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The Economic Development in a Transition Economy and Its Problems: The Czech Case

English Pages, 21. 11. 2000

A serious discussion of the transition would require dealing with many important and definitely non-trivial issues. I will mention only some of them:

1. Transition is a sequence of policy decisions, not a once-for-all policy change (therefore, the dispute about gradualism or shock-therapy which dominated the debate at the beginning was wrong).

2. Transition is based on human choices (influenced by ideas, prejudices, dreams and interests), not on scientific knowledge. (Famous Misesian and Hayekian arguments about the importance of human action or of human design are more than relevant at this point).

3. Transition brings democracy, but more democracy enhances the power of interest groups. Their vested interests block further reforms (the hypothesis of a J-curve or a reversed J-curve as alternative explanations of transition dynamics).

4. During the transition from communism to a free society the first task was to fully concentrate on solving the dichotomy “oppression vs. freedom”, while the no less important dichotomy “anarchy vs. order” (as these terms are used by Ch. K. Rowley, What Is Living and What Is Dead in Classical Liberalism, The Independent Review, Vol. 1, No. 1, Spring 1998) was – especially in the first period – not seen as crucial. That is to say, freedom was preferred to order. As a consequence, the institution formation, which was certainly not neglected, was not pushed to the forefront. The inherited low level of trust in the state and its institutions has not been left behind and remains to be low. Saying that I do not, however, accept the currently fashionable idea that the transition can be divided into the so-called first and second generation reforms, where the first generation reforms consists of liberalization and deregulation together with restrictive measures to achieve the macroeconomic stability, while the second generation reforms are devoted to “transparency in government and financial activities, good governance, sound legal, regulatory and supervisory frameworks, and fiscal policy sensitive to the social and economic needs and situation of its citizens” (as it was recently defined at the IMF and World Bank conference in Washington, D. C. in November 1999). The transition is indivisible and as one who was co-responsible for such a historic change I have to argue that we have always been aware of both aspects of transition.

5. Another critical factor affecting transformation costs is the interaction of formal vs. informal rules on the one hand and the gap between rules and their implementation on the other.

6. Transition is “a homework”. It must be done at home and everyone must be an active part of it. To guarantee the widespread domestic participation becomes crucial for its success. The reform cannot be imported, the local knowledge (together with domestic participation and experimentation) is of significant importance.

The challenge how to proceed was enormous even when the battle about ideology was won, when the market economy (as opposed to various third ways) was accepted as the necessary outcome. The problem was:

- to minimize the inevitable economic decline which was to follow the fundamentally changed economic environment (which was partly the consequence of the transformation strategy itself, partly the unintended result of the collapse of former division of labor in the communist “commonwealth” on the one hand and of the dramatically increased globalization and, therefore, competition on the world markets on the other);

- to eliminate the inherited excess demand (or forced savings) at the moment of price liberalization without initiating galloping inflation or even hyperinflation;

- to set the exchange rate at a level which would have made it possible to liberalize foreign trade without creating a very dangerous external imbalance which could easily lead to instability and crisis;

- to liberalize prices and foreign trade without creating difficult social conditions and without provoking deep micro-economic disruptions;

- to deregulate markets with a very imperfect market structure (without waiting for the evolution of perfect markets);

- to privatize the state ownership rapidly, efficiently, with sufficient domestic participation and in a socially tolerable way (in this respect I must disagree with J. Stiglitz’s recent, well-publicized propositions defending the Chinese way – gradualist liberalization and deregulation without privatization);

- to change institutions, rules and legislation rapidly and efficiently but in a democratic way.

The dominant task was to keep the transformation going and not to get stuck in the “underreform trap” of partial, disconnected measures, which aggravate the economic situation and discredit reforms and reform politicians. To avoid falling into such a trap was very difficult, if not impossible.

The transition countries succeeded in the above-mentioned tasks with mixed results. I have no ambition analyzing the other countries as such analyses are usually very superficial (and may be biased) and will instead concentrate more on the Czech experience.

The first stage of transition was characterized by visibly higher costs than benefits – at least in the eyes of the Czech public. The Czech Republic´s transformation shake-off led to a significant output loss: it amounted to one third of industrial output, to one fourth of agricultural output and to one fifth of GDP. The Czech figures are relatively high but they are lower compared to most of the transition countries. I am nevertheless convinced that there was no way to avoid such results. The demand for products previously sold at subsidized prices disappeared practically “overnight” and to rapidly find new buyers was impossible.

