How Yugoslavia Can Save Itself

By Sachs, Jeffrey; Lipton, David.

YUGOSLAVIA POSES one of the most difficult challenges for political and economic transformation in Eastern Europe. The country is crisscrossed by deep fracture lines: two alphabets, three religions, four languages and six rivalrous republics. In recent months, the survival of the nation itself has seemed at stake, as the fractious tendencies of the republics have worsened under the weight of economic collapse.

A new economic reform plan proposed by President Janez Drnovsek and Prime Minister Ante Markovic could pull Yugoslavia back from the brink. As economic advisers to the Yugoslav president, we have worked on this plan and can explain how it would address Yugoslavia's current difficulties-and perhaps those of other Eastern European nations that are struggling to make the transition to a market economy.

The government's new economic proposals are bold, similar to Poland's attempt to jump to a market economy. The Yugoslav shock program has several simultaneous aims: to stop Yugoslavia's hyperinflation, which has reached the startling rate of 50 percent per month (12,000 percent at an annual rate); to open the country's borders to international trade in a bid to reintegrate Yugoslavia with Western Europe; and to reintroduce private ownership of businesses, banished after Yugoslavia adopted socialism under Marshall Tito at the end of World War II. To understand the new strategy, we must understand how Yugoslavia arrived at the current debacle. It is a now-familiar story-the collapse of a gravely inefficient socialist economy under a mountain of foreign debt-but with important twists. Yugoslavia's socialism is distinct, based on worker self-management, and so the precise form of collapse has also been distinct.

In the Yugoslav system, workers' councils decide on wages. This has proved to be the equivalent of putting the fox in charge of the chicken coop. With nobody in the firm to watch over capital, the workers inevitably have tried to swallow up profits in the form of high wage payments, lighter workloads and other forms of hidden compensation. Worker self-management had other traps. The worker's income was too closely tied to the profitability of his own firm; the government protected workers in loss-making firms by an expensive system of subsidies.

The trajectory since the late 1970s is familiar from the case of Poland and Hungary, not to mention Argentina and Brazil. In order to keep the economy moving, despite the underlying structural weaknesses, the Yugoslav government borrowed heavily on world financial markets, running up about $19 billion in debt to the West. This borrowing covered up the crisis for a few more years, until the easy borrowing vanished in the early 1980s. Since that time-coinciding with Tito's death-Yugoslavia has been in a downward slide. Economic growth came to a halt; inflation accelerated; and the removal of Tito's strong hand freed the republics to renew their destructive feuding.

Strangely, though, it was International Monetary Fund advice that helped cause Yugoslavia to drift from high inflation into hyperinflation. In negotiating a loan in 1988, the IMF told the Yugoslavs that at all costs they must protect their export competitiveness. The IMF instructions were to devalue the Yugoslavian dinar each month by the rate of the expected inflation.

The problem with this recipe, however, is that currency devaluation is not just an offset to inflation but can also be a fundamental cause of inflation. Each devaluation led to a rise of import prices, and these higher prices were quickly transmitted to higher wages through a widespread scheme of wage indexation. Even the money supply went up automatically, because most Yugoslav bank accounts are denominated in foreign currency.

The first step of the new economic program will be to stop this merry-go-round of devaluations and inflation. Starting tomorrow, Jan. 1, the government will commit to stabilize the value of the dinar by fixing it in value to 7 Deutsche marks. The prime minister has promised that the currency will be "convertible": anyone who wishes to bring his dinars to a bank can buy foreign currency on demand at the new stable price.

The government is also spearheading a return to private ownership, symbolized by the opening of Yugoslavia's first stock exchange last week in Ljubljana. And the government is slashing trade barriers, to introduce greater foreign competition and integrate the economy more closely with the European Community.

The necessary steps will have to be accomplished in the context of a deep political crisis among the feuding republics, a crisis that has been worsened immeasurably by the past decade of economic decay. Fortunately, some of the built-up pressures in the system will be released by the emergence of multiparty competition and the end of the communist monopoly of power. Well-targeted Western assistance can have a huge payoff. Yugoslavia should receive urgent IMF and World Bank financial support as well as debt relief and a development loan from the EC.

Yugoslavia's reforms, like Poland's, are crucial experiments in Eastern Europe's struggle to establish market economies within democratic societies. Their success can help pave the way for the rest of Eastern Europe, and Yugoslavia's in particular could provide lessons for another multi-national, multi-ethnic society in deep crisis, the Soviet Union.

Jeffrey Sachs, professor of economics at Harvard University, and David Lipton are advisers to several Latin American and East European governments.