Transformation process and the J‐curve problem

International Journal of Social Economics Transformation process and the J-curve problem Helmut Wagner

Article information: To cite this document: Helmut Wagner, (1996),"Transformation process and the J-curve problem", International Journal of Social Economics, Vol. 23 Iss 10/11 pp. 73 - 87 Permanent link to this document: http://dx.doi.org/10.1108/03068299610149462

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Transformation process and the J-curve problem

Transformation process and the J-curve problem

Helmut Wagner

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Fern University, Hagen, Germany

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Introduction The process of economic reform began in most Eastern European countries with all or most of the central planning system still in place. Most of these reforms were piecemeal and did not constitute a comprehensive programme. Nevertheless they were important steps towards a market economy. These initial reform steps began at different times in these countries between 1987 and January 1991 (Czechoslovakia having been the latest one among them) with the exception of Hungary which already began instituting limited reform measures in 1968. The “new economic mechanism” there allowed firms to have some control over internal finances, encouraged limited competition and established the right to engage in foreign trade directly, rather than through a foreign trade organization. The phase of starting limited reform measures has to be differentiated from the phase of adopting a kind of comprehensive programme. Comprehensive programmes started in most countries around 1990-91 with the exception of Hungary (1988), Poland and Slovenia (1989) having started earlier and Russia (1992) later. This paper describes what a comprehensive programme consists of, why a J-curve in output and employment arises and with what consequences. Then a model is proposed and, finally, the possibilities and limitations of external help of avoiding a structural extension of this J-curve problem are discussed. Elements of a comprehensive transformation programme A comprehensive transformation programme consists of an institutional or structural adjustment part and a stabilization part. The institutional part Standard and modern theoretical reasoning in economics and political economy as well as empirical experience from developing countries (Wagner, 1989; 1992) suggest that each country in transition – transitional country (TC) – has to implement a lot of institutional or structural adjustment reforms. These necessary reforms include (there is a broad consensus among economists about these institutional necessities at present) the establishment of: This paper was presented at the Seventh World Congress of Social Economics in Verona, 3-7 August 1994.

International Journal of Social Economics, Vol. 23 No. 10/11, 1996, pp. 73-87. © MCB University Press, 0306-8293

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• • • • • • • • •

a stable legal framework; a two-tier banking system; a well-functioning tax system; institutional conditions for a well-functioning capital market; privatization and restructuring; deregulation and liberalization; an antitrust authority; a broad educational and training system; and a social safety net.

A stable legal framework. The classical Soviet-type system operated in the virtual absence of economic legality (the term “economic legality” refers to laws in the economic sphere, especially contract, tax and bankruptcy laws), which, however, is a prerequisite to a successful transition to a market economy (Litwack, 1991). In the absence of legality, the system will not be able to implement a credible commitment to private property rights or any other effective market incentive mechanism. A two-tier banking system. Monetary discipline can only be credibly precommitted if there is an autonomous central bank. Therefore, the traditional “monobank” system has to be turned into one based on an autonomous central bank and a large number of competitive commercial banks. For further explanation, see Wagner (1993a). A well-functioning tax system. TCs need urgently to introduce broad-based taxes and to develop the capacity for tax administration. This can be seen as an institutional supplement of the two necessary conditions for reducing or avoiding a destabilizing budget deficit, which are fiscal consolidation and elimination of subsidies. Institutional conditions for a well-functioning capital market. Credit and financial markets in TCs lack depth and breadth. The complex information system necessary in a market economy to assess risk and creditworthiness of investments is underdeveloped. In the centrally planned economies, there were no incentives to accumulate such information. Losses of enterprises were financed automatically and the government, as a “lender of last resort”, provided extensive insurance without charging the appropriate premium. This imperfect information structure, superimposed on the complex web of interfirm credit that links the fortunes of efficient and inefficient enterprises, are major obstacles to a successful transformation process. They may, as Calvo and Frenkel (1991a) emphasized recently, result in a “bad” equilibrium in which socially profitable long-run investments are crowded out by socially less profitable short-run investments. This consideration underscores the benefits of an early development of domestic capital markets, as well as the desirability of

