The Paris summit meeting of the G7 countries in July 1989 invited the Commission of the European Communities to coordinate Western assistance for economic reform in Hungary and Poland. The Commission subsequently convened a meeting of those countries interested in participating in the effort, which became known as the Group of 24. Within the Commission, a corresponding structure was established under the leadership of Directorate General I (External Relations). This became known as the PHARE Task Force (Poland and Hungary: Aid for Economic Reconstruction). The Task Force includes representatives of different services, notably Directorate General II (Economic and Financial Affairs), and encompasses a wide range of activities and substantial expenditures.
Such a programme requires a background of economic analysis. Like all the international organizations that have become involved in the economic transformation of Eastern Europe, the EC had only limited internal staff resources for this analysis. To complement these resources, the Commission convened a group of external advisers, drawn from several Community countries as well as from Hungary and Poland. The work of the advisers was coordinated by CEPR Director Richard Portes and the meetings in Brussels were chaired by Jorge Braga de Macedo, Director of National Economies and representative of DG II in the Task Force.
The article below sets out the main issues that featured in their discussions and highlights some of the findings contained in the set of papers prepared for the Commission. The views expressed in these papers, which will be published in the March 1990 issue of DG II's review, European Economy, are the responsibility of their authors alone.

When Does an Economic Regime Change?
An economic regime is a set of rules and institutions that embody the overall framework for economic activity and determine the behaviour patterns of economic agents. An economic reform sufficiently far-reaching to mark the rejection of bureaucratic socialism and the start of the transition to a new system would be a regime change. But it is not clear what set of measures is enough to define a regime change and bring about the desired change in expectations.
Some advisers to Solidarity originally proposed 1 November 1989 for a `Big Bang' in Poland, rejecting the past `cold turkey', with no opportunity for fallback. The government implemented a smaller bang on 1 January 1990, having reached agreement with the IMF on a macroeconomic stabilization package. Even if this goes far enough to qualify as a regime change, any assessment must judge whether it will prove to be irreversible. The `New Economic Mechanism' introduced in Hungary on 1 January 1968 was supposed to bring an irreversible transformation, but it was not clear until (at least) late 1972 that it had not done so.
Economic reforms in Eastern Europe now are much more fundamental than their predecessors. The Polish package of 1 January was certainly designed to signify a `regime change'. The ground had been prepared in the autumn, notably with significant fiscal consolidation. There was a substantial relative price adjustment for energy (with more to come), but the measures introduced were mainly those of macroeconomic stabilization. The primary objective was to control inflation. Preliminary data indicate that prices initially increased more than expected, but there was nevertheless a clear deceleration, and the authorities maintain they are `on course' to the 1-2% monthly rate intended for the second half of 1990.

It is not yet clear, however, that macroeconomic expectations have adjusted to the extent required for a regime change. Nor is there any transformation yet on the micro side, despite some encouraging signs. In Hungary, a strong current of opinion argues that a decisive regime change is essential in the form of an immediate `action programme' to be implemented in the three months following the elections of 25 March.

The `Anchors' of a Stabilization Programme
Previous stabilizations elsewhere give us a fairly good understanding of the nexus among excess demand, inflation, the real interest rate, the nominal and real exchange rates, indexation, and a possible wage freeze. Pegging the nominal exchange rate is one signal of a change in the policy regime and can strongly influence behaviour. It can bring immediate benefits in terms of lower inflation but is costly if the attempt to reverse inflationary expectations fails. To make the regime change effective and credible requires other anchors and policies.

The main issue is fundamentally political: the costs and benefits of immediate (perhaps severe) austerity or the opposing risks of hyperinflation; political catastrophe might ensue from either. A country in democratic transition will tend to delay adjustment. To counter this tendency, aid should be conditional on stabilization.

The Polish stabilization programme is not `monetarist', if only because of the `heterodox' element of incomes policy implemented through partial indexation of money wages. Without any way of financing deficits except monetization (absent a government bond market), the distinction between fiscal and monetary policies is in any event not clear. The nominal anchors for the programme appear to have been the exchange rate and money wages; while for real variables, policy focused on the real money supply and the real interest rate. Some regarded the initial exchange rate devaluation as excessive, but there has of course already been a substantial real appreciation since 1 January.

