Janos Kornai


Excerpts from




 Janos Kornai

(Paper for the World Bank
‘Annual Bank Conference on Development economics' ­
, April 18-20, 2000 )




Ten years have passed since the publication of my book The Road to a Free Economy; Shifting from a Socialist System—the Example of Hungary (referred to hereafter as Road) It was the first book in the international literature to put forward comprehensive proposals for the post-socialist transition. This paper sets out to assess the book as the author sees it ten years later.


Ownership reform and development of the private sector


Road took issue with the basic concept of ‘market socialism’. It rejected the idea that the dominance of state ownership should be retained, but connected up with market coordination. My position on this irritated the advocates of market socialism. It incurred the wrath of many reform economists in Eastern Europe and many old-style social democrats in the West.

The book reflected its author’s credo, supporting an economic system in which private ownership would dominate. In this respect, the views in the book did not differ from many proposals originating from the West. However, this broad agreement leaves open important questions. Which is the best road to such a system? Once the transition is over, what will the ownership structure of the economy be like? Which formation, of the many possible variants of capitalism based on private ownership, is the one to aim for?

… This paper sets out two pure strategies in compact form. Most of the detailed, practical proposals came close to one or other of these strategies and confrontation between them lay at the center of the debates.


Strategy A

Retrospectively, I would call this the strategy of organic
It has five main characteristics.


1.  The most important task is to create favorable conditions for bottom-up development of the private sector. The main impetus behind the growth of the private sector is mass de novo entry. This development has to be assisted by several means:

*   The barriers to free entry have to be broken down.
*   Private ownership has to be guaranteed security. Institutions have to be founded that enforce the fulfillment of private contracts.
*  ‘Affirmative action’ applied with the requisite caution is needed to promote the development of the private sector, for instance in tax and credit policy


2.  Most of the companies hitherto in state ownership will have to be privatized. The basic technique for doing so is sale. The state assets have to be sold mainly to outsiders, giving preference to those who are not only paying a fair price for it, but in addition, make a commitment to invest in the company. If the buyer is an insider, a genuine price must still be paid. Insider privatization cannot be allowed to degenerate into a concealed form of give-away.


3.  It follows from characteristic No. 2 that any give-away distribution of state property must be avoided.


4.  Preference must be given to sales schemes that produce an ownership structure with the following features:

The company has a dominant owner. This may be a business person or a group of owners, or a privately owned company that has already a history of private ownership. The last may be domestically owned or foreign-owned. A particularly desirable type of owner is a strategic investor who is prepared to back the company by giving it a significant injection of new capital.

Where the form of a public limited company is chosen, there is no need to avoid a situation in which some of the shares become dispersed. However, it is desirable every company, where possible, having a ‘core owner’ in the sense just outlined.


5. The budget constraint on companies has to be hardened, This is the key to ensuring the financial discipline essential to operating a market economy. A set of new laws will have to be passed, including bankruptcy law, accounting law and banking law. Following the legislative phase, all these laws should be consistently enforced, The ‘trinity’ of privatization, liberalization and stabilization will not suffice for a successful transition. Hardening the budget constraint has equal importance with these.

State-owned companies that are making chronic losses do not need to be privatized at all costs or sustained artificially for too long. As the budget constraint hardens, it performs a process of natural selection among them. Those that are profitable can be sold, sooner or later. Those that are unreliable, because they have zero or a negative value, must have bankruptcy proceedings taken against them, not be given away. Privatization through bankruptcy and liquidation is one of the main techniques used for changing ownership.

The private sector’s proportion of gross production will grow on the one hand because new private businesses are appearing, and on the other because the state sector is shrinking. The second process takes place in two ways: state-owned companies may be sold to private owners, or they may go bankrupt and exit.


Strategy B.

This I would call retrospectively the strategy of accelerated
It can be described in terms of three characteristics.


1, The most important task is to eliminate state ownership as fast as possible.


