Economics of Transition and European Integration Winter Semester 20092010 Evgeni Peev

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Economics of Transition and European
IntegrationWinter Semester 2009-2010Evgeni Peev

• I. Introduction

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• I. Basic Transition Issues
• II. What Are Institutions?
• III. Washington Consensus Policy (1990-95)
  Institutions
• Do Not Matter
• IV. Policy Shift since 1995 Institutions Matter
• V. Institutional Convergence (Divergence)
  Empirical
• Evidence
• Political Institutions
• Democracy and Economic Freedom
• Progress of Reforms
• Country Governance
• Enterprises

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I. Issues (1) Democracy-Dictatorship Dilemma

• When communism collapsed, the expectation in the
  West was that the former communist countries
  would become both free market economies and
  democracies.
• In many cases this happened (CEE, The Baltic
  States)
• but not in all (Russia, most FSU).
• In principle, a country might remain a
  dictatorship and still introduce economic reforms
  that create market and capitalist institutions
  (e.g. Singapore).

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Issues (2) Institutions (Do Not) Matter?

• Large literature has established a relationship
  between the quality of a countrys economic
  institutions and performance (e.g. economic
  growth Barro (1991) Mueller (2003). Countries
  with low levels of corruption, strong property
  rights and other institutions that underpin
  market systems grow faster.
• Alternative view Glaeser, La Porta,
  Lopez-de-Silanes and Shleifer (2004) argue that
  economic and political institutions are
  endogenous, and that the key exogenous
  determinants of economic growth are a countrys
  stocks of human and social capital.
• Transition countries began the transition process
  as dictatorships with weak economic institutions
  and relatively large stocks of human capital.
• Yet some became democracies and (relatively) free
  market economies, while others remained or
  reverted to authoritarian regimes with regulated
  economies.

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Issues (3) The State (Creative) Destruction

• When the transition process began, the
  totalitarian state was a major actor in all
  transition countries state-owned enterprises had
  dominant position and there was preponderance of
  bureaucratic coordination (instead of market
  coordination).
• The transition process has at least two
  dimensions with respect to state activity (1)
  privatization of state enterprises and the
  liberalization of economic activities, and (2)
  changes in government expenditures, transfers and
  taxes.

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• (1) In the beginning of transition, the political
  underpinnings of a set of powerful formal
  economic institutions were removed overnight.
• (2) In most cases, the new politicians were
  either not willing or not able to slow the
  resultant institutional collapse.
• (3) Since the new institutions were not available
  immediately, firms were left to struggle in an
  immensely chaotic environment
• (4) There was substantial political consensus on
  the outlines of institutional construction.
• This consensus was especially the case for the
  countries that had the goal of entry into the
  European Union.

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• Questions
• But how long would such construction take and how
  successful would it be?
• Which institutions would be built most quickly
  and which would take more time?

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II. What Are Institutions?

• Institutions are the rules of the game. They
  include formal laws, informal norms of behavior
  and the shared beliefs about the world (North,
  1990).

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• At a very basic level, the following types of
  institutions can be identified
• 1. Those produced by private bodies with a formal
  role promoted or facilitated by the state, e.g.,
  self-regulation of stock markets arbitration
  courts accounting standards boards.
• 2. Political institutions, e.g., legislatures,
  electoral processes, etc.
• 3. Institution-like behavior by state
  administrative bodies, e.g., criminal law
  enforcement by justice departments product
  safety and health standards by ministries patent
  registration by a patent office.
• 4. The effects of the actions of independent
  quasi-governmental bodies, e.g., central banks
  issuing money and regulating banks stock-market
  regulators protecting investors bureaus
  licensing prescription medicines.
• 5. The legal system, e.g., contract law for
  transactions systems of definition and
  enforcement of property rights corporate
  governance law and enforcement the courts and
  bailiffs.

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Approaches to study institutions

• Traditional institutional economics
• It challenges the mainstream neoclassical
  economics with the fundamental assumption that
  economics cannot be separated from the political
  and social system within which it is embedded
  (e.g. Geoffrey Hodgson)
• New institutional economics (NIE)
• It tries to integrate neoclassical economics and
  institutionalism (e.g. Ronald Coase, Douglass
  North)
• Public Choice
• It studies nonmarket behavior using economic
  methods it is application of economics to
  political science (Dennis Mueller)

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III. Washington Consensus Policy (1990-95)
Institutions Do Not Matter

• The conventional wisdom for post-communist
  transition
• policy is based on three pillars
• stabilization, liberalization and privatization
  
• The policy agenda is summarized in a list of
  policy
• prescriptions by John Williamson (1990,1993), who
  coined
• for them the term Washington Consensus.

