Tag: Transition

The Political Economy of the Latvian State Since 1991: Some Reflections on the Role of External Anchors

Posted on February 2, 2015 | Policy Brief

This brief discusses the role of external anchors or goals such as WTO accession, NATO and EU accession in Latvia’s development strategy since 1991. On the one hand the external goals ‘depoliticised’ many potentially contentious areas of Latvian life. On the other hand, some developments would not have happened or would not have happened as fast without the constraints imposed by the external goals. For example liberalisation of the citizenship laws was prompted by NATO accession and the balance was tipped when the rejection of Latvia from fast-track EU accession talks in December 1997 led Latvia to abandon its quota or ‘windows’ naturalisation system. Most recently, Eurozone accession was an externally defined exit strategy from the austerity episode induced by the economic and financial crisis. Today there are no big external goals left to guide policy making. Home grown problems such as inequality require home grown solutions. But even now an external dependency persists. For example a long needed reform of the financing model of higher education has had to wait for a World Bank report published in September 2014 for action to be taken.

On January 1^st, 2015 Latvia assumed the Presidency of the European Union. This milestone represents a certain level of maturity of the Latvian state and offers an opportunity for reflection on some aspects of how politics and political economy have evolved in Latvia between 1991 and today.

After Latvia regained independence in 1991, it faced (at least) two political economy challenges: one was to disentangle the economy from the Soviet system in which it had been deeply integrated, and the second, perhaps more difficult challenge, was to create an independent nation state. At a formal level, the solution to the latter challenge appeared straightforward – assume continuity of the Latvian state. Effectively this meant reinstating the pre-war constitution, which was indeed done for the most part. Symbolically this continuity was signalled by, for example, calling the first post-Soviet parliamentary elections held in June 1993 the elections for the 5^th Saeima (parliament). The elections for the 4^th Saeima had taken place more than 60 years earlier in October 1931.

At a practical level the challenges were more complex – Latvia had had no practical experience of statehood for nearly fifty years and mistakes were made. For example, Latvia initially diplomatically recognised Taiwan rather than the Peoples Republic of China.

There was a presumption that newly independent Latvia should become a market economy but little consensus on how this should be achieved. This is in contrast to Estonia where a group of ‘young market economy Turks’ were able to implement a kind of zero option i.e. zero tariffs, fast privatisation, etc. In Latvia there were strong protectionist sentiments and the initial privatisation was a muddled process.

Advice and advisers were abundant in post-independence Latvia. In the early 1990s, Latvia was awash with international advisers: the IMF and the World Bank were both present, the Germans were advising on a constitution for the Bank of Latvia, the British were active in public administration reform, the Danish advised on research and higher education and so on. Advice was often conflicting with different advisers promoting their own visions of structures as models that Latvia should adopt e.g. on legal and education systems. Today, we see something akin to this in the Eastern Partnership countries such as Moldova and Ukraine.

There was a general sense of the desirability of a ‘return to Europe’ but no plan or strategy. Nevertheless, even without a conscious plan a strategy emerged – namely a strategy of external anchors.

The external goals or anchors that emerged included the following:

World Trade Organisation, 1998
NATO, 29 March 2004
European Union, 1 May 2004
Eurozone, 1 January 2014

The most important effect of the external anchors was that they ‘depoliticised’ many potentially contentious areas of Latvian life. This has been particularly important given the fragmentation that has historically dominated Latvian politics. Thus, in the interwar period, no less than 32 different political parties were represented in the Saeima. In the early post-Soviet parliaments, similar tendencies were observed with newly created parties being the winners in terms of the number of seats in the first four elections. The election of 2006 was the first in which the previously largest party returned as the largest party. Between the first post-Soviet election in 1993 and the 2014 election, there have been no less than 17 governments which mostly have been uneasy coalitions of 3 or 4 partners with divergent views and interests. In this context the benefit of external anchors is self-evident.

The external anchors each contributed in different ways: WTO accession contributed to modify the protectionist sentiments that were rife in the early years of independence. Rather curiously, Estonia, which adopted a radical free trade policy right from the first days of independence, had more difficulties in achieving their WTO membership than ‘protectionist’ Latvia. Estonia was obliged to implement additional economic regulations in order to conform to the rules of the WTO and the EU (to which it was committed to join as its WTO application proceeded), and as a consequence, Estonian WTO accession was delayed to 1999. The WTO accession process also gave Latvia’s fledgling Foreign Ministry invaluable experience of multi-lateral negotiation.

