and providing technical assistance. The adjustment process is not only a function of fiscal and monetary policy that can be settled by negotiations with international organizations. The key to successful transformation in this region—which cannot be expressed in terms of tidy figures, and what really makes the difference between these countries—is the evaluation of the improvement of institutions, including the behavior of economic agents.

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