Wiener Institut für The Vienna Institute

Internationale for International

Wirtschaftsvergleiche Economic Studies

PROPOSAL
FOR A NEW PHASE OF COOPERATION BETWEEN THE

GLOBAL DEVELOPMENT NETWORK

AND THE
VIENNA INSTITUTE FOR INTERNATIONAL ECONOMIC STUDIES
for the period of 2011 to 2013

‘CRISIS EFFECTS: GROWTH PROSPECT, SOCIAL

IMPACT AND POLCY RESPONSES
IN SEE AND CIS’

Rahlgasse 3 Telefon: (+43-1) 533 66 10 E-Mail: wiiw@wiiw.ac.at

A-1060 Vienna Fax: (+43-1) 533 66 10-50 Website: www.wiiw.ac.at
Contents

1. Introduction ..................................................................................................... 1
1.1 Global Development Network ............................................................................... 1
1.2 Co-operation between GDN and wiiw .................................................................. 1
2. Outline of the proposal ................................................................................... 4
2.1 Motivation .............................................................................................................. 4
2.2 Areas and regions of research.............................................................................. 5
2.3 Research competition: Methodology, Areas of Study, and Data ......................... 6
2.3.1 Macroeconomic effects............................................................................ 6
2.3.2 Microeconomic effects ............................................................................. 8
2.3.3 Policy response ....................................................................................... 8
2.3.4 Improving labour market institutions ........................................................ 9
2.3.5 Political economy implications ............................................................... 10
2.3.6 Research competition ............................................................................ 11
2.4 wiiw research....................................................................................................... 11
2.4.1 Macroeconomic effects. Inequality and the Crisis: A Causal Inference
Analysis ................................................................................................. 11
2.4.2 Microeconomic effects. Microeconomic analysis of short and medium
term crisis effects on poverty and vulnerability of households in SEE:
The cases of Bulgaria and Romania ..................................................... 13
2.4.3 Methodology .......................................................................................... 15
2.4.4 Data ....................................................................................................... 16
3. Conclusion .................................................................................................... 18
References ................................................................................................................... 19
4. Organization of the project ........................................................................... 21
4.1 wiiw Research Team........................................................................................... 21
4.2 Deliverables of the project .................................................................................. 22
1. Introduction

1.1 Global Development Network

The Global Development Network (GDN) was set up as an offshoot of the World Bank to
promote quality research on economic and social questions of development and transition,
coming from researchers living in these countries. Its objective is to build local research
capacity, produce research that is relevant for policy making in transition and developing
regions and link research institutes from eleven regions with more than 9.500 researchers
in more than 100 countries. GDN has five major activities:
• Global Research Projects (GRP), promoting research on specified topics on a global
scale, with a comparative perspective and with the purpose of bridging the gap between
research and policy advice. Currently there are 2 GRPs ongoing, one on the topic of
‘Strengthening institutions to improve public expenditure accountability’ and another one
on ‘Varieties of governance: improving public service delivery’.
• Inter-regional Research Projects (IRP), supporting regional network partners in com-
parative projects that are small in scope than GRPs.
• Regional Research Competitions (RRC), encouraging local and regional capacity build-
ing;
• Policy Outreach for impact evaluation activities;
• Global Policy Dialogues, providing an opportunity for consultation between regional
experts and policy makers, researches and experts from IFIs, supporting the improve-
ment of evidence based policy formulation;
• Annual Conferences, acting as fora for researchers from developing and transition
countries to present their research and be connected to the global research community;
• The Global Development Awards and Medals Competition, the largest international
contest for research on development; and
• GDNet, its electronic network, a knowledge base and similar dissemination activities

Over the years, GDN was able to substantially increase its output of research and increase
its network. It relocated its headquarters from Washington to New Delhi, demonstrating the
importance it puts on decentralizing know-how and policy advice. In February 2008 it has
become an International Organization. GDN is receiving funds from many government
sponsors and some private donors.

1.2 Co-operation between GDN and wiiw

Cooperation between the Vienna Institute for International Economic Studies (wiiw) and
the Global Development Network (GDN) – with the support of the Austrian National Bank
(OENB) and the Ministry of Finance (BMF) – has now been going on successfully for sev-
eral years.

1
The aim of the cooperation between wiiw and GDN is to serve as a hub for South-East
Europe (SEE). In this function wiiw works as an independent partner of GDN, setting its
own research agenda and with its own project management. The cooperation supports
research of high quality in the region and connects researchers in the region with the
global activities of the GDN. It is also intended to contribute to the building of capacity for
research and policy evaluation by connecting economists and social scientists of South-
East Europe with those from the European Union and the rest of the world.