Apart from the obvious security benefit, NATO membership was conditional on the creation of the Latvian anti-corruption Bureau (KNAB) and on the liberalisation of citizenship legislation, the latter because NATO was concerned about the prospect of a member state with a large number of non-citizen residents.

EU accession represents the biggest and most significant anchor. The requirement of candidate countries to accept the EU acquis communautaire took huge swathes of economic and social legislation out of the political arena. While the economic criteria for accession presented few difficulties of principle for Latvia – most people were in favour of a market economy – the requirement of respect for and protection of minorities presented problems for many Latvian politicians and liberalisation of the citizenship law was resisted until after 1997 when the rejection of Latvia from fast-track EU accession talks in December 1997 prompted a rethinking of Latvia’s intransigent position on the quota or ‘windows system’.

It is hard to over-estimate the impact of EU accession on Latvia. What would Latvia be like today if it were not a member state of the EU? There are sufficient tendencies even now in Latvia to suggest we would observe something like a tax-haven, off-shore economy, probably with weak democratic institutions. EU accession has saved the Latvian people from something like such a fate.

Even later in Latvia’s largely self-inflicted financial and economic crisis of 2008-10 it was the ‘Holy Grail’ of accession to the Eurozone that politically anchored Latvia’s famous austerity programme.

What of today? The ‘big’ external anchors are used up, and Latvia today:

Is the fourth poorest country in the EU with GDP per capita in 2013 at 67% of the EU average (only Croatia, Romania and Bulgaria are poorer);
Is a particularly unequal society – Latvia has some of the worst poverty and inequality indicators in the EU;
Has a shadow economy at 23.8% of GDP (data on 2013; Putniņš and Sauka (2014)); and
Has an internationally uncompetitive higher education system.

These and other problematic aspects of Latvian life and society are home grown and it is hard to imagine external anchors that can improve poverty or inequality, that can reduce the size of the shadow economy, or which can improve the quality of the Latvian higher education system.

Nevertheless, Latvian policy makers seem to be addicted to the external anchor concept and often find difficult to progress without it. The recent experience of reform of the financing of higher education illustrates. Latvia has historically had a funding mechanism for universities and other higher education institutions based entirely on student numbers. The lack of a link between funding and quality has resulted in a Latvian higher education system that is strong on enrolment but low on quality e.g. as measured by peer-reviewed publications. At some level this has been understood and there has been much talk of reform. Although various reports and evaluations have been published, there has been little progress on concrete reform until the Ministry of Education commissioned the World Bank in December 2013 to produce a report on funding models for Latvia. The final report was delivered in September 2014 and action has now been taken to adopt the World Bank recommended three-pillar model where the funding criteria will now include performance and innovation.

Of course, the new model will not solve all the problems of Latvian higher education – far from it – but it illustrates the pervasive nature of policy makers seeming dependency on external anchors.

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References

Putniņš, Tālis & Arnis Sauka (2014). “Shadow Economy Index for the Baltic Countries. 2009-2013,” The Centre for Sustainable Business at SSE Riga, May 2014.

Managed Competition in Health Insurance Systems in Central and Eastern Europe

Posted on October 28, 2013 | Policy Brief

This policy brief summarizes common trends in the development of health care systems in the Czech Republic, Slovakia, and Russia in late 1990s–early 2000s. These countries focused on regulated competition between multiple health insurance companies. However, excessive regulation led to various deficiencies of the model. In particular, improvements in such quality indicators of the three health care systems as infant and under-five mortality are unrelated to the presence of multiple insurers or insurer competition.

A number of transition countries in Central and Eastern Europe and the former Soviet Union introduced health care systems with compulsory enrollment, obligatory insurance contributions unrelated to need and coverage according to a specified package of medical services. This so-called social health insurance (SHI) model (Culyer, 2005) is regarded as a means for achieving universal coverage, stable financial revenues, and consumer equity (Balabanova et al. 2012; Gordeev et al., 2011; Zweifel and Breyer, 2006; Preker et al., 2002). While most transition countries chose to only have a single health insurance provider on the market, the Czech Republic, Slovakia, and Russia allowed competitive (and often private) insurers in the new system. However, the evidence from the three countries shows excessive regulation of health insurers and limited instruments for insurer competition within indebted post-reform health care systems (Naigovzina and Filatov, 2010; Besstremyannaya, 2009; Medved et al., 2005). Consequently, the three countries may have been over-enthusiastic in putting large emphasis on market forces in the reorganization of health care systems in economies with a legacy of central planning (Diamond, 2002).

