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Notes for the Speech at the Center for European and Russian Studies at UCLA

English Pages, 14. 11. 1997

1. It is a great pleasure and honor to be at this prestigious Center, which has been for decades connected with several leading experts in the field of the so called „sovietology“.  I will try to use this opportunity for making a few comments about our way of  looking at both the past and the present times. 

2.  In spite of our relative isolation from the world-wide economic discussion and the critical assessment of the centrally planned economy in the communist era, we tried - all the time and with many complications - to  follow the Western economic literature. In addition to the well-known contributions of Austrian School (Mises and Hayek), Chicago School (Friedman, Stigler, Becker), German Ordoliberalism (Eucken), Public Choice School (Buchanan, Tullock), people like me were influenced by Gregory Grossman and especially by his „Notes for a Theory of the Command Economy“, which I read already in the sixties.

It helped me and us to understand the socialist economy as an economy which is more administered than planned, as an economy of conflicts of interests rather than an economy of perfect or „so far“ imperfect planning. As a consequence of it  we began to view socialist economy as the economy where the dominant relationships were not vertical but horizontal ones (no matter how strange and distorted these relationships were, given the absence of well-defined property rights and given the existence of disequilibrium and administered prices).

3. We got additional important impulses from the Public Choice School which   demystified political decision-making processes and we understood - perhaps more than some of our Western colleagues - the real meaning of the term „government failure“. 

It prepared us for the enormous and unrepeatable transformation task, for the fight with the proponents of various dangerous and slippery third ways. We did not and do not trust the state and I have to confess that the new, additional degree of mistrust came from our practical experience - as ministers of finance or prime ministers we had to „play“ the role of the state. 

4. We knew we had to privatize, deregulate and liberalize as much and as fast as possible. Not doing it rapidly creates a danger we will establish a partialized and weak state and transform our free society into a corporativist (or syndicalist) one. We must not give the interest groups the opportunity to consolidate and strengthen their position in the economy and the entire society. Politics is neither a formulation of theoretical blueprints, nor their  implementation by an enlightened powerful elite. Instead, politics is a process of bargaining with the existing pressure groups. 

5. The book of my speeches which was published in 1991 was called „A Road to Market Economy“. Somebody suggested the other day in Washington D.C. that the title should be „ A Bumpy Road to Market Economy “, which is a good point.

This recent accident was undoubtedly the most important phenomenon of instability in our whole post-communist era. We have to admit that we did not succeed in finding an easy and straightforward way how to prevent it.

Was it possible to avoid it at all? It is too early to give a final answer but I have some reservations about it - given all political and economic domestic and international constraints - and will therefore try here, today to briefly discuss some relevant arguments in this respect as I see them.

A) The exchange rate regime and the exchange rate level

The collaps of communism „happened“ in the moment when the economic profession believed in fixed exchange rates and in the advantage of anchoring the economy by means of one fixed point - especially in a situation when all other variables undergo large changes and fluctuations. I have to confess that I was originally afraid of introducing such a rigid regime but the first impressions were positive because we succeeded in choosing an exchange rate which functioned well for very long 76 months. By sufficiently devaluating the crown on the eve of price liberalization we formed something what I later called the „transformation cushion“. The exchange rate cushion (as well as the parallel wage cushion) appeared to be crucial for the whole subsequent transformation process. The inflation differential was in our case not as big as in some other transforming countries but the appreciation in real terms reached in 76 months almost 80 %, which was too much. Although we have been constantly checking the remaining thickness of our exchange rate cushion, as we see it now, we - probably in the middle of 1996 - missed the most suitable moment for the abolition of the fixed exchange rate regime. The question is, however, whether the subsequent movements of the rate of exchange would have been less dramatic than they were in reality in recent months. The vulnerability of an emerging market economy is in this respect very high and, probably, unavoidable.

The tentative lesson No. 1: fixed exchange rate regime should not last too long.

B. Investment - savings imbalance

The economic recovery has been - since 1993 - relatively rapid (in European terms). It was pulled by strong investment demand (with only modestly growing private consumption and exports and with stagnating or declining government expeditures).

The rapid growth of investments seems to be unavoidable. The problem is in the structure of investments. The overwhelming feeling of obsolescence of infrastructure (of all kinds) after four decades of communism together with overambitious „green“ attempts to rapidly undo the well-documented environmental damage, caused by the absence of private property and a market economy led to an extremely high investment ratio (33% in 1996). Only a smaller part of investments was „productive“ in the narrow sense, and contributed to industrial restructuring and modernization. To reconcile strong investment demand with domestic savings was almost impossible because we did not succeed in creating the atmosphere of „belt-tightening“ as the only way how to overcome the heavy burden of the communist heritage. The problem is clear, the solution not.

The tentative lesson No. 2: it is necessary to restrain the „catching-up“ ambitions and the impatience of society as much as possible.

C. Wage - Productivity Nexus and the Degree of Competitiveness

Price liberalization, accompanyied with rather restrictive macroeconomic policy, generated another significant transformation phenomenon - the wage cushion, because wages went up much slower than prices. As a result of it, real wages could - for some time - grow faster than GDP or productivity without undermining competitiveness of the whole economy. It gave our enterprise sector a breathing time which only a part of it effectively used for radical restructuring. We were, however, not able to prolong the process of emptying the cushion. The government could not control the private sector and was not able (or strong enough) to block the growth of salaries and wages in the public sector. The relatively rapid growth of wages in the private sector was made possible by soft (or unsufficiently hard) granting of credits by the banking sector and by the slow process of bankrupcies on one hand and by strong demand for labor and very low unemployment on the other. Non of these factors could be directly controlled by the government. 

