Abstract

“Nothing so needs reforming as other people’s habits.” Mark Twain

Several years ago, few, if any, observers would have predicted in either scope or pace the historic events now under way in Central and Eastern Europe and in the republics of the former Soviet Union. Yet these events are changing the shape of the European continent and the world at large. As a result, a unique opportunity now exists to build an orderly international system of a truly universal character, free of the tensions that have so divided the international community since the Second World War. This section presents some ideas for achieving that goal.

The tasks ahead for the region are daunting and will affect all facets of human society. Within the economic domain, the challenges that confront the Central and Eastern European nations—and the major economies of the rest of the world if they are to help the reforming countries—are unprecedented. Meeting the challenges and completing the tasks will require not only persistence in Central and Eastern Europe, as well as in the former Soviet republics, but vision in the rest of the world to prevent the numerous risks in reform from obscuring the immeasurable returns to be derived from a harmonious international environment.

The countries to Europe’s east have decided to convert their systems of economic organization from central planning into market-based regimes.60 This endeavor, initially perceived with a good deal of optimism, is increasingly seen as an arduous process, fraught with pitfalls and calling for a large dose of determination in the reforming societies. As for the rest of Europe and the world, the fundamental aim must be to actively assist the reforms so that these countries can be integrated into the world economic system with a minimum of disruption. Interesting in this context are the divergent trends under way in the two European hemispheres. In Western Europe, the economics of integration are proceeding ahead of the politics of integration; indeed, political circumspection may be the thorniest obstacle to economic unification. In Central and Eastern Europe (and in the republics of the former Soviet Union), the politics of reform are moving faster than the economics of reform; in fact, harsh economic realities may prove a barrier to the political evolution of these countries. For both sides of the continent, the uneven pace of economic and political change may well turn out to be the toughest hurdle to overcome.

Desirable though internal economic reform and external economic integration are, their complexity is a matter of primary concern. A strong argument can be made that the transition to a market economy will prove harder to achieve than its antithesis had been, the process of collectivization. In other words, it is probably easier to destroy a market than to build one.61 There is, of course, a good deal of accumulated knowledge both about the workings of centrally planned systems and about the operation of market-based regimes, but it is of limited use because the former is rapidly becoming obsolete and the latter has yet to become applicable. As such, the transition between the two regimes resembles a voyage on uncharted waters and has often been described that way.

Nonetheless, care should be taken to avoid exaggerating the depth and width of those waters. What is needed, and what this section aims to provide, is a discussion of the real and apparent differences between East and West in the specific context of the process of economic adjustment and reform. In this effort to distinguish true from imaginary obstacles, some selected background issues and a few basic elements of an effective strategy for adjustment and reform are identified. This is followed by a discussion of the design and implementation of economic policies in a number of Central and Eastern European countries. Next, essential differences are separated from differences in degree in the experiences in Central and Eastern Europe and the West. The section concludes with some general thoughts on how best to assist the reform efforts. Underlying the whole section is the issue of rules and discretion, the balance between which can be of particular importance in the area of reform.

General Setting

The events of the past few years in Central and Eastern Europe and the dismemberment of the Soviet Union (with the subsequent emergence of the Commonwealth of Independent States) provide a good illustration of the interaction between political and economic factors over time. A fundamental force behind the rapid political change in the region has clearly been the below-par economic performance under central planning, the evidence of which became more and more obvious as improved communications technology and closer world economic interdependence rendered the Iron Curtain increasingly porous. In turn, the rapid pace of political transformation has raised expectations and created a demand for equally speedy economic reform.

There are several common themes that can be gleaned from the experience of the various countries in Central and Eastern Europe and in the former U.S.S.R. The first and most dramatic one is the widespread recognition that central planning has not worked well as a principle for efficient economic organization. Though countries have sporadically acknowledged this failure, it is only now that the inadequacy of central planning is generally accepted, as demonstrated by the concrete actions taken across the region to dismantle it.

In contrast with most past reform efforts, there is also broad recognition that attempts to improve the system without discarding the fundamental tenets of a command economy will fail. Earlier attempts at change were based on the premise that reform within the central planning regime was feasible. Accordingly, partial efforts were made to improve elements of central planning without seeking to change the regime as a whole; those efforts included improving the operations of the state enterprises, providing for a measure of decentralization in decision making, and allowing more room for private activities.62 Current reform efforts, on the contrary, do not seek to improve selected parts of the centrally planned system but have abandoned it instead. The objective now is a wholesale change in regime, a radical reform in the principles of economic organization.

Elements of an Effective Strategy

The complicated rhythm that has developed between rapid political evolution and the slower pace of economic reform underscores some of the most difficult challenges facing the Central and Eastern European countries, as well as the former Soviet republics. The first factor fuels expectations of a speedy change. The second factor suggests the impossibility of fulfilling those expectations, especially when a complete transformation of the economy is intended and required.

