Working Paper
Long-Term Growth and Welfare in Transitional Economies

This paper analyses the long-term growth and welfare impact of the transition to the market economy in the countries of Eastern Europe. We define welfare as the average real net wage after payments of social security contributions to fund a paygo-type pension system, and of taxes to service the interests on the accumulated public debt.We examine four sets of factors that will influence growth and the welfare of wage earners up to the year 2030. First, we argue that the accumulation of physical capital will be affected by a sharp initial fall in the capital stock, by a medium-term decline in savings and investments, and by efficiency gains following marketisation. Second, the human capital stock is expected to experience a similar short-term erosion because of the recent upsurge in human capital flights and the current decline in the quality and quantity of education being provided. Third, we also argue that the transition's population crisis, which has entailed large upswings in mortality and sharp drops in fertility, will affect negatively labour supply and dependency ratios, particularly over 1995-2020. Finally, we examine changes in pension policy and their negative inter- and intra-generational welfare effects. In the absence of policy changes, future generations will have to bear the consequences of growing government expenditure in the form of higher current pension transfers and of future debt-servicing costs.The overall impact of these factors is simulated by means of a mini-model which calculates changes in potential output, gross average wage, pension bill and welfare over 1990-2030. The simulation results indicate that the long-term growth of potential output will remain modest until 2020 because of the slow accumulation of both physical and human capital, and the stagnation of labour supply. The situation will be especially critical in Russia, where output is not expected to reach its pre-transition level by 2030. Second, welfare is expected to grow at an even slower rate. In the worst cases, it will increase at below one per cent a year, after a very large fall over 1990-95. The model shows that even some increase in the saving rate would not affect growth significantly. The large and negative long-term impact of demographic changes on net wages can only be alleviated by decreasing the pension and tax burden on future generations. An increase in the retirement age, an early recovery in fertility rates, and a faster preservation/accumulation of production factors, will be decisive for the improvement of welfare in the medium and long term.