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finding ways to “clean” the balance sheets of enterprises and banks by cancelling bad debts. Privatization and restructuring. Privatization and restructuring are the two phases of enterprise reform, which is the heart of the transformation process. Passing control of major enterprises into private hands, first, has a symbolic value as a sign of a largely irreversible commitment to market-economic transformation. Second, it enlarges the availability of products particularly by creating the incentives to produce efficiently and to reduce market disequilibria as fast as possible. (However, real gains from private ownership will take years to manifest themselves.) Privatization is often assessed as the most difficult and novel reform package for TCs (see Lipton and Sachs, 1990). The recent experiences in East Germany and elsewhere appear to prove this assessment (particularly as for the privatization of large enterprises (see Fischer, 1991). Successful restructuring may take even a longer period of time. Restructuring denotes the task of making state-owned firms competitive. The artificial price structure in the prior centrally planned economy led to systematic distortions and to the wrong mix of production. This wrong mix implies that, after price liberalization, some firms will have to be closed. Moreover, the lack of (market economy) trained managers and other professionals appears to be a main problem as to a quick success. Deregulation and liberalization. As mentioned above, the price system in centrally planned economies is artificially distorted. The best or quickest way of ensuring an economically rational price system in TCs is by opening the economy to foreign trade. Exposing domestic producers to foreign competition is particularly important in economies (such as in the TCs) where industries are monopolized to a much greater extent than elsewhere. At an appropriate exchange rate, trade liberalization also creates the right incentive for potential exporters. As manifold historical experience has shown, price liberalization can cause a rapid increase in the availability of products. However, price liberalization has to be supplemented by deregulation and demonopolization to develop competitive markets. While price regulation prevents prices reflecting scarcities on the respective markets and so delivering useful information to (asset) investors, monopolies set inefficiently high (or, with respect to international competitiveness, too high) prices. An antitrust authority. As mentioned above, the economies in the TCs are monopolized to a much greater extent than elsewhere. In order to break up the large conglomerates and to avoid future cartels, it is necessary to institute an antitrust authority. It would be, however, unrealistic, to expect an antitrust authority in the TCs to have sufficient knowledge and power in time to prevent the large state-owned conglomerates exercising monopoly power and increasing prices. Therefore, as emphasized above, these enterprises have to be exposed to foreign competition. A broad educational and training system. As already mentioned, there is a wide-ranging lack of trained managers, bankers and other professionals which

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hinders TCs becoming competitive on the world market and closing the International Journal of Social development gap in a short period of time. A social safety net. TCs will have to institute a social safety net, particularly Economics for those affected by the new phenomenon of open unemployment, in order to 23,10/11

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get or maintain the necessary political support for the painful transformation process. This, furthermore, allows social protection to be shifted off the shoulders of firms, thereby facilitating resource reallocation. The social safety net should be directed not only to unemployment benefits, but also to government-sponsored retraining programmes, and social security schemes.

The stabilization part Transition countries generally start with a monetary or liquidity overhang that – in politico-economic practice – implies inflationary tendencies and makes monetary disinflation policy a necessary supplement of structural adjustment policy. There are, in principal, three alternatives for TCs to reduce this monetary overhang: (1) by increasing the attractiveness of domestic currency deposits; (2) through a reduction in liquidity; (3) through a rise in prices associated with a price liberalization. The problem with (1) (means changing forced to voluntary savings) is that it may have adverse implications for the government budget, since the banking system in TCs is “owned” to a large extent by the government. Therefore, a rise in the rate of interest paid by banks – which is needed to increase the attractiveness of domestic currency deposits – is a drain on the budget. This again would have negative implications for the credibility of the stabilization programme. A reduction in liquidity (2) could be implemented either through direct confiscation (a monetary reform) or through open market sales of assets (in the context of privatization). The main problem with confiscation is political support which may be eroded by the unequal loss of (though false because it was mainly useless) real monetary wealth involved (the tax associated with a monetary reform is not distributed evenly across the population). A problem with conducting open market sales, on the other hand, may lie in the absence of conventional financial instruments and in the underdevelopment of capital markets. However, in TCs, the government owns a large portion of existing assets, so that in the context of a privatization programme the excess liquidity could be absorbed through open market sales of the housing sector and of state enterprises. (Here, expectations in the private sector about the (non-)sterilization of the sales revenues collected by the state also become relevant as for the credibility of the stabilization programme.) In practice, however, there are a lot of hindrances, mainly because of the difficulties in designing an effective

