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Ma.cropoliciesin Transitionto a Market Economy:A Three-YearPerspective

Public Disclosure Authorized Leszek Balcerowiczand Alan Gelb

Countries in transtion to market economieshave had to implement macroeconomic stabilizaton programsat the same time that they were engagedvi massiuechanges of their poliical isitutons and the systemic frameorks of therr economies. What has been the interactionof stabilizationwith economicliberalzaon and dwepinstitutional reform in the countriesof Eastern Europe,in partcular, the reations among initial con- ditons, politicaldevelopment, reform strategi, and outcomes?Expec in Eastern Public Disclosure Authorized Europe suggeststhat when then is a politicalbrakthrough (as n the countriesunder review) a radical stablzation-liberalization strategyis probably the kast nsky approac to re/om and will not constrainotput orstructuralreform over the mediun tenn. Even stabilization that is initially succfid in ai inflation villlater come under pressurebecause of soci policiesand the strral transitionsimpelled by reform.Several factors are identifiedthat affect the credibilityof reforms,and lessons are derivedfor counties that have stabilizedand those that yet face this task.

T he collapseof parry and state dominationof societyand the economyleft the countres of Eastern Europe and the former Soviet Union facing a daunt- Public Disclosure Authorized ing dual challenge: to move toward competitive market economies while at the same time maintaining and strengthening newly gained democracies. The eco- nomic transition in these countries is viewed here as having three elements: macro- economic stabilization; liberalization of prices, markets, and entry, and deep institutional change. This article focuses on the problem of achieving macroeco- nomic stability and sustaining macroeconomic balance through the transition. Countries in transition must implement stabilization policies in the midst of deep changes in political institutions and in the systemic frameworks of their economies. In the context of such large changes outcomes usually ascribed to macroeconomic policies can strongly influence systemic and political developments. Conversely,

Lesek Balccrowiczisprofessor of economicsat the WarsawSchool of Economics.Alan Gelb is division chief TransitionEconomics Division, at the WorldBank The authorsgrateflly acknowledgethe con- Public Disclosure Authorized tributionsof staff of the WorldBank, the IntenationalMonemry Fund, the Bank for International Setdemcnts,and Planeconand the assistanceof RaquelArtecona and NikolayGueorguie. Responsibility for errors and shortcomingsis that of the authors alone. Proeedings of the World BankAnnual Conferenceon Development Eonomics 1994 01995 The International Bank for Reconstructionand Development/ THE vORWl BANIC 21 :p ,4Z ,, ,. - - MUacpolices in Transitionto a MarketEconomy: A Thre-YearPerpedive

macroeconomicpolicies can have a large impacton outcomestraditionally attrib- uted to structuralor institutionalpolicies. We therefore emphasizethe pattern of interactionbetween macroeconomic policies, systemic changes, and politicaldevel- opments-rather than the detailsof individualprograms and outcomes,which are, in anv event,subject to unusuallylarge measurementproblems. The core countries in the analysisare those in EastemEurope with longer post-1989reform experi- ence-Bulgaria, Czechoslovakia and its successors, Hungary, Poland, and Romania-but comparisonsare madewith other countriesas appropriate.

"Destroyed Capitalism": Initial Conditions and Measurement Problems "Theres no use trying," she said, "one can't believeimpossible things." "I daresayyou haven't hadmuch practice," said the Queen ... "Why,some- timesI've believedas much as six impossiblethings before breakfast."

-Lewis Carroll,Through the LookingGlass

The Common Legacy... After forty or more years of communismthe "destroyed capitalism"of Eastern Europe and the SovietUnion differedfrom both the temporarily'suspended capi- talism" of postwar Germany and the "distorted capitalism" embracedby Latin American and other dirigiste economies. In the economies characterizedby destroyedcapitalism, institutions reflected a fundamentallydifferent system of orga- nization and incentives(Kornai 1992). With few exceptionsprivate activity was severelyrepressed, and privateownership of assetswas limited to savingsdeposits and part of the housingstock. The restrictedrole of the privatesector had importantimplications for economic institutions,including the operationof factormarkets. Medium-size and large state enterprisesdominated output and employment.Industry was overbuit, especially machinebuilding and heavy industry;services, particularly trade and distribution, were underdevelopedand highlyconstrained. Government played a majorfinancial role, intermediatingbetween enterprises and betweenhouseholds through subsidies and transferprograms, and spendingaccounted for more than half of gross domes- tic product (GDP).Much of the revenuebase was providedby the enterprisesector, where surpluseswere concentratedamong relatively few firms(in contrast,in mar- ket economiesstate enterprisesare usuallya fiscaldrain). The featuresof destroyedcapitalism shaped many institutionsand professions, includingthose of the legalsystem. Statistical systems were not adaptedto dealing with large numbersof smallfirms or individualtaxpayers, and enterpriseshad prim- itive marketing and accounting capabilities.But nowhere was the legacy of destroyedcapitalism more pronouncedthan in the financialsector. Banking systems may have been "deep" (as measuredby the ratio of balancesto output), but finan- Balcewouiczand Gelb 23 cial flows accommodated decisions on the real economy. There was no experience of indirect, market-based monetary policy. Payments systems were primitive. Passive, monopolistic state banks lacked the capability to evaluate creditworthiness, and risk was socialized. Foreign trade was dominated by a few monopolistic organizations. Autarkic trade patterns emphasized bilateral exchange between the members of the Council for Mutual Economic Assistance (CMEA), with increasingly adverse implications for product quality, as shown, for example, by the low prices of Soviet automobiles on Western markets (Roberts 1993). Relative prices were distorted; prices of energy and essential goods and services were heavily subsidized so that cash wages (subject to centralized norms) could be kept low and investment levels high. Official trade margins were tightly controlled. Repressed inflation was widespread, reflecting an absence of b .oad commodity markets and a "shortage" economy, where demand for goods (and labor) often exceeded supply at controlled prices. Queuing, rationing, and hoarding were com- mon responses, although use of these practices differed among countries and over time. The prevalence of "seller's markets" had profound implications for behavior. Enterprise managers set production goals to meet the requirements of bureaucratic bargaining processes (including spurious quality improvements) rather than those of markets and clients. Parallel prices often were multiples of official prices. Input stocks were hoarded, and inventories of unfinished investments were large.

