Past accomplishments sad

After the presidential elections there will be a rare opportunity for the government and Parliament to implement a comprehensive economic reform program. As in most countries, a window of opportunity is opening to implement a comprehensive reform program during the first months after the election, in which the people gave the President a second term to make basic changes in economic policy, and society will still need several years to ripen for a new national election campaign. However, for a new wave of reform to begin as well as to expose attempts to mask post-election policy under the customary “dividends” to be reaped from “investing” capital in pre-election projects, it is most important to closely examine what has been done by whom and how during the last ten years in Ukraine.

Many observers point to alleged macro-stabilization (i.e., low inflation and a steady exchange rate) as a chief success of the reform process in Ukraine since the hyperinflation of the early 1990s. Indeed, prices and the exchange rate have been quite stable in recent years.

Under the Soviet regime also prices and exchange rates were stable. However, this stability was a false stability, maintained through artificial controls over prices and exchange rates, achieved at the cost of shortages of goods and low living standards. Similarly, today’s stabilization in Ukraine is a false stability in that it has been achieved through spending National Bank foreign reserves, implementing official and hidden controls on trade, and the prevalence of various price controls and soft-budget constraints that allow non- market prices.

One can compare the three stages of the Ukrainian economy over the last decade: the Soviet shortage economy, the hyperinflationary economy, and the barter/arrears economy. In the Soviet economy, prices were controlled officially and shortages represented an implicit tax on consumers. In the hyperinflationary economy, prices were non-market prices in that constant changes in the overall price level creates considerable fluctuations in relative prices, and printing money represented an implicit tax on consumers. In the barter/arrears economy, prices again are non-market ones: An enterprise might agree to a price for a good and then either not pay it (arrears) or pay in kind with other goods (barter). In both cases, the prices are not market prices since they do not represent the price for which customers are actually willing to pay in money. Barter and arrears also represent a hidden tax on the population since they are promised one wage but, because they are either not paid or paid in kind with goods whose market price is lower than their nominal price, they receive wages and salaries lower than promised.

All three periods involved either high inflation or repressed inflation. In the Soviet period, repressed inflation could be defined conceptually as the inflation level that would have resulted if prices were freed. In the current barter/arrears period, repressed inflation could be defined as the inflation level that would result if enough money were printed to cover the difference between market and nominal prices of bartered goods and services plus the nominal prices of outstanding arrears.

It seems therefore that the current so- called stabilization of the economy is over- valued in importance by the government and Western observers. Stabilization is supposed to be one tool in achieving economic growth; it is not supposed to be an end in itself.

The original formulation of the tasks of economic transition, set forth in the early 1990s, were, in order: liberalization, stabilization, privatization, and institutionalization. While one might argue over their proper sequencing, it seems that liberalization appropriately should come first in this sequence, and the extent to which stabilization in Ukraine is being maintained through de-liberalization of the economy suggests that fundamental economic policies have to be rethought.

The current pseudo-stabilization and de-liberalization have created rent-seeking intermediate winners, who benefit from rents derived from various controls on financial markets and who have an interest in blocking true liberalization.

In thinking about how to understand Ukraine’s economic problems, it is important to keep in mind where the driving force of economic activity comes from. Namely, individuals seek to maximize their well- being, and this is why they work. Those who are particularly gifted with business skills open and manage enterprises. The government does not need to stimulate this desire in individuals. It is there naturally. The task of government thus is not to determine which sectors of the economy are the highest priority or to somehow stimulate people and enterprises to work. Individuals and enterprises already have an innate desire to work. The purpose of the government must be to remove various barriers and to create conditions so that individuals and enterprises can work. Such an understanding leads to a reversal of the government’s role in society, from initiator and central planner during the Soviet period, to enabler during the market period.