The Importance of `Robust Sequencing'
There is by now a conventionally preferred order for economic liberalization in LDCs: the current account of the balance of payments should normally precede the capital account, and removing distortions in goods markets should take priority over factor markets (in particular, capital markets). Liberalizing trade first avoids the danger that lifting capital controls before lowering trade barriers might lead to an inflow of capital and an undesirable appreciation of the real exchange rate, as occurred in some Latin American countries in the 1970s.
There are specific issues that feature in the cases of Poland and Hungary. A key question, for example, is whether privatization can accompany or should follow restoring macroeconomic equilibrium and (then) establishing reasonable relative prices. It is widely agreed that privatization is not a preferred instrument for absorbing household purchasing power, which in any case is not now a problem in Poland. There is also a consensus that the labour market, long characterized by excess demand side-by-side with underemployment of workers in the factories, should be freed as much and as soon as possible.
In Poland, price stabilization (with a `phased liberalization') has been the authorities' top priority. The tools are fiscal consolidation (cutting subsidies to energy and interest rates, a new tax on enterprise assets, and broadening the enterprise tax base by eliminating exemptions); a tough incomes policy (more than intended, with inflation higher than expected and only partial indexation); and a `managed float' of the exchange rate, with the intention to hold the 1 January peg against the dollar until May. The programme assumes no servicing of official external debt this year, but payment of 15% of interest due on medium- and long-term private debt as well as full servicing of trade credits.
Structural change will follow, in a second stage of the reform programme. A new statute on privatization has just been put to parliament and has already provoked considerable debate and lobbying over the future ownership rights of the enterprise's workers. The authorities have begun to break up major monopolies, to allow some restructuring consequent on the financial squeeze hitting firms, and to introduce a competition policy. It is not clear how far all this will go before substantial privatization.
This sequence may not be robust to `overshooting' on the macro side, of which there is already some evidence. The danger is that the incomes policy and enterprise cost-plus pricing will yield excessive real wage cuts and a fall in real demand, with enterprises reducing output and employment beyond the 5-10% expected. This would threaten fiscal imbalance as well as political instability. Fiscal imbalance would in turn undermine the key objective, the control of inflation. Moreover, an excessively tight squeeze, along with delay in adjusting relative prices, would distort the valuation of enterprises to be privatized.
There is considerable debate over sequencing in regard to privatization in Hungary. Some see privatization as an urgent means of eliminating state bureaucratic power once and for all; others stress the negative economic consequences of privatization without proper preconditions, macro and micro, as discussed below.

Fiscal Reform and Budgetary Consolidation
Reform requires not only being able to budget in stable monetary magnitudes, but also transparency: the reduction of hidden subsidies and taxes that are much larger even than in Italy or Portugal. The intricacies and overall `levelling' thrust of the tax-subsidy system are related to `tutelage' of ministries over enterprises. `Levelling' results from relating net tax (or subsidy) directly and more than proportionally to net profits (or losses), so as to eliminate differences among the after-tax results of enterprises. Ministries endeavour to negotiate favourable treatment for the enterprises for which they are responsible. The tutelage system is at the heart of the lack of competition in the bureaucratic economic system, so that attacking it will generate considerable resistance from the nomenklatura. This is a major behavioural and institutional constraint limiting progress towards a market environment.
Analytically, designing fiscal reform and understanding its effects require careful distinction among several important phenomena: tax revenue that arises from inflation; the implicit intermediation tax (or subsidy) arising from unduly wide (or narrow) margins between banks' borrowing and lending rates; the Tanzi effect, whereby real tax revenue is lost in an inflation (and fiscal imbalance thus exacerbated) because taxpayers delay their payments so as to take advantage of the declining value of the currency; and negative real interest rates (which need not be pathological).
In both countries there will be a major effort to broaden the tax base and cut subsidies. There has been substantial tax reform in Hungary over the past few years, and the budget deficit is already down to manageable levels, with a further significant cut expected for 1990. But there are still large subsidies to housing and serious problems with public debt management. The effective tax on trade with CMEA is an important source of budget revenue, which would thus lose from some proposals for CMEA reform.
The high rate of the new Polish tax on enterprise capital has been criticized, partly because it is fixed in nominal terms and hence will be a greater threat to enterprise solvency (and thus to output and employment) if inflation is brought under control. In this sense, the tax is pro-cyclical. New Polish statutes on personal income taxation are in process, but preparations for VAT are going more slowly.