Basic Principles

It is no longer a novelty to say that the transition from a command economy to a market-based system not only will be protracted but will also be complex; there are neither categorical answers nor unambiguous blueprints to guide the reform. In the abstract, however, an argument can be made that a few strategic principles can help reform, at least in the macroeconomic policy sphere: simplicity; reliance on policy rules; and unequivocal signals that the changes in economic policy are irrevocable. Enacting these principles may help build the cohesion and resilience in the social and political fabric that are needed for radical transformation.

Simplicity in the design of a policy strategy, for instance, eases not only its implementation but also its acceptance. Reliance on policy rules helps contain inertia and reflexive behavior in the economy based on past experience. (A strategy providing for policy discretion, in contrast, would tend to perpetuate such inertia and reinforce the obstacles to change.) A strong and credible announcement of the new policies elicits and encourages the attitudinal changes needed for reform to succeed.

Two characteristics of centrally planned economies, more specifically two of their weaknesses, are the prevalence of aggregate and sectoral shortages and relative price distortions. This pair of features motivates two often mentioned aspects of the strategy of transition toward the market: the introduction of domestic financial discipline—to eliminate aggregate shortages or excess demand; and domestic price liberalization together with the opening of the economy—to ease sectoral shortages, introduce a rational relative price structure, and free competitive forces. But for these policy initiatives to yield results, action must be taken from the outset to establish the rules of the game that steer economic behavior in the new environment.63 These rules provide the necessary conditions for the operation of a market economy and include the establishment of clear ownership and property rights, the dismembering of the state’s role in the economy, and the development of legal, fiscal, and social security institutions that provide the framework for a constructive and sustained interaction of the government with the private economy.

Pace and Sequence of Reform

Given that actions will be required to influence most, if not all, aspects of economic behavior, the questions of their pace and sequence inevitably arise. These questions apply generally to the implementation of all economic policy and have been raised frequently in connection with adjustment and reform efforts in other types of economies. It is not surprising, therefore, that they have received attention in the context of reform in command economies.

With respect to the pace of reform, views continue to differ about the relative merits of a fast (“shock”) or a slow (“gradual”) approach to the reform effort. The balance of opinion and, most importantly, the revealed preference in the countries undertaking economic reforms, has been for rapid action. Two different but not mutually exclusive reasons account for this preference. One is the conviction that speedy policy implementation will increase the effectiveness of the reform process. Another is the recognition that fast action is made somewhat inevitable by the lack of resources in these economies; on this reasoning, a rapid pace is more a matter of necessity than of choice. Given these considerations, rapid policy decision and implementation seem the best course, particularly with respect to those areas where measures are likely to take a long time to yield results. This said, however, the challenge confronting the policymaker is to select a path fast enough to provide clear signals, and thus elicit positive responses in the economy, but not so rapid as to prove counterproductive or unfeasible.

Much has been written about the appropriate sequence of reform, with views also differing widely on this issue though some agreement can be discerned. In the abstract, coherent arguments can be made for phasing in reform measures, if only because there is a limit to how much can be done at one time. But a strong case can also be made for a comprehensive approach to reform, that is, for simultaneous rather than sequential action.64 It has been observed that partial actions rarely add up to a complete result,65 whereas simultaneous action may foster synergy by averting the potentially adverse effects of piecemeal measures and by helping to consolidate support for the reform process. Here again, this view must be tempered by the inherent difficulty in reform implementation as the checklist for effective reform is nothing less than staggering: fiscal discipline, monetary stabilization, price liberalization, opening the economy to international trade and capital flows, state-enterprise restructuring, privatization, and so on. Each step seems necessary, yet neither a single one nor a subset of them appears sufficient in itself for effective reform. This leaves the policymaker with the difficult choice of where, if anywhere, to draw the line on how far actions need to go to ensure reform.

Stabilization and Adjustment Under the Reform Process

It may be possible to clarify the pace and sequence of reform by distinguishing among three stages of policymaking: policy decisions, policy actions, and policy results. The time profiles of these three categories do not coincide, yet they do represent conceptually separate phases in what is essentially a continuous process.66

Speed and simultaneity apply particularly to the policy decisions that need to be taken in a variety of areas: legal, institutional, social, and economic. Some of those decisions must be translated into immediate policy actions, while others require follow-up later in the reform process. Thus, although policy decisions are best taken together at the outset of reform, their conversion into concrete policy actions does not need to be simultaneous. The speed and timing of policy results are the most difficult to control. Some results can develop very rapidly, while others take hold slowly. The fact that policy actions take time to yield results is not unique to the centrally planned economies in transition, however; it applies to all types of economies. General experience indicates that the attainment of results, both in timing and in degree, depends critically on the appropriateness and timeliness of the required policy actions. Indeed, given the interaction between expectations in the economy and the credibility of policies, it can be argued that opportune, determined, and credible policy actions will elicit synergetic reactions, thereby hastening results.

Stabilization and Adjustment

It was pointed out earlier that two of the characteristic features of centrally planned economies are the presence of shortages and relative price distortions. The elimination of the chronic shortages can be seen as one of the major aims of the macroeconomics of reform, which revolve around the introduction and maintenance of domestic financial discipline in the reforming economy. But for financial discipline to yield the desired results, it must be accompanied by the elimination of relative price distortions because an economically sound relative price structure is essential for effective macroeconomic management. Price reform also provides the link with the microeconomics of reform, by contributing to an efficient allocation of resources and easing sectoral shortages.

