Ten Years of Transformation
Paul R. Gregory
Professor of Economics
University of Houston
Houston, Texas
Guest Professor
Frankfurt Transformation Institute
European University Viadrina
Frankfurt (Oder)
Guest Lecture presented at EUV-Frankfurt on Tuesday, July 13, 1999
THE FACT OF LIMITED TRANSFORMATION SUCCESS
The transformations of the
planned economies of the former Soviet Empire to market economic systems began
roughly 10 years ago. This means that we
can now study the transformations of
more than 25 economies over a period of
ten years, for a total of 250
annual statistical observations. [1] Such a data set gives us a rich base for
drawing conclusions about the course of transformation to date.
The clear transformation
“successes” of Central Europe and the Baltic States account for less than one
fourth of the more than 25 transformations currently underway. The early
transformation successes of Central Europe in Poland, Hungary, and the Czech
Republic caused us to underestimate the difficulties of transformation. Now, we
must be more skeptical about the outcome of transformation in the remaining
transformation economies. We cannot rule out that key countries like Russia and
Ukraine will ultimately “fail,” leaving them mired in a „virtual economy“ of
stagnant output, barter transactions, corruption, crony capitalism, and rising
poverty. If Russia and Ukraine – two nuclear powers that accounted for over
80 percent of the former Soviet Union’s population and output – fail,
industrialized Europe faces an unsettled future, both economically and
politically, no matter how successful Central Europe, Southeastern Europe, or
the Baltic States.
Given the rather limited
success of transformation to date, we must ask whether the West – as represented by our leading international
organizations – shares responsibility
for the current failure of three quarters of the transformation economies. Have
we given the transformation economies bad advice and inadequate assistance?
Should transformation have proceeded differently?
A DECADE OF CHANGE
Transformation
has changed the face of the world economy. The world of mid 1999 is a different
place from 1989. I doubt that this century has seen a decade of such dramatic
economic change, particularly in Asia, which advanced rapidly, and in the
former Soviet Empire, which collapsed economically.
The following figures put
the events of the past decade in appropriate perspective.
Figure 1 compares the U.S. Great Depression of the 1930s with the declines of
the transformation economies over the past decade. The figure divides the
transformation economies into
“successes” and “failures,” where the successes are Central Europe, Slovenia,
and the Baltic States, and the failures are everyone else, but primarily Russia
and Ukraine. Figure 1 shows that the American Great Depression was
mild and relatively short compared to the transformation “failures.”
Surprisingly, the transformation “successes” suffered output declines as deep
as those of the Great Depression and recovered more slowly than the U.S. in the
1930s.
Figure 1 shows that the
“successes” suffered, on average, four years of decline, for a cumulative
output loss of around 30 percent – an output loss similar to that of the U.S.
Great Depression. Poland was remarkable in that it experienced only two years
of negative growth. The “failures,” on
the other had, suffered an average of seven years of negative growth, for a
cumulative loss of half of output. For example, Russia and Ukraine today
produce about half of the output they produced at the beginning of
transformation!
These sobering numbers
underscore that even the transformation successes suffered considerable
hardship and loss of relative economic position in the course of
transformation.
Figure
2 shows shares of world output in 1980 and 1999. With Southeast Asia and China
growing rapidly and the transformation economies experiencing severe and
sustained output losses, the shares of world output of the transformation
economies fell from more than 10 percent in 1980 to 4 percent in 1999, while
the share of Southeast Asia and China increased from 6 percent to 15 percent. In a word,
transformation caused what was once the world’s second largest economy, the
USSR, (by some measures) basically to disappear from the radar screen.
If one thinks that real GDP
data overstate the economic impact of the transformation, we can use
non-economic indicators to capture the magnitude of the economic catastrophe
that befell the transformation failures.
Figure 3 shows that Russian and Ukrainian families stopped having children
and began to die in larger numbers in the 1990s. Although the reductions in
fertility and increases in mortality do not appear to be that large to the
inexperienced eye, such large changes within such a short period of time have
only occurred during wars or extreme famines. Also unusual is that the
mortality increases hit primarily males aged 30-55. Infants, children, women,
and the elderly were largely spared. It remains a puzzle why specifically middle-aged Russian and Ukrainian men began
to die in such large numbers as a consequence of the economic depression?