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privatization programme, partly also because of the lacking interest of the households. Nevertheless, economically, a reduction in liquidity appears to be the best of the three alternatives. (Here a possible best strategy would be to combine open market sales of assets with a currency reform of freezing financial balances above a certain level and permitting their later use to purchase assets which are being privatized. See Fischer and Gelb (1991).) Besides the problems just mentioned, however, implementation of this strategy takes quite a long time. Hence, TCs that want to proceed faster tend to opt for an alternative (a rise in price associated with price liberalization). Theoretically this only means a one-time price level rise. In practice, however, if only because of staggered wages and prices, it means inflation. The problem is that it may extend to hyperinflation if inflationary expectations rise and speculation starts. A main channel of inflationary dynamics here is the rise of money circulation associated with inflationary expectations. Moreover, the pressure on the fiscal stance of the government becomes greater as tax revenues decline because of the Olivera-Tanzi effect. Only by establishing institutional stabilization preconditions quickly (see above), can the danger of hyperinflation be stopped or prevented. The fear of hyperinflation leads some TCs to liberalize prices only step by step trying so to restrict inflationary dynamics. This approach has the advantage of giving the TCs time to introduce the other relevant reform packages necessary to stabilize the economy (before liberalizing it totally). (The disadvantage, on the other hand, is the long-enduring acceptance of price distortions and misinvestments involved.) Stabilizing the economy – as emphasized above – however, also presupposes additional institutional conditions which alone can ensure programme consistency and credibility. These are, as explained earlier, mainly a reduction in liquidity and a price rise associated with price liberalization, although – because of the interdependence of the institutional reforms mentioned – other components also matter. The reason for this is as follows. Inflation expectations are decisive for actual inflation, not only for tomorrow’s but already for today’s inflation. Inflation expectations are determined not only (less) by today’s policy or the pure announcement of tomorrow’s policy intended but also (more) by the perceived possibility of a policy course announced (or anticipated) to be associated with stability. (Here, one also has to consider that there is a lengthy delay between the time of the political decision to initiate institutional reforms and the time of its actual implementations. As recent experience in TCs has shown, the behaviour of the private sector during the pre-implementation period is governed by the expectations of the reform rather than by the policy measures themselves. Such anticipatory elements reflect themselves in prices, exchange rates, rates of interest and other important economic variables; and this can well be in a way that destabilizes the economy (see Calvo and Frenkel, 1991b).) This alone makes a policy course credible. This, however, presupposes the long-run consistency of the policy programme as well as its implementability. Insofar as the

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conditions of the consistency and of the implementability of stabilization programmes are the same in traditional developing countries and TCs, the experiences and theoretical analyses as to failures of stabilization programmes in developing countries matter for TCs (Wagner, 1992). Transition costs Sequencing and timing problem As mentioned before, there is no dispute about the necessity of the above reforms. There has, however, been an intense debate about the right timing and sequencing of the reforms. An appropriate way to view the transition process to a functioning market economy in Eastern Europe is as the sequential introduction of packages of complementary institutional reforms. The content of each of these packages depends critically on the initial conditions faced by the respective country, with the elements of strategy arising from the interplay between politics and economics. The following discusses only the timing problem. As to the sequencing problem, the former chief economist of the World Bank, L. Summers, for example, contends that: (t)here is broad agreement that macroeconomic stabilization, followed by price and trade reform, should occur at the very beginning of the reform process. Tax reform, the development of a social safety net, and measures to encourage the private sector should follow quickly thereafter. Restructuring, privatization, institutional, regulatory and legal reform can be addressed early in the reform process, but completion of reform in these areas will take more time. Financial liberalization, full convertability of the capital account and full wage liberalization should come in later in the reform sequence (Summers, 1992, p. 32).