The fight against inflation was more successful. Due to a lesser inflationary imbalance we “enjoyed” during the communist era and due to a very cautious and restrictive macroeconomic policy after its end, but prior to the price liberalization, the highest annual rate of inflation was “only” 57% (in the year of price liberalization). It rapidly declined to a 10% annual rate in the following years to reach 2% in 1999. It was a visible success but – as usually – there was the other side of the coin. Low inflation did not wipe out inherited debts (both of the state and of the individual firms).

Balance of payments problems were more difficult. As a result of sufficiently restrictive monetary and fiscal policies and of sharp devaluation of the Czech crown prior to the foreign trade liberalization, the dangerous trade imbalance did not occur and thus it was not necessary to stop its development by introducing administrative measures. The problems however occurred several years later.

It is difficult to summarize privatization in only a few words. It needs a special lecture but at least two remarks are necessary here. One – relatively easy – task is to privatize individual firms “forgotten” in the state hands in a standard market economy, which has all necessary, markets-supporting institutions (and domestic capital). Such a process I call classical privatization and I haste to add that I have no comparative advantage to any lecturer from any Western university to discuss it here. On the contrary, this is something we had to – ten years ago – passively learn and we did not and do not have ambitions to add anything to the well-known privatization procedures.

Our task was, however, different. We had to privatize the entire economy, where everything (starting from the smallest hairdresser or grocery store) was in the hands of the state. There was no market economy, no capital markets, no domestic capital. I call this process of privatizating such an economy the transformation privatization and, symmetrically, I dare to say that the expertize of foreign consultants in this field was close to zero. (Their only interest was to help to transfer the property into the hands of their Western clients as quickly as possible). We were forced to introduce simple procedures (now easily criticized), to let the maximum number of citizens of the country be involved and to prefer the rapid transfer of property to higher privatization revenues. That was the basic reasoning behind our idea of voucher privatization (more in my “A Short or Long Way to Privatization”, in “An Austrian in France”, 1997, La Rosa Editrice, Torino).

The main feature of the second stage (1993 - 1996) was resumption of the economic growth which led to the equalization of short-term costs and benefits. In the Czech Republic

- it brought about a real wage increase of about one third;

- it did not undermine the position of the Czech crown which remained nominally stable;

- it was, however, characterized by an extremely high investment ratio, by widening investments-savings gap, by growing trade deficit, by massive inflow of foreign capital and, gradually, by deteriorating balance of payments position.

Relatively rapid economic growth, balanced budget, stable exchange rate, low inflation, very promising inflow of foreign capital, international acceptance (early membership in OECD) made us relatively comfortable and we did not pay sufficient attention to the first “warning” signals of growing pressures and tensions, which – in a small, open economy – manifest themselves not in domestic inflation but in balance of payments (current account) difficulties. We hoped that the transformation recovery could continue. Its vulnerability was further reinforced by change in the international atmosphere following the Mexican crisis. At that moment the third stage began.

The task of the government, and especially of the monetary authorities, was to slow down the growth of domestic aggregate demand and to ensure “soft landing”. We did not succeed. The central bank made a fundamental mistake and its “overkill” destabilized the entire economy. The coincidence with the East Asian crisis made the situation even worse.

It resulted in a standard process of a financial or currency crisis:

- tightening of monetary policy brought about problems within the banking sector which were followed by severe complications in the real sector of the economy;

- it led to growing uncertainty among foreign investors (and especially speculators);

- economic growth started declining (with a standard lag following the change of monetary policy);

- budget revenues began to fall and the government attempted to balance the budget by cutting expenditures in the middle of the fiscal year (which contributed to further decline of aggregate demand);

- the increasing instability led to the attack on the Czech crown (with the absence of an early, pre-attack abandonment of the exchange rate parity) and the currency crisis fully developed;

- the result of it was a 10% devaluation and an enormous loss of hard currency reserves;

- as in all similar cases, the consequent political instability further deteriorated the economic atmosphere;

- extreme vulnerability of the banking and financial sector together with the unnecessary monetary restriction led to several bank failures and to a growing credit disintermediation;

- economic growth became negative;

- surprisingly, and irrationally, we were witnessing continuation (and even reinforcement) of the monetary restriction in the form of high real interest rates and of stricter reserve requirements (and other similar regulatory measures) in the moment when the economy needed the opposite. The behavior of the central bank reflected then the prevailing IMF prescriptions which led to so many unnecessary problems in other transition economies or emerging markets.

