The economic transformation of Central and Eastern Europe, Eastern Germany and the republics of the former Soviet Union has proceeded at a tremendous pace over the past two-and-a-half years. The initial wave of euphoria that followed the opening of the iron curtain gave way to pessimism once the scale of the economic reconstruction required came to be recognized. The prospects and choices now facing the transforming economies formed the focus of a CEPR conference on `The Economic Consequences of the East', held on 20/21 March in Frankfurt am Main. The conference was organized by Peter Bofinger, Professor of Economics at the Universität Würzburg and Research Economist at the Landeszentralbank in Baden-Württemberg, and Rudiger Dornbusch, Ford International Professor of Economics at Massachusetts Institute of Technology, both Research Fellows in CEPR's International Macroeconomics programme. CEPR gratefully acknowledges the generous hospitality of the Deutsche Bundesbank and the financial assistance provided by the UK Department of Trade and Industry for this conference, which formed part of CEPR's research programme on Economic Transformation in Eastern Europe. Some of the research presented was undertaken under the auspices of grants to CEPR from the Commission of the European Communities under its SPES and ACE programmes and the Ford Foundation. A volume of papers presented at the conference is now available from CEPR (see box).
The Outlook for the Main Regions

In the first paper, `Eastern Europe in the Year 2000: Hopes and Fears', John Flemming (European Bank for Reconstruction and Development) discussed two bench-mark cases. First, a `success scenario', with 7% real annual growth and incomes doubling in ten years, may be attained if the West is willing to lend to the region, West European markets exhibit growth and openness, and the `peace dividend' is prudently disbursed. Domestic economic policies should follow the pattern of West German post-war reconstruction, with initially low consumption levels to allow the privatization and restructuring of the capital stock to proceed with stringent application of bankruptcy laws where necessary. Second, a `stagnation scenario' may result if shifting political coalitions with neither a common programme nor the support of a competent civil service induce uncertainty that inhibits investment, or if regulation and self-regulation prove inadequate to limit distortions in the financial sector.

Rudiger Dornbusch (MIT and CEPR) warned that populism may lead to extreme monetary instability as a result of rising budget deficits; East European governments can expect foreign investment only if they allow investors to retain full control of their capital. Dariusz K Rosati (UN Economic Commission for Europe, Geneva, and Foreign Trade Research Institute, Warsaw) noted that promises made early in the transition had created unrealistic expectations and stressed that policy-makers should focus not only on macroeconomic policies but also on changes in institutional structure. Hans-Werner Sinn (Universität München) pointed out that future generations will reap the benefits of the transition; political resistance from the present generation, which has to bear its social costs, is only to be expected.

In his paper, `Real Adjustment in the Transformation Process: Risk Factors in East Germany', Horst Siebert (Institut für Weltwirtschaft, Kiel) focused on the policy responses required by risk factors in Eastern Germany's transformation. He showed that catching up with West Germany in ten years would require annual private and public investments of DM 80 and DM 40 billion respectively (compared with their 1991 levels of DM 50 and DM 22.4 billion), together with the removal of key bottlenecks: continuing uncertainty over property rights and inadequate infrastructure in terms of administration, transport and telecommunications. Siebert recommended discontinuing the Treuhand's role in privatization by the end of 1994 by closing down firms for which it has not then found a buyer. Explicit structural policies or industrial targeting would be counterproductive since they would forgo competition as an exploratory device. Finally, while noting the risk that continued transfers to the East may encourage the development of a `Mezzogiorno' syndrome, Siebert maintained that a consolidation strategy to reduce such expenditure could avert this danger and allow the `new frontier' to stimulate the growth of both Germanies and of the world economy.
Michael Burda (INSEAD and CEPR) stressed the benefits of large public investment in Eastern German infrastructure; in particular, the financing of specific labour market polices may help to keep workers in touch with the market and prevent a loss of skills, although there is a clear danger of westward migration by the better skilled. Klaus Masuch (Deutsche Bundesbank) argued that the share of public relative to private investment will be far too large, since the high wage level permits investment only in `high-tech' industries. Otmar Issing (Deutsche Bundesbank) pointed out that Eastern Germany's transition will be difficult because the large differences in incomes, which were accepted in the West after World War II, are not acceptable now.

In his paper, `Miracle Prescriptions Postwar Reconstruction and Transition in the 1990s', Holger Wolf (MIT) noted that West European reconstruction in the 1950s had been supported by several beneficial factors not available to the East today. Market institutions were alive and well, so previous trade contracts could be revived; the region still produced almost half of world output, so much of the demand stimulus from national reconstruction policies fell to other West European economies. Nevertheless, Wolf drew three lessons for Eastern Europe today: long-term real wage growth required short-term sacrifice in capital-constrained economies; low corporate tax rates and real interest rates significantly increased investment ratios; and neither state- nor market-led reconstruction efforts proved wholly satisfactory. While the UK model was successful in achieving a rapid return to full capacity utilization, it failed to promote sustained growth and prevented structural change; the (West) German model risked becoming stuck in a low-production equilibrium.