(See, however, Fischer and Gelb (1991) and Wagner (1992; 1993b).) In general, there are two main strategies of implementing the above reforms that the East European countries can choose: the first one is a “big bang” strategy, the second one is a “gradualistic” way. These two strategies have different time structures of transformation costs and development gaps. A “big bang” strategy tries to implement reforms as fast as possible no matter how costly they are in the short run. An extreme case example is East Germany (Sinn and Sinn, 1991; Wagner, 1993a). By contrast, a “gradualistic” strategy tries to spread the transition costs over a longer period of time. In traditional developing countries, for example, either strategy has successfully been implemented (World Bank, 1991). A “big bang” strategy seems not to be very promising in East European countries because (if) it implies a drastic temporary decrease in living standard for most people and big redistributions in wealth that are regarded as unjust by the population. (This has been avoided or mollified in East Germany by huge transfer payments from West to East Germany. None of the East European countries can expect such big transfer payments.) Furthermore, a big bang approach is hindered by the unavoidable time it takes to change fundamental societal institutions, the implementation of which is a precondition for other necessary institutional changes. (Here, East Germany has had the big advantage that it could take over almost the whole institutional infrastructure of West

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Germany whereas East European countries must, or try to, establish their own institutional framework from scratch.) On the other side, a gradualistic strategy often is regarded as hesitant behaviour. This can lead to a loss in credibility of the reform policy or the reform will of the government. Consequently private initiatives, started by governmental measures, slow down. The implementation of reform measures therefore can fail.

Transformation process and the J-curve problem 79

The J-curve problem A “big bang” strategy as well as a “gradualistic” way of transformation produces transition costs. These costs may reflect a J-curve effect or even an underdevelopment trap. “J-curve-effect” describes the tendency of a transitory decrease in output and employment. Table I gives a short survey on the hitherto transition costs in some of the TCs. Industrial productiona Romania

Poland

Bulgaria

Czechoslovakiac

Hungary

Russia

1990 1991 1992 1993 1990 1991 1992 1993 1990 1991 1992 1993 1990 1991 1992 1993 1990 1991 1992 1993 1990 1991 1992 1993

–17.8 –19.6 –21.8 –10.0 –24.3 –11.9 4.2 7.0 –12.5 –21.7 –22.0 –8.0 –3.5 –21.2 –11.5 –3/–12 –9.8 –21.5 –9.8 0 –0.1 –8.0 –18.8 –18.0

Notes: a Percentage change over previous year b End-of-the-year data c For 1993 Czech Republic/Slovak Republic 1993: estimated data Source: OECD, IMF, UN

Unemployment rateb (%) 1.3 2.7 9.0 10.0 6.1 11.5 13.6 15.0 1.6 11.7 15.0 18.0 1.0 6.8 8.0 3.5/13 1.6 7.5 12.0 15.0 1.4 0.1 0.8 1.5

Inflation (%) 5.1 165.5 210.4 200.0 585.0 70.0 43.0 35.0 26.0 334.0 90.0 75.0 10.0 58.0 11.0 19/22 28.0 35.0 23.0 21.0 5.0 91.0 2,000.0 1,100.0

Table I. Economic indicators for the transformation costs

The main causes of present “J-curve-effects” in Eastern Europe can be seen in International Journal of Social the following: • A demand shock – arisen from the decay of the COMECON-market that Economics not only means reduction in demand but also “regional disintegration” 23,10/11

