Few topics have received as much discussion in transition economies as have the social costs of market-oriented reforms.
Yet the empirical evidence upon which the debate is based is far from complete. This is in part due to the difficulty of comparing poverty lines across countries: poverty has both absolute and relative dimensions, and is quite different in Zambia than it is in Poland, for example. It is also difficult to distinguish the effects of prolonged economic crisis on the poor from those of difficult but necessary macroeconomic adjustments. And the truly poor and vulnerable tend to have a weak political voice, and therefore little influence on the debate about social costs. Not surprisingly, the numerous attempts to implement safety net measures during economic adjustment in both developing and transition economies have had varied results
This experience has led to an evolution of thinking about social welfare issues during transition, which has implications not only for the design of safety net measures in the short term, but also for the reform of social sector institutions over the longer term
During the first wave of adjustment programs in the early 1980’s, most attention was focused on developing the appropriate mix of policies to achieve stabilization and structural reform, and little attention was paid to the issue of social costs. This changed by the mid-1980’s. Firstly, a consensus gradually developed on the appropriate policy mix: the reduction of fiscal deficits, the elimination of price controls and trade restrictions, the introduction of realistic and unified exchange rate regimes and positive real interest rates, and shift to a reliance on the private sector rather than on the state to run most productive enterprises. As this consensus became clear, policymakers could begin to focus attention on social welfare issues
Secondly, by the mid-1980’s, as the results of adjustment policies became clear, a broad debate began about their social costs. Concerns about these costs were heightened by the publication of a highly critical study by UNICEF in 1987.
Initially, this debate focused solely on the social costs of adjustment policies and resulted in a numerous efforts to develop safety net measures within the multilateral development banks.
Yet by the late 1980’s, the debate was altered once again by evidence from country experience. It became increasingly clear that the poor fared far worse in the countries that failed to adjust than in those that adjusted in a timely manner. The contrasting examples of Chile and Peru are illustrative. During the adjustment crisis in the early 1980’s in Chile, the poor were effectively protected from declines in social welfare through targeted employment and nutrition policies. With the subsequent resumption of growth in the late 1980’s and early 1990’s, poverty decreased substantially: falling from approximately 45% of the population in 1986 to 28% in 1994. In contrast in Peru, during a prolonged period of “postponed” adjustment from 1985-90, which resulted in hyperinflation and economic collapse, per capita consumption fell 50% on average. It fell even further for the poorest two deciles: over 60%. Poverty rates rose from 17.3% in 1985 to 54.7% in 1990.
In Africa, meanwhile, the few countries that successfully adjusted also had better records on the poverty reduction front than did non-adjusters.
Adjustment is a necessary but not a sufficient condition for poverty reduction, however, and there are still many unanswered questions. The first of these is the relationship betweeen poverty and inequality, and here the evidence is far less convincing, although some recent work clearly suggests that poverty increases with inequality.
Another important area which is increasingly recognized as critical to poverty reduction, but where we have very little empirical evidence, is that of institutional reform.
Nevertheless, it is very difficult to either reduce inequality or implement institutional reform in the absence of growth. And while some countries that adjust, such as Bolivia, grow more slowly than others, such as Peru, due to resource endowments, institutional structure, and a variety of other factors, overall, adjusters outperform non-adjusters on the growth and poverty reduction front.
There are two reasons why non-adjusters perform poorly on the poverty reduction front. First of all, cross-country evidence demonstrates a clear relationship between growth and poverty: poverty declines during periods of growth and, alternatively, increases during periods of recession.
While adjustment has short-term costs, its ultimate objective is to achieve sustainable growth. Thus countries that adjust successfully also tend to reduce poverty. Beyond the issue of adjustment, empirical evidence suggests that countries that maintain market-oriented macro-policies over time, and in particular liberalized trade regimes, grow much faster than do those that do not, regardless of initial conditions.
Secondly, while adjustment has costs for certain sectors, it provides a coherent policy framework in which one can identify and protect vulnerable groups. In contrast, it is very difficult to protect poor and vulnerable groups in a haphazard policy framework, where macroeconomic distortions and high inflation erode real income levels and provide numerous opportunities for rent-seeking. The poorest tend to be the least able to protect themselves from the costs of inflation, while the wealthy are better positioned to pursue strategies such as sending assets abroad. At the same time, the poor are less able than wealthier groups to use economic distortions for personal profit, such as through speculating on exchange rate differentials.