The establishment of domestic financial discipline requires the correction of aggregate stock (accumulated) and flow (current) imbalances. These imbalances, which are the counterparts of past and present shortages in the economy, have monetary and fiscal aspects, and policy actions in both domains are needed to redress them.

Stock Imbalances

The stock imbalance in centrally planned economies typically surfaces in the form of a liquidity overhang—an excess supply of money or, more broadly, of bank liabilities. In addition, another far less mentioned stock imbalance that affects bank assets and is closely connected with accumulated public sector deficits is the portion of essentially unrecoverable assets in bank portfolios, which typically are claims on nonviable state enterprises.67 The correction of these two stock imbalances involves monetary and fiscal measures. In the monetary sphere, some of the liquidity overhang will likely be corrected through a rise in the price level associated with the adjustment of relative prices. But its full elimination may require additional action, such as a monetary reform or its equivalent.68 In the fiscal domain, the asset portfolio of banks must be strengthened. This will call for the generation of public sector resources to rehabilitate and capitalize the banks, thus influencing the design of fiscal policy.

Flow Imbalances

Flow imbalances reflect current aggregate shortages in the economy; their elimination also depends upon fiscal and monetary action. From the standpoint of monetary management, the solution means aligning the stock of money and the demand for money. As experience in market economies indicates, balancing money supply and money demand is no mean endeavor. This is an area where the basic principles outlined in the earlier section on an effective strategy can help, particularly in the context of centrally planned economies, where estimating money demand is likely to be especially hazardous. The simplest rule for monetary management in these cases is the adoption of a currency board principle. This principle provides for domestic monetary expansion only to the extent that it corresponds to the accumulation of foreign exchange reserves. As such, it represents a clear rule, and a sharp departure from the accommodating monetary management typical of a centrally planned economy; if held to, this principle makes a strong statement and can affect expectations. Beyond its clarity and simplicity, the attractiveness of the currency board approach lies in its presumption that any domestic monetary expansion will be demand driven, as it can only occur through voluntary sales of foreign exchange.

Of course, less stringent monetary rules can be devised that permit monetary growth to reflect factors other than the accumulation of net international reserves. For example, it would be possible to allow an increase in the money stock to reflect the purchase of domestic assets, in other words, to reflect domestic credit expansion. The lesser stringency of this rule, however, will compromise credibility because the rule is less clear with regard to the nature of the monetary expansion—that is, whether it is demand or supply determined—and less simple since it embodies two sources of monetary expansion instead of just one.

From the standpoint of fiscal management, the typical (and possibly minimum) aim is a balanced budget in the government or the public sector at large. As pointed out earlier, however, in the presence of weak bank portfolios, fiscal management must allow for bank capitalization, which means generating budget surpluses large enough to service the government paper issued to the banks in lieu of their unrecoverable assets. This consideration can clearly complicate fiscal policy.

Question of Anchors

Domestic financial policy rules such as those described above typically must be supported by nominal anchors, particularly when price stability is a goal. An anchor that has been increasingly used is the exchange rate, which exhibits a specific advantage in the case of command economies. Because these economies traditionally suffer from distorted relative prices, an exchange rate anchor immediately translates the world relative price structure into domestic currency terms. Accordingly, using the exchange rate as an anchor rapidly exposes the extent of domestic price distortions needing correction.

For the anchor and the price liberalization to be effective, however, not only is domestic financial discipline required but income moderation—specifically wage moderation—must also prevail, particularly when inflation is present. Actually, in such circumstances a wage anchor may be needed to provide supplementary support to the exchange rate, at least in the initial period of reform. A wage anchor may also be necessary when inflation is not a particular problem, to prevent wage costs from constraining domestic output and reducing exports.69 It hardly needs noting that the use of anchors is equivalent to the setting of rules.

Complexities in Policy Design and Implementation

A dilemma often arises when an exchange rate anchor is used to bring about price stability in an inflationary setting: domestic financial discipline and wage moderation do not immediately arrest inflation, so that prices continue to increase for some time (albeit, at declining rates) while the nominal exchange rate remains unchanged. During this period, the exchange rate anchor reduces the upward pressure on the price level but at the possible expense of impairing competitiveness. Thus, even when domestic financial and wage restraints are in place, there are risks for the viability of the exchange rate anchor. The risks obviously increase when discipline on the financial or wage front falters.

In principle, when confronting this dilemma it would be useful to ascertain the relative priorities attached to the price stability and balance of payments objectives. When controlling inflation is paramount, the role of the exchange rate anchor may be so necessary as to justify the consequent risks to competitiveness: the potential and actual impairment of competitiveness would provide the incentive needed to maintain domestic financial and wage discipline. If such discipline is not restored promptly, however, and inflation does not fall sufficiently fast, the damage to competitiveness may be so severe as to bring the balance of payments constraint to the fore, thus rendering the credibility of the exchange rate suspect and its role as anchor unsustainable.

