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10/01/91

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Soviet transition to capitalism in wrong order, economist says

STANFORD -- In their brave attempt to move toward a market economy, the Soviets "got the order of liberalization wrong," Ronald McKinnon, an expert on financial markets and their controls argues in a new book.

"Where the Soviets went wrong was not any better understood by Western economists, who applied, and still apply, premature pressure to decontrol prices, float the exchange rate, privatize and decentralize decision making before proper fiscal and monetary control over the Soviet economy is secured," he said.

A centrally controlled socialist country in transition to a market economy must limit government spending and create a full- fledged internal revenue service and a well-defined market for domestic money and credit before liberalizing further, said McKinnon, the William Eberle Professor of International Economics at Stanford.

Well-meaning but misguided reformers who don't understand the financial control mechanisms of centrally planned economies "want to take an ax to those controls and not replace them with anything else," McKinnon says. "President Bush falls into that camp."

In his book, The Order of Economic Liberalization (Johns Hopkins University Press), McKinnon reviews the history of financial policy in Japan and Taiwan, two countries that got the order of liberalization "more or less right." Other countries whose progress he charts include South Korea, Hong Kong, Singapore, Chile and Thailand.

Most other countries in Asia, Latin America and Africa have gotten the order wrong. Examples are Nicaragua, Brazil, Peru, Bangladesh and Pakistan. The result has been runaway inflation and declining government revenues for basic public services.

Desperate, many governments reimplement price controls or other forms of central planning. The Soviet Union, for example, cancelled plans to eliminate price controls in early 1991. China's government is starved for tax revenue, threatening economic reform.

What is the correct order of liberalization? McKinnon lists these steps:

1. Restrict government spending to a reasonable percentage of the gross national product and collect taxes to support it.

"Otherwise, the liberalization process itself will create deficits in the public finances," he said.

In China, for example, government revenue from enterprise profits fell from 20.6 percent of the gross national product when liberalization began in 1978 to just 7 percent in 1988.

"Although not as devastating, the PRC's loss of monetary control with consequent inflationary pressure since 1985 has been similar to that experienced in the Soviet Union," McKinnon said.

In socialist economies where the government has owned the industrial and agricultural property and set wages, the surpluses of these enterprises effectively constitute taxes. Once the state moves out of business, the confiscation system must be replaced with "a comprehensive and uniform system of explicit business and personal income taxes according to well-established canons of taxation," McKinnon said.

The Soviet Union has implemented some "ad hoc taxes," but they don't constitute a replacement system.

2. Set up a domestic capital market so that depositors receive and borrowers pay substantial real (inflation-adjusted) interest rates.

Enterprises and households will cause runaway inflation and waste resources through hoarding excess inventories if real interest costs aren't passed on, he said.

The state banking system in a socialist economy is a "passive" system, which requires reform if it is to be an effective restraint on others who would bid up the price of scarce resources beyond their real value, McKinnon said.

"However, the authorities should move cautiously, perhaps waiting for some years before establishing independent commercial banks that are only indirectly regulated or controlled by the central bank."

3. Unify the foreign exchange rate for all current transactions.

Until all importers and exporters pay the same exchange rates, the government can't eliminate controls over who can import and export without ruining the country's fiscal credibility.

The Soviets dismantled their state trading company in 1989 before unifying exchange rates.

"In such a chaotic situation with literally hundreds of different exchange rates and where the price of foreign exchange may be 10 times as expensive for some purposes as for others, no market mechanism can ensure that such decentralized foreign trade is efficient," McKinnon said. "Threatened defaults on foreign exchange payments by individual Soviet enterprises are now significantly impairing the Soviet Union's external credit standing."

4. Convert import-export quotas to tariffs as the "optimal first step in an eventual move to free trade."

A premature move to free trade can "provoke the widespread collapse of domestic manufacturing," as occurred in East Germany and Poland in 1990, he said.

"Quotas and other direct administrative controls on importing and exporting generally distort the economy much more than do 'equivalent' tariffs," McKinnon said.

5. As one of the last steps, eliminate exchange controls on foreign capital flows.

Households and enterprises shouldn't be able to move capital in and out of the country until after the national market has been liberalized and domestic inflation curbed. That is, internal borrowing and lending must take place freely at unrestricted rates of interest, and depreciation of the international exchange rate must stop first.

Premature elimination of exchange controls can lead to "unwarranted capital flight or unwarranted buildup of foreign indebtedness or both."

Keeping exchange controls does mean that "you are not going to get a rush of funds from Western countries buying up everything right away. I don't think that's optimal anyway," he said. "Japan in the 1950s and 1960s demonstrated that a wide-open capital market is by no means necessary to get your hands on technology."

McKinnon began to write his book on the order of liberalization of monetary policy in less developed countries, but the dramatic events of perestroika prompted him to apply the liberalization sequence to all socialist countries in transition. For the Asian Development Bank, he is currently detailing the sequencing order for China, Vietnam, Laos, Mongolia and Myanmar (formerly Burma).

"The Achilles' heel of each of these is that their public revenue stream has gone kaput," McKinnon said. "All are developing significant inflation."

Analyzing the situation in the Soviet Union and Eastern Europe is more difficult because they are splitting apart politically.

"The division process tends to obscure some of these underlying considerations of socialist economies in transition," he said.

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