Bridging 'the Great Divide': Countering Financial Repression in Transition

Abstract

The large and widening gap between economic performance in Eastern European transition economies and those of former Soviet Union has been dubbed the Great Divide by Berglof and Bolton (2002). This paper provides a rationale for gap based upon concept of financial repression. The magnified effects of transition to market can be attributed to government manipulation of financial markets in these countries, with divide defined by length of time that governments relied upon financial-market manipulation to finance government fiscal policy. Policies undertaken to assist in financing government expenditures caused financial repression and financial fragmentation, to use terms introduced by McKinnon (1973). After an introductory section, I introduce a theoretical model of real and financial sectors in transition. The dynamic path to equilibrium from transition is derived. It is shown to have a tendency toward output contraction and hyperinflation when government policies promote financial repression. In third section this hypothesis is examined with macroeconomic data from Ukraine for period 1992 - 2001. This data is consistent with hypothesis, although other factors (e.g., recession in trading partners) are also shown to be important.