Transition Economies

At the end of communism, all these countries were experiencing great economic problems. The old, highly centralized socialist economic system had become ossified. Although it had mobilized labor and capital for industrialization, it failed to keep up with modern economies. Its chronic shortcoming was shortages, as the centralized allocation system failed to balance supply and demand for the millions of goods and services characteristic of a modern economy. It was incapable of promoting efficiency or quality improvement because it focused on gross production, encouraging excessive use of all inputs. Its ability to innovate was very limited, too. The socialist economy suffered from a dearth of small enterprises and creative destruction (the destroying of the outdated by new and better products and services; see creative destruction). As free resources dried up, growth rates started stagnating. In addition, an ever-larger share of the Soviet economy, about one-quarter of GDP in the 1980s, was devoted to military spending in the arms race with the United States. The stagnation of the standard of living bred public dissatisfaction, which in turn prompted excessive wage increases and held back necessary price rises. In Poland and the Soviet Union, budget deficits and the money supply grew rapidly toward the end of communism, causing hyperinflation—more than 50 percent inflation during one month—drastic falls in output, and economic collapse (Kornai 1992).

Market economic transformation was initiated mainly by peaceful political revolutions heralded by a cry for “a normal society,” meaning a democracy and a market economy based on private property and the rule of law. The causes of the collapse of communism were multiple, and their relative importance will remain in dispute. The economic failure was manifold and evident. Political repression and aspirations for national independence also helped cause the collapse. The multinational states—the Soviet Union, Czechoslovakia, and Yugoslavia—fell apart. The Soviet Union’s inability to keep up with the United States in the arms race and in high technology was also a factor. The European Union attracted the East-Central European nations, which demanded a “return to Europe.”

At the beginning, the transition’s direction was clear, but its final aims were not. Overtly, everybody advocated democracy, a normal market economy with predominant private ownership, a rule of law, and a social safety net, but their eventual goals ranged from the American-style mixed economy to a West European–style welfare state to market socialism. Instead of arguing about aims, people argued over whether the transformation to a market should be radical or gradual.

A radical program, “shock therapy” or “the Washington consensus,” became the main proposal for how to undertake the systemic change. It amounted to a comprehensive and radical market reform. Key elements were swift and far-reaching liberalization of prices and trade, sharp reduction of budget deficits, strict monetary policy, and early privatization, usually coupled with international assistance conditioned on reform measures. The program’s main advocate was Jeffrey Sachs of Harvard University, but mainstream Anglo-American macroeconomists; the International Monetary Fund (IMF); the World Bank; the Ministries of Finance of the G-7; and leading policymakers in Poland, the Czech Republic, the Baltic states, and Russia also supported it. Radical reform became the orthodoxy. Advocates used many arguments. The success of reform was in danger if a critical mass of market and private enterprise was not formed fast enough. A semireformed system would maintain major distortions that would cause people to seek privileges and subsidies, and would deter investment. The social and political costs of slow reform would be much greater because a semireformed system could not perform well. People were prepared to accept only a limited period of suffering (Fischer and Gelb 1991; Lipton and Sachs 1990; Shleifer and Vishny 1998). Shock therapy was applied in Poland, the Czech Republic, and the three Baltic states (Estonia, Latvia, and Lithuania).

In opposition to the radical reform program, numerous gradual reform programs were formulated. Some favored more gradual deregulation of foreign trade or prices. Others wanted more gradual reduction of inflation rates, budget deficits, and monetary expansion. Many argued that the quality of privatization was more important than its speed. The opponents of radical reform were diverse. Some were theoretical economists who believed that more gradual reform would minimize social suffering. Others, ranging from social democrats to communists, wanted to minimize the role of the market. The most important protagonists, however, were state enterprise managers, state officials, and political economists in the former Soviet Union. All gradualists maintained that the state was strong and capable of social engineering. Gradual reform came to dominate in Hungary, southeast Europe, and most of the former Soviet Union. Late in the day, Professor Joseph Stiglitz of Columbia University became the leader of the gradualists (Murrell 1992; Roland 2000; Stiglitz 2002).