...and Its Implications for Measurement Even in established market economies standard statistical data provide only an incomplete description of economic reality, but in countries in transition data defi- ciencies and biases are much more serious (for more extensive discussions, see UIpton and Sachs 1990; Berg and Sachs 1992; Berg 1993a,b; Bratkowski 1993; and Balcerowicz 1993a). The statistical system inherited by the transition countries focuses on the contracting public sector rather than on the expanding private sec- tor, and while output was overreponed before transition, now there are strong tax incentives to underreport. Conventional statistics fail to reflect the sharp improve- ment in the quality and range of goods and in the composition of output stemming from market-oriented reform, instead applying the same "welfare weights" to pre- and postreform aggregates.And when prices are freed, conventional statistics over- state increases in the price level relative to an initial situation with unsatisfied demand at official prices. This bias distorts all deflated variables, particularly wages, which appear to fall more, relative to a consumer price index (CPI), than do real purchasing power and consumption. And conventional statistics do not measure welfare gains from the elimination of queuing, which may be considerable. Reported unemployment data also are problematic. They are heavily influenced by incentives to report and typically are smaller than true labor redundancy, includ- ing that hidden within enterprises; indeed, the relation between unemployment and redundancy may vary a great deal among countries.' Cross-border transactions are 24 Macropoliciesn Transitionto a MarketEconomy: A Three-YearPerspeaiue poorly reported,giving rise to sometimesmassive errors in trade data; there is still no perfectway to compareruble and hard currencytrade, and so to distinguishthe impact of the collapseof CMEAmarkets from that of the reforms themselves. Reported fiscal deficits can seriouslyunderstate true consolidatedgovernment deficits,particularly where the centralbank supports enterprises with cheapcredit (although,at the sametime, enterprisesmay assume some functionsof government, includingproviding unemployment benefits and social services)for an extended period. Finally,such basic statisticsas stock-buildingand enterprisemarkups and profitsare severelydistorted by inflationand rapid disinflation,and bankprofits can be spuriousbecause of inadequateloan-loss provisioning. These data biases are not neutral with respect to types of reform program. Althoughmany benefitsof reformwill be more seriouslyunderreported the faster the economymoves away from the inheritedstatistical system, the swifterare the reforms the more rapidly will the inefficienciesof the old economicsystem be revealed.These inefficienciesinclude hidden unemployment,inefficient invest- ments,excessive input stocks, repressedinflation and the associatedcosts of queu- ing, and "purelysocialist" output for which demand can be maintained(if at all) only in a socialisteconomy. Instituting market-based monetary policies will make subsidiesand lossesmore tranwarent Invariably,the fiscalbudget becomesthe repositoryfor the lossesof the previoussystem.

Country-Specific Factors and the Stabilization Problem Despitethe commonalitiesof theirheritage, the transitioneconomies inherited very different macroeconomic,structural, and systemicconditions. These conditions determinedthe environmentin whichthese countries began reform and thus the rel- ative difficultyof achievingstabilization. The differencesin thoseconditions reflect longstandingdifferences in policiesand in the politicaldevelopments that pre- ceded-and followed-the breakdownof the one-partystate. Even with conservativemacroeconomic policies all socialist countries were plagued by shortagesresulting from supply rigiditiesand forced substitutionin demandat administrativelyfixed prices. Resolving such microeconomicallyinduced shortagesis part of the liberalizationproblem, and a one-timecorrection of the price level will be needed to accommodate large changesin relative prices, along with suf- ficientmacroeconomic discipline to preservestability in the liberalizedenvironment. Countriesalso facedmacroeconomically induced imbalances, reflected in a mix of shortagesand open inflation(depending on the degreeof price control)and, to the extentthat overexpansivepolicies had been externallyfinanced, high external debt. Only some of the core countriesfaced an urgentinternal stabilization problem at the start of reform.In Bulgaria,Poland, and Romaniathe weakeningof the commu- nist regimewas manifestedin progressiveloss of economiccontrol and increasing macroeconomicimbalances driven by growingconsumption. But Czechoslovakia,in keepingwith a longtradition of macroeconomicconservatism, preserved spending dis- ciplinethroughout its politicaltransition. The stabilizationproblem was also less Balcerowiczand Gelb 25 urgent in Hungary,where both the politicaland the economictransitions began in a more stableand liberalizedenvironment and involvedfar more continuitythan the transitionsin the other countries.Like Bulgaria and Poland,however, Hungary had accumulatedlarge foreign debts. In contrast,Czechoslovakia was essentially debt-free, and Romaniahad repaidpreviously contracted foreign debts by the end of the 1980s. The magnitudeof the initialstabilization problem the core countriesfaced is sug- gested by the strength of open and repressedinflation in their economies.Open inflation was most serious in Poland, and repressedinflationary pressures were strong in Bulgaria,Poland, and Romania.Czechoslovakia's economy was macro- economicallybalanced yet microeconomicallydistorted, with keyrelative prices way out of line and a large foreignexchange premium on a smallparallel markeL The core countries faced structural problems of varied seriousnessthat were reflectedparticularly by dependenceon CMEAtrade and the sizeof industry'sshare in the economy.Other conditionsshaping the reform environmentinduded the extent to whichthe old economicsystem had been reformedand the strengthof the labor movementafter reform: a strong labor movementtended to produce a wage push, which complicatedthe stabilizationeffort. In addition to external debt Bulgariainherited perhaps the most difficultstructural problem: its high depen- dence on CMEAtrade implied lossesof 16 percent of GDP or more with the col- lapse of that trade. The trade collapsewas a large external macroeconomicshock for all countries,with particularlysevere effectsfor sectorsthat dependedon the Soviet market. Romania's industry was unusually concentrated, with a hydrocarbon- based complexdependent on imports from the SovietUnion. Polandtoo had sen- ous structural problems, as well as high foreign debt and strong trade unions; however,following reform, its privateagricultural sector outperformed state-domi- nared systemselsewbere. Other than dependenceon CMEAtrade the main liability of Hungary's relativelyopen and reformed economywas its high level of foreign debt At the other end of the spectrum,debt-free Czechoslovakia had a weak trade union movement,and the CzechRepublic would later be able to separate awayits most seriousproblems of industrialstructure with its split from Slovakia. Also vital for the reform environmentare political developmentsduring eco- nomic transition.Hungary has been dose to a model of politicalstability, with a smooth transitionand the governmentfreely elected in March 1990 still in power in 1994. Czechoslovalia'sfar more radicalpolitical transition involved elections in June 1990 and June 1992, both held accordingto a predeterminedtimetable. The country'ssplit in early 1993 wasa seriouspolitical shock, resulting in fiscalgains to the CzechRepublic and lossesto Slovakia,yet in the CzechRepublic the same eco- nomicteam has functionedsince December1989. The other countrieshave experiencedfar lesspolitical stabifity. Poland formed its first nonconmmunistgovernment in September1989 and launchedits reform pro- gram three monthslater. Followingpresidential elections in late 1990, a new gov- ernmentwas seatedin early 1991. Nevertheless,essentially the same basicteam was responsiblefor the economyuntil December1991. After the parliamentaryelections in October,however, the pace of politicalchange visibly quickened. By April 1994 26 Maaopolices in Transitionto a MarketEconomy: A Three-YearPerspecive

Poland had gone through three governments and five ministersof finance; three of the ministers resigned. In Bulgaria, where a coalition government initiated an eco- nomic program in early 1991, the period up to February 1994 saw two parliamen- tary elections and three governments. Since early 1991 Romania has had as many governments, and it held parliamentary elections in September 1992. Romania has been the only country in which the government was forced to resign (in September 1991) under the pressure of widespread industrial unrest and riots. For a stabilizationplus transition program, perhaps even more than for stabiliza- tion in a nontransition economy, political developmentsform an important part of the conditions for implementation.Elections in an early stage of implementationtend to raise inflationary expectations and reduce the propensity of state enterprises to adjust because of expectations of a change of direction in economic policy. Frequent tumrnoverof governments and niinisters slows the implementationof structural and institutional reforms. Thus the political framework for stabilization has been less favorable in Bulgaria, Poland, and Romania than in Hungary and the former Czechoslovakia As discussedbelow, experience shows that the period of "extraordi- nary politics" that foliowsa major political breakthrough and the discreditingof the old order can create conditions conduciveto effecting a determined stabilization.A vital element of that breakthrough in Eastem Europe (as in the Baltics)was undoubt- edly the sense that the long period of Soviet domination was at an end.