When priority is given instead to balance of payments objectives, protecting competitiveness is the predominant concern, and the risks attached to the exchange rate anchor are not worth running. A policy that envisages the exchange rate as an instrument for achieving balance of payments goals rather than price stability is required. Such a policy must be supported by financial and income moderation just as the anchor strategy was. Without such moderation, adjustments in the exchange rate, though temporarily able to protect competitiveness and the balance of payments, will also contribute to domestic price increases. In this way, inflation can reach critical levels.70

In practice, however, the nature of an economic imbalance often dictates its own solution. When a country has no access to international capital markets and its international reserve availability is limited, exchange rate policy must be geared to balance of payments objectives. In situations characterized by relatively strong international reserve positions and by concern for inflation, an exchange rate anchor for price stability is the appropriate course of action. This strategy also often requires international financial support to supplement international reserve use and enhance its credibility.

Difficulties in policy design and implementation also arise in the closely related area of monetary management. Where the exchange rate anchor is used, a most relevant but difficult design issue is the level at which the anchor should be set, because an appropriate level can be decisive for the resolution of the price stability versus competitiveness dilemma. Another complex issue is the estimation of the monetary overhang. The uncertainty surrounding the size of the upward adjustment in prices induced by price and trade liberalization makes the calculation particularly problematic. These difficulties compound the process of designing a path for monetary expansion. Errors in the measurement of the overhang and the price change can render a given rate of monetary expansion either too tight or too expansionary.71 With regard to policy implementation, monetary management in reforming economies is complicated by the rudimentary state, or even lack, of financial markets and by general structural weaknesses in the financial system. Some of these problems derive from vulnerable bank balance sheets, lack of competition and segmentation in credit markets, and inadequate accounting practices.

Fiscal policy implementation is also fraught with difficulties. The risks arise not only from the large uncertainty that surrounds reforming economies in transition but also from deep-seated resistance to essential aspects of fiscal adjustment and reform. The issue of curtailing subsidies acquires particular importance here, as does the subject of state-enterprise restructuring.72 In any type of economic system, subsidies are difficult to eliminate and hard budget constraints are difficult to establish, but this is particularly so in centrally planned economies where subsidies and soft budget constraints have long been central features. In addition, the disruptions caused by the reform process will need to be mitigated by public social expenditure, such as the provision of income support to those becoming unemployed, a factor that threatens to upset any fiscal balance that is achieved, let alone afiscal surplus.73

Incomes policy is another area where close vigilance is warranted. Typically, nominal wage guidelines are an important component of macroeconomic management. Such guidelines can bring demand developments in line with supply and, where the exchange rate performs as an anchor, can protect competitiveness. Incomes policy also controls costs; as such, it can help focus enterprise attention on the importance of restraining costs as a means of diminishing the resurgence of soft budget constraints.

Structural Reform

At this stage, the microeconomics of reform and the institutional aspects of reform become relevant. Although for expository purposes these issues are often separated from macroeconomic management, in practice all these dimensions of the reform process must be intimately linked for an effective transition to a market system.

Design and Implementation

The microeconomics of reform include the liberalization of domestic prices, the opening of the economy to international trade in goods, services, and capital, and the dismantling of exchange controls.74 Though, in principle, reforms like these would appear straightforward, they actually involve numerous difficult choices and to carry their effects through must have support from other areas of reform. An important example of the interaction among various reform measures is the fact that liberalization must be accompanied by the development of competitive market structures if it is to yield results. More specifically, the process of liberalization and opening up of the economy affects state enterprises, some of which are likely to prove nonviable in the new environment; an immediate corollary is the desirability of closing those enterprises; this, in turn, requires the establishment of bankruptcy laws and procedures.

As experience gathers in the process of reform, restructuring may not be sufficient—wholesale reconstruction of many industries may be needed to set economic activity and growth on a sound and sustained path.75 In effect, what is at stake is the viability of a capital stock built up over several decades on the basis of persistently distorted relative prices. A significant part of such a capital stock is unlikely to prove capable of competing in a market environment, and the question is whether to devote scarce resources to salvaging it or to build an altogether new capital stock. It can be persuasively argued that the best strategy would be to address at the outset those sectors where decisions to start anew may be required, since these choices are the most difficult to make. Ability and determination to undertake hard measures may prove the best route for establishing the credibility of reform and eliciting the required behavioral changes.

