July 08, 2003

Notes: Blanchard on Transition

Olivier Blanchard's view on the transition from communism to capitalism as of the mid-1990s. If I read his Economics of Post-Communist Transition right, the key problem was the absence of a Marshall Plan to keep demand high and employment high during transition. In the immediate aftermath of World War II in Western Europe, the Marshall Plan allowed countries to maintain high aggregate demand without worrying about balance-of-payments constraints. There was no similar inflow of hard currency in the early 1990s to allow transition governments to create the demand to rapidly reemploy those laid off from state industries. The Bush I Administration had, because of the Reagan deficits, "more will than wallet."

As a result, Blanchard argues, high unemployment led to a fear of reallocation and restructuring, and the slowing of the entire process of reform down to a glacial pace. If only demand and employment could have been kept high during the initial stages of transition...

And since the mid-1990s? Since Blanchard wrote his book, what has happened? If I read the data right, economic progress in Central Europe has been slow, in Eastern Europe has been very slow, and in the former Soviet Union (where there never was the social consensus that becoming a Western European market economy was desirable) has been appallingly slow.

Olivier Blanchard (1997), The Economics of Post-Communist Transition (Oxford: Oxford University Press: 0198293992).

p. 3: For most of the countries of Eastern Europe, electricity consumption numbers suggest a smaller decline in output than official GDP estimates. But for Central Europe, the numbers for electricity consumption growth are roughly similar to those for GDP growth. For example, in Poland from 1989 to 1994 measured GDP growth was equal to -8.7 percent, electricity consumption growth to -10.1 percent...

pp. 3-4: ...the decline was far from uniform.... The picture is one of a much larger decline for industrial production than for aggregate output, followed by a weaker recovery.... This worse performance of manufacturing points to an essential aspect of transition... reallocation. By the standards of market economies, centrally-planned economies had too large a manufacturing sector, too small a service sector. Thus part of the adjustment must take the form of a reallocation of activities from manufacturing to services...

pp. 11-12: The high unemployment rates... convey only imperfectly the nature of unemployment. What matters to the unemployed is not so much the unemployment rate but the probability that they can find a job if unemployed.... [A] high unemployment rate is consistent with two very different labor markets: a highly active labour market in which many workers go through unemployment on their way to other, better jobs or a sclerotic labour market in which unemployment is a stagnant pool, and where the unemployed have little hope.... [U]nemployment in Central Europe is so far of the second type.... [T]he exit rate to employment [in Poland]... 3 percent a month in 1995... compared to... in the United States... 24 percent...

p. 41: ...two reasons why transition was associated with an initial decline in output and employment in the state sector... [in addition to] the effects of price liberalization and the elimination of subsidies.... The first was the disappearance of the central planner, and the sheer problems of organizing production.... Markets could not do the job overnight. The second was the... appearance of new private opportunities, making state production even more prone to bargaining failures, and thus to collapse...

p. 41: Shleifer and Vishny [1993] have argued in the context of Russia that political decentralization has led to competition among rent-seekers--be they politicians, building inspectors, and so on--with large adverse effects on the growth of the new private sector... (Empirical evidence on the number and the size of bribes needed to run a business in Ukraine... given by Kaufmann and Kaliberda [1995].)

p. 62: A large unemployment pool and small flows in and out of unemployment have led to a high proportion of long-term unemployment. One of the lessons of high unemployment in Western Europe is that the long-term unemployed often become marginalized. Will central Europe be able to avoid the Western European outcome of lingering high unemployment?

p. 61: How did state firms react...? How did they decide how much to decrease employment and how much to adjust wages? Whose interests were represented?

pp. 61-2: How much restructuring has actually taken place? Why was there so much opposition to outsider privatization? Does insider privatization make a difference?

p. 73: Once the budget constraint was hardened, [state] firms had to trade off employment against wages.... Employment was reduced but not to the core, leaving firms with excess employment...

pp. 79-80: The fact that state firms were unlikely to restructure was the motivation behind the initial programmes for large-scale outsider privatization.... One.. direct sales... auctions to potential outside investors. The other was mass privatization.... The problem turned out to be the opposition of insiders in firms.... [W]orkers and managers were often able to ensure that their firm was neither sold to outsiders nor put on the mass-privatization list. At a national level, they were able to delay, often indefinitely, mass-privatization programmes...

pp. 84-5: ...insider-owned firms dong more restructuring than state firms but less than new private firms...

p. 94: In short, the unemployment pool has been stagnant. Unemployment benefits have not been particularly generous.... [I]t is not difficult to understand why workers have generally opposed measures which put their jobs at risk, such as privatization or restructuring...

pp. 110-111: This benchmark model gives a stark picture of transition... high unemployment [and then] the economy goes through a first phase where no restructuring takes place. Depressed labour market conditions, and the risk of a long stay in unemployment... lead workers in state firms to oppose restructuring. During that period, the action only comes from private employment creation, which decreases unemployment over time. As unemployment decreases, it eventually reaches the point where there is no longer opposition to restructuring in state firms. From then on, transition takes place both through private employment creation and restructuring of state firms.... The model points to the importance of two factors.... The... size of the initial shock, and the induced level of initial unemployment.... [T]he strength of private employment creation...

p. 117: ...from an efficiency point of view privatization rules that are more generous to insiders are highly desirable. They lead restructuring to start earlier, and lead to both higher private employment creation and a higher speed of restructuring thereafter.... The efficiency gain comes at a distributional cost...