Economic Policy and Political Breakthrough Given initial conditions, whether economic policy can shape outcomes in a con- trolled way depends on political developments. Extreme political instability may render economic policy uncontrollable, so that the outcome is a product of initial conditions, external factors, and political chaos. 'With that in mind, consider three important dimensions of economic policy: * Launching speed: the interval between a political breakthrough and the launching of a coherent economic program. * Phasing: the timing of the launching and implementation of the main com- ponents of the program. * The implementation rate for each main component. The importance of launching speed becomes clear when we analyze economic transition from the perspective of political economy. The period following a great political breakthrough, such as those experienced in Eastern Europe and the Baltics, is characterized by a special mass psychology.In the interval between the discredit- ing of the old political elite and the coalescingof new interest groups, conditions are especially favorable for technocrats to assume positions of political responsibility. There is also a greatly increasfAprobability that the population will accept difficult, normally controversial economic policy measures as necessary sacrifices for the common good (Balcerowicz1994b). But the experience of Eastern Europe suggests that this period of "extraordinary,politics" usually lasts no longer than one to two years. Then, "normal politics" reemerges,when political groups are much less will- Bakcerowiczand Gelb 27 ing to accept such measures-or their distributional implications.The timing of dif- ficult economic measures can therefore be expected to affect their acceptance. With respect to phasing, consider the three sets of policy reform measures: macroeconomic stabilization, microeconornic liberalization, and deep institutional restructuring. Stabilization policy involves fiscal and monetary restraint, exchange rate management, and possiblywage or other controls. Liberalization policy elimi- nates legal or bureaucratic restrictions on economic activity, including price con- trols, quantitative restrictions on foreign trade, limits on foreign exchange convertibility,rationing and the command mechanism,and barriers to setting up and developing private firms.2 Liberalization policy primarily supports a rapid shift toward a market economy and spontaneous growth of the private sector. Institutional restructuring policy, which involves, for example, privatization of state enterprises and reform of legal codes and tax administration, creates the fundamen- tals of a capitalist economy and makes possiblewell-functioning financial and labor markets. As discussed below, single policies alone do not determine economic out- comes. Stabilization outcomes, for example, are the result of liberalization and insti- tutional restructuring as well as the stabilization policy. The implementation rate is the rate at which reformed polides are effected rela- tive to the maximum possible speed for that type of changpeWe term rapid policies as more radical and more gradual polides as less radical.3 Gradualism may reflect initial conditions. For example, if a government had earlier undertaken substantial price liberalization or started reform from a balanced macroeconomy, only limited furithr decontrol or macroeconomic tightening may be needed. Or the initial eco- nomic situation may allow radical approaches, but the actual policy may be gradu- alist by design or because of political drift. Radical reforms, in contrast, are invariably introduced deliberately. Clearly, stabilizaton and liberalization policies can be implemented much faster than most deep institutional changes.A radical strategythus involvesa two-stagetran- sition to a market economy. In the fir stage the economy is largely 'marketized thanks to lbealization policy, and stabilized, tianks to stabilization policy, but it remains market socialistrather than capitalist In the second stage, if stabilizationand liberalizationpolicies are successful,their gains are consolidatedand deep institutional change is completed under macroeconomic stability. Alternative scenarios involve delayingor interrupting stabilizaton or liberalization,or both, or implementingthem over a longer period during which deep institutional change might be effected. A comparison of the economic reform policies of the core countries, focusing on the speed with which reform packages were launched and the scale of changes achieved, suggestssome general observations: Bulgaria and Poland responded to severe macroeconomic imbalances with radical programs introduced soon after the political breakthrough (three months afterward in Poland but a year afterward in Bulgaria). Private sector Liberalization and institutional change advanced much more slowly in Bulgaria, however, and by the end of 1993 growing fiscal imbalance and ris- ing enterprise losses and arrears threatened to derail reform. Romania, inher- 28 Macropolicesin Transitionto a Market Economy:A Three-YearPerspectiuc

iting a lesssevere macroeconomic situation, adopted a lessconsistent, stop- go macroeconomicpolicy but launcheda renewedstabilization and liberal- ization program at the end of 1993. * With a far smaller stabilizationproblem but distorted relative prices, Czechoslovakiaimplemented radical liberalizationsafeguarded by tough macroeconomicpolicy. * Hungaryresponded to a moderatelydifficult macroeconomic situation with more gradualiststabilization and liberalizationpolicies. The responselargely reflectedinitial conditions, induding a more liberalizedprice system,but it was also a deliberatechoice; the governmentcould have opted for a more radical program,which the main opposition parties favored. In contrast, Romania'sgradualism did not reflectfavorable initial conditions but wasdic- tated by politicalfactors. * The countriesthat adoptedradical stabilization policies also adoptedradical price liberalization,raised many administeredprices, and largelyliberalized foreigntrade. In contrast,Romania implemented a much more stepwiselib- eralizationand delayeddecisive price and interestrate adjustments. • Countriesundertaking radical reforms also tended to take a radicalapproach toward external debt inherited from the old regime.Among the heavily indebtedcountries, only Hungarycontinued to fullyservice its debt.

Stabilization Outcomes What were the outcomesof these moderatelyheterodox stabilization programs for inflation,internal and externalbalance, and the restructuringof the economy?None of the countriesimplemented an orthodoxstabilization program that relied solely on fiscaland monetaryrestraint. The severityof initialdistortions ruled out broad relianceon price controls(as in someof the heterodoxprograms implemented else- where).But the dominanceof the statesector and the absenceof ownerswho would resistexcessive wage pressures called for temporarilymaintaining, or evenstrength- ening,inherited wage controls. All countriesmaintained tax-based wage controls, at ieast through the initial phase of transition.Among the countries facing severe macroeconomicproblems, Poland devalued its currencyand peggedthe exchange rate, Bulgariafloated its currency,and Romaniafloated its currencybut intervened heavilyin foreign exchangemarkets and restrictedconvertibility. Czechoslovakia devaluedand peggedits exchangerate; Hungarydevalued and movedto a crawling peg. Thus there were two variantsof the somewhatheterodox programs: one with wagecontrols and one with both wagecontrols and peggedexchange rates.

Disinflationand Eliminationof Shortages In Bulgaia, Poland,and Romania,where repressedinflation was strongest,prices and exchangerates mighthave been expectedto overshootlonger-run equilibriums at the start of reform; in the event,initial price increasesgreatly exceeded projec- Blakerowiczand GeIb 29 tions (Bruno 1993).Czechoslovakia's price increasealso acceded projections.But perhapsbecause inflationary expectations had not becomedeeply institutionalized, except in Romania, the initial inflationary burst lasted only a few months. Nevertheless,only Czechoslovakia-whereinitial macroeconomicimbalances had oeen least serious-managed to bring inflation to below 20 percent after a year. Hungary kept inflationmoderate in 1990 and 1991 as it further decontrolledits alreadyrelatively liberalized price systemand raisedadministered prices. Continuingto exert upward pressureon price levels,however, were the need to financefiscal deficits that reemergedafter the first year of reform, the introduction of new indirect taxes (notablyvalued added taxes), and the adjustmentof key administeredprices (rents, energy,public transport)(Orlowski 1993a,b). Although no countryfully adjustedprices in one step, Polandeffected especially large adjust- ments at the beginning;Czechoslovakia and Hungaryadjusted prices more gradu- ally. At the end of 1993 most countries still subsidizedresidential rents and householdutilities, however. Romaniesinflation profile wasan outlier.Despite an apparentlytight macroeco- nomicprogram and far slowerprice liberalizationthan in the other countries,infla- tion remainedabove 200 percentafter 1990and reacceleratedafter 1991.An initial phase of decontrolin 1990 stalledand partiallyreversed in 1991; liberalizationwas resumnrdin 1992 but becamepervasive only in May 1993 withthe liftingof restric- tionson trade margins.Romania also maintaineda numberof export restrictions. Priceand trade liberalizationand the eliminationof restrictionson privatebusi- ness,combined with restrictive'macroeconomic policies, were remarkablyeffectve in eliminatingshortages. Agricultural markets in Poland,for example,swung from chronic shortageto excesssupply in little more than a month as householdsand farmersdishoarded stocks and food ceasedto be used for animalfodder. Food aid and export controls added to food surpluses (Kwiecinskiand Quaisser 1993). Businesssurveys and interviewswith managersof industrialstate enterprisesin sev- eral countriessuggest that a demandbarrier rapidlyreplaced input shortagesas the main constrainton output,at leastfor establishedfirms. Surveys in Polandshow that most managerssaw the new environmentas credibleand not as a short interlude before a return to "businessas usual." Sharp increasesin nominalinterest rates in January 1990 appear to have played an importantsignaling role, even though real rates did not immediatelybecome positive. Many state enterprisemanagers began to take initiativestoward restructuring,despite high uncertaintyabout the macro- econormLicoudook, constraintson corporategovernance set by enterprisecouncils and trade unions, and limitedinformation about their options(Gelb, Jorgensen, and Singh1992; Pinto, Belka,and Krajewski1993). Whether managersin other coun- tries took such initiativesis lessdear.