With the implementation of adjustment programs in many countries, the debate has shifted somewhat, from an emphasis on short-term safety nets to one on appropriate macroeconomic policies coupled with longer term investments in health and education. Recent research exploring the long-contested relationship between inequality and growth has found that investment in longer term social welfare policies, education in particular, has positive effects on growth and therefore poverty reduction.
The effects on growth of transfers – a category which includes safety nets – are mixed, and seem to depend on the nature of the transfers and how they are allocated.
This should come as no surprise, as the ability of safety nets to reach the truly poor and vulnerable depends to a large extent on the political context and on the administrative capacity in particular country contexts. This does not diminish the important role that safety nets can play as transition tools, but does emphasize the importance of evaluating investments in safety nets in the broader context of social policy. From both political and administrative standpoints, it is much easier to set up short-term safety net programs than it is to implement reforms of the public sector institutions that deliver basic services. At least in Latin America and Africa, this, combined with concern about the immediate costs of adjustment, may have resulted in too much emphasis on safety nets at the expense of attention to the institutions that provide basic social services.
A brief review of selected experiences with safety nets policies helps explain the changing nature of the debate on the social costs of adjustment. It also provides relevant lessons for the transition economies, many of which have made far less progress either in implementing effective safety nets or in reforming social welfare institutions than have countries in other regions.
Safety Nets: Lessons from Experience
The cross-regional record of safety nets is mixed. In some cases, safety net programs have been able to reach the poor and vulnerable and contribute to the political sustainability of economic reform at the same time. Yet in other cases, they have merely been short-term palliatives to stave off the political opposition of vocal groups, and have had little impact on either poverty reduction or the longer term political sustainability of reform.
There are two reasons for this mixed record. First of all, the overall policy framework is critical. Safety nets cannot serve as poverty reduction tools – or even provide effective social welfare protection – in the absence of policies to generate sustainable growth in the long-run. Safety nets are short-term mechanisms which can play an important role during transition periods. The benefits they provide, however, such as short-term employment and income support, cannot substitute for macroeconomic reform and sustainable growth on the one hand, and for basic social welfare policies, such as primary health and education, on the other. And safety nets must complement rather than contradict the general direction of the macroeconomic reform program: they should not generate fiscal deficits or create labor market distortions.
In practice, safety nets have not always been implemented according to these principles.
The second reason for the mixed record of safety nets is that their implementation is not free of political constraints, and there are distinct trade-offs between directing benefits to the politically vocal versus the truly needy. The conventional wisdom, and usual practice, is that the poor have a weak political voice, and governments in the process of implementing reform and facing intense political opposition have few incentives to focus safety net benefits on the poorest. In addition, the poorest are often not as directly affected by adjustment measures as are slightly better off urban consumers. Thus governments tend to respond to this political trade-off by focusing most of the benefits of compensation efforts during reform on vocal rather than needy groups. Yet it is not necessarily cost-effective, from either a political or poverty reduction perspective, to concentrate all benefits on vocal opponents of reform, as they are unlikely to be as well off as they were prior to reform, regardless of the level of compensation. In contrast, reaching groups previously marginalized from public benefits is likely to have greater political as well as poverty reduction effects. This is more likely to occur if benefits are distributed in a manner that incorporates the participation of beneficiaries, thereby increasing their political voice as well as their economic potential. This is best demonstrated by numerous countries’ experiences with demand-based social funds.
Such a dynamic is not always possible, and there are political contexts where governments must expend a fair amount of resources in order to placate the opposition of vocal and organized opponents of reform, or reforms will be politically unviable and face reversal, an outcome which tends to be far worse for the poor.
There are positive examples of countries which implement extensive macroeconomic reforms which ultimately generate growth, and in which safety nets are an important part of the reform process. The models for successful safety nets differ. The contrasting examples of Chile and Bolivia, for example, demonstrate how the choice of a safety net program reflects different political and institutional contexts. In Chile, reform was implemented under authoritarian regime and in a highly developed institutional framework. The government was able to rely on a pre-existing and extensive network of mother and child nutrition programs, and target them to the poorest sectors. A series of public works employment programs were also targeted to the poorest by keeping the wage level well below the minimum. Public social services were re-structured to benefit the poor, and private alternatives were introduced for those who could afford them. While per capita social expenditure decreased during the crisis years, it increased for the poorest deciles.
