Political economy of reform

1
Political economy of reform

• Economics of Transition

2
The importance of political constraints

• Political constraints appear to have played a
  major role in the actual transition process in
  all transition countries, especially in blocking
  parts of the restructuring process.
• Some examples
• Plans to cut subsidies to SOEs were canceled
• Fiscal subsidy cuts to firms transformed in in
  hidden subsidies (bank credit and interenterprise
  arrears)
• Heavy worker resistance to closing inefficient
  state enterprises.

3
Introduction to Political economy of reform (PER)

• Political economy of transition belongs to a more
  general field that tries to integrate political
  science economics.
• Also there is a general literature on political
  economy of reform summarized by Dani Rodrik JEL
  94) with the main conclusion not necessarily so
  that authoritarianism allows for more sustained
  economic reforms, it is rather the existence of a
  deep crisis that forces government to really
  reform).

4
Introduction to Political economy of reform
(PER), cont.

• Political economy arguments are at the center of
  discussion about speed and sequence of reform
  (big bang vs. gradualism)
• big bang ? window of opportunity
• gradualism ? build on reforms
• There is a trade off between a big bang strategy
  where reforms are proposed simultaneously and
  gradualism where they are realized in sequence
  and the expected outcomes as well as the
  realization of reforms will also depend on the
  sequencing of reforms.
• In what follows we always assume the existence of
  complementarities between reforms.
• Which type of approach can be seen as desirable
  depends also on the type of uncertainty that
  characterizes the process (individual uncertainty
  vs. aggregate uncertainty).

5
Theory of political economy of transition reform

• Normative PER ? decision making problems of
  reformers subject to political constraints.
• Based on Agenda-setting hypothesis ? government
  has monopoly over design and sequencing of reform
  packages (parliament votes on a take-it or
  leave-it base or population in a referendum),
  normative PER then develops general principles of
  reform package.
• Positive branch of PER ? analysis of clash of
  interest groups.

6
Ex-ante and ex-post political constraints

• Two types
• Ex-ante political constraints ? feasibility
  constraints. Block decision-making and prevent
  acceptance of reforms.
• Ex-post political constraints ? backlash and
  policy reversal
• These two types of constraints must be dealt with
  differently.
• Ex-ante constraints ? compromises, credible
  compensation for losers, decisions delayed.
• Ex-post constraints ? attempts to create
  irreversibility

7
Political constraints without uncertainty

• (reforms with sure efficiency gains)

8
How to relax political (ex-ante) constraints?

• a) compensating transfer to losers
• partial reform
• packaging reforms to get majority support
• creation of institutions making compensating
  transfers credible in a sustained way
• waiting for deterioration of the status quo (cf.
  Dani Rodrik JEL paper)

9
Compensating transfers to losers

• Compensating transfer is an obvious way to buy
  off losers of reform. In the real world this is
  not easily done. Difficulties
• i) Redistributive transfer can have high
  distortionary costs, especially in transition
  countries, where fiscal administration is young,
  large budget deficits are common and enforcing
  tax collection is inefficient.
• ?social safety net is an example, where we have
  large distortions because of a lack of proper
  targeting?
• ii) Arguments of information assymmetry between
  policy maker and economic agents who are
  potential losers.

10
Compensating transfers to losers cont.

• Example lay off of all workers of a SOE. ? How
  should we compensate workers? Without asymmetric
  information compensation structure should be
  according to exit costs ? when there is
  asymmetric information all workers have to be
  paid the highest compensation (those who find
  easily a job elsewhere will not reveal that gt
  have to be paid highest compensation).

11
Compensating transfers to losers cont.

• Likely solution Partial layoffs where workers
  with highest exit costs keep their job. From an
  efficiency point of view, this would be the least
  desirable outcome as those with lowest outside
  options remain in the firm. There are, however,
  powerful arguments against this whole set-up, see
  e.g. Gerard Pfanns work on downsizing, where
  firm keeps the best workers in partial layoff.

