The reduction in inflation since the early 1990s right across the transition area is remarkable, particularly given the chaotic conditions at the outset. Inflationary pressures that had long been suppressed by price controls turned out to be one of the lesser challenges, as nascent policymaking institutions wrestled with collapsing output, employment, and fiscal revenues, as well as military conflicts and redrawn national boundaries. In such conditions, most currencies, new and old, collapsed, and inflation surged. But these difficulties notwithstanding, disinflation has been achieved throughout the region. Once undertaken, it was swift and there is no systematic evidence that it compounded output losses. Furthermore, major resurgences of inflation have been the exception. And in this lower inflation environment, growth has resumed, with formal evidence suggesting a direct link between reduced inflation and the resumption of growth.
The robustness of output during disinflation reflects three factors.
The context for disinflation was better than it appeared: in the highest inflation cases, there was little inertia in prices and political support for disinflation was often strong; financial fragility rarely deepened during disinflation; and after the hurdle of initial relative price adjustment, price liberalization helped.
Inflation stabilization was implemented first, without waiting for the completion of allencompassing structural reforms, and it was intended to be rapid.
Comprehensive fiscal consolidation underwrote disinflation, and funding sources were diversified through the development of financial markets.
Just as collapsing tax revenues, rigid expenditures, and limited financing options had forced heavy reliance on seigniorage—notably in the Baltics, Russia, and other countries of the former Soviet Union in the early 1990s—so fundamental fiscal adjustments, usually focused on expenditure cuts, underlay disinflation. However, inflation stabilization did not require “fiscal solvency,” as defined by a primary surplus sufficiently high as to stabilize the public debt-to-GDP ratio. This is probably because dynamic solvency (the prospective evolution of the primary balance), rather than a snapshot of the primary balance, matters more in an environment characterized by deep structural changes. In addition, the relationship between fiscal adjustment and disinflation becomes more blurred at moderate inflation levels, when inflation is likely to be driven more by expectations than by fundamentals.
The role of monetary frameworks in strengthening disinflations is more controversial. Some, perhaps surprisingly few, countries adopted formal exchange rate pegs as their principal nominal anchors, especially in the disinflations after 1993. Most formally floated, though some of these pegged informally at times. Those that pegged throughout generally stabilized relatively rapidly but also experienced persistent moderate inflation, despite firm fiscal adjustment. The latter reflected Belassa-Samuelson effects and the correction of undervalued pegs through inflation above international levels, and was accommodated by capital inflows whenever domestic sources of monetary growth were restrictive. In some cases where fiscal adjustment accompanied an initial appreciation of the nominal exchange rate, such as Croatia and the former Yugoslav Republic of Macedonia, disinflation was more rapid and low inflation was sustained. Both formal floaters and countries that pegged their exchange rates attempted to boost the credibility of their chosen monetary frame-works by deepening the independence of their central banks and by disinflating in the context of IMF-supported programs.
The progress made in reducing inflation should not obscure the fact that the achievements are—with few notable exceptions—not long-standing. Even aside from the major inflation reversals (including Russia during the summer of 1998), a number of countries have experienced some resurgence of inflation (Armenia, Belarus, and Uzbekistan), and in some cases (Belarus and Uzbekistan), price controls on basic consumer goods have recently been intensified. It would be premature to presume that labor markets and financial markets in transition economies now generally discount a low inflation environment. For this reason alone, policymakers that are perceived to believe that inflation has fallen far enough are at risk of losing control of inflation once again. This risk is even evident in countries that experienced persistent moderate inflation, where inflation has repeatedly exceeded official targets, albeit within manageable margins thus far.
But even where a moderate inflation environment is reasonably assured, there is much to commend more ambitious goals—to lower inflation to industrial country levels soon. The estimated threshold above which inflation involves significant output costs appears to be close to industrial country inflation rates for fully fledged market economies, and this provides the relevant benchmark for the most advanced transition economies, including the Czech Republic, Estonia, Hungary, and Poland. With sizable relative price changes already achieved and substantial structural reform in place, those sequencing arguments that favor structural reform first may now be satisfied, setting the scene for further disinflation. And given that successful transition may entail currencies that appreciate in real terms and relatively large current account deficits—trends normally associated with weak policies—low and falling inflation may help to sustain investor confidence and the associated capital inflows.
Finally, there is no statistical evidence that the costs of disinflation are generally significant in transition economies, even at moderate inflation levels. This echoes findings for market economies (Ghosh and Phillips, 1998). And even if persistent moderate inflation has increased inflation inertia, rapid productivity growth should diminish the impact on profitability and employment of any inertia there may be in nominal wages during disinflation (Deppler, 1998).
Countries with persistent moderate inflation, as well as other advanced transition countries, now enjoy almost ideal circumstances for low-cost disinflation and would benefit from lowering inflation further. The commitment of many of them to achieving industrial country inflation rates in the near future in the context of entry to the European Union is appropriate, and others should be no less ambitious about their inflation goals.