Inflation Stabilization in

Reforming Socialist Economies:

The Myth of the Monetary Overhang

John H. Cochrane
University of Chicago

Barry W. Ickes
Pennsylvania State University

1. Introductionl
The central economic question facing the reforming
Eastern European countries and the Soviet Union
(Reforming Socialist Economies, or RSEs) is how to
arrange the transition to a market economy. A critical
element of this process is the transition from a regime of
centrally controlled prices to a system in which prices are
determined by market forces.
In most areas of economics, the baseline policy
recommendation is no policy; that is, no policy until well-
documented market inefficiencies can be found, and until
it is convincingly argued that the cumbersome machinery
of political control is not less desirable than the market
inefficiency it is designed to redress. In the case of RSEs
the situation is a bit different. The status quo is not one of
market failure, but rather of market absence. In this case
the natural policy recommendation would be to introduce
markets as fast as possible.

1. This paper is derived from Section 2 of "Stopping Inflation in

Reforming Socialist Economies: Some Pleasant Monetarist
Arithmetic," presented at the Winter AEA meetings, December 1990.
We thank John Farrell for many helpful and stimulating comments on
an earlier draft of this paper. We retain responsibility for any
remaining errors.

97
98

Furthermore, one can say that the central problem in

socialist economies is that goods are allocated by political
mechanisms. A detailed step-by-step transition plan, as has
been advocated by a number of authors (e.g., Tirole 1991),
implies a continuing set of interventions, whose nature and
timing will be continually renegotiated through the
political process. What these economies obviously need is
to remove politics from the allocation of resources. A
credible (because irreversible) sudden liberalization
accomplishes this goal.
It has been argued, however, that this otherwise
standard advice does not apply to the RSEs as a result of
their financial predicament. The most common objection
to a sudden and complete financial liberalization is the
comment, "What do you do about monetary overhand?"
The argument is that if prices are freed, agents will dump
their excess money balances on the goods market, causing
a dramatic rise in prices, which will, in turn, set off a wage-
price spiral, and thus inflation.
Fear of this inflation, and its political consequences,
has delayed the freeing of prices and other important
economic reforms. For example, Abel Aganbegyan, one of
the most influential of the early architects of perestroika,
has argued that state control of prices is needed to control
inflationary pressures when "the economic system of
management begins" (1988: 48). Stanislav Shatalin, the
author of the "500 day plan," has recently argued that "the
first priority is to stop the collapse of the ruble."2
Fear of the monetary overhang has had practical
consequences. According to Susan Linz (1990: 36) price
reform in the Soviet Union has been consistently delayed,
out of a fear that "if prices were allowed to adjust freely,
[it] would cause prices to skyrocket, generating a politically
unacceptable situation." Fear of the overhang thus

2. Quoted in Francis X. Clines, "For Kremlin's Economist, Always a

Plan," New York Times, September 21, 1990.
 99

postpones what is, perhaps, the most important element of

economic transition: price reform.
The idea that a liberalization of prices would lead
through a liquidation of the monetary overhang to a
large rise in the price level, is not exclusive to economists
from Eastern Europe. Thus William Nordhaus argues:
"Applying the crude quantity theory suggests that prices
would have to rise more than 50 percent to extinguish the
overhang. Unless neutralized, the ruble overhang will
produce a sharp one-time rise in prices when prices are
decontrolled" (1990: 302-3).
The supposed monetary overhang has also been used
to justify even more drastic "reforms." Some authors argue
that the best way to deal with the monetary overhang is
through a currency reform; essentially a confiscation of old
currency and accounts denominated in that currency.
Dornbusch and Wolf (1990), for example, find a lesson for
the Soviet Union and Eastern Europe in the postwar
experiences of countries with "monetary overhangs:
monetary reform, early and decisive, is an essential
precondition for reconstruction" (1990: 34).3
A prominent example of a monetary reform is the
recent confiscation in the Soviet Union of fifty- and one-
hundred-ruble notes. Though this move undoubtedly had
other motivations,4 it was partially defended as a desirable