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with negative scale effects (see in the context of modern “theory of regional integration” , e.g. Krugman, 1991). • An institutional-political shock – emerged from the destruction of old institutions and the slow progress of establishing new market-economyconform institutions. This implies political destabilization which slows economic growth (which can be explained in the context of “new institutional economics”, e.g. Brunetti, 1992; North, 1984). • A monetary and fiscal policy shock – arisen from the (necessary) efforts to reduce the monetary overhang and to prevent inflationary pressure in the context of liberalization and deregulation. This induces recessionary effects on output and employment (which can be explained in the context of “modern macro-economics”; e.g. Blanchard and Fischer, 1989; Wagner, 1989). The main problem, however, is not the “J-curve-effect” itself but the danger of getting into an underemployment and underdevelopment trap (symbolized by a “L-curve”). This “trap” describes the tendency of getting stuck in a situation where production capacities are not fully employed and living standard gaps are not diminished or may even steadily widen. This danger can be explained in the context of theories of polarization (e.g. Wagner, 1993b), theories of legitimation crises (e.g. Wagner, 1991b) and theories of economic instability (e.g. Wagner, 1987; 1989). Besides these well-known explanations one can point at another important indirect effect. It originates from an anticipatory recession effect of transformation on the world economy, i.e. also on the Western economies. This effect is based on anticipated future expenditures in Western countries for rebuilding Eastern economies or for preventing economic decline and political disorder which would have negative spillovers on the West. This alone could theoretically explain (the deterioration of) J-curve effects. In practice, however, this is only one factor among many factors (see above). The next section concentrates on this specific explanation and shows how this could be modelled in a standard (mainstream) economics way. A simple model It shall be shown in this section that part of the J-curve problem can be modelled in a reasonable way by deriving under-/overshooting tendencies in interest rates within a traditional dynamic macro-economic model. Based on these under-/overshooting tendencies one can substantiate an anticipatory recession in the context of the transition process. It will point out the danger that this anticipatory recession may produce a retardation or even a reversal of the

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reform process. This, however, could turn the transitory economic crisis or recession into a permanent structural crisis or depression. Since space is limited, the model, its implications and its restrictions can only be discussed briefly. The logical structure of the kind of models referred to is as follows. For ease of graphical exposition, one starts with two endogenous variables, the financial market price and a goods market variable. The financial market price jumps discontinuously in anticipation of future events. The goods market variable is “sticky”; i.e. it adjusts gradually over time. Adjustment following unanticipated exogenous disturbances to policy variables (representing the “fundamentals”) follows a unique saddle path. This assumes that the speculative bubble paths eventually collapse to the relevant saddle path. Such models exhibit financial market overshooting in reaction to monetary disturbances and undershooting with respect to goods market disturbances. In the following only the simplest version of such models, which is an integrated world model is discussed. Actually, it is a version of an Aoki average model (Aoki, 1981) and a dynamic version of a world ISLM model discussed in Branson et al., 1986. The same model without equation (4) but with price dynamics is used in Wagner (1991a) (see also in more detail, Branson (1992)). Here the financial variables are bond prices and short-term and long-term interest rates, and the fundamentals are monetary and fiscal policy. The model illustrates the possibility that an anticipated fiscal expansion can cause a recession by driving up long-term rates. The following exposition is based on the simplest fixed-price ISLM model of a closed economy or here the “world economy”. This, however, is sufficient to describe the link from fundamentals to expectation dynamics in financial markets. Price dynamics will be added at the end of this section. The basic model can be stated in four equations: (1) yd = cy + a(iL – πe) + d Aggregate demand S m – p = ky + bi LM (2) . d y = f( y – y) Gradual output adjustment (3) L L S Êi = i – i Term structure of interest rates (4) d L ( y = aggregate demand; y = output; i = long-term nominal interest rate; iS = short-term nominal interest rate; d = budget deficit; πe = expected or “core” inflation; m = nominal money balances; p = price level; E = rational expectations operator; c, a, k, b and f are parameters; all variables except interest rates are in logarithms. Note: A hat (ˆ) over a variable denotes its proportional rate of change and a dot its time derivative.) Equation (1) gives aggregate demand as a function of output, the real longterm (actually consol) interest rate, and budget deficit (i.e. the exogenous component of fiscal policy). Expenditure is – in Keynesian fashion – assumed to be a function of current income. (It herewith is assumed that the Ricardian neutrality assumption (see Barro, 1974) is too strong.) The expected or “core”

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inflation rate πe is given exogenously in equation (1), and set at zero for the time being. It will be endogenized later. Equation (2) is the traditional LM curve equating real money supply and demand. Equation (3) gives the change in output over time as a gradual adjustment to the excess of demand over output. Equation (4) specifies the term structure of interest rates. It provides one link with the future and thus brings expectation dynamics into the model. The dynamics of the model are described in the ISLM diagram of Figure 1.