Five rounds of research have until now been conducted on SEE. In the first round
(2000-2002), macroeconomic developments, programmes and policies were analysed.1 In
the second round (2002-2004), reforms, enterprise development and European Union (EU)
integration were the main topics of research. The third round (2005-06) centred on the ‘Im-
pact of Rich Countries’ Policies on Poverty’ and the fourth round (2007-08) dealt with mi-
gration. The last round (2009-10) dealt with inequality, income distribution and the contribu-
tion of fiscal systems to alleviate inequality. That phase was finalized at the end of Decem-
ber 2010. For the first time the regional focus of the project was widened to also include
some CIS countries. There was a separate research call and the papers commissioned
through this call were of high quality. The final reports are now being edited. The best pa-
pers from this phase were being presented in a draft version at the Annual Conference in
Prague on January 2010.

wiiw’s contribution to the cooperation with GDN has consisted of several components:
• establishing and implementing the Southeast European Research network through re-
search competitions that are organised by wiiw; guidance for researchers who partici-
pate in the competition, workshops and dissemination activities via the Balkan Observa-
tory (a joint project with LSE) and the European Balkan Observer (a joint project with
the Belgrade Centre for European Integration);
• participating actively in the Global Research Project (GRP), through papers by wiiw
researchers; mentoring of young researchers from the region who participate in the
GRP;
• contributing to the review process of the Regional Research Competition of GDN via its
Central European hub in Prague (that is run by CERGE);
• wiiw in-house research.

Over the years wiiw has succeeded to establish itself as a respected partner of GDN and
continuously increased the ties with GDN and expanded the common activities at the re-
quest by GDN.2:

1
For papers in rounds I and II see “The Balkan Observatory” at: www.wiiw.ac.at/Balkan
2
For further details see Zwischenbericht to OeNB, January 2008 and March 2010.

2
• at the Annual conference in Beijing in 2007 wiiw organized a panel on “Disparities in
Development patterns in Europe and Asia;
• at the Annual conference in Brisbane in 2008 wiiw organized a workshop on “Inequality
and Public Finance”;
• for the GRP on migration (2007-2009) wiiw researchers were asked to contribute to the
development of the methodology and mentoring of a research team in Macedonia;
moreover wiiw contributed funds to this project on the basis of the contract with GDN;
• at the Annual Conference in Prague in January 2010 wiiw organized a separate work-
shop on ‘Inequality and Public Policy’.

In addition to working with GDN wiiw builds on the synergies within the project to increase
its own research capacity on Southeast Europe, expanding its database, particularly the
data on Albania, Bulgaria, Kosovo, Macedonia, Montenegro and Serbia, increasing the
scope and improving the quality of its research. Over the years, a number of younger re-
searchers have been employed by wiiw and they have contributed to wiiw’s ability to study
and monitor the SEE states and economies and to increase its expertise in new areas of
study of particular interest for an institute that deals with international and transition eco-
nomics.

In our view, the cooperation between wiiw and GDN has several advantages for Austria in
general (in addition to the advantages for wiiw), in particular the participation in a global
research network with interest for the research community and capacity building and net-
working within the region and the possibility to contribute to shaping the agenda of policy
advice in SEE. A continuation of this cooperation will further enhance Austria’s role as a
regional hub, not just in business but also in scientific discourse.

3
2. Outline of the proposal

2.1 Motivation
Distributions (of income, wealth, power) are usually stable and tend to change relatively
slowly (Acemoglu and Robinson 2005). This is clearly and more specifically the case with
the inequality of income and capabilities, but also with other aspects of social differentia-
tion, and with poverty and other measures of absolute deprivation. These slow moving
changes are usually driven by the persistence of growth, by institutional and other devel-
opment, and by the quality of the policy responses. Structural shifts in distributions, how-
ever, are often prompted by either external shocks, like crisis, or by internal shocks, like
regime changes or large scale reforms. Some of these shocks may be reversed, but some
have more enduring effects. The issue then is whether the current economic crisis is such
an external shock and whether in some cases it may lead to enduring changes in the dis-
tribution of incomes, capabilities or other values of interest. First empirical observations
tend to point in this direction at least in countries and regions that are of interest for this
research, i.e. Southeast European (SEE) and CIS countries (wiiw (2010).

Due in part to the lag in the available data, previous GDN SEE & CIS research on inequal-
ity, which was just completed at the end of 2010, focused on the pre-crisis developments.
Multidimensional aspects of inequality have been described and analysed for the period of
prosperity for most of the countries neighbouring the EU. Special emphasis was put on the
analysis of the effects of public policy. In the late 1990’s and early 2000’s the process of
European integration allowed most of the transition economies to aim for the best of both
worlds: equity and economic development. Low real interest rates helped to improve eco-
nomic growth and increase financial access which contributed to the reduction of inequal-
ity. Sustained public spending was also instrumental to reducing inequality while also sup-
porting growth in good and bad times. All in all, the emerging social differentiation and in-
come inequality increasingly resembled that in the developed countries, particularly mem-
bers of the European Union.

The social impact of the world financial crisis of 2007 and 2008, however, started to show
up in 2009 when economic activity decreased sharply throughout Southeast Europe and
the CIS region. In most of these countries, the drop in GDP was above the EU average of
about 4% in absolute terms. As a consequence unemployment started to rise throughout
the region in 2009. Except for Turkey and those countries that are mainly relying on ex-
ports of fuels and metals, growth prospects for the years to come are very modest and a
further increase of already high unemployment is quite likely. It can be expected that espe-
cially less skilled employees and various vulnerable groups will be strongly affected with
rising poverty risk. The number of wage earners is expected to decrease further and the
people eligible to receive various types of transfers or to start living on pensions will in-
crease. These adverse employment and income prospects will have substantial repercus-

4
sions for the economic and political developments in the countries in the southern and
eastern neighbourhood of the EU. In other words, current expectation is for a structural
break in growth and development in these regions (Bruegel and wiiw, 2010).

