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Converting military capacity to civilian use: A two-sector model of an economy in transition
Structural Change and Economic Dynamics, vol. 5, no. 1, 1994
CONVERTING M I L I T A R Y C A P A C I T Y TO C I V I L I A N USE: A T W O - S E C T O R M O D E L OF AN E C O N O M Y IN T R A N S I T I O N S. M A N S O O B
MURSHED
1
The paper presents an analytical two-sector macroeconomic model of the type employed for the former Soviet Union. Partial liberalization turns a repressed inflation disequilibrium macroeconomic regime into an open inflation regime; one which continues to be characterized by disequilibrium, due to excess demand. Inflation proceeds in the two sectors, fuelled by real wage resistance and excess demand. A macroeconomic role is given to the conversion of the military production complex to civilian use. Thereafter, the effects of devaluation as well as increased consumer goods and technological aid are considered. Increases in the rate of conversion could be even more inflationary unless accompanied by policies to lower excess demand as well as schemes to improve the quality of the current converted sector.
1. I N T R O D U C T I O N
The recent dramatic events in what were the centrally planned economies of Eastern Europe culminated in political disintegration, especially of the former Soviet Union. A part of the process of change is the restructuring of these economies and their transition to ' m a r k e t ' economies. The tasks associated with this economic transformation seem to be without parallel in recent economic history and this has aroused considerable interest in the economics profession. Most studies concern themselves with sectoral issues such as trade, debt, exchange rates, or privatization; macroeconomic issues receive relatively less attention, although examples do exist, such as Bennett and Dixon (1993). This paper will concern itself with macroeconomic issues involving converting military capacity to civilian use, a process known as conversion, as well as the role of 'structural' inflation. Although the intention is to make general points, the experiences most closely related to the analytical model in the paper are those in the successor states of the former Soviet Union, particularly those new countries left with a significant military capacity such as Russia and the Ukraine. It is useful to dwell briefly on the previous economic regime as it helps to concentrate the mind on the present. What were the sources of the inefficiencies of the previous system which were so universally proclaimed? These are best described in the words of the Hungarian economist Janos Kornai as the 'shortage syndrome' (Kornai, 1980, 1986). The shortage syndrome is said to emanate from the phenomenon 1 NI Economic Research Centre, 46-48 University Road, Belfast, N. Ireland BT7 1NJ, UK.
© Oxford University Press 1994
25
26 s. M. MURSHED of the soft budget constraint, where firms have little incentive to use optimally the inputs available to them. The result is a chronic excess demand for inputs and the consequent shortage syndrome. In the aggregate or macroeconomic sense we could describe the old Soviet economic condition as a generalized excess demand regime with supply as the constraining factor. Such a characterization of a macroeconomic regime is due to Malinvaud (1977), who may not have had the Soviet economy explicitly in mind, but this description was emphasized by Murshed (1987, ch. 6) when describing the then Eastern bloc. In more succinct language, such a macroeconomic regime is described by Malinvaud as a 'repressed inflation' regime--one in which there is a fundamental disequilibrium caused by excess demand; this excess demand is prevented from becoming open by rationing (other examples of repressed inflation regimes could be wartime western economies). It is our intention to pursue the disequilibrium approach in this paper, and attempt to analyse the disequilibrium dynamics characterizing the former Soviet economy at the present time. We will demonstrate that the reform process could convert a repressed inflationary regime into an open one, without necessarily fully resolving the root of the problem (excess demand). The history of the Soviet economy in the past two decades suggests stagnation and the failure of the 'extensive' model of economic growth, which is input-intensive. As Sen (1992) demonstrates, the Soviet economy between 1960 and 1987 displayed rising capital-output ratios, as well as falling shares of consumption relative to investment in GDP. Since the advent of Gorbachev and perestroika leading to the law on state enterprises of 1987, the first attempt at the reduction of economic centralization, the problems of shortage and inefficiency at the level of the economic enterprise seemed to have become more acute, according to most observers (see, for example, Ofer, 1990; IMF, 1990; Aslund, 1991). The breakup of the Soviet Union and the CMEA has also contributed towards growing shortages. Returning to the present, we have to take stock of the current state of the reform process which has been underway for some time. Here we have to distinguish between the experience of Central European countries and the successor states of the former Soviet Union. It is widely accepted that macro-stabilization is a necessary prerequisite for growth and progress in other areas. In this respect, the elimination of the stock of excess demand (rouble overhang) was considered a priority. This would involve price reform as well as the drastic reduction of the government budget deficits which had emerged in the twilight years of the old regime. Studies show that the former Soviet republics have been less successful in this regard than other Central European nations, see IMF (1993) who estimate the budget deficit in Russia and Ukraine at 23 and 37~ of G D P in 1992. The inflation performance has been similarly poorer in the countries of the former Soviet Union at 1202~o (CPI) in 1992 compared to, say, 43~ in Poland. The decline in G D P in the same year was on average 18.5~ in these countries, compared to a much more favourable performance in Central Europe. All of these indicators suggest that much more needs to be done in the former Soviet republics and that the reform process has still a long way to run. Another stylized fact is the continuation of a sheltered sector in receipt of subsidies. Bennett and Dixon (1993) emphasize this in their two-sector model. The model we
CONVERTING
M I L I T A R Y C A P A C I T Y TO C I V I L I A N U S E
27
shall employ is also a two-sector model, but different from theirs. We shall employ the fix-price, flex-price dichotomy to differentiate a more protected (I) sector and a more open (A) sector respectively. Our model will also generate a system of structural inflation, one in which the excess demand for consumer goods generates inflation via real wage resistance. Money plays an accommodating role in the process, unlike in the model of Bennett and Dixon (1993). The major analytical innovation of the paper is the introduction of a role for military conversion in the macroeconomy via augmenting the supply of the I sector. The Soviet military production complex has always been a major producer of civilian goods and consumer durables in addition to armaments (Sen, 1992); this tendency increased in the Gorbachev era. The importance of conversion has been stressed by analysts of the former Soviet Union (Deger, 1990; Cooper, 1991; Sen, 1992) who believe that it may be central to the reform process there. It should be noted that authors such as Sen (1992) are highly critical of the quality of conversion thus far. This is because of the military production complex's even greater insularity to 'market forces', when compared to the civilian production sector. Nevertheless the military production complex is still a vast repository of capital goods and high quality human resources. Our model goes on to analyse the dynamics of the two-sector model which generates inflation and has a central role for conversion. We analyse the effects of a policy-induced change in the pace of conversion, exchange-rate depreciation as well as increased aid. With respect to the last, our model is able to distinguish between various types of aid, technical as well as the type augmenting the supply of consumer goods, thus allowing some qualitative comparison between the two. The rest of the paper is organized as follows: the next section presents the salient features of the analytical model; section 3 outlines the process of disequilibrium dynamics; section 4 examines the effects of variations in parameters including exchange rate devaluation, aid, productivity changes and a rise in the rate of conversion; and finally section 5 briefly presents some conclusions. 2. THE MODEL
We will characterize the macroeconomy into two broad sectors. We term the first the agricultural or consumer goods (A) sector. We would expect to include food items as well as other consumer goods in this sector. For the purposes of macromodelling, what matters foremost is the type of market clearing employed rather than the physical nature of the good. The market-clearing mechanism employed in that sector is of the flex-price variety, as proposed by Hicks. In other words, excess demand leads to price increases and vice versa. Our rationale for employing the flex-price mechanisms is the wide ranging market-orientated price liberalization which has taken place in the states of the former Soviet Union. Equilibrium (demand equals supply) in the A sector is given by: PAQA, = PADA(Y; a) "4- PAF(aPt/E)
(1)
where QA represents output of the A sector, assumed exogenous for the sake of
28 S. M. M U R S H E D
tractability; PA is the price; DA represents domestic demand for A, which is an increasing function of 'real' income Y (defined below) and a decreasing function of the domestic terms of trade, a, o- = PA/Pbwhere P~ is the price of the other (industrial) sector; F represents foreign or export demand, a negative function of PA hence o and a positive function of the nominal exchange rate E, when E increases the domestic currency depreciates. Our rationale for including the economy's exportable goods into the flex-price A sector is that the price of the exportable is likely to be sensitive to international market forces and demand. F ( . ) in (1) is obtained from F(PA/E), dividing both PA and E by P~. We now turn to the other sector, the industrial or investment (I) goods sector. We postulate that the output of this sector will be marketed in fix-price conditions. This means that prices change as costs alter, but excess demand or supply leads to quantity changes to clear the market. Quantity adjustments are crucial to the analysis of conversion, as this process also occurs in quantities. The price of the I sector, P~ is a constant mark-up, set equal to unity for convenience, on variable cost:
PI = [ a m + EPmM ]
(2)
where a = L/Q~ is the fixed labour-output ratio and the inverse of labour productivity; Wis the nominal wage; Pm is the price of an intermediate input which is imported from the West and EPmM is the cost of the intermediate input in the production of one unit of output in the I sector. In making the intermediate input imported we are introducing, in an extreme form, perhaps, technological dependence on the West. In order to keep the algebra tractable we assume that one unit of the input, M is required in one unit of output, Q~, in the industrial sector, as in Findlay and Rodriguez (1977). Since part of the total value of the sector is imported, in order to arrive at the net domestic value added of that sector we subtract the value of the intermediate input from gross output P~ql = PIQI - EPm (3) where ql is net output in the I sector and QI gross output. Dividing (3) by P~ yields: ql
Q,(1 - EPm'~pI/
or,
QI = qlA
(3')
where A = ~/(~
-
EPm).
