The former Soviet Republic of Ukraine has experienced the worst of what economic transition has to offer: since 1991, the country has dealt with dramatic falls in output, employment, productivity, and investment; persistent fiscal deficits despite declines in real GDP; and inflation rates that set records in 1992-93. Table 1 provides a summary of Ukraine's key economic indicators. In the five years since achieving its independence in late 1991, Ukraine may aptly be described as an "economic basket case."
Perhaps no other economic issue has been more perplexing than Ukraine's two-year slide into hyperinflation in late 1993, followed by its long drive towards stabilization by 1996-97. From 1991-93, Ukraine had the worst inflation record of any former Soviet republic, with average monthly price increases of 33 percent from 1992 to mid-1994, when the long road to monetary stabilization began.[1] (See Table 2.) In his path-breaking study on the subject, Cagan (1956) defined hyperinflation as general monthly price increases in excess of 50 percent. According to Cagan's definition, Ukraine has had seven instances of hyperinflation, six of them being the entire second half of 1993. The seventh, November 1994, occurred on the verge of Ukraine's drive to stabilization.[2]
As economic theory would predict, Ukraine's price inflation was accompanied by a rapid expansion of the money supply. Changes in Ukrainian monetary aggregates from 1989-96 are presented in Table 3. Ukrainian definitions of money largely correspond to the usual conventions, so that interpretations of "narrow money" (M1), and "broad money" (M2) aggregates are fairly straightforward. The period of greatest monetary expansion was 1992-94, followed by a prolonged and dramatic fall in rates of monetary growth after the second quarter of 1994. These trends are depicted in Graph 1. Changes in the rates of money growth are captured in Graph 2, which depicts the quarterly exponential (continuously compounded) rates of money growth from 1992-96. The year 1994 represents a watershed in the inflationary process, with monetary growth rates consistently falling from the second half of 1994 through year-end 1996. The data indicate that monetary stabilization was achieved, roughly, by year-end 1996, permitting the introduction of Ukraine's permanent currency, the Hryvnia, in September 1996.
Changes in the aggregate monetary series from 1992-96 raise certain important questions concerning the government's management of the economy: What were the root causes of Ukraine's descent into hyperinflation in 1993? Was the persistent inflation connected with Ukraine's chronic fiscal deficit? What changed in 1994-96 to bring inflation down? What was the magnitude of the "inflation tax" reaped by the government? And who paid the inflation tax? Was Ukraine's successful monetary stabilization the result of a supreme act of political will on the part of Ukraine's second president, Leonid D. Kuchma,? Or was the liquidation of Ukraine's inflation the product of the irresistible logic of inflation's progress?
Examination of the fiscal deficit reveals that real revenues and expenditures have been remarkably robust in the face of the output collapse, especially during the period of highest price inflation in 1992-93. Table 4 presents the quarterly consolidated budget results from 1992-96. These data are depicted in Graph 3. Indications are that between 1992 and 1996, 45-60 percent of GDP was redistributed annually through the national budget. Further, when extrabudgetary funds and off-budget subsidies to state-owned and other enterprises are included, the percentage climbs to between 51-63 percent of GDP. During the same period budgetary revenues, though high, never exceeded 50 percent of GDP. The inevitable results were large and persistent deficits.
There are three ways to finance the fiscal deficit: borrowing domestically, borrowing externally, and/or inflation. Thus,
D = B + F + M
where: D = fiscal deficit (including quasi-fiscal expenditures, extrabudgetary fund balances, and directed credits to state enterprises);
B = change in state domestic debt;
F = change in foreign debt; and,
M = change in money creation.
Ukraine has employed a combination of all three financing sources to cover its fiscal deficits, but it overwhelmingly resorted to new money creation in 1992-94. Table 5 presents the annual budget outturn from 1992-96, including estimated sources of deficit financing. From 1992-95, no more than 20 percent of the fiscal deficit was financed from borrowing, either domestically or from abroad. Rather, due to the relative immaturity of Ukraine's domestic securities market, and its limited capacity to borrow abroad, monetization of the deficit was vigorously employed.
It will be argued below that the root cause of the Ukrainian inflation of 1992-95 was a policy of emitting currency in the form of budgetary and off-budget credit subsidies to state-owned and other large enterprises. During this period, Ukrainian economic policy emphasized loose and cheap credit to enterprises, coupled with the interposition of administrative controls to reduce or suppress the inevitable inflationary pressures. It was this combination of policy instruments that briefly gained for Ukraine a reputation as the "most economically illiterate nation on earth." The actual situation was much more complex, however, and the choices facing the authorities much less straightforward than whether or not to stabilize. For the politics of economic policy making militated against the aggressive pursuit of monetary reform. Throughout 1991-96, state-owned enterprises and powerful sectoral interests lobbied aggressively for the continuation of government policies lavishing large amounts of "soft credits" on industry and agriculture. This appeared to the government as an imperative in light of the unprecedented collapse in output. In 1992, off-budget subsidies and directed credits to industrial and agricultural enterprises amounted to some 16 percent of GDP. In 1993 and 1994, the central government continued to mandate that the financial sector extend huge amounts of nearly interest-free credits to enterprises.