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• (1) Macroeconomic policies aimed at economic
  stability, namely
• fiscal discipline
• unified and competitive exchange rates
• tax reform, including the broadening of the tax
  base and cutting marginal tax rates
• redirection of public expenditure priorities
  toward health, education and infrastructure
• secure property rights.

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• (2) Liberalization policies aimed at structural
  reform and growth
• (vi) Foreign trade liberalization
• (vii) Financial liberalization
• (viii) the elimination of barriers to foreign
  direct investment.

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• (3) Policies aimed at structural reform and
  growth through
• the reduction of state intervention
• (ix) deregulation
• (x) privatization.

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The First Transition Years based on Washington
Consensus Policy

• (1) Fears of hyperinflation rather than recession
  dominated macroeconomics governed
  microeconomics. The extent to which
  macroeconomics dominated was most clearly
  exemplified by the IMF's short-term focus on
  raising taxes in Russia, while largely ignoring
  sensible tax reforms (Black et al. 2000).
• (2) Rapid liberalization was advocated without
  consideration of its effects on the governance of
  contractual relations.
• (3) Transaction costs during and after the
  process of privatization were rarely discussed.
• (4) A simple political economy, which emphasized
  the destruction of the old institutions, trumped
  the institutional approach, which emphasized the
  dangers of an institution-free environment.

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IV. Policy Shift since 1995 Institutions Matter

• In the early transition (1990-95), the
  institutional research hardly played any role at
  all, but now the institutional issues are a
  central focus of the transition literature.
• Why?
• (1) In Europe, with the greater prominence of
  more heterodox modes of analysis, there was
  probably a greater emphasis on institutions than
  in the U.S., where neoclassical analysis was
  relatively more popular.
• (2) Coase (1992) commented in his Nobel address
  "The value of includinginstitutional factors in
  the corpus of mainstream economics is made clear
  by recent events in Eastern Europe. These
  ex-communist countries are advised to move to a
  market economy, and their leaders wish to do so,
  but without the appropriate institutions no
  market economy of any significance is possible."

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• (3) Gerard Roland (2000) has described how the
  transition process has helped to change the very
  mode of analysis within economics "The events
  of transition have further contributed to a
  change in focus in thinking about economics and
  have very much reinforced the institutionalist
  perspective, emphasizing the importance of the
  various institutions underpinning a successful
  capitalist economyThus, there is a shift of
  emphasis from markets and price theory to
  contracting and the legal, social, and political
  environment of contractingtransition has forced
  us to think about institutions not in a static
  way but in a dynamic wayhow institutions can
  evolveand how one can get stuck in inefficient
  institutions."

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The reasons for change

• the continuing recessions in the CIS countries
  after
• stabilization,
• (2) accumulating evidence on widespread
  corruption,
• (3) an epidemic of broken agreements
• (4) increasingly common ad hoc observations that
  firm
• governance left much to be desired, and the like.

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In retrospect

• On what should have been done had economists
  pursued the institutional line of thinking more
  strongly in early transition, there is little
  agreement.
• (1) The idea of retaining some of the old
  institutions (e.g., Murrell, 1992) was rejected
  as not politically desirable because of the
  putative danger of the return of communism.
• (2) The experience of East Germany indicates that
  immediate implementation of first-best
  institutions is not a panacea.
• (3) The success of China suggests that
  transitional institutions, produced by
  incremental change, can be productive.

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V. Institutional Convergence(Divergence)
Empirical Evidence

• 1. Political Institutions
• Beck Thorsten, George Clarke, Alberto Groff,
  Philip Keefer, and Patrick Walsh, 2001.
• "New tools in comparative political economy The
  Database of Political Institutions."
• DPI
• Direct presidential regime 0
• Strong presidents elected by assembly 1
• Parliamentary regime 2
• See Mueller and Peev (2009) below.

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2. Democracy and Economic Freedoms

• Democracy index
• Freedom House measures democratization covering
  seven categories electoral process civil
  society independent media national democratic
  governance local democratic governance judicial
  framework and independence and corruption.
  Freedom House has provided numerical ratings
  based on a scale of 1 to 7, with 1 representing
  the highest and 7 the lowest level of democratic
  progress.
• Economic Freedom Indexes
• Heritage Foundation measures several aspects of
  economic freedom ( indexes are based on a scale
  of 0 to 100, with 100 being the highest level of
  economic freedom).
• Business freedom is the ability to create,
  operate, and close an enterprise quickly and
  easily.
• Trade freedom is a composite measure of the
  absence of tariff and non-tariff barriers that
  affect imports and exports of goods and services.