Next we take up Kornai's (1980, 1986) notion of the shortage economy, in that notional or ex-ante demand for the I sector's product, D~, exceeded effective supply. In the past this shortage would have been resolved by explicit physical rationing, i.e. when: P~ql < PIDI
(4)
the net effective domestic supply of output, ql was constrained by the availability of M. The available quantity of M would, in turn, depend on the balance of payments
CONVERTING
MILITARY
CAPACITY
TO CIVILIAN
USE
29
constraint, the ability of the economy to import from the West depending on how much it could export to the West and how much it could borrow. Recent developments, however, put a new complexion on the process of rationing this fixed quantity of ql. This is due to the gradual conversion of some of the existing military production capacity into civilian industrial use. This allows the effective supply of the I sector to be augmented and can bring about a regime switch from a rationed market to a quantity-clearing market. Quite obviously there are difficulties with the pace of conversion. In the long-run there will be a constraint on the ability of the converted military sector to supply I goods. But in the short-run it is reasonable to assume that the military sector can augment supplies of the I sector from existing stocks without importing inputs, given the vast resources (including human capital) made available to it at very favourable prices during the previous regime. We can rewrite (4) after normalizing by P~ as: q, + G, = / ~ ( Y, a).
(5)
The left-hand side of (5) represents total supply of the I good and the right-hand side indicates total demand. Supply is made up ofq~, which is the net amount available from the civilian sector for absorption and the supply from military conversion, G~, the latter equilibrating supply with demand in the I sector. As far as demand in the I sector is concerned, we make it an increasing function both of real income, Y- and a = PA/PI. We further postulate that existing civilian capacity in the I sector is a decreasing function of the exchange rate, E, and an increasing function of the quantity of the imported input, M, available. As E rises (depreciates) the domestic cost of M rises, lowering the domestic value added of Q~; and, of course, an increase in M for fixed E and Pm has the opposite effect. Thus: qi =- ql( E, M ) .
(6)
We need to define the concept of real income. Nominal income, Y, is the sum of the value of the two sectors, plus the converted military sector's output of I goods. This could be viewed as output and income from three sectors, one producing A goods and two making I goods. Thus: Y = PAOA + P~q, + P~G,.
(7)
In order to arrive at real income we deflate nominal income in (7) by a cost of living index, P, where p = -D~r,l-a -I--A , (8) a and 1 - a are the expenditure shares of the A and I sector in the representative consumption basket (see Dornbusch, 1980). This gives us:
Y = ffaOA d- a~-lq, A- o'~- 1G I (9) where a = PA/Pt. Similar to the Dornbusch (1980) traded/non-traded good model we have one input, M (an intermediate input which is an investment good), and one export (F). We do not include consumption imports as it only complicates the derivation and M could
30
S. M . M U R S H E D
be viewed as containing a consumption component. We can introduce a relation describing the current account of the balance of payments, B, obtained from (3') and
(1): B = aF(')
-- ( A / P O q I ( . )
-- r E D / P ~ .
(10)
This is written out after normalization by P~. The first term on the right-hand side of (10) denotes exports and the second term imports. The last term indicates debt servicing, where D is foreign currency denominated debt and r stands for the interest payments on these. We are not imposing a requirement of current balance (B = 0); deficits in B are financed by capital flows leading to future debt-stock increases and debt-servicing consequences. See Murshed (1990, 1993) on the explicit analysis of debt-servicing issues.
3. D Y N A M I C S
In our analysis of the dynamics of economics in transition belonging to the former Soviet Union there are a number of stylized facts we wish to emphasize. First and foremost we wish to analyse the possible role played by the conversion of military capacity to civilian use in augmenting the supply of goods in the economy. As indicated in the Introduction, the military production complex had a particularly privileged status in the former Soviet Union. This means that it is a relatively large repository of resources and capital (human as well as physical) which can be diverted to civilian production. We also wish to analyse the hyperinflationary process in these economies. This is, to a large extent, a direct result of money supply growth, but this in turn is a reflection of a degree of residual 'softness' in the economy unlike in Central European economies. Parts of the economy are sheltered by subsidies and wages are not always at market clearing levels. One could argue that there is a degree of 'real wage resistance', to employ a term popularized by Hicks and Kaldor. Real wage resistance can exist when there has been a decline in the level of real wages due to economic reforms. This real wage resistance could be a major contributory factor in the inflationary process leading to a price-wage-price spiral, as We shall see below. Of course, our stylized model represents an extreme form of this phenomenon, but it does illustrate what could still be a major contributory factor to inflation. After outlining the dynamics we will proceed in section 4 to consider variations in parameters which are of potential significance. These include the effects of devaluation or exchange rate depreciation in increasingly open economies; the effects of assistance in the form of technological aid to the I sector or more fungible assistance to the A sector in the form of greater availability of consumer goods; and a speeding of the rate at which is converted to civilian use. We proceed by modelling real wage resistance following Dornbusch (1980). Workers are interested in a particular standard of living, reflected in a r e q u i r e d r e a l w a g e , w. Since there are two goods in the consumption basket, the cost of living is indicated by the price index in equation (8). Thus w = W/P
(11)
CONVERTING MILITARY CAPACITY TO CIVILIAN USE 31 where the required real wage, w, is a nominal wage, W, divided by P in (8), an increase in P will lead to increases in the nominal wage, IV, given w and successful real wage resistance. Following Dornbush (1980) we relate the required real wage to a required terms of trade, & Given real wage resistance, the actual terms of trade, 6, must equal the required rate dictated by worker aspirations: 0"~ 8.
The evolution of money wages would be given by:
( v / w = ~[~ - 8 ]
(12)
where ~ > 0 is an adjustment parameter. Utilizing (12) and (2), the equation for I sector price dynamics becomes ~/p~ _
yea - 5]
(13)
1 + EPm/aW" Equation (13) thus gives us the price dynamics for the industrial sector, where if the actual terms of trade exceed the required rate, ~r > 8, P~ would be increased due to real wage resistance. Next we consider the price dynamics of the agricultural or consumer goods, A, sector. We have already indicated that this is a flex-price sector where excess demand causes the price, PA, to increase. Thus from equation (1)
PA/PA = ~b[DA(') + F ( ' ) - QA]
(14)
where ~b > 0. We may now combine (14) and (13) to examine the evolution of the terms of trade, a; recall that a=PA/PI. Thus, subtracting (13) from (14): PA/PA -- PffP~gives ~[o-
O'/G = q~[DA(") q- F ( ' ) -- QA]
-
8]
1 -k- EPm/aW"
(15)
Equation (15) implies the possibility of steady-state inflation, as first pointed out by Cardoso (1981) and analysed also in Murshed and Sen (1989). By steady-state inflation we imply the possibility of both PA and P~ increasing, but at the same rate, i.e. if PA/PA=/~I/PI, then (15), which is the difference between the two, would be zero - ~ l a = O. But how could such a phenomenon come about? Supposing that, as is proposed, there is a liberalization of the consumer goods market, making its price openly market determined. Given supply bottlenecks, there could be excess demand for the A sector's output such that PA/PA > 0 in (14) which is now opened up. This would mean an increase in the cost of living [(8) and (11)] and, given real wage resistance, would cause money wages to increase in (12), as the actual terms of trade is above the required rate. This could, in turn, mean a rise in industrial goods prices, ~/P~ > 0, in (13). Thus, there could be positive and equal rates of inflation in both sectors which could come to a steady-state equilibrium in the short to medium term; as this process is clearly unsustainable in the long run.
