BRADFORD CENTRE

FOR
INTERNATIONAL
DEVELOPMENT

2007/2008

Macroeconomic Analysis for Development

Using a relevant theoretical framework, assess how policy reforms in

developing or transitional economies could potentially contribute towards
worsening income distribution and poverty in some of these countries. Critically
analyse measures that could be taken to remedy these effects?

UB
07014568

By
Aboubaker Suleiman A.BADI

word count: 3,928

Introduction

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The transition economy is an economy which is changing from a centrally planned

economy to a free market. Transition economies undergo economic liberalization

(letting market forces set prices and lowering trade barriers), macroeconomic

stabilization where immediate high inflation is brought under control, and

restructuring and privatisation in order to create a financial sector and move from

public to private ownership of resources.

In this process, some nations have been experimenting with market reform for

several decades, while others are relatively recent adopters (e.g., Republic of

Macedonia, and Serbia). In some cases reforms have been accompanied with

political upheaval, such as the collapse of a government (the Soviet Union), a

declaration of independence (Croatia), or integration with another country after The

fall of the Berlin Wall (East and West Germany). In other cases economic reforms

have been adopted by incumbent governments with little interest in political change

such as East Asian countries (China and Vietnam). Transition trajectories also differ

in terms of the extent of central planning being relinquished (e.g. high centralized

coordination among the Commonwealth of Independent States CIS) these countries

suffered much loss in terms of economic and political aspects. All governments

faced difficult choices such as the implementation of reform policies, establishment

of new institution and amendment of the constitution.

In the process of transition, most countries’ economic indicators were worsened

severely and living conditions have been declining in a number of people. It is an

indisputable fact that this transition increased vulnerability and uncertainty in these

countries. From the beginning of transition, it generates a discussion about what

kinds of strategy is suitable for successful reforms among the scholar and policy

makers.

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On the other hand, the trends in the body of knowledge which guides and justifies

the practice of development, in particular, the ideas propagated by international

development agencies, and focuses on the shift in thinking which occurred in the

1980s with the introduction and widespread adoption of an approach to the practice

of developing countries known as the ``Washington Consensus'' (Gore 2000). In

broad terms, this approach recommends that governments should reform their

policies and, in particular: pursue macroeconomic stability by controlling inflation

and reducing fiscal deficits; open their economies to the rest of the world through

trade and capital account liberalization; and liberalize domestic product and factor

markets through privatization and deregulation. Propagated through the stabilization

and structural adjustment policies of the International Monetary Fund (IMF) and

World Bank, this has been the dominant approach to development from the early

1980s to the present.

Thus, this paper, by analysing the conceptual framework of transitional economies,

will critically analyse the policy reforms in developing or transitional economies. This

will also review the theory of property right, ownership change through privatization,

depending on the Key facts which help to achieve that such as Income poverty

during transition, by referring to review some theoretical thoughts on measuring

welfare.

The Conceptual Framework of Transition

According to the World Bank (1996) through the World Development Report 1996

“From Plan to Market”, which insisted that issues of policies make differences in

economic performance, particularly due to countries implemented efficient policy for

capitalist economy such as liberalization and macroeconomic stabilization.

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Appropriate economic policies, liberalization of markets and trade, establishment of

new business, and stable price control policy, provided economic recovery and

growth even though lacking of clear property rights and stable market institutions.

This conclusion is not necessarily convincing discourse after the decade passed

from initial attempt. On the contrary, most counties conducted liberalization without

strong institutions and legislation it led to the economic turmoil and social disorder.

Admittedly it is sure that “policies of liberalization and stabilization have been the

major factor shaping the adjustment process in Central and Eastern Europe (CEE)

and the Newly Independent States (NIS) and have been vital to China’s and

Vietnam’s rapid growth” (WDR, 1996, p.142).

Generally, this transition was occurred within the countries have similarity in terms of

history, geography and social and economic system. It might be an advantageous to

examining the experience of countries have similarity mainly because we could deal

with the issue of extra factor such as history and culture easily. Furthermore, it

seems that inherited characters of the former Soviet bloc provide the valuable insight

for us whether or not institutional factor (including historical, cultural and political

condition) is significant for economic development.

Transition can be seen as a journey from a central planned economy towards a free

markets economy. For instant, the transition nature of Central and East European

(CEE) countries is suggested by the term ‘post-communism’, which highlights the

persistency of the old regime and the continuing process of transformation (Pridham,

2003). Similarly, many have referred to the countries in transition as mixed

economies, in the sense that they carry on some characteristics of old system, but

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still miss some features of the capitalist economy. the missing pieces of transition

are believed to be the cause of a rather unstable state, which could potentially

contribute towards worsening income distribution and poverty, it could also led to an

increase of organized- crime. According to Rose-Ackerman (1996) believes that

while stability facilitated corruption in the past, instability and unpredictability are the

sources of corrupt incentives in the present situation of many transition economies.

