Nearly 50 participants attended the first major workshop of the Centre's research project on Economic Transformation in Eastern Europe, which was held in London on 22/23 February. The workshop was organized by David Newbery, Director of the Department of Applied Economics, Cambridge, and a Research Fellow in CEPR's International Trade and Applied Microeconomics programmes, and chaired by CEPR Director Richard Portes. The workshop was funded by grants from the Commission of the European Communities under its ACE programme, the UK Foreign and Commonwealth Office and Department of Trade and Industry. The research presented also benefited from support by the UK Economic and Social Research Council, the French Conseil National de la Recherche Scientifique, and the Commission of the European Communities under its SPES and PHARE programmes.

Fiscal Reform in Hungary and Poland
In the first of two papers on the current tax reform in Hungary, `The Safety Net During Transformation: Hungary', David Newbery (Department of Applied Economics (DAE), Cambridge, and CEPR) considered its implications for income distribution. Hungary currently has a more equal pre-tax income distribution and a less progressive tax system than the UK, but the inequality of income distribution is likely to increase as a result of the reforms. The transition will require redistributive measures and some form of safety net for those displaced and disadvantaged by the reforms. Failure to provide these would not merely be inequitable: it may threaten political cohesion and the future of the reform process if a government committed to reform were voted out of office.
Stephen Pudney (DAE, Cambridge) presented a paper on `Tax Reform in Hungary: Analysis of Household Survey Data'. His study remained at a preliminary stage because of problems encountered in obtaining and processing data. He proposed to use the 1987 and 1989 Budget Surveys to study the effects of the 1988 tax reform on household behaviour, the distributional effects of changes in prices, wages, government expenditure and subsidies, and the changing structure of employment as the private sector expands.
David Winter (University of Bristol) noted that the welfare state plays an important role in Western economies and may play such a role in the reformed East European economies. He suggested that Newbery's comparison with the much larger UK probably overstated the effects of systemic change and warned that well-off groups may co-opt any form of institution provided by a safety net, but he acknowledged that a generous unemployment benefit system might reduce resistance to reforms by making the necessary redundancies less painful. János Gács (Institute for Economics and Market Research, Budapest) pointed out that Hungary's social welfare systems were already in crisis before its transition to market economy, while Tony Atkinson (LSE) suggested that the Hungarian government's ability to influence income distribution may be very limited and warned that targeted benefits may suffer from low take-up rates. István Székely (DAE, Cambridge) noted that many of the benefits would be administered by local authorities, whose finance is presently in a mess and which are controlled for the most part by the opposition parties.Brunon Gorecki (University of Warsaw) and Christophe Starzec (Centre d'Etude des Revenues et des Coûts, Paris) discussed their research on `The Impact of Economic Transition on Consumption Patterns in Poland', in which they used an annual survey of 30,000 households to examine how changes at household level will feed back into consumers' aspirations. Gorecki noted that the published aggregate data are inadequate for assessing effects of changing income distribution, the structure of expenditure and the processes of personal saving and intergenerational transfers (especially of housing). Predictions are difficult because several factors operating simultaneously price liberalization, the withdrawal of subsidies and hyperinflation have substantially reduced both living standards and the real value of personal savings. Food, housing and maintenance are now clearly more expensive than before the price reforms and account for much higher proportions of income.
David Winter warned comparing living pre- and post-reform living standards was difficult, since moving from planned to market prices overstated the measured fall in living standards, while Grzegorz Kolodko (Ministry of Finance, Warsaw) noted that official data might also mislead because they took no account of shortages or self production.

Privatization
Presenting a paper on `Privatization in Czechoslovakia, Hungary, Poland and the USSR', written jointly with Paul Hare, Irena Grosfeld (Conseil National de la Recherche Scientifique and Département et Laboratoire d'Economie Théorique at Appliquée, Paris) noted the widespread agreement that privatization in Eastern Europe is not merely a means of improving economic performance but a fundamental element in the move to a market economy. Although recognizing owners other than the state is a major step, privatization on this scale requires other critical decisions concerning the scope of the programme, the speed of its implementation, the degree of government involvement, legal restrictions on ownership, the extent of restitution to former owners, the extent and form of social protection, and the management of the remaining state sector.
Grosfeld compared the different experiences of privatization in Czechoslovakia, Hungary and Poland and observed that Hungary favours opening up to foreign ownership over internal redistribution, while Poland has a strong self-management lobby. She maintained that sequencing is related to the speed of reform and that privatization requires a parallel development of the financial sector, while the management of the remaining state sector is probably the least well-thought-out issue.
Paul Seabright (Churchill College, Cambridge, and CEPR) noted that the separation of ownership from control may produce agency problems for larger firms, whose owners may be unable to enforce control. Ease of exit may dissuade owners from exercising their votes to influence the running of the company: they may prefer simply to sell their shares, which will not be in the enterprises' long-run interest. A successful transition to a market economy will require the introduction of managerial incentives within firms, regulations to prevent private monopolies, and incentive structures for state agencies. Equity constraints also deserve attention, since rapid privatization will lead to mistakes in valuations and increased inequality in the distribution of assets.
David Begg (Birkbeck College, London, and CEPR) suggested that East European governments' major problem is their lack of credibility and that they must decentralize. The Czechoslovak experience suggests that foreign investors should be allowed to buy privatization issues `quick and cheap', but the valuation of Czechoslovak companies is complicated by their inheritance of large and arbitrary debts, while quick privatization is prevented by the policy of restitution. István Székely suggested that rapid privatization with random valuations may harm the financial system and lead to problems of public debt and hence to inflationary pressures. Valuation errors could also lead to an `insider problem' if the old guard has access to information on bargains. Attila Chikán (Budapest University of Economics) noted that management in Hungary had already enjoyed considerable independence even before the current series of reforms, which it could reasonably expect to retain.