They also note that "monetary reform is a necessary but not sufficient
condition" for successful reform (Dornbusch and Wolf 1990: 35).
One motive stated by the leadership was to confiscate wealth that was
criminally acquired. The argument was that people who had large
cash holdings acquired them illegally. This seems at odds with the
actual situation; most "speculators" hold their wealth in dollars or D-
marks, while many Soviet citizens had begun holding cash rather than
savings deposits for fear that the latter would be confiscated. See
Esther Fein, "Soviets Withdrawing 33% of Currency," New York
Times, January 23, 1991. Valentin Pavlov, the Prime Minister of the
Soviet Union, also argued that the confiscation was a response to a
western plot to topple the Soviet government (New York Times,
February 13, 1991), but little credence is given to this motive. It seems
clear that these were only excuses, and that the primary motive was
confiscation of excess money balances.
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measure to "soak up the monetary overhang." Whether or

not the confiscation was successful in (temporarily)
soaking up purchasing power, and it is doubtful that it was,
given the crude fashion in which it was carried out, it
seems clear that the underlying rationale for such policies
is the fear of a monetary overhang.
The monetary overhang is seen as an impediment to
implementing reforms (i.e., price liberalization) that would
otherwise be welfare improving. Thus Ronald McKinnon
argues that such a delay may be a second-best solution: "In
the face of a monetary overhang, economic efficiency
could worsen as 'liberalization' proceeds" (1990: 136).5
This paradox, that crucial reforms must be delayed
because of the overhang, is expressed well by Feldstein:

Free prices are the essence of a market system. But if

prices were decontrolled now, Soviet economists and
Western experts who look at the Soviet economy say
that there would be an explosion of the Soviet price level
because of the overhang of previously accumulated
rubles. That double overhang is a reflection of the
forced saving by the population of a monetized series of
very large budget deficits over the last several years ...
with prices frozen in the Soviet Union, the monetized
deficits have created the dramatic shortages that we
have all heard about and ... at the same time, ... have
created the accumulation of substantial money balances
(Feldstein 1990: 93-94).

Sometimes the argument for delay is based as much

on political as economic imperatives: "Before one moves

5. McKinnon explains: "The monetary imbalance makes the transition to

a more market-oriented economy too difficult to orchestrate, and
makes the transitional welfare costs too heavy. Thus, the Soviet and
republican governments are forced to continue existing price controls
as a second-best method of pinning down the nominal price level
even though relative prices are badly misaligned and greatly distorting
the economy' (McKinnon 1990: 136).
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to create markets, to free prices, or to open the economy,

market-type monetary and fiscal systems must be
established, after the resolutions of the old excesses ...
[T]olerating high rates of price increases, which will be
very difficult to stop is politically unacceptable and
economically disruptive" (Ofer 1990b: 98-99).

2. The Monetary Overhang

The presence of a "monetary overhang" and the need

to do something about it before real price reform can start
has thus become part of the conventional wisdom.
However, the whole notion of a monetary overhang
violates the most basic of economic principles.6
The usual story is that consumers receive money
wages, but, because the prices are fixed below market
clearing levels the stores are emptied, and consumers have
nothing to do with their money but store it in mattresses or
place it in savings accounts at confiscatory interest rates
(the "savings overhang").7 When prices are liberalized,
consumers will unload this stock of money, resulting in a
sudden dramatic rise in the price leve1.8
This story implies that the shadow value of money is
zero. Consumers accumulate excess money balances
because there is literally nothing else to do with the
money. They are off any economically motivated money

Alexeev, Gaddy, and Leitzel (1990) also doubt the presence of a ruble
overhang on institutional and empirical grounds.
Many analysts tend to discuss the money overhang and the savings
overhang as if they were the same phenomenon. But the former is a
question of whether agents are off their money demand schedules,
while the latter is a question about whether agents are off their
optimal intertemporal consumption schedules. Since money demand
and savings behavior are determined by different factors, it seems
worthwhile to distinguish them.
Most writers specify a "surge in inflation," but we will distinguish
between price level changes and sustained inflation, even in
describing stories we do not agree with.
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demand curve. While this situation might be possible in a

true command economy in which all resources are directly
allocated, all socialist economies have significant second
economy ("black") markets,9 and had them even at their
worst. Thus, consumers face an operational margin: hold
money, or spend it on goods in the second economy.10
Similarly, consumers do not hold high savings
balances because there is "nothing else to do with the
money." At any moment they can dissave and buy black
market goods. Their decision not to do so does not reflect
any operative constraint, but is rather a reflection of their
opportunities: i.e., they think they are better off leaving
their wealth in the bank, even at confiscatory interest rates,
and using it, either alone in the second economy or
combined with time in rationed markets, to buy goods at a
later date.11
Once we admit that the shadow value of money
cannot be (or have been) zero, analysis of money holdings
and their likely response to a liberalization of prices
becomes a standard question of money demand and
velocity. The price level is determined by the intersection
of money supply and money demand. We will assume that
the money supply is constant, or growing at a constant rate,

On the second economy of the Soviet Union see, for example,

Grossman 1981.
This was pointed out more than a decade ago by Grossman
(1981:86): "[T]he very presence of a large second economy, and
particularly of a black market, in a sense does away with repressed
inflation, despite fairly rigid control of official retail prices. In the
second economy, prices tend to be high enough to eliminate any
overall 'monetary overhang." Proponents of "money overhang"
sometimes admit this point, but counter that black market goods are
too high prices, so consumers are forced to hold money because
there are no "affordable" goods to buy. This is just another word for
choosing to hold money rather than spend it, and so admits our
point and the analysis that follows.
We analyze the savings overhang in the next section.
 103

through the transition.12 Changes in money demand are

governed by changes in velocity and changes in nominal
income. Thus, we analyze the likely changes in velocity and
nominal income through a liberalization, and trace their
effect on prices.