Recently, we have entered the fourth stage. It can be characterized as a moment of reaching the turning point in regard to the economic growth. Its resumption is based upon the growth of consumption and exports whereas the resumption of investments has not yet arrived. Its occurrence rests on the change of the climate in the banking sector, and such a change depends on accepting –by the central bank, foreign investors and international financial institutions – the fact that our banking problems reflect current macro-situation rather than the micro-problems of the banking sector. There is no doubt that the transition country has (and will have) an external and financial vulnerability which can easily bring about repeated fluctuations and problems. But the structural weaknesses reflect the current stage of evolution of such countries more than mistakes and errors on the side of reformers as it is – with the prevailing “moralistic attitude” on the side of the international community – usually interpreted. But that is another story…

When we speak about the external dimension of the transition problem, there is on the one hand the issue of incompatibility (or difficult compatibility) between genuine vulnerability of transition economies, their high degree of openness (as a result of radical liberalization and deregulation), growing interdependence of the world economy (sometimes called globalization) and an enormous degree of capital mobility. On the other hand, post-communist countries in Central and Eastern Europe are facing another new phenomenon – a high degree of European integration or unification.

The first issue is relatively new. The processes of transition in the past – in Spain and Portugal in Europe or in Latin American countries – were always characterized by the compatibility problem of exchange rate regimes and domestic macrostabilization policies. There is a huge literature about it.

Growing capital mobility and globalization created a more recent problem of “incompatible trinity” (Stanley Fischer) of mobile capital, fixed exchange rates, and domestic monetary policy.

The post-communist world has added to it another dimension and we now have a tetragon instead of triangle. The earlier, well-known problems are to be solved in a country where – at the same time – markets are created by means of privatization, by legislation, by new forms of regulation, etc. The economic instability cannot be avoided (see my “Promoting Financial Stability in the Transition Economies of Central and Eastern Europe”, in Maintaining Financial Stability in a Global Economy, Federal Reserve Bank of Kansas City, 1997) but the question is: at what price.

I have always rejected the so called sequencing imperative in transition as an attempt to mastermind the transition in a constructivistic way – with one exception: macroeconomic control must be guaranteed prior to the price (and foreign trade) liberalization. There is a plenty of evidence in favor of it. Recent developments have confirmed another rule: sound banking and financial system is a precondition for liberalization of financial flows (capital account liberalization). It is not a surprising conclusion, especially in a world of a very high level of capital mobility and of huge international capital flows. Whereas the first sequencing rule was sufficiently recommended (as it has the easily statistically documented macroeconomic characteristics), the second one not. It does not mean that the international institutions did not stress the importance of sound banking (and similar issues) but

- it is not quantitatively measurable, it is not transferable into one indicator, it has been changing over time due to the business cycle fluctuations;

- the overall liberalization was supported by anyone (without qualifying it rationally) and to have any objections to it was considered an unforgettable sin.

The atmosphere in the economic profession and in international financial institutions is quite different now. Everyone criticises the old approaches as insufficient for providing a foundation for rational and efficient economic policymaking and for crisis prevention and resolution. And in addition to it there are many reservations (to put it mildly) to the IMF´s effectiveness.

The new European context represents another problem. The rapid pace of unification increases the vulnerability of weaker partners and the advantages for the stronger ones. It would be appropriate on condition there is wage and price flexibility (in both directions) and labor mobility. If such flexibility and mobility do not exist fiscal transfers must take place (as in any other currency area which is normally at the level of the state). The unwillingness of the EU to accept such a logical argumentation is another complication for transition countries of Central and Eastern Europe (see my The Current European Challenge, The View from Prague, Kieler Vorträge, No. 126, Institut für Weltwirtschaft, Kiel, 1999). These countries have opened themselves to the EU more than the EU to them. The EU politicians do not like to hear it and they may always argue that they do not force us to join the EU. But that would not be fair as everyone knows that in the current atmosphere it is not possible not to participate in the European integration process. It creates, however, another part of the costs of transition we have to pay.

To conclude, the first decade of the transition was a fascinating period for all who were part of it (both on its active or passive, winning or losing sides) and we can confidently say that the old system is a history which has no chance to come back.

Václav Klaus, Notes for a lecture in De Nederlandsche Bank, Amsterdam, November 21, 2000