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MACRO NOTES

Partial reforms: Citizens pay costs, lobby groups win

An expansive fiscal policy has immense consequences for the economy. It can ruin a country's rating by giving rise to external instability. It can render monetary policy ineffective, break down the fixed exchange rate regime, and triple public debt and contingent liabilities in the course of a few years. On the other hand, an expansive fiscal policy can keep the economy running in high gear for some time and help win elections. Fiscal policy in general plays a central role in determining overall economic development. Together with monetary policy, it influences short-term economic growth, balance of payments, debt levels and inflation rates. The policy shapes the entrepreneurial environment and dictates income redistribution.
Much of the traditional economic theory concerning the politics of economic reform is based on the assumption of a J-curve. A J-curve simply describes the consumption pattern after reforms start - reforms drive aggregate consumption down in their early stages, before future consumption reaches a level higher than that initially. The traditional theory assumes the short-term losers of the reforms such as the unemployed, pensioners, and threatened state bureaucrats, will take revenge on the reforms at the first opportunity, leading to populist parties gaining power and halting the reforms.

An expansive fiscal policy has immense consequences for the economy. It can ruin a country's rating by giving rise to external instability. It can render monetary policy ineffective, break down the fixed exchange rate regime, and triple public debt and contingent liabilities in the course of a few years. On the other hand, an expansive fiscal policy can keep the economy running in high gear for some time and help win elections. Fiscal policy in general plays a central role in determining overall economic development. Together with monetary policy, it influences short-term economic growth, balance of payments, debt levels and inflation rates. The policy shapes the entrepreneurial environment and dictates income redistribution.

Much of the traditional economic theory concerning the politics of economic reform is based on the assumption of a J-curve. A J-curve simply describes the consumption pattern after reforms start - reforms drive aggregate consumption down in their early stages, before future consumption reaches a level higher than that initially. The traditional theory assumes the short-term losers of the reforms such as the unemployed, pensioners, and threatened state bureaucrats, will take revenge on the reforms at the first opportunity, leading to populist parties gaining power and halting the reforms.

According to the old theory, in order to implement radical reforms, the state should be "isolated" from the pressures created by these short-term losers until consumption reaches such high levels that it will create a majority of winners. This was the basis for the view that authoritarian governments (such as in Chile) had an advantage in implementing radical reforms. But the recent evidence from countries in central and eastern Europe counters this conventional wisdom.

The World Bank's Joel Hellman shows that early net winners might be at least as influential as losers. Evidence suggests that it is precisely the most democratic countries (i.e. countries most vulnerable to short-term losers through a free voting system) that implemented the most radical reforms. Even though the early reform governments were often voted out of office, succeeding governments have not in general rejected reforms and in some cases have even intensified them.

Hellman argues that the most common obstacles to the progress of reforms came not from reform losers, but rather from early reform winners such as enterprise insiders, local officials, and managers of state banks and companies. 'Crony capitalists' bought companies dirt cheap only to strip their assets, managers of state companies profited from full trade liberalisation that was implemented at the same time as domestic prices were subsidized, local officials were bribed into preventing others gaining entry to the market, and managers of state banks stripped deposits by giving credit to friends.

Early stages of reforms have created immense arbitrage opportunities [the opportunity to be involved in riskless trade] that provided these short-term winners with concentrated rents [enormous profits]. It was then in the very interest of these winners to block specific advances in the reform process since these would eliminate special advantages and market distortions upon which their own early reform gains were based, Hellman argues.

Therefore, the winners strove to prolong the maintenance of partial reforms. The usual interests of these winners included the prevention of FDI inflows into banks and industry, the imposition of trade barriers, the maintenance of poorly defined property rights, and inefficient law enforcement. Data suggest that the highest social costs in terms of output declines occurred in countries that implemented partial economic reforms as opposed to advanced reform countries or countries without any reforms at all. The same holds true for income inequality, which changed more dramatically in Russia than in central Europe.

Slovak elections analyses have suggested that the voters supporting the government of 1994-1998 [led by Vladimír Mečiar - Ed. Note] consisted largely of citizens with a basic level of education (these people have suffered most from unemployment) and pensioners. Both of these groups suffer in the early stages of reforms, and are early short-term losers. Traditional economic theory would suggest that the government should have favoured these groups. Surprisingly, Slovakia offers a very poor replacement rate (the ratio of average pensions to average wages), and unemployment benefits are low in general.

There were many factors behind the fiscal policy slippage in recent years. For one, the government still lacks knowhow in proper fiscal monitoring, though it does listen to IMF experts. However, in view of the previous discussion, it is informative to consider short-term winners as the possible driving force behind the slippage from 1996-1998.

Anecdotal evidence suggests that the possible winners could be among the new owners of privatised companies, building companies involved in highway, dam, and nuclear power constructions, managers of state companies and monopolies, retail bankers (because of the lack of competition in the retail banking sector and cases of possible deposit-stripping in several Slovak banks), and owners of inefficient domestic companies that are facing foreign competition (because of the implementation of import certificates and tariffs). The possibly high concentrated gains in the hands of these winners could have been one of the important reasons for the slippage during those years.

A version of this article will appear in the forthcoming book Economic Policy in Slovakia 1990-1999.


Jan Toth is Chief Economist at Dutch investment bank ING Barings in Bratislava.

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