Having that in mind, the main hypothesis to be tested is the following: The crisis shock
introduces structural breaks in the distribution (e.g. increase of inequality) across different
dimensions conditional on the change in potential speed of growth, the quality of develop-
ment, and the induced or adopted policy changes.

2.2 Areas and regions of research

The regions to be analysed are South-Eastern Europe and the CIS. It would be interesting
to also include a region of emerging economies in a wider inter-regional project. Turkey
and perhaps some other countries among the emerging markets may be of particular in-
terest because they diverged with the transition countries before the crisis and seem to be
diverging again after the crisis albeit in the different direction at least when it comes to the
prospects for economic growth: in the first instance lagging behind, while currently forging
ahead of the countries in transition, especially those in Southeast Europe. On the other
hand, they share some of the same shocks and some of the same mechanisms of the
transmission of shocks due to trade and financial integration with the economies of the
European Union.

The areas of research are the following:

(i) To check the influence of growth, development, and policies on distributional vari-
ables: the macroeconomics of potential growth, the effects of institutional changes,
and of policy reforms should be looked at and the effects on labour markets and in-
come distribution assessed.
(ii) To look at effects of the crisis on various social groups and households, especially
when it comes to employment, capabilities, and poverty: the microeconomic effects
and impacts of both shocks and policies should be investigated.
(iii) Political economy and sociology of the policy response and of the absorption of
shocks will be included.

As in earlier GDN SEE & CIS projects, some of the research will be done in house and
some through a research call. Current research will not be just a continuation of the previ-
ous work on inequality and public policy but also a check on the robustness of the findings
in the previous research due to changing economic circumstances but also due to chal-
lenges to the political economy of these regions raised by the current crisis. Here we first
describe the areas of research and possible methodologies that should form the basis for
the call for research proposals and, then, describe the research that is to be done by wiiw.

5
2.3 Research competition: Methodology, Areas of Study, and Data
At the macro level, the persistence of distributions, e.g. inequality and the structural break
hypothesis is now increasingly being studied with the natural experiment type of methodol-
ogy. The idea is to look at the consequences of shocks on the shift in the distribution of the
variables of interest (e.g. income, wealth, power) and then check for the persistence of the
new distributional regime. In the SEE and CIS regions (and also in the other emerging
economies), there are persistent characteristics, e.g. in the labour markets or in capabilities
that could be explored. There is also the differentiated effect of the crisis that could allow
for natural experiment type of analysis.

In addition, policy impact analysis is clearly needed. On the micro level, policy impact
analysis could be useful. There are developed methodologies to studying local political
economy and the sociology of local communities that could be explored (e.g. the substitu-
tion of social support mechanisms where state support fails and vice versa).

Much of all these studies will involve simulations of various kinds. Clearly, the crisis is an
evolving thing. So, there will be limitations on the data and on information in general. But it
does not make sense to wait for data to accumulate in order to look at these issues. So,
some ingenuity will be needed in the design and implementation of the methodologies and
in the use of data and in the simulation of the effects of crisis and of changes in social dif-
ferentiation, e.g. in inequality and poverty.

2.3.1 Macroeconomic effects

Various methodologies will be employed to determine the possible change in the potential
growth rate and to deduce the types of development and policy constraints that a possible
decline of the potential growth rate may have for development and for distributional vari-
ables of interest (Bruegel and wiiw, 2010).

2.3.1.1 Financial flows and inequality

The key problem in macroeconomic research is the difficulty to identify causal relations and
thus causal effects (Hoover 2001, Gligorov 2010). This is partly because of the need to rely
on micro-founded policy impacts and partly because of the inherently general equilibrium
nature of macroeconomics; in that context, causal effects tend to be hard to define and
thus identify. Still, the current crisis has prompted significant policy re-evaluations, espe-
cially when it comes to financial and fiscal policies. It is expected that in some of the re-
gions of emerging Europe, e.g. n Southeast Europe, the availability and the access to fi-
nance is expected to be major constraints in the medium run. That may prove not to be the
case in the CIS region. As a consequence, there may be significant differences in the ac-
cess to finances in these two regions. Similarly, in other emerging markets, e.g. Turkey,
the problem may be that of too much inflow of money and capital and speedy increase in

6
access to them by households and corporations. Thus, while Southeast Europe may be
starved to finances, countries in the CIS and in other emerging markets may face the prob-
lem of too much inflow of money and capital. These different financial situations will have
effects on income distribution and on other distributional variables. In both cases there will
be social and distributional effects and possible long term consequences that will be as-
sessed.