2. The main technique for privatization is some form of give-away, for instance a voucher scheme, whereby the property rights in state-owned companies to be privatized are distributed free and equally among the country’s citizens. This approach may be linked with toleration or even encouragement for take­overs by managers. In many cases this turns out to be a pseudo management buy- out, as the managers pay a very low price, which is almost tantamount to receiving the property rights in the company free of charge 


3. There is no need to show any dispreference for dispersed ownership. In fact, it may actually be preferred. What needs to be emphasized is that all citizens will share in the property rights of the formerly state-owned companies, so that ‘people’s capitalism’ develops.


Mere there are only three characteristics, not five, as with strategy A. As for the two attributes not mentioned: Advocates of strategy B also approved of ‘bottom-up’ private enterprise developing, but they did not give it emphasis in their proposals, whereas it was placed in the forefront of ownership reform by advocates of strategy A.

If the supporters of strategy B had been asked at the time, they would have approved of hardening the budget constraint in principle. They did not press in their writings for the retention of a soft budget constraint, but the requirement of a hard budget constraint became lost in their proposals, and not by chance. They expected that privatization will automatically harden the budget constraint. I will return to this in the context of the Czech and Russian experiences.

The most important difference between the two types of strategy is not the items in each set of characteristics, but which items receive greatest emphasis. Where should political attention, legislative and administrative capacity, intellectual interest and research activity be focused? There is a strong difference between the two strategies in this respect. A emphasizes healthy growth of the new private sector, while B underlines rapid liquidation of the state sector.


Road and other writings of mine that appeared about the same time outlined and recommended strategy A. I was not alone in doing so; quite a few others put forward similar views. Here and throughout the rest of the paper I confine the survey only to the views taken by the Western profession, in the academic world and at the international financial institutions. I would like to underline with high appreciation here the positions taken by Andreff (1992), Bolton and Roland (1992), Brabant (1992), McKinnon (1992), Murrell (1992a, 1992b and l992c), Murrell and Wang (1993), and Poznanski (1992). However, it was certainly a small minority of Western academic economists who supported a strategy of organic development of the private sector. The vast majority of the profession accepted and popularized the strategy of rapid privatization, often using quite aggressive arguments to do so.


Ten years after, I am reassured that strategy A, promoting organic growth of the private sector, was the correct position to take. Strategy B, a forced rate of privatization, was inferior at best and expressly harmful at worst.

Before presenting comments to the performances of four countries, a brief statistical comparison will provide some background information. There is close causal relation between healthy development of the private sector, hardening of the budget constraint, forceful restructuring of production, and as the ultimate result, the growth of labour productivity. The last of these indicators is more expressive, in the present context, than the figure for per capita GDP, because it sheds a clearer light on the effect of restructuring. The state-socialist system left behind it a legacy of mass unemployment on the job. Strategy A is prepared to dispose of this legacy, even if it means taking painful and unpopular measures. Strategy B shrinks from doing so. Now the labour productivity in Hungary in 1998 was 36 per cent higher than in 1989, while in Poland it was 29 per cent higher. In the Czech Republic it was still only 6 per cent higher than in the last year of socialism. The situation is especially serious in Russia, where labor productivity in 1998 was still 33 per cent lower than in 1989 (Economic Commission for Europe, 1999, pp. l28-l31).


The outstanding embodiment of the success of Strategy A is, of course, China. Nevertheless I do not include it in the cross-country comparison. A careful evaluation has to include a comparison of initial conditions and the prevailing political structure, which are vastly different in the post-Soviet and Eastern European regions on the one hand and in China on the other. This analytical task is far beyond the scope of this paper. =


Clearly, Hungary has followed strategy A. In terms of all the five characteristics described earlier, the Hungarian transition came closest to following a line of organic development of the private sector,….Hundreds of thousands of new small and medium-sized firms came into being. Tightening of the budget constraint in the first half of the 1990s allowed a process of natural selection to sweep over the corporate sphere. This coincided with a perceptible strengthening of financial discipline.


In Poland, occasional statements appeared to flirt with the idea of strategy B, but economic policy in practice remained close to strategy A. A high proportion of Polish economists today recognize that the main explanations for the successes of Polish development, apart from the successful macro stabilization, included the mass of new entries, the vigorous ‘bottom-up’ growth of the private sector, and the inflow of foreign capital.