Restructuring, Competitiveness and European Integration
Michael Landesmann and István Székely (DAE, Cambridge) presented some preliminary work in a paper on `Industrial Restructuring and the Reorientation of Trade in Eastern Europe'. They compared the histories of structural change and specialization in Czechoslovak, Hungarian and Polish industries; analysed the short-run characteristics of the current restructuring process; and compared their structures with those of Western Europe, which may represent suitable `target' structures.
Output data illustrate the considerable divergences among these countries' development paths: Czechoslovakia is the most dependent on trade with the rest of the former CMEA, while Hungary and Poland had been reorienting their trade towards the West since the mid-1980s. Hungary had a higher trend growth of exports to the West than Czechoslovakia or Poland, and the three countries' export structures are clearly shaped by Western demand patterns rather than by differences in their reform processes. Landesmann and Székely compared a number of compositional indices of these economies' trade specialization towards the European Community with those of EC member countries. The former CPEs performed better for high-volume than for high-value goods, and Hungary's export structure was the closest of the three to that of the EC members.
Székely also used a distance index of structural difference on value added and employment for 1966 and 1988 to show that Czechoslovakia's industrial structure remained very stable throughout this period, while Hungary's changed considerably: indeed it resembled Austria's more closely than Czechoslovakia's. (No data were available for Poland.) He concluded that Czechoslovakia is likely to have a hard time, since it has little experience of structural change.
In a paper entitled `Costs and Subsidies of Hungarian Exporting Firms', László Halpern (Institute of Economics, Budapest) reported work using micro, company-level data for 1981-9. Hungary's transition from rouble trade began in the mid-1980s, so the impact of the present reforms is smaller than elsewhere. Halpern found that rouble trade was the most profitable sector for domestic companies during 1982-7, since when it has declined sharply, while home sales were second until 1984. Subsidies to exporters had a significant impact on their profitability in the early 1980s, but not since then. Most of the exporting companies in his sample were large firms, whose contribution to exports has recently been increasing.
Gábor Oblath (Institute for Economics and Market Research, Budapest) noted that subsidies had alleviated the negative impact on exports of Hungary's move to competitive pricing in 1980. Liberalization replaced regulation after 1985, and the system of profit equalization between rouble and non-rouble trade had had some strange effects, but these developments gave Hungary a better starting-point for the transition to a market economy than its East European neighbours.

Convertibility and Stabilization
Presenting a paper on `The Transition to Convertibility for Eastern Europe and the USSR', Richard Portes (CEPR and Birkbeck College, London) argued that credibility is critical to the reform process in Eastern Europe. If it is sustainable, convertibility cuts off one major channel of possible government intervention and may thereby provide credibility to macroeconomic stabilization policies. The experience of the LDCs suggests that there are advantages in using a crawling rather than a fixed peg to maintain the real exchange rate. It is important not to misjudge the initial rate too: an excessive initial depreciation in Poland produced inadequate competitive pressure on domestic markets and substantial inflation. Empirical work is needed to assess how rising import prices affect profit and output levels and how much of the recent credit squeeze in Poland and Czechoslovakia should be attributed to devaluation. Portes noted further that Hungary and Poland both adapted rapidly to their roles as exporters, but an ex post empirical analysis of supply responses is required to determine the extent to which their responses were price induced and the mechanics of their price responses for a given convertibility regime.
Jean-Charles Asselain (Université de Bordeaux I) presented a paper on `Convertibility and Economic Transformation', in which he argued that a unified exchange rate is essential to market pricing, and that grants to exporting enterprises and the self-financing of imports are no more defensible than the self-financing of investment as a whole.
Peter Bofinger (Landeszentralbank Stuttgart and CEPR) agreed with Asselain's main points but noted that the experience of Yugoslavia and Poland warned of problems. Both are far from achieving full convertibility and have high inflation, as a result of applying market economy macroeconomic policies to countries with non-market microeconomic structures.
In a paper on `Alternative Paths to Macroeconomic Stability in Czechoslovakia', Wojciech Charemza (University of Leicester) used a disequilibrium model to demonstrate that `full economic reform' i.e. privatization, trade liberalization and the abolition of central planning will give rise to a substantial inflationary impulse in Czechoslovakia, as a result of domestic and external imbalances and Pareto-inefficient market structures. These inflationary pressures may be reduced through a more gradualist approach and export competitiveness improved through subsidies to foreign trade enterprises, internal convertibility, active interest rate policies and demonopolization (with some protection from foreign competition in the short run).
László Halpern pointed out that Czechoslovakia cannot avoid trade with the rest of the former CMEA, and that seeking to do so would reinforce the inflationary pressures it faces.