2.3.1.2 Distributional effects of public spending

The changes in fiscal policies are already having and will undoubtedly continue to have
significant impact on the distribution of income and other distributional variables. These
effects have been increasingly investigated and some of the available methodologies
should be checked, improved upon, and implemented in the current research (Romer and
Romer 2010, IMF 2010, Alesina and Ardagna 2010). Most of the macroeconomic studies
look at the effects of changes in tax systems and policies on the distribution of income and
wealth. Much less is known about the effects of public spending, which are particularly
affected by the current crisis, though it is clear that the effects are strong. The problem is
mostly one of proper modelling and measurement of these effects. Income and other dis-
tributional effects of public investments in infrastructure or in human capital should be im-
puted in order to measure the effects on, for instance, income distribution and in order to
be able to project the long term effects of the structure and the level of public spending on
social inequality. This is essentially an ex ante impact analysis which will have to be based
on the method of imputation of direct and indirect effects of the structure of public spending
on the internalised and expected changes in the distribution of income, wealth, power and
other resources.

2.3.1.3 Intergenerational justice and investments

Finally, distributional effects are strongly inter-generational. This is especially true in coun-
tries, like the ones we are studying, that face significant investment needs in order to spur
long term growth and development. This suggests the need to clarify how the social dis-
count rate is determined and what policies are most effective in influencing the relative
importance of current versus future consumption. Countries differ in the amounts that they
spend on e.g. public investments or in other words in how much they value current as op-
posed to future consumption. Similarly, countries differ in the amount of private savings
and investments, which again suggests that there are significant differences in the propen-
sity to save and thus that social discount rate, the rate at which future consumption is dis-
counted, is relatively high. Thus, there are significant differences in how inter-generational
justice is perceived in different countries. This is an area of research that has not received
much attention in studies of countries in transition and is especially important in the wake
of the current crisis that challenges the inherited model of growth and also of social and
inter-generational equilibria. We aim to develop methods to identify the determinants of

7
differences in the rate at which future consumption is discounted. For instance, in some
Asian emerging markets, social discount rate seems to be quite low, while the opposite is
the case in many countries in Southeast Europe and in the CIS. Current crisis may be
changing that as savings are growing in one set of countries while consumption is pre-
ferred more than before in the other set of countries. The aim is to determine why.

2.3.2 Microeconomic effects

2.3.2.1 Crisis effects on income and poverty

Here the aim is to survey the early effects of the crisis on economic activity, income and
poverty among the SEE and CIS countries. It will also be looked at growth and distribution
forecasts for the medium term. Finally political economy implications of the changes in the
distribution of income will be analysed.

2.3.2.1.1 Early crisis effects

Based on available micro data it is intended to thoroughly describe the effects that the cri-
sis has had on the economic activity and incomes of the populations of Southeast Europe
and the CIS. The developments of wages, transfers and pensions will be distinguished in
detail. This will give an opportunity to identify vulnerable groups that are affected by unem-
ployment, economic inactivity and poverty. Differentiation by age, gender and skills of indi-
viduals will be made. This should give a proper picture of the early consequences that the
crisis had on the distribution of incomes and the incidence of poverty.

2.3.2.1.2 Stress test 2011-2013

Given the fact that longitudinal micro data typically comes with a lag of two years, by mid
2012 it will only be possible to analyse data from 2009 and 2010. Therefore, based on mi-
crodata and longer time series stress tests will be performed for the period of 2011 to
2013. This will give a hint at the potential medium run effects that the crisis has on eco-
nomic activity, income and poverty development.

2.3.3 Policy response

The standard policy response to economic downturns in the transition economies in many
Southeast and CIS countries is based on fiscal adjustments as in many cases monetary
policy is handcuffed by a fixed exchange rate regime. In a few cases, such as Romania or
Serbia a flexible exchange rate regime is being used to counter act external shocks. How-
ever in many cases a currency board or a fixed exchange rate regime is coupled with a
pro-cyclical fiscal policy stance. After bad experiences in periods of hyper inflation at the
beginning of the transition process a fixation of the local currency to the Euro is a social
consensus in many transition economies, such as for instance in Croatia. So far hardly any
country has tried an alternative way to cope with real exchange rate crises. It is mostly Slo-

8
venia that is trying to make use of wage policy with the help of a social partnership type of
a model to maintain stable international competitiveness and domestic demand. Slovenia
has a high level of unionisation and collective bargaining coverage as compared to other
transition countries. In general, the continental Western European neo-corporatist industrial
relations system as for instance applied in Austria (see Knell and Stiglbauer, 2009) has not
evolved in the transition economies. There, rather a transformation of industrial relations
into a segmented system, which is more similar to the deregulated labour markets of An-
glo-Saxon liberal market economies, can be observed (see Benczes, 2006).

In the research competition we do not want to discourage proposals that deal with fiscal
and monetary issues. However we would like to encourage proposals that deal with the
issues of wage bargaining and social partnership in SEE and CIS countries as an alterna-
tive policy response to external shocks.