At the beginning of the 1990s, the leaders in what became the Czech Republic were the first who wanted to apply strategy B. Václav Klaus, the country’s economist prime minister, championed the voucher scheme, arguing for its adoption in the international arena. …The program was applied energetically. Since then, the question of why it did not yield the results expected by its initiators has been the subject of several analyses. In the first phase, the assets were dispersed among millions of voucher owners, just to be concentrated again afterwards in what are known as investment funds. However, the funds lacked the capital strength to develop the backward companies or put in real investment. They were intertwined with the large commercial banks, where the state was dominant or even the sole owner. Such an ownership structure was incapable of building up strong corporate governance.

The restructuring dragged on. Despite the strident, Chicago-style free-enterprise rhetoric directed at the outside world, the budget constraint remained soft in reality. Whereas privatization by sale engenders natural selection, the transfer of property rights by give-away distribution conserves the existing structure.

The performance has been disillusioning. Strategy B seems to have been a significant factor behind the problems, although some serious mistakes in macroeconomic policy also contributed to the way the economy has lagged and relapsed.


Perhaps the saddest example of the failure of strategy B is provided by Russia. Here every feature of the strategy appeared in an extreme form: a voucher scheme imposed on the country, coupled with mass manipulated transfers of property into the hands of management and privileged bureaucrats. In this environment a historically unprecedented ‘ownership reform’ occurred, one in which the ownership of natural resources, especially oil and gas, was expropriated by the ‘oligarchs’.

All these occurrences are closely connected with the survival of the syndrome of the soft budget constraint, in a form where it infiltrates and does even greater damage to every cell of the economy and body politic. Russia has become a ‘non­payment society’, as a recent study appropriately described it …Companies do not pay their suppliers, any more than employers their employees or debtors their lending banks. This is all tolerated by the executive and the judiciary. In fact, the state sets a bad example by often falling behind with the wages and insurance contributions of state employees and with pensions.


What were the intellectual sources for those who advanced the two strategies?


Let me begin with …the introspection. Which works and intellectual strands influenced me most as I thought about ownership reform at the end of the 1980s? One source was the work of Hayek, or more precisely his ideas on the development of the market economy and its opposition to ‘constructivism’ (Hayek 1969 and 1990). I felt it was grotesque that our Czech colleagues, while referring to Hayek on several occasions, should be sitting at their desks concocting the rules of the game for the voucher scheme and state prescriptions for putting it into practice. Hayek attached enormous importance to the spontaneity of capitalism, to the way it picks out, by evolutionary means, the viable institutions that are capable of survival.


My other intellectual source was Schumpeter—not the Schumpeter of Capitalism, Socialism and. Democracy (1929), placing naive hopes in market socialism, but an earlier Schumpeter (1911), identifying the entrepreneur as the central figure of capitalism. Schumpeter’s market economy is not a sterile, equilibrium-bound, Wairasian world, but a world of real rivalry, in which live people set about founding new firms, conquering new markets, and introducing new products. I felt that Eastern Europe, after its numbing dose of bureaucracy, needed thousands and tens of thousands of Schumpeterian entrepreneurs. Closely connected with this is Schumpeter’s other, oft-quoted idea of creative destruction. This combines in my current of thinking with hardening of the budget constraint and the painful, but essential process of natural selection by the market that ensues from it. A powerful process of exit and entry is the driving engine for reallocating resources from less productive to more productive firms.


A third source is the image of the beginnings, the development and the consolidation of capitalism, formed in my mind from a variety of readings. This includes the French Annales school, the writings of Fernand Braudel and others, which clarify the evolutionary nature of the process, and studies of the commercial laws and financial discipline introduced with a firm hand under early capitalism.’


Finally, I was certainly strongly influenced by the study of socialist systems. I did not use the term “institution” in every second paragraph as it recently has become fashionable to do, but I think I understood what a system means, and what the difference is between socialism and capitalism; and I was sufficiently aware that this difference will not disappear just by privatization, stabilization and liberalization.


