Chapter 17

Chapter 17 Sequencing, Gradualism, and the Political Economy of Adjustment © Pierre-Richard Agénor The World Bank 1

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Stabilization and Structural Adjustment The Order of Liberalization Political Restraints and Economic Reforms Shock Treatment or Gradual Approach

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Recent literature has focused on three issues:  timing of reforms;  sequencing of reforms;  speed of reforms.

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Stabilization and Structural Adjustment

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Policy complimentarity between macroeconomic adjustments and structural adjustments man argument in favor of shock therapy. However, may also have conflicting effects. Structural policies may have a longer time frame than short-run macroeconomic policies. Importance of interpreting and understanding price signals supports stabilization objective proceeding first.

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The Order of Liberalization

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Many distortions simultaneously present in an economy. First-best solution would be to remove all distortions at once; never a realistic option in practice. In reality, second-best solution must then be optimized as a combination of,  sequencing measures that are broad enough in scope to ensure a first-best solution in the long run;  minimizing adjustment costs.

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Liberalization of External Accounts 

Sequencing trade and capital account liberalization:  Many economists have argued to liberalize trade prior to the capital accounts.  Reason: capital inflows resulting from capital account liberalization may cause real appreciation while nascent trade liberalization requires a real depreciation.

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Edwards and Van Wijnbergen (1986):  Evaluated welfare effects of liberalization.  Conclusion 1: liberalization can have ambiguous effects on welfare because of three types of effects:  direct effects, occur in the market and time period in which the reform has taken place;  intratemporal indirect effects, occur within the period in which the reform occurs because of the interaction between two or more distortions in different markets;

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intertemporal indirect effects, result from the inherently dynamic nature of liberalization policies. They imply that a reform in one period may alter the equilibrium in distorted markets in the next period.  Conclusion 2: current account should be opened first. Implication of uncertainty: Conley and Maloney (1995):  Considered a two-period model with uncertain benefits to economic liberalization.  Two-part liberalization program:  current account liberalization in period 1; 10  complete opening of capital account. 

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With uncertain benefits, agents base consumption path on marginal productivity of capital in period 2. Liberalization will thus lead to a surge in consumption, a current account deficit, and an increase in foreign borrowing by private agents. Ex post potential for boom-bust cycles.

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Financial Reform and the Capital Account 

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Capital outflows: spurred by capital account liberalization in the face of financial repression.  Particularly large when credibility (sustainability) of the structural reform not fully established.  Many economists agree; capital account should only be opened after financial market liberalization. Prudential supervision and regulation of the banking system concurrent with financial liberalization vital. 12

Sequencing Labor Market Reforms Edwards (1989):  Labor mobility needed to facilitate the reallocation of resources across sectors. Labor reform should precede trade reform.  Wage formation and macroeconomic stability; tying wages to future inflation rather than past inflation.  Labor reforms be a contemporary to macroeconomic reforms.  However, difficult to introduce (Agénor, 1996).

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Political Constraints and Economic Reforms

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New political economy analyzes economic policy from both a normative and positive perspective. Normative: issues related to the effect of institutions on policy formation. Positive: focusing on the types of policies that are more likely to emerge from specific political and institutional settings.

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Modeling Political Conflict 

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Timing of economic reforms; recognition that reforms generate winners and losers. Short-run winners may differ from long-run gainers. May lead to backtracking. Assuming existence of a welfare-maximizing benevolent social planner not realistic. Policy choices reflect the resolution of conflicts of interest between groups with different goals.

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Key question: How conflicts lead to delays in reform?  Distributional conflict approach: based on models of war of attrition. Each group uncertain about other groups net benefits from reform and their willingness to pay.  Uncertain benefits approach: groups uncertain of their own benefits, leading to a status quo bias.

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Benefits of Crisis  Making delay of reform more costly can accelerate implementation of stabilization program (Drazen and Grilli, 1993).  For example, episodes of hyperinflation more easy to terminate that episodes of chronic inflation.  Rodrik argued that this view suffers from two problems:  element of tautology, crisis as an extreme case of policy failure;  difficult to falsify, “crisis…not yet ‘severe enough’”. 18

Political Acceptability and Sustainability Wyplosz (1993):  Uncertainty and the difficulty of sustaining reform process. Model illustrated:  Consider economy with N identical workers faced with possible reform.  Reform calls for initial cut in labor force, by , followed by both a return to full employment in period 2 and a gain in productivity. 19

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Without reform,

Y0 : L N. 

With reform, national income drops in period 1,

Y1 : (1-  )L N, and rises in period 2,

Y2 : H N . 20

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Reform is efficient on aggregate level by inequality,

Y2 Y0 Y1 + > Y0 + 1+r 1+r

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Y0: national income without reform; Y1: national income in period 1 with reform; Y2: national income in period 2 with reform.

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Reform is efficient for laid off worker if,

L H L + > 0+ 1+r 1+r

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L : wages (labor productivity) without reform. H : with reform wages.

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Setting  = 1 / (1 + r) and rearranging (see pp. 62930), efficiency condition is given by,

+ <  

H L

1+ < 

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(4) ensures efficiency but does not ensure welfare.

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Welfare analysis  Let (ch) be a utility function for consumption at period h.  Ex ante political acceptability given by,

E[(c1) + (c2)]  (1 + ) (c), ~

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E: mathematical expectations operator. : time preference factor.

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How government can create sufficient support?  b: unemployment benefits.  Suppose government and individuals are unable to borrow against future income.  In presence of b, (5) is rewritten as,

 (1 - )v L b + v(b) 1-

{

}

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 (1 + )v(L) - v(H)

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Two ex post conditions for political acceptability:  For the losers,

v(b)  (1 + )v(L) - v(H) 

For the winners,

 v L b  (1 + )v(L) - v(H) 1-

{

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Ex ante condition (6), a weighted average of ex post conditions. See Figure 17.1 for graphical solution. See pg. 633 for discussion when government is 26 assumed able to borrow funds.

F i g u r e 1 7 . 1 I n c o m e D i s t r i b u t i o n a n d P o l i t i c a l A c c e p t a b i l i t y R e g i o n s

E [ ( ) ] u c 1 L o s e r s ' u t i l i t y W i n n e r s ' u t i l i t y C

( 1 + ) ( ) ( ) u u     L H

BA

e x p o s t

e x a n t e

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S o u r c e : W y p l o s z ( 1 9 9 3 , p . 3 8 3 ) .

e x a n t e

b

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Social Safety Net:  Increasing recognition of importance alongside adjustment program.  Often include the following components:  targeted subsidies and cash compensation;  unemployment benefits, severance pay, and public works schemes.

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Shock Treatment or Gradual Approach? 

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Shock treatment argument based on complementarities between policy instruments. Arguments for gradualism:  Preexisting distortions, which cannot be removed at the time the reform program is announced.  Imperfect credibility, tantamount to a distortion in the intertemporal price of tradable goods.  Congestion externalities, may create too much transitional unemployment (relative to the market optimum) after a shock treatment (Gavin, 1996).  Weak financial system. 29

Political arguments Pro-Shock:  prevents interest groups from forming;  reform administrations need to take advantage of honeymoon window to execute reforms quickly. Pro-Gradualism:  may help to minimize adjustment costs and limit the distributional burdens on particular groups in the initial phases of reform.

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