2.3.4 Improving labour market institutions

Our hypothesis is that in most countries of the region the wage bargaining system is highly
fragmented and wage inequality is often above the level of benchmark countries. As a re-
sult employment and skills levels are below their potential and domestic demand and ex-
ternal competitiveness are depressed. So far, the literature has mainly described the la-
bour market institutions in transition countries (see e.g.: Funk and Lesch 2004, Mailand
and Due 2004, Avdagic 2005, Arandarenko 2004). Its potential role as a substitute and/or
complement for monetary and fiscal policy was hardly touched upon. We would like to
support research proposals that describe the current state of wage setting processes and
the organisation of vocational training and skill upgrading as well as the potentials for an
improved social partnership providing alternative macroeconomic policy options. The main
motivation being that in the sphere of labour market institutions some of the main channels
for the transmission of the economic crisis on social differentiation can be found and that
these are also of particular interest from a political economy perspective. The crucial impor-
tance of high quality industrial relations was also emphasised by the European Commis-
sion in its latest Industrial Relations report (EC, 2009). Higher trade union density is corre-
lated with lower wage inequality and an increase in wage bargaining coverage is asso-
ciated with lower in-work poverty. Also, Blanchard and Philippon (2004) report that cooper-
ative labour institutions play an important role in alleviating unemployment rates. This is of
utmost importance, especially in the context of the current economic crisis.

2.3.4.1 Wage setting process

The existing status of the labour relations and the social dialogue in the region will be de-
scribed. The prime focus will be on the wage setting processes and the political economy
factors that influence these processes. The organisational level of the employers’ and em-

9
ployees’ institutions will be examined. The distributional effects of the national labour mar-
ket institutions will be estimated.

2.3.4.2 Organisation of vocational training and skill upgrading

Apart from the wage level also the level of skills is crucial for the development of internal
and external demand of the region analysed, as many of these countries have not devel-
oped an internationally competitive manufacturing sector that could provide labour to a
large share of the population. We will therefore study the current organisation of vocational
training and skill upgrading. This includes an analysis of the influence of workers’ and em-
ployers’ organisations on the education and training especially in technical jobs relevant for
potentially export oriented manufacturing.

2.3.4.3 Potentials for improved social partnership

Finally we will try to conclude from the above examination of the existing wage setting
processes and the organisation of in-plant skill enhancement and develop relevant policy
recommendations for an improvement of social partnership in the countries analysed. This
includes an assessment of the political economy factors that are potentially impeding as
well as conducive to a reform of the labour market institutions. The analysis will take care
of the potential macroeconomic role of an improved social partnership in SEE and the CIS
based on seminal papers in this field such as for instance Calmfors and Driffill (1988) but
also more recent papers such as Sidiropoulos and Zimmer (2009).

2.3.5 Political economy implications

Crisis as severe as the current one can be trusted to lead to significant social tensions and
political changes. Both can be expected to have significant effects on the social differentia-
tion as a consequence of the choice of policy responses. These responses, however, need
to be studied with the view of the ability of particular social and political institutions to adopt
specific policies as shaped by the diverse and conflicting social and political interests. This
is the familiar problem of structural reforms and of their consistent implementation. Not
enough is known about the way in which social and political interests are represented in
various counties of the regions that will be studied within this project. For instance, income
distribution is strongly affected by income policies which are often determined with a par-
ticular interest in mind. As quite a number of policy changes have been taking place during
and in the aftermath the crisis, analyses of these reforms could reveal the interests that
were the most important in their choice and implementation.

Based on the above analysis of existing data and the forecast exercise, we will make as-
sumptions on the potential political economy implications that the changes in the composi-
tion of income between wage earners and receivers of other forms of income have. This
will also touch upon the issues of sustainability and adequacy of social systems. A host of

10
issues will be addressed in order to take account of the complex structure of bargaining
between various social and political interests over various distributional variables.

2.3.6 Research competition

The methodologies, the topics, and the data sources discussed above can be seen as the
framework within which research proposal should be formulated. We expect proposals that
describe the methodology and the data sources by the persons applying for research in
this project. One of the main aims of GDN, with whom this project has been developed, is
capacity building, which inter alia implies the ability to formulate the hypotheses and to
develop methodologies to test them. Here we suggest the type of research that we would
like to see and in which research capacity should be developed. As in the past rounds of
research competition, originality and adequacy will weigh heavily on the inclusion of spe-
cific research projects into the overall research program.

2.4 wiiw research

In this section we will describe in more detail the wiiw in-house research.

2.4.1 Macroeconomic effects. Inequality and the Crisis: A Causal Inference Analysis
In the years prior to the world financial crisis, transition economies experienced high (in
some cases double-digit) GDP growth rates. Convergence to the EU average income level
seemed to be feasible within reasonable time. The influx of credit and direct investments
from abroad was the main engine of growth; some countries also experienced rising remit-
tances due to outward migration. A number of transition economies with abundant re-
sources benefited from the ballooning commodity price bubble. Policy makers throughout
Central, East and Southeast Europe (CESEE) differed in their ability to implement policies
to deal with their often overheated economies.

During this period income inequality decreased especially in countries with higher GDP
growth rates. This relationship was found in earlier wiiw GDN-SEE-CIS research on ine-
quality and growth (see Holzner, 2010). Even signs of labour shortages were reported in
several transition economies. Wages were rising and thus stabilising or even reducing
poverty and inequality. The shape of a Kuznets curve was observable, especially with the
sharp increase of inequality in the early stages of transition and a subsequent improvement
after the year 2000 when growth became more robust throughout the transition countries
(see Leitner and Holzner, 2008). Earlier studies have rejected the Kuznets hypothesis for
transition economies (see Wan, 2002), a hypothesis that was thought to be an empirical
regularity confirmed by Barro (2000) and others.