Velocity Effects on Money Demand

Holding real incomes constant, for the moment, a

price level surge due to liberalization can occur only if
velocity surges upon liberalization, or, equivalently, if
consumers will demand a much smaller quantity of real
money balances for a given level of income in the
liberalized economy than before. On the other hand,
velocity may decrease (consumers will be willing to hold
more money balances) during a reform, so the fact of price
reform in and of itself may actually help rather than hurt
the process of stabilizing inflation. Therefore, we start by
analyzing the likely effects of a price reform on velocity.
It is plausible that consumers in socialist economies
had substantially higher money demands at given income
and interest rate levels than consumers in free market
economies. First, cash is essentially the only means of
payment; socialist economies have none of the check and
credit card means to finance transactions that exist in the
west. Similarly, consumer credit essentially did not exist, so
consumers would be expected to hold larger savings
accounts on average as they built up the wealth to finance
consumer durables purchases.
Second, the variance of purchasing opportunities is
much greater in a (rationed) socialist than a market
economy. This is because of the instability of the supply
system, and the frequent shortages of goods that occur (see

12. In Cochrane-Ickes (1990) we analyze the effects of a cut in subsidies

or a rise in official prices on the fiscal deficit, and hence on money
growth. We show that such a policy leads to lower steady-state
inflation, and given velocity, leads to decrease in inflation (correctly
measured) even in the transition.
104

Ickes and Zhang 1990). When the probability is high that

the stores will run out of goods, households will be induced
to hold sufficient cash balances so that they can enter a
queue when one breaks out. If you pass by a store that
happens to have potatoes, you had better have in your
pocket enough cash for a month's supply (or however
much they will sell you). In a market economy, you can pay
with a check or credit card, or simply buy less, knowing
that you can return the next day.
Thus, as a result of the lack of cash substitutes and
credit arrangements, as well as the need to have cash on
hand immediately when a purchasing opportunity shows
up, standard money demand analysis predicts lower
velocity in socialist than market economies. However, we
might suspect that both effects on velocity may take some
time to show up, and thus will contribute little to the short
run dynamics of a price reform attempt, which is the fear
that the "money overhang" engenders. Certainly, price
reform will not bring checks, credit cards and other means
of payment overnight, as a result of the price reform itself.
Thus, the rise in money velocity due to the emergence of
cash substitutes for making transactions may well be
expected to take years, as the new institutions take root.
One can argue about how quickly consumers will start to
hold less "walking around" cash in order to take advantage
of vanishing purchasing opportunities as goods become
more commonly available, but it is at least arguable that
this process will require at least several months. It will
require goods to start showing up in the stores!
On the other hand, velocity typically declines (real
money demand rises for a given level of income) at the end
of high inflation. During an inflation, real money demand
is depressed, since the value of money declines quickly
over time. When the inflation ends, consumers are once
again willing to hold higher real money balances, so
velocity declines, and the money stock can increase with no
change in income or the price level.
 105

This phenomenon is well studied empirically. For

example, Sargent (1986) studied the ends of
hyperinflations, and found that money growth continued at
a high pace following price stabilization, to satisfy the
higher demand for real balances in a non-inflationary
setting. Dornbusch (1988) has also pointed to a tightening
of credit and the subsequent rise in real interest rates due
to the increase in money demand as a major problem in
the end of high inflations. Thus, one can usually count on
velocity changes to make a stabilization easier, rather than
harder.
One might object that this analysis applied to the
ends of actual inflations rather than repressed inflations.
But we can expect this effect even if the initial inflation
was repressed. Suppose, in fact, that the initial inflation is
repressed, so that instead of posted prices increasing, lines
are simply getting longer. Since money must be combined
with time to purchase goods, the (shadow) value of money
declines over time in this situation, even though the posted
prices do not change. Consumers have an incentive to buy
goods that they do not immediately need and hoard them,
rather than hold money balances, since the goods will be
harder to buy tomorrow.13 Alternately, we can measure
the shadow value of money by prices on the black market.
Since second economy (black market) prices rise during a
repressed inflation, the value of money declines over time,
so consumers will want to hold less of it, and prefer to
store durable goods instead. Following either argument we

