1. Lecture 10. Political Economy of Reform (based on Roland)

2. Lecture outline Political justifications of economic policies Political constraints A simple model of political economy of reform Status quo bias Mechanisms for enacting reforms Gradual reforms vs. radical reforms Does democracy facilitate reforms?

3. Political justifications of economic policies “Window of opportunity” Privatization is a device for creating constituency for further reforms Argument for gradual reforms - Going slow so that the doubters could see the benefits of reform The use of International Monetary Fund conditionality by politicians

4. Political constraints Ex ante vs. ex post constraints Ex ante constraints determine what kind of reforms could be accepted to start with Ex post constraints determine what kind of reforms would not be overturned after they have been implemented Reasons for difference: uncertainty and reversal costs Aggregate uncertainty vs. individual uncertainty

5. Model of political economy Notation: p = probability that any given individual would benefit from reform; G>0 = NPV payoff for those who gain; L<0 = NPV payoff for those who lose; (the payoff to status quo =0)  = discount factor (  <1;  =1 means no discounting) c = cost of reversal, c>-L (i.e. reversal costs are smaller by absolute value than NPV of loss from reform)

6. Model of political economy (cont.) Assume risk neutrality Issue: what are the conditions for adopting a reform? Assume first that c=0; then each individual expects on average to get from reform E = pG + (1-p)L If E<0 nobody would vote for reform

7. Model of political economy (cont.) If c=0, then everybody would vote for reform if E>0 (but note that if c=0, reform is not credible, i.e., it can be easily reversed); this is because people would want to get a one-period benefit from reform even if it is reversed after one period Let c>0. Now, E>0 is not enough to get votes for reform, because voters know that if p<0.5, reforms will be reversed with probability 1 (if c is not very large, i.e., c < -L)  voters would adopt reform only if E>0.5 and p>0.5 (if c is not too small, e.g., c is such that E - c < 0)

8. Status quo bias This is an example of the status quo bias Reform happens only when both ex ante and ex post constraints are fulfilled Anther (more important) reason for status quo bias is risk aversion Example: U=W 1/2 ; let W 0 = 9  U=3 Let W 1 =16 with p=1/2 and W 2 =3.61 with probability (1-p)=1/2  expected gain=0.5*(16-9)+0.5*(9-3.61)=0.805>0 but expected utility after reform is 0.5*4+0.5*1.9=2.95<3

9. Overcoming status quo bias compensating transfers to the losers (examples: Chinese payouts to the old guard bureaucracy) [required retirement] engaging in gradual reforms that minimizes the number of losers (e.g., dual track approach) waiting for the pre-reform economy to get into a real crisis, so that reforms are inevitable.

10. Overcoming status quo bias (cont.) Problems with compensations: –commitment problem (compensations are paid over a period of time). New institutions might need to be created or laws passed that would make credible commitment to compensations –government revenues need to be collected (difficult for the economies in transition with weak tax administrations) –the presence of asymmetric information and weak administrative ability to implement targeted payments (e.g., it might be difficult to distinguish between “good”” workers who do not need compensation b/c they find other jobs, and “bad” ones, so compensation is paid to everybody and that’s expensive)

11. Overcoming status quo bias (cont.) Problems with gradual reform as a way to overcome political constraints: –lower efficiency than complete reforms, partly as a result of not exploiting complementarities (this may undermine the idea or market reforms) –it does not resolve the uncertainty about outcome of full reform –reversal is relatively easy, creating difficulties with commitment

12. Overcoming status quo bias (cont.) Advantages of gradual reforms: –less costly to implement and to less to pay to the losers –gradual reform is less costly to reverse and, therefore, it makes it easier to get people to agree to it (also, easier to experiment) –gradual reform (if sequenced correctly) can create constituencies for reform (e.g., privatizing good enterprises first)

13. Dual track reforms Apparently successful in China Not implemented in East and Central Europe and FSU Reasons: –The disadvantages of dual track might have outweighed its advantages in E. Europe and FSU –governments in some of those countries were not sufficiently strong to enforce dual track and might have lacked credibility to implement it

14. Sequencing of reforms Privatizing better enterprises first (already mentioned) Competition policy should be introduced early; otherwise, private monopolies can capture the state & it would be too late However, competition policy can work only if the state is reasonably strong to begin with

15. Political considerations vs. economic efficiency Example: economic efficiency might require more labor shedding during privatization, but political considerations might require less unemployment. If political considerations put an upper limit on the level of unemployment, then it might put a limit on the speed of privatization (these political considerations are in addition to the fiscal constraints on the speed of privatization)

16. Democracy vs. autocracy There are advantages and disadvantages to either system of government in terms of implementing reforms Given democracy, is a system with strong executive power better suited for conducting reforms? But the choice of political system is not up to the reformers; countries where population was more pro- reform, create broad coalitions to implement these reforms, while countries that were ambivalent about market reforms probably were ambivalent about democracy as well and they ended up with strong executive power.

17. The role of EU accession EU accession provides –Clear goal –Strengthens commitment to reforms and credibility of policies –Financial help and expert assistance –Access to new markets

18. The role of IMF IMF can provide loans that the country cannot obtain in the private markets IMF’s assistance usually comes under certain conditions (e.g., eliminating subsidies to enterprises, reducing budget deficit, etc.) IMF conditions can be politically useful for advancing reforms, but IMF threat of punishment is credible only for countries that are not too important strategically  IMF’s assistance helped reforms in Bulgaria, but not in Russia or Ukraine