32 s. M. MURSHED We can introduce the perfect foresight variant of rational expectations into the dynamics of the consumer goods (A) sector in (14). This will mean that rational speculators bring about equilibrium in that market by raising prices when there is excess demand. But this assumption of rational expectations does not alter the above dynamics if we have real wage resistance and mark-up pricing in the industrial (I) sector. It should be pointed out that the dynamic analysis is very similar to Dornbusch (1986). There is real wage resisistance as in equation (12) of our model. There is a Phillips curve mechanism in the goods market sector similar to the pricing rule for the I sector in (13). Lastly, there could be perfect foresight in the dynamics of the A sector in (14) similar to that in asset markets in Dornbusch (1980, 1986). This may cause jumps in the terms of trade, but the point is that excess demand for A will still push up PA and hence IV, via real wage resistance and finally P~ through mark-up pricing. Inflation could continue in the steady state if PA and P~ grew at the same rate. To put a stop to this inflation would require exogenous policy measures to reduce aggregate demand. Before attempting to depict these results diagrammatically, we need to describe the quantity adjustment process in the I sector, where we have postulated that excess demand is met by an increased 'conversion', G~. Thus from equation (5), using (6):
(~I
= ~/E/~(")
-- ql(')
(16)
-- GI]"
In Fig. 1, the II curve describes equilibrium in the industrial goods market (demand = supply) and is obtained from (16) setting G~ = 0 in G~, a space. Similarly, the AA curve describes equilibrium in the A sector, and is obtained from !14) setting /bA = 0. The ~ = 0 curve is obtained from (15) along w h i c h [)A/PA = P I / P I , hence 6/~ = [gA/PA --~P~ = 0. The required terms of trade is a horizontal line at the desired rate.
(I
"{3 "6 or*
E
_••11 AA
6=0
..~I'~1 '--'~// / /
E1
I! ~ = .___~ PA (price of the _'A'_sector -. _ _ good) i PI (price of the T sector good) I
Conversion
FIG. 1. Phase diagram and equilibrium relations.
G,
CONVERTING
MILITARY
CAPACITY
TO CIVILIAN
USE
33
In Fig. 1, E 1 indicates the point where we have 'steady-state inflation'. At E 1 there is equilibrium in the I sector, but excess demand for consumer goods such that the AA curve is above E 1. This causes consumer goods price inflation which, via real wage resistance, causes wages and I sector prices to increase. Positive inflation in both sectors proceeds at E1 in Fig. 1. We move on to consider variations in the parameters of the model.
4. VARIATIONS IN PARAMETERS
In order to proceed to capture the effects of parameter changes G~ and a, we totally differentiate (16) and (15) and arrange them in matrix form (see Appendix). 4.1. Devaluation Under a fixed/managed exchange-rate system, devaluation is a direct policy decision, often motivated by a desire to improve the balance of payments. Even under floating exchange rates, the exchange rate is rarely independent of government policy actions. With floating exchange rates a depreciation of the exchange rate (rise in E) is often a result of expansionary monetary policy/rising inflation. In what follows we refer equivalently to a direct policy-induced devaluation or an indirect depreciation of E as a result of rising money supply/inflation. dGx dE
blla22-bzla12 A
(17)
and do" - -
dE
~ ( 1 - - Dllo" e - 1)(q~F2 -[- ~) =
A
(18)
where A > 0 (see Appendix for the various alj and blj). Devaluation or exchange-rate depreciation is a mixed blessing. It worsens inflation by raising P~ as it raises the domestic cost of the imported intermediate input, M. It could even add to these inflationary pressures when it is expansionary; by raising income, Y, it adds to the already existent excess demand pressures in the economy. This is because higher income increases domestic demand for both goods. Point B in Fig. 2 is indicative of both of the above-mentioned effects, whereas point C refers to a more moderate rise in inflation with only the effect of a rise (depreciation) in the exchange rate, E, on P~ via the domestic cost of intermediate input imports. Note that the AA schedule is omitted from Fig. 2 and subsequent figures to avoid clutter. As far as real income is concerned, this will rise if the aggregate demand effects outweigh the aggregate supply effects of the rise in E (point B in Fig. 2). The aggregate demand effect comes via exchange rate depreciation on the demand for exports, F 2, and this effect is positive. The aggregate supply effect comes via the increased domestic
34
S. M. M U R S H E D
II 2 II
I1~ ~1 =0 0
Gi FIG. 2. A rise in E. price of imported intermediate inputs on output, and is negative, qll < 0. If the opposite is true and the negative supply effect dominates the positive demand effect, 'contractionary devaluation' ensues at point C in Fig. 2 with falling real income. Note, however, that even these output (real income) effects need to be qualified in the light of disequilibrium dynamics. When devaluation or depreciation is expansionary, it raises the required rate of conversion, GI, as well as having a more pronounced (upward) effect on inflation. When it is contractionary, as far as output and employment is concerned, it lowers the demands on the rate of conversion as well as increasing inflation less dramatically. What would be the effects of devaluation or exchange-rate depreciation on the current account? From (10) dB
da
ql
d E - ( F + aF1)dE + a F 2 + P1 -- (EPm) 2 d E - Aq, i - (rD/Pt) dE.
(19)
Note t h a t F i < 0 , F2 > 0 a n d q H < 0 . It could worsen or improve the current account. There are four types of effects here. First, devaluation raises inflation, hence PA. This lowers exports as the first term on the right-hand side of (19) suggests. But the direct effect of devaluation increases exports as the second term indicates. Thirdly, devaluation lowers output in the I sector as imported intermediate imports cost more, output falls and imports decline as the third and fourth terms in (19) indicate. The final term represents the increased debt servicing necessitated by a devaluation or depreciation of the currency, worsening the current account. 4.2. A n Increase in the Availability o f M This could come about either because of increased technological aid or the relaxation of C O C O M restrictions on imports of technology. dGi dM
-
b12a22 - - b 2 2 a i 2
A
(20)
CONVERTING
MILITARY
~ II1
CAPACITY
TO CIVILIAN
USE
35
II
61 = 0
~=0
GI FIG. 3. A rise in M. This is positive by the stability conditions do -
O.
(21)
dm As expected, an increase in the available quantity of the intermediate input would allow gross and net output of the I sector to increase, as the constraint on output is relaxed, allowing the pace of conversion Gl to be relaxed. On the one hand, this is good news for the domestic economic managers; but it is bad news for those who would like to see a greater pace of disarmament, as the rise in M lowers G~ and hence the pace of disarmament. Nothing happens to o", as the excess demand in the steady state for consumer goods of the A sector remains, this pent up or repressed demand having been let loose or triggered off by liberalization; increasing M only raises productive capacity in the I sector but not the A sector. In Fig. 3 both schedules shift leftwards and we move from A to B. As far as the current account is concerned, from (10) it will worsen if the rise in M is due to increased imports. If, however, the rise in M is due to an unrequited transfer the current account is unaltered. 4.3. An Increase in
QA
This rise in the output of the A sector, could come about either as a result of productivity improvements or more general aid and transfers from the West. dGl
[ - q J D i l a ~ ( ~ b D A 2 - s~ ~t_ (~F1) _ q~al 2 .~_ q~DAlo"a~D12]
dQA
A dG
dQA
-
# ~ [ O a l o " ~ + (/~1o" ~ - 1 - - 1)]
(22)
(23)
A
The plausible result regarding the terms of trade, o" = PA/P~ is for it to fali, this would occur if DA1 + ~1 < 1 in (23), i.e. if the income effects on demand for the A and I
36 S. M. MURSHED 11 ~=0 ~1 =0
GI FIG. 4. Rise in QA (aid or productivity). sector outputs were both small. In terms of Fig. 4 this causes a downward shift in the terms of trade curve, indicating a fall in a and the easing of inflationary pressures. From (10) this will also improve the current account. As far as the demand for the I sector's output is concerned, the final result is ambiguous in (23). If there is excess demand for I sector goods then the II curve shifts rightwards with the final equilibrium at C, indicating a rise in G~ to make up for the excess demand. For this to occur, the income effects of the transfer or productivity increase in QA would have to be relatively substantial as far as the demand for the I sector's output is concerned (D~I relatively large). If, however, excess supply emerged in the I sector following the rise in Q~ the II curve would shift rightward and there would be a slowdown in pace of conversion from military to civilian production, G~ would fall at point B in Fig. 4. Increased aid in the form of 'consumer goods' is beneficial for the economy as it lowers excess demand and inflationary pressures irrespective of what happens to GI. 4.4. An Increase in the Rate of Conversion, It should be emphasized that we are speaking of a rise in the rate of conversion, not its levels. dGi
do-
-
-
b14a22 >/
if
0
-b14a21 />
0
b14
if
~<
b14
0
~<
(24)
0.