Fiscal Deficits, External Financing, and Monetaiy Policy Reforminitially led to sharp reductionsin reported fiscal deficits,particularly in Bulgariaand Poland,where deficitshad been large beforereform. The largestturn- 30 Macropoliciesin Tramsitionto a Market Economy:A Tbree-YearPerpectivw around, more than 10 percent of GDP,came in Poland, which ran a sizable surplus in 1990. In 1992, however, large fiscal deficits reemerged in all the countries except Czechoslovakia,which, along with Hungary, initially maintained a conservative fis- cal stance. But Hungary's deficit widened sharply in 1992 and 1993, to more than 7 percent of GDP. The increase reflected mainly an unexpectedly large decline in corporate taxes-a surprising result considering that Hungary had by far the most reformed tax system. Bulgariasaw its deficit explode to 13 percent of GDP in 1993. The reemergence of serious fiscal deficits reflected depressed economic activity, as well as longer-run processes of systemicchange and costly social policies. Current accounts, like fiscal balances,were at first unexpectedlystrong. Bulgaria, Czechoslovakia.Hungary, and Poland all ran surpluses in the early stages of reform, although Bulgariaand Poland would not have been able to had they been fully ser- vicing their foreign debts. By 1993, however, for all but the Czech Republic (which gained a fiscal benefit of some 4 percent of GDP on the separation from Slovakia), current accounts had swung back into deficit. The deterioration was especiallysharp for Bulgaria and for Hungary, which in 1992 had been able to finance its deficit domestically because a sharp rise in household financial savings coincided with a sharp fall in net domestic credit to enterprises. Romania again followed a different pattern. A demand explosion combined with a contracting economy to worsen the current account by 14 percent of GDP between 1989 and 1990. Current account deficits continued through 1993 even though the budget was in ostensible surplus until 1992; current account deficits and sharply higher inflation therefore preceded an open fiscal deficit by three years. Romania's failure to stabilize after 1990 reflected mainly a self-fulfillingmonetary policy failure that helped to undermine the credibility of the reform program and made subsequent stabilization far more difficult. At the start of reform Romania had a command, rather than a market-socialisteconomy, and strong ties between indus- trial ministries and enterprise managers continued after 1990. Far more than in the other countries, industrial lobbies, representing heavy and petrochemical industries and regies autonomes (strategicsectors that were not to be commercialized)exerted great political power, as did the agricultural lobby. Firms continued to have access to credit at interest rates far below inflation. Real rates on bank loans averaged about -58 percent in 1991-93, and National Bank rediscounts were availableeven more cheaply until the end of 1993. National Bank losses contributed to a real con- solidated government deficit of about 21 percent of GDP in 1992, which was financed in part by monetary expansion. In Romania, as in the other countries, deflated monetary aggregatesand credit to enterprises contracted at the start of reform. The enterprise sector responded to the cut in real bank credit by increasinginterenterprise borrowing, which soared to 190 percent of bank credit by the end of 1991. Surveys of Romanian enterprises left lit- de doubt about their payment priorities: wages first, suppliers last (Calvo and Coricelli 1993). That ranking of priorities suggeststhat weak credibility-not invol- untary lending-caused the credit explosion. In contrast, interenterprise credit actu- ally declined relative to bank credit in Poland in 1990, as the credibility of the BaCerowiaand GeIb 31 hardened budget constraintand the high real cost of borrowingmadc enterprises less inclinedto extend such credits. Interentcrprisecredit was containedat 20 per- cent of bank credit in Czechoslovakiaand Hungary.At the end of 1991 Romafnia eliminatedthe overhangof interentecrprisedebts, which had made evaluatingcred- itworthinessimpossible, through a globalcompensation scheme. Canceling out the net debt requiredthe injectionof heavilysubsidized credits from the NationalBank, -vhichadded to inflationarypressures and underminedthe credibilityof futuresta- bilization policies. Further compensationshave since been needed, suggestinga 'low-disciplinearrears equilibrium." 4 In addition to continued credit subsidiesfrom the National Bank, Romania's inflationin 1992 reflectedthe need to financean open fiscaldeficit of 7 percentof GDP.This deficitwas causedin large part by fiscalsubsidies, which increasedfrom 8.6 percent of GDP in 1991 to 11.4 percent in 1992 (subsidiesin the other coun- trieshad by then been cut to an average3.6 percentof GDP).By 1993 fiscalbalance ostensiblyhad been restored by sharp spendingcuts, but off-budgetinterventions were still significant,and the inflationtax wasbeing leviedon rapidlyshrinking leu balances.Romanians were buildingup foreignexchange deposits (a third of M2 by early 1994) and fleeingthe leu. Until initiation of its stabilizationprogram in late 1993,Romania's monetary policy, and the erosionof its financialbalances, was not unlikethat of Russiaafter 1992 (Easterlyand VieiraDa Cunha 1994). Both coun- tries formally"deregalated" deposit rates, but their state-and enterprise-dominated banking systems have temporarily benefited from inflationary expropriation of householders'deposits. In contrast, the radicalstabilizers that raised deposit rates to positivereal levels soon after the first shock of price liberalizationsaw sustainedremonetization and conversionof foreign exchangedeposits into domestic assets as their currencies reappreciatedfrom initiallyvery devaluedlevels. The cumulativedollar return on Bulgariandeposits for the two yearsafter May 1991 was about 60 percent

Stabilizaion and Restrcturing What did the financialside of stabilizationimply for the restructuringof the real economy?In the three radical reformers-Bulgaria,Czechoslovakia, and Poland- real interestrates werenegative during the sharpinitial spikeof price liberalization, so that the real burdens of domesticdebt were suddenly written down (muchlike external debt in Bulgariaand Poland).In Hungary,where price liberalizationhad been under way far longer and reform involvedmore gradual adjustmentin the price level,the writedownwas more modest and was soon reversed,but external debt servicewas sustained,at heavyfiscal cost. Real borrowingrates subsequentLy averagedabout 15 percentin Polandand Hungaryand 8 percentin Czechoslovakia. With modest growth in deflated credit volumesnet of enterprisedeposits and large interest rate spreads,sthe net resourcetransfer from banks to enterprises (definedas the expansionof net credit less the net interest bill due from the enter- prisesto the banks)was negative.Enterprises therefore had to proceedwith physi- 32 Macropoliciesin 7iTnsirion to a Markt Eronomy:A Three-YearPentpecuiw cal restructuringin a highlyresource-constrained financial environment and to rely on cash flows for new investments.The main questionabout the bankingsystem, then, is how it redistributesscarce resourcesbetween firms: efficiently-toward profitable,growing (private sector) firms-or perversely-rollingover loans to loss- makersand postponingadjustment? This questionis takenbelow. Net transfersfollowed a differentpattern in Romania.Negative real interestrates offsetthe contractionof realcredit, particularlyin 1991,the yearof the globalcom- pensation.The net resourcetransfer from banksto firmswas thereforepositive but unsustainablebecause of the erosionof leu deposits.

