Prospects for Ukrainian Economic Reform

It has been well over a year since Ukraine’s Maidan revolution spent away the kleptocratic regime of Victor Yanukovych; Crimea was annexed by Russia and a separatist war began in Eastern Ukraine. The nation remains gripped in the patriotic fervor of the revolution and a fundamental paradigm shift in the nation’s political framework has occurred. Yet the euphoric honeymoon aura of revolutionary days have long ended and the gritty reality of reconstructing a nation with a crony oligarchic post-Soviet economy, in the midst of an on off war, is setting in. In the paragraphs to follow, I will look at the progress and prospects of economic reform along with the institutional, political, and economic difficulties of such a colossal project.

First, in order to understand Ukraine today it is vital to understand the transition that led to the present. The state of contemporary Ukraine, filled with decaying Soviet era infrastructure, hopeless vodka infused alcoholics, widespread illicit sex tourism and mass migration, was not an inevitable outcome following the collapse of the Soviet Union. The transition from communism, took an array of different forms in Eastern Europe and the Soviet Union. Simplistically, the competing theories of how the transition ought to have been handled were split between a “big bang shock therapy” approach in transitioning to capitalism versus a gradualist approach which involves slowly implementing capitalist reform. The big bang is commonly referred to as the “Washington Consensus” which claims that the success of nations is based on the pace of their economic liberalization. The Washington mantra being: “good economics is good politics,” meaning: liberalized markets lead to long term prosperity with temporary pain[i]. The poster children of nations that implanted this approach successfully include Poland, the Czech Republic and the Baltic countries. The gradualist approach in contrast, believes that capitalism cannot be constructed overnight. In this approach, the failure of Russia’s big bang approach was typically juxtaposed with China’s successful gradualist approach[ii]. Ultimately, both views have their merits and the success of either approach depends upon the unique characteristics of individual nations.

Ukraine does not neatly fit into the shock therapy “Washington Consensus” or gradualist approach. In fact, Ukraine’s failure was likely its inability to take a stand. The conflict between the Western half of Ukraine that wished to ‘return to Europe,’ which saw the Soviet era as an aberration in Ukraine’s historical development, and the Eastern half that wished to remain tethered to Russia, which saw themselves as fraternal brothers was as apt a description right after Ukraine’s independence as it is today. This confusion over national identity led to a certain state of compromise which involved the continual Jockeying of national political power between the east and west, whilst the pace of economic reforms drove on slowly relative to successful transition countries. In this sense, a classical shock therapy critique of a gradualist approach is apt. Political power still largely remained within the hands of the Soviet era elite, and the possibility of reform early on faded as a quasi-capitalist rent seeking state was formed. Therefore, Ukraine should have done significantly more with the opportunity that it had for reform in the initial transition. Economically, Ukraine was very similar to Poland in terms of per capita GDP around 1990, yet the trajectories that these two countries took over the next 20 years, were very different.

Still, the shock therapy approach is too simplistic an argument for why Ukraine failed, which avoids the institutional, political, and economic difficulties of economic transition. Recent theoretical economic research has disputed the mantra that “good economics is good politics,” questioning if there are really clearly good economic policies across countries, places and times. As Daron Acemoglu elucidates:

“Counterfactual analyses that ignore political economy factors, like those that do not take account of general equilibrium effects may give misleading answers. Convincing micro or even macro (general equilibrium) evidence about the effects of a particular policy change on economic outcomes is not itself sufficent [sic] to gauge what the implications will be when such a policy is encouraged or implemented”[iii].

 Essentially, Acemoglu means that finely tuned and sophisticated economic models are worthless unless the institutional and political economy power dynamics of economic policies are understood. From a purely theoretical economic perspective, an economy that is controlled by private agents rather than state agents should be more efficient and conducive to growth, yet in practical application, dynamic shifts in economic power can lead to abusive power relations or sharply negative welfare consequences that have the potential for popular backlash, all from supposedly “good” economic policies. For advanced economies, certain policies seem obvious, yet as Gerald Roland claims:

 “Successful institutions of capitalism are already present in advanced economies, and we tend to take them for granted when reasoning on economies in transition or on developing economies where such institutions are absent. The transition experience has therefore very much reinforced the institutionalism perspective in economics and a shift in emphasis in economic thinking, from the analysis of markets and price theory to that of contracting and to the legal, social and political environment of contracting”[iv].

Among economists, there has been an apparent acceptance of the general idea that institutions matter in economic development and economic transition. Quantifying how much they matter is difficult, but there is little doubt that they are a vital consideration in any attempts at reform. In Ukraine today, a new project to fundamentally transform an economy is again unfolding. Is the international community falling into the same pitfalls that it did in the past in pushing an orthodox shock therapy agenda as it did during the transition in the 90s?