(25)
Recall, ] J I > 0, azl > 0 and a22 < 0. The crucial parameter is the sign of b14. If the level of conversion is already high such that the sum of supply, net output, q~ and available military capacity geared to civilian production exceeds demand, then bl~ > 0 will lead to falling levels of G~ and o-. If, however, the opposite is true, and the existing 'converted' capacity is small
CONVERTING MILITARY CAPACITY TO CIVILIAN USE
37
II
6=0
Gi FIG. 5. Rise in the rate of conversion.
relative to demand, the required conversion level, GI, will rise, as will the steady state rate of inflation, a. In terms of Fig. 5, an increase in the rate of conversion shifts the II schedule along the ~ = 0 schedule. If b14 > 0 then the new equilibrium is at point B. On the other hand, if bt4 < 6, the increase in the rate of conversion will have failed, excess demand and inflation will have risen, as shown by point C in Fig. 5. The conversion of military productive capacity to civilian production is an important component of the reforms and transition taking place in the economies of many of the successor states of the former Soviet Union. Our analysis points out that conversion will only help to reduce the inflationary pressures already present in the economy if the existing converted capacity is high relative to excess demand, D~(b~4 > 0, point B in Fig. 5). The more plausible outcome, however, is at point C where increases in the rate of conversion worsen inflation. To avoid such an adverse result would require (i) demand-side measures to lower excess demand, /~, via contractionary monetary policies, say, or incomes policies to moderate wage growth; and (ii) supply-side policies to improve the 'quality' of conversion, making the military production complex more responsive to civilian consumption needs. This would result in an increase in the effective supply of the G~ currently available. In a nutshell, successful increases in the rate of conversion which help to lower inflation (point B in Fig. 5) could require the simultaneous pursuit of additional demand- and supply-side policies. From (10) successful conversion will improve the current account if inflation, and hence PA, declined.
5. C O N C L U S I O N S
Let us conclude by summarizing our results as follows. (1) Devaluation or depreciation of the currency is a mixed blessing. It worsens the
38
S. M. M U R S H E D
inflationary pressures in the economy as well as putting greater demands on the conversion process if it succeeds in raising output. If devaluation is contractionary, the rise in inflation is moderated and the required rate of conversion is lower. It may not even improve the current account of the balance of payments. (2) A greater availability of technology inputs in the I sector because of aid raises productive capacity in that sector, lowers the required pace of conversion from military to civilian use, but has no effect on inflationary pressures. (3) Technical progress in the A sector or aid in terms of consumer goods lowers inflationary pressures, but has ambiguous effects on the conversion process. Aid in this form is preferable to technical aid as it is more beneficial (efficient) to the macroeconomy by lowering inflation, as well as being desirable on humanitarian (equity) grounds. (4) An increase in the rate of conversion will only help to lower excess demand and inflation if the effective supply of existing converted capacity is high relative to the prevalent excess demand in the economy. Otherwise increases in the rate of conversion could have the perverse effect of raising inflation. To avoid such a perverse outcome might require the simultaneous pursuit of demand-side policies or incomes policies; as well as supply-side policies to improve the quality of converted capacity, making it more consumer orientated, hence augmenting the effective supply of the existing converted capacity. Note that such a policy package could fully eliminate the dynamic disequilibrium described by E 1 in Fig. 1. The fully stabilized outcome with no excess demand and no (steady-state) structural inflation would be at point E 2 in Fig. 1, which could also correspond to point B in Fig. 5.
Our model attempts to capture some of the stylized features of the macroeconomies of the successor states to the former Soviet Union. We have emphasized structural causes of inflation and the role of conversion. We noted that the pace of reform has been slower than in neighbouring Central European states, with hyperinflation persisting along with substantial budget deficits and a relatively large sheltered segment of the economy. Much remains to be done and a lot hinges on the current reform process. Aid from the West is crucial in this respect and we have examined two different types of aid. Further depreciation of the currency could be counter-productive. It is the inefficiency in the supply side of the economy which is at the heart of the matter; any reform process failing to resolve this problem as well as take into account the social costs of reform in terms of unemployment and poverty will, like faith without charity, come to nothing.
ACKNOWLEDGEMENTS
I am grateful to Somnath Sen, Alan Winters, participants at the Warwick 1991 Conference on Eastern European economics, as well as two referees and the editor of the journal for invaluable comments and suggestions on earlier versions of this paper.
CONVERTING
MILITARY CAPACITY TO CIVILIAN USE
39
REFERENCES ASLUND, A. (1991). 'Prospects for Economic Reform in the USSR'. Paper presented at the World Bank's Annual Conference on Development Economics, Washington DC, 25-26 April 1991. BENNETT, J. and DIXON, H. D. (1993). 'Macroeconomic Equilibrium and Reform in a Transitional Economy', Centre for Economic Policy, Discussion Paper, no. 758. CARt)OSO, E. (1981). 'Food Supply and Inflation', Journal of Development Economics, 8, 269-84. COOPER, J. (1991). 'Military Cuts and Conversion in the Defence Industry', Soviet Economy, 7, 121-42. DEGER, S. (1990). 'World Military Expenditure', in World Armament and Disarmament, SIPR! Year Book, 1990. Oxford University Press, Oxford. DORNBUSCH, R. (1980). Open Economy Macroeconomics. Basic Books, New York. -(1986). Dollars, Debts and Deficits. MIT Press, Cambridge, MA. FINDLAY, R. and RODmGUEZ, C. A. (1977). 'Intermediate Inputs and Macroeconomic Policy Under Flexible Exchange Rates', Canadian Journal of Economics, 10, 208-17. IMF (1993). World Economic Outlook, May 1993. International Monetary Fund, Washington DC. , IBRD, OECD and EBRD (1990). The Economy of the USSR, Summary and Recommendations. Washington DC, December. KORNAL J. (1980). Economics of Shortage. North-Holland, Amsterdam. -(1986). 'The Soft Budget Constraint', Kyklos, 39, 3-30. MAHNVAUD, E. (1977). The Theory of Unemployment Reconsidered. Blackwell, Oxford. MURSHEO, S. M. (1987). 'Analytical Models of North-South Interaction', PhD thesis, University of Birmingham, UK. (1990). 'Stabilisation Policy, Commercial Policy and Debt in a North-South Framework', in G. Bird (ed.), The International Financial Regime. Academic Press, London. (1993). 'The Impact of East West Interaction on North-South Interaction', Journal oflnternational Development, 5, 171-81. and SEN, S. (1989). 'Inflation and Macroeconomic Adjustments in a North-South Model', Greek Economic Review, 11, 95-118. OFER, G. (1990). 'Macroeconomic Issues of Soviet Reforms', Department of Economics, The Hebrew University of Jerusalem, Working Paper, no. 222. SEN, S. (1992). 'The Economics of Conversion: Transforming Swords to Ploughshares in the Soviet Union', in G. Bird (ed.), Economic Reform in Eastern Europe. Edward Elgar, Aldershot, UK. -
-
-
-
-
-
APPENDIX
[al,
a12][dGl]=]-bll b~ bla
bl,
aM
La21 a22JLdaJ Lb~l b22 b2a b24J/dQa
L dO d where: a l l = 0(OIl O':t- 1 -- 1) a12 = 0DIII-~o-~- 1QA + (ce -- 1)0-~ 2ql d- (~ -- 1)0"~-2G1] + 0DI2
a21 = 4'Onla ~-1 a22 = qbDAI[~tr~-IQA + (ce -- 1)a~-2ql + (~ -- 1)a ~ 2GI] + qSDA2 + qSF1 -- ys b l l = q n 0 ( 1 - DI1a ~ - t) b12 = qi20(1 - / ~ 1 c r~- 1) b13 ~- --0DI10-ct
b l , = G~ + q~(.) - / ~ ( . )
(A,)
40 S. M. M U R S H E D b21 = --q~DA10-~ lqll -- (bF2 -- 2 b22 = --q~)DA10-~- lql 2
b23 = ¢(1 -- DA10"~) b24 - 0. N.B. Du>0,
D~2 > 0,
DA1 > 0,
DA2<0
FI<0,
F2>0,
qu<0,
q12>0
where
F2
=
_Fl0-Pi/E2
'
7[0" -- 6] E2Pm/aW
and
1 s - - 1 + EP,,"
The trace of the Jacobian can be signed as negative using the Slutsky condition (DA2 > DA1DA, QA includes DA). The determinant, A, is given by: m=
I//(D110- ct-1
--
1)(q~Dn2 + ~bF1 -- sy)
-- (aDAl(aa~'- lQa + (o: -- 1)a~-2ql + (~ -- 1)a~-2G 0 -- dpDAla~'- l@Di2 . We assume A > 0 by the requirement of stability. As far as the slopes of the various curves are concerned: dali dGi
a11>0 at2
da a21 -- a = 0 = -- > 0 dGl a22
d0-/dG~ AA is given by (A.3), except the last term is omitted from a22.
