Why did Ukraine stabilize the currency when it did? What factors propelled Kyiv to curb its habit of inflationary finance? What were the actual dynamics of the process? And what lessons can be drawn from Ukraine's experience? Given that the long drive to stabilization began in the second half of 1994, it is tempting to credit the political changes that swept through Ukraine that year, particularly the election in July of former Prime Minister Leonid Kuchma as President of Ukraine. But this ascribes a great deal to a single individual. Further, it was decidedly to the advantage of state enterprises and their patrons in the nomenklatura to inflate the karbovanets. In addition, stabilization itself is a politically and procedurally difficult objective to achieve. It often takes more than one attempt to succeed (Dornbusch, 1992). A "credible commitment" on the part of the government to reducing inflation is necessary in order to convince citizens of the reality of the coming stabilization. It is usually necessary to signal such commitment with deep and painful cuts in the fiscal deficit. What, then, would prompt the Ukrainian authorities to take this unpleasant road?
There appears to be little doubt that excessive fiscal deficits pose a significant threat of runaway inflation, and even collapse of currencies (Easterly, et. al., 1994). The issue is not without controversy, however. Sargent and Wallace (1981) explored the "unpleasant arithmetic" of monetarism, arguing that, in an environment of increasing inflation, even short-term financing of government deficits via bonds would be insufficient to contain the inflationary impulse. Their model implies that, although tight monetary policy may be able to fight inflation temporarily, it will eventually lead to higher inflation. Such a situation logically results only where monetary policy fully accommodates fiscal laxity. Unfortunately, Ukraine has not devised an independent monetary authority capable of imposing fiscal discipline on the government. During 1991-96, the NBU, which ought to fill this role, remained subordinate to parliament and/or the government, and a captive to its "soft budget" policies. In the absence of an independent monetary authority, how did Ukraine achieve stabilization?
The German economist Willem Buiter (1987) contradicts Sargent and Wallace, arguing that runaway inflation under conditions of large and growing budget deficits cannot lead to ever-higher inflation. He argues that unsustainably high deficits actually may cause inflation to decline, and even lead to deflation. But not hyperinflation. Buiter's arguments hold important implications for countries like Ukraine, insofar as his analysis circumvents the standard "heterodox" IMF recommendation to stamp out inflation through a stringent process of fiscal reform. The controversy basically turns on whether a "rational expectations" or an "adaptive expectations" process is at work in the public's evaluation of future inflation. Under rational expectations, the public would fairly accurately anticipate the government's moves to inflate the currency, incorporating such assessments in its money demand function, thereby (at least partially) counteracting and frustrating the government's actions. Under adaptive expectations, the public largely reacts to the government's actions, based on new price information as it becomes available. The government obviously has greater advantages under adaptive expectations, insofar as the public's expectations will tend to remain below actual inflation.
Havrylyshyn, et. al. (1994) overcome Buiter's criticism of Sargent and Wallace by decoupling actual from expected inflation, making seigniorage a stochastic variable subject to a degree of uncertainty. Under these conditions, the public will have difficulty getting a true fix on the government's long-run money supply function. Jurgen von Hagen (1994) argues that, "if this is done in the right way, high and even increasing inflation rates can persist for quite a while in a rational expectations equilibrium although the deficit is unsustainably large" (p. 378). If that is the case, then it would be possible to observe rather long periods of accelerating inflation before stabilization were to occur. Indeed, this does not preclude inflation reaching its apex immediately preceding stabilization. Stabilization can occur quite suddenly, regardless of how expectations are formed, where the growth in the real money stock butts up against the economy's resource constraint. Ultimately, then, all cases of accelerating inflation are unsustainable, and must reach an end.
The present argument sidesteps this controversy somewhat, however, by focusing on the essentially adaptive nature of expectancy formation in transition economies. Bruno and Fischer (1990) argue that the assumption that economic agents form their inflationary expectations adaptively makes sense under conditions in which reliable data on government budget deficits is not available, and/or when the government's policy and data pronouncements possess little credibility. Both conditions were abundantly present in Ukraine during 1991-96; government-provided economic information was widely distrusted. The only reliable source of information about inflation which was broadly available was the changing price level itself. To compound matters, the Ukrainian public experienced shocks resulting from partial price liberalizations which caused monetary velocity to temporarily overshoot the equilibrium level (de Ménil, 1996). Such price shocks had the effect of confusing the public by obscuring the real source of the price rise. Another source of confusion were the government authorities themselves, who were prone to attribute rising prices, variously, to: consumer price liberalization; monopoly pricing by state firms; rising costs of Russian energy imports; and/or currency speculation. Even the fall in output was blamed. As this analysis has shown, however, government credit policy was the main culprit throughout.
If inflationary expectations are formed adaptively, then the real money stock held by households will be determined by the public's expectation of future inflation. But with a lag. Both households and enterprises will reduce their money holdings in response to anticipated inflation. Dollarization can, and did occur in Ukraine, when the "flight from domestic currency" got under way. (Refer to Graph 10.) Such broad conversion into hard currency actually can accelerate inflation, as people jettison their money at ever-faster rates. Dornbusch (1992) argues that lags in forming expectations will tend to shorten as inflation accelerates. Despite the best efforts of the public to seek new information about changing prices, in periods of accelerating inflation expected inflation remains below actual, current inflation. This means that the demand for real balances can fluctuate, or even increase, and with it the inflation tax base. This provides the government with tremendous latitude to benefit from inflation. But it is doubtful that the public can be deceived so for very long. Economic actors and institutions will adapt to accelerating inflation by rearranging their financial affairs, and shortening their commitments, so that, "with sufficient adaptation, the inflation tax can be almost totally evaded, and hence the budget deficit cannot be financed" (Dornbusch, 1992: 24). Stabilization becomes the sole option. Hyperinflation thus leads inevitably to stabilization, precisely according to the irresistible logic of inflation's progress.
To summarize the main points: Under conditions of hyperinflation, the government prints money at ever-increasing rates. Because the public's expectations are formed adaptively in response to new price information, expectations will lag behind actual inflation, never quite catching up. Under these conditions, the inflation tax base may shrink dramatically, and with it the opportunity to finance budget deficits with inflation. Theoretically, the government can continue to finance its deficit as long as the rate at which it prints money outpaces the rate of public adaptation. However, a threshold exists beyond which a weary public becomes convinced that deficits cannot be controlled, and thus that inflation will "never end." At that stage, currency collapse can occur almost instantaneously. While a complete collapse did not occur in Ukraine, that does not invalidate the logic of adaptive formation of inflationary expectations, which has the effect of progressively narrowing the government's policy options. At some critical point, the government will have no choice but to stabilize the money supply. This is, in fact, what occurred in Ukraine. The Ukrainian stabilization and currency reform of 1996 was thus no great product of the government's political will to reform the monetary system. It had simply exhausted its options.
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