Much of the economic debate around transition policies in Eastern Europe centres around the speed and sequencing of reforms. In Discussion Paper No. 860, Research Fellows Mathias Dewatripont and Gérard Roland argue that gradualist reform packages are generally easier to design than those based on the `big bang' approach ex ante and can therefore start sooner. Their careful sequencing may also build constituencies for further reform and reduce their reversibility ex post. They develop a model of transition in which the government chooses the speed and sequencing of reforms. Since these involve large aggregate and individual uncertainty, a negative aggregate outcome will induce pressures for their reversal; while the high reversal costs of a `big bang' may be advantageous once reform is under way, they may also make such an approach politically infeasible ex ante. Gradualism enables reforms to start more easily by providing the additional option of early reversal at lower cost, after a partial resolution of uncertainty.

Dewatripont and Roland argue that the strong complementarity of reforms may give a further advantage to gradualism, since it allows the creation of constituencies for further reform. If partial reforms are unstable, there is a choice at each stage between accepting the next reforms or reversing the previous ones. If the initial reforms prove successful, correct sequencing can then generate support for less popular measures during the transition. Beginning with the more painful reforms will undermine popular support for reforms, in contrast, which may lead to their unnecessary reversal. Dewatripont and Roland acknowledge that the option of early reversal under gradualism could deter investment leading in turn lead to early reversal, but the option value of waiting to invest will always be high during transition. Gradualism that generates a greater investment response before uncertainty is resolved may reduce reforms' ex post reversibility. The authors conclude by suggesting that this may account for Hungary's comparative advantage in attracting foreign direct investment into Eastern Europe.

The Design of Reform Packages Under Uncertainty
Mathias Dewatripont and Gérard Roland

Discussion Paper No. 860, November 1993 (IM)