(A.2) from(16)
(A.3) from (15)
CONVERTING M I L I T A R Y C A P A C I T Y TO C I V I L I A N USE: A T W O - S E C T O R M O D E L OF AN E C O N O M Y IN T R A N S I T I O N S. M A N S O O B
MURSHED
1
The paper presents an analytical two-sector macroeconomic model of the type employed for the former Soviet Union. Partial liberalization turns a repressed inflation disequilibrium macroeconomic regime into an open inflation regime; one which continues to be characterized by disequilibrium, due to excess demand. Inflation proceeds in the two sectors, fuelled by real wage resistance and excess demand. A macroeconomic role is given to the conversion of the military production complex to civilian use. Thereafter, the effects of devaluation as well as increased consumer goods and technological aid are considered. Increases in the rate of conversion could be even more inflationary unless accompanied by policies to lower excess demand as well as schemes to improve the quality of the current converted sector.
1. I N T R O D U C T I O N
The recent dramatic events in what were the centrally planned economies of Eastern Europe culminated in political disintegration, especially of the former Soviet Union. A part of the process of change is the restructuring of these economies and their transition to ' m a r k e t ' economies. The tasks associated with this economic transformation seem to be without parallel in recent economic history and this has aroused considerable interest in the economics profession. Most studies concern themselves with sectoral issues such as trade, debt, exchange rates, or privatization; macroeconomic issues receive relatively less attention, although examples do exist, such as Bennett and Dixon (1993). This paper will concern itself with macroeconomic issues involving converting military capacity to civilian use, a process known as conversion, as well as the role of 'structural' inflation. Although the intention is to make general points, the experiences most closely related to the analytical model in the paper are those in the successor states of the former Soviet Union, particularly those new countries left with a significant military capacity such as Russia and the Ukraine. It is useful to dwell briefly on the previous economic regime as it helps to concentrate the mind on the present. What were the sources of the inefficiencies of the previous system which were so universally proclaimed? These are best described in the words of the Hungarian economist Janos Kornai as the 'shortage syndrome' (Kornai, 1980, 1986). The shortage syndrome is said to emanate from the phenomenon 1 NI Economic Research Centre, 46-48 University Road, Belfast, N. Ireland BT7 1NJ, UK.
© Oxford University Press 1994
25
26 s. M. MURSHED of the soft budget constraint, where firms have little incentive to use optimally the inputs available to them. The result is a chronic excess demand for inputs and the consequent shortage syndrome. In the aggregate or macroeconomic sense we could describe the old Soviet economic condition as a generalized excess demand regime with supply as the constraining factor. Such a characterization of a macroeconomic regime is due to Malinvaud (1977), who may not have had the Soviet economy explicitly in mind, but this description was emphasized by Murshed (1987, ch. 6) when describing the then Eastern bloc. In more succinct language, such a macroeconomic regime is described by Malinvaud as a 'repressed inflation' regime--one in which there is a fundamental disequilibrium caused by excess demand; this excess demand is prevented from becoming open by rationing (other examples of repressed inflation regimes could be wartime western economies). It is our intention to pursue the disequilibrium approach in this paper, and attempt to analyse the disequilibrium dynamics characterizing the former Soviet economy at the present time. We will demonstrate that the reform process could convert a repressed inflationary regime into an open one, without necessarily fully resolving the root of the problem (excess demand). The history of the Soviet economy in the past two decades suggests stagnation and the failure of the 'extensive' model of economic growth, which is input-intensive. As Sen (1992) demonstrates, the Soviet economy between 1960 and 1987 displayed rising capital-output ratios, as well as falling shares of consumption relative to investment in GDP. Since the advent of Gorbachev and perestroika leading to the law on state enterprises of 1987, the first attempt at the reduction of economic centralization, the problems of shortage and inefficiency at the level of the economic enterprise seemed to have become more acute, according to most observers (see, for example, Ofer, 1990; IMF, 1990; Aslund, 1991). The breakup of the Soviet Union and the CMEA has also contributed towards growing shortages. Returning to the present, we have to take stock of the current state of the reform process which has been underway for some time. Here we have to distinguish between the experience of Central European countries and the successor states of the former Soviet Union. It is widely accepted that macro-stabilization is a necessary prerequisite for growth and progress in other areas. In this respect, the elimination of the stock of excess demand (rouble overhang) was considered a priority. This would involve price reform as well as the drastic reduction of the government budget deficits which had emerged in the twilight years of the old regime. Studies show that the former Soviet republics have been less successful in this regard than other Central European nations, see IMF (1993) who estimate the budget deficit in Russia and Ukraine at 23 and 37~ of G D P in 1992. The inflation performance has been similarly poorer in the countries of the former Soviet Union at 1202~o (CPI) in 1992 compared to, say, 43~ in Poland. The decline in G D P in the same year was on average 18.5~ in these countries, compared to a much more favourable performance in Central Europe. All of these indicators suggest that much more needs to be done in the former Soviet republics and that the reform process has still a long way to run. Another stylized fact is the continuation of a sheltered sector in receipt of subsidies. Bennett and Dixon (1993) emphasize this in their two-sector model. The model we
CONVERTING
M I L I T A R Y C A P A C I T Y TO C I V I L I A N U S E
27
shall employ is also a two-sector model, but different from theirs. We shall employ the fix-price, flex-price dichotomy to differentiate a more protected (I) sector and a more open (A) sector respectively. Our model will also generate a system of structural inflation, one in which the excess demand for consumer goods generates inflation via real wage resistance. Money plays an accommodating role in the process, unlike in the model of Bennett and Dixon (1993). The major analytical innovation of the paper is the introduction of a role for military conversion in the macroeconomy via augmenting the supply of the I sector. The Soviet military production complex has always been a major producer of civilian goods and consumer durables in addition to armaments (Sen, 1992); this tendency increased in the Gorbachev era. The importance of conversion has been stressed by analysts of the former Soviet Union (Deger, 1990; Cooper, 1991; Sen, 1992) who believe that it may be central to the reform process there. It should be noted that authors such as Sen (1992) are highly critical of the quality of conversion thus far. This is because of the military production complex's even greater insularity to 'market forces', when compared to the civilian production sector. Nevertheless the military production complex is still a vast repository of capital goods and high quality human resources. Our model goes on to analyse the dynamics of the two-sector model which generates inflation and has a central role for conversion. We analyse the effects of a policy-induced change in the pace of conversion, exchange-rate depreciation as well as increased aid. With respect to the last, our model is able to distinguish between various types of aid, technical as well as the type augmenting the supply of consumer goods, thus allowing some qualitative comparison between the two. The rest of the paper is organized as follows: the next section presents the salient features of the analytical model; section 3 outlines the process of disequilibrium dynamics; section 4 examines the effects of variations in parameters including exchange rate devaluation, aid, productivity changes and a rise in the rate of conversion; and finally section 5 briefly presents some conclusions. 2. THE MODEL
We will characterize the macroeconomy into two broad sectors. We term the first the agricultural or consumer goods (A) sector. We would expect to include food items as well as other consumer goods in this sector. For the purposes of macromodelling, what matters foremost is the type of market clearing employed rather than the physical nature of the good. The market-clearing mechanism employed in that sector is of the flex-price variety, as proposed by Hicks. In other words, excess demand leads to price increases and vice versa. Our rationale for employing the flex-price mechanisms is the wide ranging market-orientated price liberalization which has taken place in the states of the former Soviet Union. Equilibrium (demand equals supply) in the A sector is given by: PAQA, = PADA(Y; a) "4- PAF(aPt/E)
(1)
where QA represents output of the A sector, assumed exogenous for the sake of
28 S. M. M U R S H E D
tractability; PA is the price; DA represents domestic demand for A, which is an increasing function of 'real' income Y (defined below) and a decreasing function of the domestic terms of trade, a, o- = PA/Pbwhere P~ is the price of the other (industrial) sector; F represents foreign or export demand, a negative function of PA hence o and a positive function of the nominal exchange rate E, when E increases the domestic currency depreciates. Our rationale for including the economy's exportable goods into the flex-price A sector is that the price of the exportable is likely to be sensitive to international market forces and demand. F ( . ) in (1) is obtained from F(PA/E), dividing both PA and E by P~. We now turn to the other sector, the industrial or investment (I) goods sector. We postulate that the output of this sector will be marketed in fix-price conditions. This means that prices change as costs alter, but excess demand or supply leads to quantity changes to clear the market. Quantity adjustments are crucial to the analysis of conversion, as this process also occurs in quantities. The price of the I sector, P~ is a constant mark-up, set equal to unity for convenience, on variable cost:
PI = [ a m + EPmM ]
(2)
where a = L/Q~ is the fixed labour-output ratio and the inverse of labour productivity; Wis the nominal wage; Pm is the price of an intermediate input which is imported from the West and EPmM is the cost of the intermediate input in the production of one unit of output in the I sector. In making the intermediate input imported we are introducing, in an extreme form, perhaps, technological dependence on the West. In order to keep the algebra tractable we assume that one unit of the input, M is required in one unit of output, Q~, in the industrial sector, as in Findlay and Rodriguez (1977). Since part of the total value of the sector is imported, in order to arrive at the net domestic value added of that sector we subtract the value of the intermediate input from gross output P~ql = PIQI - EPm (3) where ql is net output in the I sector and QI gross output. Dividing (3) by P~ yields: ql
Q,(1 - EPm'~pI/
or,
QI = qlA
(3')
where A = ~/(~
-
EPm).
