IMF’s program in Ukraine: How to create a new Greece

By Yuriy Gorodnichenko (UC Berkeley)

More information came in about the deal between the IMF and the new government in Ukraine. While some conditions (e.g., switch hryvnya (Ukraine’s currency) to a floating exchange rate regime and depreciate to correct external imbalances) appear reasonable, others appear to be surprising given the experience of the Great Recession.

Specifically, the fiscal position of the government in Ukraine is weak with a deficit of 5 to 9 percent of GDP—the exact magnitude depends on how one treats “off-balance sheet” liabilities (e.g. state owned enterprises). Clearly, a fiscal consolidation is needed. The IMF demanded that the government raise taxes (about 2 percent of GDP), cut spending (about 3 percent of GDP), remove energy subsidies to population (1 percent of GDP), and freeze minimum wages. The government agreed to raise energy prices charged by utilities by 50 percent starting May 1, 2014. The program envisions a gradual expenditure-led fiscal adjustment—proceeding at a pace commensurate with the speed of economic recovery and protecting the vulnerable—aiming to reduce the fiscal deficit to around 2½ percent of GDP by 2016. In short, the IMF wants Ukraine to implement a massive, front-loaded fiscal contraction.

This is a bad idea. First, many commentators observed a strong negative correlation between fiscal consolidation and GDP growth in Eurozone countries during the Great Recession (see Figure 1). While the IMF demonstrated more flexibility with respect to fiscal reforms in these countries, it was still far too aggressive on forcing countries to keep balanced budgets. PIGS countries had to implement large fiscal consolidation, they had deep recessions, and even now they have weak economic growth.   



Figure 1: Austerity in the Euro area; source: Paul Krugman’s blog.



Second, recent research has converged on the consensus that fiscal multipliers may be particularly large during recessions ([1], [2]) and financial crises ([3]) so that fiscal consolidations could be particularly painful when economies are weak. Even IMF economists acknowledge that fiscal multipliers could be larger than the IMF thought. That is, the IMF consistently underestimated the negative effects of fiscal contraction during the Great Recession (see Figure 2). Olivier Blanchard, the chief economist of the IMF, argues that the timing for fiscal consolidation should be “less now, more later.” In other words, fiscal consolidation should be done when economies are doing well rather than when they are depressed.

Figure 2.  Growth Forecast Errors vs. Fiscal Consolidation Forecasts in Europe.
Figure plots forecast error for real GDP growth in 2010 and 2011 relative to forecasts made in the spring of 2010 on forecasts of fiscal consolidation for 2010 and 2011 made in spring of year 2010; and regression line. Source.

One may argue that fiscal consolidations should be front-loaded because i) a crisis may be the only time when politicians can do reforms, ii) a fiscal consolidation may restore confidence and resume economic growth, iii) fiscal consolidation could be the only feasible option to balance the budget. While these could be good arguments, I believe that none of them applies to Ukraine: i) Ukraine is going to implement wide-ranging reform as a part of its association agreement with the EU anyway; ii) given a very low income per capita, Ukraine is likely to grow fast in the medium run (fighting corruption is by far more important in restoring confidence); iii) many countries committed to loan vast resources to Ukraine and so it can weather short-run difficulties.

In summary, fiscal consolidations in weak economic conditions could be a kiss of death. One could have expected that the IMF is going to learn from its mistakes but the program between the IMF and Ukraine suggests otherwise. At this rate, the IMF can turn Ukraine into Greece, a country with deep and prolonged economic contraction and continued political instability. Is this what the IMF wants to achieve?

Putin's Brazen Demand In Return For Him NOT Invading Ukraine

By Paul Gregory (Hoover Institution and University of Houston)

An unexpected late-night call from Vladimir Putin to Barack Obama has raised hopes for a diplomatic solution to the Ukraine crisis. Do not hold your breath Washington D.C.!  Putin’s vague assurances that Russia favors diplomacy over tanks were sufficient to lure John Kerry to redirect his plane to Paris for talks with his counterpart on Monday. But, rest assured, Putin’s diversion from arms to diplomacy is designed to test whether he can get the United States to sell out Ukraine without an invasion that would further isolate Russia and inflict serious damage on its economy.

Putin’s diplomats are already making the case for an agreement that creates an emasculated Ukraine comprised of loosely connected regions, each conducting its own economic and foreign policy (and free to join Russia if they wish), with a powerless figure-head government twiddling its thumbs in Kiev. And Ukraine: Say good by to joining the European Union under such circumstances. You are no longer a country.

Russia’s immediate target is Ukraine’s May 25 presidential election. If it proceeds smoothly and its results are as expected, Putin would loose his one rationale for armed and covert intervention: His claim that Ukraine’s illegitimate government, brought to power by an  extremist-neo-Nazis Putsch, orchestrated by the United States, leaves him no choice but to intervene on behalf of Ukraine’s beleaguered ethnic Russians.

The expected election of a moderate reform president, with no record of  ethnic enmity, and the miserly showing of right-wing candidates, would reveal to the world the hollowness of Putin’s portrayal of Ukraine as Serbia-Kosovo boiling cauldron of ethnic animosity. The Ukrainian people seem to be showing great wisdom in uniting behind a consensus candidate, whom the Russians would find difficult to discredit.