Microeconomic Distortions, Price Liberalization, and Restructuring
It is essential to recognize the extent and long history of price distortions in these economies. Deeply irrational prices and investment allocation go back 40 years. The resulting patterns of production and capital stock are immeasurably further from an `equilibrium' than in any middle-income developing country contemplating liberalization.
Thus freeing prices and unifying the exchange rate will make many product lines, plants and enterprises appear hopelessly uneconomic. Simply bringing energy prices close to world prices, rationalizing the enterprise tax-subsidy system, and establishing a positive (low) real interest rate will do this.
But the new position will still not be anywhere near equilibrium. In the ensuing adjustment, it is important to distinguish temporarily uneconomic from permanently unviable activities, just as between illiquidity and insolvency. Moreover, price distortions are both cause and effect of baroque tax-subsidy systems, and simultaneous efforts to rationalize both will interact.
Thus workers should not be sacked, capital stock scrapped, nor enterprises closed in the short run unless it is very clear that they are unviable in the long run. All this, as well as the inadequacy of accounting systems and data, indicate great difficulties for anyone (including `the market') seeking to value the assets of firms to be privatized.
An independent `receivership agency' could identify the hopeless cases and arrange temporary help for the rest. But this will be difficult to do without endangering the credibility of bankruptcy and perpetuating tutelage and financial indiscipline. Poland is creating a Restructuring Agency for enterprises in financial difficulty and beginning to train `company doctors' to operate for it. The competence and independence of this agency would seem as important as for the central bank in a market economy. Its rules governing permissible temporary financial assistance should be as unambiguous as possible.
The key areas for price adjustment are energy prices in Poland and foreign trade prices in Hungary. Progress will be slow in both cases. Labour market rigidities are a recognized problem, but the new unemployment benefit system in Poland is a major advance. 60,000 registered in January, and the path of this figure over the forthcoming months will be the best index of labour market tension (vacancies have already fallen sharply).