Institution-Building Efforts

Both the macroeconomics and the microeconomics of reform depend closely on the prompt buildup of market-supporting institutions and rules—that is, on the development of an institutional infrastructure to buttress the functioning of a market system.76 Such an infrastructure includes a legal system to guide the conduct of economic transactions and to help enforce market-determined accountability; an accounting and auditing system to aid economic decision making and to bolster such accountability; a fiscal system to foster an efficiency that is in line with social preferences; a social insurance system to contain the hardships of market solutions and to provide intergenerational transfers; and sectoral reforms to correct problems in the labor market, the state-enterprise sector, the external sector, and the banking system, as well as in the pricing regime. Perhaps the most fundamental priority in this broad area of institutional reform is the establishment of clear ownership and property rights. Without clarification of these rights, many of the necessary ingredients of reform, such as investment, new attitudes toward work and production, and an improved definition of the role for government and the process of privatization, are unlikely to materialize. A clear system of ownership, therefore, is an urgent imperative and the means must be found to ensure its feasibility; without it, other aspects of reform—for which the establishment of ownership rights is a necessary condition—cannot be launched.77

Balance in the Policy Mix

The need for a balanced mix of policies surfaces in most, if not all, areas of reform: macroeconomic, microeconomic, structural, and institutional.

With regard to macroeconomic management, balance is essential on at least two levels: the mix must ensure domestic financial policies that are consistent with the nominal anchors, if these are part of the policy package, or with income guidelines and exchange rate management, if these are part of the strategy. Balance must also prevail among fiscal, monetary, and incomes policies themselves so as to avoid burdening any one policy with the shortcomings of another. A typical example of an unbalanced policy mix is one where monetary policy carries the full burden of inflation control, that is, it does not receive the support of the other two policy areas. In general, experience has shown that without reinforcement, strict implementation of monetary policy is unlikely to keep inflation down for long without impairing other aspects of economic performance. In essence, a balanced domestic macroeconomic policy mix merely reflects the need to attain and maintain an appropriate level and composition of aggregate demand, with the composition of demand balanced in three key dimensions: its public and private components—hence, the importance of fiscal policy; its consumption and investment components—hence, the importance of monetary policy (generally, interest rate policy); and its domestic and foreign components—hence, the importance of competitiveness, or consistency between exchange rate and incomes policy and the domestic financial stance.

Balance is also required on the microeconomic front to ensure that supply responses develop in the economy. Domestic price liberalization without steps to open the economy to foreign competition and improve the distribution system will not lead to efficient resource allocation. In such circumstances, little can be expected in the way of additional output.

Besides balance at the macroeconomic and the microeconomic levels, a successful transition toward the market also requires an appropriate blend between these two areas of reform and the actions taken to restructure the economy and build up its institutions. Only in the presence of such an admittedly complex balance can the interplay of demand (the macroeconomic aspect) and supply (the microeconomic element) in a sound market (the structural and institutional dimensions) yield optimal results.

In sum, it is clear that fundamental issues are involved in the search for balance in the global policy mix—the role of government, state-enterprise reform, and privatization. Transparency in all these domains can go a long way toward promoting the change in economic behavior needed for the process of transition to succeed. In this way, all aspects of reform must be successfully orchestrated: from the din of transition, a symphony must arise.78

Differences Between Economic Systems—How Significant for Reform?

Differences between centrally planned and market-based economies abound. Accordingly, there are risks in seeking to transfer the experience of market economies to command economies.79 Yet, it would also be inadvisable to presume that little of relevance can be derived from the stabilization, adjustment, and growth experiences of developed and developing market economies.

Essential Differences

The primary difference between the starting point of Central and Eastern European economies, as well as that of the former Soviet republics, and their final destination is the absence of market-supporting institutions and rules. The creation of those institutions and the establishment of those rules is the hardest challenge these countries must meet. This task is made no easier by the lack of guidance. Most economic literature on adjustment and growth in market-based economies assumes the existence of a market-supporting institutional infrastructure; little has been written about what to do in its absence.

As discussed in the previous section, a market infrastructure comprises a legal and regulatory framework, an accounting and auditing system, a fiscal regime, and a social insurance framework. But a critical element underpinning this market-supporting institutional setting has yet to be mentioned—the existence and observance of a code of conduct, a set of rules of the game which is typically absent in centrally planned economies. Such a code of conduct includes the willingness to make individual economic decisions, to assume risks, and to accept responsibility for the consequences of those decisions.

Only through overcoming these basic differences will the transition to a market system work, and the establishment of an institutional framework and a corresponding code of conduct are time-consuming endeavors. Nevertheless, it is only in the context of these systemic changes that attitudes and behavior in reforming societies will adapt to the change in the economic setting.

Differences in Degree

Other seeming differences between market and centrally planned economies are more numerous and straddle most economic policy spheres; they are more apparent than real. In terms of strategy, the pace and sequence of adjustment and reform, as well as the lags in the effect of economic policies, are such issues, in that they are general and analytically equivalent in the two types of systems. Their presence or absence does not depend on the system. Even such central questions as the role of government are common to market- and command-type regimes. These differences, then, are a matter of degree, not of the systems’ basic natures.

On the macroeconomic front, it is clear that the complexity of coping with fiscal issues, such as soft budget constraints, subsidies, budget deficits, and state-enterprise management, does not belong exclusively to centrally planned economies. The same is true of monetary issues, such as the liquidity overhang (a specific instance of an excess supply of liquid assets), and the difficulty of forecasting the demand for money. On the exchange rate front, too, the dilemma between price stability and competitiveness, or the difficulty of determining the appropriate level for an exchange rate anchor, applies both to market and planned economies.