This brief addresses the results of Besstremyannaya (2010), which assesses the impact of private health insurance companies on the quality of health care system. While various performance measures reflect different goals of national and regional health care systems (Joumard et al., 2010; Propper and Wilson, 2006; OECD, 2004; WHO, 2000), aggregate health outcomes directly related to the quality of health care are commonly infant and under-five mortality (Lawson et al., 2012; Gottret and Schieber, 2006; Wagstaff and Claeson, 2004; Filmer and Pritchett, 1999). Consequently, Besstremyannaya’s (2010) analysis regards mortality indicators as variables reflecting the overall quality of health care system.

The estimations employ data on Russian regions in 2000-2006. The results indicate that regions with only private health insurers have lower infant and under-five mortality. However, given the low degree of competition on the social health insurance market in Russia, we hypothesize that this effect is mostly driven by positive institutional reforms in those regions. Indeed, incorporating the effect of institutional financial environment, we find that the impact of private health insurers becomes insignificant.

Development of a Social Health Insurance Model in the Czech Republic, Slovakia, and Russia

At the beginning of their economic transition, the Czech Republic, Slovakia, and Russia established a model for universal coverage of citizens by mandatory health insurance (Balabanova et al., 2012; Medved et al., 2005; Sheiman, 1991). The revenues of the new SHI system came from a special payroll tax and from government payments for health care provision to the non-working population. The main reason for combining certain features of taxation-based and insurance-based systems was the desire to establish mandatory health insurance as a reliable source of financing in an environment with unstable budgetary revenues (Lawson and Nemec, 2003; Preker et al., 2002; Sheiman, 1994). The insurance systems instituted in the three transition countries correspond to the major SHI principles implemented in Western Europe: contributions by beneficiaries according to their ability to pay; transparency in the flow of funds; and free access to care based on clinical need (Jacobs and Goddard, 2002).

The Czech Republic, Slovakia, and Russia placed emphasis on regulated competition, decreeing that SHI should be offered by multiple private insurance companies with a free choice of the insurer by consumers. Managers of private insurance companies were assumed to perform better than government executives (Lawson and Nemec, 2003; Sinuraya, 2000; Curtis et al., 1995), so an intermediary role for private insurance companies was seen as a key instrument for introducing market incentives and improving the quality of the health care system (Sheiman, 1991).

However, the activity of health insurance companies in the three countries was heavily regulated, since the content of benefit packages, size of subscriber contributions, and the methods of provider reimbursement were decided by government, and tariffs for health care were frequently revised (Lawson et al., 2012; Rokosova et al., 2005; Zaborovskaya et al., 2005; Praznovcova et al., 2003; Hussey and Anderson, 2003). In particular, Russian health care authorities enforced rigid assignments of areas, whose residents were to be served by a particular health insurance company (Twigg, 1999) and imposed informal agreements with health insurance companies to finance providers regardless of the quality and quantity of the health care (Blam and Kovalev, 2006). As a result, the three countries experienced an initial emergence of a large number of health insurance companies, followed by mergers between them, resulting in high market concentration (Sergeeva, 2006; Zaborovskaya et al., 2005; Medved et al., 2005).

In Russia, the Health Insurance Law (1991) specified that until private insurers appeared in a region, the regional SHI fund or its branches could play the role of insurance companies. Therefore, several types of SHI systems emerged in Russian regions in the 1990s and early 2000s: the regional SHI fund might be the only agent on the SHI market; the regional SHI fund might have branches, acting as insurance companies; SHI might be offered exclusively by private insurance companies; or SHI might be offered by both private insurance companies and branches of the regional SHI fund (Figure 1). The variety of SHI systems reflects the fact that many regions opposed market entry by private insurance companies (Twigg, 1999). Indeed, the boards of directors of regional SHI funds usually included regional government officials (Tompson, 2007; Tragakes and Lessof, 2003) who were reluctant to reduce government control over SHI financing sources (Blam and Kovalev, 2006; Twigg, 2001). The controversy with health insurance legislation created a substantial confusion at the regional and the municipal level (Danishevski et al., 2006).

Figure 1. Health insurance agents in Russia in 2000-2006, (number of regions)

This context suggests that Russian regions provide an interesting study field to address the impact of private health insurance companies on the quality of health care system. In particular, the wide variety of SHI systems across Russian regions, as well as the gradual introduction of the health insurance model in Russia provide a sufficient degree of variation in practices and outcomes to allow for a well-specified empirical analysis.