THE
WASHINGTON CONCENSUS
International
Institutions, such as the International Monetary Fund and the World Bank,
approached the transformation problem in a naïve manner in the late 1980s and
early 1990s: They thought that the transformation problem was not much
different from the problems they had addressed in other parts of the globe,
particularly in Latin America. This type
of thinking was reflected in their recovery blueprint for the transformation
countries, now called the Washington Consensus. The Washington Consensus
consisted of following advice for the transformation economies:
1.
Macroeconomic stabilization is essential. Transformation to a market
economy cannot be achieved if inflation is excessive. Insofar as excessive
budget deficits represent the main source of inflation, budget deficits must be
reduced. Stable money and prices will
encourage other steps towards a market economy.
2.
Privatization creates a constituency for a market economy.
Privatization should therefore proceed quickly even if it is flawed.
3.
Stable exchange rates attract foreign investment and integrate the
transformation economies into the world economy. Exchange rates, therefore,
should not be flexible, market-determined rates.
The IMF, in particular,
promoted the Washington Consensus by insisting on conditionalities. If a
transformation country wished to receive assistance, it was required to enact
policies consistent with the Washington Consensus recipe.
We must consider whether the
Washington Consensus strategy was appropriate for the transformation economies
or whether transformation would have proceeded as well or better in its
absence. It should be noted that criticism of the Washington Consensus has been
limited, at least until recently, perhaps due to the fact that the IMF is a
major provider of public assistance.
MACROECONOMIC STABILIZATION
The average inflation rates in for the transformation successes
and failures tell a rather positive story (Figure
4). Both groups experienced a surge of inflation at the start of
transformation, after which inflation settled down to more normal rates. Most
of the “successes” experienced near-hyperinflation in the first year or two of
transformation (Hungary was spared entirely) before settling down to more
moderate rates of inflation. The Baltic States had one year of near-1000
percent inflation, while Poland had one year of 600 percent inflation. The inflation
story of the “successes” follows exactly what one would expect from textbooks:
Price liberalization meant a “one-shot” increase in the price level – not
sustained inflation. After the initial shock of price liberalization, inflation
settled down to manageable rates.
The “failures” of the former Soviet Union had two to three
years of hyperinflation, while three “failures” in Central and Southeastern
Europe (Slovak Republic, Bulgaria, and Romania) initially avoided the worst of
hyperinflation. Those economies ravaged
by armed conflict experienced substantial hyperinflation.
The positive feature of the inflation graph is that even
the worst transition failures have been able to overcome hyperinflation, to
settle down to a “manageable” inflation rate. Of course, by the standards of
Western industrialized countries, inflation in the transformation economies is
high, but it does not appear to be so high as to preclude economic growth.
Figure 5 shows,
however, the real social effects of hyperinflation on the transformation
economies; namely, a dramatic increase in income inequality and poverty.
Textbooks tell us that hyperinflation redistributes income, and the higher the
inflation the greater the income redistribution. Inequality increased much more in the
transformation failure economies than in the transformation successes. This
figure proves the textbooks to be correct.
Can we regard the conquering of inflation as a major
achievement of the4 Washington Consensus? Whom should we thank for the relative
price stability of the transformation economies – international advisors or the
countries themselves? The Washington Consensus ranked price stability as the
most immediate goal of transformation. International advisors had to overcome
the reluctance of local economists to agree that inflation is caused by
excessive monetary expansion and budget deficits.
My own view is that the transformation economies
themselves largely decided on their own
against excessive inflation. Two fairly obvious points about hyperinflation are
that it is easy to understand that economies cannot long survive hyperinflation
and that hyperinflation is caused by excessive monetary creation typically
associated with budget deficits. No leader wishes to be blamed for
hyperinflation. The very central banker who engineered Russia’s hyperinflation
(called the world’s worst central banker, by the way), upon being returned to
the position in 1998, avoided hyper-inflationary emissions and lobbied for
fiscal austerity. Former Russian Prime Minister Primakov, entirely lacking
liberal credentials and under great pressure to pay back wages, notably did not
resort to the printing press during his tenure in office. I therefore attribute
the anti-inflation decision to domestic politics rather than to the pressure of
international organizations.
