Blog Post

The slow-reform trap

Ukraine is perhaps the most convincing example of a victim of slow reform. Since independence in 1991, it has missed several political windows of opportunity to comprehensively reform its economy and state institutions. Had these reforms been put in place, today Ukraine would be a different country. 

By: Date: June 17, 2015 Topic: Innovation & Competition Policy

A never-ending controversy

The question of optimal reform strategy, especially its speed and degree of ambition, has been repeatedly debated in relation to various historical occasions. The best-known controversy refers to the first period of post-communist transition in central and eastern Europe and the former Soviet Union in the 1990s. It was framed as the ‘shock therapy’ versus ‘gradualism’ debate.

The emotional term ‘shock therapy’ was introduced purposely by the opponents of fast, radical and comprehensive reforms: nobody likes shock or wants to be treated in this way. Opponents argued that ‘shock therapy’ ignored the organic building of institutions (Murrell, 1992), induced the downward demand-driven spiral of falling output and increasing unemployment (Nuti and Portes, 1993; Laski and Bhaduri, 1997), led to deterioration of fiscal accounts (Aghion and Blanchard, 1993) and put newly-born democracies at risk (Przeworski, 1991). A gradual approach would result in less economic and social pain and better institutional outcomes.

Somewhat similar rhetoric (‘austerity’ versus ‘growth’) could be heard twenty years later when the financial and public debt crises hit several European economies. Again, the opponents of fast fiscal adjustment and structural reforms argued about ‘self-killing austerity’ (Krugman, 2010; DeLong and Summers, 2012) – in other words, a hypothetical situation in which fiscal adjustment leads, via a demand multiplier higher than 1, to unacceptable output and employment losses and, as a result, further deterioration of fiscal balances.

Facts tend to favour fast reform

The verdict of historical experience is definitely in favour of fast and comprehensive reforms. Among the former communist countries those that moved quickly (the Baltic and central European countries) recorded the best economic, social and political results (Dabrowski, 2013). They reduced the period of corrective output decline to 2-3 years and limited its depth. They enjoyed the earliest returns to rapid economic growth. They recorded smaller income and wealth inequalities, less corruption and better institutional outcomes, including stable democracies. In 2004, they became EU members, which further anchored and reinforced the positive results of institutional transition, and helped in their further modernisation.

Countries that for various reasons delayed reform or implemented it in a more gradual manner, suffered from prolonged periods of deep output decline. In the extreme cases of Russia, Ukraine and Moldova, this lasted almost 10 years and involved cumulative losses of more than 40 percent of pre-transition output. Countries of the former Soviet Union (except for the Baltic states) and of south-eastern Europe, ie those where reforms were slower and less effective, suffer from greater income and wealth inequalities, the dominance of oligarchs over economic and political life, corruption and organised crime, poor governance and weak rule of law. Several former Soviet Union countries returned to autocracy.

The recent financial crisis experience in Europe also demonstrates the advantage of front-loading fiscal adjustment and structural reform. The Baltic countries (especially Latvia), heavily hit by the crisis in 2008, exited the crisis much faster and with much smaller output and employment loses than Greece (see Balcerowicz, 2014; Aslund, 2015a).

Why does fast reform result in better outcomes?

The potential advantages of rapid reform can be explained by the size of imbalances, which must be addressed, the expectations of economic agents, policy and systemic consistency and political economy factors (Dabrowski, 1996). Of course, these arguments apply to a situation in which an economy must respond to a major shock or overcome large structural and institutional distortions. In case of minor shocks or smaller distortions, there is more room for gradualism.

If the economy suffers from large fiscal, monetary or balance-of-payments disequilibria, the minimal size of adjustment must be large enough to close the existing gap and change the expectations of economic agents. If it fails to do so, imbalances will deepen and economic agents will take a pessimistic view of the economy’s prospects. They will react with flight from domestic money, by withdrawing bank deposits and with capital flight, which will make things even worse than before (the mechanism of multiple equilibria). The attempt to soften the adjustment burden by external borrowing (from the International Monetary Fund or other official creditors) is not always available and cost-free. The official creditors impose conditions, and the loan must be repaid in future. Furthermore, economic agents must believe that a less ambitious but externally supported adjustment package offers the prospect that the country will remain solvent in the medium-to-long-term.

The need to close a financial gap and change market expectations means that a gradualist approach is rarely successful in returning a country to macroeconomic stability – for example, by fighting high inflation, overcoming balance-of-payment crises or avoiding public debt default, once economic agents have already started to panic. There is more room for a gradual approach in other reform areas (Table 1). However, choosing such an approach always involves economic and social costs.