Debate is one thing and implementation is another. In practice, radical reformers were opposed initially by state enterprise managers and later by new businessmen, who were benefiting from transitional market distortions. Many of the anticipated stumbling blocks did not materialize. For instance, labor unrest and popular unrest were minimal, and the large military-industrial complex was timid. Paradoxically, the problem was not the losers but the winners, who made fortunes on the large short-run subsidies garnered during the transition (Hellman 1998). Postcommunist transition is best understood as strife over these subsidies (Åslund 2002).

Many economists have undertaken ambitious multi-country regression analyses. Although statistics remain poor, economists widely agree that certain major market reforms increase real growth (Berg et al. 1999). Although the effects are often hard to disentangle because various reforms often occur simultaneously, decontrol of prices and foreign trade appears to have had the greatest impact. Also, inflation needs to fall below 40 percent a year to allow growth, and privatization is unequivocally beneficial. Governments that pursue such sound economic policies adopt more market-oriented legislation than less ambitious reformers do.

The liberalization of consumer prices and imports was surprisingly easily accepted, and many transition countries—for example, Poland, Estonia, and Russia—abolished all import tariffs to overcome the massive shortages. What proved harder was deregulating prices and exports of commodities because well-connected people wanted to purchase oil, metals, and grain at low prices fixed by the state and sell them on the free-world market at a multiple, making a huge profit. Usually, such decontrol was possible only after a major crisis.

Inflation was the main economic problem in the early transition. Thirteen countries had fourteen instances of hyperinflation, almost as many hyperinflations as had been registered in prior world history. Many countries entered their transition with high public expenditures boosted by populism. A flawed consensus held that these countries “needed” public expenditures as high as those of West European countries. The East-Central European countries have managed to collect such large state revenues, while most post–Soviet countries saw their revenues shrink in the midst of hyperinflation. Finance ministries had to be strengthened to bring government expenditures under control. Similarly, central banks had to be reinforced and had to tighten monetary controls and eliminate subsidized credits.

Only Central Europe and the Baltic states succeeded in their early stabilization efforts. Most of the other countries faced new financial crises, notably Bulgaria in 1996–1997 and Russia in 1998. These crises were caused by excessive budget deficits leading to untenable public debt. An underlying reason was usually semifiscal expenditures, such as public refinancing of loss-making banks in Bulgaria or tax rebates through barter payment of taxes in Russia. Under barter payment, companies paid their taxes in kind by agreeing to build roads or provide other products, extracting sweetheart deals. These renewed financial crises delivered great shocks, inspiring fiscal discipline. Policies on exchange rates have varied greatly. The first successful stabilizations, in Poland and Estonia, were based on pegged (temporarily fixed) exchange rates or currency boards with fixed exchange rates. Misalignment and financial crises, however, have led many countries to adopt floating exchange rates.

Privatization has been the most controversial reform because it is a conspicuous distribution of wealth, and all vie for a larger share. Moreover, privatization has been monumental and unprecedented in scope. Small-scale privatization of small shops has usually been undertaken relatively easily by selling them cheaply to their employees. Similarly, much of public housing has been sold for a nominal price to tenants. Agricultural land has been restituted in the Baltics and Central Europe. Land reform occurred early where agriculture is vital to the national economy, but later in other countries.

The privatization of large enterprises has been most controversial. The objectives have varied, including privatization for its own sake; for enterprise performance; for state revenues; for the attraction of foreign capital; for the satisfaction of employees, managers, or other domestic stakeholders; and for corporate governance. The debate has been polarized between advocates of early mass privatization and protagonists of piecemeal case-by-case privatization. The Czech Republic and Russia pioneered mass privatization of large enterprises through vouchers, which were distributed to all citizens and could be used to purchase shares of large enterprises. Hungary, Poland, and Estonia, by contrast, focused on case-by-case sales (Boycko et al. 1995; Stiglitz 2002). Economic analyses increasingly show that privatization has been beneficial. Start-ups and enterprises with foreign capital have performed the best to date, but enterprises that have participated in mass privatization are swiftly improving their records. Private ownership seems to matter in the long run.