Currently, the continued support of the IMF, embodied this year as a $17.5 billion loan, is the one reason that Ukraine has not yet defaulted. In the fourth quarter of 2014, Ukraine’s economy contracted 14.8% compared to a year earlier, while it’s currency, the hryvnia, has lost two-thirds of its value in the past 15 months. Pensions have shrunk, real wages have gone down, the purchasing power of its currency has plummeted, and consumer energy costs have increased despite the decrease in global energy prices due to formerly high energy subsides being cut. A full blown financial crisis in terms of sovereign default, banking panic, or currency crises are all very real possibilities. Deposits in Ukrainian banks have been shrinking due to a lack of consumer confidence in the currency while liquidity remains challenged from an increase in nonperforming loans. Recently, Ukraine’s fourth largest lender has been declared insolvent, and the central bank’s benchmark interest rate hovers around 30% in an attempt to protect the highly fragile financial situation[v]. Fiscally, Ukraine had a deficit of -10.3% of GDP at the end of 2014, and its debt to GDP ratio is expected to approach 70% by the years end. The war alone, according to Ukrainian president Petro Poroshenko, is eating up $10 million a day[vi]. Ukraine can only last so long unless drastic change occurs.

In the face of such a reality, it is difficult to maintain any hope. The IMF claims it is enthusiastic about the prospects of stabilization, yet their projections seem dangerously static and there is immense uncertainty in the economy, most significantly stemming from the war in eastern Ukraine. At any moment, the war could get very hot thereby not only draining government coffers, but general investor and consumer confidence. The IMF program is largely one of austerity which is potentially dangerous and destabilizing. Again, these may be good economic policies in theory, but in practice the will of the people to be able to bear the pain of such reforms must be taken into account. Still, the IMF has wised up somewhat and realized the potential dangers as it noted in a recent report: “There is no point in glossing over the situation on the ground in Ukraine. If the conflict in the East of the country intensifies – and we all certainly hope it won’t – then one has to be concerned about the sustainability of the expected recovery”[vii]. The IMF in general, has begun to make overtures to the potential danger of relentless austerity, but it is still to be seen in actual policy for which Ukraine may be an experiment.

Questions also must be raised as to whether reform can occur when the current political administration is run by a former oligarch, Petro Porosehnko, the owner of Ukraine’s largest confectionary company. A recent clash between the administration and another oligarch, Ihor Kolomoisky, over the control of UkraNafta ,a state oil company, where Kolomoyskyi held a 42% stake has raised questions about the intention of the regime. In the past it was claimed that Kolomoyskyi: “milked the company for cash, withholding billions of hryvians in state dividends” and he paid “5m a month…to protect his stake in the lucrative enterprise”[viii]. In the face of such rent seeking, the Ukrainian parliament passed a law that changed the procedure of voting, thereby weakening Kolomoyskyi’s control over the company. Kolomoyskyi responded by sending a group of armed men who erected barricades around the company’s headquarters. Kolomoyskyi ultimately backed down, and has also recently been dismissed as governor of Ukraine’s Dnipropetrovsk region. Still, questions remain as to whether the move was conducted in order to actually check corrupt excess or if it was just a case of an oligarch overstepping his boundaries in the face of the new regime. Regardless of the true intentions of the action, it at least gives some glimmer of hope that the institutionalized system of corruption and elite interests are being challenged.

If Ukraine has a hope of having a successful transition, and not once again being mired in a post-soviet economic malaise, the lessons of transition and the importance of institutional and political economy realities must be understood. First, Ukraine must form its own independent vision of change free from foreign intervention. It ought not just blindly implement what the IMF commands or blindly follow what other transition countries successfully did in the past or be subject to the whims of orthodox economics. Ukraine must be understood as a unique case with its own unique problems and necessary prescriptions. Second, patience is of the utmost importance. Institutions do not change overnight nor do consumer or investor expectations. Thirdly, there should still be no excuse for bad economic policy. Short term economic pain should not mean permanently offsetting vital economic reforms. Finally, perhaps the greatest lesson to be understood concerning economic reform was best explained by Nobel Prize winning institutional economist, Douglass North, who wrote that, “Economic change is an ubiquitous, ongoing, incremental process that is a consequence of the choices individual actors and entrepreneurs of organizations are making every day”[ix]. No matter what state planners may attempt, the fragility of human understanding in the face of immense complexity and uncertainty must be taken into account.

 

Works Cited:

[i] Aslund, Anders. Building Capitalism: The Transformation of the Former Soviet Bloc. New York: Cambridge University Press, 2002.

[ii] Stiglitz, Joseph. “Whiter Reform? Ten Years of the Transition.” working paper., World Bank, 1999

[iii] Acemoglu, Daron 2010. “Theory, General Equilibrium and Political Economy in Development Economics.” Journal of Economic Perspectives, 27(2): 17-32.

[iv] Roland, Gérard. 2002. “The Political Economy of Transition.” Journal of Economic Perspectives, 16(1): 29-50.

[v] http://rt.com/business/237161-ukraine-nbu-deltabank-bankruptcy/

[vi] President v Oligarch The Economist March 28 2015

[vii] https://www.imf.org/external/np/speeches/2015/040715.html

[viii] President v Oligarch The Economist March 28 2015

[ix] North, Douglass. Institutions, Institutional Change and Economic Performance. New York: Cambridge University Press, 1990.