In the past year the prevailing mood among East Europeans and in the Western analytical and policy communities has shifted from optimism and enthusiasm for reform to pessimism. In Discussion Paper No. 559, also available as the Introduction to `The Path of Reform in Central and Eastern Europe', Special Edition No. 2 of European Economy, CEPR Director Richard Portes discusses the sources of this pessimism: exogenous shocks to demand and supply, adjustment costs, misjudged sequencing and other policy errors, relating in particular to their initial macroeconomic stabilization programmes.

Despite the well-known shocks the world economic slow-down, the collapse of intra-CMEA trade, the shift of trade to `world market prices', and East Germany's `open border shock' the regime changes in Eastern Europe now appear irreversible. The central feature of its economic liberalization is a drastic change in relative prices to bring about major restructuring. The adjustment costs have been exacerbated, however, by deep-rooted problems in capital and labour markets. Continued uncertainty about legal and financial infrastructures, pressures for restitution, and restrictions on market access to the European Community have all depressed investment, as indeed have delays in the privatization and commercialization of state-owned enterprises and the debt overhang in Bulgaria, Hungary and Poland.

Portes notes that the labour market policies adopted have not encouraged the mobility such restructuring requires, while the expectations and behaviour of firms are even harder to change than those of households. Reforming economies with limited administrative capacity should rationalize the allocation of productive resources before worrying about the pricing and distribution of consumer goods. They should concentrate initially on the necessary changes in corporate control, the financial environment of state firms and the banking system rather than the `monetary overhang' and household behaviour.

While exchange rate adjustment in Czechoslovakia and Poland may be inevitable, the credibility of macroeconomic policies may now be impaired by the mere appearance that such a move is an ad hoc accommodation. This may be just as damaging as the specification of a rule that the authorities cannot subsequently follow. Such signs of inexperience in macroeconomic policy should not be surprising: the domestic authorities have no practice of manipulating these instruments, while the international institutions failed to appreciate the extent to which the former environment differed from that of even the most distorted countries of Latin America.

Portes concludes that if the unresolved issues of corporate control, financial restructuring, convertibility and exchange rate policy are tackled quickly and sensibly, the prevailing pessimism may prove exaggerated; but the final outcome will depend on the chosen path of reform and the availability of Western assistance.

The Path of Reform in Central and Eastern Europe: an Introduction
Richard Portes

Discussion Paper No. 559, May 1991 (IM/IT)