In her opinion, a stable system operating under the rule of law is a prerequisite to a

successful transition, as can reduce the worsening income distribution and poverty.

If transition is seen as a process leading from plan to market and involving major

changes in the nation's economic system, then transition can be considered more or

less completed. however, as Lavigne (1999) points out, if other factors are

considered, such as long-term economic stagnation, lack of adequate management,

and increasing the poverty rate among large sectors of the population, then transition

may not be over and the implementation of structural as well as the creation of

effective financial institutions are seen as indispensable.

According to the European Bank for Reconstruction and Development (1994)

suggests that transition can be regarded as an end in itself, as it gives, in principle,

the individual the right to basic choices, which is a fundamental aspect of a person's

life (EBRD, 1994).

Property Right, Ownership Change through Privatization

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The existence of private property rights may be the most basic element of a market

economy and therefore implementation of these rights is the main indicator of

transition process.

According to the European Bank for Reconstruction and Development EBRD (1996)

developed set of indicators to measure the progress in transition. The classification

system was originally created in the EBRD's 1994 Transition Report, but has been

refined and amended in subsequent Reports. The EBRD's overall transition

indicators are:

 Large-scale privatisation.

 Small-scale privatisation.

 Governance and enterprise restructuring.

 Price liberalisation.

 Trade and foreign exchange system.

 Competition policy.

 Banking reform and interest rate liberalisation.

 Securities markets and non-bank financial institutions.

 Infrastructure reform.

At the time the socialist system collapsed, in transitional countries the state owned

most of the assets, such as land, natural resources and enterprises. State ownership

meant the essential control rights over these assets, such as the right to determine

their use and allocation. Privatisation implied removing established control right from

state authority and transferring them to private owners.

As the World Bank (1996) report, before anything could be privatised, reasonably full

property rights had to be established, as ambiguous property rights could allow profit

shifting, tax evasion, and asset looting, as well as potentially contribute towards

6
worsening income distribution and poverty , and the large benefit goes to the new

manager.

economic theory suggests that property arrangements have a crucial impact on the

way in which an economy functions. It is believed that clearly defined property rights

can help towards a secure environment that can support economic growth and

poverty reduction by contributing to the creation of effective owners. Private owners

will try to maximise the benefits and use productively the assets because they incur

not only the benefits but also the costs driving from their use. but even so, there is no

guarantee that the new managers and directors of enterprises well not try to pursue

personal objectives.

Privatisation has been one of the main priorities of economic transitions. Privatisation

meant creating a private sector and changing formerly state-owned enterprises into

privately owned ones. It may be defined as a legal transfer of property rights from the

state to private agents (Lavigne, 1999). While Shleifer and Vishny (1994) see

privatisation as a way to define property rights by redistributing both control rights

and cash flows. The argument that by increasing clarity of ownership the gains from

trade are also increased is the central economic argument for privatisation. They

also believe that unambiguous property tights are likely to reduce destructive

behavior and disputes over property rights and worsening income distribution.

However, privatising property rights seems to be a necessary but not a sufficient

condition for overcoming the problem of inequality and the worsening of income

distribution, it will not be the deterrent of eliminate the bribery and corruption of

public officials.

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The question whether economic transition is an opportunity for increased corruption

and inequality, or a protection against it, in other words, is there a link between the

Income poverty and economic transition process?.

Income poverty during transition

It is well-known that many transition countries suffered from severe contractions in

income levels. While in some countries, the economies have stabilized and returned

to positive income growth, in others the contraction has continued to this day. The

next figure shows that only six countries in 1998 have managed to surpass their per

capita income level they had in 1988.

According to the World Bank (1999,2000) many countries are still between 20-50%

below that level. In fact, Milanovic (1998) demonstrates that the income losses

suffered by many transition countries are higher and more persistent than they were

during the Great Depression in the Western capitalist world.

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Since the beginning of the transition process income poverty increased in all

countries in the region. Impoverishment of people reflected economic crisis - a steep

fall in output, massive unemployment, a fall in real wages and a rise in income

inequalities. This section presents trends in income poverty since1987, and will take

a closer look at welfare in transition countries before and after the transition. And will

be analysis by using a recent study by Gruen and Klasen (2001, 2003b) which

investigated well-being in transition countries and comparable middle-income

countries between 1988 and 1995, with a review on some theoretical thoughts on

measuring welfare.

According to the World Bank (1996) the poverty line for developing countries was $1

a day, the increase of poverty in transition countries was sixfold but poverty rates

were low. Between 1987 and 1993 the poverty rate for the region increased from

0.6% to 3.5% of the total population (World Bank,1996 p.4).