Clearly, long-term economic growth cannot occur with
hyperinflation, but the experience of the transformation economies shows that
fiscal austerity and tight money are not sufficient conditions to create
growth. If transformation required only the overcoming of excessive inflation,
all of the transformations would have been successful.
PRIVATIZATION
Privatization represents the second pillor of the Washington Consensus. International Advisors, such as Harvard Institute for International Development in Russia, were not so naïve to believe that privatization could occur quickly and fairly in countries such as Russia and the Ukraine. They gambled on the fact that a quick privatization would create an interest group in favor of capitalism that would prevent communism’s return. Privatization, even if it meant creating robber barons and financial oligarchs, was a superior result to continuation of state owned enterprises. Moreover, it was argued that, even if enterprises fell initially into the wrong hands, this error could later be corrected as efficient managers would eventually buy out the original inefficient managers.
Figure
5 correlates the private share of output in transformation economies with
their rate of economic growth over the past four years. If privatization were
the key to economic growth, we should see a positive correlation. Regretably
for the Washington Consensus, the figure fails to reveal a correlation of any
kind. The relationship between privatization and economic growth is random.
Critics
of quick privatization argue that formal conversion of state enterprises into non-state enterprises
was ineffective because the new owners/managers lack the proper motivation to
manage their assets efficiently. It took decades or centuries for the
industrialized West to create the norms, the incentive systems, and the
certainty of property rights to prevent asset stripping. Too often the new
owners/managers view their enterprises as something that can be robbed, rather
than as something whose long-term value should be maximized.
STABLE EXCHANGE RATES
The third pillar of the
Washington Consensus is that exchange rates should be fixed or should remain
within a predetermined band so as to encourage international trade and the
inflow of foreign investment. Transition governments were therefore encouraged
by international organizations to intervene in foreign exchange markets using
their precious international reserves, some of which were supplied by the IMF
in the form of loans. Surprisingly, the IMF opposed currency board
arrangements, the one arrangement that gave fixed exchange rates long-term
credibility.
The IMF encouraged stable exchange rates and state
intervention in currency markets despite a long history of failed attempts to
manage exchange rates. Investors and business persons know enough economic
history to know that there are virtually no long-run successes when it comes to
managing exchange rates, particularly when the domestic economy is being
subjected to enormous shocks and traumas. Therefore, I fail to see how
long-term investment and trade would be encouraged by managed exchange rates.
I would also question the wisdom of encouraging
capital-poor countries to waste their limited ability to borrow and to
accumulate capital on building up international reserves to support their own
currencies.
An even more troubling issue is how the IMF and the transformation country is to decide which exchange rate to support in a world of dramatic change. It is hard enough for stable industrial economies to manage their currencies. How could one expect economies undergoing enormous shocks to their systems to pick the “right” exchange rate? Or will they pick an untenable exchange rate and then waste their international reserve trying to support that exchange rate?
Figure 6 uses
Ukrainian exchange rates to illustrate the difficulty of picking and supporting
the right exchange rate. The top figure shows Ukrainian/Russian ruble nominal
and real exchange rates; namely, the real and nominal values of the Ukrainian
currency relative to its markets in the “East.” The bottom figure shows
Ukrainian UAH/ECU nominal and real exchange rates; namely, the nominal and real
values of the Ukrainian currency relative to its “Western” markets.
The top figure shows a complicated relationship to the
ruble, but a general tendency towards appreciation in both nominal and real
terms. The bottom figure shows a nominal depreciation relative to the ECU, but
a steady trend towards appreciation of the real exchange rate.
I do not wish to make a complete analysis of these exchange
rates. I only wish to point out that the conditions required for a stable
exchange rate scarcely exist. Inflation rates are quite different; the Asian
crisis with its devaluations cut into Ukraine’s Asian markets, and so on. The
Russian devaluation occurring in Ukraine’s major international market clearly
had a major effect on Ukraine’s exports and imports.