D. Kauffman and A. Kaliberda (1995), "Integrating the Unofficial Economy into the Dynamics of Post-Socialist Economies: A Framework of Analysis and Evidence" (Washington: World Bank).

Andrei Shleifer and Robert Vishny (1993), "Corruption," Quarterly Journal of Economics 108:3 (August), pp. 599-618.

Posted by DeLong at July 8, 2003 03:28 PM | TrackBack


If the Reagan deficits caused the Bush I Administration to have more will than wallet, why did not the much higher WWII deficits cause the same problem for the Truman Administration?

Posted by: Will Allen on July 8, 2003 06:09 PM

Good and interesting question. But I do know that when I was wandering around Washington in 1990 or so talking about how we needed a Marshall Plan for Eastern Europe, the answer I got over and over again was that we couldn't afford it because of our large budget deficit.

Posted by: Brad DeLong on July 8, 2003 06:36 PM

What I suspect that meant was that it was more vital to use tax revenues to purchase votes with middle class entitlements.

Posted by: Will Allen on July 8, 2003 08:37 PM

The Marshall Plan point is a good one, but I fear that to undestand what is happening in Eastern Europe (and what may be about to happen) you really can't avoid getting into the demographics.

They are soooooo special.

One of my blog readers alerted me recently to the work of Swedish demographer Bo Malmberg. Especially to:

Four Phases in the Demographic Transition


The four phases are: childhood, young adult, middle age, old age.

Now clearly the western european societies at the end of WW2 were - more or less - in the young adult phase, while the East European ones of the ninetess were approaching old age. This difficulty has been compounded by outward migration of working age population in the ninetees (remember this migration is supposed to happen in the young adult phase), and a further collapse of domestic fertility.

I think path dependence and lock-in may be important here, and if you will have a cyclical model with shocks, please remember that not all shocks are positive. As they say: the road to hell is paved with the best of intentions.

Posted by: Edward Hugh on July 8, 2003 11:45 PM

Perhaps a large war induced deficit combined with a large returning employable population is less a concern than a large self induced deficit with no foreseeable prospects of greatly increased economic activity?

Posted by: Stan on July 9, 2003 05:59 AM

Fitch affirmed the AAA rating on US soveriegn debt today, but warned of reduced flexibility in responding to shocks as fiscal and current account deficits mount. That same problem prevented a Marshall Plan type response at the end of the Cold War. So here we are again, surrendering our ability to take opportunities when they come, to change the world to the good...and for what?

Speaking of the Marshall Plan, Charles Kindleberger passed way yesterday, may he rest in peace.

Posted by: K Harris on July 9, 2003 06:14 AM

"The problem was that there was no Marshall Plan"?!?!

Please, please, let this dreadful cliche of economic analysis be put to rest. Since it is true that there are very few economic problems in the world which would not be solved by a transfer payment equal to 3-4% of US GDP, there is always a sense in which "the problem was that there was no Marshall Plan". But to tell us that things would probably have gone better if the USA had stepped in and written a check for nearly a quarter of a trillion dollars is hardly a triumph of economic analysis, or indeed economic analysis at all.

The Marshall Plan was meant to pay for the reconstruction of capital assets which had been destroyed by having bombs dropped on them. It wasn't a payment made to smooth consumption during a period of self-imposed fiscal austerity. There is no useful analogy to "post-Communist transition".

Furthermore, the whole point about post-Communist transition was that according to the Harvard Institute rhetoric of the time, is wasn't *meant* to cause any "transition problem" creating a need for massive financing in the first place. If the problem was that the shock therapy policy mix created large unemployment upfront, then the problem was the policy, not the absence of some deus ex machina to magically sort it all out.

One of the first things I ever wrote on my own weblog dealt with this sort of question, pointing out that in the case of Russia there was actually a "reverse Marshall plan"; a massive outflow of hard currency as the oligarchs tried to stow their ill-earned gains offshore, making use of the helpfully deregulated capital markets to do so.

Posted by: dsquared on July 9, 2003 08:26 AM

Shock therapy "wasn't *meant* to cause any "transition problem" creating a need for massive financing in the first place".

Oddly I can't remember anybody claiming that massive dislocations (i.e., transition problems) were going to be totally avoided with shock therapy? Most of the claims about the advisability of shock therapy in the literature were simply that it was better to make the changes quickly to minimize those negatives. The piece above tends to reaffirm those claims to some degree in that one of the expected problems was that vested interests would try to prevent changes and thereby merely drag the process out.

Posted by: Stan on July 9, 2003 08:52 AM

Why couldn't the respective central banks of each of the post-Communist countries keep demand high and employment high during the transition period?