In the microeconomic and structural domains, similarities abound as well. Relative price distortions are not typical of centrally planned economies alone. Issues connected with state-enterprise reform and control are also widespread. The problem of vulnerable banking and financial institutions, which confronts a number of reforming economies, has arisen too among market-based systems.

Differences of degree also characterize the policy mix. Indeed, the need for balance between monetary and fiscal policy (and for consistency among them, incomes policy and exchange rate management) has been long recognized in the context of market-based economies. In turn, the importance of keeping progress in the macroeconomic and the microeconomic areas commensurate is no new revelation; it has been repeatedly underscored in the context of the linkages among adjustment, development, and growth. The need for proper balance between macroeconomic management and system reform poses equivalent analytical challenges in both types of economies.

Final Remarks

It is abundantly clear that the tasks confronting the Central and Eastern European countries and the former Soviet republics in their voyage toward market environments are daunting. But the benefits that they and the world economy can derive from a successful transition are innumerable. It appears imperative, therefore, that efforts are made in all quarters to maximize the effectiveness of the reform efforts under way.

As far as the reforming countries are concerned, an urgent order of business is to eliminate promptly the essential differences discussed above. Establishment of market-supporting institutions should be an absolute priority. Parallel with this, it is important to learn from the experiences of the developed and developing market economies about those issues where only differences in degree have been identified. In the process, critical questions, such as the role of government, must be addressed, and priority must be given to the most pressing issues, such as the establishment of clear ownership and property rights. Activity on these fronts will help induce the supply responses that can ease the reform path.

To reach the final destination, however, requires persistence in policy implementation, even in the face of adversity, if the proper signals are to be given and credibility is to be ensured. It is also important to exhibit transparency in the strategy, the instruments, and the objectives of reform in order to gather the necessary consensus. Building such a consensus means prompt recognition that the original overoptimistic expectations on the speed of the reform process and its ability to yield rapid results have been somewhat unrealistic. But these are areas where support from the rest of the world economy can help.

The role of the market economies in easing the process of reform in Central and Eastern Europe and beyond can be critical on a variety of fronts. Given the importance of setting up market-supporting rules of the game in the region, a first responsibility of market economies is themselves to abide by those rules, implying openness of markets, respect for budget constraints, and support for the integration of national economies into the world system. Policy advice, both in the area of building an institutional infrastructure and in the area of macroeconomic and structural management, can also smooth the reform process.

Thus, on one level assistance consists of preaching by example and drawing lessons from past mistakes. On another level, it consists of making resources available to support the adjustment effort required for reform. In making resources available, the amount and terms of assistance must be compatible with the adjustment effort and the prospects of the reforming economies. Moreover, its disbursement must be clearly linked to performance under the reform process. These two considerations are related in a particularly complex way in that they exhibit elements of both substitutability and complementarity. On one side, it can be argued that if policy conditionality (the linkage of resource availability to performance in policy implementation) is well defined and linked to a substantial adjustment effort, the provision of ample amounts of resources on favorable terms or on terms that do not produce undue risks is appropriate. But then, if performance is strong, the likelihood is that less, rather than more, financing on soft terms will be required.

Given the importance of fostering reform efforts, generous support is a fair reward for determination, breadth, and depth in policy implementation. In other words, an appropriate trade-off may be established between the degree of concessionality and the degree of conditionality attached to external assistance. Such a trade-off seems particularly well suited to the reforming economies of Central and Eastern Europe and the former U.S.S.R., where the emphasis must be on setting conditions for the prompt establishment of a market-based system. Given the externalities that can be expected from a successful transition in the region, the terms of repayment, though admittedly important, should not be the only consideration. The effectiveness of the effort to create a market will depend more on the determination, persistence, and strength of policy implementation than on the particular timing of policy results, on which repayment is contingent. Policy implementation is at the very center of conditionality, so it is conceivable that by stressing it more than the financial terms of external assistance the likelihood of the reforms succeeding may be improved. A cautionary note must be sounded, however: this approach, like many others of a similar nature, carries a risk of moral hazard.80 To minimize this risk, it is critical to design and measure policy conditionality in a manner sufficiently clear and precise that the related access to concessional assistance and aid will help, not hinder or delay, the reform process. Though important and delicate, this is not a new problem, and it is amenable to reasonable solutions, even in areas where conditionality has not been extended in the past.81

A trade-off between concessionality and conditionality can also be a means to resolving potential conflicts between political and purely economic objectives. It can also be argued that it may give rise to an important measure of synergy. Generous financial support can help shield reform efforts by establishing protective mechanisms—such as policy safeguards to correct slippages or adapt to unexpected deviations and still yield results; financial safeguards to cover unanticipated needs or shocks that do not require policy adjustment (for example, transitory and reversible events); and social safeguards to soften the burdens of change and thus widen the acceptance of reform.

