Chapter 6 Inflation and Growth in the Transition Economies

Manuel Guitián, and Robert Mundell
Published Date:
June 1996
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Robert A. Mundell

Two centuries after the French Revolution, the years 1989–92 saw another revolution, fractured into seven parts: (1) the collapse of Communism in Eastern Europe and the Soviet Union; (2) the evacuation of Soviet armies from Eastern Europe; (3) the unification of west and east Germany; (4) the breakup of the Soviet Union and the formation of the Commonwealth of Independent States (CIS), composed of the former Soviet Union except the Baltic countries; (5) the dissolution of Yugoslavia and the creation of the successor states of Slovenia, Croatia, Bosnia and Herzegovina, Serbia-Montenegro, and the former Yugoslav Republic of Macedonia; (6) the “velvet divorce” of the Czech and Slovak Republics; and (7) the termination of the cold war. These remarkable developments in the political sphere set the stage for almost equally momentous events in the economic sphere.

From the beginning, economists debated the merits of alternative paths through the transition. Two schools rapidly emerged. One, quickly dubbed “shock therapy” or “big bang,” advocated rapid dismantling of the state bureaucracy, comprehensive privatization, macroeconomic stabilization, and decentralization of economic decision making through marketization. Against this approach, the “gradualist” school stressed patience, the potential waste and social costs of the big bang approach, and a slower path to reform that would preserve viable features of the old system while introducing desirable new elements of the market system at a more deliberate pace.

From a purely theoretical standpoint, the problem of the rapidity of the transition falls into a general category of economic problems relating to speed of adjustment. The optimal speed balances the sacrifice of delay in achieving a desirable objective against the cost of waste and inefficiency inherent in going too fast. Blueprints can depict the “final” equilibrium, but human beings take time to adjust their mentalities to a new modus operandi. Moscow was not built in a day.

Behind the debate also lay an unmentionable political possibility. In 1989 and 1990, a window of opportunity was open for effecting the transition. But it was not known for certain how long it would stay open. There was an irresistible temptation to pre-empt recidivism by planting the poison pill of irreversibility.

Also, advocates of the big bang miscalculated. They expected, and pushed for, a massive infusion of tens of billions of dollars of aid from Western countries and international institutions that never materialized. Foreign aid—if it did not have to be repaid—would have made it possible to reach the goals of the transition faster and with a smaller sacrifice of domestic consumption. Massive injections of foreign aid—the figure of $150 billion was mentioned—might have kept the Soviet Union together, changing completely the political equations of the revolution.

An essential feature of the transition is reform and a reduction of the public sector. In many Communist countries, the state produced private goods where it had a comparative disadvantage and scrimped on the production of public goods where it had a comparative advantage. The mecca for government activity lies in managing social overhead capital, including transportation, communication, and education, rather than in providing food, clothing, shelter, and luxury goods that can be produced more efficiently by the private sector.

The speed at which the transition can take place is contingent partly on how quickly resources can be shifted from the public to the private sector and partly on the ability of each sector to finance its own spending. Two situations need to be avoided. One is a contraction of public output that is greater than the expansion of the private sector; this results in unemployed resources and a contraction of GDP. The other is a contraction of spending by the public sector at a pace slower than its revenue base, leading to central bank financing of the resulting budget deficit and an outbreak of inflation.

Several years after the transition began in Eastern Europe and the countries of the former Soviet Union, some conclusions can now be drawn. Unfortunately, the failures are many and the successes few, suggesting that the cost of the transition was far beyond what had been anticipated. One failure was the contraction of output. Government output in most countries declined much more rapidly than private output expanded, leaving in its wake unemployment and massive contractions in GDP. In a few of the countries, the contractions had ended by 1993 and recovery had begun. But by the end of 1995, not a single country had recovered its pretransition level of GDP.

Another failure that stands out is monetary stability. In every transition country, tax revenues fell short of government spending and governments had recourse to central bank financing. In the countries of the former Soviet Union, the problem was further complicated by the initial use of the Soviet ruble, which was quickly Russified. As Russia moved into rapid inflation, the other ruble zone countries became involuntary victims of the imported inflation tax; in defense, they quickly moved to create their own national currencies. This move substituted made-at-home inflation for imported inflation as the new national central banks were mobilized to finance the government budget deficits. Inflation was therefore pervasive, if at different rates, throughout the area.