These safety nets were critical to protecting the welfare of the poor during deep recession. Unemployment, for example, peaked at almost 30% of the workforce in 1982. Yet welfare indicators such as infant mortality not only continued to improve, but accelerated in their rate of improvement during the crisis years. Chile’s record was possible because of its extensive, pre-existing social welfare system and its relatively efficient public sector institutions. Political context also played a role: a democratic government might face greater obstacles to re-orienting social welfare expenditures to the poorest at the expense of the middle sectors than the Pinochet regime did. Yet it is important to note that the targeted approach has been maintained and even extended since the transition to democracy in Chile.
Bolivia, in contrast to Chile, had much higher levels of poverty and far less developed institutions. The government implemented the Emergency Social Fund (ESF), a demand-based social fund (the first of its kind) which relied on proposals from beneficiaries to allocate projects, and on local governments, NGO’s, and the local private sector to implement them. While the ESF was not able to target the poorest sectors, as they were the least able to present viable project proposals, the program was able to reach large numbers of poor at a critical time (1 million people out of a population of 7 million benefited from ESF projects). At the same time, the ESF provided important impetus to local organizational and institutional capacity. Since the “completion” of adjustment, the ESF’s successor, the Social Investment Fund (SIF) relies on the same basic principles, but focuses specifically on health and education benefits rather than on short-term employment, and incorporates collaboration with the line ministries into its operations.
This is an attempt to overcome one of the primary drawbacks of social funds: while operating outside the realm of the mainstream public sector is precisely what makes social funds flexible and rapid, it also signifies that they do not contribute to reform of the public sector.
Both the Chilean experience with targeted social policies, and Bolivia’s with the incorporation of beneficiary participation have helped to shape the debate on safety nets as well as social welfare policy more generally. The Chilean experience emphasizes the importance of targeting safety net efforts (and social policies) to the truly needy in order to provide effective protection. The Bolivian experience, meanwhile, demonstrates the importance of incorporating the participation of the poor and of local institutions in order to enhance the sustainability of poverty reduction efforts.
There are also a plethora of examples of countries that have failed to implement comprehensive reform and where safety net policies have neither led to sustainable poverty reduction efforts, nor have they reached needy groups. One such experience was the DIRE program in Senegal, a country which has postponed important structural reforms for over a decade. The DIRE, a credit program designed to help laid-off civil service workers and unemployed university graduates during adjustment, channeled interest free loans to these groups, without incorporating need criteria nor project viability into the allocation of loans. Not only did the resulting projects have an extremely high failure rate (32%), but over three million dollars were lost or “filtered” through the public bureaucracy. This is hardly an efficient manner to allocate resources in one of the poorest countries in Africa, nor did it contribute to sustainable reform. The DIRE’s failure was due to poor design as well as to political objectives superseding poverty reduction ones. In addition, and perhaps most importantly, because the program was not part of a government commitment to a comprehensive macroeconomic reform effort, it was not sustainable in either economic or political terms.
While safety net efforts in adjusting countries have a mixed record, the experience provides some important lessons, both for future safety net policy and for social welfare policy more generally. The effectiveness of targeted social safety net benefits has highlighted the extent to which the allocation of basic social services such as health and education is skewed towards better off groups in many countries, and the need for better targeting of social welfare benefits in general. While social expenditures have to be at a realistic level, and in many countries in Latin America these expenditures fell well beyond desirable levels during the debt crisis, the allocation of expenditures is as critical as overall amounts, if not more so. In Brazil, for example, only 18% of the poorest income groups – who account for over 40% of the population – are covered by social security, and receive only 3% of social security benefits. In Venezuela, over 50% of the education budget is spent on higher education.