The point is that, even under conditions of great stability,
it is extremely difficult to pick the “right” exchange rate. Under the highly
unstable conditions of transformation, it is triply difficult. The result can
be the choice of the wrong exchange rate.
Defending a currency can be
an expensive process. The country’s scarce financial resources must be devoted
to currency-market interventions. Stabilization funds must be borrowed either
from the IMF or from other sources. These scarce resources are clearly wasted
if the end result is a devaluation of the national currency. This was indeed
the case in Russia and Ukraine in August of 1998, when both nations ran out of
international reserves and were forced to devalue their currencies.
Another issue is whether the IMF faces a conflict of interest in its stance in favor of stable exchange rates? The IMF is basically a form of world banker, placed in charge of world currencies and financial systems. The IMF is basically a representative of lender interests. It wishes to insure that international lenders are repaid and that the IMF itself is repaid. The IMF therefore views devaluations as contrary to the interests of international lenders because devaluations make it difficult for countries like the Urkaine and Russia to repay their international debts. On the other hand, a lower currency may indeed be in the country’s own interests -- say to promote exports.
Figure 7 provides information on foreign capital flows to the transformation successes and failures. It shows that the successes received about $200 per capita in the most useful type of foreign capital – foreign direct investment. The failures received virtually no FDI even though included in the failures are the oil rich Caspian states. The most striking number is the fact that the capital-poor failures actually exported their savings on a net basis to the industrialized West! Although these countries were receiving grants, loans, and other forms of financial inflows, they sent more abroad than they received. The limited funds that the failures attracted were attracted primarily by government whose treasury bills and other notes were more attractive to domestic and foreign investors than were industrial borrowers.
SHOCK THERAPY VERSUS GRADUALISM: THE CREATION OF A NEW ECONOMIC SYSTEM?
It would be a mistake to argue that transition success
depends on the growth of investment.
Such a conclusion assumes that investment will be put to good use. Unless,
enterprise managers wish to maximize the long-run value of the enterprise, they
will waste investment resources. Government officials may order financial
institutions to invest in projects that preserve employment but do not make
economic sense. Investment will be put to good use only if the proper
institutions, norms, and oincentives are in place. It is uncertain what would
happen to economic growth among the transformation failures if, by some
miracle, massive volumes of investment were made available, say by
international lenders.
Clifford Gaddy and Barry Ickes argue that investment is
likely to be wasted than put to productive use in the “virtual economies” of
the failed trasformation economies such as Russia and Ukraine. Investment
funds, according to Gaddy and Ickes, are likely to go to “value subtracting”
companies, who create less value than the resources they use up – much like
the German Ruhr coal industry uses up
more value than it creates. Only in the transformation failures, value
subtraction takes place throughout the entire economy.
The virtual economy of value subtraction came about due to
the desire to minimize change, to preserve jobs in unprofitable companies, and
because powerful forces, what Mancur Olson called distributional coalitions,
benefit.[2]
The balance of power falls into the hands of those, who for reasons of
corruption, avoidance of bankruptcy, or continuation of the Soviet-style
system, are satisfied with the current state of affairs. Workers are attracted
by the promise that they can keep their current jobs even though they are not
paid regularly. Opportunities for corruption are maximized by the failure to
create meaningful reform, creating another constituency for the status quo.[3]
The virtual economy theory suggests that the transformation
failures may be stuck in a permanent low-level equilibrium in which output
cannot grow, the state cannot collect taxes, barter replaces monetary
transactions, and corruption is rampant. The truly frightening prospect is that
virtual economy is „stable“ in that the key decision makers favor its
continuation and there is no strong voice for meaningful change.
The virtual economy and collapse of capital formation are
clearly interrelated. Neither domestic nor foreign investors wish to invest in
an economy that is corrupt, avoids the use of money, props up failing
enterprises, and lacks a rule of law.
Economies dominated by
corruption and crony capitalism are not unique to the transformation economies.