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• Monetary freedom combines measures of price
  stability and price controls.
• Property rights freedom is an assessment of the
  ability of individuals to accumulate private
  property, secured by clear laws that are fully
  enforced by the state.
• Investment freedom is an assessment of the free
  flow of capital, especially foreign capital.
• Financial freedom is a measure of banking
  security as well as independence from government
  control.
• Freedom from corruption is based on quantitative
  data that assess the perception of corruption in
  the business environment.
• See Mueller and Peev (2009) below.

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3. Progress of Reforms

• EBRD http//www.ebrd.com/country/sector/econo/stat
  s/index.htm
• Transition indicators
• The measurement scale for the indicators ranges
  from 1 to 4, where 1 represents little or no
  change from a rigid centrally planned economy and
  4 represents the standards of an industrialised
  market economy.
• Assessments are made in nine areas
• (1) Large scale privatisation,
• (2) small scale privatisation,
• (3) governance and enterprise restructuring,
• (4) price liberalisation,

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• (5) trade and foreign exchange system,
• (6) competition policy,
• (7) banking reform and interest rate
  liberalisation,
• (8) securities markets and non-bank financial
  institutions, and
• (9) infrastructure.
• This is important, but we also study the
  functional convergence (divergence) between the
  New Member States and the EU-15, e.g. convergence
  of both structures and behaviour.

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4. Country Governance

• World Bank Governance Indicators
• Daniel Kaufmann, Aart Kraay, and Massimo
  Mastruzzi (2006) and other their colleagues
  construct indicators of six dimensions
  governance
• 1. Voice and accountability (VA), the extent to
  which a countrys citizens are able to
  participate in selecting their government, as
  well as freedom of expression, freedom of
  association, and free media
• 2. Political stability and absence of violence
  (PV), perceptions of the likelihood that the
  government will be destabilized or overthrown by
  unconstitutional or violent means, including
  political violence and terrorism
• 3. Government effectiveness (GE), the quality of
  public services, the quality of the civil service
  and the degree of its independence from political
  pressures, the quality of policy formulation and
  implementation, and the credibility of the
  governments commitment to such policies

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• 4. Regulatory quality (RQ), the ability of the
  government to formulate and implement sound
  policies and regulations that permit and promote
  private sector development
• 5. Rule of law (RL), the extent to which agents
  have confidence in and abide by the rules of
  society, and in particular the quality of
  contract enforcement, the police, and the courts,
  as well as the likelihood of crime and violence
• 6. Control of corruption (CC), the extent to
  which public power is exercised for private gain,
  including both petty and grand forms of
  corruption, as well as capture of the state by
  elites and private interests.

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Fast Institutional change since 1995see the
World Bank site www.govindicators.org

• (1) In sum, although institutional levels were
  low at the start of transition, there were
  remarkable improvements over the 1990s.
• (2) By the beginning of the present century, the
  quality of institutions in transition countries
  was roughly as expected given levels of economic
  development.
• (3) These results suggest a reevaluation of the
  usual assumption that institutional development
  is a slow process.
• Question How were these aggregate institutional
  developments produced?

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• In sum, returning to the categorization of
  different types of institutions above
• Political institutions seemed to have developed
  fastest in TE.
• (2) The legal system and independent governmental
  bodies have made important contributions.
• (3) State administration, that is the core
  governmental bureaucracy has been very slow to
  change and offers a compelling example of
  relative failure of institutional adjustment.

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5. Enterprises

• Business Environment and Enterpirse Performance
• Surveys (BEEPS) by the World Bank and EBRD
  (1999-)
• BEEPS observe state capture in transition
  economies.
• State capture refers to the actions of
  individuals, groups, or firms both in the public
  and private sectors to influence the design of
  laws, regulations, decrees, and other government
  policy instruments to their own advantage as a
  result of the illicit and non-transparent
  provision of private benefits to public officials
  (Hellman et all, 2000).

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• Four states of the world for business actors
• State capture and selective law enforcement
  against their competitors, etc. captor firms
• State capture and no selective law enforcement
  not typical
• No state capture and selective law enforcement -
  not typical
• (4) No state capture and no selective law
  enforcement not affiliated firms.