Chile, in contrast, provides a good example of how social expenditures can be made far more effective in reducing poverty when they are targeted. With the transition to democratic regime in 1990, the targeted approach of the military government was maintained, while social expenditure was increased at a rate of almost 10% per year. Because the demand of upper and middle income groups for social services is now in the private sector, government increases were able to disproportionately benefit the poor. As is noted above, poverty has fallen markedly: from 45% in 1986, to 40% in 1990, to 28% in 1994, and is projected to fall to 17% by the year 2000 if the economy maintains its current trajectory of 6% annual growth.
Bolivia, meanwhile, provides an important example of how the incorporation of beneficiary participation can lead to more sustainable poverty reduction efforts, and in particular enhance local institutional and organizational capacity. In Bolivia, the demand-based approach is now being extended to reforms in the education sector, in addition to the SIF’s cooperation with the ministries.
In many other countries, however, social expenditure remains skewed to wealthier groups. Public focus on the social costs of reform and on short-term safety net measures, particularly in the absence of progress on the macroeconomic reform front, can divert attention from necessary reforms in the mainstream social sectors. Precisely because many safety net programs are implemented outside the mainstream public institutional framework, they avoid addressing difficult problems within it. This underscores the importance of safety nets being implemented in a broader context of macroeconomic reform. When safety net measures are implemented effectively, and introduce key principles such as targeting of the poorest and the incorporation of beneficiary participation, they can provide impetus – as well as some guiding principles – for the broader process of social sector reform.
The Next Stage: The Politics of Reforming Social Sector Institutions
While there are clearly political trade-offs involved in the implementation of safety nets, the politics of implementing permanent reforms of the institutions that deliver public services are even more complex. Reform of such institutions requires more implementation capacity than does macroeconomic reform or the implementation of safety net measures, and entails very different political dynamics. The providers of public services tend to be politically powerful and highly organized, while the users, although numerous, tend to be diffuse and poorly organized. It is no surprise that most governments, already faced with the political challenges of macroeconomic reform, postpone or avoid more difficult reforms of public institutions, particularly when the implementation of visible safety net policies can address public concern about social welfare issues, at least in the short term. Yet in most countries that complete adjustment programs, it becomes evident that in the long run, for growth to be sustainable, there are no alternatives to reform – or complete restructuring -of the social sectors. In much of Latin America, for example, public attention has shifted from the costs of adjustment measures to concern about the quality and quantity of basic public services, particularly health and education.
Despite these difficulties, it is possible to make progress in reforming social sector institutions, and to do so under democratic regime. In Latin America, Chile is the country that has made the most progress in implementing structural reforms of the social sectors, and it did so under authoritarian rule, and also had a pre-authoritarian legacy of relatively efficient public sector institutions and a qualified civil service.
Yet the reforms have been maintained and even extended since the 1990 transition to democracy. And since then, a number other countries in Latin America – and a few in Africa – have implemented “Chile-style” reforms under democratic regime. Progress has been most visible in the social security arena in Latin America, but there have also been some reforms in the health and education sectors, which tend to be even more complex and more difficult to reform than social security.
The policy framework – rapid and extensive macroeconomic reform – has been critical to the political viability of these reforms. Extensive economic change provides governments with unique political opportunities to implement additional reforms in the social welfare arena, as it undermines the position of established interest groups, which often monopolize the benefits of public services at the expense of the poor.
Slow or stalled economic reform, in contrast, allows such groups greater political opportunities to maintain their privileged positions.
In addition to the political opportunities provided by reform, expectations of the state are already very weak in much of the developing world, which also makes it easier for governments to introduce change. Poor management over time, coupled with the fiscal constraints imposed by the economic crisis and debt problems of the 1980’s, resulted in a deterioration of the quality and coverage of basic public services in most countries. Upper and middle-income groups who could afford to have shifted to private systems, leaving the poor and lower-middle income groups as the primary users of public services. This reduces the potential opposition to reforming public systems, yet at the same time highlights the importance of social service reform for poverty reduction. In countries where the public sector is particularly weak, extensive institutional restructuring, as well as reallocation of expenditures, may be necessary.