But who are affected by the transformation process: the "working poor", the

unemployed and children. Income poverty is mainly associated with low pay,

unemployment, youth and low education. According to a survey by the World Bank

(1996), poverty is analyzed according to socio-economic groups and demographic

characteristics. However, in real life many of the losers have several risk factors. As

well as having no work many of the unemployed are also young, low skilled, have

large families and live in rural areas or small towns – a group of characteristics that

greatly increases the risk of poverty. The world bank survey shows that most people

in transition countries fall into poverty because their earnings from work are very low.

For instance, in Russia in 1993, 66 per cent of poor people had jobs and in Poland

60 per cent (World Bank 1996a pp. 15 and 115).

9
However, people accept low pay because they have few job opportunities. Being

formally employed in the state sector also allows them to maintain social benefits

linked to the job such as cheap housing. According to Rutkowski (1996) In

Macedonia, Croatia, Hungary, Bulgaria and the Czech Republic one fifth of all

workers fall into the low pay category. Low pay is common in Russia and the CIS

countries where wage arrears worsen the situation. During 1993 and 1994 only 40

per cent of the workforce in Russia was being paid fully and on time (Klugman 1996;

p.6). Keeping workers on low pay and delaying payment permit state enterprises to

avoid massive lay-offs and keep the unemployment rate at artificially low level in

Russia and many CIS countries (Commonwealth of Independent States), (Standing

1995).

The Gini coefficient was developed by the Italian statistician Corrado Gini and

published in his 1912 paper “Variability and Mutability". The Gini coefficient is a

measure of statistical dispersion most prominently used as a measure of inequality

of income distribution or inequality of wealth distribution. It is defined as a ratio with

values between 0 and 1: the numerator is the area between the Lorenz curve of the

distribution and the uniform distribution line; the denominator is the area under the

uniform distribution line. Thus, a low Gini coefficient indicates more equal income or

wealth distribution, while a high Gini coefficient indicates more unequal distribution. 0

corresponds to perfect equality

(everyone having exactly the

same income) and 1

corresponds to perfect inequality

(where one person has all the

income, while everyone else has

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zero income). The Gini coefficient requires that no one have a negative net income

or wealth:

The figure shows the graphical representation of the Gini coefficient (The area of the

whole triangle is defined as 1.)

However, also on its distribution. Prior to transition, income inequality was very low.

The columns of the following Table show how income inequality measured by the

Gini coefficient changed drastically between 1988 and 2002. ( a recent study by

Gruen and Klasen, 2001 ).

( a survey study by Gruen and Klasen, 2001 ).

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Table 1 shows that, for all countries, except Uzbekistan, the distribution of incomes

has become more unequal. The magnitude of the worsening, however, varies

considerably across countries. Central European countries experienced relatively

moderate increases in inequality whereas in Russia, the Gini coefficient almost

doubled.

Income inequality metrics or income distribution metrics are techniques used by

economists to measure the distribution of income and economic inequality among

the participants in a particular economy, such as that of a specific country or of the

world in general. These techniques are typically categorized as either absolute

measures or relative measures. However, there is a large axiomatic and applied

literature on well-being measurement which will be summarized briefly as follow.

Income distribution has always been a central concern of economic theory and

economic policy. Classical economists such as Adam Smith, Thomas Malthus and

David Ricardo were mainly concerned with factor income distribution, that is, the

distribution of income between the main factors of production, land, labour and

capital. Modern economists have also addressed this issue, but have been more

concerned with the distribution of income across individuals and households.

Important theoretical and policy concerns include the relationship between income

inequality and economic growth.

As Gruen and Klasen (2003b) pointed out that, for international comparisons of

economic welfare, and real per capita income, the typically Purchasing Power

Parities (PPP) is still the most widely used indicator, which can be derived from

utilitarian welfare economics, but it requires strict assumptions regarding individual

preferences and utility functions, especially when comparisons made across time

12
and space. Furthermore, a particularly problematic is its neglect of income

distribution which can only be justified with the highly unrealistic assumptions of

linear utility functions or an equal or ’optimal’ distribution. The literature also

suggests a number of indicators that combine income and its distribution, for

instance, (Sen, 1982; Dagum 1990) points out more recent empirical observation on risk

aversion also supports the hypothesis that higher inequality does have a negative impact on

individual welfare levels. The theoretical arguments for incorporating the distribution of

income into a meaningful measure of economic welfare are multiple and well known.

Simultaneously, a separate literature has developed that has focused on developing and

analysing subjective measures of well-being (Easterlin, 1995; Headey, et. al, 2004)

Subjective measures of welfare rely on the self-assessment of individuals. People are ask to

evaluate their overall satisfaction with their lives or their happiness. Subjective well-being

(SWB) therefore captures many different aspects individuals are concerned about and offers a

self-rated view on welfare.

