(Reprinted from HKCER Letters, Vol. 11, November 1991)
The Challenge of Monetary Reform
in Eastern Block Countries
The Steps of Reform
I became interested in the above topic when I was preparing for a conference in Shanghai where I had to speak on monetary and fiscal problems of the reform process in China. I was later invited to Budapest and Moscow, and last year I had to study the German currency reform, so I have been drawn more and more into these problems. All these countries share the common background of having been planned economies. Here I would like to first discuss the preconditions for the reform of such economies.
I think the reform steps should take the following sequence: First introduce a private law regime, then private property, then look at the monetary overhang -- that is, to create a sound monetary and fiscal system -- and only after these, the freeing of prices. Finally, there is the freeing of international economic transactions. This last step is important for two reasons: first, to introduce competition for firms which have usually been monopolies in the planned economy; and second, to attract foreign investment and know-how. I really believe that one should not begin with the freeing of prices. It should be one of the last steps, and the freeing of international transactions perhaps even somewhat later than that.
Unfavorable Economic Environments
Let me go to the monetary and budgetary problems of the reform. First, a planned economy is steered by the planning of certain amounts or stocks of goods. One is not at all concerned with financial and monetary relationships. Money incurred is just used to finance what has already been decided upon. There is really no budgetary restriction. If a plant or conglomerate has losses because of the plans, they will be financed. If it has profits, they will just be siphoned off. So the monetary and financial system is absolutely subordinated.
The next thing to face is a monetary overhang or repressed inflation. Prices are usually set below market-clearing levels, first because of ideological reasons. It has to be pretended that people can get the necessities at very low prices. Second, more importantly, bureaucrats want the power to determine how goods are rationed. As an example, in the Soviet Union in 1989, there were savings deposits of about 300 billion rubles and there were no stocks of goods which corresponded to that. There were, in addition, 250 billion rubles which had accumulated with firms, pension funds, labor funds, and so on, and these were monetary overhang too. Also, it has to be noted that in these economies there are really two circuits of money which are divided, one for consumption and the consumers and so on, and the other among the firms where payments are made by transfer. As soon as the system is cleared, the two circuits would combine, and this could make the monetary overhang more prevalent.
Another thing concerning the initial conditions of reform is that there is really no tax system. For instance, in East Germany, about 75 percent of government revenue was based on profits of the firms. Since they were formerly government-owned, the government could just take them away through the accounting system. Only 25 percent of government revenue came in by taxes. There was thus no budgetary control of the government.
Problems Arising from Reforms
As the reform process gets started, usually the budgetary situation deteriorates. Why is this so? It has to do with the sequence mentioned above. Countries like China and others started with freeing some or many prices, but kept the essential prices of food and housing under control. However, freeing some prices means, of course, that some firms have inputs with free prices and some output with controlled prices. As a consequence, more of the firms go into deficits, and the deficits have to be financed out of the government budget. Moreover, goods with very low prices have to be compensated by subsidies. These together have adverse effects on the expenditure side. On the revenue side, with free markets and at least some decentralization, perhaps even some privatization, the government cannot just siphon off the profits of the firms; otherwise, motivation would be lost. With no tax system in place, government revenues usually go down. Also, with some prices freed, the monetary overhang becomes more prevalent since the two circuits mentioned above are combined. As a result, the initially repressed inflation turns into an open inflation, especially if the budgetary deficit is financed by money creation. People would think that these are consequences of the reform, and would begin to look at reforms with suspicion.
The situation is worsened by the fact that reforms usually do not include only the freeing of prices, but some decentralization of the economic system, as well as some privatization. Privatization is a rather lengthy process, and the functionaries often are not very much in favor of it. They are, however, in favor of decentralization -- to local communities, to provinces, and so on. In Hungary they go even further and decentralize to the firms. In a sense, it is private property without private property. Nobody knows to whom the firm belongs, while it is usually the management that controls it. If the firm makes losses, unemployment will rise in the region. With decentralization but not privatization, there is a strong incentive not to allow bankruptcy even if it is formally permitted. Firms that would go bankrupt are instead financed by giving credit. With decentralization occurring in the monetary system as well, there is pressure for banks to extend credit and for central banks to finance by money creation. There is no real control of the money supply, no financial limitation, and no budgetary control of the firms. As a consequence, you got this inflation in China. In Hungary, when I was there in 1989, it was 20 percent; now it is 40 percent. Should the reforms need to slow down due to these political-economic consequences, they have to take the form of a credit crunch. There are no capital market or money market instruments available as policy tools. The government can only limit credit. But then, whoever has the most political influence on the banks gets the credit.
Taking the Right Steps
The above accounts of the monetary and fiscal aspects may give a rather gloomy outlook, and I should therefore say what steps should be or should have been taken. I spoke already about the sequence of reform. First, one should introduce some tax system, since there is no such system; and if one wants to have a less hierarchical fiscal system, one should introduce a very simple tax, one that is easily calculated and monitored, and applicable to both publicly and privately owned firms. This can be a turnover tax, or perhaps, in time, a value-added tax.
The next thing to do is to cut subsidies, price subsidies, and firm subsidies. It is a hard decision for politicians obviously, because it implies unemployment, and with the big restructuring of the economy which has to take place, it implies a lot of unemployment. I can recall telling the Deputy Finance Minister of Hungary in November 1989 that I believed he would not be re-elected anyhow, so he should set himself a monument by doing the necessary reforms with high political costs. Unfortunately, he did not believe me.
Then comes the monetary overhang. This would mean a monetary reform, like that which took place in Germany, cutting down this monetary overhang to what is expected to have in the form of goods. I suspect there is not very much of goods in most of these countries. However, it can help a little bit by turning what could not be given to holders of money into vouchers with which they could buy their flats, for instance, or participate later as shareholders of firms.
For some countries, there is the necessity to take some steps to reduce the monetary debt vis-a-vis foreign countries. Since foreign debt is not expressed in the domestic currency, obviously it cannot be removed with currency reform. As a consequence, what one would usually need is a moratorium of, say, eight years for interest payments and paying back the debt. I think that the creditor countries would be very prepared to do this if one takes the economic reform seriously.
Then one has to reform the banking system, and should, in a sense, make the central bank independent. Different monetary regimes are possible for small countries. Perhaps the currency board system would prove to be an appropriate mechanism, but the understanding of this question is rather limited in these countries. They have not had monetary authority for decades. For a big country like Russia, perhaps this may not be the right thing to do, but one could at least fix the exchange rate, which would lead to a similar system in a certain way.
Finally, of course, one should free prices. It would be helpful if the economic system has already been decentralized and privatized as much as possible. Our experience, however, is that privatization is a very difficult process. It takes time, especially if there is no well-functioning legal system.
The last step would be to free the currency and introduce currency convertibility. Probably one should not take it as one step. I think, with the terribly distorted allocation of resources, there is probably the need for some undervaluation for some time to make the dynamic process less painful. It is quite true one has to end up with as liberal a system as possible, but I would not recommend doing it at once -- it would ruin too much. In East Germany this had to be done at one time only because of international political reasons and the migration inside Germany, though economically it is not the best solution.
Dr. Peter Bernholz is a Professor of Economics at the University of Basel in Switzerland. He has been a member of the Council of Advisors of the German Minister of Economics and was a member of the Macro Economic Policy Group of the Commission of the European Community. The above is an abridged version of a talk he recently delivered at the Centre.