October 14, 1995
Abstract: We explain the ways in which the organization of markets influences the process of macroeconomic stabilization in countries in transition. First, we argue that aspects of market organization cause economic policies to have persistent effects over time. As a consequence, market organization influences the response of enterprises to macroeconomic policy and, so, the change in macroeconomic conditions that a given type of stabilization policy is likely to produce. In turn, these changes in macroeconomic conditions affect the ability of the government to sustain the policy, as well as introduce new policies to promote reform.
We focus in great detail on the way in which market organization causes policies to have persistant effects. We examine the role of market organization in stimulating investment and growth, and, ultimately, in improving a country's fiscal balance. We use an option-value approach to understand the process of investment, and find that market organization affects the investment process by influencing, primarily, its sunk costs, its downside risk, and profits foregone while waiting to invest. When incentives to invest are not adequate to stimulate growth, fiscal imbalances increase, and the likelihood of future macroeconomic instability rises. In this environment, excessively tight monetary policy can exacerbate the difficulty of stabilization. Instead of signaling "toughness," such policy might simply be viewed as not credible.
At the core of our more narrow argument are empirical questions concerning the relationship between market organization, investment, and growth. Therefore, we follow our theoretical analysis with an empirical analysis of this relationship. First, we provide cross-country evidence that market infrastructure in countries in transition is very underdeveloped and, in some aspects, might be deteriorating. The absence of adequate infrastructure suggests that the spatial structure of industry determines the types of investment that can most easily take place. Hence, we provide a cross-country comparison of patterns of industry location, with their implications for investment and job growth. All else equal, we expect inter-industry reallocation to be more sensitive to problems in investment than intra-industry reallocation. Finally, we demonstrate, using data from a recent survey of Russian enterprises, that market organization, in fact, has led to a pattern of growth in which intra-industry reallocation is the dominant determinant of growth.
We conclude by discussing the implications of this relationship for stabilization and reform. The clear result of our analysis is that shock therapy programs are less likely to be successful when the incidence of vertical dependence among firms is great and market infrastructure is highly underdeveloped.
*To request a copy of this paper, send an email message to bwickes@psu.edu