Integral to the sustainability of such reform efforts is altering the political balance so that the beneficiaries of reform have a stronger voice in the political debate. Many of the successful reform efforts have included explicit or implicit efforts to create new stakeholders in reformed systems. Chile’s education reform, for example, which introduced choice between public and publicly-subsidized private schools, created substantial numbers of new stakeholders in the private education system. Zambia’s health reform, by devolving responsibility for management and resources to local level actors, has similarly created new stakeholders who have proven to be capable of resisting central level efforts to reverse the reform process. The Peruvian government is attempting to build support for the privatization process by selling off a portion of public company shares through a “citizen participation” program, which allows low-income investors to buy shares in installments at low interest.
The Bolivian government is planning a similar scheme, which will distribute 50% of the proceeds from privatized companies to all adult Bolivians as shares in a new private pension scheme.
While these are positive trends, there is a great deal of room for progress. East Asia’s investments in basic education early on, coupled with sound macroeconomic management over time, are now paying off as higher sustained growth and lower levels of poverty than in other regions.
Latin America’s progress on the macro-reform front in recent years has been impressive. It is only now turning to the social investment side of the equation, and results will take time. Chile, which began its process of reform in both these arenas much earlier than the other countries in the region, is now seeing results in terms of both growth and poverty reduction. Other countries will follow suit, but only as they complete both sides of this policy equation. Thus social sector reforms will be critical. Most countries in Africa, meanwhile, with the exception of a few, have yet to implement the macroeconomic reforms which can make social sector reforms economically and politically possible.
Lessons for the Transition Economies
The record of safety nets and social policy reform in the developing world are relevant for the transition economies, although the contexts are quite different. Firstly, the macro-transformations in the transition economies are necessarily far more extensive than the adjustments in developing countries are. In many cases entire workforces must be de-industrialized. Existing social welfare systems, many of which are run through public enterprises rather than the central government, are fiscally unsustainable and are not designed to cope with poverty and unemployment resulting from the transition to the market. This obviously makes it more difficult to provide effective safety nets. One potential approach for safety net policies in such a context is to concentrate specific programs on pockets of high unemployment, where social funds or public works could alleviate negative welfare effects, and at the same time to target the universal system of social welfare benefits, such as monetary allowances, to particularly vulnerable groups, such as children in large families. Under the current structure, these benefits are universally provided, but due to fiscal constraints, their real value is marginal and eroding further. Targeting these benefits to vulnerable groups would allow governments to raise their levels enough to reduce poverty without adding to the fiscal burden.
Secondly, the politics of the process are more complex in the transition economies: expectations of the state are higher, reform has stalled in many cases, and the concerns of some politically influential groups, such as pensioners, dominate the public debate, while very little attention is paid to the situation of even needier and more vulnerable groups, such as the children of the working poor. The public debate on social welfare in the transition economies has mistakenly focused on two issues – the plight of pensioners and the pace of reform – while excluding several equally critical ones. Pensioners have fared worse than the average in some countries (most notably the countries of the former Soviet Union) and better than the average in others (the Eastern European countries). In general not all pensioners are vulnerable, and it is elderly pensioners living alone that are at risk. In contrast, children in large families, most of whom have at least one parent working, are the group that is most likely to be poor in all the transition economies.
The debate about rapid versus gradual reform has focused on the high social costs purportedly associated with rapid reform. Yet in the countries that pursued rapid reform and were able to implement it fully: Poland, Czechoslovakia, Estonia, Latvia, and Albania, inflation was brought down quickly, and growth has begun to recover, which will have consequent effects on poverty reduction.
In large part reflecting the extent to which production under central planning did not reflect genuine consumer demand, output declined markedly in the initial reform stages in these countries. Gradual reformers have merely postponed these inevitable declines, and now lag far behind the faster reformers in terms of recovering growth. In addition, contrary to common assumptions, gradualists have not fared better in the political arena: more of them have been voted out of office than have their radical counterparts.
In few countries has the debate focused on social sector reform. And even in the strongest performing radical reformers, such as Poland and Czechoslovakia, attempts at social sector reforms, such as pension reform, have stalled due to political opposition. Only Estonia, which for several years had the most pro-market government of the transition economies, has moved ahead with pension reform. Yet progress in this arena is critical. No other region has experienced a deterioration of basic social welfare indicators, such as infant mortality and life expectancy, as have the transition economies.