Data and Results

In our analysis we use data on Russian regional economies between 2000 and 2006 (as based on data availability). Our measures of health outcomes are given by the pooled regional data on infant and under-five mortality. Our key explanatory variable is the presence of only private health insurers in the region. Arguably, the coexistence of public and private health insurance companies does not enable effective functioning of private health insurers owing to their discrimination by the territorial health insurance fund. Therefore, in the empirical estimations we focus on the presence of only private health insurers in the region, regarding it as a measure of effective health insurance model. The analysis also employs a variety of important socio-economic and geographic variables influencing health outcomes (per capita gross regional product (GRP), share of private and public health care expenditure in gross regional product, share of urban population, average temperature in January).

The results of the first set of our empirical estimations demonstrate that the presence of only private health insurers in a region leads to lower infant and under-five mortality. Furthermore, an increase in the share of private health care expenditure in GRP leads to a decrease in both mortality indicators. The result is consistent with numerous findings about the association between personal income and health status in Russia (Balabanova et al., 2012; Sparling, 2008).

Prospective reimbursement of health care providers is associated with a decrease in infant and under-five mortality. The finding suggests the existence of a quasi-insurance mechanism in the Russian SHI market. Operating in an institutional environment where provider reimbursement is based on prospective payment, private insurance companies in effect shift a part of their risk to providers (Glied, 2000; Sheiman, 1997; Chernichovsky et al., 1996).

Table 1. Factors leading to decreased infant and under-five mortality in Russia

Notes: * indicates that the coefficient is statistically significant in a parametric regression

Although our analysis shows that the presence of only private health insurers is statistically associated with improvements in infant and under-five mortality, we believe that the influence is indirect. Namely, the overall positive institutional environment in the region may result in both a decrease of mortality indicators and a lower coercion of regional authorities towards the presence of private health insurance companies.

To test this hypothesis, we use financial risk in a region as a measure of institutional environment and incorporate it in the analysis through an instrumental variable approach. (We measure financial risk by an expertly determined rank ordered variable by RA expert rating agency; this variable reflects the balance of the budgets of enterprises and governments in the region, with lower ranks corresponding to smaller risk.)

In line with our hypothesis, the results suggest that the presence of private health insurance companies now becomes insignificant in explaining infant and under-five mortality.

Discussion

The existing literature suggests that the improvement in infant and under-five mortality in the Czech Republic, Slovakia, and Russia can be attributed primarily to an increase of health care spending (Gordeev et al. 2011; Besstremyannaya, 2009; Lawson and Nemec, 2003) rather than being an effect of the social health insurance model with multiple competing insurers. It should be noted that insufficient government payments for the non-working population and a decline of the gross domestic product in the early transition years left SHI systems in the three countries indebted (Naigovzina and Filatov, 2010; Sheiman, 2006; Medved et al., 2005), which undermined the development of the managed competition in the health care provision.

In Russia (and also in the Czech Republic and Slovakia) there is little competition between insurers, and surveys show that the main factors causing consumers to change their health insurance company are change of work or residence, and not dissatisfaction with the insurer (Baranov and Sklyar, 2009). The fact that law suits on defense of SHI patient rights are rarely submitted to courts through health insurers (Federal Mandatory Health Insurance Fund, 2005) may also be evidence of the failure of Russian health insurance companies to win customers on the basis of their competitive strengths.

Summary and Policy Implications

The above findings as well as the other mentioned literature suggest that improvements of infant and under-five mortality in the Czech Republic, Slovakia, and Russia are not associated with the positive role of managed competition in the social health insurance system. In particular, in Russia the decrease in infant and under-five mortality is likely to be related to financial environment, rather than the existence of insurance mechanisms or competition between health insurance companies. One possible explanation of this absence of effect may come from the excessive regulation of the private insurance markets, as well as the insufficient competition between insurers. Importantly, the health insurance reform, implemented in Russia in 2010, both addressed underfinancing (by raising payroll tax rates) and took a step towards fostering provider competition, by allowing private providers to enter the social health insurance market (Besstremyannaya 2013). However, insurance companies are still not endowed with effective instruments for encouraging quality by providers, which may greatly undermine their efficiency.