Exchange Rate Outcomes Althoughthe three radicalreformers pursued different exchange rate management, their exchangerate profilesafter reformshowed strong parallels.The initialdeval- uationsin Czechoslovakiaand Polandset their newly unifiedrates at about 4 times the purchasingpower parity (PPP)level; Bulgari.., with low reserves,saw the freely floatinglev brieflydevalued to almost10 timesPPp.6 Nevertheless, independent of whether exchangerates were peggedor floating,real rates convergedwithin a year towardlevels of between1.8 and 2.5 timesPPP, with Czechoslovakiamaintaining a more competitiverate than Poland.The lev reappreciatedstrongly toward a market to PPP ratio of 2 until October 1993, whenthe wideningfiscal imbalance and an increasinglychronic buildup of tax, socialsecurity, and interestarrears helped to provokea foreignexchange crisis and a seriesof devaluationsthat halvedthe lev's externalvalue. The expectedratio of marketto PPPrates for countrieswith realper capitaincomes comparable to thoseof EasternEurope is about 2, accordingto 1985 data of the UnitedNational International Comparison Programme (Ahmad 1992); in this sensethe exchangerates were convergingtoward 'normal' levels. Hungary's real exchangerate had slowlydepreciated by 25 percent over the period 1985-90. More so than the other countries,Hungary pursued a deliberate exchange-rate-basedstabilization after 1990. It encouragedforeign borrowing and foreigndirect investment to offsetits heavydebt service burden and at the sametime to build reserves.Hungary's policy of limitingdevaluations considerably dampened inflation,particularly for industrialgoods (Solimanoand Yuravlivker1993), but resultedin steadyreal appreciation, with the forint reachinga valueof 1.6times PPP by early 1993. In real exchangerate movementsRomania again displayed a distinctivepattern. With continuedheavy interventionin goods and foreign exchangemarkets, the exchangerate movederratically, and the officialrate tended to depreciaterelative to PPP rather than to firm at levelsdose to expectedlonger-run values. By 1993 the officialrate was still more than 3 timesPPP Grey and blackforeign exchange mar- kets were active, however,with the National Bank allocatinglimited foreign exchangeon a pro rata basison the officialauction and with premiabetween 25 per- cent and 40 percent.The real effectiveexchange rate wastherefore even higher than the officialrate. Strong depredationof the leu reflectedthe partialand contradic- Balcerowiczand Gelb 33 tory nature of Romania's reforms, particularly the subordination of monetary pol- icy to cushion loss-making firms rather than to reestablish confidence in the cur- rency. In late 1993 Rornania initiated renewed stabilization efforts, including sharp increasesin interest rates to positivereal rates and exchangerate unification. These efforts led to a substantial decline in inflation, to 5 percent a month by early 1994, and a considerable firming of the leu.

Was Radical Reform Too Radical? Monetary and fiscal policies thus have been powerful tools in containing inflation and stabilizing exchange rates, possibly because inflationary processes were not deeply institutionalized at the start. But were the radical programs too tough? Not only were the initial price increases higher than projected, but deflated credit aggre- gates and measured output levels were lower, and current accounts considerably stronger, than expected (Bruno 1993). Considering data lags and the uncertainty accompanying the programs, deviations from projections are not surprising. How should policies have responded to new information? Should they have been relaxed to take advantage of space on the external account? Or should they have been main- tained (or tightened further) to reduce the likelihood that the unexpectedly strong surge in prices would translate into sustained high inflation? Such conundrums are endemic in stabilization programs. Both options have risks that cannot be considered in isolation from the political situation. Policies could indeed appear too tough to be cre&d--, particularly if there is no major political breakthrough. But relaxation poses risks of rising inflation, progressive indexation, loss of credibility, and cosl ier (and politically less acceptable) stabilization in the future. The transition ecor'oaies generally were not highly indexed; that could argue for speedy relaxation once the initial price spike had dissipated. But main- mining macroeconomic stability in a liberalized economy requires fundamental changes in behavior, particularly for enterprise managers long used to an accom- modating budget constraint and a passive banking sector. This problem is com- pounded by the inevitable lag of institutional reforms, including privatization, behind radical stabilization and liberalization. Because the phase of current account improvement was short, and because all the countries (with the possible exception of Czechoslovakia) faced an external balance constraint again by 1992, the risks of relaxation far outweighed any temporary benefits.

Liberalization, Relative Prices, and Competition After price and trade liberalization, most relative price ratios appear to have approached world levels relatively rapidly in Bulgaria, Czechoslovakia, Hungary, and Poland (Berg 1993a). In some cases policy slowed the transmission of international prices; in other cases, otably agricultural marketing and input supply, domestic monopolies in processing and distribution prevented a full pass-through of world prices. Although the ratio of market to PPP exchange rates is only a rough indicator, 34 Macrpolicies in Transition to a Market Economy: A ThI-Year Perspecive it suggests that prices for a wide range of goods should have converged to close to their long-run levels within about a year of the start of radical reforms; comparative costs would then play a more important role in determining real exchange rates. The elimination of temporary "exchange rate protectione exposed finns to the full pres- sures of domestic and international competition, squeezing industrial enterprises' margins and creating pressures for selective protection (Schaffer 1993; ACED 1993). The persistent undervaluation of the leu seems to have limited competitire pres- sure from abroad in Romadia; although data are inadequate, the pattern of reported profitability in the regies autonomesand the commercialized sectors suggests that price controls were more important than foreign competition in determining markups and profits. Large formal devaluations did not simply imply a relative price shift in favor of sectors producing traded goods. Exchange rate unification reduced the relative prices of many goods (especially high-quality consumer durables and foreign travel) that had been obtainable only through parallel exchange markets with high premit Not surprising, consumption of high-quality consumer durables increased sharply at the same time that the corresponding domestic industries faced a demand barrier. Thus consuners benefited from unification, while state enterprises that had pur- chased commodities at official prices and sold at artificially high market prices lost. Interpreting inflation rates and exchange rate movements in transition is further complicated by the divergence between consumer and producer prices in most tran- sition economics. hlt Bulgaria, Hungary, and Poland consumer prices rose more rapidly than industrial producer prices, while Romania showed, if anything, the opposite tendenq. In addition to indirect taxes and technical factors that can cause price indexes to diverge,7 the relative rise in consumer prices appears to reflect two transitional processes First, relative prices of previously heavily subsidized essential services are realigned, and second, trade and distibution margins widen from pre- viously repressed levels as the service sector is privatized and Western marketing pat- terns take hold. Indeed, the service sector has often led to CPI inflation- In contrast, service prices lagged behind the CPI in Romnaniauntil May 1993, when margns were freed. Romania was also the only country in which budgetary subsidies increased as a share of GDP after reform- These important differences in pricing policies show up in household budgets, where the share of nonfood essentials rose sharply in the other countries after 1989 but fell in Romania despite a possibly deeper decline in living standards (Cornia 1994; UNICEF 1993). A widening wedge between industrial producer prices and the CPI has several implications. Part of the CPI inflation in the period following an inidal stabilization comes from a relative price adjustment in favor of previously suppressed or heavily subsidized nontraded sectors. This price adjustment increases financial pressures on industry and agriculture-the traditional tradables sectors-which must contend with wage demands boosted by rising consumer prices. Increases in the prices of nontradables offset, in part; the impact of an initial devaluation on competitiveness. To the extent that price increases reflect cuts in consumer subsidies, higher wages represent a progressive monetization of the overall consumption bundle; to the Bakerowczand Gdb 35 extent that they reflect growing trade and distribution margins, they are part of the process of shifting resources away from state-dominated industry to build private wealth in the service sectors. For these reasons, as well as the fiscal consequences of systemic changes, it is unrealistic to expect inflation rates to fail to levels typical in OECD countries imunediatelyafter initial stabilizations. They need to be sufficiently high for a period to accommodate relative price shifs.