13. Households also have a savings motive for holding goods. Given
rapid depreciation of the purchasing power of the currency, as
evidenced by prices in the black markets, and given the lack of
financial assets that bear market interest rates, households hoard
goods. One reads all sorts of stories about the hoards of goods
people have collected, such as one graduate student in Krasnodar,
who has collected 370 pounds of potatoes, 110 pounds of pickled
cabbage, 175 pounds of onions, 35 pounds of beets, 20 pounds of
garlic, 20 cans of peas, and 3 sticks of salami (Bill Keller, "Soviet
Food Is Short for Many, but Others Find Ways to Cope," New York
Times, Wednesday, December 5, 1990).
106

can expect the same re-monetization effects to take hold

when price liberalization and budget reform stabilize a
repressed inflation as they do in a free-market inflation.
One element of the money overhang story that
velocity must rise with liberalization derives from the view
that inflation must increase in the transition period. In this
view, price liberalization must naturally imply large
increases in the posted prices of previously rationed goods.
During the period in which those prices increase, it is
claimed that the usual nominal interest elasticity of money
demand will cause a rise in velocity, exacerbating the
transitional inflation.
In our view, this story is mistaken. The mistake
comes from taking posted prices at face value. It is evident
that posted prices on previously controlled goods will rise
when they are decontrolled. However, this rise does not
mean that the shadow value of money falls, and thus it
does not follow that consumers should want to hold less
money during this period. When prices are highly
subsidized, money and time (or some other rationing
device) must be combined to purchase goods at subsidized
prices. A rise in the posted price of such a good does not
necessarily represent a lowering of the purchasing power
of money. In fact, it is possible that the greater ease of
buying goods (lower amounts of time required to make a
purchase) overcomes the higher posted price, so that the
shadow value of money increases even as posted prices
increase. Therefore, the fact of a high measured inflation,
or a large increase in the posted prices of rationed goods,
may not induce an increase in velocity (properly
measured) or a flight from money.

Income Effects on Money Demand

So far, we have analyzed the effects of velocity

changes through the period of liberalization. We have
argued that the large increase in velocity through the
transition, predicted by the "money overhang" view is
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unlikely. But the fundamental question is deeper: we want

to analyze the likely path of inflation and price levels
through a liberalization, holding the nominal money stock
constant. Part of the answer to this question involves likely
effects of velocity, but we should also examine the effects
of changes in nominal income.
A rise in posted prices of rationed goods implies an
increase in nominal income. Holding interest rates
constant, money demand should depend on transactions
prices, not shadow (or black market) prices: if the posted
prices on rationed goods double, then money demand
should also double (other things held constant).14
Therefore, if velocity and the nominal money stock are
constant through the transition, we expect an increase in
the (correctly measured) value of money, i.e., a decrease in
the level of black market prices, and the (correctly
measured) overall price level. In summary, though the
measured price level an index of the posted prices of
rationed goods will rise as prices are liberalized, the true
price level the inverse of the value of money is likely to
substantially decline in a liberalization.
We thus call into question two of the channels
through which liberalization is supposed to lead to a
decrease in money demand. Since liberalization of official
prices does not cause the shadow value of money to fall, it
will not lead to a flight from money. And since
liberalization increases nominal income, it induces an
increase in money demand. Consequently we expect a
liberalization to result in a fall in second economy prices.15
Our prediction of a fall in black market prices in the
wake of an increase in official prices seems to have been

More precisely, money demand will not quite double, since the
component of nominal income corresponding to black market goods
does not change.
In Cochrane-Ickes (1990) we show that this is indeed the case in the
context of a model where the fiscal source of inflation is the
subsidies associated with fixing official prices below market-clearing
levels.
108