Table 1: What can be done gradually? Experience of post-communist transition

Area Can be done gradually If YES, what are negative implications?
Macroeconomic stabilisation NO
Domestic liberalisation YES Price distortions, fiscal problems, delayed de-monopolisation and privatisation
External liberalisation YES Price distortions, weaker competition, less pressure for restructuring
Privatisation YES Delayed restructuring, pressure for macropolicy, intensive rent-seeking, informal privatisation
Restructuring of the state sector (subsidisation) YES Delayed restructuring, fiscal crisis, other pressure for macropolicy, intensive rent-seeking, the information and political barrier in monitoring, credibility problem

Source: Dabrowski (1996)

 

Gradual domestic and external liberalisation means a longer period of price distortions (often associated by additional fiscal and quasi-fiscal costs), weaker competition, and less pressure for restructuring. Privatisation of over-regulated public enterprises working in a restricted competition environment remains highly problematic. On the other hand, slow privatisation delays the restructuring of enterprises, and creates negative pressures for monetary and fiscal policies. Furthermore, slow privatisation and enterprise restructuring encourages rent seeking, corruption and spontaneous informal privatisation (stripping profits and assets). It also creates information and political barriers in monitoring state-owned firms.

Time is the most precious political resource

Although slower reform can reduce immediate political resistance and the associated risks for policymakers, it delays the potential gains and sometimes multiplies the reform pain because of the necessity of repeating unpopular adjustment measures several times.

In addition, gradual reforms are not easily manageable. By definition, they extend the transition period before the new policy regime is fully operational. In many spheres, the new policies and mechanisms must reach the minimum threshold to become effective (the critical mass of reform). In the meantime, an interim regime is required to avoid a systemic vacuum. Such a hybrid regime might suffer from information barriers and lack of consistency. It often creates intermediate winners who oppose further change (Krueger, 1993; Hellman, 1998). On the other hand, economic agents might not consider gradual change to be credible and can delay adjustment of their market behaviour. Again, expectations play an important role in this respect.

Policymakers dealing with reform will not enjoy unlimited political windows of opportunity. On the contrary, the political credit that they receive (as a result of election, revolution, extraordinary mobilisation of society, etc) is usually time-limited. If not used effectively, it might not be quickly granted again. If wasted several times, the consequence might be social disappointment and the opening of the political door to populists of various colours.

Ukraine: negative consequences of slow reform

Ukraine is perhaps the most convincing example of a victim of slow reform. Since independence in 1991, it has missed several political windows of opportunity to comprehensively reform its economy and state institutions. Had these reforms been put in place, today Ukraine would be a different country. Most probably, it would have been able to avoid the current deep economic crisis and avert the threat of external aggression. Instead, subsequent governments have built a distorted market economy and deeply dysfunctional state institutions controlled by oligarchs and suffering from extremely high levels of corruption (see Dabrowski, 2007; Aslund, 2015b, chapter 4).

The most tragic failure came after the Orange Revolution in 2004. The broad political support for democratic change and deep institutional and economic reform was lost because of a political split inside the ‘Orange’ camp, in particular, the permanent political infighting between then-president Viktor Yushchenko and twice prime minister Yulia Tymoshenko (2005 and 2007-10). The growing popular disappointment led to the election victory in 2010 of Viktor Yanukovych, who built a kleptocratic regime, strengthened Ukraine’s dependence on Russia and ran populist macroeconomic policies.

Have the lessons of the Orange Revolution sunk in?

The next political window of opportunity for serious reform came in early 2014 after the tragic events of the Euro-Maidan and the collapse of Yanukovych’s regime. The new Ukrainian authorities have made general pro-reform declarations, but these do not seem to be supported sufficiently by concrete policy measures, especially in the critical areas of fiscal, balance-of-payment and structural adjustment. The same must be said about the international financial aid packages granted to Ukraine in April-May 2014 (see Dabrowski, 2014) and again in March 2015 (see Dabrowski, 2015), which have not been accompanied by sufficiently strong policy conditionality, and which remained underfunded.

The insufficient fiscal adjustment and structural reforms conducted in 2014 led to the dramatic balance-of-payments crisis at the end of that year and in early 2015. The National Bank of Ukraine’s foreign exchange reserves reached the critically low level of $4.7 billion in February 2015 and the hryvnia lost almost two thirds of its value compared to the beginning of 2014. This accelerated inflation, which will reach the annual level of 46 percent in December 2015, increased the level of public debt above 90 percent of GDP and led to the deterioration of the balance sheets of several Ukrainian banks and companies.

The new fiscal adjustment package backed by the IMF Extended Fund Facility programme (approved in March 2015) again looks insufficient in terms of the amount of financing and attached conditionality. It does not go far enough in the two key areas of fiscal and structural reform, ie, in bringing household gas and heating tariffs to the full cost-recovery level (in the meantime the latter has increased substantially as result of the hryvnia’s devaluation), and pensions, ie increasing both the statutory and effective retirement age.