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References

Balabanova D, Roberts B, Richardson E, Haerpfer C, McKee V. 2012. Health Care Reform in the Former Soviet Union: Beyond the Transition. Health Services Research 47(2): 840-864.
Baranov IN, Sklyar TM. 2009. Problemy strakhovoi modeli zdravookhraneniya na primere Moskwy i Sankt-Peterburga (Problems of insurance model in health care: the example of Moscow and Saint Petersburg). In X International Conference on the Problems of Development of Economy and Society, Yasin E.G (ed), Moscow: Higher School of Economics, vol.2.
Besstremyannaya GE. 2013. Razvitie systemy obyazatelnogo meditsinskogo strakhovaniya v Rossijskoi Federatsii (Development of the Mandatory Health Insurance system in the Russian Federation) Federalizm 3: 201-212
Besstremyannaya GE. 2010. Essays in Empirical Health Economics. PhD thesis. Keio University (Tokyo).
Besstremyannaya GE. 2009. Increased public financing and health care outcomes in Russia. Transition Studies Review 16: 723-734.
Blam I, Kovalev S. 2006. Spontaneous commercialization, inequality and the contradictions of the mandatory medical insurance in transitional Russia. Journal of International Development 18: 407–423.
Culyer AJ (2005) The Dictionary of Health Economics, Edward Elgar.
Danishevski K, Balabanova D, McKee M, Atkinson S. 2006. The fragmentary federation: experiences with the decentralized health system in Russia. Health Policy and Planning 21: 183–194.
Gordeev VS, Pavlova M, Groot W. 2011. Two decades of reforms. Appraisal of the financial reforms in the Russian public healthcare sector. Health Policy 102(2-3): 270-277.
Hussey P, Anderson GF. 2003. A comparison of single- and multi-payer health insurance systems and options for reform. Health Policy 66: 215-228.
Jacobs R, Goddard M. 2002. Trade-offs in social health insurance systems. International Jthenal of Social Economics 29(11): 861-875.
Lawson C, Nemec J, Sagat V. 2012. Health care reforms in the Slovak and Czech Republics 1989-2011: the same or different tracks? Ekonomie a management 1, 19-33.
Lawson C, Nemec J. 2003. The political economy of Slovak and Czech health policy: 1989-2000. International Political Science Review 24(2): 219-235.
Medved J, Nemec J, Vitek L. 2005. Social health insurance and its failures in the Czech Republic and Slovakia: the role of the state. Prague Economic Papers 1:64-81.
Praznovcova L, Suchopar J, Wertheimer AI. 2003. Drug policy in the Czech Republic. Jthenal of Pharmaceutical Finance, Economics and Policy 12(1): 55-75.
Preker AS, Jakab M, Schneider M. 2002. Health financing reforms in Central and Eastern Europe and the former Soviet Union, in Funding Health Care: Options for Europe, Mossalos E., Dixon A., Figueras J., Kutzin J. (Eds.), European Observatory on Health Care Systems Series: Open University Press, 2002.
Rokosova M, Hava P, Schreyogg J, Busse R. 2005. Health care systems in transition: Czech Republic. Copenhagen, WHO Regional Office for Europe on behalf of the European Observatory on Health Systems and Policies.
Sheiman I. 1991. Health care reform in the Russian Federation. Health Policy 19: 45–54.
Sheiman I. 2006. O tak nazyvaemoi konkurentnoi modeli obyazatelnogo meditsinskogo strahovaniya (On so-called competitive model of mandatory health insurance). Menedzher Zdravoohraneniya 1: 52-58.
Sheiman I. 1997. From Beveridge to Bismarck: Health Financing in the Russian Federation’. In Innovations in Health Care Financing, Schieber G. (ed.), Discussion Paper 365, 1997, Washington DC: The World Bank.
Sinuraya T. 2000. Decentralization of the health care system and territorial medical insurance coverage in Russia: friend or foe? European Jthenal of Health Law 7:15–27.
Sparling AS. 2008. Income, drug, and health: evidence from Russian elderly women. PhD dissertation. University North Carolina at Chapel Hill, UMI Dissertations Publishing.
Tompson W. 2007. Healthcare reform in Russia: problems and perspectives. Working Papers 538, OECD Economics Department
Tragakes E, Lessof S. 2003.Russian Federation, Health Care Systems in Transition, The European Observatory, WHO, Europe.
Twigg J. 1999. Obligatory medical insurance in Russia: the participants’ perspective. Social Science and Medicine 49: 371–382.
Twigg, JL. 2001. Russian healthcare reform at the regional level: status and impact. Post-Soviet Geography and Economics 42: 202–219.
Zaborovskaya AS, Chernets VA, Shishkin SV. 2005. Organizatsiya upravleniya i finansirovaniya zdravoohraneniyem v subjektah Rossijskoi Federatsii v 2004 godu (Organization of management and finance of healthcare in Russian regions in 2004)
Zweifel P, Breyer F. The economics of social health insurance. In The Elgar Companion to Health Economics, Jones A. (ed.), Edward Elgar, 2006.
Wagstaff A. 2010. Social health insurance reexamined. Health Economics 19: 503–517.

