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The IMF and its Ukraine shock therapy

By Calvin Price
web posted November 17, 2014

In the 1990s, post-Soviet Russia, then President Boris Yeltsin introduced a policy called shock therapy to combat the failing Russian economy.  Prices had been climbing, inflation was out of control, unemployment was rising, and industries were failing.  Communism hadn't been good to the Russian economy and once the government was unable to strong-arm the market, everything went wrong at once.  In this chaotic mess, Yeltsin instituted shock therapy and the market only got worse.  In April, the IMF began releasing funds to Ukraine as part of a $17.01 billion aid package with stipulations that Ukraine immediately enact shock therapy policies.

Shock therapy is composed of a few different policies, principally releasing price and currency controls, relinquishing state subsidies, and opening or liberalizing trade.  In a healthy, capitalist economy, these measures would have little to no affect, but that is not the case in Ukraine.  Here are the exact goals the IMF has, according to the managing director and chair Christine Lagarde: "The program focuses on (i) maintaining a flexible exchange rate to restore competitiveness; (ii) stabilizing the financial system; (iii) gradually reducing the unaffordable fiscal deficit; (iv) eliminating losses in the energy sector, while enhancing social safety nets; and (v) decisively breaking with problematic past governance practices." Practically all of those goals fall under traditional shock therapy procedures, with the exception of (iii).

Shock therapy has noble goals, but it goes about them in the wrong way.  Take the first aim set by Ms. Lagarde, maintaining a flexible exchange rate.  While this is good in the long-term, it can wreak havoc in the short-term.  When a previously government back currency in an unstable economy becomes unpinned, the value of that currency can fluctuate wildly.  An unfortunately common mistake in monetary policy is an overreaction, doing too much or too little in order to solve a problem.  Shock therapy approaches with the view that doing something drastic to kick the market back into action is better than letting the economy right itself.  There can be a lot of pressure on political figures to make decisions, but such radical reforms in quick succession can do much more harm than good.

The third goal, reducing the fiscal deficit, is a stand-alone positive goal.  Ukraine faces a dire political situation with wrecked industries and a pseudo-war on the eastern front.  They will have to spend far more on defense spending than they currently are, which will come at the expense of the fiscal deficit currently incurred that will only balloon in the future.

The fourth goal of the loan is split in its aims.  Infusing money into desperate industries is a necessity in Ukraine; the energy sector is particularly important because Russia controls much of the energy Ukraine imports.  Establishing social safety nets at this point, however, seems an unnecessary and wasteful endeavor.  Even under the best of economic circumstances establishing extra legislation and needless control over businesses can be hurtful, but this is especially true in Ukraine, where the government needs to focus on stimulating business, not restricting it.

Past governmental practices are always good ones to break with when they harm the economy.  The Yanukovych government didn't have a particularly good economic record, so it is a sound plan to break off from their economic doctrines.  However, a sudden shift is never a good thing.  The market responds best to moving in increments, not the harsh changes inherent in shock therapy.

On the whole, Ukraine's economic situation is not as bleak as it could be.  They experienced a sharp government change, lost a lot of productivity, their main industries are weak, and they have to spend a lot on defense in order to fight the pseudo-war with Russia on their eastern border.  Their political and economic foundation is poor, but they haven't lost everything yet.  One can only hope that they survive the incoming shocks. ESR

This is Calvin Price's first contribution to Enter Stage Right. © 2014 Calvin Price.

 

 

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