Next we take up Kornai's (1980, 1986) notion of the shortage economy, in that notional or ex-ante demand for the I sector's product, D~, exceeded effective supply. In the past this shortage would have been resolved by explicit physical rationing, i.e. when: P~ql < PIDI
(4)
the net effective domestic supply of output, ql was constrained by the availability of M. The available quantity of M would, in turn, depend on the balance of payments
CONVERTING
MILITARY
CAPACITY
TO CIVILIAN
USE
29
constraint, the ability of the economy to import from the West depending on how much it could export to the West and how much it could borrow. Recent developments, however, put a new complexion on the process of rationing this fixed quantity of ql. This is due to the gradual conversion of some of the existing military production capacity into civilian industrial use. This allows the effective supply of the I sector to be augmented and can bring about a regime switch from a rationed market to a quantity-clearing market. Quite obviously there are difficulties with the pace of conversion. In the long-run there will be a constraint on the ability of the converted military sector to supply I goods. But in the short-run it is reasonable to assume that the military sector can augment supplies of the I sector from existing stocks without importing inputs, given the vast resources (including human capital) made available to it at very favourable prices during the previous regime. We can rewrite (4) after normalizing by P~ as: q, + G, = / ~ ( Y, a).
(5)
The left-hand side of (5) represents total supply of the I good and the right-hand side indicates total demand. Supply is made up ofq~, which is the net amount available from the civilian sector for absorption and the supply from military conversion, G~, the latter equilibrating supply with demand in the I sector. As far as demand in the I sector is concerned, we make it an increasing function both of real income, Y- and a = PA/PI. We further postulate that existing civilian capacity in the I sector is a decreasing function of the exchange rate, E, and an increasing function of the quantity of the imported input, M, available. As E rises (depreciates) the domestic cost of M rises, lowering the domestic value added of Q~; and, of course, an increase in M for fixed E and Pm has the opposite effect. Thus: qi =- ql( E, M ) .
(6)
We need to define the concept of real income. Nominal income, Y, is the sum of the value of the two sectors, plus the converted military sector's output of I goods. This could be viewed as output and income from three sectors, one producing A goods and two making I goods. Thus: Y = PAOA + P~q, + P~G,.
(7)
In order to arrive at real income we deflate nominal income in (7) by a cost of living index, P, where p = -D~r,l-a -I--A , (8) a and 1 - a are the expenditure shares of the A and I sector in the representative consumption basket (see Dornbusch, 1980). This gives us:
Y = ffaOA d- a~-lq, A- o'~- 1G I (9) where a = PA/Pt. Similar to the Dornbusch (1980) traded/non-traded good model we have one input, M (an intermediate input which is an investment good), and one export (F). We do not include consumption imports as it only complicates the derivation and M could
30
S. M . M U R S H E D
be viewed as containing a consumption component. We can introduce a relation describing the current account of the balance of payments, B, obtained from (3') and
(1): B = aF(')
-- ( A / P O q I ( . )
-- r E D / P ~ .
(10)
This is written out after normalization by P~. The first term on the right-hand side of (10) denotes exports and the second term imports. The last term indicates debt servicing, where D is foreign currency denominated debt and r stands for the interest payments on these. We are not imposing a requirement of current balance (B = 0); deficits in B are financed by capital flows leading to future debt-stock increases and debt-servicing consequences. See Murshed (1990, 1993) on the explicit analysis of debt-servicing issues.
3. D Y N A M I C S
In our analysis of the dynamics of economics in transition belonging to the former Soviet Union there are a number of stylized facts we wish to emphasize. First and foremost we wish to analyse the possible role played by the conversion of military capacity to civilian use in augmenting the supply of goods in the economy. As indicated in the Introduction, the military production complex had a particularly privileged status in the former Soviet Union. This means that it is a relatively large repository of resources and capital (human as well as physical) which can be diverted to civilian production. We also wish to analyse the hyperinflationary process in these economies. This is, to a large extent, a direct result of money supply growth, but this in turn is a reflection of a degree of residual 'softness' in the economy unlike in Central European economies. Parts of the economy are sheltered by subsidies and wages are not always at market clearing levels. One could argue that there is a degree of 'real wage resistance', to employ a term popularized by Hicks and Kaldor. Real wage resistance can exist when there has been a decline in the level of real wages due to economic reforms. This real wage resistance could be a major contributory factor in the inflationary process leading to a price-wage-price spiral, as We shall see below. Of course, our stylized model represents an extreme form of this phenomenon, but it does illustrate what could still be a major contributory factor to inflation. After outlining the dynamics we will proceed in section 4 to consider variations in parameters which are of potential significance. These include the effects of devaluation or exchange rate depreciation in increasingly open economies; the effects of assistance in the form of technological aid to the I sector or more fungible assistance to the A sector in the form of greater availability of consumer goods; and a speeding of the rate at which is converted to civilian use. We proceed by modelling real wage resistance following Dornbusch (1980). Workers are interested in a particular standard of living, reflected in a r e q u i r e d r e a l w a g e , w. Since there are two goods in the consumption basket, the cost of living is indicated by the price index in equation (8). Thus w = W/P
(11)
CONVERTING MILITARY CAPACITY TO CIVILIAN USE 31 where the required real wage, w, is a nominal wage, W, divided by P in (8), an increase in P will lead to increases in the nominal wage, IV, given w and successful real wage resistance. Following Dornbush (1980) we relate the required real wage to a required terms of trade, & Given real wage resistance, the actual terms of trade, 6, must equal the required rate dictated by worker aspirations: 0"~ 8.
The evolution of money wages would be given by:
( v / w = ~[~ - 8 ]
(12)
where ~ > 0 is an adjustment parameter. Utilizing (12) and (2), the equation for I sector price dynamics becomes ~/p~ _
yea - 5]
(13)
1 + EPm/aW" Equation (13) thus gives us the price dynamics for the industrial sector, where if the actual terms of trade exceed the required rate, ~r > 8, P~ would be increased due to real wage resistance. Next we consider the price dynamics of the agricultural or consumer goods, A, sector. We have already indicated that this is a flex-price sector where excess demand causes the price, PA, to increase. Thus from equation (1)
PA/PA = ~b[DA(') + F ( ' ) - QA]
(14)
where ~b > 0. We may now combine (14) and (13) to examine the evolution of the terms of trade, a; recall that a=PA/PI. Thus, subtracting (13) from (14): PA/PA -- PffP~gives ~[o-
O'/G = q~[DA(") q- F ( ' ) -- QA]
-
8]
1 -k- EPm/aW"
(15)
Equation (15) implies the possibility of steady-state inflation, as first pointed out by Cardoso (1981) and analysed also in Murshed and Sen (1989). By steady-state inflation we imply the possibility of both PA and P~ increasing, but at the same rate, i.e. if PA/PA=/~I/PI, then (15), which is the difference between the two, would be zero - ~ l a = O. But how could such a phenomenon come about? Supposing that, as is proposed, there is a liberalization of the consumer goods market, making its price openly market determined. Given supply bottlenecks, there could be excess demand for the A sector's output such that PA/PA > 0 in (14) which is now opened up. This would mean an increase in the cost of living [(8) and (11)] and, given real wage resistance, would cause money wages to increase in (12), as the actual terms of trade is above the required rate. This could, in turn, mean a rise in industrial goods prices, ~/P~ > 0, in (13). Thus, there could be positive and equal rates of inflation in both sectors which could come to a steady-state equilibrium in the short to medium term; as this process is clearly unsustainable in the long run.