11
However, economic growth in CESEE experienced a dramatic trend reversal after the
global financial crisis erupted, international capital flows went dry, and international trade
broke down in late 2008. As many other countries, most transition economies witnessed a
substantial recession in 2009. In the recovery period, however, some countries are faring
better than the others. Those economies that had a large export oriented industry sector
and that performed a more flexible real exchange rate policy were able to gain from the
international trade rebound and could thereby leave recession much quicker.

In our new research we want to estimate the influence that the crisis had upon income
inequality in CESEE. We will employ quarterly data on inequality, GDP growth and growth
explaining factors from before and after the crisis. This data is available for the majority of
transition countries. In order to make a causal inference using the observational database
at hand that most likely suffers from omitted variable and selection bias as well as possible
simultaneous causality we shall employ an instrumental variable (IV) method. The model
applied is a two-stage least-squares (2SLS) model following Acemoglu (2010), respectively
Acemoglu and Johnson (2007). The second stage relationship can be described as fol-
lows.
I it = αgit + ζ i + µt + ε it , (1)

where Iit represents income inequality in country i and quarter t and g represents economic
growth. The parameter of interest α, measures the relationship between inequality and
growth. The variables ζ and µ represent country and time dummies respectively and ε is
the error term. To overcome the problem of biased estimates of α we define the first stage
relationship to be as follows.
~
g it = βGit + ζ i + µ~t + uit , (2)

where G is a growth explaining variable and the remainder consists again of country and
time dummies as well as an error term. The growth explaining indicator G is defined as
follows.
Git = (1 − C t )Gitpre + C t Gitpost , (3)

where C is the intervention dummy for the global financial crisis, that is equal to 1 for all
dates after the third quarter 2008. Gpre refers to the pre-intervention growth explaining indi-
cator and Gpost to the post-intervention growth explaining indicator respectively. Gpre will be
calculated as a normalised index consisting of two major pre-crisis growth explaining fac-
tors, the share of foreign capital influx in GDP as well as the share of fuels, ores and metal
exports in GDP. Consequently, Gpost will be calculated as a normalised index consisting of
two major post-crisis growth explaining factors, the share of industry in GDP as well as the
index of real exchange rate appreciation. This is not necessarily a permanent new growth
model. However, we consider it to be the relevant one for the immediate period after the
crisis for which data is available.

12
Thus, the first stage is based on the theory that global crisis intervention will change the
growth model for the transition economies from a foreign capital fuelled to an export lead
growth model. The second stage is derived from a Kuznets curve type of theory.

The data used will stem from national central banks and statistical offices as well as the
wiiw Monthly Database on Eastern Europe and Eurostat. As a proxy for income inequality
we will calculate a simple Gini coefficient using data for average net wages and number of
employed by NACE categories as well as number of unemployed and pensioners and av-
erage unemployment benefits and pensions. This type of data is available for the majority
of transition economies on a monthly, respectively quarterly, basis from national statistical
offices. All the other data is readily available from the national accounts and the balance of
payments.

As a result we expect a confirmation of the hypothesis that the global financial crisis has
changed the growth model of the transition economies and that this in turn has significant
consequences for income distribution in the region. Corresponding policy recommenda-
tions will be drawn from these results. A publication in an international peer reviewed jour-
nal will be aimed for.

2.4.2 Microeconomic effects. Microeconomic analysis of short and medium term crisis
effects on poverty and vulnerability of households in SEE:
The cases of Bulgaria and Romania
Income poverty and social exclusion are still widespread phenomena in the SEE countries.
Although absolute poverty rates have declined due to rising average real incomes in both
Bulgaria and Romania up to the economic crisis, an increase in income inequalities inhib-
ited to reduce significantly the vulnerability and relative poverty of households. In 2008, in
Bulgaria 21% and in Romania 23% of the households are in or at risk of poverty according
to EU methodology. Together with Latvia the latter two SEE countries are those EU mem-
bers with the highest poverty rates in the period before the economic crisis (Atkinson and
Marlier, 2010). This also highlights that fiscal and social policies materialising in the tax and
transfer systems were not designed efficiently to improve the situation of vulnerable groups
in times of high GDP growth rates. However, the financial and economic crisis represents a
substantial shock to the welfare situation of households in the whole CESEE region,
thereby further worsening the position of poor households and pushing larger parts of the
population into vulnerability.

In the wiiw analysis of short and medium term effects of the crisis we will examine various
channels of the macroeconomic shock on household welfare. The most important ones are
the labour market and income channel, the credit channel and the changes in the fiscal
and social policies (see Figure 1). In order to detect the structural changes of the income
positions we perform stress-tests (for a more detailed description see 4.2.1 below) based

13
on household survey data. Since household survey data is available only with a delay of
two years, in order to analyse even the short term effects of economic shocks on poverty
such stress-tests are necessary.