12
Compensating transfers to losers cont.

• ???) Weak commitment power of decision makers
  with regard to future compensating transfer.
• ?Difference between CE and CIS former
  established rapidly an UB system and other
  elements of social safety net, unlikely that this
  would be dismantled with a later government,
  while latter did develop this system only
  partially?

13
Partial reform

• Obvious disadvantages
• Lower efficiency gains than in a complete
  reform ?extreme case partial layoff of
  essentially best people?
• Losses of complementarities of bundled reforms
• In an extreme scenario, partial reform
  generates little learning and might become pure
  noise ? outcomes worse than status quo
  absolutely and zero learning about results of
  complete reform (for some time in 90s maybe
  Ukraine comes closest to that!)

14
Partial reform cont.

• Advantages
• i) Asymmetric information and heterogeneity of
  exit costs and high efficiency costs of raising
  funds to compensate losses.
• If I only need to compensate low exit cost
  worker then in connection with high costs of
  raising funds, partial reform might be more
  efficient than full reform.
• ii) Building constituencies for further reforms.
• Strategy make status quo less attractive
• Divide rule by example 2/3 of workers have
  to be laid off in a sector, a majority of workers
  need to agree to this. By having small layoffs,
  where laid-off are not fully compensated, one
  might get a majority of workers to agree if it is
  clear that compensation packages will be worse
  down the line (then even those immediately laid
  off might agree).

15
Packaging reforms to gain majority support

• In some cases (in case without uncertainty), a
  big bang reform packaging several reforms
  together may obtain support by the majority while
  individual reforms would be blocked, even if it
  was optimal to implement reforms sequentially.
• This will be the case, for example, when a reform
  damaging a majority is proposed as part of a
  package benefiting a majority.
• Ex. Fiscal and trade reform (Martinelli and
  Tommasi, 1997). 3 groups one always gains, one
  always loses, one gains only from one (trade).
• Optimal solution first fiscal reform ? trade
  reform together excessive unemployment rather
  than smooth adjustment. BUT taken separately,
  no majority.
• Putting the two reforms together, if the total
  outcome for 3 is still positive, also group 3
  supports the package, so there is a majority and
  the package is approved.

16
Creation of institutions making compensating
transfers credible in a sustained way

• Policy maker can create institutions with a
  commitment to transfers
• Extending voting, i.e. enfranchising the poor, is
  such an institution, median income lt mean wage,
  one-man-one-vote-system might guarantee that
  redistribution is here to stay.
• See also the introduction of massive income
  support system in CE for non-employment

17
Waiting for deterioration in the status quo

• Dani Rodriks paper in JEL gives some examples of
  that when the status quo is deteriorated, then it
  is relatively easy to push through a sustained
  reform effort. So waiting for the deterioration
  of the status quo might be a strategy (hard to
  believe though that such a deterioration will not
  strongly affect future reform path)
• On the other hand, one reason Balcerowicz et al.
  could push through a big bang program was that
  the status quo was greatly deteriorated.

18
Political constraints with uncertainty
19
Ex-ante and ex-post political constraints, cont.

• Ex-ante and ex-post constraints will be the same
  if no uncertainty and no reversal costs.
• However,Fernandez and Rodrik (1991) show that,
  ex-ante and ex-post constraints may differ
  substantially in the presence of uncertainty.
• Aggregate uncertainty uncertainty about
  economy-wide effect of reform
• Individual uncertainty uncertainty who will be
  winners and losers
• Aggregate uncertainty reversal costs ? harder
  to implement reform.
• For reforms to take place they have to satisfy
  both the ex-ante (majority must be benefiting
  from it) and the ex-post political constraints
  (not risking to be reversed).
• For this reason they speak of status quo bias
  against reforms.
• It is interesting to note that in this model
  majorities shift over time. This aspect is very
  important in determining the optimal sequencing
  of reforms.