Future Research
There then followed a roundtable discussion in which topics introduced by different speakers were followed by general contributions from the floor. Discussing industrial restructuring and the reorientation of East European countries' external trade, Dariusz Rosati (Foreign Trade Research Institute, Warsaw) suggested investigating the sluggish response to liberalization of Polish industry, which has suffered no bankruptcies and indeed enjoyed high liquidity and profitability. Research should also address the change in the commodity structure of foreign trade, the impact of stabilization policies, relative price changes arising from liberalization and differences in micro- and macroeconomic responses. The restructuring by enterprises that were previously highly dependent on exports to the Soviet Union will be of particular interest.
Alasdair Smith (University of Sussex and CEPR) suggested that open trade can have anti-competitive effects for economies with concentrated industrial structures. Investment by multinational corporations in Eastern Europe may be significant, and the progress of the European Community's single-market programme indicates the importance of changes in the East for Western Europe, particularly in the agricultural sector. Dalia Marin (Institut für Höhere Studien, Wien, and CEPR) suggested that East European countries may face information barriers to entry in Western markets: if Western consumers are incompletely informed, then potentially vital East European exports may be sold only at a discount, and even then price competition may not suffice. She suggested comparing Eastern Europe's prospects with the experience of the NICs and in particular Korea's development through export-led growth. Riccardo Faini (Università di Brescia and CEPR) questioned whether managers have incentives to increase the quality of work and noted that the evidence from the LDCs suggests industrial concentration can lead to quality improvements for the more competitive industries.
Introducing a discussion of exchange rates and international monetary relations, David Begg argued that East European countries that stand to secure a high future return on investment should borrow now. If the social return is greater than the world rate of interest with some adjustment for risk then maintaining balanced budgets is silly, and monetization should be dealt with directly. Macroeconomic stabilization policies will only be credible if they are accompanied by suitable micro policies, however, and targeting fiscal policy and maintaining a strict ban on subsidies are more credible than arguing for a balanced budget. Borrowing for unemployment benefit might be the best investment East European countries can make, if it will allow them to achieve the restructuring they require with a minimum of social conflict.
Begg argued that devaluation followed by a fixed rate was only credible as a temporary measure, and he proposed a partial-accommodation, crawling peg system instead. Successful monetary policy will require institutions similar to those in the West. East European countries should import Western banks with their skills in credit evaluation, and for the moment they should emphasize exchange rate rather than monetary targets.
Gábor Oblath noted that the East European debt problem is most serious in Hungary, where the issue is overpoliticized and the arguments irrational. Hungary regularly services its huge debt which it has never rescheduled at a cost which in 1990 was greater than the decline in its GDP. Poland's strategy of non-payment is widely viewed as dangerous, but the reasons for this remain unclear.
In a discussion of taxes, benefits and housing markets, John Flemming (Bank of England) expressed concern at the use of trade taxes as transitional adjustment mechanisms and argued that domestic taxes be used instead. Richard Hirschler (World Bank) described the work of the Bank's Socialist Economies Unit, which is engaged in a four-year project on enterprise response in Czechoslovakia, Hungary and Poland. The unit will also study the legal framework of reform in Bulgaria, Czechoslovakia, Hungary, Poland and Yugoslavia; social expenditures and changes in the safety net; and trade reform and the costs of adjustment.
István Székely noted the importance of capital market imperfections to the operation of the housing market, which will have important implications for savings behaviour and holdings of financial assets. Stephen Pudney suggested that the `demographic time-bomb' of the pensions and benefits system, which is well documented in the West, may also present problems for Eastern Europe. He suggested that researchers investigate the possibility of privatizing some part of the benefit system such as pensions.
In a discussion of competition policy, regulation and financial markets, Colin Mayer (City University Business School, London, and CEPR) argued that bankruptcy is a highly inefficient mechanism. He suggested that the merits of restructuring loans and banks' representation on company boards will depend on the role of the central bank, and that Eastern Europe must take care to choose the appropriate Western model (since bankruptcies are treated quite differently under US and German law, for example). The design of rules to regulate financial institutions in particular that relating to take-over law will also be important for restructuring. Stock markets are experiencing liquidity problems in secondary trading, and one might ask how to improve this.
Discussing migration, Riccardo Faini proposed that researchers investigate its microeconomic motivation (since it appears to be more sensitive to wage levels than to wage differentials), the determinants of its duration, and its implications for public finance and training. He also sought to assess the impact of migration on remittance flows and the extent to which capital mobility might substitute for labour mobility. In closing the workshop, Richard Portes noted that migration would probably become a major additional theme of the Centre's programme on the Economic Transformation of Eastern Europe.