Excerpts from

The Role of Institutions in the Transition to a Market Economy

by Michael D. Intriligator

in:  The Transition to a Market Economy,Tarmo Haavisto ed.

Edward Elgar, Cheltenham, UK;  Brooksfield, US



The transition from a centrally planned to a market economy, particularly in the case of Russia, Ukraine and the other successor states of the Soviet Union, including the Baltic states, is one of the most important questions facing the world today. How to accomplish this transition is certainly one of the most important challenges to economics since the reconstruction of Europe after World War II. 1 The Soviet economy had until recently been the second largest economy in the world, but its successor states are now in a state of economic collapse. The fundamental problem is that the Soviet successor states have disbanded the institutions of central planning but they have not yet established the institutions of a market economy. In the vacuum that resulted from the absence of those bodies that enable an economy to function, whether it be a centrally planned or a market economy, there have been unprecedented economic declines in the Soviet successor states. These declines include sharp reductions in output, enormous increases in prices, large and growing actual or functional unemployment, increasing numbers of workers who are not being paid, reductions in real wages and living standards, the loss of social services, and capital flight, resulting in potential political and social instability.2 In addition, some of the Soviet successor states have become riddled with crime, including asset stripping by managers of newly privatized establishments and tremendous increases in the role of the mafias in the economy.3 Thus, a functioning market economy remains a rather distant prospect...


...Should the transition use a gradual evolutionary approach or a sudden revolutionary one? In January 1992, President Boris Yeltsin introduced in Russia the radical reform represented by the 'SLP' approach of stabilization, liberalization and privatization under the name of 'shock therapy.' The other Soviet successor states have also introduced some elements of this SLP approach. The 'stabilization' part of SLP refers to macroeconomic stabilization, with limits on government deficits, on growth in the money supply, on imbalances in the balance of payments and so on, involving macroeconomic, monetary and international stabilization. The 'liberalization' part of SLP refers to price liberalization, freeing prices and allowing them to move to realistic market prices through the pressure of market forces. The 'privatization' part of SLP refers to privatizing the former state enterprises, turning them into corporations, as in Western market economies. Given the declines experienced following the introduction of this SLP approach, a reasonable question is whether it should continue or whether it should be replaced by some other approach. In particular, what should be the role of supporting domestic economic, legal, political and social institutions? ....



In response to these fundamental questions, this paper contends that it is necessary to establish the relevant economic, legal, political and social institutions in order to prevent the further collapse of the economies of the Soviet successor states. It further contends that the SLP approach will not spontaneously create these institutions and, thus, the government or perhaps local governments, with help from external public and private sources, should take a major role is establishing these institutions.

These conclusions follow from a consideration of the basic transactions of a market economy and the institutions necessary for such transactions to take place. The most important of the institutions needed for a market economy are a legal system, including both business law and property law; a related system of property rights; a credit system; a system of commercial and investment banks; classified advertising; an accounting system, and other institutions, including a sound currency and a social safety net. In the absence of these institutions, enterprises, whether privatized or not, will not have the proper incentives to produce and to invest. .... a relatively greater economic role for the government may be the way - and perhaps the only way - to facilitate the development of those institutions needed for a market economy. .... there must be a recognition of the need for government to take initiatives in the establishment of these institutions, which would take an unacceptably long time, if ever, to form in the absence of such initiatives. ...In general, the goal should not be a pure laissez-faire market economy, but rather a mixed economy like those of Western industrialized economies. Such economies are not completely decentralized in that they involve the government acting as a regulator, as an initiator and, in other capacities as well, influencing the economy. ...



....The basic transaction of a market economy is extremely simple: one economic actor, ... has something to sell and another wants to buy it, so they make a mutually profitable transaction. ...Now consider what is necessary for this basic microeconomic transaction to happen. First, both ... must know what they own ...making necessary a system of property rights.  Second, ...advertising, ...and other information systems. Third, they must have some way of ... settling disputes ... making necessary contracts, laws, courts, a commercial code and so on. Fourth, ... a financial system, including both commercial and investment banks and other financial intermediaries. Fifth, ... an insurance system. Sixth, ... an accounting system. Seventh, ... they must have access to money both as a unit of account and as a means of payment.

....the economic reform carried out so far has created a system that is virtually ideal for the transfer of property to either second echelon bureaucrats or organized crime. The situation in these nations is like the 'robber baron' period of unfettered capitalism during the last century, but even more extreme, where the current robber barons are the mafias and corrupt bureaucrats, including enterprise managers.


The building of the economic and other institutions needed for a market economy is totally different from the current privatization campaign that exists in some of the Soviet successor states.... Simply changing the labels on existing entities will not change much, particularly if the same managers are running the same institutions, using the same workers and the same (largely obsolete) capital and technology. ...The issue is not that of changing labels on existing entities, but rather that of creating those new institutions that would make possible private market transactions. These institutions, which lie at the core of a market economy, evolved over centuries in Western economies, but they must develop rapidly in the Soviet successor states to prevent their further economic decline. These states do not have the time needed for such institutions to evolve. That will require an activist government, ideally with help from other nations and international organizations to foster their creation or to create them directly.