Figure 1

Income and labour market

Household welfare:
Macroeconomic Credit market Vulnerability & poverty effects
shock

Policy responses:
Changes in the tax and trans-
fer systems

One of the first immediate impacts of the economic crisis hitting households was a rise in
unemployment rates and an even stronger decline in employment in most SEE countries.
While in many EU countries GDP growth revived in 2010, in the SEE region the current
outlook shows a delay in the economic upswing and a protracted period of sluggish de-
mand development. Therefore the observed loss in employment is expected to lead to
lower labour force participation over the medium term especially for low and medium
skilled groups of the population.

Before the financial crisis lead to a credit crunch in the transition countries, household debt
levels rose swiftly especially in those transition countries that experienced an accelerated
catching-up process. Although levels of indebtedness of households in Bulgaria and Ro-
mania are not as dramatic as in e.g. Estonia, Latvia or Croatia the growth rates of house-
hold consumer and mortgage lending where among the highest in the most recent period
before the crisis. Hikes in interest rates, credit restrictions and currency devaluation caused
rising debt levels and financial vulnerability of households throughout the region.

Furthermore the substantial fall in output led to changes in the transfer and tax policies.
Even more so in the short to medium term governments are eager to reduce their crisis
induced budget deficits by lowering their social expenditures and raising taxes.

The composite effect of the crisis transmitted via the various economic channels is a rise in
poverty. However, the reduction in welfare levels will not only concern the low income
groups but spread throughout the middle class. For our analysis this implies that not only

14
the change in the level and structure of poverty and vulnerability is of interest, but also in
the income levels and distribution in general.

2.4.3 Methodology
In order to simulate the effects of the crisis on household welfare, vulnerability and poverty
our analysis will pursue the following steps:

First we assess the welfare situation of households in Bulgaria and Romania as well as
their debt service burden before the crisis, based on EU-SILC data. This will give us the
first insight into the structure of poverty in the two countries. Moreover the use of house-
hold survey data allows assessing the poverty-reducing capacity of the tax and transfer
systems. EU-SILC data contains detailed information on taxes on income, wealth and so-
cial contributions, respectively. Moreover the effects of the transfer system can be traced
with the help of 9 different categories of benefits and allowances, included in the survey
data.

In the second step we will identify the vulnerability of households to economic shocks by
comparing the actual debt service burdens to indicative thresholds. Similar approaches
were performed in the literature (e.g. Beer and Schürz, 2007; Albacete and Fessler, 2010;
Tiongson et al., 2010). Local national bank figures on the development and structure of
“non-performing loans” will be used to calibrate the debt service burden thresholds. In addi-
tion, first crisis effects can be analysed based on the EU-SILC data for 2009, which will be
available by March 2011. Since EU-SILC is a rotating panel it is also possible to keep track
of the majority of households over time.

Third, we perform stress tests, i.e. households are made subject to various macro-
economic shocks induced by the financial crisis in order to simulate the changes in income.
The magnitude of these shocks will be calibrated by making use of aggregate economic
data up to the end of 2011 and forecast figures for the period thereafter. The first shock to
be implemented is the fall in employment and rise in unemployment. The selection of a
particular household to be affected by any of the quoted shocks will be based on an unem-
ployment probability model, as widely used in the literature (see e.g. Pissarides and
Wadsworth, 1989, 1990; Brown and Sessions, 1996). In the case of unemployment, the
likelihood of becoming unemployed of one or more members of the household is drawn
from a probit model, where unemployment is a function of e.g. an individual’s socioeco-
nomic background, demographic characteristics or geographic location. In order to account
for the structural changes in the economic downturn we apply in our shock analysis differ-
entiated unemployment and employment changes for population subgroups, e.g. employ-
ment and unemployment changes by gender, educational attainment groups, regions,
economic sectors. The alteration in the labour force participation of the household mem-
bers thus translates into income changes. However, in addition to the changes in employ-

15
ment and unemployment further shocks have to be taken into consideration in order to
simulate the changes in the income situation of households. In the course of the crisis also
the incomes of many employed decreased substantially. Thus, employees will be shocked
with the structural changes stemming from national wage data. Furthermore, in SEE coun-
tries for many households, especially those of vulnerable groups, remittances represented
a substantial source of income before the crisis. The worsening of the employment situa-
tion of immigrants in EU-15 countries during the crisis led also to a dwindling of remittance
flows into the SEE countries from 2008 onwards. EU-SILC data contains information on
‘Inter-household transfers’ that can be used for this analysis. Using a probability model for
remittances households will be shocked with the changes in remittance inflows to the
countries analysed.

In step number four we will analyse the income changes due to alterations in the tax and
transfer structure, stemming from austerity packages introduced by the respective SEE
governments. Due to rising refinancing costs of public debt in the course of the crisis al-
most no CESEE country was able to perform countercyclical fiscal policies. Nevertheless,
the substantial drop in output led to budget deficits, which governments are eager to re-
duce as soon as possible. Therefore a reduction of social expenditures is taking place and
expected to be reinforced in the coming years. We will simulate the effects of these public
policy changes for broad categories of transfers and taxes depending on the availability of
explicit information on public policy changes. In general, EU SILC data contains detailed
social-economic information on individuals and as mentioned above various tax and trans-
fer categories, so that the effects of social policy changes can be assigned to single
households.