The tentative lesson No. 3: The rate of growth of wages is not a „free“ policy variable (as is sometimes implicitly suggested by external observers and advisors).

D. Quality of Markets, Economic Strength and High Degree of Foreign Trade Liberalization

With the benefit of hindsight it can be argued that the scope and rapidity with which former communist countries opened their economies and adopted currency convertibility was much larger and faster than in similar historical moments in the past. As we all know, it took much longer time to do it in Western Europe and Japan after the war. And, in addition to it, it was done in the situation of high degree of globalization of world markets and in the situation of enormous structural shifts in the financial system itself as well as in the moment of sophisticated protectionism in developed countries (in Europe especially). We do not know whether it was a blessing or a curse. The entry of strong firms from developed countries into our unprotected markets was much easier than the entry of our technologically, financially and organizationally much weaker firms into their „occupied“ and protected markets. When I dare to say that I do not mean it as an advocacy of the policy of sheltering the markets of young, unmature industries. I use it, however, as a part of my explanation of our trade deficit.

The tentative lesson No. 4: A small, open, industrial ex-communist economy pays - in the short run - more for trade and currency liberalization than a big, less opened and less industrial economy.

E. Fiscal and Monetary Policy Mix

Until very recently, we succeded in having either surplus or balanced budgets and a relatively cautious monetary policy (with unknown shifts in the velocity of money).

It seems natural to argue that the growing external imbalance required some degree of macroeconomic tightening. But the politicians had the feeling that to have budgets without deficits for seven consecutive years is the maximum they could offer. To criticize them (in this respect) seems to me inappropriate.

Some degree of money supply deceleration was necessary as well. It did happen in our case but to slow down the annual rate of money supply growth from 18-20% (in the first half of 1996) to 10-12% (in the second half of 1996) and to 6-7% (in the first half of 1997) by the not preannounced step of the Central Bank was something which - at least - asks for a discussion of the real meaning of the central bank independence. It had - as expected - faster impact upon aggregate supply than demand and contributed to the apparent economic slowdown (if not decline), to unexpected budgetary problems (on the income side), to heavy political conflicts and uncertainty and, finally, to the increased financial instability as well as to the recent currency weakness. 

The tentative lesson No. 5: To make sharp changes in monetary policy proves to be very dangerous.

F. Fragility of Financial Institutions

Financial institutions (banks and other financial intermediaries) in the post-communist countries have many „childhood“ problems and cannot be relied upon contributing sufficiently to the stability of the whole economy. Whether we wanted it or not, the banks and other financial institutions were an integral part of the transformation process and could not get the status of a „clean“ outsider as was sometimes suggested. They inherited difficult loan portfolios, with their transformation and privatization involvements they added to it not much less contraversial assets, they have complicated ownership structures, etc. The masterminding of their evolution is, however, impossible.

There is no doubt that the fragility of our financial markets was an additional complicating factor. Their lack of transparency and stability contributed to the slowdown of capital inflows and aggreviated thus the balance of payments problem. The only relevant question is what could have been done ex ante.

Capital markets are different from ordinary markets and they probably need more government intervention or regulation than ordinary markets. The problem is how to intervene, how to regulate them without constraining them unnecessarily and without expecting too much from the regulator who is a human being as the rest of us (with his well-defined utility function which he tries to maximize) and who operates in a world of intensive rent-seeking and in a world of the well-known fallacies of regulation. I am not very optimistic about regulation in general and about regulation of capital markets in particular.

Our capital market has grown much faster than anyone expected, especially when we gave it a strong accelerating impulse by our voucher privatization. In the early nineties I fully shared Joseph Stiglitz’s view that „to a large extent, equity markets are an interesting and amusing sideshow, but they are not at the heart of the action“ because we started our economic transformation with heavy reliance on the banking system. While trying to expand it rapidly we probably underestimated the need to impose sufficiently high capital requirements and, at the same time, we did not succeed in strictly dividing the financial and production sectors of the economy. We - more or less - accepted the German (or continental) type of banking with its strong inter-relationships between banks and firms in the production sector. We see many problems with it now but I am not sure we could have started differently.

With the spontaneous evolution of our financial markets, with literally millions of shareholders and hundreds of investment companies and funds, mostly as a by-product of voucher privatization, we failed in generating the sufficient degree of information about the financial position of individual firms. It is connected with the lack of intensity of transactions in our today’s markets which is unavoidable (the markets are shallow and, therefore, not efficient), and it may be - at the same time - the result of delayed legislative measures on the side of the government.

The question of lags in public policy is, however, not simple. Joseph Stiglitz mentioned in his study that „much of the return in capital market consists of rent-seeking and I have to admit that in the past some of us did not immediately believe all the critics of our capital markets because they usually played their own card and did not take into consideration the existing stage of the evolution of the whole economic system. Their criticism was very often indistinguishable from the complaints of those who just occured a loss by making a wrong investment.

The main problem is not the legislation itself. The problem is law enforcement, efficient control and rational regulation. There is a clear need to speed up the judicial procedures and to establish specialized financial courts dealing with bankruptcies and matters related to capital markets.

The tentative lesson No. 6: The capital markets begin to function faster than you expect and before you try to regulate them.

6. We are not in a „brave new world“ of perfect markets and of perfect governments. It remains our task to minimize the inevitable instability in an unmature and young but highly democratic, pluralistic and open society. 

Václav Klaus, University of California in Los Angeles, 14. November 1997