They can readily be found in Asia, Latin America, and Africa. Figure 7 shows that economies that share Russia’s poor
institutional rating (as measured by the Heritage Foundations “6 includes
economies that share similar low economic freedom rankings with Economic
Freedom Index”),[4]
have either grown slowly or have shrunk, like Russia. Figure Russia. In fact,
economies with similar „reform“ rankings have grown, on average, at negative
rates over the past decade, whether the transition economies are included or
not. Figure 6 provides a depressing
scenario for the virtual economies --
decades of negative or zero growth in a non-reform environment. This scenario
is to be avoided by a vigorous attack on corruption, strong protection of
property rights, tax reform, enforcement of bankruptcy laws, the end to
subsidies of value-subtracting enterprises. This laundry list is familiar to
the leaders of the virtual economies, who have lacked the political will or
desire to carry it out.
The Role of the State and of Foreign Investment
The transformation economies
need investment and technology, but they lack both the supply of investment and
the demand for investment. A large portion of domestic investment finance is
diverted abroad in the form of capital flight. The diversion of limited
investment capital, both domestic and foreign, to cover the state deficit is
another impediment to growth. International organizations, such as the
International Monetary Fund, may have unwittingly contributed to this
diversion.
At the beginning of transformation, the former
administrative-command economies used more than half of their resources for the
state (including state funded investment). When confronted with the realities
of transformation, it became apparent that they could not longer devote such a
share of resources to the state. The state began to shrink because taxes could
not be collected and/or the tax base was shrinking along with output. State
spending, however, was not reduced as quickly as tax revenues, and the
transformation economies began to record large budget deficits.
The decline in production in the transformation successes
was relatively short-lived. They reformed their tax systems and other
institutions; they were able to collect
enough taxes to keep the government’s share relatively high, and large budget
deficits were avoided. The transformation failures failed to reform their tax
systems, and were unable to collect tax revenues as output continued to
collapse and tax-paying discipline disappeared. The result was a substantial
drop in tax collections, while state spending did not contract as fast – resulting
in large state deficits.
In the transformation failures, the state ceased to be a
net supplier of investment funds, but became the private sector’s major
competitor for investment funds. The funds that these states received by
selling state obligations were not available to private enterprises. Instead of
directing attention to funding private investment, the governments actively
borrowed from domestic and international savers, who considered lending to the
state safer than lending to unknown private enterprises. Moreover, the
governments of transformation failures were ill-advised by international
investment banks, who taught them how to float loans abroad, and by the IMF,
which told them to raise taxes rather than reduce spending.
GROWTH PROSPECTS: NEAR TERM (5 YEARS)
The 25 countries that have had to navigate
transition have faced similar challenges. Those economies that were a part of
the Soviet Union faced particularly tough problems given the integrated nature
of the Soviet planning system. To make matters worse, a number of former Soviet
republics have had to deal with civil wars and wars with neighboring states
that have particularly dragged down their economic performance.
Compared
to the rapid growth of the countries of Southeast Asia (prior to the Asian
Crisis), sporadic growth rates in excess of 5 percent are not dramatic, but, if
sustained, such rates could lead to long-term increases in relative economic
positions. However, this pattern of not achieving „breakout“ rates of growth
suggests a characteristic of the transition; namely, that the burden of the
Soviet period was immense. There tends to remain in place an unprofitable state
or heavy industry sector (protected by the virtual economy) that pulls down the
overall rate of growth). The carryovers of the administrative-command system do
not disappear quickly.
PROSPECTS
Given the vast institutional, social, and
political changes that are occurring in Russia and the unpredictability of
their eventual outcomes, it would be foolhardy to make long-term (20 year)
projections of the Russian economy. The
best one can do is to identify the factors that will determine Russia’s
long-term growth outcome.
Reform Versus
Status Quo
I
have already mentioned that certain vested interests may prefer to preserve the
status quo. Russia’s virtual economy is, in fact, a device for the preservation
of the status quo. Russia’s status quo contains features that are inimical to
growth: corruption, preservation of loss-making enterprises, lack of incentives
to maximize owner value, criminal restrictions on entry, and so on. At this
juncture, Russian politics are in too much flux to predict whether meaningful
market-economy reform will be completed over the next decade. If further reform
is not enacted, Russia’s long-term growth prospects are limited.