32 s. M. MURSHED We can introduce the perfect foresight variant of rational expectations into the dynamics of the consumer goods (A) sector in (14). This will mean that rational speculators bring about equilibrium in that market by raising prices when there is excess demand. But this assumption of rational expectations does not alter the above dynamics if we have real wage resistance and mark-up pricing in the industrial (I) sector. It should be pointed out that the dynamic analysis is very similar to Dornbusch (1986). There is real wage resisistance as in equation (12) of our model. There is a Phillips curve mechanism in the goods market sector similar to the pricing rule for the I sector in (13). Lastly, there could be perfect foresight in the dynamics of the A sector in (14) similar to that in asset markets in Dornbusch (1980, 1986). This may cause jumps in the terms of trade, but the point is that excess demand for A will still push up PA and hence IV, via real wage resistance and finally P~ through mark-up pricing. Inflation could continue in the steady state if PA and P~ grew at the same rate. To put a stop to this inflation would require exogenous policy measures to reduce aggregate demand. Before attempting to depict these results diagrammatically, we need to describe the quantity adjustment process in the I sector, where we have postulated that excess demand is met by an increased 'conversion', G~. Thus from equation (5), using (6):
(~I
= ~/E/~(")
-- ql(')
(16)
-- GI]"
In Fig. 1, the II curve describes equilibrium in the industrial goods market (demand = supply) and is obtained from (16) setting G~ = 0 in G~, a space. Similarly, the AA curve describes equilibrium in the A sector, and is obtained from !14) setting /bA = 0. The ~ = 0 curve is obtained from (15) along w h i c h [)A/PA = P I / P I , hence 6/~ = [gA/PA --~P~ = 0. The required terms of trade is a horizontal line at the desired rate.
(I
"{3 "6 or*
E
_••11 AA
6=0
..~I'~1 '--'~// / /
E1
I! ~ = .___~ PA (price of the _'A'_sector -. _ _ good) i PI (price of the T sector good) I
Conversion
FIG. 1. Phase diagram and equilibrium relations.
G,
CONVERTING
MILITARY
CAPACITY
TO CIVILIAN
USE
33
In Fig. 1, E 1 indicates the point where we have 'steady-state inflation'. At E 1 there is equilibrium in the I sector, but excess demand for consumer goods such that the AA curve is above E 1. This causes consumer goods price inflation which, via real wage resistance, causes wages and I sector prices to increase. Positive inflation in both sectors proceeds at E1 in Fig. 1. We move on to consider variations in the parameters of the model.
4. VARIATIONS IN PARAMETERS
In order to proceed to capture the effects of parameter changes G~ and a, we totally differentiate (16) and (15) and arrange them in matrix form (see Appendix). 4.1. Devaluation Under a fixed/managed exchange-rate system, devaluation is a direct policy decision, often motivated by a desire to improve the balance of payments. Even under floating exchange rates, the exchange rate is rarely independent of government policy actions. With floating exchange rates a depreciation of the exchange rate (rise in E) is often a result of expansionary monetary policy/rising inflation. In what follows we refer equivalently to a direct policy-induced devaluation or an indirect depreciation of E as a result of rising money supply/inflation. dGx dE
blla22-bzla12 A
(17)
and do" - -
dE
~ ( 1 - - Dllo" e - 1)(q~F2 -[- ~) =
A
(18)
where A > 0 (see Appendix for the various alj and blj). Devaluation or exchange-rate depreciation is a mixed blessing. It worsens inflation by raising P~ as it raises the domestic cost of the imported intermediate input, M. It could even add to these inflationary pressures when it is expansionary; by raising income, Y, it adds to the already existent excess demand pressures in the economy. This is because higher income increases domestic demand for both goods. Point B in Fig. 2 is indicative of both of the above-mentioned effects, whereas point C refers to a more moderate rise in inflation with only the effect of a rise (depreciation) in the exchange rate, E, on P~ via the domestic cost of intermediate input imports. Note that the AA schedule is omitted from Fig. 2 and subsequent figures to avoid clutter. As far as real income is concerned, this will rise if the aggregate demand effects outweigh the aggregate supply effects of the rise in E (point B in Fig. 2). The aggregate demand effect comes via exchange rate depreciation on the demand for exports, F 2, and this effect is positive. The aggregate supply effect comes via the increased domestic
34
S. M. M U R S H E D
II 2 II
I1~ ~1 =0 0
Gi FIG. 2. A rise in E. price of imported intermediate inputs on output, and is negative, qll < 0. If the opposite is true and the negative supply effect dominates the positive demand effect, 'contractionary devaluation' ensues at point C in Fig. 2 with falling real income. Note, however, that even these output (real income) effects need to be qualified in the light of disequilibrium dynamics. When devaluation or depreciation is expansionary, it raises the required rate of conversion, GI, as well as having a more pronounced (upward) effect on inflation. When it is contractionary, as far as output and employment is concerned, it lowers the demands on the rate of conversion as well as increasing inflation less dramatically. What would be the effects of devaluation or exchange-rate depreciation on the current account? From (10) dB
da
ql
d E - ( F + aF1)dE + a F 2 + P1 -- (EPm) 2 d E - Aq, i - (rD/Pt) dE.
(19)
Note t h a t F i < 0 , F2 > 0 a n d q H < 0 . It could worsen or improve the current account. There are four types of effects here. First, devaluation raises inflation, hence PA. This lowers exports as the first term on the right-hand side of (19) suggests. But the direct effect of devaluation increases exports as the second term indicates. Thirdly, devaluation lowers output in the I sector as imported intermediate imports cost more, output falls and imports decline as the third and fourth terms in (19) indicate. The final term represents the increased debt servicing necessitated by a devaluation or depreciation of the currency, worsening the current account. 4.2. A n Increase in the Availability o f M This could come about either because of increased technological aid or the relaxation of C O C O M restrictions on imports of technology. dGi dM
-
b12a22 - - b 2 2 a i 2
A
(20)
CONVERTING
MILITARY
~ II1
CAPACITY
TO CIVILIAN
USE
35
II
61 = 0
~=0
GI FIG. 3. A rise in M. This is positive by the stability conditions do -
O.
(21)
dm As expected, an increase in the available quantity of the intermediate input would allow gross and net output of the I sector to increase, as the constraint on output is relaxed, allowing the pace of conversion Gl to be relaxed. On the one hand, this is good news for the domestic economic managers; but it is bad news for those who would like to see a greater pace of disarmament, as the rise in M lowers G~ and hence the pace of disarmament. Nothing happens to o", as the excess demand in the steady state for consumer goods of the A sector remains, this pent up or repressed demand having been let loose or triggered off by liberalization; increasing M only raises productive capacity in the I sector but not the A sector. In Fig. 3 both schedules shift leftwards and we move from A to B. As far as the current account is concerned, from (10) it will worsen if the rise in M is due to increased imports. If, however, the rise in M is due to an unrequited transfer the current account is unaltered. 4.3. An Increase in
QA
This rise in the output of the A sector, could come about either as a result of productivity improvements or more general aid and transfers from the West. dGl
[ - q J D i l a ~ ( ~ b D A 2 - s~ ~t_ (~F1) _ q~al 2 .~_ q~DAlo"a~D12]
dQA
A dG
dQA
-
# ~ [ O a l o " ~ + (/~1o" ~ - 1 - - 1)]
(22)
(23)
A
The plausible result regarding the terms of trade, o" = PA/P~ is for it to fali, this would occur if DA1 + ~1 < 1 in (23), i.e. if the income effects on demand for the A and I
36 S. M. MURSHED 11 ~=0 ~1 =0
GI FIG. 4. Rise in QA (aid or productivity). sector outputs were both small. In terms of Fig. 4 this causes a downward shift in the terms of trade curve, indicating a fall in a and the easing of inflationary pressures. From (10) this will also improve the current account. As far as the demand for the I sector's output is concerned, the final result is ambiguous in (23). If there is excess demand for I sector goods then the II curve shifts rightwards with the final equilibrium at C, indicating a rise in G~ to make up for the excess demand. For this to occur, the income effects of the transfer or productivity increase in QA would have to be relatively substantial as far as the demand for the I sector's output is concerned (D~I relatively large). If, however, excess supply emerged in the I sector following the rise in Q~ the II curve would shift rightward and there would be a slowdown in pace of conversion from military to civilian production, G~ would fall at point B in Fig. 4. Increased aid in the form of 'consumer goods' is beneficial for the economy as it lowers excess demand and inflationary pressures irrespective of what happens to GI. 4.4. An Increase in the Rate of Conversion, It should be emphasized that we are speaking of a rise in the rate of conversion, not its levels. dGi
do-
-
-
b14a22 >/
if
0
-b14a21 />
0
b14
if
~<
b14
0
~<
(24)
0.