Adapting to Capitalism

Posted on January 21, 2013 | Policy Brief

Author: Jenny Simon, SITE

When transitioning to a free-market economy, do people adapt to the new circumstances immediately? Undoubtedly, major shifts in the political system do not escape people’s notice. They often follow extended demonstrations, spectacular coups d’état or even violent uprising. However, the changes in economic institutions that go along with such transitions, and their implications for optimal economic behavior, although fundamental, may not be apparent immediately. The German reunification provides the opportunity to study this learning process.

Shock “Therapy” the Market Way

Posted on September 5, 2011 | Policy Brief

Policy Brief Image with Tall Buildings Representing Transition, Market Economy and Shock Therapy

Twenty years after transition began and the merits of “shock therapy” were argued the most hotly, (former) transition countries are hard hit by global shocks originating in Western market economies. Although discussions now focus on troubles in Western developed countries, countries in Eastern Europe and the CIS were particularly hard hit in 2008/09. This should not come as a surprise given their pre-crisis vulnerabilities. As transition countries opened up to trade and capital flows—like other countries that want to reap the benefits of the global economy—they also became subject to the shocks that hit open economies. The very high current account deficits and/or reliance on commodity exports prior to the crisis exposed many countries in this region to two of the shocks that have been most costly to emerging markets and developing countries in the past, namely sudden stops in capital flows and terms of trade shocks. However, the lesson from the crisis should not be that opening up is bad in general, but that shock absorbers should be put in place to minimize the damage market-based “shock therapy” can do.

Shock Therapy and Transition

It is now twenty years since the failed 1991 coup that led to the breakup of the Soviet Union and started the transition from plan to market in (then) communist countries. A few years earlier, in 1989, the Stockholm Institute of East European Economies was set up at the Stockholm School of Economics. Its first director was Anders Åslund who was a strong proponent of shock therapy (see Åslund 1992). The basic idea was that a rapid transition from plan to market through changing institutions, privatizations and other liberal reforms would minimize the cost of transition. There are still different views on the merits of shock therapy as a reform strategy, but this brief will not address this debate.

In the wake of the academic debate of shock therapy, the broader research agenda was put under the heading “transition economics”, which became a new field in economics. This also lead Erik Berglöf, the new director of the Stockholm Institute of East European Economies, to change the institute’s name to the Stockholm Institute of Transition Economics, or SITE for short, the name we still use today. The economics of transition was also the title of the fifth Nobel symposium in Economics (Berglöf and Roland, 2007).

The use of the label “transition economics” may see a revival in the aftermath of the Arab spring. However, the economic issues that now face the (former) transition countries are much the same issues that emerging markets, developing countries and also advanced countries around the world grapple with. This is not least true when we look at what has happened in the current crisis.

Below this brief will argue that the shock therapy ex-communist countries were subject to in the early 90’s has been changed to the shock “therapy” open market economies around the world have been facing for a very long time. And just as there were heated debates on what the right therapy was then, the world is now debating what the “therapy” for the current shocks should be.

Output Drops Around the World

Significant drops in output have not only been observed in countries transitioning from plan to market but have occurred with regularity throughout modern history in countries around the world. The figure from Becker and Mauro (2006) shows the frequency of countries that entered into a major output loss event—defined as a cumulative loss of at least 5 percent of initial GDP in an event that last at least two years—during the 20th century. In the after-war period, a relative modest 5 to 10 percent of countries have entered into a period of significant output loss. However, in the great depression, almost half of the countries for which data is available entered into a period of significant loss of output.

Since the methodology used in Becker and Mauro follows countries until they return to pre-crisis levels of GDP, it is too early to provide a full account of what the number would be in the current crisis that started in 2008. Nevertheless, it is straightforward to compute how many countries have experienced output losses in 2008/09 (which is the first criteria to satisfy in the Becker and Mauro measure) and this number is close to fifty percent, on par with the great depression. This is not to say that the total output loss will be as high as in the great depression, but it clearly tells the story that this is the worst global crisis we have seen since then in terms of how many countries have been affected. The share of countries affected at the onset of this crisis varied greatly in different parts of the world and at different levels of development. The most surprising statistic from this crisis is that 90 percent of advanced economies experienced an output drop whereas “only” 40 percent of emerging market countries did. The regional differences between emerging markets are also striking; 85 percent of countries in Central and Eastern Europe (CEE) and more than half of CIS countries saw output decline, far above other regions.