According to a recent study by Gruen and Klasent (2005) which give a brief overview

regarding the measures of the inequality-adjusted income-based measures of economic

welfare.

The study apply four inequality-adjusted well-being measures which jointly consider mean

income μ and its distribution, and assume that an unequal distribution of income will reduce

the level of welfare W.

W =μ (1−Ι ) where :0 ≤ I ≤1

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The well-being measures used differ with respect to the implemented index of

inequality I. The amount by which welfare is reduced given a particular income

distribution also differs across the measures.

The first two measures will be based on the Gini coefficient G. Sen (1982) proposed

the following welfare measure:

S=μ (1−G)

where: μ isthe meanincome∧G is theGini coeffocoent .

The Sen measure has a sound theoretical foundation and can be derived from

interdependent preferences for which there is considerable empirical support. Which

mean income and the Gini coefficient are combined to arrive at a welfare level. Since

function does not only consider individual incomes but the entire income distribution.

On the other hand, Dagum (1990) developed a variant of this measure. For a given

distribution of income, the Dagum measure clearly imposes a larger welfare penalty

than the Sen measure.

μ (1−G )
)
D= = μ¿
1+G

The Dagum measure depends on imposing a higher penalty for inequality as the

denominator imposes an additional penalty for inequality. The Dagum measure can

also be based on interdependent preferences and additionally implies that people

receive a further welfare penalty from the people ahead of them in their income

distribution which also appears to be a reasonable assumption.

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In addition the use of welfare-based measures. The Atkinson index (also known as

the Atkinson measure) is a measure of economic income inequality developed by

Anthony Barnes Atkinson. The distinguishing feature of the Atkinson index is its

ability to gauge movements in different segments of the income distribution.

According to Deaton (1997) The equally distributed equivalent income is the amount

of income that, if distributed equally would yield the same welfare level as the actual

mean income and its present (unequal) distribution . The general form of this

measure is:

N 1
1
[
A 2= ∑ x1−ϵ
N i=1 i ] 1−ϵ

For ϵ =1 :
N
1
¿ ( A 1 )= ∑ ¿(¿ x i )¿
N i=1

Comparing the Atkinson class measures to the Gini based measures, the former

also obey transfer sensitivity. Hence, poorer income groups receive a higher weight

and any transfer that happens among the poor will lead to a more pronounced

change in welfare than a similar transfer among the rich. For many researchers this

seems to be a more desirable property than the sensitivity of the Gini based

measures which will be greatest among the mode of the distribution. Moreover, the

Atkinson measures are sub-group consistent. Any increase in income within a sub-

population will, ceteris paribus, increase aggregate welfare.

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In contrast, a higher income received by the richest could lower aggregate welfare

when applying the Gini based measures. The increase in mean income can be more

than offset by the increase in inequality. While the Atkinson measures thus appear to

be theoretically more sound, according to Amiel, et. al (1999) the empirical evidence

appears on risk and inequality aversion as well as subjective well-being seems to

favor the Gini-based measures.

the Atkinson ϵ ¿ 1 and the Dagum measure can be seen as benchmarks to the

welfare analysis. For any given income distribution, the Atkinson ϵ ¿ 1 reduces

welfare the least, whereas the Dagum measure imposes often the greatest penalty

for inequality.

Comparing income distributions among countries may be difficult because benefits

systems may differ. For example, some countries give benefits in the form of money

while others give food stamps, which might not be counted by some economists and

researchers citation needed therefore not taken into account in the Gini coefficient.

Finally, It is theoretically justified and empirically important to adjust incomes by the

amount of inequality to arrive at more meaningful measures of well-being. Applying

these measures indicates that inequality can have a sizeable impact on well-being.

Conclusion

The transition economies have not performed as well as many had expected.

Economic performance has also varied widely across the transition countries. , this

16
paper attempted to analyse the conceptual framework of transitional economies, by

analyse the policy reforms in developing or transitional economies. Then, also review

the theory of property right, ownership change through privatization, depending on

the Key facts of the subject fundamental which is inequality in the income distribution

and poverty during transition. Finally, a review of some theoretical thoughts on

measuring welfare.

The major changes will need to occur to complete the transition. Changes can be

either superficial or deep, including creation of new institutions, changes in

incentives, changes in processes, and transformation of the role of government.

These deep changes are much more difficult and time-consuming because they

involve structural reforms and require a major modification of attitudes, incentives,

and relationships.

Furthermore, the decline in income equality in these countries and their experiences

with privatization, it is likely that their governments will be asked to play a more

positive role in income redistribution. Policy makers should work hard to harmonize

the concept of the role of the state that seems to prevail in many of their legislatures

with one that is feasible, given the existing macroeconomic conditions and level of

institutional and economic development.

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