Access to Foreign Capital
The Chinese
Model: Can’t Undo Democratization
Appeal of China: Growth acceleration
during transformation, something that Gorbachev thought was possible.
A Return to the Administrative-Command Economy?
Currently, Russia is caught between an
administrative-command economy and a quasi-market economy. Powerful forces in
the Russian Duma may prefer a return to the administrative-command economy. If
a successful return to the administrative-command system could be engineered,
the effect on economic growth might initially be positive. This is due to the
fact that Russia’s capital stock is geared to producing the products desired by
planners and a simple upward shift of the PPF might occur.
In my view, it is idle to even speculate about a return to
the „true“ administrative-command system because such a return is now
impossible. The system requires a total dictatorship, elimination of market
ties between producers, and other features that cannot be reconstituted in
modern Russia. The likely result would be an aborted attempt to return to the
old system, creating even more chaos and confusion with the result being a
continuation of negative growth.
The Iron Colonel (Pinochet) Model
The extreme power of the General Secretary position allowed
Gorbachev to embark on radical economic reform despite a party leadership that
did not favor reform and a public that was generally supportive of the
established system. [5]
It may require similar power from a Pinochet-like „Iron Colonel“ to push
through the decisive phases of economic reform that remain. Such an Iron
Colonel remains to be identified, and it is quite likely, such a figure will
never emerge on the Russian political scene. Russian history is replete with
cases of major events being dictated by the personality of the leader. The
Soviet administrative-command system would have been much different without
Stalin. Perestroika would not have occurred (when it did) without Gorbachev.
Hence the fate of Russia’s growth may again depend upon the emergence of an
individual, who would change in a
favorable way the system’s operation.
A Militarist Model?
In the absence of restoration of a political dictatorship
in Russia, a model of growth based upon a militarization of the Russian economy
is unlikely. As noted above, the populace wishes consumption and will act
forcefully to protect its living standards. The Russian population, already
deprived, would scarcely stand by to witness a return to high proportions of
GDP devoted to defense. Moreover, given the strong constraints on the state
budget, it is unclear where the financing of military expenditures would come
from. Privatization has shifted income from businesses to households, and the
profit share of the economy has shrunk. It is hard to see the „surpluses“ from
which military expansion would be financed.
Will Gradual Improvements Work?
We now recognize the difficulty to creating economic
institutions. Western business persons, trying to establish Russian ventures,
are taken back by the slow pace of institutional change. Oil executives wait
for years for a finalized version of Production Sharing Arrangements. Foreign
and Western businesses operating in Russia must wait for better and simplified
tax regulations that never seem to be finalized. Laws must go through different
readings in the Duma and, with each reading, significant amendments are
introduced.
It is now clear (in the absence of an Iron Colonel model)
that institutional change will be gradual in Russia. What is not clear is
whether gradual change (incrementally in the right direction) will cumulate
into sufficiently significant change to create a climate for growth and
investment?
The famed „virtual economy“ model explains to a degree why
change is so slow in coming about. Vested interests have become deeply rooted
and change, even in the direction of a more rational economy, tends to threaten
their interests.
The late Mancur Olson argued that, once vested interests in
the form of distributional coalitions become established, they can prevent or
reverse the direction of reform.[6]
Russia shows signs of domination by distributional coalitions – oligarchs,
corrupt officials, and Mafia groups. Russia lacks Olson’s „stationary
bandit/dictator“ who can overcome vested interests to create a more rational
economy.
A large number of economies do not grow (or experience
negative growth), especially on a per capita basis. Of the approximately 120
countries for which per capita real GDP growth records were available in 1997,
some 20 had either zero growth or negative growth. Some countries do not grow
at all over long periods of time. In the two decades of the 1980s and 1990s
(1990-1997), some 23 countries experienced negative growth either in one or
both decades.[7]
Labor Unrest as a Shock to the Model
Russia has had a taste of labor unrest. Coal miners block
the trans-Siberian and unpaid school teachers engage in hunger strikes. The
remarkable feature of Russia’s labor unrest has been its relative quiescence
given the dramatic privation of Russian industrial workers. This quiescence is
either the result of the long tradition of ineffectual labor union
representation or of the fact that industrial workers now have alternate
employments that are more meaningful than their „principal“ jobs – selling,
repairing, driving, etc.