The analysis will conclude with an updated picture of the welfare situation of households
stemming from short and medium term effects of the crisis. We expect not only poverty to
rise due to increasing unemployment and other income changes, but also middle income
households to experience precarious welfare losses, thereby sliding into vulnerability. Fur-
thermore, due to the rise of debt to income ratios the financial vulnerability of parts of the
households will increase. Thus the simulation will allow assessing the tax and transfer poli-
cies of the governments in the course of the crisis in terms of efficiency in reducing first
round poverty effects. Since the analysis is based on micro data we will not only be able to
describe the upcoming situation of poverty but also overall distributional changes in house-
hold welfare.

2.4.4 Data
The analysis will draw on different datasets available for transition countries. The basis for
the microeconomic analysis of household welfare will be the EU Survey of Income and
Living Conditions (EU-SILC). Since 2008 Bulgaria and Romania have been covered by the
EU-SILC User database. In the very year a special module was included in EU-SILC, sur-

16
veying the wealth and debt situation and structure of households. Thus it is possible to
analyse the vulnerability of the population just before the outbreak of the financial crisis. In
order to simulate the effects of the different economic shocks, we will use most recent na-
tional and EU structural datasets available. Thus, for example, in order to analyse the ef-
fects of labour market and income shocks we will use detailed LFS and wage data. In or-
der to incorporate the changes of household debt we will make use of data provided by the
respective national banks as well as by international banks engaged in the region.

In order to improve the robustness of the results we will make use of consumption structure
data based on national Household Budget Surveys (HBS). In the case of Bulgaria and
Romania this can be used as a further tool in order to estimate the extent of the welfare
shock experienced by households.

17
3. Conclusion
The main goal of the research that is here outlined is to determine whether the current cri-
sis, which has had severe consequences for growth and social differentiation in Southeast
Europe and in CIS countries, has led to structural shifts in social inequality and through
which channels? This is a project developed and implemented within the research coop-
eration between wiiw and the GDN. The execution of the project is in two parts: through
specific projects chosen through research competition in order to satisfy a major goal of
GDN which is capacity building in Southeast Europe and in other developing countries.
The second part consists of the research by the wiiw researchers and is here outlined in
greater detail. The aim is that these research efforts are complementary in order to im-
prove the quality and provide some mentoring to the researchers from the target regions -
Southeast Europe, the CIS, and possibly some other emerging markets (e.g. Turkey).

The main topic is chosen in order to check the social effects of the current crisis and to
determine whether a structural break in the distribution of income and other values has
occurred or can be expected. Increase in inequality, if it happens, tend to have significant
impact on growth and on social and political responses. We aim to test the hypothesis that
a significant shift in distributional variables has occurred in a number of countries and to
look at further social and political consequences – both at the macro and the micro levels.
Significant insights into the social effects of financial crisis and possibly policy implications
in order to influence these shifts are expected to be achieved with this research.

18
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20
4. Organization of the project

4.1 wiiw Research Team

The GDN project has allowed wiiw to build up additional research capacity to study South-
East Europe. Synergies from the project – in the form of increasing its network as well as
deepening wiiw researchers’ know-how and experience – help the institute to produce the
information on SEE that it offers as a public good.

The researchers involved in this project will be:

Leon Podkaminer (senior economist, wiiw; project leader)

Vasily Astrov (economist, wiiw)

Vladimir Gligorov (senior economist, wiiw)
Peter Havlik (deputy research director, wiiw)
Mario Holzner (economist, wiiw)
Michael Landesmann (research director wiiw)
Sebastian Leitner (economist, wiiw)
Josef Pöschl (senior economist, wiiw)
Robert Stehrer (senior economist, wiiw)
Hermine Vidovic (senior economist, wiiw)

Statistical assistance will be provided by

Boriana Assenova (statistician)
Nadja Heger (statistician)
Beate Muck (statistician)
Monika Schwarzhappel (statistician)

Project management will be provided by

Veronika Janyrova (project manager)

21
4.2 Deliverables of the project
• Research Competition
wiiw will organise a research competition for researchers in Southeast Europe and the
Commonwealth of Independent States. The areas of research are outlined in section 2.3.

• Interregional Research Project

Contribution to an Interregional Research Project will be through cross country macro-
studies, individual country studies and studies using microeconomic data sets. The IRP will
use uniform methodologies and wiiw will provide clear methodological guidelines for all
three types of studies.

• GDN Annual Conferences

wiiw will participate in the upcoming GDN Annual Conferences and may again organise its
own panel or half-day workshop at one of those conferences.

• CERGE GDN RRC

wiiw will continue to support CERGE-EI in Prague with organising the GDN Regional Re-
search Competition (RRC) for researchers in CEE.

• wiiw In-house Research

The work for the Interregional Research Project will be complemented by wiiw’s in-house
research along the lines outlined in section 2.4.

• Policy dialogue
wiiw will organise a policy dialogue on the results of the research conducted with the partic-
ipation of international experts.

22