In addition, due to demographic as well as economic changes, existing systems are simply not sustainable from a fiscal standpoint. Pension systems in particular, which account for the bulk of social expenditure in most transition economies, are likely to present the most immediate financial crises in the absence of social security reform. Pension spending as percent of GDP ranges from 5-6% in Russia and the Baltics to 12% in Poland and Hungary.
The debate over social sector reforms in the transition economies resembles the stalled debates over social welfare reform in the OECD countries. Yet the social welfare and financial situations in the transition economies are far more fragile. And a Catch 22 type of scenario is also in play, the maintenance of current social welfare systems in many countries is part of the explanation for stalled reforms. Under the enterprise-based social benefits system, if workers become unemployed, they lose access to social welfare benefits. This is one of the principal reasons that managers are reluctant to lay off redundant workers, keeping them on the payrolls even if they do not work or get paid, so that they can maintain access to critical benefits such as health and education services.
While it is evident that social systems in transition economies need reform, there is no clear example in the region for countries to turn to. Recently even the highly successful Czech prime minister, Vaclev Klaus, faced an electoral setback over the social sector reform issue. As he lost his majority in parliament by a narrow margin, he now needs to make extensive efforts to build a new coalition of support for his reform agenda.
Some OECD countries, such as Italy, have attempted to implement social security reform, yet because the reform was watered down due to union opposition, it is likely to be far less effective in either providing better pensions or reducing the government’s implicit debt. Other countries, including the United States and France, are debating the issue, but with little progress to date. The rapid reformers in the transition economies should look to Latin America, not to the OECD countries, for examples. Chile is by far the world’s leader in the social security reform arena, with its complete switch to an individual contribution-based system, which is credited with substantially increasing that country’s savings capacity.
Now other countries, such as Peru, Colombia, and Argentina provide hybrid models to examine in addition. And rapid reformers also should capitalize on the political context: it is much easier to implement far-reaching change at a time when the overall policy framework is in flux, and interest groups have yet to establish clear positions (as in the Latin American examples), than in a status quo policy framework (like that of the OECD countries).
Prior to concluding, two tactical points are worthy of note. The first is the need to alter the political balance through strategies that create new stakes in the process of reform. Czechoslovakia, with its voucher privatization strategy, provides a prime example of such a strategy. While many observers criticize the measure from an economic efficiency standpoint, virtually all observers concur that the program was key to building widespread support for the privatization process, thus making it irreversible. In contrast, in Russia, voucher privatization was poorly implemented, allowing insider traders to dominate the process and monopolize the benefits, further de-legitimizing the process of reform in the public mind. Chile’s social security reform was based on the concept of creating new stakeholders in the private system. Explaining and selling the reform to potential participants was key to its success, even in an authoritarian context.
This points to the second critical tactical component of reform: government communication. Effective government communication has been key to the success of macroeconomic and sectoral reforms in a variety of contexts
It is particularly critical in the transition economies, where public anxiety about the social costs of reform is high, and understanding of the market process and of the potential benefits of social welfare reforms is very low.
The misguided debate on poverty in the transition economies noted above is case in point. An effective government communications policy, to explain and sell reforms to the public, will be key to any successful social sector reform effort in these countries. For example, if the public understood that the trade-off from increasing expenditures on pensions might well be a reduction in immunizations for children, the debate over social sector reform might be more conducive to reform.
There is no clear recipe or model for successful social sector reform in the transition economies. Yet there are valuable experiences in the developing world, and in particular in Latin America, with both safety net policies and with social sector reform, that are far more relevant for the transition economies than are the experiences of the OECD countries. Several conditions necessary for effective safety nets and for social welfare policy emerge from these experiences. Firstly, in the absence of a sound macroeconomic policy framework, no social welfare reform is likely to succeed. Secondly, targeting social expenditures on the poorest sectors makes them far more effective from a poverty reduction standpoint. Thirdly, there are major political obstacles to reallocating expenditures to the poorest, but a context of rapid and far-reaching macroeconomic reform provides governments with political opportunities for doing so. And political opposition can in part be overcome with strategies that involve the beneficiaries in the process of reform, thereby creating new stakeholders. Finally, effective government communication with the public will be critical to any reform effort.
Homi Kharas delivered the keynote address at IFPRI’s annual staff retreat on September 12, 2018. He explored the evolving development agenda and its implications for policy research.