Massive labor unrest would be one way to shock the Russian
virtual economy into a new leadership and new economic model. What is unclear
is the type of economic system that a rebellious labor would demand. Demands to
return to the old system may be more likely than demands for real reform,
although popular disapproval of New Russians and oligarchs is high. Poland is
an example of the positive use of labor unrest, but that may be a historically
unique case.
Regional Experimentation
The weakening of the central
government that has been occurring over the past five years appears to raise
the prospect of regional experiments with alternate economic systems. The
competition of regional experiments could therefore lead to the eventual choice
of a better economic system for all of Russia. Although appealing, it seems
unlikely that regional experiments can solve the problem. The regional economy
must operate within the framework of a national economy and its laws,
regulations, and policies.
CONCLUSIONS
Economists accustomed to studying the industrialized
countries have come to think of economic growth as a normal phenomenon. Falling
real GDP is something that occurs rarely, during unusual periods of recessions.
We tend to forget that for many economies positive growth of output and of
output per capita are not normal. Such countries are beset by corruption, poor
economic and political institutions, and
massive rent seeking. Distributional coalitions ensure that their share of the economic
pie is maintained or enlarged, but few worry about expanding the size of the
pie.
Through
the Soviet experience of steady but declining growth, we have also come to
associate positive growth with Russia and the other former Soviet republics.
After all, the Soviet Union represented a formidable enemy, whose military
power was once seen as equaling our own. The Soviet Union fell apart abruptly,
without much of a plan to create a market economy in place of the
administrative-command system. Massive corruption, rent-seeking groups, and
distributional coalitions formed quickly in the absence of a strong sense of
what should be done – shock therapy, gradualism, do-nothing policies? Russia’s
massive employment machine located primarily in massive industrial enterprises
was threatened, and an ad hoc system of hidden subsidies, barter, and arrears
formed to keep this system afloat. The final outcome is not clear. Russia could
easily fall into the group of countries that either stagnates or further shrinks.
It could also join the group of transition successes.
Light at the
End of the Tunnel?
During the Vietnam War, U.S. military leaders spoke optimistically of a “light at the end of the tunnel” – a phrase denoting that victory was really just around the corner. Many observers of the transformation of the former Soviet Union have been anxiously awaiting this “light at the end of the tunnel.” Figure 2 seemed to suggest such a light at the end of the 1990s: The majority of transition failures reported positive growth in 1997 and 1998, and five (Azerbaijan, 6%, Belarus 10%, Georgia 11%, Kyrgystan 10%, and Slovak Republic 7%) reported growth in excess of 5 percent. Does this resumption of positive growth suggest that, at long last, the transformation is succeeding generally?
We cannot be sure of the meaning of these positive growth rates. They could be telling us that there are limits below which output cannot fall. If so, growth would be inevitable at some point in time. The positive growth figures could be statistical fabrications, or they could be real signs of significant turning points.
Figure 4 is a scatter plot of 1997
growth rates and inflation rates for those countries that recorded positive
growth. It shows whether growth is the result of increasing aggregate demand or of increasing
aggregate supply. If growth is
predominantly the result of aggregate demand, we would expect the combination
of growth and high inflation. If growth is the result of aggregate supply, we
would expect growth and low inflation. The scatter plot reveals relatively high
growth and relatively low inflation for the transformation “successes” – growth
induced by supply-side changes. But it reveals that five of the transformation
“failures” combined positive growth with rates of inflation in excess of 20
percent – deemand-induced growth. The best illustration is Belarus, which
reported a 10 percent growth rate and a 64 percent inflation rate in 1997.
Demand-induced growth can be a dangerous phenomenon for the transformation economies because it may signal a return to the administrative-command methods. For example, state purchases financed by government deficits may be used to purchases of products (such as construction and equipment) produced by inefficient state enterprises for which there is no real market demand.
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