Price decontrol has not led to efficient resource allocation in Eastern Europe since the reforms required have proved surprisingly difficult to introduce. Privatization has stalled, and the collapse of output and hence profits in the state-owned enterprises (SOEs) in the mean time has dramatically eroded the tax base, while the introduction of efficient tax systems is taking longer than initially expected Governments must now cut expenditure or risk reigniting inflation through the inflation tax, and fears of massive unemployment are now a major deterrent to privatization. Enterprise reform is now emerging as Eastern Europe's core economic problem, but it is proving impossible to attain efficiency in enterprises whose current and future ownership are in limbo.

In Discussion Paper No. 738, Research Fellow Sweder van Wijnbergen focuses on Poland, noting that ownership of SOEs remains ineffective and control diffuse even two years after the breakdown of central authority. Incumbent managers and workers alike have every incentive to decapitalize their enterprises and increase debt through excessive wage claims before the announced ownership changes are implemented. This debt overhang prevents simple privatization by auction, since outsiders cannot know the cause of a firm's distress, so restructuring must now take place <MI>before<D> privatization, even though this is better left to new private owners. Most of the new commercial banks are also insolvent, since claims on SOEs dominate their asset portfolios, so successful restructuring must address enterprise debt and bank recapitalization jointly. Simply applying Western bankruptcy procedures on the basis of current data on enterprise profitability would introduce a destructive bias towards liquidation and delay, while introducing Western-style unemployment insurance would lower its social costs but almost certainly also contribute to its indefinite extension.

Van Wijnbergen concludes by stressing the need to incorporate all the incentive problems specific to Easter Europe into the design of policies, which in some cases will produce advice that is novel and as yet untried. The pay-off to imaginative policy design and explicit attention to the political constraints and incentive problems that are specific to the region are difficult to overestimate.

Enterprise Reform in Eastern Europe
Sweder van Wijnbergen

Discussion Paper No. 738, November 1992 (AM)