borne out by the recent (April 1991) price increases in the

Soviet Union. The Financial Times (May 1, 1991: 1)
reports that the "only bright spot ... is that the surge in
state prices has pushed down black market prices,
particularly for electronic goods."
Furthermore, a true price liberalization, together
with a liberalization of trade and the institution of private
property, should result in a longer-term rise in real
incomes. That is, after all, their purpose. The increase in
real income should similarly raise money demand, and
hence depress inflation at constant velocity and money
stock. This is, admittedly, a longer term effect. However, it
is likely to occur over about the same horizon as the rise in
velocity we expect due to the introduction of modern
means of payment including checks and credit cards, at
least partially offsetting the latter effect.
Moreover, with prices freed there should be a one-
time increase in the supply of goods in the market as
enterprises cease hoarding goods for speculative reasons.
Given the vagaries of the supply system in the pre-reform
setting, enterprises hoard inputs as insurance against
supply failures. With the liberalization of prices, these
stocks are no longer necessary, indeed are a burden.
Consequently, one would expect, as has occurred in the
Polish case, enterprises to dump excess inventories as their
cash needs increase (i.e. to buy scarce inputs at higher
prices). Notice that this effect, unlike the long term rise in
real income, ought to be rather sudden, and introduce a
strong downward push to velocity. It is simply the re-
monetization effect applied to enterprises following
liberalization.
This effect is likely to be quite large in magnitude.
According to Shmelev and Popov (1989: 133), inventories
in the material sector (i.e. excluding services and
agriculture) comprise about 80 percent of Soviet national
income! They cite a number of humorous examples, such
as that of a distribution base for production equipment in
the western Siberian oil center of Nizhnevatorsk that had
 109

accumulated 130,000 reed paintbrushes, valued at 200,000

rubles, that it could not sell due to restrictions on resale
(Shmelev and Popov 1989: 137).
A price liberalization may not only induce
enterprises to reduce their hoards of goods, it may also
greatly increase their demand for money. In the pre-
reform setting the enterprise's demand for money stems
solely from the need to make wage payments.16 For all
other inputs transactions were simply recorded in the
books of the State Bank. But after a price liberalization,
enterprises will presumably demand money to facilitate the
purchases of inputs. Notice that, as in the case of the
dumping of hoards, this is a one-time, albeit permanent,
effect. But just as in that case it occurs in the beginning of
the liberalization.

Summary

In summary, price liberalization has various effects

on money demand through its impact on velocity and
nominal income. Some lead to an increase in the demand
for money, while others lead to a decrease. Effects that
lead to rises in money demand help lower inflation during
the liberalization episode, and the price level thereafter;
effects that lead to a decrease in money demand raise
inflation during the liberalization episode. The effects that
lead to a rise in money demand include the immediate rise
in the relevant nominal income (agents will need more
cash, but less time, to purchase goods), the long term rise
in real as well as nominal income, and the increase in
money demand one expects at the end of any inflation.
Effects that lead to a decline in money demand include the
advent of more modern transactions technologies and
financial services, and the lower demand for cash to take

16. Thisignores the cash needs of the enterprise for the conduct of
second-economy transactions and bribes.
110

advantage of surprise purchase opportunities and

transactions in the second economy.
The behavior of inflation during the price
liberalization episode depends on how these contrary
effects balance each other. We suspect that the channels
for lower money demand operate over a longer time
horizon than the channels that raise money demand.
Therefore, we suspect that there will be no boost to
inflation due to agents' behavior during the transition
itself, and, at worst, the possibility of a slow long term
inflation (or need to slowly reduce the money stock) over a
period of many years, long after the stabilization episode
itself. In fact, a strong case can be made that the forces
leading to an increase in money demand will predominate
during the transition itself, so that agent's money demand
changes will help, rather than hurt, the transition.
However, no matter which of the effects we have
analyzed predominate, we want to emphasize that none of
the money demand stories deliver the massive, sudden
decrease in money demand predicted by the "money
overhang" story. In particular, a rise in official prices does
not correspond to a decline in the shadow value of money
(as measured by, say, black market prices) and hence will
not boost velocity. Thus none of the stories we have
examined predict a big rise in true inflation (as measured
by the price of black market goods, and as opposed to the
prices of subsidized and rationed goods) during the
liberalization episode.

3. The Savings Overhang

The "savings overhang" is even more tenuous than

the "money overhang," since there is no transactions
demand for savings.17 Once we admit that money does not

17. Some analysts would include a portion of savings deposits in

transactions balances. We choose, however, to distinguish money
balances and savings deposits in order to better gauge the effects of
liberalization.
 111

have a zero value, we were still able to come up with some

stories that generate a higher velocity during and after a
price liberalization. However, we are unable to come up
with similar stories for saving.
Given the existence of a black market, consumers
always face an operational decision (they are not at a
corner): they can purchase goods on the black market.
Hence, their savings cannot reflect just a piling up of
useless balances. If they in fact do save an abnormally high
amount, this must reflect a judgment that the marginal
utility of deferred purchases is higher than the marginal
utility of purchases on today's black market. Given the
existence of a black market, consumers must be on the
appropriate savings demand curve, just as they are on a
money demand curve. Thus, to evaluate the "savings
overhang" story, we can use standard theory of saving, just
as we used standard money demand theory to evaluate the
money overhang. 18
Thus once we recognize that the value of money is
not zero, because it can be used to purchase black market
goods, the standard theory of consumption and savings
applies. Saving is determinated by expectations of future
income relative to current income, and the relative rates of
return on savings accounts vs. holding durable goods and
cash. One must take some care in using correct shadow or
black market prices to infer those rates of return, and then
the theory of saving does not predict anything like the
saving overhang scenario.
Before turning to the theory, we note that the
empirical evidence adduced to support the notion of a
savings overhang is interpreted in a misleading way.
Estimates of the savings overhang are typically made by

