Eastern Europe
Declining output

Three years into the economic transition of Central and Eastern Europe, restrictive macroeconomic policies and the CMEA trade shock feature in demand-side explanations of the unexpected strength of the output decline, while supply-side explanations emphasize restructuring, strong increases of input prices and a `credit crunch'. In Discussion Paper No. 784, Research Fellow Peter Bofinger assesses economic developments in the former CSFR, Hungary and Poland, which have displayed very similar real economic performance since 1990, despite their completely different demand-side shocks and transition strategies. He also identifies their major common supply-side shocks to provide a classical explanation of the output drop. A rudimentary aggregate supply/demand analysis of the command economy indicates that the old regimes were characterized by a dual disequilibrium on the labour and goods markets. Frictionless transition to the market will inevitably entail a (temporary) reduction in the natural level of output, but real wages are not completely flexible, so this is spread over time.

Bofinger reconsiders the role of monetary policy in transforming economies and shows that the popular `credit-in-advance' approach is compatible with the `classical' view advanced here. More importantly, the absence of efficient bankruptcy laws implies that much of the credit supply is endogenous. Over-ambitious money supply targets therefore constrain the supply of credit to the private sector, which impairs the necessary restructuring of the real economy. He also shows that the `Soviet trade shock' was accompanied by a strong positive trade shock, at least for Hungary and Poland, whose exports to the West more than compensated the fall in sales to the East. Finally, in Finland, which is often taken as a yardstick to assess the impact of this trade shock in contrast with the transforming economies, real wages were on a rising trend, so exports to the Soviet Union and also to the OECD countries both fell in 1991.

The Output Decline in Central and Eastern Europe: A Classical Explanation
Peter Bofinger

Discussion Paper No. 784, May 1993 (IM)