Chapter 17 Sequencing Gradualism and the Political Economy

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

l l Stabilization and Structural Adjustment The Order of Liberalization Political Restraints and Economic Reforms Shock Treatment or Gradual Approach 2

Recent literature has focused on three issues: l timing of reforms; l sequencing of reforms; l speed of reforms. 3

Stabilization and Structural Adjustment 4

l l 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. 5

The Order of Liberalization 6

l l l 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, è sequencing measures that are broad enough in scope to ensure a first-best solution in the long run; è minimizing adjustment costs. 7

Liberalization of External Accounts l Sequencing trade and capital account liberalization: è Many economists have argued to liberalize trade prior to the capital accounts. è Reason: capital inflows resulting from capital account liberalization may cause real appreciation while nascent trade liberalization requires a real depreciation. 8

Edwards and Van Wijnbergen (1986): l Evaluated welfare effects of liberalization. l Conclusion 1: liberalization can have ambiguous effects on welfare because of three types of effects: è direct effects, occur in the market and time period in which the reform has taken place; è intratemporal indirect effects, occur within the period in which the reform occurs because of the interaction between two or more distortions in different markets; 9

è 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): l Considered a two-period model with uncertain benefits to economic liberalization. l Two-part liberalization program: è current account liberalization in period 1; è complete opening of capital account. l 10

l l l 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. 11

Financial Reform and the Capital Account l l Capital outflows: spurred by capital account liberalization in the face of financial repression. è Particularly large when credibility (sustainability) of the structural reform not fully established. è 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): l Labor mobility needed to facilitate the reallocation of resources across sectors. Labor reform should precede trade reform. l Wage formation and macroeconomic stability; tying wages to future inflation rather than past inflation. l Labor reforms be a contemporary to macroeconomic reforms. l However, difficult to introduce (Agénor, 1996). 13

Political Constraints and Economic Reforms 14

l l 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. 15

Modeling Political Conflict l l l 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. 16

Key question: How conflicts lead to delays in reform? l 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. l Uncertain benefits approach: groups uncertain of their own benefits, leading to a status quo bias. 17

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

Political Acceptability and Sustainability Wyplosz (1993): l Uncertainty and the difficulty of sustaining reform process. Model illustrated: l Consider economy with N identical workers faced with possible reform. l 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

l Without reform, Y 0 : L N. l With reform, national income drops in period 1, Y 1 : (1 - ) L N, and rises in period 2, Y 2 : H N. 20

l Reform is efficient on aggregate level by inequality, Y 2 Y 1 + 1+r Y 0 > Y 0 + 1+r (1) Y 0: national income without reform; Y 1: national income in period 1 with reform; Y 2: national income in period 2 with reform. 21

l Reform is efficient for laid off worker if, L L + 1+r H > 0+ 1+r (2) L : wages (labor productivity) without reform. H : with reform wages. 22

l Setting = 1 / (1 + r) and rearranging (see pp. 62930), efficiency condition is given by, + < l H L 1+ < (4) ensures efficiency but does not ensure welfare. 23

Welfare analysis l Let (ch) be a utility function for consumption at period h. l Ex ante political acceptability given by, E[ (c 1) + (c 2)] (1 + ) (c), ~ (5) E: mathematical expectations operator. : time preference factor. 24

How government can create sufficient support? l b: unemployment benefits. l Suppose government and individuals are unable to borrow against future income. l In presence of b, (5) is rewritten as, (1 - )v L b + v(b) 1 - { } (6) (1 + )v( L) - v( H) 25

Two ex post conditions for political acceptability: l For the losers, v(b) (1 + )v( L) - v( H) l For the winners, v L b (1 + )v( L) - v( H) 1 - { l l l } 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.

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Social Safety Net: l Increasing recognition of importance alongside adjustment program. l Often include the following components: è targeted subsidies and cash compensation; è unemployment benefits, severance pay, and public works schemes. 28

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

Political arguments Pro-Shock: l prevents interest groups from forming; l reform administrations need to take advantage of honeymoon window to execute reforms quickly. Pro-Gradualism: l may help to minimize adjustment costs and limit the distributional burdens on particular groups in the initial phases of reform. 30