18. The useof the standard theory of savings in the Soviet context has
been attacked by some Soviet specialists, such as Igor Birman
(1980), who argues that "the marginal propensity to save is not
relevant in the different conditions of the STE." We disagree. In our
opinion, the standard theory of saving is applicable in all economies,
once the constraints are properly specified.
112

comparing the growth in savings deposits to the growth in

income.19 But the calculation of high holdings of savings
relative to income, values the latter at official prices.20
Since this understates the value of nominal income (for
two reasons, one the wrong price level, two ignoring the
value of black market output), it overstates the savings
rate.
It is also hard to believe in a savings overhang on
theoretical grounds. The only reason for a large volume of
savings is that consumers must think they will get a better
deal waiting to spend tomorrow, rather than spending
today. They must believe that black market goods will cost
less tomorrow, so that the effective real interest rate is very
high. Alternatively, they could believe that rationed goods
will become more available with no significant price
increases in the future, so that the value of their savings
will be higher. Neither belief sounds very plausible.
Even if we admit that a large amount of savings
exists, what kind of events would cause a rush out of
savings into consumer goods? Again, saving is a forward-
looking decision: it is not determined by whether today is a
good time to buy relative to the past, as implied by the
saving overhang story. It is determined by whether today is
a good time to buy relative to the future. Thus, to generate
the rush out of saving and into consumer goods described
by the saving overhang story, consumers must expect goods
to be more available during the transition than afterward.
They must believe that goods will become harder to

The annual growth rate of savings deposits in the Soviet Union has
been over 10 percent, and as high as 14 percent, since 1986 (see
PlanEcon Report, v. VI, November 23, 1990).
See, for example, the calculations and discussion of excess savings in
the Soviet Union, in "Stabilization, Liberalization, and Devolution:
An Assessment of the Economic Situation and Reform Process in
the Soviet Union," European Economy, v. 45, December 1990.
 113

acquire in the future, so that it is better to buy today rather

than keep money in the bank and buy tomorrow.21
This expectation is unlikely: the whole point of a
price liberalization is that goods should become more, not
less available. The only possibility here is that, if there is a
price level increase during the liberalization, and bank
interest rates are frozen, then consumers would decrease
savings in order to hoard goods. As we have mentioned
above, true inflation, from the money or bank account
holder's point of view, and as measured by black market
prices, is unlikely to increase, and may well be negative
during a price reform.
Even if this prediction is not borne out, the solution
is simply to allow market determined interest rates along
with market determination of other prices. Then the real
interest rate would stay positive, and there would be no
reason for consumers to hoard goods instead of keeping
savings accounts in the bank. Incidentally, this fact
illustrates another reason for our prejudice that everything
should be freed at once: if prices are freed before interest
rates following advice that retail markets should be freed
before financial markets then the retail price
liberalization could fail: consumers may try to hoard goods
in trying to avoid artificially low real interest rates.
One exception to the analysis so far is consumers
who are liquidity constrained and hence must accumulate
large savings balances to purchase "big ticket" items like
automobiles. When prices are freed, and if credit markets
are present, these individuals will indeed carry lower
savings. We would expect this effect to be small, especially

21. The concern that liberalization may lead to a rush to buy goods
would seem more appropriate to a policy of delayed liberalization. If
the government announces that prices will be liberalized after some
interim period, then we would expect agents to hoard, to beat the
price increases. The problem of early announcements of price
reform, and the panic buying that ensued, was a major factor leading
to the downfall of Ryzhkov's reform program. For this reason, we
are strong proponents of immediate liberalization.
114

