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Chapter 17Sequencing, Gradualism,

and the Political Economy of Adjustment

© Pierre-Richard Agénor

The World Bank

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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; 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

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.

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Sequencing Labor Market ReformsEdwards (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 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’”.

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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.

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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 .

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Reform is efficient on aggregate level by inequality,

Y0: national income without reform;

Y1: national income in period 1 with reform;

Y2: national income in period 2 with reform.

Y2

1 + rY1 + > Y0 +

Y0

1 + r(1)

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Reform is efficient for laid off worker if,

L : wages (labor productivity) without reform.

H : with reform wages.

L

1 + rL + > 0 +

H

1 + r(2)

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Setting = 1 / (1 + r) and rearranging (see pp. 629-30), efficiency condition is given by,

(4) ensures efficiency but does not ensure welfare.

1 + +

< L<

H

(4)

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

E: mathematical expectations operator.

: time preference factor.

E[(c1) + (c2)] (1 + ) (c), ~ (5)

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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 -1 -

b{ }+ v(b)

(1 + )v(L) - v(H)

(6)

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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 -1 -

b{ } (1 + )v(L) - v(H)

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 assumed able to borrow funds.

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Figure 17.1Income Distribution and Political Acceptability Regions

Source: Wyplosz (1993, p. 383).

ex ante

Losers' utility

b

ex ante

ex post

Winners' utility

C

AB

0

E[u(c )]1

(1+)u( )- u( )L H

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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? 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.

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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.