iL, is M J X A

X

S Figure 1. Expectation dynamics

L

Y

The stationary equilibrium is at point A, where yd = y and iL = iS. Away from equilibrium, y and iL move along the saddle path XX, whereas iS moves along the LM curve. The XX saddle path comes from the combination of equation (4) and the assumption of rational expectations in financial markets. (In this nonstochastic model, rational expectations is equal to perfect foresight.) The XX path has two essential properties: first, it leads to the equilibrium and, second, along this path the expected movement of long-term rates are realized. All other paths explode away from the equilibrium. They are so-called “bubble” paths. Assuming that the market seeks out the stable XX path is equivalent to supposing that speculative bubbles are unsustainable, i.e. eventually collapse. Later in this section, this assumption will be questioned. The effects of transformation in Eastern Europe can now be interpreted as an announcement of a future outward shift in the IS curve of the world economy. This is illustrated in Figure 2. With the economy at point A, a future autonomous demand expansion is announced. The financial markets will understand that the future equilibrium is at point D, with higher interest rates. That is, the long-term rate iL will jump immediately. It will jump to iL1 in Figure 2 with output at y0. This depresses investment and pushes the economy into recession along the unstable branch from point B to point C. Output and the short-term interest rate fall to y2 and iS2,

Transformation process and the J-curve problem

i iLi s

l 3L = i 3S I 2L

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l 0L

=

I1L i 0S l 2S

D J X

C

M X

83

B Future JS

A L S y2 y0

y3

Y

respectively, while the long-term interest rate rises to iL2. When the actual demand expansion occurs, the recovery begins. Output will increase from y2 to y3, with the short-term and long-term rates rising to converge to D. What is important here, is that the financial market’s anticipation of the future demand expansion raises the present long-term interest rate and thus pushes the economy into an anticipatory recession. Addition of price dynamics We can use a simple model of “core inflation” to add price dynamics to the above model. Assuming that inflation adjusts gradually to monetary disturbances and is moreover sensitive to output disturbances, reflects the idea that inflationary expectations are adaptive, rather than forward looking. People are assumed to believe that inflation is coming down only when they see it come down. This can be taken to represent a credibility effect, where a policy change is not immediately assumed to be permanent. But it can also represent an element of stickiness on the supply side, implied for instance by staggered wage contracts. For the solution algorithm for such a dynamic closed-economy model see Wagner (1991a). . π e = a(m – πe) Adjustment of core inflation (5) . e * π (= p) = θ ( y – y ) + π Phillips curve (6) Equation (5) describes the core inflation rate as adapting to deviations of money growth (m) from πe. According to equation (6), the actual inflation rate is a Phillips curve term for deviations of output from its natural level, y*, plus the core inflation rate. Possible structural problems when not ruling out bubbles The equilibrium path in the above model is a saddle path that has the two mentioned properties: it goes into the equilibrium, and along this path expectations are realized. The first property rules out speculative bubble paths that go off to

Figure 2. Anticipated fiscal expansion

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infinity. There are at least two problems with this common line of reasoning. The first is the existence of heterogenous agents in the financial markets, and the second is the potential existence of policy bounds on price movements. To the first point: if agents are heterogeneous, i.e. differ in their knowledge or beliefs about the system, and know that they differ, the question of who acts first arises. This makes the timing of the collapse uncertain, and eliminates the presumption that a bubble cannot even begin. (If all market participants were the same, then when one participant sees that the price is on a bubble path, all would act simultaneously so that the bubble collapses. If the agents’ knowledge is complete, a bubble could never start.) To the second point: another problem with the no-bubble assumption arises if the market believes that the government will intervene to prevent the financial market price from moving too far. The clearest example is a credible target zone for the interest rate. Then the market has no reason to prefer the saddle path over any bubble path that goes to the edge of the zone. (In the context of exchange rate volatility, see Choe (1987), and for the stochastic case see Buiter and Pesenti (1990). Thus we cannot rule out the existence of bubbles and the implied indeterminacy. Thus, the J-curve transition costs derived in the above model are sorts of minimum costs to which the possibility of bubbles and an accompanying aggravation of the anticipatory recession must be added. This means J-curve effects can well extend to structural crises that may endanger the whole transformation process. Possibilities and limitations of “external help” While the East European countries can decide whether to follow a big bang or a gradualistic strategy of transition, they have not much influence (except by complying conditionalities) on the decision of the Western countries whether and how to help them in their transition efforts. These decisions of the Western countries, however, are decisive for the welfare losses in the J-curve crisis and for the coming or non-coming of the underdevelopment trap feared (supposing the above reforms are tackled seriously and implemented by the reform countries, as is typically assumed in forecasts – if they are not tackled seriously and implemented, they will fail anyway). They mainly refer to the following: • the extent of debt relief and, more generally, of financial assistance; • the extent and kind of integration of the East European countries into the West European unification process. Here one should not start from the illusion that development aid from the West arises from altruistic motives. In general, one should assume that countries usually help other countries only if they can expect some benefit. In other words, it is adequate to assume selfishness as the motivation basis of international development aid policy (see Wagner, 1993b). This makes it difficult to believe that Western countries will use debt relief or financial assistance on a large scale unless they believe that development in the Eastern countries will