Shocks 2.0

The Becker and Mauro paper also looks at the correlates of major output drops and focuses on a number of domestic and external macro, financial and political shocks as triggers of output collapses. A large dataset of shocks and output drops is used to compute the frequency of the different shocks; the likelihood that a particular shock leads to an output collapse (as defined above); and the output loss associated with such event. These numbers are then used to calculate how much different types of shocks have cost in terms of lost output for emerging markets and developing countries. The scale in the chart shows how much it would be worth in terms of GDP per annum to avoid a certain shock.

For emerging market countries, the worst shock has been sudden stops in capital flows that cost almost a percent of GDP per year. Unless countries have high levels of foreign exchange reserves, sudden stops in capital flows mean that (often large) current account deficits have to contract and even become surpluses quickly because there is no external financing available for a deficit. This, in turn, affects domestic production and demand and can have a serious effect on output. Add to this the financial uncertainty that is often associated with sudden stops and it makes it the number one shock to worry about for emerging market countries integrated in the global economy and financial markets.

Less developed countries are in several cases dependent on concentrated commodity exports to generate foreign exchange. This makes this group of countries more vulnerable to terms-of-trade shocks. The estimates of how costly these shocks are range from around half a percent of GDP per year, as is shown in the chart, to around 2.5 percent of GDP if a more extensive sample including very long-lasting output events is used.

Other shocks like currency, political and debt crisis have also been associated with significant losses in output, but tend to occur less frequently, which makes the cost per year smaller.

The 2008/09 Crisis

As was mentioned previously, not enough time has passed since the start of the crisis in 2008 to use the methodology in Becker and Mauro to compute cumulative output losses since many countries are still below their pre-crisis GDP levels. However, projected losses can be computed by using the IMF’s World Economic Outlook forecasts of GDP growth rates. If we then rank the countries according to worst output performance, CEE and CIS countries dominate the “top-ten” list with seven entries. Latvia at the top of the list is projected to lose a cumulative 40 plus percent of pre-crisis GDP during the 11 years it is projected to take the country to return to the GDP level it enjoyed in 2007. The other Baltic countries, Ukraine and Armenia have also been hit particularly hard in this crisis. Russia and Romania are close behind three advanced countries that had to seek IMF and EU assistance to deal with the crisis; Ireland, Iceland and Greece.

The forecasts used for these calculations are constantly being revised and the ranking of countries based on actual outcomes will certainly look different years from now. We can only hope that the current forecasts are too pessimistic although right now many revisions go in the wrong direction.

Could we have predicted what countries were hit in this crisis based on history? Based on the Becker and Mauro (2006) paper: Yes and no. “No” regarding the fact that overall, many advanced countries were hit this time. The paper found that in the past, the frequency of output collapses have decreased with the income level of countries, contrary to what has been the case this time. “Yes” for the fact that CEE and CIS countries were hit significantly more that other emerging markets since they were particularly vulnerable to the sudden stops and terms-of-trade shocks that the paper showed often are associated with severe output losses.

The signs of vulnerability in CEE and CIS countries were easy to see, but warnings ignored; the Baltic countries and Romania had double-digit current account deficits that where to a large part financed by external debt. For example, current account deficits in Latvia passed 20 percent of GDP in some years, far beyond the 4-5 percent deficits some Asian countries had prior to the Asian crisis in 1997. Ukraine also had large current account deficits and concentrated (metal) exports on top of that, exposing the country to both sudden stops and terms-of-trade shocks.

Russia’s dependency on energy and mineral exports was also well known, with 80 percent of export revenues coming from this source. However, the pre-crisis boom in oil and mineral prices had made Russian policy makers think this was a strength and not a vulnerability. On top of that, the strong external position of the government and central bank obscured the external financial vulnerabilities that had built up in the private sector. With the sharp decline in oil prices in the crisis, Russia was hit both by a terms-of-trade shock and a sudden stop in capital flows to the private sector.

There were of course individual countries in other regions that were showing vulnerabilities and were hit in the crisis, but the countries in the CEE and CIS region stood out as particularly vulnerable to the shocks that hit emerging market and developing countries in the past. The IMF’s Global Financial Stability Report from October 2008 summarizes these vulnerabilities in its Table 1.5 on macro and financial indicators for emerging markets very well. The shaded boxes that indicate potential problems in the table completely dominated the picture for CEE and CIS countries whereas other regions looked significantly less vulnerable. In short, history told us what shocks matter and the vulnerability indicators clearly showed where the shocks would do most damage.

