Jeffrey Sachs


The Strategy of Transition*

by David Lipton and Jeffrey Sachs


Both the economic logic and the political situation argue for a rapid and comprehensive process of transition. History in Eastern Europe has taught the profound shortcomings of a piecemeal approach, and economic logic suggests the feasibility of a rapid transition. Moreover, the macroeconomic situation is deteriorating in many countries, and therefore requires urgent attention.

The transition process is a seamless web. Structural reforms cannot work without a working price system; a working price system cannot. be put in place without ending excess demand and creating a convertible currency; and a credit squeeze and tight macroeconomic policy cannot be sustained unless prices are realistic, so that there is a rational basis for deciding which firms should be allowed to close. At the same time, for real structural adjustment to take place under the pressures of tight demand, the macroeconomic shock must be accompanied by other measures, including selling off state assets, freeing up the private sector, establishing procedures for bankruptcy, preparing a social safely net, and undertaking tax reform. Clearly, the reform process must be comprehensive.  


Politically, as well, there are powerful arguments for moving rapidly. Fragile governments facing a deep economic crisis are best able to carry out strong measures at. the beginning of their tenure. For this reason, Machiavelli’s famous advice is that a government should bring all of the bad news forward.’ Indeed, barring a political disaster emanating from the Soviet Union, probably the greatest political risk facing Eastern Europe is not a resurgence of communism, hut the Argentine trap of political and social paralysis, in which coalitions of workers, managers, and bureaucrats in the declining sectors succeed in frustrating the needed adjustments.  

For a government committed to a rapid and comprehensive program of adjustment, the first step must be to end excess demand. The shortage economy leads to rampant rent-seeking, queuing, hoarding, an anti-export bias, and an anti-private sector bias. Thus, excess demand must be eliminated first. Fiscal and monetary austerity in turn (and in conjunction with a currency devaluation) will permit the establishment of a stable convertible currency and thereby an end to the bureaucratic allocation of trade.  

The second step of reform which can he undertaken in parallel with the macroeconomic austerity program, should be to create market competition, based on the deregulation of prices, free trade, the full liberalization of the private sector and the demonopolization of the state sector. Prices should be deregulated quickly, in parallel with the macroeconomic austerity program, because the proper relative prices are crucial for all the necessary resource reallocations. Price deregulation might lead to a one-time jump in prices, but not to an ongoing inflation, as long as macroeconomic policies remain tightly constrained.


Some economists have argued that price deregulation is too dangerous in the monopolistic conditions of the Eastern European economies. But such a view does not withstand closer scrutiny. Most sectors in most countries already have numerous firms and an even larger number of separate production plants that could become separate firms. Far more important, for most industrial sectors, free trade policies (based on currency convertibility, combined with a cut in trade quotas and tariffs can provide an enormously effective mechanism for generating competition. Free trade instantly brings to bear on domestic firms the competition of the rest of the world. Even if the domestic production structure is highly concentrated when viewed internally, markets may be highly competitive if foreign producers are allowed to import without restriction.

For some nontradables industries, such as food processing in Poland, the private sector will be able to compete effectively with the state sector in a matter of weeks. But the private sector will emerge only if the proper price signals exist. Thus, a transitory period of monopolistic prices might well occur in some areas, but attempts to avoid this transitory period could lead to the failure to develop private sector competition in the longer term. In a small subset of industries, such as public utilities, telephones, and intercity rail transport prices will inevitably continue to be set by the state, as in almost any Western European economy.  

The third step of the reform process should be privatization and it is likely to take many years. In the meantime, state  enterprises, will have to be run on a tight leash with wage controls and curbs on investment - to check their financia1ly wasteful tendencies. 


In addition to these tasks, several specific challenges must also be addressed. First, as unemployment will surely rise under the reform program, the governments will have to introduce a variety of labor market policies, including unemployment insurance, job retraining, and a credit allocation to individuals who start small businesses. It should be remembered, however, that the unemployment starts from negligible levels, so that even steep rises in unemployment will tend to raise the unemployment rates to levels now existing in Western Europe. Second, Poland and Hungary, and possibly others will have to renegotiate the terms on sovereign debt. Third since the state sector will remain significant for several years, further efforts - in terms of rules for wage setting, investment, and restructuring must be undertaken so that the economy does not fall back into financial crisis after an initial stabilization.  

Skeptics often ask whether the austerity and liberalization program outlined here can produce stable prices and economic growth. They observe that in Latin America such programs have indeed ended inflation, but at the expense of hampered growth. In the case of Eastern Europe however, one can identify the primary engine of growth in the coming years: economic integration with Western Europe. If convertibility, free trade, macroeconomic stability, and liberalization of the private sector are all achieved, the power of natural market forces will reduce the gap between Poland’s $1,100 per capita income and Western Europe’s per capita income more than 10 times that level.  


With skilled workers in Eastern Europe now earning about $1 an hour, the region will provide an enormous opportunity as a production site for European, Japanese. and U.S. firms selling mainly in the West European market. By April [1989] there were 1,200 applications for joint ventures pending with the Polish Foreign Investment Agency. Hundreds, if not thousands, of firms are already examining factory sites in Eastern Europe as potential locations for parts of their production process. They are finding a highly skilled labor force, with engineers, machine tool operators, foundry workers, and so forth, that will -  under stable economic and political conditions - be able to integrate effectively into European-wide production operations. To achieve the full fruits of trade liberalization, existing trade barriers (in both directions between East and West Europe) should be removed. The Eastern European countries must negotiate a new association status with the European Community to give them guaranteed future access to Western European markets. Existing restrictions of the Coordinating Committee for Multilateral Export Controls (COCOM), banning the export of high-technology goods to Eastern Europe, will have to be removed. Investment treaties, guaranteeing repatriation rights on foreign investment, must also be negotiated.  

Much of the pessimism about growth in Eastern Europe results from the focus on the necessary decline of the region’s heavy industrial sectors. More attention should be paid to the obvious and crucial sectors, particularly in services, house construction, and light industry, that will grow considerably. Intense shortages exist in these areas, and, even under the arduous business conditions of reform communism, the private sector has been staking out a foothold in these areas. Ample opportunities exist for rapid expansion in these areas.


 Footnotes =====================================================

    * From Creating a Market Economy in Eastern Europe: The Case of Poland,” Brookings Papers on Economic Activity, vol. I, 1990. Reprinted by permission of the Brookings Institution.


1 And the former Bolivian Planning Minister, Gonzalo Sanchez de Losada, who brilliantly achieved his country’s stabi1ization and reform process in 1986-89, used to put it even more succinctly: “If you are going to chop off a cats tail, do it in one stroke, not bit by bit.”


2 In Latin America. macroeconomic stability with outward orientation has in fact produced favorable growth results especially compared with countries still mired in high inflation and protectionist policies. But many Latin American countries, unlike those in Eastern Europe, are predominantly dependent on volatile natural resource exports, and these countries have, suffered serious terms of trade declines in the past decade.


3 In the longer term the EEC should be expanded to allow for the actual membership of the East European countries.







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