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only be successful with this kind of help. This again depends on the expectation that the main institutional reforms are implemented soon. This presupposes that the reform countries are regarded as politically stable, that their reform strategies are seen as consistent and promising and the governments’ announcements are socio-politically implementable and, hence, credible. The respecting situation today in Hungary, the Czech Republic and Poland seems more favourable than in other Eastern countries like Romania or the countries emerged from the former Soviet Union. Debt relief or financial assistance, however, is in general not the crucial point. The main problem in Eastern Europe is not a lack in capital but a lack in productivity or more productive institutional environment that would make capital use more productive and investment more profitable. Raising productivity first of all presupposes institutional reform in and by the reform countries themselves. But it can also be supported by Western countries through first technical assistance, and second provision of market access to support trade and price reforms in the East European countries. In particular open markets in the long run will contribute more to increasing economic growth and development in Eastern Europe than will vast capital flows. On the supply side they will raise productivity and thereby internationally competitive supply of goods and services, and on the demand side they will increase export incomes. The situation here is similar to that of traditional developing countries. According to calculations of the World Bank, the export incomes in the traditional developing countries could be raised by more than the whole sum of official foreign or development aid if the industrial countries opened their markets. A further step would be the willingness of the West European countries to integrate the Eastern reform countries into the envisaged West European unification process. This would have a disciplinary effect on the reform process and could enhance it (as we know from the southern members of the EC). A quick integration, however, would make economic sense only if the economic structures in Eastern Europe were already adapted widely to that of Western Europe. But this is not the case. Therefore integration should come slowly, i.e. step by step, and be accompanied by structural reforms in the East European countries. Otherwise, a too early integration of the Eastern countries, for instance into an envisaged monetary union, could jeopardize the whole project of a European economic and monetary union. To sum up, opening the trade barriers against the East European countries is the least demanding and nonetheless most important element of an aid strategy of the West. Moreover, it would mean that Western “capitalist” countries would become more convincing and credible vis-à-vis the East European “postcommunist” and the traditional developing countries by presenting an example in realizing the kind of market philosophy they use to preach to them. If this way of opening the markets is not going to be chosen, and recent experience of worldwide new protectionist waves does not make oneself feel optimistic, then the consequence would likely be mass migration from East Europe to the West,