Rudolf Richter (Universität des Saarlandes, Saarbrücken) pointed to the lack of clearly defined property rights and the need to privatize state property as key difficulties facing Eastern Europe today that had not characterized the post-war reconstruction. Consensus among social groups had also been much easier to achieve in 1948 than now, when there are major political pressures for social transfers.

In his paper, `Problems of Post-CMEA Trade and Payments', Dariusz K Rosati assessed the implications of the successful functioning of the European Payments Union (EPU) in the 1950s for Eastern Europe today. The two cases were very different: the EPU members were all long-established market economies that required no fundamental restructuring once wartime distortions had been corrected; the EPU's main task had been to create the conditions for convertibility by promoting intra-group trade, while Eastern Europe must concentrate on the comprehensive restructuring of its national economies; and trade within Eastern Europe now is a much smaller proportion of the world total than trade within Western Europe was in the 1950s. Rosati used a gravity model to show that the observed shrinkage of the region's intra-trade is largely a `natural' outcome of exogenous developments: domestic recession and the dismantling of the CMEA preferential trade system. Since this trade is not sustainable at the levels observed in 1989-90, and trade with Western Europe is expected to increase, he favoured financial assistance to promote structural adjustment over any multilateral payments arrangement restricted to Eastern Europe.

Carl Hamilton (Institute for International Economic Studies, Stockholm, and CEPR) agreed that Eastern Europe had no need for a payments union, since there are no restrictions on intra-trade of the type the post-war EPU was designed to overcome. Peter Bofinger suggested that a payments union may be more appropriate for the former republics of the Soviet Union, which have much higher shares of trade in inconvertible currencies than Czechoslovakia, Hungary or Poland. Rosati replied that EPU had been a success, but it was impossible to determine whether the direct introduction of current account convertibility would have brought better results.

Presenting their paper, `Post-Soviet Issues: Stabilization, Trade and Money', Domenico Mario Nuti and Jean Pisani-Ferry (Commission of the European Communities) reviewed the Russian government's reform programmes of January and April 1992, with which it has unilaterally embarked on reform and left the other republics either to follow its lead or close their borders. These are much more dependent than Russia on the export of `soft' goods to the rouble zone, while the traditional prices of tradable goods entail implicit transfers to the other republics of some 5-10% of Russian GDP. This power imbalance is reflected above all in the continued use of the rouble throughout the region, although it has been declared the currency of Russia. Although this may seriously jeopardize Russia's macroeconomic stabilization programmes, its government will not seriously consider introducing a payments union based on separate republican currencies, since the other republics might then take it for granted that they could avert the risk of trade collapse. In order to re-establish monetary control over the whole rouble zone, Nuti and Pisani-Ferry called for the implementation of a simple rule: distribution of cash and credit in accordance with republics' shares of overall national income.

Andrei Vernikov (Institute for International Economic and Political Studies, Moscow) stressed the importance of a convertible Russian rouble following the break-up of the Soviet Union. The current multiple exchange rate system was to be replaced by a dual rate system in April, and by a single rate as soon as practicable. He maintained that theories based on purchasing power parity cannot determine this equilibrium exchange rate and proposed floating the rouble for a specified period instead.

The Role of Economic Policies

In his paper, `Incomes Policy and Economic Stabilisation: The Polish Case', written with Olivier Blanchard, Richard Layard (LSE) analysed the sources of Poland's inflation since January 1990 and assessed the contribution of incomes policy to its stabilization programme. Price shocks played a major role in early 1990, when increases in nominal interest rates and imputed depreciation had major effects on the price level, and the reduction of labour productivity further contributed to the increase of prices over wages. Wage shocks dominated in the second half of 1990, however, as wages increased more than prices. Layard concluded that the government could have improved its incomes policy by abolishing the `credit accumulation', which had allowed firms to increase wages above the norm in cases where they had been lower than prescribed in the past. Lower price indexation and longer periods between inflation adjustments would also have reduced inflation.

Simon Commander (World Bank) stressed the need for incomes policies in former centrally planned economies to restrain the inflationary pressures that arise when state-owned firms decapitalize themselves through large wage increases. Richard Portes noted that the wage tax was not designed for periods of high inflation: its introduction would lead to serious distortions.