Is Stabilization Sustainable? Feedbacks from Systemic Change The larger process of transition involves many interrelated transitions: from public ownership toward private, from industry toward services, from an economy domi- nated by large enterprises to one with many small firms, from seller's markets to buyer's markets (including the labor market, where open unemployment replaces hidden unemployment), and from CMEA product standards toward world market standards (Kornai 1993). Another fundamental change is to transform the financial sector from a passive player to an active one and to desocialize risk-bearing. Eastern Europe already has seen huge changes along these lines. The private sec- tor's recorded shares in the economy have increased especially rapidly in the Czech Republic and Poland, at first in trade and services but later in other sectors (Rostowski 1993). Little of this private sector growth is directly attributable to the privatization of state enterprises. Although private sector development has lagged in Bulgaria and Romania, thriving private economies have nevertheless arisen in these countries too. The share of industry in output and employment has fallen sharply in all the countries in favor of services and, in Romania, agriculturet Layoffs and breakups are transforming the structure of industial employment; for example, employment in Hungary's largest industrial firms fell by half between 1989 and 1991 while small firms multiplied. What do such structral and institutional transitions imply for the sustainability of macroeconomic stabilization? We consider three areas important for the credibil- ity and sustainability of stabilization programs: the supply response, fiscal sustain- ability, and banking reform.

Supply Response The asymmetric response of private and public sectors to reform argues for a dual- sector framework for explaiinig the supply response (Aghion and Blanchard 1993; Berg 1993c; Chadha and Coricelli 1993).8 Because of the composition of its output the state sector became demand constrained after markets were liberalized, compe- tition emerged, and CMEA trade collapsed. But the private sector has benefited both from demand substitution effects and from the recognition and guarantee of private property rights, which is equivalent to a growth-enhancing supply shock. Cross-country comparisons suggest two possibly surprising conclusions. First, radical stabilization is not associated with lower measured output over a period of two to three years. Indeed, the association is positive in our sample, where the 36 Macropolciesin Transition to a Ma7kflEconmy: A Three-YearPerpecive

largest cumulative contraction is in Romania, the least successfil stabilizer, and the smallest in Poland, the most successfulstabilizer. Second, stabilization does not seem to slow the transition to a private economy. Indeed, some supply-side stimuli to the private sector have been direcdy related to the severe financial squeeze on the state sector. In addition to freuing up labor for the private sector, cash-strapped public enterprises have sold and leased assets to private firms. Where state firms have not responded to a tightened budget constraint (as in Bulgaria), the private sector has tended to be crowded out. These two observations are related. Although Poland shows that state industry can recover under credible hard budget constraints (Pinto, Belka, and Krajewski 1993), one clear message of the past three years is the importance of private sector growth for the initial stage of output recovery and job creation-and hence for the sustainability of stabilization.

Fiscal Sustainability Before reform, fiscal revenues came mainly from three taxes collected through the state enterprise sector: the profits tax, the turnover tax, and the payroll tax, which funded social payments. Together these taxes accounted for almost 80 percent of tax receipts in Czechoslovakia and Poland and about 50 percent in Hungary. Because the enterprise sector concentrated surpluses and employment in large units, governments did not need to develop the capacity to tax large numbers of individuals and small businesses. But with competition, constrained demand, and an end to cheap credit, enterprise sectors could no longer concentrate fiscal resources for governments.9 Meanwhile, widespread private sector underreporting is encouraged by high profit tax rates and payroll and wage taxes that can cause gross labor costs to be double net pay. As would be expected, transition has eroded tax revenues. Fiscal sustainability is not essentially a revenue problem, however For the core countries, excluding Romania (which followed a different fiscal profile), the aver- age ratio of governnent expenditure to GDP was 61 percent in 1989. Of this, 16 percent represented subsidies and 13 percent social transfers, so that redistributive current spending accounted for half of total government expenditure. Ratios of government spending to GDP normally are far lower for market economies at com- parable levels of PPP income: about 21 percent of GDP for revenue and 22 percent of GDP for expenditure (Crunun, Milanovic, and Walton forthcoming). Recent research suggests that, allowing for the level of income per capita, an increase of 10 percentage points in the ratio of fiscal expenditures to GDP is associated with a 1 percentage point drop in the growth rate (Easterly and Rebelo 1993). That sug- gests a high premium on constraining fiscal spending-beyond simply containing the deficit-during the transition. Between 1989 and 1992 fiscal expenditure fell relative to GDP only in Bulgaria and Czechoslovakia. The considerable increase in Romania-can be attributed to ris- ing producer and consumer subsidies. In the other countries subsidies declined Balccrowi:zand Gelb 37 sharply,so that the average ratio of nonsubsidyspending to GDP rose by S per- centage points. Socialspending accounted for almost all of this increase,rising on averagefrom 13 percent to 17 percent of GDP between 1989 and 1992. Although the fiscalcosts of registeredunemployment have been limited,other social expen- diture programsare comprehensive,with pensions by far the largest component. Transitiongenerally has led to a retirement boom; only a small part of the sharp increasesin the ratios of pensionersto populationafter 1989 has been due to demo- graphic factors.Some early retirementhas substitutedfor unemployment,but much has occurred under the many specialregimes offering full pensionsfar earlier than even the low official retirement ages. As the number of pensioners increases,the number of contributors to pay-as-you-gostate pension schemesshrinks, raising dependencyratios in Bulgariato a high of 87 percent by 1992. Ratios of average pensionsto wagesalso have tended to rise; in Polandthey climbed from43 percent to 63 percent between 1989 and 1992. With minimumwages little abovepoverty lines and a need to drasticallyrestruc- ture employment,transition countries face a huge challengein designingaffordable social protection systems that avoid perverse incentives for workers. Moreover, becauseof low retirement ages and slow population growth, pensionersand aspir- ing pensionersweigh heavilyin voting-agepopulations. No country except Estonia has been able to achieve radical reform of the benefit system, perhaps because reformers did not see it as an early priority. Transitionalso raises the issue of intergenerationalequity. The time horizons of the older generationssince the onset of reform are short, and opportunitiesto accu- mulate (nonhousing)wealth largelybypass them in favor of younger entrepreneurs, often well educated, skilled in foreign languages,and able to earn high incomesin the private sector.The age-specificdistribution of wealth arisingfrom transition will thus differ markedly from the long-rn equilibrium distributions in market economies, where wealth tends to be concentrated among older generations. Transitionthus increasesthe need for intergenerationalincome transfers through the state for several decades.This need will be greatest in countres that have failed to stabilize,because of the erosion of household savingsby inflation.