By way of conclusion, the trade-off approach also conforms to comparative advantages developed in the international economy over nearly five decades. On the side of international institutions, the IMF can provide the broad framework of conditionality, as well as develop appropriate new criteria to measure policy performance in areas not normally covered by the traditional scope of conditionality. Though it would continue to provide its own assistance, the institution would focus on the monitoring, follow-up, and adaptation of policy implementation. The financial terms of access to IMF resources would be dictated by the cooperative nature of the institution, which requires that its assistance revolves among members in accordance with their balance of payments needs and adjustment efforts. As necessary, IMF conditionality could be supplemented by work undertaken elsewhere, such as by the OECD in the structural area and the World Bank in the project and sectoral domains.82 Other multilateral institutions (including the recently established European Bank for Reconstruction and Development), together with official sources of bilateral flows, would provide the bulk of the assistance on terms tailored to an economy’s capacity to adapt its production patterns and structure to market signals, thus laying the ground for a resumption of sustained activity and growth. Whenever it is clear that the prospective capacity to recover falls short of what would be required to service external assistance on market terms, the trade-off between conditionality and concessionality would provide a logical means on which to continue aiding reforms without wasting scarce resources.

In sum, the reform process typically entails a dynamic balance between rules and discretion. In the early stages, when institutions are lacking and markets are budding, reliance on rules is the best strategy. At those times, discretion must be limited not only because the means for its exercise are lacking but also because of the need to provide clear signals. As institutions develop and markets take hold, however, the balance is likely to allow for a more even distribution between the observance of rules and the exercise of discretion.

60

The scope of the reforms is much broader, encompassing actions to establish democracy and pluralism in Central and Eastern European societies. Viewed from this perspective, the transition toward a market economy is only one aspect of a widespread process of transformation. For a lucid discussion of the economic opening in the region, see Williamson (1991a). Remarkable events have also been taking place in the republics that composed the former Soviet Union. They are abandoning central planning as a principle of economic organization, and many of the points made in this paper also apply to them. For a recent discussion of events in the Soviet Union from an economic standpoint, see Havrylyshyn and Williamson (1991).

61

This seems to be the case if only because processes like nationalization are easier to accomplish than those of restitution or privatization. The fact that gradualism hardly characterized the process of collectivization also supports this point; the shock approach was typical of the introduction of central planning. It should also be pointed out that the intrinsically complex reforms under way in Central and Eastern Europe have been rendered even more difficult by events in the Middle East and by the dismantling of the trading and payments arrangements under the Council for Mutual Economic Assistance (CMEA) at the end of 1990. For a timely analysis of transitional arrangements for the CMEA countries, see Kenen (1991); also see Schrenk (1990).

62

There is an ample literature dealing with these partial reform efforts. See, for example, Kornai (1990a, 1990b); in the latter article, Kornai discusses at length the issue of transformation without reform and the weaknesses of “third form,” or hybrid, solutions. Also see the collection of papers on Hungary and Poland in Commission of the European Communities (1990a), as well as Hinds (1990), Institute for International Finance (1990), Prust and IMF Staff Team (1990), and Wolf (1990a, 1990b).

63

The importance of transparent rules of the game can hardly be overemphasized in circumstances where behavioral changes are to be effected. For a discussion of this subject in the general context of international economic relations, see Dam (1982).

64

For further elaboration of the strategy discussed in this section see Guitián (1991c). The scope of reform and policy priorities as well as the sequence of actions have been discussed recently by Dornbusch (1991) and Williamson (1991c); also see Richard Portes’s “Introduction” in Commission of the European Communities (1990a), Genberg (1991), Fischer and Gelb (1991), and Calvo and Frenkel (1991).

65

For a lucid and forceful set of arguments in favor of simultaneous policy action, see Kornai (1990c).

66

Evidence on these issues can already be found in the relatively short period since reform in Central and Eastern Europe took off. For example, a shock approach was taken in Poland toward stabilization and liberalization and in Yugoslavia toward stabilization. In Hungary, where the initial domestic imbalance was more limited, a more gradual approach was pursued; see Lipton and Sachs (1990a), Coricelli and Rocha (1991), Kornai (1990a, 1990c), Commission of the European Communities (1990a), and “Stabilization Efforts in Poland and Yugoslavia—Early Lessons” in World Bank (1991).

67

Issues connected with financial reform in centrally planned economies have been recently discussed by Brainard (1991), Blejer and Sagari (1991), Sundararajan (1990), and Calvo and Frenkel (1991). An excellent discussion of financial imbalances in east Germany can be found in Lipschitz and McDonald (1990).

68

A timely and useful analysis of historical experience with issues of liquidity overhang and monetary reform can be found in Dornbusch and Wolf (1990); also see Calvo and Frenkel (1991).

