1 Chapter 17 Sequencing, Gradualism, and the Political Economy of Adjustment © Pierre-Richard Agénor The World Bank

2 l Stabilization and Structural Adjustment l The Order of Liberalization l Political Restraints and Economic Reforms l Shock Treatment or Gradual Approach

3 Recent literature has focused on three issues: l timing of reforms; l sequencing of reforms; l speed of reforms.

4 Stabilization and Structural Adjustment

5 l Policy complimentarity between macroeconomic adjustments and structural adjustments man argument in favor of shock therapy. l However, may also have conflicting effects. l Structural policies may have a longer time frame than short-run macroeconomic policies. l Importance of interpreting and understanding price signals supports stabilization objective proceeding first.

6 The Order of Liberalization

7 l Many distortions simultaneously present in an economy. l First-best solution would be to remove all distortions at once; never a realistic option in practice. l In reality, second-best solution must then be optimized as a combination of, è sequencing measures that are broad enough in scope to ensure a first-best solution in the long run; è minimizing adjustment costs.

8 Liberalization of External Accounts l Sequencing trade and capital account liberalization: è Many economists have argued to liberalize trade prior to the capital accounts. è Reason: capital inflows resulting from capital account liberalization may cause real appreciation while nascent trade liberalization requires a real depreciation.

9 Edwards and Van Wijnbergen (1986): l Evaluated welfare effects of liberalization. l Conclusion 1: liberalization can have ambiguous effects on welfare because of three types of effects: è direct effects, occur in the market and time period in which the reform has taken place; è intratemporal indirect effects, occur within the period in which the reform occurs because of the interaction between two or more distortions in different markets;

10 è intertemporal indirect effects, result from the inherently dynamic nature of liberalization policies. They imply that a reform in one period may alter the equilibrium in distorted markets in the next period. l Conclusion 2: current account should be opened first. Implication of uncertainty: Conley and Maloney (1995): l Considered a two-period model with uncertain benefits to economic liberalization. l Two-part liberalization program: è current account liberalization in period 1; è complete opening of capital account.

11 l With uncertain benefits, agents base consumption path on marginal productivity of capital in period 2. l Liberalization will thus lead to a surge in consumption, a current account deficit, and an increase in foreign borrowing by private agents. l Ex post potential for boom-bust cycles.

12 Financial Reform and the Capital Account l Capital outflows: spurred by capital account liberalization in the face of financial repression. è Particularly large when credibility (sustainability) of the structural reform not fully established. è Many economists agree; capital account should only be opened after financial market liberalization. l Prudential supervision and regulation of the banking system concurrent with financial liberalization vital.

13 Sequencing Labor Market Reforms Edwards (1989): l Labor mobility needed to facilitate the reallocation of resources across sectors. Labor reform should precede trade reform. l Wage formation and macroeconomic stability; tying wages to future inflation rather than past inflation. l Labor reforms be a contemporary to macroeconomic reforms. l However, difficult to introduce (Agénor, 1996).

14 Political Constraints and Economic Reforms

15 New political economy analyzes economic policy from both a normative and positive perspective. l Normative: issues related to the effect of institutions on policy formation. l Positive: focusing on the types of policies that are more likely to emerge from specific political and institutional settings.

16 Modeling Political Conflict l Timing of economic reforms; recognition that reforms generate winners and losers. l Short-run winners may differ from long-run gainers. l May lead to backtracking. l Assuming existence of a welfare-maximizing benevolent social planner not realistic. l Policy choices reflect the resolution of conflicts of interest between groups with different goals.

17 Key question: How conflicts lead to delays in reform? l Distributional conflict approach: based on models of war of attrition. Each group uncertain about other groups net benefits from reform and their willingness to pay. l Uncertain benefits approach: groups uncertain of their own benefits, leading to a status quo bias.

18 Benefits of Crisis l Making delay of reform more costly can accelerate implementation of stabilization program (Drazen and Grilli, 1993). l For example, episodes of hyperinflation more easy to terminate that episodes of chronic inflation. l Rodrik argued that this view suffers from two problems: è element of tautology, crisis as an extreme case of policy failure; è difficult to falsify, “crisis…not yet ‘severe enough’”.

19 Political Acceptability and Sustainability Wyplosz (1993): l Uncertainty and the difficulty of sustaining reform process. Model illustrated: l Consider economy with N identical workers faced with possible reform. l Reform calls for initial cut in labor force, by , followed by both a return to full employment in period 2 and a gain in productivity.

20 l Without reform, Y 0 :  L N. l With reform, national income drops in period 1, Y 1 : (1-  )  L N, and rises in period 2, Y 2 :  H N.

21 l Reform is efficient on aggregate level by inequality, Y 0 : national income without reform; Y 1 : national income in period 1 with reform; Y 2 : national income in period 2 with reform. Y2Y2 1 + r Y 1 +> Y 0 + Y0Y0 1 + r (1)

22 l Reform is efficient for laid off worker if,  L : wages (labor productivity) without reform.  H : with reform wages. LL 1 + r L +L + > HH (2)

23 l Setting  = 1 / (1 + r) and rearranging (see pp ), efficiency condition is given by, l (4) ensures efficiency but does not ensure welfare.  1 +   +   < LL < HH (4)

24 Welfare analysis l Let (c h ) be a utility function for consumption at period h. l Ex ante political acceptability given by, E: mathematical expectations operator.  : time preference factor. E[ (c 1 ) +  (c 2 )]  (1 +  ) (c), ~ (5)

25 How government can create sufficient support? l b: unemployment benefits. l Suppose government and individuals are unable to borrow against future income. l In presence of b, (5) is rewritten as, (1 -  )v LL   b { } + v(b)v(b)  (1 +  )v(  L ) -  v(  H ) (6)

26 Two ex post conditions for political acceptability: l For the losers, v(b)  (1 +  )v(  L ) -  v(  H ) l For the winners, v LL   b { }  (1 +  )v(  L ) -  v(  H ) l Ex ante condition (6), a weighted average of ex post conditions. l See Figure 17.1 for graphical solution. l See pg. 633 for discussion when government is assumed able to borrow funds.

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28 Social Safety Net: l Increasing recognition of importance alongside adjustment program. l Often include the following components: è targeted subsidies and cash compensation; è unemployment benefits, severance pay, and public works schemes.

29 Shock Treatment or Gradual Approach? l Shock treatment argument based on complementarities between policy instruments. l Arguments for gradualism: è Preexisting distortions, which cannot be removed at the time the reform program is announced. è Imperfect credibility, tantamount to a distortion in the intertemporal price of tradable goods. è Congestion externalities, may create too much transitional unemployment (relative to the market optimum) after a shock treatment (Gavin, 1996). è Weak financial system.

30 Political arguments Pro-Shock: l prevents interest groups from forming; l reform administrations need to take advantage of honeymoon window to execute reforms quickly. Pro-Gradualism: l may help to minimize adjustment costs and limit the distributional burdens on particular groups in the initial phases of reform.