Privatization
Transferring most state industrial and service enterprises into private ownership is an essential element in breaking down tutelage relationships and creating a market environment. But there is no consensus on the appropriate form of privatization in Polish and Hungarian conditions. There are clear advantages to (effective) bank ownership of a substantial part of industrial equity (cf. Germany and Japan). An efficient capital market an allocation process in which capital goes to its most profitable uses does not require that a market for equity shares play a major role in raising or allocating finance for investment.
There are separate arguments for employee share ownership: democratization, incentives, and compensation for real wage cuts. But workers may be ungrateful if they are subsequently sacked or their enterprises prove unviable and are closed especially if they have had to pay for their shares; this may in turn be an undesirable deterrent to such rationalizations.
`Wild' or `spontaneous' privatization has often been carried out by the managers (or nomenklatura) primarily for their own benefit, without even any compensation to the state for the assets. This has apparently occurred frequently in both countries. It appears inefficient, socially dangerous, and distributionally undesirable.
This problem has arisen partly because the current ownership status of `state' firms is confused and controversial in both countries. The extent of self-management and workers' (or nomenklatura) control offered by existing legislation is related to pressures for substantial concessions to employee share ownership in new legislation for privatization.
Market structure and ownership are the key issues. Some argue that the only prerequisite for privatization is to subject state enterprises to market discipline. Privatization should not be delayed any longer than necessary to avoid irreparable serious errors. Yet the danger of such errors is evident. Price distortions and the lack of transparency in tax-subsidy systems make it difficult to value assets; both countries lack appropriate regulatory structures, including not only competition policy but also basic requirements of disclosure, accounting and auditing, contract and bankruptcy law; and it would be much more difficult to break up monopolies after privatization than before. Competition from abroad will be necessary in establishing competitive markets, but it cannot be sufficient.
Ownership is equally difficult. Despite the (outdated) talk of `monetary overhang', even in Hungary the population could not finance large-scale equity purchases. If the government were willing to forgo the revenue from state assets, it could give them away to the population or to the workers in the enterprises. But aside from the distortions created by having to find alternative sources of budgetary finance, the latter alternative raises difficult issues of equity and subsequent management of the firms, while the former might alienate the workers. Either is doubtless preferable to takeover by the nomenklatura; a new law should stop this in Poland.
A final possibility, which seems to be welcomed by some Hungarian opinion, is large-scale purchases by foreigners. The potential advantages of importing management, technology and markets are evident. The danger is that both price distortions and the lack of effective domestic demand for shares might allow for eign investors to acquire domestic assets very cheaply there is indeed already talk of `frontier booms', `gold rushes', `profiteering' and `carpetbagging'.
@SUBHEAD = Trade, Debt and Aid
The Comecon meeting in January was lively but inconclusive. Some called in effect for immediate dissolution of the bilateral trade and payments system, with a switch to payment in convertible currency and the abolition of government-level agreements on quantities to be traded. But even most of those who thought this was the appropriate long-run objective argued for a transition period, whose nature and duration remains to be settled. Liberalization would confront all countries except the USSR with the double problem of financing the deterioration of their terms of trade and of their budgetary position. Meanwhile, industrial production is falling in most CMEA countries, which are therefore unable to meet their commitments to supply their partners.
An East European Payments Union, analogous to the EPU that operated in Western Europe in 1950-9, is a potential mechanism to facilitate the transition. It is open to criticism on several grounds. First, the duplication of industrial capacities across the smaller countries may have made them inappropriate trade partners. On the other hand, much of industrial trade in the West is now intra-industry rather than inter-industry. Second, CMEA faces the special problem of bilateral relations between the smaller countries and the USSR. This arose in a different form for the EPU, where the motivation was in part mutual protection against the `dollar shortage' associated with the large external partner. Third, perpetuation of a `poor man's club' could hinder the urgent process of bringing these countries into the global economic system.
One approach might be to make the analogy with the EPU even closer by creating an EEPU without the USSR. The United States welcomed the EPU, which was from the outset seen as a means of promoting the transition to multilateralism and convertibility.
Assessing the options is difficult, because there is no free-trade reference point for these countries in recent history, and it is not clear that the first decade of the century is particularly relevant. Now that the range of countries intending to establish market economies extends well beyond Hungary and Poland, the transformation of East European trade and payments raises qualitatively new issues. These questions should be addressed urgently in the common framework of contemporary international macroeconomics and the economics of international trade, using the tools of quant- itative comparative economics.
The debt service burdens for both Hungary and Poland are extremely heavy. The composition of the debt differs significantly between them: most of the Polish obligations are to the Paris Club (i.e. government-guaranteed rather than commercial bank debt), while Hungary is mainly indebted to Western commercial banks. As noted above, Poland is not offering significant debt service for 1990 and is seeking debt reduction. The Paris Club will, however, resist that on the grounds that outright reduction of official debt has so far been confined to very poor countries (and hence small amounts), and governments do not wish to set a precedent applicable to middle-income highly indebted countries.
Unlike Poland, Hungary has so far avoided rescheduling, but it is clear that a new government could not implement major reforms without a very substantial reduction of debt service. Both countries are clearly overindebted, and there must be considerable doubt over extending substantial new loans to them (as opposed to grants, foreign direct investment, etc).
Aid must in the first instance be conditional on macroeconomic stabilization, a process which it can indeed greatly assist. Thereafter, the simplest `conditionality' the EC could enforce would be to offer full access to our markets in exchange for meeting the conditions we would expect from all similarly privileged trade partners e.g. current and capital account liberalization, no state aids, adherence to GATT.