Ukraine, arguably, is no longer a transition economy, but rather has completed a transition process into a new type of economy. Unfortunately, this type is not the market economy that had been hoped for. The current type of economy we might call oligarchic socialism in order to contrast it with centrally planned socialism (by using the word socialist we mean only to indicate some similarities between current economic conditions and those that existed during the Soviet period. Arguably, even the economy of the Soviet period differed substantially from any true definition of socialism). Oligarchic socialism or what others have called a virtual economy-is quite unlike a true market economy, even unlike the emerging market economies of East Central Europe. Rather, it is perhaps most similar to Central European economies 25 years ago, under what was called reform socialism or goulash socialism. Although there are considerable differences between Ukraine today and Central Europe 25 years ago, the two types of economies are similar in that they mixed elements of traditional Soviet socialism and the market, leading to various imbalances and an absence of growth.

The current economic conditions that have developed in Ukraine, and also in Russia, with their peculiar characteristics of arrears, barter, and shadow economy, seem potentially quite permanent. Without a radical change in course, despite prior hopes and expectations, these conditions may not be merely a transitional phase in the development of a true market economy but rather a quite permanent condition along a low-level equilibrium path. Current conditions differ from the Soviet period most fundamentally in that decision making is not concentrated at the center. Rather, decisions regarding allocation of resources are decentralized, made by enterprise managers or sector or local bureaucrats. The breakdown in centralized control, which is related to the end of iron-fist totalitarianism, also has allowed the development of a shadow economy where none would have been tolerated under the past system. (This shadow economy consists largely of small businesses operating mostly along market principles.)

Current conditions are similar to those of the Soviet period in that budget constraints are soft, many prices are distorted and do not signal relative scarcity, enterprises maximize production and employment rather than profit, and goods and services are “sold” without using money as the means of exchange. These characteristics apply to most old state enterprises and to the budget sphere, but not to some new enterprises, often operating in the shadow economy, enterprises which are more market-oriented.

In seeking to explain why Central European countries have developed into emerging market economies while Ukraine, Russia, and the other large post- Soviet countries have been transformed into some kind of a post-socialist hybrid economy, we suggest the following hypothesis. In Central Europe, “new” market-oriented enterprises (mostly small businesses or other enterprises with effective private ownership) became particularly widespread and strong in the early stages of reform, and the economies were open to international trade and contact with the rest of the world. The new enterprises and foreign companies dominated “old” socialist enterprises in setting the overall economic environment. That is, because of the relative strength and prevalence of “new” enterprises and openness to the outside world, a market environment prevailed: enterprises maximize profits subject to hard budget constraints and pressure from competition and owners, prices give accurate signals of relative scarcity, and money is used as the medium of exchange. Even the old socialist enterprises were subjected to this market environment and slowly reformed to conform to new conditions. The prevalence of new enterprises and openness of the economies were due both to initial starting conditions and to positive economic policies that were adopted by reformist governments (e.g., deregulation, adoption of market-oriented commercial codes, and general openness).

However, in the large post-Soviet countries, there were far fewer “new” enterprises and far less openness to the West. Old socialist enterprises dominate, perpetuating the socialist environment of loose budget constraints, poor corporate governance, distorted prices, limited competition, and barter. A market environment was not created, but rather even potentially healthy enterprises are corrupted and held back by the prevailing socialist environment. Even potentially profitable enterprises cannot find customers with money and have trouble allocating resources efficiently in the face of distorted prices. Because of tougher starting conditions (fewer new enterprises and less openness to the outside world) and failure to adopt reform policies, these countries have remained stuck along a low-level equilibrium path, having abandoned Soviet socialism but not yet having achieved market conditions.

In order to succeed, the post-election program must comprehensively address the underlying problems. New market-oriented enterprises should be supported by a substantial reduction in certain tax rates, in particular in the taxation of enterprises that create value and jobs and by means of extensive deregulation. Old state-owned, socialist enterprises should be reformed by changing the environment in which they operate, mostly through measures aimed at hardening budget constraints. The budget sphere must be radically restructured and downsized in order to be consistent with a reduced tax burden and in order to keep budget commitments within realistic limits so arrears do not continue to accrue. Policies should be adopted to open the economy internationally as much as possible to a freer flow of goods, services, currency, and people. All these measures seem to be both of high priority and also within the bounds of what is politically and institutionally feasible. They therefore should be adopted most quickly. A second wave of reforms then could follow, mostly focused on institutional issues: the banking sector, administrative reform, strengthening of corporate governance and contract enforcement, pension reform, privatization, etc.