(25)
Recall, ] J I > 0, azl > 0 and a22 < 0. The crucial parameter is the sign of b14. If the level of conversion is already high such that the sum of supply, net output, q~ and available military capacity geared to civilian production exceeds demand, then bl~ > 0 will lead to falling levels of G~ and o-. If, however, the opposite is true, and the existing 'converted' capacity is small
CONVERTING MILITARY CAPACITY TO CIVILIAN USE
37
II
6=0
Gi FIG. 5. Rise in the rate of conversion.
relative to demand, the required conversion level, GI, will rise, as will the steady state rate of inflation, a. In terms of Fig. 5, an increase in the rate of conversion shifts the II schedule along the ~ = 0 schedule. If b14 > 0 then the new equilibrium is at point B. On the other hand, if bt4 < 6, the increase in the rate of conversion will have failed, excess demand and inflation will have risen, as shown by point C in Fig. 5. The conversion of military productive capacity to civilian production is an important component of the reforms and transition taking place in the economies of many of the successor states of the former Soviet Union. Our analysis points out that conversion will only help to reduce the inflationary pressures already present in the economy if the existing converted capacity is high relative to excess demand, D~(b~4 > 0, point B in Fig. 5). The more plausible outcome, however, is at point C where increases in the rate of conversion worsen inflation. To avoid such an adverse result would require (i) demand-side measures to lower excess demand, /~, via contractionary monetary policies, say, or incomes policies to moderate wage growth; and (ii) supply-side policies to improve the 'quality' of conversion, making the military production complex more responsive to civilian consumption needs. This would result in an increase in the effective supply of the G~ currently available. In a nutshell, successful increases in the rate of conversion which help to lower inflation (point B in Fig. 5) could require the simultaneous pursuit of additional demand- and supply-side policies. From (10) successful conversion will improve the current account if inflation, and hence PA, declined.
5. C O N C L U S I O N S
Let us conclude by summarizing our results as follows. (1) Devaluation or depreciation of the currency is a mixed blessing. It worsens the
38
S. M. M U R S H E D
inflationary pressures in the economy as well as putting greater demands on the conversion process if it succeeds in raising output. If devaluation is contractionary, the rise in inflation is moderated and the required rate of conversion is lower. It may not even improve the current account of the balance of payments. (2) A greater availability of technology inputs in the I sector because of aid raises productive capacity in that sector, lowers the required pace of conversion from military to civilian use, but has no effect on inflationary pressures. (3) Technical progress in the A sector or aid in terms of consumer goods lowers inflationary pressures, but has ambiguous effects on the conversion process. Aid in this form is preferable to technical aid as it is more beneficial (efficient) to the macroeconomy by lowering inflation, as well as being desirable on humanitarian (equity) grounds. (4) An increase in the rate of conversion will only help to lower excess demand and inflation if the effective supply of existing converted capacity is high relative to the prevalent excess demand in the economy. Otherwise increases in the rate of conversion could have the perverse effect of raising inflation. To avoid such a perverse outcome might require the simultaneous pursuit of demand-side policies or incomes policies; as well as supply-side policies to improve the quality of converted capacity, making it more consumer orientated, hence augmenting the effective supply of the existing converted capacity. Note that such a policy package could fully eliminate the dynamic disequilibrium described by E 1 in Fig. 1. The fully stabilized outcome with no excess demand and no (steady-state) structural inflation would be at point E 2 in Fig. 1, which could also correspond to point B in Fig. 5.
Our model attempts to capture some of the stylized features of the macroeconomies of the successor states to the former Soviet Union. We have emphasized structural causes of inflation and the role of conversion. We noted that the pace of reform has been slower than in neighbouring Central European states, with hyperinflation persisting along with substantial budget deficits and a relatively large sheltered segment of the economy. Much remains to be done and a lot hinges on the current reform process. Aid from the West is crucial in this respect and we have examined two different types of aid. Further depreciation of the currency could be counter-productive. It is the inefficiency in the supply side of the economy which is at the heart of the matter; any reform process failing to resolve this problem as well as take into account the social costs of reform in terms of unemployment and poverty will, like faith without charity, come to nothing.
ACKNOWLEDGEMENTS
I am grateful to Somnath Sen, Alan Winters, participants at the Warwick 1991 Conference on Eastern European economics, as well as two referees and the editor of the journal for invaluable comments and suggestions on earlier versions of this paper.
CONVERTING
MILITARY CAPACITY TO CIVILIAN USE
39
REFERENCES ASLUND, A. (1991). 'Prospects for Economic Reform in the USSR'. Paper presented at the World Bank's Annual Conference on Development Economics, Washington DC, 25-26 April 1991. BENNETT, J. and DIXON, H. D. (1993). 'Macroeconomic Equilibrium and Reform in a Transitional Economy', Centre for Economic Policy, Discussion Paper, no. 758. CARt)OSO, E. (1981). 'Food Supply and Inflation', Journal of Development Economics, 8, 269-84. COOPER, J. (1991). 'Military Cuts and Conversion in the Defence Industry', Soviet Economy, 7, 121-42. DEGER, S. (1990). 'World Military Expenditure', in World Armament and Disarmament, SIPR! Year Book, 1990. Oxford University Press, Oxford. DORNBUSCH, R. (1980). Open Economy Macroeconomics. Basic Books, New York. -(1986). Dollars, Debts and Deficits. MIT Press, Cambridge, MA. FINDLAY, R. and RODmGUEZ, C. A. (1977). 'Intermediate Inputs and Macroeconomic Policy Under Flexible Exchange Rates', Canadian Journal of Economics, 10, 208-17. IMF (1993). World Economic Outlook, May 1993. International Monetary Fund, Washington DC. , IBRD, OECD and EBRD (1990). The Economy of the USSR, Summary and Recommendations. Washington DC, December. KORNAL J. (1980). Economics of Shortage. North-Holland, Amsterdam. -(1986). 'The Soft Budget Constraint', Kyklos, 39, 3-30. MAHNVAUD, E. (1977). The Theory of Unemployment Reconsidered. Blackwell, Oxford. MURSHEO, S. M. (1987). 'Analytical Models of North-South Interaction', PhD thesis, University of Birmingham, UK. (1990). 'Stabilisation Policy, Commercial Policy and Debt in a North-South Framework', in G. Bird (ed.), The International Financial Regime. Academic Press, London. (1993). 'The Impact of East West Interaction on North-South Interaction', Journal oflnternational Development, 5, 171-81. and SEN, S. (1989). 'Inflation and Macroeconomic Adjustments in a North-South Model', Greek Economic Review, 11, 95-118. OFER, G. (1990). 'Macroeconomic Issues of Soviet Reforms', Department of Economics, The Hebrew University of Jerusalem, Working Paper, no. 222. SEN, S. (1992). 'The Economics of Conversion: Transforming Swords to Ploughshares in the Soviet Union', in G. Bird (ed.), Economic Reform in Eastern Europe. Edward Elgar, Aldershot, UK. -
-
-
-
-
-
APPENDIX
[al,
a12][dGl]=]-bll b~ bla
bl,
aM
La21 a22JLdaJ Lb~l b22 b2a b24J/dQa
L dO d where: a l l = 0(OIl O':t- 1 -- 1) a12 = 0DIII-~o-~- 1QA + (ce -- 1)0-~ 2ql d- (~ -- 1)0"~-2G1] + 0DI2
a21 = 4'Onla ~-1 a22 = qbDAI[~tr~-IQA + (ce -- 1)a~-2ql + (~ -- 1)a ~ 2GI] + qSDA2 + qSF1 -- ys b l l = q n 0 ( 1 - DI1a ~ - t) b12 = qi20(1 - / ~ 1 c r~- 1) b13 ~- --0DI10-ct
b l , = G~ + q~(.) - / ~ ( . )
(A,)
40 S. M. M U R S H E D b21 = --q~DA10-~ lqll -- (bF2 -- 2 b22 = --q~)DA10-~- lql 2
b23 = ¢(1 -- DA10"~) b24 - 0. N.B. Du>0,
D~2 > 0,
DA1 > 0,
DA2<0
FI<0,
F2>0,
qu<0,
q12>0
where
F2
=
_Fl0-Pi/E2
'
7[0" -- 6] E2Pm/aW
and
1 s - - 1 + EP,,"
The trace of the Jacobian can be signed as negative using the Slutsky condition (DA2 > DA1DA, QA includes DA). The determinant, A, is given by: m=
I//(D110- ct-1
--
1)(q~Dn2 + ~bF1 -- sy)
-- (aDAl(aa~'- lQa + (o: -- 1)a~-2ql + (~ -- 1)a~-2G 0 -- dpDAla~'- l@Di2 . We assume A > 0 by the requirement of stability. As far as the slopes of the various curves are concerned: dali dGi
a11>0 at2
da a21 -- a = 0 = -- > 0 dGl a22
d0-/dG~ AA is given by (A.3), except the last term is omitted from a22.
(A.2) from(16)
(A.3) from (15)