Most gradual economist believe that using the shock policy leads to inferior outcomes. In the short term, these outcomes are worse than those associated with the gradual program. A shock therapy's short-term effects are high inflation and unemployment. Gradualists conclude that these effects weaken the credibility of the shock policy. I will highlight some of the gradual policy's flaws of employment protection at the expensive of efficiency. Using a Hungarian firm as a case study, I will show Hungary's gradual programs problem of economic inertia or stagnation. I will also describe the economic theory behind the shock program and its ability to remove inertia and force change, creating efficiency in the long term.
The internal and external macroeconomic imbalances of Hungary and Poland before the reforms, suggests some reasons why they adopted different reform policies. Two economists at the World Bank, Stanley Fisher and Alan Gelb believe that these imbalances had some important bearing on the speed and design of each country's structural reform programs. "Hungary had the largest external debt per capita and persistent inflation of 20% but, a small budget deficit. Poland had a worse macro position than Hungary, high debt and high inflation. Each countries different macroeconomic imbalances resulted in different goals set: and in 1990 Poland set for a government budget surplus of 2% and Hungary hoped to reduce their budget deficit during the year"(6).
Hungary imposed a gradual policy and Poland a shock therapy policy. Both countries preferred a conservative fiscal and monetary plan. The plan was to create a deflationary affect on their economies. Both economies were aggregate output supply determined, unlike the classical model of west, which is demand determined. Poland and Hungary both chose to eliminate government subsidies of food and consumer goods. This elimination drove down the government budget. Their tight monetary policy put a limit on expansion of credit. The ability to obtain credit is important for the market, and the lack of it imposes financial difficulty on firms.
The result of Poland's and Hungary's different policies had varying degrees of macroeconomic shocks on their economies. Since, these economies were based on supply, consumption depended on wealth. The inflation that accompanied these reforms reduces wealth. Wealth a value that equals cash holdings also declined. The long term effect on wealth was a decline in consumption as households tried to bring wealth and income back to equilibrium.
The argument for pro gradualism states that, the fast policy has larger shocks and larger falls in output and employment. The shock therapy causes a higher jump of interest rates and wage pressure. This wage pressure comes from government subsidies (a social net). The subsidies are supposed to soften the decline of employment. The gradualist Coricelli and Milesi-Ferretti point out that government imposed subsidies cause unemployment to rise. The first negative effect comes from workers preference for the subsidy over a wage increase or employment. The second negative effect is that the government loses credibility, thus, bankruptcy becomes unlikely, as loss making firms are allowed to continue operation. The loss of credibility can be explained as "discontinuous behavior were the incentive and cooperative behavior of firm managers is weakened"(p.388). Banks would rather continue investments in loss making firms than lose their own investments from restructuring. Thus banks and firms have arrears in tax payments, as they lose faith in the governments ability to continue a tight monetary supply. These negative effects are why gradualists prefer a slow policy, a policy that has smaller drops in output, less increases in interest rates and zero subsidy from the government. As there is no government subsidy work is chosen over unemployment.
The choice of wage over employment is what shock therapists describe as inertia. Inertia can be explained as stagnation, where workers are complacent with their employment. The lack of external and internal shocks creates a lack of desire to learn new skills. Jobs are kept just to sustain wages. Employment is maintained at the expense of output production quality. Hungary would lose its ability to increase structural change and finance foreign debt. All goals are sacrificed as employment is preferred over inefficient output. Brada points out that "Hungarian firms are forced to make changes in output and employment while, government reforms make it hard for firms to rapidly adjust labor and product profiles"(15).
To justify the fast policies high inflation and unemployment, I refer to the economist Josef Brada. He explains that "first there is some kind of trade off between the speed of a reform and the J-curve shape"(p.1). The J-curve theory is the most graphic model of economic despair. "Countries in deficit are generally advised to devalue their currency so as to improve the trade balance by making their exports cheaper and imports dearer. The short term effect of the devaluation is to worsen the trade balance since, quantities are unable to respond to prices in the short run, the result of devaluation is foreigners need to spend less of their currency for the countries' exports. Only in the long run, when quantities adjust, will the trade balance improve. Traced out over time, the balance of trade post-devaluation thus describes a J, first worsening and then gradually improving "(p.1)
The "big bang" reform will yield a sharp J-curve, "with a severe deterioration of economic performance as extensive reforms are introduced, followed by an equally rapid and sustained improvement as the suddenly freed market forces make themselves felt within a broad range of economic activities"(p.2). Josef Brada points out that "Gomulka (1991) argues that changes in Prices, combined with rigidities in resource allocation, will reduce the (Maximum) potential output of the economy(p.77). This inward shift of the production possibility's frontier, or worsening of the economic situation, will later be compensated by the fact that such a decline "represents Schumpeterian creative destruction, designed to release resources locked in unproductive or insufficiently productive uses, for the future use elsewhere" (p.72).
The shock program brings a worsening of the economy from high inflation and unemployment, but in the long run this brings an important change. Transformation comes as the wheels of inertia are forced to move. Workers are forced to make changes in employment and learn new skills to compete. Innovation causes output to become more efficient. The standard of living increase as prices eventually fall form competition. Government subsidies are important because the economies of Eastern Europe countries' are supply determined and wealth equals consumption. The subsidies afford the population a consistent level of wealth, or a bearable standard of living as they acquire skills needed to switch jobs.
A case study from Brada and Torok shows a Hungarian firms problem of stagnation and inertia under the gradual program (13-16).
Josef Brada, Arthur E. King: "Sequencing Measures for the transformation of socialist Economies to Capitalism: Is There a J-curve for Economic Reforms"? Research Paper Series Enterprise Behavior And Economic Reforms: A Comparative Study In Central and Eastern Europe and Industrial Reforms and Productivity in Chinese Enterprises. Research projects of the world Bank. (1991): 1-17.
Josef C. Brada., I.J. Singh., Adam Torok. " Hungarian Enterprise Behavior in The Transition: 1991-92" Research Paper Series Enterprise Behavior And Economic Reforms: A Comparative Study In Central and Eastern Europe and Industrial Reforms and Productivity in Chinese Enterprises. Research projects of the world Bank. (1991): 1-37.
Fabrizio Coricelli., Gian Maria Milesi-Ferretti. On the credibility of "big bang programs". European Economic Review 37(1993) 387-395.
Staszek Gomulka. The Puzzles of Fairly Fast Growth and Rapid Collapse under Socialism. Research Paper Series Enterprise Behavior And Economic Reforms: A Comparative Study In Central and Eastern Europe and Industrial Reforms and Productivity in Chinese Enterprises. Research projects of the world Bank. (1991):1-17.
Stanly Fischer., Alan Gelb "Issues in socialist Economy Reform."Policy, Research, and External Affairs. Working Papers. (1990):1-40