The timing of  Putin’s bid for a diplomatic solution reflects the erosion of  his Big Lie as he moves from the small Crimean to the big theater of  Ukraine. Thinking people are beginning to ask why Putin’s propagandists can cite virtually no cases of Ukrainian-on-Russian ethnic violence, only a few victims of riots or random bullets. As OSCE observers fan out through Ukraine, they are also finding no instances of extremist or neo-Nazi violence other than events staged by Russian tituski (the Ukrainian slang for paid Russian provocateurs). As days pass, even observers sympathetic to Russia will increasingly understand the fiction of Putin’s Big Lie.

The impending May 25 presidential election poses an even greater threat to the Putin Big Lie narrative. Yesterday’s filing deadline brought forth five candidates. The front runner, Pyotr Poroshenko (UDAR Party), a Ukrainian businessman and pro-European member of parliament, is projected to garner 36 percent, after UDAR’s leader former boxing champion, Vitaly Klitschko, withdrew in favor of Poroshenko. Former prime minister, Yulia Timoshenko’s anti-Russia program is projected to attract a voter tally of 11 percent, Kharkiv’s mayor, Mikhail Dobkin, representing Yanukovich’s Party of the Regions, is expected to gain 5 percent. The candidates of the two nationalist parties (Tyagnibok and Yarosh) are expected to gain one to two percent each.

Unlike the Crimean referendum, which took place under the tutelage of Kalashnikovs, criminal thugs, titoushki meddlers, and without international observers, the Ukrainian presidential election will be watched by hundreds of certified observers,  monitoring polling places and the election count. The Ukrainian election commission, unlike its Russian counterpart, is allowing in all contenders, who can distribute their election material and most likely appear on Ukrainian media (which is currently blacked out in the East and South).

The Russian and Ukrainian people are not stupid, despite being barraged by Putin’s Big Lie. Russia’s rulers cannot afford to let their subjects see a real democratic election. For most Russians, quasi-democratic elections are, at best, a distant memory dating back to Boris Yeltsin.

Putin cannot allow this election to take place. It will reveal the trivial support for the so-called radical neo-Nazi nationalists. Putin cannot spin Poroshenko, who has served in several governments,  into an anti-Russian neo-Nazi radical. True Timoshenko made inflammatory anti-Putin statements, which will limit her appeal to the broad Ukrainian electorate. It seems Ukrainian voters, who sympathize with her years in prison on trumped up charges, feel she had her chance to rule and failed. It is time for new blood.

Putin’s diplomatic push, therefore, is against the May 25 election. His diplomats propose (Lavrov and Itar-Tass News Agency) that the presidential election be declared illegal to be replaced by ill-defined regional and local referenda. Before any national election, Russian diplomats demand, Ukraine must adopt deep constitutional reforms (when and how?) so that they can have “a president supported by all.” (Quite a task in a country as divided as Putin would have us think).

Putin’s top diplomat (Lavrov) lays out the rationale for Russia’s proposed treatment of Ukraine as follows:

“Frankly speaking, we don’t see any other way for the steady development of the Ukrainian state apart from as a federation.”

Lavrov’s proposed plan calls for each region to:

“control of its economy, taxes, culture, language, education and external economic and cultural connections with neighboring countries or regions… Given the proportion of native Russians [in Ukraine], we propose this and we are sure there is no other way.”

In a word, Putin wants Ukraine to be partitioned into autonomous regions, with a figurehead national government in Kiev – a round-about way of breaking up Ukraine. And he expects Barack Obama to accept!

Putin’s diplomats warn the West that, if their proposals are not accepted, Russia reserves the right to take appropriate (military) action. In typical Russian negotiating style, the right to intervene militarily in Moldavian breakaway regions is added to the mix. (I guess the Baltic states are next).

What do Ukraine, the United States, and Europe get in return for the de facto  breakup of Ukraine? Answer: The promise that Russia will not invade.

To their credit, the Ukrainian Foreign Ministry forcefully rejected Russia’s demands immediately as follows:

“The ultimatum and the didactic tone of these statements demonstrate that as the real aggressor Russia does not accept any control over its own behavior. Under the barrels of its machine guns, this aggressor demands only one thing — the complete capitulation of Ukraine, its dismemberment, and the destruction of Ukrainian statehood. Russia’s proposals for federalization, a second official language, and referendums are viewed in Ukraine as nothing less than proof of Russia’s aggression. We sincerely regret that Minister Sergei Lavrov had to voice them.”

Ukraine’s foreign ministry proceeded to return fire:

“We would like to propose to the Russian side that before issuing ultimatums to a sovereign and independent state, it turn its attention to the disastrous conditions and complete powerlessness of its own national minorities, including the Ukrainian one… Why not hold referendums on broad autonomy and, if necessary, the independence of the subjects of the Russian Federation?”