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and a massive labour migration problem for the EU. Insofar Western Europe would be serving its own interests by providing open access to its markets (see Wagner, 1993c). Conclusions A comprehensive transformation programme includes institutional innovations as well as monetary disinflation policy. In particular the latter necessarily produces recessionary J-curve-like output and employment costs. In addition, effects of anticipatory recessions, based on anticipated future expenditures of Western countries for rebuilding eastern economies (or for preventing economic decline and political disorder), may arise. To reduce the induced J-curve transition costs and their possible deterioration in the transformation countries, Western help is necessary. As has been argued in this paper, the most effective help would be the opening of the trade barriers against the transformation countries. References Aoki, M. (1981), Dynamic Analysis of Open Economies, Academic Press, New York, NY. Barro, R.J. (1974), Are government bonds net wealth?, Journal of Political Economy, Vol. 82, pp. 1095-117. Blanchard, O.J. and Fischer, S. (1989), Lectures on Macroeconomics, Cambridge, MA. Branson, W.M. (1992), National Economic Policies and International Financial Stability, Mimeo, Princeton. Branson, W.M., Fraga, A. and Johnson, R.A. (1986), “Expected fiscal policy and the recession of 1982”, in Preston, M.H. and Quandt, R.E. (Eds), Prices, Competition and Equilibrium, Alan, Oxford, pp. 109-26.. Brunetti, A. (1992), Politisches System und Wirtschaftswachstum, Chur, Rüegger. Buiter, W.H. and Pesenti, P.A. (1990), Rational Speculative Bubbles in an Exchange Rate Target Zone, NBER Working Paper No. 3456, Cambridge, MA. Calvo, G.A. and Frenkel, J.A. (1991a), “From centrally planned to market economy, the road from CPE to PCPE”, IMF Staff Papers, Vol. 38, pp. 268-99. Calvo, G.A. and Frenkel, J.A. (1991b), Obstacles to Transforming Centrally Planned Economies: The Role of Capital Markets, NBER Working Paper No. 3776. Choe, Y. (1987), The Indeterminacy of Short-run Exchange Rates in a Managed Float Regime, Princeton University Woodrow Wilson School Discussion Papers in Economics No. 128, May. Fischer, S. (1991), Privatization in East European Transformation, NBER Working Paper No. 3703. Fischer, S. and Gelb, A. (1991), “The process of socialist economic transformation”, Journal of Economic Perspectives, Vol. 5 No. 4, pp. 91-105. Krugman, P.R. (1991), Geography and Trade, MIT Press, Cambridge, MA. Lipton, D. and Sachs, J. (1990), “Privatization in Eastern Europe: the case of Poland”, Brookings Papers on Economic Activity, Vol. 2, Washington, pp. 293-341. Litwack, J.M. (1991), “Legality and market reform in Soviet-type economies”, Journal of Economic Perspectives, Vol. 5 No. 4, pp. 77-89. North, D. (1984), “Government and the cost of exchange in history”, Journal of Economic History, Vol. 44, pp. 255-64.

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Sinn and Sinn (1991), Kaltstart – Volkswirtschaftiche Aspekte der Deutschen Vereingung ( Jumpstart), Mohr, Tübingen and MIT Press, Cambridge, MA. Summers, L. (1992), “The next decade in central and Eastern Europe”,in Clague, C.H. and Rausser, G.C. (Eds), The Emergence of Market Economies in Eastern Europe, Cambridge, MA, pp. 25-34. Wagner, H. (1987), The Costs of a Purely Monetary Disinflation Policy: The Case of Long-run Involuntary Unemployment, March, Working Paper No. 443, Department of Economics, MIT, Cambridge, MA. Wagner, H. (1989), Stabilitätspolitik (Stability Policy), Munich, Oldenburg. Wagner, H. (1991a), “Dynamic aspects of disinflation – on the determinants of the sacrifice ratio”, in Feichtinger, G. et al. (Eds), Operations Research 1990, XV. Symposium, Methods of Operations Research, Vol. 64, Meisenheim. Wagner, H. (1991b), “Einige Theorien des Systemwandels im Vergleich – und ihre Anwendbarkeit für die Erklärung des gegenwärtigen Reformprozesses in Osteuropa”, in Backhaus, J. (Ed.), Systemwandel und Reform in östlichen Wirtschaften, Marburg, S. pp. 17-40. Wagner, H. (1992), Why Do Stabilization Programs in Developing Countries Fail So Often? – Lessons for Eastern Europe, Research programme on Development Studies Seminar Discussion Paper 03/92, Princeton University, NJ. Wagner, H. (1993a), “Reconstruction of the financial system in East Germany, Journal of Banking and Finance, Vol. 17, pp. 1001-19. Wagner, H. (1993b), Wachstum und Entwicklung, Theorie der Entwicklungspolitik (Growth and Development, Theory of Development Policy), Munich. Wagner, H. (1993c), “Economic development in Eastern Europe and migration push”, in Heckmann, F. and Bosswick, W. (Eds), Migration Policies – A Comparative Perspective (forthcoming). World Bank (1991), World Development Report 1991, Oxford.

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