since the development of consumer credit markets will

take time.
So far, we have discussed rates of return (correctly
measured, i.e., using the shadow value or black market
value of money rather than posted prices of rationed
goods) as determinants of savings. The other determinant
of saving is, of course, income: consumers raise their stock
of savings if they think income in the future will decrease,
and vice versa. One can make a case that this channel
produces some of the effect predicted by the savings
overhang: Before the liberalization, it is a reasonable
expectation that things are only going to get worse, so
consumers will want to save. As long as real interest rates
(again, measured relative to black market goods) on
savings accounts are slightly positive, they will hold such
accounts rather than hoard durable goods. After a
liberalization, consumers may expect that incomes will
rise, and thus decrease their stock of savings.22
This channel is limited, however, by two
considerations. First, the liberalization would have to be
completely unexpected. If consumers expect a
liberalization and subsequent rise in incomes, they will not
have a large stock of savings to begin with. Second,
consumers will not unload their entire stock of savings on
getting news that future incomes will be higher. They will
follow the usual permanent income rule and spend a
constant fraction of their entire wealth, including savings
and present value of labor income, in each period. The
change in expectations of future income means that a
larger fraction of the initial stock of savings will be spent
each period, say from 5 percent to 10 percent, but the
theory of saving does not predict that consumers will

22. Alexeev (1991) shows that savings may increase if price controls are
lifted in official markets. The reason is that agents need not save as
much for retirement with controlled prices they can use their
leisure time and queue in official markets and then resell in the
parallel market. When price controls are lifted, the value of leisure
in "retirement" falls, and savings increases.
 115

suddenly dump their entire stock in favor of consumer

goods.
The initial experience of the Polish and East German
liberalization confirms our view: consumers did not, after
all, rush out to spend all their savings, but seemed to spend
it, if at all, quite carefully.23

4. Monetary Reform Versus Price Reform

As we noted in section 1, many argue that a

monetary reform is a precondition for stabilization in
RSEs. First wipe out the "monetary overhang" and then
other economic reforms can be undertaken. An alternative
strategy, the one followed in the Polish case, is to free
prices instead. In this section we discuss the relative merits
of these two courses of action.
In theory, an excess supply of money can be absorbed
either by an increase in the price level or a decrease in the
stock of money (through repurchase or confiscation).
Proponents of the latter strategy (e.g. Edwards 1990,
Dornbusch and Wolf 1990) accept this theoretical
equivalence, but argue on practical grounds that the latter
strategy is the less costly alternative. The key objection to
freeing the price level, it is argued, is the inflationary spiral
that may result. The argument is that due to indexation

23. The Economist noted (July 21, 1990: 13) that ". . . East Germany's
recent experience suggests that the overhang may not exist: on
monetary unification, its people did not rush to spend all their new
D-marks. Most likely, Eastern Europe's other savers will be equally
cautious." Note that the East German case is especially interesting in
that the monetary union itself further inflated the money supply by
trading East German marks for D-marks at an overvalued rate.
Presumably East Germans understood that this was a one-time stock
effect. In the Polish case, the Sachs-Balcerowicz plan brought
inflation down from an annual rate of 700 percent for 1989 to an
annual rate of 1.8 percent in August, prior to the Kuwait crisis. See
PlanEcon Report, volume VI, no. 38-9, September 28, 1990. One may
question, however, whether the Polish case is really applicable, since
the hyperinflation of 1989 must have wiped out most people's money
holdings prior to the liberalization.
116

and the so-called Oliveira-Tanzi effect,24 inflation may

accelerate.
Notice how the argument that freeing the price level
will lead to an inflation explosion is based on the notion of
a monetary overhang. The idea is that when prices are
freed the initial jump in prices will create the environment
for an inflationary explosion. A good description is given
by Edwards:

[T]o the extent that there are (implicit or

explicit) multiperiod contracts and indexation,
the major price level jump required to
eliminate the overhang is likely to set in
motion serious inflationary pressures that will
perpetuate themselves for several periods.
Moreover, to the extent that the initial price
level jump generates expectations of further
large price changes, desired velocity will try to
anticipate (expected) future inflation putting
additional pressure into the system (Edwards
1990: 11).

As we argued in section 2, the notion of a monetary

overhang is suspect. Hence, the premise that price reform
will lead to a (correctly measured) price level jump is
called into question. Nonetheless, it is worth pursuing the
contrast between these two types of reform a bit further, in
that it elucidates important aspects of the RSE setting that
are often ignored in calls for monetary reform.
A monetary reform deals only with the stock
problem. It is a policy designed to absorb an excess money
stock. It does not deal with the flow problem, excessive
money growth resulting from the monetization of fiscal
deficits. Price reform, on the other hand, attacks this