According to press accounts, Putin laid out the terms of his political initiative to Obama in their late night call. I would presume that our president would have responded that the United States has not right to intervene in the internal affairs of a sovereign nation, much less tell it when to hold its elections or amend its constitution. I fear, however, that Obama is looking for a diplomatic breakthrough that he can trumpet to the American people as a victory of his wise diplomacy. Well, let John Kerry see how much Russian flexibility there is in Paris.

If John Kerry signs on to any substantive part of the Russian proposals, we have betrayed Ukraine and the Ukrainian people. Nevertheless, I can imagine John Kerry returning waving a piece of paper that promises peace in our time. He will say that Russia has kindly agreed not to invade Ukraine and only wants some minor changes in the Ukrainian constitution, which will make things better for all parties. We can continue to work together with Russia to solve the really big issues of our time in Iran and Syria. The reset is still on.

If such a disaster happens, poor Ukraine will understand it is on its own to face the Russian juggernaut. Maybe the U.S. will increase the number of lunch boxes it has promised Ukrainian troops.

If the United States were to fall into Putin’s trap, there would be rejoicing in the Kremlin. The wet-behind-the-ears, naïve U.S. president has fallen for it one more time.

How should Ukraine grow? A tale of three countries

By Yuriy Gorodnichenko (UC Berkeley)

Ukraine is at a critical junction in its history since it became an independent state in 1991. Victor Yanukovych and his corrupt government are deposed by the people of Ukraine, yet the menace of Russian invasion into mainland Ukraine creates a sense of insecurity and uncertainty about the future. What lies ahead of Ukraine is not clear. However, one can look at the historical economic performance of Ukraine to understand the roots of current problems and the potential for future development.

In 1991, immediately after Soviet Union’s collapse, Ukraine and Poland had similar levels of GDP per worker, while Russia was significantly richer (see Figure 1). All three countries experienced a typical decline of output in the early stages of transition from planned to market economies. In Poland, the contraction was relatively short and shallow. In contrast, both Russia and Ukraine had deep contractions which lasted until mid to late 1990s. The Ukrainian economy contracted by staggering 60 percent, which is extremely unusual for country not plagued by war or civil unrest and which makes the Great Depression of the 1930s a modest recession.  

Figure 2. GDP per worker, source: World Bank

By 1995, Poland had a higher GDP per worker than Russia, which was a remarkable reversal of fortunes. Russia started to catch up after 2000 when oil and gas prices increased significantly. While Ukraine began to grow at about the same time, the growth rate was very sluggish. In fact, it was so slow that even by now it has not reached the level of output it had in 1989. The Russian economy came back to the 1989 level in 2006, but its level of output per worker is still lower than the Polish one - which more than doubled since early 1990s. Remarkably, while the Great Recession hit the Russian and Ukraine economies very hard, the shock was much less noticeable in Poland.

Should Ukraine emulate Russia or Poland? While the output per worker is a useful metric of economic welfare in a country, it is clearly incomplete and can hide important differentiation in the quality and sustanability of economic development. Figure 2 shows that the sources of economic growth are likely to be very different between Poland and Russia. According to estimates of the World Bank, over 30 percent of GDP in Russia was a rent based on natural resources. On the other hand, the rent in Poland was less than 5 percent of GDP. Clearly, the high growth in Russia requires high oil/gas prices and, at some point, this source of growth is likely to run into diminishing returns and therefore Russia is likely to run into a slowdown. One may recall that the Soviet Union had a similar cycle when high growth and living standard were sustained by high energy prices in the late 1970s and early 1980s, but the Soviet economy had really hard time (and eventually collapsed) when energy prices fell. Obviously, Ukraine, with the rent at less than 10 percent, can’t grow like Russia but the path of Poland suggests that economic growth does not have to build on natural resources.

Figure 2. Natural resources rents as percent of GDP, source: World Bank

The distribution of the benefits of higher economic growth in Russia and Poland is also likely to be different. While it’s hard to come by consistent time series on distribution of income in these three countries, one can examine the evolution of life expectancy. If the fruits of economic growth are available to few, one may reasonably expect that life expectancy is going to stagnate. In contrast, rising life expectancy is likely to be associated with a more even and just distribution of income.

Figure 3 shows that life expectancy fell in Russia to 65 years. While life expectancy also fell in Ukraine, the decrease was not as bad as in Russia and life expectancy in Ukraine has been consistently higher in Ukraine than in Russia. This is remarkable given that Ukraine has a much lower level of output per worker than Russia. Nonetheless, the most striking part is that life expectancy in Poland has been rising steadily and now it’s eight (!) years longer than in Russia. Hence, the quality of economic growth is considerably better in Poland than in Russia.

Figure 3. Life expectancy, source: World Bank

In summary, Poland and Ukraine had similar initial conditions after the collapse of the Soviet empire. Poland’s economy really took off while the lack of economic growth in Ukraine has been tragic in many ways. Many people in Russia and Ukraine believe that Ukraine needs a strong hand, like Putin in Russia, to guide the economy to economic growth and come close to Russian standards. However, a handful of statistics discussed in this blog suggests that a much more desirable route is to emulate Poland that had really built its success on decentralization of economic and political decision as well as free enterprise of the market economy.