In his paper, `The Experience with Monetary Policy in an Environment with Strong Microeconomic Distortions', Peter Bofinger questioned the efficiency of monetary policy in the transitional economies. He showed that microeconomic distortions can have several negative effects on the transmission mechanism of monetary policy. A policy of monetary austerity may therefore crowd out profitable enterprises or at least lead to random selection among profitable and unprofitable enterprises. He found no clear evidence of a non-accommodating monetary policy stance in the Czechoslovak or Polish stabilization packages, since real interest rates remained negative and the fall in real credit was mainly attributable to the depreciation of outstanding liabilities under high inflation. He recommended transferring all existing enterprise debts to a government agency that would swap them for government bonds. Agencies following the Treuhand model should then be established to monitor state-owned enterprises and banks in order to prevent the re-emergence of such bad debts.

Alexander Swoboda (Institut Universitaire des Hautes Etudes Internationales, Genève) disputed Bofinger's assumption that inter-enterprise credits represent misallocation of resources and argued that macroeconomic stabilization should have priority over financial market reform for political reasons. Werner Riecke (National Bank of Hungary) reported that much of Hungary's banking system is now privately owned, so structural problems are small. He also queried the proposed clearing of inter-enterprise credits; in Hungary such clearing could deal with only 2% of the total of these credits. John Tatom (Federal Reserve Bank of St Louis) argued that business credits are a poor indicator of the tightness of monetary policy, and he attributed the industrial decline to the collapse of intra-CMEA trade.

Richard Portes (CEPR and Birkbeck College, London) then presented his paper, `The Impact of Eastern Europe on the European Community', which emphasized the importance of free access of Central and East European exports to Community markets in the relationship between the two regions. Portes criticized the recent Association Agreements for maintaining restrictions on `sensitive' products (up to 35-45% of these countries' exports into the Community) and for including anti-dumping and safeguard provisions that can only undermine the confidence of potential investors in EC-oriented production. To improve coordination of aid efforts, Portes proposed establishing a single office in each of these countries and in Russia with the tasks of identifying and eliminating duplication of efforts and conflicting signals to recipients, helping to reach a policy framework agreed between donors and recipients, and monitoring execution and performance.

André Sapir (Commission of the European Communities, Université Libre de Bruxelles and CEPR) suggested that the European Community's future cooperation with Eastern Europe should follow its present pattern of cooperation with EFTA. Carl Hamilton maintained that EC-EFTA cooperation focuses principally on economic concerns, but political integration may be more important to Eastern Europe. Joan Pearce (Commission of the European Communities) suggested using the existing coordination instruments of the G-24 in the integration process.

Presenting his paper, `Financial Markets and Public Finance in the Transformation Process', Vito Tanzi (IMF) showed that Central and East European financial markets retain many imperfections, despite recent reforms. The newly created banking systems can neither mobilize savings nor channel them towards their most productive uses; nor are they truly independent. They therefore continue to face both governments and enterprises with a form of `soft budget constraint'. Nationalization of commercial banks' bad loans could give them a solid capital basis, which would allow them to play a major role in enterprise restructuring. Reform of public finances will have to include: setting up a tax administration virtually from scratch; the reform of the tax system, which should be simple and easily administered; the establishment of budgetary institutions; the reform of public expenditure; and the reform of social security systems.

Alfred Steinherr (European Investment Bank) suggested redeploying the former staff of the central planning offices to set up the new tax administrations. Hans-Werner Sinn emphasized that the market economy is founded on institutions that include not only organizations but also social norms and civil contracts that are too costly to develop in an evolutionary process: such sophisticated institutions should therefore be imported from the West.

Gérard Roland (Université Libre de Bruxelles and CEPR) presented a paper on `Issues in the Political Economy of Transition', which applied conventional political economy analysis to the specific conditions of economic transition. He showed that democracies are not necessarily less committed than dictatorships to the implementation of reform packages, and paralysis in political decision-making can be avoided if governments have sufficient agenda-setting power. There is a risk specific to the transition of `status-quo bias': reforms that are clearly favourable to the majority ex post may be difficult to adopt ex ante. This can be overcome, however, by adequate `sequencing tactics': introducing first reforms that will win a majority, and implementing those that will hurt a greater number of people later. Roland concluded by recommending a four-phase sequencing for economic transition: democratization; privatization; liberalization; and restructuring.

Bruno Frey (Universität Zürich) argued that authoritarian regimes cannot solve the political problems of Eastern Europe; the world's richest countries are all democracies, and wealth creation in Eastern Europe can only be achieved by establishing private property and efficient administration, which are only possible in a liberal democratic system. Richard Portes mentioned that the conditions for high economic growth in Chile and South Korea had been established by very strong regimes. Peter Bofinger closed the discussion by suggesting the transfer of some public tasks to newly created independent institutions (such as Germany's Treuhandanstalt), which might be better able than elected governments to withstand political pressures.