Isn't the central bank supposed to pump liquidity into the system when demand is too low and pump liquidity out when demand is too high? Why is it claimed that the USA needed to take on that role?

Any help would be appreciated.


Posted by: KRZ on July 9, 2003 09:35 AM

Stan, you're misremembering. I clearly remember numerous speeches by Sachs, Summers and others in which they basically pushed the claim that the only solution to rising unemployment and falling output was to speed up the pace of reform. Have a look at any Wall Street Journal article about Germany or Japan and you will still see people pushing structural reform as a cyclical remedy.

KRZ: lack of hard currency. Central banks can pump domestic money into an economy, but that doesn't help to finance a trade deficit, because foreigners want paying in foreign currency.

Posted by: dsquared on July 9, 2003 09:46 AM

Thank you dsquared.

Why were most Eastern European economies running dangerously high trade defecits at the time?

Did the Eastern European economies start importing goods from the West on a grand scale after their transition? Or was it that after the transition the Eastern European economies were finding it more difficult to pay for the Western goods they had imported in the past?

hmmm... I guess it could be both.


Posted by: KRZ on July 9, 2003 10:02 AM

KRZ, my memory of eastern European economic statistics from the 80's is imperfect at best, so I can't offer a citation in support of the answer I'm going to offer, but it is the story I recall getting as in an undergrad poli-sci class a year after the wall came down. If I'm remembering right, the answer is both.

The massive trade deficits of the post-communist states started well before they were post-communist. Through the 70's and 80's, European banks lent a great deal of hard currency to Warsaw pact countries, primarily to finance what was at the time a rapidly growing trade between eastern and western Europe, but also because western European governments encouraged their bankers to make the loans for political reasons.

There was a fairly strong awareness in the east of the need for more modern western made goods if they were to have any productivity growth. Only trade could finance that. But, since the demand for western goods in the east exceeded the demand for eastern goods in the west, and trade was always complicated by various embargos and anti-Soviet treaties, the eastern countries began running deficits and western governments decided that it wasn't too high a price to pay for peace in Europe.

Romania was the only exception - Ceaucescu ordered the state to produce goods for export in the mid-80's in order to pay off Romania's hard currency debts at a huge social cost. As a result, in '89 Romania was debt-free.

The collapse of the old order then almost immediately created even larger trade deficits, because goods and services that had been obtained through barter and political machinations among the Warsaw Pact states now had to be purchased with hard cash. Lines of production that had worked across borders withing the Warsaw Pact were broken by the collapse of states able to guarantee delivery and the disappearance of the soft currency transactions that could finance them. Only imported goods from the west could replace them, and imported goods could only be paid for in with western currencies. A trade deficit is what you get when you buy stuff and can't export to pay for it.

Posted by: Scott Martens on July 9, 2003 10:36 AM

Thanks Scott

Would it be fair to characterize the argument in this manner?

1) Eastern European countries were running high trade deficits with the West

2) After the Communist transition, Eastern European economies suffered large drops in demand and high unemployment due to sudden structural change.

3) The central banks of Eastern European economies did not increase the money supply to stimulate demand because this would have increased the interest paid on their foreign debts causing a BOP crises.

Isn't this the kind of currency-crises scenario that the IMF was created to deal with?

Does anyone have any idea how large most East European trade deficits were relative to their GDP during the early 90's?


Posted by: KRZ on July 9, 2003 11:01 AM

Scott, outside of energy almost all of the various command economy exports were subsidized greatly. When the subsidies began drying up, the exports slowed.

DD, what you relate doesn't contradict the reasoning I gave nor does it necessarily support your earlier characterization. Reasonably accurate guestimates hold that most of these economies were ALREADY contracting at fairly rapid rates BEFORE the political changes occurred. Unemployment and underemployment were both going up. I'm pretty sure that Sachs, et.al. were merely saying that speeding up the changeover would lead to a faster turnaround. In other words "shock therapy" was the least bad option.

Posted by: Stan on July 9, 2003 11:28 AM

"the key problem was the absence of a Marshall Plan to keep demand high and employment high during transition" - "There was no similar inflow of hard currency in the early 1990s to allow transition governments to create the demand to rapidly reemploy those laid off from state industries."

How's about Eastern Germany? Apparently, a Marshall Plan alone would not have done it ...

Posted by: Konrad on July 9, 2003 03:19 PM

I don't recall there being a "sudden drop in demand and high unemployment" in the early nineties in Poland, Czech/Slovak and Hungary.
If anything there was a release of a lot of pent up demand.

There was a good bit of inflationary overhang, but due to shock therapy at least in Poland it was fairly quickly brought under control.

The price level did a big one time jump in Poland, mostly due to currency reform. The high unemployment (currently around 20% in Poland according to official statistics) came later on in the decade circa 97', once the structural reforms slowed or ground to a halt and German style labor laws/welfare state policies were put in place. The absence of a Marshall Plan could've been a factor in why the reforms petered out, though the casual channel through which this would've operated is not at all obvious to me. A series of weak/opportunistic post transition governments seems to have played a much larger role.


Posted by: rdk on July 9, 2003 05:43 PM
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