69

I am indebted to Peter Kenen for having brought this wage-cost argument to my attention. Bruno (1990) provides an extensive examination of nominal anchors in open economies, including the possible need for many of them. On the issue of system overdetermination, Bruno acknowledges the “prima facie contradiction in an argument that calls for the fixing of more than one nominal variable at a time,” but he points out that it “rests on the assumption of full certainty” and goes on to argue that in conditions of uncertainty the issue “must be redefined in an expectational sense. Given the potential benefits of success and the high risks of failure of a sharp disinflation, tying one’s boat to several anchors rather than one would seem to be a prudent policy as is the portfolio diversification of risk in the optimal menu of risky assets” (p. 26). Kenen’s point concerning the supply effects of wage costs is important in this context. After all, though Bruno’s reasoning is appealing, “more” instruments need not be equivalent to a “less uncertain” environment. Actu-ally, it can be argued that uncertainty calls less for additional tools and more for a relatively predictable use of those that are available.

70

Here again, evidence can be found in the experiences of Hungary, Poland, and Yugoslavia. The predominant aim in the case of Hungary was strengthening the balance of payments position, and nominal adjustments in the exchange rate were correspondingly effected to ensure competitiveness. In the cases of Poland and Yugoslavia, on the other hand, inflation was the paramount concern, and the exchange rate was therefore anchored at a fixed level vis-a-vis the U.S. dollar in the former country and vis-a-vis the deutsche mark in the latter. Examples of the difficulties involved in either policy, but also of their potential effectiveness, are well illustrated by these countries’ experiences: Hungary witnessed an increase in inflation and Yugoslavia, confronting a severe balance of payments constraint, had to adjust the exchange rate. In Poland, on the other hand, price performance has improved as has the external position, so the exchange rate anchor has not yet exhibited strains. See “Stabilization Efforts in Poland and Yugoslavia—Early Lessons” in World Bank (1991).

71

For further discussion of these issues in the case of Poland, see Calvo and Coricelli (1991), Concern” and Rocha (1991), and Lipton and Sachs (1990a). Also see Calvo and Frenkel (1991) for an extensive examination of the demand, supply, and portfolio effects of credit policies.

72

For a more extensive discussion of fiscal issues in the process of transition to market-based regimes, see Holzmann (1991), Tanzi (1991a, 1991b), and Kopits (1991).

73

Yugoslavia provides a good illustration of some of the problems discussed in the text; see World Bank (1991). A brief examination of the social aspects of the transition in reforming economies can be found in Schweitzer (1990).

74

The paper does not discuss the scope of external liberalization: whether it should be complete (with regard to both the current and capital accounts) or partial (current account first and capital flows later on). This same issue arises in reforming centrally planned economies in connection with currency convertibility, the scope of which can also be complete or partial. My preference is for complete convertibility but views on this issue are yet to arrive at a consensus. For an extensive discussion of the subject of convertibility in these economies in transition, see Jacques J. Polak “Convertibility: An Indispensible Element in the Transition Process in Eastern Europe” and John Williamson’s own essay “The Economic Opening of Eastern Europe” in Williamson (1991b); issues of capital flows are examined in Guitián (1991b) and International Monetary Fund (1991).

75

In addition to the issues discussed in the text, the microeconomics of reform also encompass a variety of sectoral questions not addressed in this paper; they concern distribution systems, energy, environment, housing, agriculture, and manufacturing. As for the need for full-scale revamping of sectors in the economy, Gros (1991) notes that in east Germany the “disastrous state of the environment, obsolete industry and outdated public infrastructure require that almost the entire stock of private and public capital be rebuilt” (p. 8).

76

General and insightful discussion of the importance of the institutional aspects of reform will be found in Dornbusch (1991) and Williamson (1991c).

77

An insightful discussion of the dilemmas posed by the interconnection and different time horizons of privatization and restructuring can be found in Blanchard and others (1991). For a specific country example, see Lipton and Sachs (1990b) who have examined the issue of privatization in Eastern Europe, particularly with respect to Poland.

78

The 1990 WIDER report on Reform in Eastern Europe (Blanchard and others, 1991) goes into the intricacies of weaving together the major building blocks of reform: stabilization, liberalization, privatization, and restructuring.

79

The need for caution in the extrapolation of developed market-economy experiences to regimes based on central planning is the main subject of Marer (1991). In the context of this paper, which argues that real differences between East and West should not be exaggerated, Marer’s message is that neither should apparent differences be overstressed. Once again, an issue of balance is at stake.

80

Such issues of moral hazard are part and parcel of the exercise of conditionality, so the risk mentioned is not new, though it may give rise to relatively complex questions. A specific example of an area where moral-hazard risks clearly arise is the international debt strategy as discussed in Section III.

81

This expansion is what may give rise to complex questions in the sense that to be effective, conditionality may have to extend beyond its traditional macroeconomic sphere and pure efficiency criteria. Admittedly delicate issues are involved here, but they are not insoluble.

82

The argument in this paragraph deals only with the economies in Central and Eastern Europe and addresses basically the question of how to foster reform. The effectiveness of reform requires completion; so the trade-off between conditionality and financial terms of assistance is, in this sense, a singular event. But the general argument for such a trade-off can be extended beyond the issue of reform to areas like development. In this context, the idea would be to keep the terms of assistance commensurate with the economy’s capacity to develop and examine the possibility of a trade-off when the latter falls short of the former.

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