24. The Oliveira-Tanzi effect refers to the decline in real government

tax revenue that results from rapid inflation, due to the lag in tax
collection.
 117

problem directly. The reason is that in RSEs the subsidies

produced by price controls are a major component of the
fiscal deficits.25 By freeing prices, the fiscal source of
inflation is directly attacked. Thus in the RSE context,
while a monetary reform deals only with the stock
problem, the supposed overhang, price reform deals with
the flow problem.
In comparing monetary reform and price reform it is
important to consider the relevant initial conditions for the
typical RSE. We refer, in particular, to the distorted
relative price structure. Forty (or in the case of the Soviet
Union, seventy) years of socialism has left these economies
with grossly distorted relative prices. Unlike Latin
American countries where fiscal deficits have been the
cause and price controls the political response, in RSEs
price controls are the primary culprit in the onset of the
stabilization crisis. The distortions introduced by price
controls in Latin American countries are orders of
magnitude smaller than in RSEs. Hence the Latin
American lessons for monetary reform and price reform
may not apply to RSEs.
A monetary reform does not deal with this
problem.26 A price reform, on the other, is designed
precisely to deal with this problem. It means that serious
economic reforms can proceed more quickly.
The situation in RSEs and in the Soviet Union is, in
many ways, exceptionally conducive to price reform.
Unlike the Latin American cases where institutions have
adapted to deal with inflation (i.e. indexation), in RSEs the
repressed official price level made such institutions

Soviet subsidies for food alone are just about equal to the
government's budget deficit. A recent estimate by V. 1. Scherbakov,
chairman of the Labor and Social Ministry of the Soviet Union, is
that food subsidies are running to about 120 billion rubles annually,
a figure just about equal to the projected deficit for 1991 (cited in
New York Times, February 14, 1991).
Dornbusch and Wolf (1990) see monetary reform as a prelude to
price reform.
118

unnecessary. Consequently inertial effects are of less

importance in this case.
The same point can be made about the tax system.
The bulk of tax revenue in RSEs comes from two sources;
turnover taxes, which are essentially specific duty excise
taxes, and remittances of enterprise profits. Income taxes
are essentially irrelevant. Hence the delay in collections is
relatively short, and little real revenue is lost to this source.
Consequently, the Oliveira-Tanzi effect is likely to be of
little consequence if prices are freed. This consideration
would seem to eliminate one of the proposed dangers of
price liberalization, as posed by proponents of monetary
reform.
Using monetary reform as a means to prevent
inflation poses problems of its own. A monetary
confiscation is difficult to execute. The anticipation of a
monetary reform may trigger a run on goods, as
households try to convert their savings into goods prior to
the reform.27 In the democratic RSEs there is the
additional problem of its political unpopularity. A
monetary reform represents, in effect, a breach of trust
with the population. It is true that for the RSEs the trust
was broken by the prior regimes, but this may not ease the
political unpopularity of such policies.

27. There is some evidence that this may have happened in the Soviet
Union. Historically savings deposits have run about three times the
level of cash holdings. But in the last two quarters of 1990, the
increase in cash holdings of the population was on the order of 2.5
times that of savings (PlanEcon Report, November 23, 1990: 11).
According to the word on the street, the public was afraid of a
confiscation of savings accounts. In the event, they were fooled; the
currency reform confiscated cash instead. But this clearly points out
how the expectation of monetary reform can lead to the hoarding of
goods, and then to a hurried attempt at a confiscation.
 119

5. Conclusion

We have argued in this paper that fears about a

monetary or savings overhang are not well founded.
Consequently, fear that inflation will erupt if prices are
liberalized may be misplaced. This suggests that delaying
price reform until the overhang is brought under control is
the wrong strategy for RSEs. Rather we would suggest that
immediate liberalization offers the best hope for a smooth
transition.
Nothing in our analysis suggests that confiscatory
monetary reforms will not achieve their intended macro-
economic effects of lowering the price level. However, our
analysis suggests that such policies are unnecessary. We
predict that a liberalization of official prices will lead to no
rise, and indeed probably a fall, in second economy (black
market) prices or other measures of the true value of
money. Hence, we do not predict a flight from money and
consequent economic dislocations in the wake of
liberalization.
This paper has been concerned with macro-
economics. However, we must emphasize that freeing
prices without a transformation of ownership will not work.
Managers of state-owned properties will continue to have
little incentive to follow the signals of prices and wages.
However, without free prices it is impossible to privatize,
since no one can assess the economic value of state assets.
Therefore, privatization and price liberalization must be
undertaken simultaneously.
Privatization requires prices that reflect opportunity
costs. Privatization and other microeconomic reforms in
RSEs have been held hostage to fears of inflation due to
the monetary overhang. The point of our analysis is that
fear and delay are unnecessary. In fact, delay of price
reform is the more costly strategy since it builds up
expectations that reform will not be carried out at all, and
it allows interests to coalesce that oppose real reform. If
fear of the monetary overhang is, as we argue, misplaced,
120

then this should not be allowed to delay the

implementation of serious economic reform.

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