20
Individual uncertainty

• When uncertainty is purely individual or
  idiosyncratic, it is known in advance whether
  there will be reform reversal or not if reforms
  are adopted, given the (known) ex-ante
  probability of gaining or losing from reform.
• If there is reversal, no reform will be adopted
  provided reversal costs are big enough.
• In this framework, big bang is never dominated by
  gradualism and in some cases strictly dominates
  gradualism (thanks to bundling)
• No interim reversal under gradualism and no
  reversal after two reforms (payoff identical to
  big bang if there is no discounting effect
  otherwise big bang dominates because of
  complementarities)
• Interim reversal under gradualism and reversal
  after two reforms (no reform tried)
• Interim reversal under gradualism but no reversal
  after two reforms interim status quo bias
  (gradualism dominated by big bang if it has a
  positive outcome).

21
Aggregate uncertainty

• With aggregate uncertainty, it is not clear
  anymore what will be the final outcome of reform.
  In this case we have several possible outcomes
  both for big bang and gradualism.
• This is a reflection of the ignorance about the
  transition process as well as the ignorance of
  agents involved. It is also a reflection of the
  possible existence of multiple equilibria.
• If we assume the existence of complementarities,
  the net present value of the partial reform is
  always considered to be lower to the present
  value of the full reform, as we miss the
  benefits of complementarities (interim
  suffering).
• However, it is also true that observing the
  outcome of the partial reform may give
  information about the potential outcome of a full
  reform and allow us to reverse the reform before
  having implemented the full reform (at a lower
  cost).

22
Aggregate uncertainty, cont.

• Big bang can still be optimal when
• There is very high interim suffering
• There is no learning from partial reform
• The expected outcome of the big bang package is
  positive and large.
• Gradualism is more likely to be optimal when
• First reform is informative (probability of early
  reversal lt1 and gt0)
• Learning has to be fast enough
• Early reversal is less costly than full reversal.

23
Aggregate uncertainty, cont.

• Gradualism in this context has the option of
  learning and early reversal at lower cost that is
  absent in big bang.
• This can prove a significant advantage,
  especially when costs associated to reversal in
  big bang are high in the case of a bad aggregate
  outcome.
• It is interesting to note that the option value
  of early reversal raises a wedge between the
  ex-ante expected payoff of a gradualist program
  and that of a big bang strategy.
• In this case gradualism might be ex-ante
  attractive even if big bang is not.
• ? a gradualist strategy can be a useful way to
  overcome the status quo bias of reform!
• On the other side, the fact that big bang has
  larger reversal costs makes reversal less likely
  and this might be considered a positive
  characteristics.

24
Aggregate uncertainty, cont.

• This model can have interesting implications in
  terms of timing of transition programs. If the
  default payoff declines with time, and the
  expected payoff of gradualism is larger than that
  of Big Bang
• A gradualist program will start earlier
• Big bang program will be observed on countries
  where crisis perceptions are greater (after
  missed opportunities of gradualism Hungary and
  China vs. Poland and Russia).

25
Aggregate uncertainty, cont.

• This model can have interesting implications in
  terms of timing of transition programs. If the
  default payoff declines with time, and the
  expected payoff of gradualism is larger than that
  of Big Bang
• A gradualist program will start earlier
• Big bang program will be observed on countries
  where crisis perceptions are greater (after
  missed opportunities of gradualism Hungary and
  China vs. Poland and Russia).
• Going back to political constraints, we can
  identify an ex-ante/ex-post trade off between big
  bang and gradualism
• ? looking at ex-post political constraints big
  bang is preferable (reduces the probability of
  reversals window of opportunity)
• looking at ex-ante political constraints,
  instead, gradualism has the advantage of reducing
  resistance to the adoption of reforms (as it is
  more easily reversible).

26
Aggregate uncertainty, cont.

• The previous results were obtained in a
  representative agent framework (all individuals
  had identical perceptions about the probability
  distributions associated with various aggregate
  outcomes).
• It is possible, however to imagine an alternative
  framework, where agents have different subjective
  beliefs about the likelihood of given aggregate
  outcomes (reformers vs. conservatives).
• In such a framework, gradualism might be the best
  solution to allow reformers to start the reform
  process even in presence of a majority of
  conservatives with a preference for the status
  quo.
• More generally, the flexible approach to reforms
  provided by gradualism may explain why
  politicians often take a gradual approach to
  large-scale reforms even in presence of
  complementarity of reforms.