The officially measured declines in output have been shocking. Fortunately, these huge drops are not credible because communist statistics exaggerated output, while capitalist statistics fail to cover much of what is going on in the economy. The quality of produce has radically improved, as substandard goods no longer find takers. Major structural changes have occurred. The prior overindustrialization has disappeared, and service sectors have expanded sharply. The huge military-industrial complex has shrunk to West European dimensions. In Russia, for example, military spending is now about 5 percent of GDP, falling from almost 25 percent of GDP in the former Soviet Union. Millions of new small enterprises have been created.

The decline in standard of living has been much less than the real contraction in output because consumption has grown sharply as a share of GDP and because much of the prior investment was forced and, therefore, not very valuable. A major concern, however, is that income differentials have risen sharply: in East-Central Europe to a West European level, in Russia to an American level, and in some post-Soviet countries even to a Latin American level. Curiously, pensions initially increased sharply as a share of GDP, while families with children have suffered disproportionate poverty. Complaints about deteriorating education and health care are standard, but in most transition countries their share of GDP has actually risen while these government-run systems appear to be in great disarray (Milanovic 1998). A few countries’ governments have deregulated labor markets (Estonia, Latvia, and Kazakhstan), and many have reformed pensions, introducing a privately funded element. On the whole, though, these reforms are lagging.

International assistance has been greatly disputed. Jeffrey Sachs argues that the West should have done much more, and earlier, for the transition countries, while many others have complained about the IMF being too interventionist. In hindsight, international assistance has been significant, but not generous, and has played a crucial role in the success of the transitions. The IMF has played a key role in virtually every successful stabilization program, and it has been able to “graduate” many of the transition countries, as none has high inflation any longer. The World Bank and USAID have acted on a broader front, particularly assisting in privatization. Private philanthropist George Soros and his Open Society Institute have set an example for support of civil society, education, and much else.

Outcomes have varied remarkably in terms of political system, economic system, and economic growth. Three trajectories are apparent. Radical reformers in Central Europe and the Baltics have built democratic and dynamic market economies with predominantly private ownership. Gradual reformers in southeastern Europe and most former Soviet republics have had greater problems achieving democracy. Their market economies are still marred by bureaucracy, though most property has been privatized. Three countries—Belarus, Turkmenistan, and Uzbekistan—have maintained their old dictatorship, state control, and dominant public ownership, doing little but ejecting the Communist Party.

These contrasting outcomes can be explained by the different goals of these regimes. While their dominant slogans were to build democracy, a market economy, and rule of law, postcommunist countries followed three starkly different policy paths. Radical reformers really wanted democracies and dynamic market economies. At the other end of the spectrum, a few autocrats desired little but the consolidation of their power. In the middle, countries pursued policies imposed by dominant elites who wanted to make themselves wealthy on transitional market distortions. Not surprisingly, the correlation between democracy, marketization, and privatization has been very strong.

Since 1999, economic development has taken another turn. By cutting government spending and introducing low or even flat tax rates, the former Soviet countries have excelled, with an average growth of 6 percent per year for five years and almost balanced budgets. The early successful reformers in Central Europe have stopped at a mediocre growth rate of 3 percent per year, with large budget deficits, current account deficits, and unemployment. Their public expenditures have stayed at a West European share of GDP. These countries have become, as Hungarian economist János Kornai put it, social welfare states “prematurely,” with excessive taxes and social transfers impeding economic growth (Kornai 1992, p. 15). The picture of success appears to be partially reversed. Yet, the post-Soviet countries are lapsing into more authoritarian systems, while East-Central Europe remains democratic. Much of East-Central Europe acceded to the European Union in 2004,2 and this appears to have stimulated democracy rather than economic growth.

Transition economics have brought a few new insights to economics. How to launch the transition mattered so much not because the workers or the people objected, but, it turns out, because the elite were the strong interest group that had to be mollified. Because much output under socialism was of so little value, whether real output declined during the transition is still in dispute. Privatization and enterprise restructuring have been the most pioneering areas, and the final verdict on their success is not yet in. Corruption is widespread, but this tends to happen in all countries where government officials have a large amount of discretionary power (see corruption), not just in transition economies. Macroeconomic stabilization and liberalization hardly offered anything very unexpected, apart from technicalities such as barter. As time passes, the peculiarities of transition economies wane.