William Davidson Institute Working Paper 402
comments on the relationship between monetary and fiscal discipline under various
exchange rate mechanisms. Section 4 analyses the risks of speculative attacks that
may occur under fixed exchange rates regime. Sections 5 to 9 analyse in depth the
Romanian monetary and exchange rate mechanisms and point to the main factors that
harmed the effectiveness of the disinflation policy in the late nineties. The conclusion
and some policy implications are presented in the last Section.
FIRST PART: THEORY
2. Inflation and monetary policy in a centralised transition economy
At the beginning of the transition process, many international experts and
organisations viewed the basic transition economy as a standard economy hit by a
large adverse supply shock, which have to solve simultaneously a problem of
monetary overhang and of declining output. Ten years later, everyone seems to agree
that the initial approach to reform in these countries built on over-simplified
representations of the reality. Some older and recent criticism has put forward the
intrinsic ineffectiveness of orthodox reforms in highly disorganised economies and
advocate the need to enforce “institutions” (the state and the market included) as a
necessary precondition to successful reform (Blanchard, 1997; Stiglitz, 1999;
Rodrick, 1999).
In this section, we would like to briefly comment on the factors that might
have justified a doze of chronic inflation during the first years of transition (different
from the corrective inflation that accompanied price liberalisation in a context of
monetary overhang). We describe a hypothetical economy, whose fundamental
features are emphasised in an extreme way. The basic framework refers to a country
that did not benefit from early programs of partial and gradual reform in the late
1980s. The purpose of this section is to tell the inflation story in a straightforward
way, then to investigate whether this story is still true.
Formerly socialist economies were highly centralised: in general, a given
commodity or service was produced by a few huge state-owned firms; some
commodities were produced by only one firm and sometimes, a given firm had only
one buyer for its products. (Such organisation made central plan easier to be set up).
Imagine then the chain of production of a final consumption good. If one of the firms
got out of the market, the whole chain would collapse. Of course, this is quite an
extreme characterisation, but it is not a very unrealistic picture for highly centralised
countries like Romania, Bulgaria or Russia, at least at the beginning of the transition
process. Intuitively, one may see then why governments were keen on letting burst
some of the firms.
To produce, firms need energy and other inputs. While the other inputs are
produced at home, energy is bought in the world market (of course, some other
essential inputs would also be bought overseas). Thus, any devaluation would have
deteriorated the balance sheet of the representative firm. If the capital market is not
functioning well, the representative firm will not be able to borrow against future
income and would buy less of the other inputs. Consequently, the devaluation would
imply a reduced output and even the exit of the firm of the market. In order to avoid
the collapse of production chains, governments in transition economies have initially
subsidised the firms in trouble (gave them money or blocked energy prices). The
increased public deficit was in general financed by the central bank. Often with a lag,
the consecutive increase in money supply led to an increase in prices, which put