What intellectual influences could have worked upon the advocates of strategy B, to produce their vision of how to ‘construct’ capitalism at a rapid pace? It is not sufficient to refer in general terms to the influence of “mainstream economics”. Even if the adherents of Strategy B do not refer to them, I am convinced that they were strongly influenced by two authors. One (by an irony of fate indeed) was Marx and the other was Coase. I concede that they make strange bedfellows.


Sophisticated Marxists would call what strategy B adopted ‘vulgar Marxism’. I might add that what it took over from Coase is ‘vulgar Coase-ism’ as well. Vulgar Marxism in this context means a simplified formula: the change of ownership is not just a necessary condition of capitalism, but a sufficient one. Capitalist property relations form the base that goes on to create its own superstructure: the institutions, political organization an. ideology required to operate the capitalist base.

The real course of history showed earlier and the post-socialist transition confirmed that the relation of base and superstructure is far more complicated than that. The mere existence of capitalist property relations is not a sufficient condition for the consolidation of capitalism. …even if it is feasible under certain conditions, it is not certain that having a rapid and drastic ownership reform before the transformation of the auxiliary institutions is the most beneficial sequence.


I would express the simplified formula of vulgar Coase-ism like this. It does not matter if the initial allocation of legal entitlements is inefficient. An efficient allocation will ultimately appear.  … I think Coase, if he had taken part in this debate, would have added three warnings to the second sentence of the formula (Coase 1960). An efficient allocation will appear provided:

* the exchange is on a perfectly competitive market,  
* the exchange is free, there are no barriers to recontracting, and  
* the recontracting involves no transaction costs, or at least, the costs are very low.


Let us return to the arguments heard in the debate.


1. The advocates of strategy B were eager to cite ethical considerations. Every citizen must be given an equal share of the former property of the state for reasons of fairness. Experience has proved conclusively that this is a hypocritical argument. The initial allocation remained for a very short period, before it gave way to a high degree of concentration of the ownership of the former property of the state. In the case of Russia, it obviously led to an absurd, perverse and extremely unfair form of oligarchic capitalism … The sale of state assets, if it takes place at a correct price, does not alter the distribution of wealth or income. The wealth of the state is not reduced, it simply changes form. Revenue from privatization has to be invested usefully, not consumed..


2. Great emphasis was placed on the sociological aspect in the line of argument pursued by the advocates of organic development. The process of embourgeoisement of society, with the development of a property-owning class, is essential to the consolidation of capitalism. … there can be no running ahead, no attack without strong rear-guard. The appearance of institutional investors cannot substitute for a radical transformation in the stratification of society. This argument was confirmed by the first decade of post-socialism. There is a close correlation between the measures of economic success and the restratification of society.


3. The arguments that most appealed to economists concerned economic efficiency. This field has demonstrated the superiority of strategy A the most convincingly. It has been shown that de novo private companies are generally more productive than those that remain in state ownership or those that were formerly in state ownership and privatized during the transition. Experience supports the proposition that diffuse ownership and the preservation of the soft budget constraint is retarding the increase of productivity ….


4. Finally, there are the political arguments. There is no disputing today that the voucher program and the postponement of painful restructuring were crucial to the victory of the governing party in the second free Czech elections. That was the single case in the Eastern European region in the last decade in which the same government continued for a second term. By that yardstick, the privatization campaign was a success. By contrast, the coalitions that ruled in the first parliamentary cycle in Hungary and Poland fell at the second general elections. The rival coalitions that took office pursued basically the same strategy A as their predecessors. Four years later, after abstaining from using a give-away privatization as an election weapon, they suffered defeat in their turn. So strategy B proved more favorable according to the Machiavellian criterion of retaining power.


The advocates of strategy B everywhere, and especially in Russia, cited repeatedly the argument that if the ‘window of opportunity’ opens for privatization, the opportunity has to be seized and the privatization carried out rapidly. …This argument can be neither confirmed nor denied by purely logical, speculative means.

I think there is a faulty, upside-down causal explanation behind this argument. If the privatization had taken another course, without so many glaring abuses and vain social losses being associated with it, there would not be such strong nostalgia in Russia for the communist system.






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