Nominal-Real Tradeoffs and the Effects of Monetary Policy: the Romanian Experience

Due to the persistence of relatively soft budget constraints and poor government credibility, the survival strategy of Romanian state-sector firms means eschewing profit maximization in the short run in favor of insider utility maximization. This takes the form of attempts at both reducing layoffs and minimizing real wage losses on the background of substantial adjustment in real output. Nominal adjustment (especially pricing and arrears) is favored over riskier and more costly real adjustment, since firms are risk-averse in the longer run. From an operational viewpoint, the representative firm's objective becomes that of maximizing liquidity flows subject to constraints regarding labor hoarding systemic limits to debt default and spontaneous restructuring. Empirical evidence supports the idea of an inflation-output tradeoff (in terms of variations around trends) where increases in expected inflation and/or expected gross nominal arrears have a significant negative impact on real industrial output, while unexpected inflation (and defaulted debt) exhibits positive but insignificant coefficients. The tradeoff persists even when controlling for demand-side factors. Monetary variables do not appear to cause this tradeoff, but rather seem to be mediating it. Persistence is also much more pronounced in inflation than it is in real output. Monetary policy measures then tend to have an asymmetric impact: they are likely to affect the nominal side more than the real one; monetary aggregates tend to have a sharp short-run impact compared to the stronger and longer-lasting effects induced with a lag by changes in interest rates; required reserves, because of their lesser political visibility, have for a long period been a more effective instrument of monetary policy management compared to refinancing rates, when the central bank's independence was ambiguous. Finally, in the context of a specific credit channel fueled both by commercial bank loans and by differential access to defaulted debt, short-term credit to the state sector exhibits adverse selection features compared to loans extended to private-sector firms, with the latter being in the position of net creditor due to the predominance of hard budget constraints. Firm immunity (given by size, political sensitiveness of the respective industry, importance as regional employer, etc.) to punitive interventions either on the part of government authorities or creditors seems to play a large role in the proliferation of financial indiscipline as a repeated game, with large, poorly efficient firms initiating arrears growth and other firms following either voluntarily (due to cost-of-credit differences) or involuntarily (because of a liquidity squeeze). Interestingly, arrears are not perfect substitutes for credit, while both M2 and nongovernment credit appear to accommodate increases in gross arrears. The transmission of monetary policy via a credit channel is also interesting in the post-1996 context of central bank deposit taking meant to sterilize excess liquidity due to relatively high capital inflows. The policy conclusions point to the limited effectiveness of monetary policy in macrostabilization of structuural reforms, privatization, financial discipline and improvements in corporate governance are absent or slow; the need for austere monetary policy in sustaining these measures; and the danger of expansionary policy aimed at growth and/or employment objectives. Institutional reforms at the central bank level (improvements in the independece of the monetary authority, stating price stability as the paramount objective of monetary policy, instituting multi-annual inflation targets in the context of a consistent macro policy mix, etc) are also examined.