THE ECONOMICS OF TRANSITION Central and Eastern Europe ref: transtnplus332cbs march 2010

Objectives By the end of this lecture students should: n be aware of the characteristics of a transition economy and major macroeconomic trends n understand why western economic policies were not be directly applicable n be able to understand and explain why some Central European Economies (CEEs) were able to join the EU, while others were not

BACKGROUND n Planned economy v market economy n Performance of transition economies n Macroeconomic stabilisation & Microeconomic (institutional) reforms n How economic theory explains U shaped response to output n How relevant is western macroeconomics?

TRANSITION (transformation) n Change from a centrally administered economy (CAE) to a market economy (ME) n Main issues considered here - see handout –property rights –domestic prices –domestic output & employment –financial institutions –budget revenue n Hard Budget Constraint (HBC) - Kornai The Socialist System

INITIAL PERFORMANCE OF TRANSITION ECONOMIES n See handout with data n Progress in transition n inflation n output n unemployment n budget n Poland(1st 1/1/90),Romania, Russia

STABILISATION POLICIES n Similar menu in countries. Choose speed and sequence n Initial fall output in all countries - bigger than expected n Macroeconomic stabilisation n Microeconomic (structural) reforms n For CREDIBILITY -simultaneous announcement

(Macro) Stabilisation package n Price liberalisation -cornerstone of ME n Macroeconomic stabilisation –low inflation - Restrictive monetary policy –Incomes policy –Balance budget n Foreign trade liberalisation

Structural measures: institutional reforms (micro) n Market environment –banking sector –financial sector –tax structure –commercial law n Privatisation n Others

APPLICATION n Initial debate : –Shock therapy v gradualism –Sequencing n Debate late 1990s; why did output fall sharply? –See O Blanchard ch2 for relevant theory How do we achieve future sustainable growth? n Transformation traps (Portes, 1994) –overemphasis on macroeconomic policy –inadequate micro foundations –financial intermediation not developed

Macroeconomic policies n Some argue tight macro policies lead to fall in output n Others (Blanchard, Begg); macro policies not the principal driving force n Sound macro fundamentals necessary but insufficient for stabilisation (Begg) –may be undermined by inadequate structural reform

Example: monetary policy n A major transformation trap - not recognise key role of banks (Portes) »transition banks learning the market system (ab initio) - mistakes in lending n Eg1.Firms avoided HBC –undermines interest rate as instrument of monetary policy n Eg2.Composition of credit distorted n Eg3. Higher interest rates increased loans ! –adverse selection problem

LATE 1990s/ 2000s n 3 CEECs, (Poland, Czech, & Hungary), in particular strengthened the performance of market supporting institutions, –Successful transformation to market economies –GDP rose above pre-transition levels n Similarly for Baltic states & Slovenia n EU accession countries

n SE Europe & Russia - lagging n Some CAEs have still not reformed sufficiently to enter the EU n Divergent patterns of economic reform mirrored by political reform (EBRD 2003) –Thus, political reform & credibility are vital

Post accession: consider benefits/costs to CEEs & EU n Include; –Budget –Competitive pressure on EU15 & EU global competitiveness »Anglo-Saxon / French /Nordic approaches in EU? »Opportunites and threats for EU15 –Agriculture –Structural funds –Migration –Voting & decision making

–FDI –Trade flows

Credit Crunch & CEECs –EBRD Transition Reports - Good source

CONCLUSION n The nature of CAEs & market economies varies significantly n This summary indicates that stabilisation policies were important, and a lack of structural reform was a major feature n Credibility of reforms important n Output initially fell further than expected, but did recover in CEECs

Additional references n Refs for Fiscal & Monetary policy n Begg,Monetary policy during transition; progress & pitfalls in Central & Eastern Europe,Oxford Review of Econ Policy,vol 13,no.2,1997 n Buding & Van Wijnbergen,Fiscal policies in Eastern Europe as above n Papazoglu et al, Potential trade effects of the 2004 enlargement, World Economy 2006