Therapy 2.0

What are the policy lessons from this? Countries will always be subject to different types of shocks, and the question is how these shocks can best be absorbed to minimize the economic costs. In other words, what is the “therapy” needed to deal with these shocks? A key challenge is to find the policies and tools that strike the right balance between crisis prevention and high sustainable growth. Isolation to protect against external shocks is certainly not the answer.

Early warning systems (EWS) that identify vulnerabilities ahead of time and give policy makers time to reduce these vulnerabilities and thus avoid crisis is of course what everyone dreams of. The IMF and others have worked on various EWS models since the Mexican and Asian crises with mixed success (see Berg, Borensztein and Pattillo, 2005). With this crisis, the G20 and other groups of policy makers have made new calls for developing EWS, at times seemingly unaware of past efforts and the limited success in this area.

However, at the IMF the more formalized or mechanical EWS models are complemented with both bi-lateral and multilateral surveillance with the bulk of the findings made publicly available and communicated to relevant policy makers. These surveillance efforts contain much more information than more limited EWS models and also come with policy recommendation on how to deal with potential vulnerabilities.

There are of course limitations also with the surveillance by the IMF and other international and domestic organizations. First of all, they have to get it right and at the right time. This is far from trivial, not least because of our limited understanding of the links between the financial sector and the real economy. And even when the analysis gets it “right” in the sense of identifying vulnerabilities, it may take a long time before vulnerabilities translate into real problems and during this time, the analysis and recommended policies may seem misguided.

This is linked to the second major issue; to make relevant policy makers (politicians) listen to and take action on the advice. There is a reason Reinhart and Rogoff called their book “This time is different” since this is often the response to warnings from the IMF and others that suggest a party has been going on for too long and the punch bowl needs to be taken away.

Given the limitations of early warnings and surveillance more generally, there remains a strong need to reduce vulnerabilities in a systematic manner and develop tools to deal with the crises that were not prevented. This will require both domestic measures and a strong commitment to international cooperation. The latter part is of course extremely important right now in order to find appropriate solutions (read debt resolutions) to the problems cross-border banking and capital flows have created. It will also be key in setting up the rules for the future: what capital requirements should banks have; (how) should financial transactions or institutions be taxed; how can cross-border supervision be made more efficient; what type of crisis resolution mechanisms should be put in place both at the international and regional levels; etc, etc. Unless there is broad international agreement on these issues they will do little to address the weaknesses that were at the heart of this crisis.

On the domestic side, the usual IMF recommendation of creating a stable macroeconomic environment—with fiscal room to maneuver and a monetary policy that leads to stable prices—is always going to be part of a countries ability to absorb shocks. For countries that are integrated in international financial markets, exchange rate flexibility and a reasonable level of international reserves seem to be advisable. Jeanne and Rancière (2008) analyze optimal foreign exchange reserves for countries that are subject to sudden stops. Becker (1999) instead looked at accumulation of government assets as part of an optimal public debt and asset management strategy in a world with bailouts of the private sector which seems particularly relevant today.

The macro side should of course be combined with strong domestic supervision of the financial sector; structural policies that lead to sustainable growth in a competitive global environment; and strategies in commodity exporters to reduce the vulnerabilities associated with a narrow export base.

Although advanced countries get most of the attention in the international financial press today, emerging market and developing countries should not think that this is a new world were the shocks of the past do not matter to them. They do, so better get ready for “shock therapy” the market way while there still is time.

Bibliography

Becker, T., (1999), “Public debt management and bailouts”, IMF WP 99/103.
Becker, T. and P. Mauro, (2006), “Output drops and the shocks that matter”, IMF WP 06/172.
Berg, A., E. Borensztein, and C. Pattillo, (2005), “Assessing Early Warning Systems: How Have They Worked in Practice?”, IMF Staff Papers, 52:3, 462-502.
Berglöf, E. and G. Roland (2007), The economics of transition—The fifth Nobel symposium in economics, Stockholm Institute of Transition Economics (SITE) and Palgrave Macmillan.
IMF (2008), Global Financial Stability Report, “Financial stress and deleveraging”, October, Table 1.5 p.46.
Jeanne, O. and R. Rancière, (2008), “The optimal level of international reserves for emerging market countries: A new formula and some applications”, CEPR Discussion Papers 6723.
Reinhart, C. and K. Rogoff, (2009), “This time is different: eight centuries of financial folly”, Princeton University Press.
Åslund, A., (1992) “Post-Communist Economic Revolutions: How Big a Bang?”, Center for Strategic & International Studies, Washington D.C..

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