Baking Reform and the Enterp Sector At the start of stabilizationprograms banks were typicallypassive and inexperienced creditors. Rolloversof loans and capitalizationof unpaid interesthave led to a dual financialsystem in which loans are heavilyconcentrated among a few;usually less profitable enterprises.But considerablelearning-by-doing in the banling sectors of the more advancedreformers has resulted in a progressivetightening of financial constraintson loss-makingfirms, although loan quality probably is stil detenorat- ing in the other countries. In addition to improving banling services, one major objective of financial reform is to resolve the allocation of the stock of bad debt After stabilizadonthis stock of debt is no longer eroded by inflation but tends to expand becauseof posi- 38 Macmpoliaes in Transitionto a Market Economy:A Thee-Yar Parpctive tive real interest rates. A second majorobjective is to ensure that new credits flow to solvent,growing firms, to avoid creatinganother seriousloan portfolioproblem. The two objectivesare dosely related.Incentives for prudent commerciallending cannot be establishedin the absenceof properlycapitalized banks: solvingthe flow problem requires addressing the stock problem. Conversely,recapitalization, if repeatedas part of the processof unearthingand provisioningagainst bad debt, threat- ens to underminethe credibilityof the hard budgetconstraint. Some argue for a third objective:to givebanks an activerole in corporategovernance of the enterprisesec- tor-not becausethey are an idealchoice but for wantof other plausibleoutside strate- gic owners and becausethey have the most knowledgeof the enterprises-and, throughthis arrangement,an activerole in resolvingthe bad debt problem. Countriesare addressingthis complexset of interrelatedproblems through vari- ous strategies,usually including a mix of debt transfersto specialinstitutions, debt- equity swaps, and bank recapitalizationand provisioning financed in part by governmentand in part by largespreads.1 0 The ultimatefiscal costs of resolvingprob- lem loans still are not known, but they will be considerable for all countries (Dittus forthcoming;Gomulka 1993). In Hungary,for example,the costs of provisioning against bad loans accounted for 4 percentagepoints of the 10 percentagepoint spread betweenlending and borrowingrates in 1992, and the effectof new provi- sioningrules on banks' profitabilitycut profit tax revenuesby 2 percentof GDP. Hardeningbudget constraints and moving to sound financeis not likely to be achievedquicldy. The institutionalchange in the bankingsector and other financial marketsneeded to fully privatizecommercial risk will take time. Risk will remain high, in part becauseof the preponderanceof new firms (includingthose split off from old firms)without a track record in the new econoniicenvironment. In addi- tion, in most countriesin transitionlegal processes still favor debtorsover creditors. Necessaryyet abrupt measuresto fullydecentralize risk could encouragebanks to hold excess liquidityand lead to the withdrawalof credit from many potentially viable clients.As a practical matter, governmentbudgets therefore probablywill haveto bear someof the costs of problemloans for some time, if spreadsare not to be so large as to inhibit good firmsand furitherweaken bank portfolios.