This paper reviews these changes in outputs and prices and sets the stage for an analysis of alternative approaches to the transition, especially in countries that, like China, cannot afford large contractions in output and monetary instability.

The Contractions

How great was the supply collapse during the transition? Between the end of 1989 and the end of 1992, real GDP in the Eastern European countries—for present purposes, Eastern Europe will be represented by Poland, Hungary, the Czech Republic, the Slovak Republic, Romania, and Bulgaria—fell cumulatively by 22.1 percent, an enormous decline; the contraction was 7.6 percent in 1990, 11.6 percent in 1991, and 5.6 percent in 1992. It was reversed, however, in the following year, with positive growth of 0.3 percent in 1993, increasing to 3.5 percent in 1994 and to 3.8 percent in 1995 (see Table 1).

Table 1.Changes in GDP(In percent a year)
Eastern Europe−11.6−
Former Soviet Union−9.7−18.7−12.9−17.5−6.0
Source: WEFA, Eurasia Economic Outlook, various issues.
Source: WEFA, Eurasia Economic Outlook, various issues.

If the contraction was large for Eastern Europe, it was enormous for the new countries that emerged from the collapse of the Soviet Union. Real output in the countries of the former Soviet Union had fallen by half by the end of 1994. This collapse was made up of successive declines in real GDP of 3.7 percent in 1990, 9.7 percent in 1991, 18.7 percent in 1992, 12.9 percent in 1993, 17.5 percent in 1994, and 6 percent in 1995.

Let us now look more closely at the contractions in individual countries. Table 2, which depicts the contractions in six Eastern European countries, shows that the maximum decline in output ranged from 18.7 percent in Poland to 36.4 percent in Bulgaria. Recovery began in 1992 for Poland, 1993 for Romania, and 1994 for the other four countries. The “J” curve seems to apply to these countries, although as noted earlier, in none of the countries had output reached the pretransition level by the end of 1995.

Table 2.GDP Growth Rates in Eastern Europe(In percent a year)
Czech Republic1.2−14.2−6.6−
Slovak Republic−2.5−14.5−7.0−
Source: WEFA, Eurasia Economic Outlook, February 1996.
Source: WEFA, Eurasia Economic Outlook, February 1996.

Table 3 depicts indexes of output for both the six Eastern European countries and the other countries that were members of the former Soviet Union for 1990–95. The last column measures output in 1995 as a percentage of output in 1989. It is obvious from the table how devastating the output contractions have been. Even in Poland, where recovery began earlier, output had still, by 1995, not caught up to the 1989 level. In only 5 of the 21 countries was output less than 20 percent below its 1989 level. Other countries were not so “lucky.” In three of the countries, output was only between 60 percent and 80 percent of the 1989 level. In nine of the countries, output was between 40 percent and 60 percent of the 1989 level. In three of the countries, output was between 20 percent and 40 percent of the 1989 level; and in one of the countries (Georgia), output was less than 20 percent of the 1989 level.

Table 3.Index of Output in the Transition Economies(1989=100)
Czech Republic98.984.978.878.680.783.9
Kyrgyz Republic104.899.483.171.953.250.0
Slovak Republic98.983.277.374.177.781.5
Source: WEFA, Eurasia Economic Outlook, February 1996.
Source: WEFA, Eurasia Economic Outlook, February 1996.

Theories of the Contractions

Before analyzing the contractions, it is useful to draw some conclusions about their distribution among the 21 countries. The contractions were distributed in distinct groups among the Eastern European countries and those of the former Soviet Union. High contractions were associated with the three Caucasian republics, owing partly to war and civil strife and partly to their economic isolation. Another group of countries in Central Asia had mixed results depending importantly on their mineral dependence and on the extent to which they had attained their transition objectives. Oil and gas exports have sustained the incomes of Uzbekistan and Turkmenistan, but this source of revenue may also have postponed the transition and put the contractions, if indeed they prove to be an indispensable part of the transition, further into the future.