27
Complementarity and momentum of reforms

• Complementarities can allow gradualism to build a
  momentum for reforms that might not be built in
  case reforms were separable.
• It may be good to start with a reform having a
  high likelihood of bringing benefits to a
  majority, in order to build support for more
  difficult reforms
• Example of momentum under gradualism
• decollectivization in agriculture (China 1978).
  From 1 in 1979 to 90 in 1984. Increased
  agricultural output
• support of rural constituencies for second phase
  dual-track price system (market prices on excess
  production - to achieve support for reforms in
  cities)
• New constituencies for further reform
  restructuring of SOEs with layoffs and
  privatization.
• ? We go back to the issue which sequence is best?

28
Optimal sequencing

• What is the optimal sequence of reforms when
  gradualism dominates a big-bang strategy?
• Three aspects are particularly important in
  defining a correct sequencing of reforms
• Unbundling of reform package in given sequences
  should not lead to the loss of informativeness
• Sequencing should make the reform process ex-ante
  acceptable
• Sequencing should aim at building constituencies
  and momentum for further reform and satisfy
  ex-post political constraints.
• Note Objectives 2 and 3 may or may not be
  conflicting with each other in determining an
  optimal sequencing of reforms.

29
Optimal sequencing, cont.

• Different expected outcome if we have two
  reforms with positive expected outcomes it is
  better to start with the one showing the highest
  expected outcome (lower probability of
  first-period reversal and increased probability
  of both being achieved)
• Differences in riskiness introducing the risky
  reform first increases the option value of
  reversibility (increased volatility), increasing
  the expected outcome.
• Differences in constituencies the sequencing of
  reforms may affect reform reversibility after
  implementation of a first reform, depending on
  the expected costs and benefits of reform
  continuation for the pivotal voter, by affecting
  the identity of the pivotal voter at the
  interim stage (the implementation of the first
  reform may cause the pivotal voter to change).

30
Optimal sequencing, cont.

• Exogenous vs. endogenous reelection or future
  support and related literature the case for big
  bang or gradualism or a particular reform
  sequencing may be influenced by the nature of
  the probability of reelection.
• If the loss of power of the incumbent government
  is caused by exogenous forces, the advantage of a
  big bang approach is that the government can
  constrain a potential successor government by
  choosing today policies more difficult to
  reverse.
• On the other side, if policymakers face an
  endogenous probability of reelection, they should
  work to build constituencies by starting with
  more popular reforms. In this case, political
  backlash may be just the consequence of wrong
  sequencing.

31
Optimal sequencing, cont.

• Observed patterns in transition economies
  (creation of support)
• Development of small private sector
• Best firms privatized first (profit channel vs.
  job creation channel)
• Setting up new institutions (political reform and
  other institutional changes)
• Phase of restructuring and closing money-losing
  enterprises is generally delayed.

32
Speed of reform and endogenous investment

• The design of the reform package can affect the
  final outcomes that can be attained.
• For example, the speed of reform (big bang vs.
  gradualism) can affect the response of foreign
  investment to the reform process itself.
• In his book, Roland derives two main results
• When the level of investment DOES NOT affect the
  reversal probability, the investment response
  under gradualism is ALWAYS higher before
  uncertainty resolution, because of the lower
  option value of waiting (you lose less)
• When the level of investment DOES affect the
  probability of reversal, then both gradualism and
  big bang may generate higher investment response
  before TOTAL uncertainty resolution. (Gradualism
  better when probability of good states is lower).
  Before ANY uncertainty resolution, however, in
  this case more irreversibility is created and
  investment is higher under big bang.