In several important spheres, the major reform agenda is still far behind. This includes, for example, the reform of the judiciary and law-enforcement agencies, local and regional government, fighting corruption, bank restructuring, comprehensive business deregulation, civil service reform, tax and customs administration and tax collection procedures and privatisation of state-owned enterprises.

A race against time

This brings us to the question of effectiveness of the leadership of the new president, parliament and government, all elected on the pro-reform and pro-European platforms in 2014. Without any doubt, the new authorities received an explicit pro-reform political mandate, but the question is if they are willing and able to use it for the right purpose. This also involves the question of policy coordination between the president and prime minister (in the context of an unclear demarcation of their responsibilities), between the government and the Verkhovna Rada (parliament), and within the government coalition.

Obviously, the conflict with Russia distracts attention, political energy and resources from the domestic reform agenda. However, it also helps to consolidate and mobilise society around the president and government, and can justify politically unpopular decisions. Time is working against the new Ukrainian authorities. Slow progress on reform will delay economic recovery and will weaken the Ukrainian state. It will make the period of pain and sacrifices longer with no visible gains. This might lead to popular disappointment and a weakening of the pro-reform mandate. In fact, a decline in the popularity of the president and the government has been already observed (see Barker, 2015). Its further decline will not help in confronting the domestic reform agenda and external threats.

References

Aghion, P. and Blanchard O.J. (1993) On the speed of transition in central Europe, European Bank for Reconstruction and Development (EBRD), Working Paper, No. 6, July

Aslund, A. (2015a) Revisiting the Latvian and Greek Financial Crises: The Benefits of Front-Loading Fiscal Adjustment, CASE Network Studies and Analyses, No. 477, http://www.case-research.eu/sites/default/files/publications/S%26A477.pdf

Aslund, A. (2015b) Ukraine: What Went Wrong and How to Fix It, Peterson Institute for International Economics, Washington, DC

Balcerowicz, L. (2014) Euro Imbalances and Adjustment: A Comparative Analysis, Cato Journal, Vol. 34, No. 3 (Fall)

Barker, A. (2015) Poll highlights divisions among public on tackling Ukraine crisis, Financial Times, June 10, http://www.ft.com/intl/cms/s/0/b28f38ae-0ec3-11e5-848e-00144feabdc0.html#slide0

Dabrowski, M. (1996) Different Strategies of Transition to a Market Economy: How do They Work in Practice?, The World Bank, Policy Research Working Paper, No. 1579, March

Dabrowski, M. (2007) Ukraine at a Crossroad, CASE Network Studies and Analyses, No. 350, http://www.case-research.eu/sites/default/files/publications/17209093_S%20and%20A_350_Dabrowski_0.pdf

Dabrowski, M. (2013) Central and Eastern Europe and the CIS: 20 years on, in: Turley, G. & Hare, P.G. (eds.): Handbook of the Economics and Political Economy of Transition, Routledge

Dabrowski, M. (2014) Ukraine: Can meaningful reform come out of conflict? Bruegel Policy Contribution, Issue 2014/08, July, /publications/publication-detail/publication/843-ukraine-can-meaningful-reform-come-out-of-conflict/

Dabrowski, M. (2015) The harsh reality of Ukraine’s fiscal arithmetic, Bruegel Policy Contribution, Issue 2015/07, /download/parent/881-the-harsh-reality-of-ukraines-fiscal-arithmetic/file/1798-the-harsh-reality-of-ukraines-fiscal-arithmetic/

DeLong, J.B. and Summers, L.H. (2012) Fiscal policy in a depressed economy, Brookings Papers on Economic Activity, Spring, pp. 233-297

Hellman, J. (1998) Winners Take All: the Politics of Partial Reform, World Politics, vol. 50, pp. 203-234

Krueger, A.O. (1993) Political Economy of Policy Reform in Developing Countries (The Ohlin Lectures), The MIT Press

Krugman, P. (2010) Self-defeating Austerity, The New York Times, July 7, http://krugman.blogs.nytimes.com/2010/07/07/self-defeating-austerity/

Laski, K. and Bhaduri, A. (1997) Lessons to be drawn from main mistakes in the transition strategy, in: Zecchini, S. (ed.): Lessons from the Economic Transition. Central and Eastern Europe in the 1990s, New York, NY: Springer- Science + Business Media LLC

Murrell, P. (1992) Evolution in economics and in the economic reform of the centrally planned economies, in: Clague, C. and Rausser G.C. (eds.): The Emergence of Market Economies in Eastern Europe, Oxford: Basil Blackwell

Nuti, D.M., and Portes R. (1993) Central Europe: the way forward, in: R. Portes (ed.): Economic Transformation in Central Europe. A Progress Report, London: Centre for Economic Policy Research

Przeworski, A. (1991) Democracy and the Market: Political and Economic Reforms in Eastern Europe and Latin America, Cambridge: Cambridge University Press

 

 


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