Ten Lessons From the perspective of stabilization, postsoialist countries now fall into two groups. Exceptfor Romania,the core countries,together with Albania,Slovenia, and two of the Balticstates, have had somesuccess in containinginflation following price liberalizationand now must consolidatemacroeconomic stability while deep- ening institutionalreforms. Most of the others,many with new currencies,have not yet succeededin holding inflationat even moderatelevels. The experienceof the more advancedreformers offers lessonsfor both groups of countries. A general lessonis that, in addition to economicpolicy, what mattersin deter- mining outcomes are initial conditions, political developments, and external factors. On balance, the core countries that faced the most serious macroeconomic problems Bakericz and Gelb 39 may also have inheritedthe most difficultstructural conditions for stabilization,as well as high foreign debt and powerful trade unions. It is not dear that countries that had earlier undergone a phase of market socialism were at an advantage. Their institutions may have been somewhat better adapted to market conditions, but decentralization of management to enterprises created difficult political problems for further reform in Poland, and an apparently less urgent need for reform may have encouraged policy drift in Hungary. 1. Radical is less risky. The countries of Eastern Europe and the former Soviet Union that have managed to contain inflation to low or moderate levels have all experienced major political breakthroughs combining democratization and renewed national independence. The record suggests that when there is both high initial macroeconomic imbalance and a major political breakthrough of this kind, a radical approach involving forcefiulstabilization measures and rapid liberalization is almost surely the least risky option. Initial stabilization has been most successfill when rad- ical programs have been launched during an early period of extraordinary politics following the breakthrough. The reversion to normal politics after an initial hiatus complicates fiuther stabilization by raising inflationary expectations, slowing the implementation of structural and institutional reforms, and reducing the propensity of state enterprises to adjust-Bulgaria is an example. Normal politics is especially problematic if it involves extreme political fragmentation. Successful stabilization requires fundamental behavioral and institutional changes in an economy still dom- inated by state enterprises. One function of radical reform is to signal the need for such change through a fundamental shift in regime. If that dcange is not achieved, chronic financial indisopline and mounting arrears can rapidly erode a reform pro- gram and destroy the credibility of a financially disciplined equilibrium. 2. There is no simple link between type of reform and politial stabiity. Contrary to popular opinion, the degree of political instability does not appear to have a sim- ple relationship to the type of economic program: consider, for example, the Czech Republic and Hungary (both stable but with different political transitions and very different economic programs) or Poland and Romania (both unstable, but one sus- taining a radical program and the other not). 3. Don't fine-tune at the start. It is better to err on the tight side than to try to fine-tune policies in the early stages to take advantage of the temporary balance of payments relief that appears as inflation is brought under control. Failure to stabi- lize initially will lead to a need for further attempts, but from weakened economic and political bases and with lower credibility. In any case, the inevitable uncertainty makes successful fine-tuning impossible. 4. Monetary and fiscal policy can stabilize in transition. Monetary and fiscal poli- cies can be powerful instruments for containing inflation to moderate levels (very low inflation may be difficult to reconcile with the need for continued price realign- ment) and for stabilizing exchange rates, possibly because inflationary processes are not deeply institutionalized at the start. Conversely,stabilization can be elusive after initial price liberalization if financial policies fail to support the holding of domes- tic financial assets. The main failure in Romania (and in Russia and other countries) 40 Macropolidesm Tansition to a Aiket Econony: A Three-YearPerspectiv has been monetary and interest rate policy; lack of credibility in this area may encourage arrears. Minimum interest rate targets may be needed for an extended period to protect uncompetitive, state-dominated banks from decapitalizing house- hold balances. 5. Wage controls are vitaL All the countries relied on wage controls, which become important as privatization inevitably lags behind stabilization and liberal- ization policy. The enterprise sector needs to preserve retained earnings to finance its restructuring and is likely to have to effect a net resource transfer to the bank- ing system as stabilization is consolidated. Some countries, such as Romania and Russia, have temporarily continued positive transfers to their enterprises, but these transfers become unsustainable as financial balances erode. And because the trans- fers are related to political pull rather than to performance, they also are likely to be inefficient. 6. Liberalization reinforcesstabilzation. In theory a government could achieve stabilization while retainig extensive state control of the economy. But in practice there has been a dose relation between stabilization and liberalization exr-pt on the wage front. Policymakerswho valued stabilization also valued liberalization. Cutting fiscal subsidies and avoiding large central bank losses due to subsidized credits (a major weakmessin Romania and many countries of the former Soviet Union) have been important elements of macroeconomic adjustment. Most fundamental, stabi- lzing a heavily controlled economy that retains extensive price controls and strong insttutional links between government and enterprises is very difficult even for a strong state because the enterprises can blame these controls for their losses. In addi- tion, the enterprises always have better information than the government and can take advantage of their lack of autonomy to claim subsidies. Romania shows how problematic this option is. 7. The importance of exchange rate pegs depends on the nature of infationary expecations. Some of the tansition countries pegged their exchange rates to pro- vide another nominal anchor. The experience of Bulgaria, as well as that of Latvia and Slovenia, suggests that the importance of fixing the exchange rate is a more open question than the need for wage controls. It may hinge on whether deeply embedded inflationary expecttions concern price increases (as in Latin America) or mosdy shortages. 8. Radical stabilization and liberalization polxiy encourages recovery and transi- tion to a private economy. Country experience suggests no adverse medium-run tradeoffs between stabilization (with its accompanying liberalization) and either out- put or the speed of transition to a private economy. Failure to stabilize wastes valu- able time and will delay recovery. Measures to promote private sector development, including privatizing small assets and providing access to commercial real estate, should be essential components of a stabilization package because of their impor- tance for the supply response. 9. After nittial stabilzation, credbk, sustainable reform nill require a Strong growth response by the private sector; fiscal reform, especially on the spending side, and probably some external spport; and resolution of bad debts without redig Balexrudz axd Gelb 41 the crvedibilityof budget constrains. The inevitable lag of institutional reform behind stabilization and liberalization suggests that an extended phase of fiscal pressure is to be expected in a radical reform program. In theory a fiscal balance condition can set an upper limit to the speed of transition from a public to a private economy. Although this tradeoff is appealing, in practice the aim of preserving tax receipts is a poor argument for deliberately slowing this transition because revenues are in any case not sustainable. It is counterproductive to try to maintain fiscal revenues by supporting public enterprises with quasi-fiscal subsidies through the banking system: rampant fiscal deficits will shatter the credibility of reform. On the other hand, very high (actual or anticipated) taxation will slow the private economy, which will need to finance rapid growth mostly out of retained earnings. Slow private sector growth also will undermine reform. The main fiscal reforms must, therefore, center on spending. Even after the elim- ination of subsidies, ratios of expenditure to GDP are far above those usual in mid- dle-income countries, largely because of social transfers. Severe resource c onstraints will prevent economies from rapidly growing out of these ratios, particu&arlyif the budget also has to bear the costs of previously hidden inefficiencies. Spending analy- ses, including detailed studies of the incidence of social benefits, are needed to show where adjustments will be less painfuL But it is difficult to cut expenditures abruptly (especially after the end of "extraordinary politics") when trying to preserve a democratic consensus in favor of reform. Unlike in nontransition stabilizing economies, fiscal deficts in transition economies must be seen in a medium-term perspective, with greater emphasis placed on reducing government spending and improving its composition. In the interim external finance will be needed to allow larger fiscal deficits than conventionally acceptable to be financed without excessive monetary expansion. For the same fiscal reasons, reductions in debt service obliga- tions are critical to the success of radical reform in heavily indebted countries. Especially because financial systems can transfer few resources to borrowers in the stabilization phase, measures to limit credit rollovers to loss-mnaldngstate firms and to encourage lending to private firms need to be put in place relatively quicldy, even if banks cannot immediately assume a leading role in initiating bankruptcies. It is also vital to "activate" at least part of the banking system as fast as possible, to support the reorganization of the enterprise sector without, however, creating expectations of bailouts that weaken the credibility of reform. How best to resolve the bad debt problem depends on the country's conditions; the Czech Republic, Hungary, and Poland offer a range of experience suggesting that progress is possi- ble. Across-the-board debt relief is problematic, however, and a simple one-off res- olution of the bad debt problem is probably unrealistic. 10. Failre to stabilize at first does not awgze against continuing instional restrucnt g and liberalization.Consider countries still grappling with major stabi- lization problems in the absence of a major political breakthrough (or having failed to stabilize initially in the aftermath of a breakthrough). How should these countries proceed? Clearly, their task is difficult because of continued economic weakening and the likelihood that indexation mechanisms will be strengthened. One lesson is 42 Maropolicies in Transitionto a Market Economy: A Three-YearPerspeaive to exploit the credibility imparted by any major political discontinuity to implement a detennined stabilization program. Even while not yet stabilized, however, these countries should proceed with liberalization and institutional reforms as rapidly as they can. These reforms will not realize their full potential until macroeconomic sta- bility is achieved. But they can improve the underpinnings for future stabilization and may strengthen a constituency in support of a future stabilization effort.

Notes 1. For example,in 1992 a third of Hungary's registcredunemployed workers (12 percent of the labor force) may have been worling, but in Russia,where registered unemploymcnt is oniy 1 percent, actual unemployment has been estmated at 10 percenL 2. For a more detailed breakdown of policies,see Fischerand Gelb (1991). 3. The term rdical is preferred to the more emotive big bang becausethe second term impliesa possi- bility of effectingall changes immediately-,see Balcerowicz(1994a,b). 4. The countries that have needed to resort to global compensation (RoMamniaand Russia) have also achieved less policy credibility for stabilization. Bulgaria'sexperience in 1993 supports the view that decreased credibilityof reform (m Bulgia's case, the stalling of institutional restruacuringafter initial stabilization and liberalization)leads to explosivegrowth of arrears of all types (ACED 1993); if suffi- dently widespread,these arrears create a low-disciplineequilibrium (see Rostowski1992). S. Large spreads in transition countries reflect four factors: limited competition,cosdy reserverequire- ments, the banking systcm's need to generatc resources for modenization, and the need to provision against loan losses and recapitalizethe banks. 6. Becausc historical indicators of real exchange rates are not a useful guide to long-run equilibrium market rates, a rato of nominal exchangerates to cstimated purchasingpower parity (PPP)rates is used to suggest the level of the rcal exchange rate 7. The consumer price index (ClI) is a Laspeyresindex, and weightingmay bc inauate; the producer price index (PPr)is a Pasche index, and coverageof industralcproducts may be limitedLThe continued divcrgencebetween CPI and PPI, especiallyin Bulgaria,suggests that mcasurementanomalics are seious 8. Extensivediscuion of the relative importance in explainingoutput of measurementerrors, demand shocks, supply shocks (includingthose effected through credit contractions), trade disruption, decline in "information capital," and increased uncertainty cue to the change in cconomic systnm is beyond the scope of this article (but see, for cxample, Bleer and others 1993). 9. This effect has been somewhat offset in the carly stas of reform by cuts in subsidies and deficient inflation accounting, whih susaincd taxes by decapitalizingenterprises (ichaffer 1993; Barbone and Marchetti forthcoming).For an ectcdsivetreatuent of fiscal issues in transition, see Tlizi (1993). 10. It is not yet dclar how well the strateies have worked; for reviewsof the stratcgiesthat differcnt countries have adopted, see Pleskovic(1994); Transition(1994); BIS(1993); Dittus (forthcoming).

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