33
Back to Normative PER
34
Normative PER cont.

• Increasing ex-post constraints, lowering the
  possibility of reversal
• Normally low ex-ante constraints go hand in hand
  with high ex-post constraints. Has we have seen,
  however, good sequencing and well-designed
  compensation schemes will make reversal more
  unlikely.
• Sometimes the strategy was used to take advantage
  of a window of opportunity and make a reform
  irreversible.

35
Normative PER cont.

• Ex. Mass privatization in Russia, insider
  privatization but here irreversibility (very hard
  to give it back to the state) is very strong
  existing state structures had been deliberately
  weakened gt impossible to organize a reversal.
• The downside of this irreversibility in the
  Russian case asset stripping, weak performance,
  ? inequality and corruption, ? capture of the
  state by oligarchs gt ? welfare. gt Greater
  reversibility with a better privatization policy
  might have meant a smaller fall in welfare.

36
And, finally, positive PER
37
Positive PER

• Explains differences in rent seeking and how
  special interests may capture regulatory bodies.
  In general we look at institutions affecting
  costs and benefits of rent seeking.
• Some questions
• Is it easier (or preferable) to pass reforms when
  the executive branch of government has relative
  autonomy, or is it better to have it closely
  checked by the legislature?
• Is a presidential regime preferable to a
  parliamentary regime in terms of deciding
  reforms?
• Is it better to have coalition governments or
  majoritarian governments to pass reforms?
• Is a large number of veto players a good or a bad
  thing (blocking good/bad reforms)?
• Normally these things are exogenous, but in
  transition they are more or less endogenous.

38
Positive PER, cont.

• Hellman (1998) democratic transition countries
  more fragmented party systems, coalition
  governments, uninsulated executives ? most
  progress with reforms.
• Hypothesis better accountability /closeness of
  politicians to voters / less capture by vested
  interest groups.
• Drawback mechanisms of checks and balances
  creating accountability can also create
  attrition/ paralysis of decision.
• Reformers are usually seen as special
  politicians having in mind the success of
  efficiency-enhancing reforms. In this case,
  insulating them from the pressure of interest
  groups might be a good thing.
• Drawback possible insulation also from voters
  and opportunity for well organized interest
  groups or for the opportunistically oriented
  politician (to commit abuse).

39
Positive PER, cont.

• Example
• One interesting paper makes point that e.g. in
  Russia (and this can be extended to Ukraine)
  oligarchs are interested in weak property rights
  gt they then can easily convert social and state
  assets into private ones for their own use.
• ? Oligarchs try to capture state regulatory
  bodies to prevent the establishment of strong
  property rights (unexpected result- maybe a
  priori one would have thought that the rich are
  interested in secure property rights).
• Differences in the strategy of rent seeking
  between e.g. Poland and Russia is not fully
  explained yet
• ? Poland has a collective memory of capitalist
  society but also within socialism powerful social
  networks catholic church, solidarity trade
  union, nothing of the kind in Russia and FSU. gt
  one might speculate whether this lack of social
  networks made it easier for insiders and
  nomenklatura to capture the state.

40
Positive PER, cont.

• ? Understanding properties of various political
  institutions in generating efficiency-enhancing
  reforms is an important orientation of future
  research.

41
Conclusions
42
PER and performance

• ? Wide differences in economic performance can be
  explained as consequences of different reforms
  implemented under different political
  constraints.
• Other possible aspects
• Geopolitics and economic performance.
• 1.
• CE shift to Western Europe (shedding satellite
  image) and linking in with EU gt after initial
  output fall, fall into lawlessness, corruption,
  and extreme state capture could be prevented.
• It is not so in Russia, where we have the lost
  empire syndrome.

43
PER and performance cont.

• 2. PER and disruption of CMEA trade.
• Collapse of CMEA trade was not purely exogenous.
• EBRD and IMF tried a dual-track approach as far
  as trade was concerned (2nd track additional
  trade with western businesses). When CE countries
  wanted to freely trade with West, SU insisted on
  world prices for all its trade gt CMEA broke
  down.
• Conscious policy choice by e.g. CR and Poland to
  see trade with West as a priority.