Initial conditions, policies and growth in the former Soviet bloc

Contents

Introduction

Macroeconomic stabilisation and growth

The role of institutions

Liberalisation policies

Initial Conditions and Soviet Legacies

Conclusion and implications for the future

Bibliography

Introduction

By the late 1980s, the ever more apparent failures and shortcomings of the planned economy and the collapse of the Communist political system in almost all countries of the Soviet Block enabled dramatic changes to all parts of society and the economy. Since the market economies of Western Europe and North America were the obvious reference point, transforming the planned economies into functioning market economies became a priority. This transition would ensure a better allocation of resources as well as technological progress and innovation and foster sustainable economic growth. To achieve this, it was necessary to profoundly change the underlying structures and incentives of the planned economy. While each country embarked on its own path towards a market economy, there is little dispute as to what reforms were necessary to get the new economic system going. Following Hare these include: (1) macroeconomic stabilisation; (2) price and trade liberalization; (3) privatization and enterprise restructuring; and (4) institutional reforms.¹

This essay examines the impact of some of these reforms on growth. It will also look into how initial conditions explain differences in growth outcomes that can’t be fully explained by policy choices. Focusing on inflation and fiscal balances, the first section will explore the role of macroeconomic stabilization in fostering growth. This is followed by section 2 and 3 which examine institutional reforms and liberalization. Section 5 takes a look at initial conditions in the form of overall development and economic distortions at the start of the transition period. Section 6 concludes and draws implications for the future.

Macroeconomic stabilisation and growth

There appears to be a broad consensus in the literature that achieving macroeconomic stabilization is essential for economic growth. Macroeconomic stability is usually measured by the inflation rate and fiscal deficits. Its absence complicates planning and discourages saving and investment. Inflation rates in the early 1990s were as high as 4500% dropping to an average of 7% in 2007 in the transition countries as transition progressed and stabilization was achieved.² The significance of stabilisation is made clear by a paper by Havrylyshyn and Rooden in which they find that macroeconomic stability, measured by inflation rates and fiscal deficits is highly significant in explaining economic growth and accounts for up to 90% of the variation in growth across the region.³ Their results are supported by Gerry, Lee and Mickiewicz whose estimations show a consistently negative impact of higher inflation on growth.⁴ Similarly Hare finds that higher inflation and larger deficits are associated with deeper recessions at the outset of the transition process in 1992 to 1994.⁵ Falcetti, Lysenko and Sanfey’s estimations find comparable results for fiscal balances, arguing that a large fiscal deficit leads to lower growth rates.⁶ This is also supported by findings from the European Bank for Reconstruction and Development (EBRD). These show a negative impact of fiscal deficits and an especially big impact in the early transition years.⁷

Realizing that high inflation is bad for growth naturally raises the question how far inflation rates should be reduced. There are studies finding that the relationship between inflation and growth is nonlinear and that, once inflation is below a certain threshold it does no more harm. There is however no consensus as to where this threshold is. Christoffersen and Doyle find that inflation rates above 13-15% can reduce output growth by 0.2%. They state the examples of Armenia and Russia which have reduced their inflation rates by 9 and 7 times, thus increasing growth by 1.8% and 1.4% respectively. However, their findings also suggest that increasing inflation if it is below the threshold does not benefit growth.⁸ Reviewing the literature, Falcetti, Lysenko and Sanfey put the threshold at 10-20% and citing (Loungani and Sheets (1997)) find that an inflation rate above 500% leads to a decline in economic growth by 2% in the following year and a loss of 4% over the long run.⁹ Yet another threshold is found by Fischer, Sahay and Vegh at 50%¹⁰ and the EBRD in its 1999 transition report puts it at 30%. They also support the notion that reducing inflation if it is already below the threshold does not have any measurable effect. They further argue that every economy probably has its own threshold.¹¹

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¹ Hare, ‘Institutions in transition’, in P. G Hare and Gerard Turley(ed.), Handbook of the Economics and Political Economy of Transition, London and New York, Routledge, 2013, pp. 34-46 (p. 34)

² Ibid., pp.18-19

³ Havrylyshyn and van Rooden, ‘Institutions Matter in Transiton, But so do Policies’, Comaparative Economic Studies, 45, 2003, pp. 2-24 (p. 14)

⁴ Gerry, Lee and Mickiewicz, ‘Governance, Institutions and Growth: empirical lessons from the post-communist transition’, in Enrico Marelli and Marcello Signorelli (ed.), Economic Growth and Structural Features of Transition, United Kingdom, Palgrave Macmillian, 2010, pp. 41-60 (pp. 44-45, 55)

⁵ Hare, ‘Institutions in transition’, in P. G Hare and Gerard Turley(ed.), Handbook of the Economics and Political Economy of Transition, London and New York, Routledge, 2013, pp. 34-46 (p. 41)

⁶ Falcetti, Lysenko and Sanfey, ‘Reforms and growth in transition: re-examining the evidence’, EBRD Working Paper, 90, 2005, pp.1-26 (p.12)

⁷ European Bank for Reconstruction and Development, ‘Transition Report 2008: Growth in Transition’, EBRD Transition Report, 2008, pp.1-224 (p. 2)

⁸ Christoffersen and Doyle, ‘From Inflation to Growth: eight years of transition’, Economics of Transition, 8 (2), 2000, pp. 421-451 (pp. 435-437)

⁹ Falcetti, Lysenko and Sanfey, ‘Reforms and growth in transition: re-examining the evidence’, EBRD Working Paper, 90, 2005, pp.1-26 (p.2)

¹⁰ Fischer and Sahay and Vegh, ‘Stabilization and growth in transition economies: The early experience’, IMF Working Paper, 31, 1996, pp.1-33, (p.17)

¹¹ European Bank for Reconstruction and Development, ‘Transition Report 1999: Ten years of Transition’, EBRD Transition Report, 1999, pp. 1-299 (p. 62)