Another distinct group of countries included the Baltic countries, Belarus, and Bulgaria. Increasing contractions in these countries were associated both with a high degree of dependence on trade from the member countries of the Council for Mutual Economic Assistance (CMEA, which collapsed in 1991), and on the severity of deteriorations in the terms of trade. The two largest states, Russia and Ukraine, were less dependent on trade than the other countries of the former Soviet Union, yet suffered substantial contractions of 47 percent and 54 percent, respectively. The difference in experience of the two countries could be accounted for partly by the fact that Russia’s terms of trade improved over the period whereas Ukraine’s worsened. The countries where output contracted the least were four Eastern European countries—Poland, Hungary, Czech Republic, and Slovak Republic. In these countries, the preconditions for the transition were most advanced.

Three broad types of explanation have been adduced to account for the contractions of GDP.1 One is that the statistics are hopelessly flawed and that the contractions are therefore a kind of statistical mirage. It can be argued also that measures of GDP before and after the collapse of Communism are biased; they exaggerate the level of output early in, or before, the transition and understate it later. This is because, first, much output produced under Communism was not competitive in world markets, so that GDP figures translated at existing exchange rates exaggerated pretransition output and, second, that later in the transition the statistical authorities succeeded in recording the declines in state-produced output but lacked the facilities to record the expansion of private output.

Without denying an element of truth to the statistical alibi—the full truth cannot be known until the figures are revised and corrected—it would nevertheless be a great mistake to deny the existence of the contractions. It is inconceivable that the underreporting of new private output, starting from a scanty base, could be on a scale large enough to offset the collapse of government output, which, at the beginning of the transition, constituted a major proportion of GDP.

Another type of explanation focuses on the trade collapse of countries within the CMEA bloc. This effect can be divided into three components: a terms of trade effect (which, however, worked in reverse for Russia), an export multiplier effect, and an import bottleneck effect. There is no doubt that the collapse of trade played a significant role in causing the output declines by rendering a large part of specialized production for exports unprofitable. This is especially true in the countries that were most dependent on trade before the transition.

A third general explanation emphasizes the slowness of the supply response. This could be due to the dulling of the entrepreneurial spirit under Communism or to the legacy of Communist laws and bureaucracy, which stifled enterprise formation. If the first explanation were true, it would follow that the Eastern Europe and Baltic countries, which had experienced Communism only since World War II, should have retained more of the entrepreneurial spirit from pre-Communist societies and had the smallest contractions and the most rapid recoveries. The theory cannot be ruled out for most of the Eastern European countries but it does not seem to apply to the Baltic countries, where the collapse of trade was particularly acute.

The bureaucratic legacy of Communism has certainly played a role in inhibiting the growth of private enterprise. Private enterprise was impeded by (1) tax rates that compared unfavorably with taxes on state enterprises; (2) laws and regulations restricting the size of the workforce and restrictions on firing; (3) an unstable monetary system, which impeded the calculation of profit opportunities; (4) restrictions on foreign exchange; (5) the absence of credit facilities in a well-functioning capital market; and (6) state control of banking that penalized private enterprise. Progress toward marketization and free enterprise has tended to be more rapid in the countries of Eastern Europe than in the former Soviet Union.

The Inflation Factor

What about the inflation factor? Have countries with moderate or low inflation fared better than countries with high inflation or hyperinflation? Table 4 presents some of the relevant information. It is apparent that there is a positive relationship between the magnitude of the contraction and the average rate of inflation. Leaving out the special case of Uzbekistan, low contractions were associated with low inflation and high contractions were associated with high inflation.

Table 4.Changes in Price Level(In percent)
Czech Republic10.057.912.518.09.710.0
Kyrgyz Republic4.1107.41,090.01,366.087.231.0
Slovak Republic10.
Source: WEFA, Eurasia Economic Outlook, various issues.
Source: WEFA, Eurasia Economic Outlook, various issues.

Association does not, of course, prove causality. Although it is generally agreed that low inflation is conducive, and high inflation detrimental, to efficiency and growth, it would be a mistake to conclude that the cause of high contractions was inflation. On the contrary, without denying the importance of the feedback effects, it would be more accurate to conclude that high contractions, by reducing government revenues, created budget deficits that made inflationary finance necessary and caused the inflation. In turn, the monetary and fiscal chaos, initially an act of desperation, had feedback effects that exacerbated the contractions and delayed the recoveries.

For a more extended analysis see R.A. Mundell, “The Great Contractions in Transition Countries,” in Stabilization Policies in the Transition Countries, ed. by M. Skreb and M. Blejer (Cambridge: Cambridge University Press, forthcoming).

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