...Government policy must focus not only on creating those institutions necessary for a market economy but also on fostering the creation of new economic entities to use them. ...Policy initiatives should focus on the creation of new efficient economic entities that can compete effectively in the world economy, such as have been established recently in China and elsewhere. They could, for example, be fostered through industrial development offices organized on both an industry and a regional basis. T... By contrast, current policy in the Soviet successor states appears to concentrate on sustaining the existing inefficient production units through privatization, direct subsidies and so on, rather than creating efficient new economic entities.



... Central planning lasted in the Soviet Union from 1928 until 1985, ... It is currently fashionable ... to criticize central planning, but it did lift what had been a backward and largely agricultural economy to the level of the second largest economy in the world, ... This economy, built under central planning, was also able to fight and to win the biggest war in the history of the world against the Nazis, with relatively little help from its allies in the West. The postwar period under central planning witnessed significantly rising living standards and the modernization of the economy. Thus, one must give at least some credit to central planning, which, despite its well-known deficiencies and excesses, 'worked' in the Soviet context. ... Even more relevant is the failure of economic reforms in the Gorbachev era, from March 1985 to the end of 1991,...


One was the anti-alcoholism campaign to reduce drunkenness, particularly in the workplace, by making vodka difficult or expensive to obtain. Instead, it had the effect of stimulating home production of vodka, with the side effect of the disappearance of sugar and a substantial reduction in tax collections. Another was the acceleration campaign to speed up the production of goods, which failed to increase output. A third was the quality improvement campaign to improve the quality of consumer goods, but which instead led to the wholesale rejection of low-quality goods by inspectors whose prior experience had been to ensure quality of military goods. A fourth was the conversion campaign, which attempted unsuccessfully to convert military plants to produce civilian goods. A fifth was the campaign for joint ventures and private initiatives that stimulated some interest but did not lead to much activity once domestic or foreign entrepreneurs assessed the difficulties and risks involved. These various attempts all failed. Each tried to do something that was impossible: to change the Soviet economy without changing the institutions of the economy.....

The present situation in the Soviet successor states involves an attempt to establish a market economy through some or all of the elements of the SLP programme of stabilization, liberalization and privatization. It has, however, instead resulted in economic decline, impoverishment of the vast majority of the populations of these states, and social polarization. While more far-reaching and revolutionary than those of the Gorbachev period, the economic reforms in the Soviet successor states have a basic flaw similar to the various Gorbachev reforms to improve economic performance. Like the Gorbachev reforms, they do not take account of the lack of the relevant institutions and have little chance of succeeding without them. Conversely, if these institutions were in place, the current reforms would be much more effective.

A major example is privatization as the route to a market economy. This reform is largely superficial in that little or nothing has really changed when an establishment has been privatized. As already noted, the privatized firm has the same capital, labour, management, sources of supply, sales channels and so on., as its predecessor. Thus, privatization is like a new 'Potemkin Village', where appearances only hide the reality. The incentives supposedly created by privatization fail to produce output and investment in the absence of market institutions. Rather, the incentives for managers under current conditions are to take as much as possible out of the privatized enterprises by stripping them of assets and lodging the proceeds in foreign accounts. Altogether, privatization, whether of small enterprise or of major industry, is absorbing too many resources, including capital, managerial talent and government activity, with too little of these resources devoted to the development of new private firms and the institutions of a market economy. A better approach would have a more activist government involved in establishing such institutions and encouraging the formation of new enterprises. This more activist government might well be the national governments in the Baltic states and the smaller Soviet successor states and the local governments in Russia (the oblasts) and other large Soviet successor states.




Consideration of both the microeconomic foundations of a market economy and past economic reforms has led to an appreciation of the importance of the institutions of a market economy. The creation of these institutions should be a major part of the economic reform programme, with the government either fostering their creation or, if necessary, creating them directly. Some, such as the legal institutions, are the province of government in any case and are thus public institutions. For others, such as entities in banking and finance, accounting and insurance, it is possible for the government to create them and then spin them off to the private sector. They are the quasi-public institutions. Three public institutions are of fundamental importance in establishing a market economy and, each being the province of government, their creation requires governmental initiatives, ideally in the first phase of reform. The first is a system of property rights, which would establish the basis for ownership and clarify the issue of who owns the assets in the economy. Legalizing the right to own and to sell property is not enough in a society in which the state had owned many assets. The title for these assets, including much of the productive capital in the economy, land and natural resources, is now clouded in that it is not clear precisely who owns them. In many cases there are competing claimants for this capital, including managers, workers, local councils, regions and others. For the future, ownership of existing property must be determined, and, in general, property rights must be defined and understood, including such basic concepts as exclusivity (that is, the right to exclusive use of the property) and alienability (that is, the right to sell or to transfer the property). Failing this, individuals will not exercise their rights to resources in a manner facilitating production and investment.


Closely related to property rights is the second such fundamental public institution, a legal system, including a civil code and a commercial code. Property rights are part of the legal structure and lead to contracts, which form the basis of a functioning market economy. Without contract rules and mechanisms for their enforcement a market economy cannot function. Business law, including a commercial code and anti-monopoly laws, is also essential for providing a framework for market transactions of all kinds. The legal system requires much more, however, than just legislation of laws. The government must also provide the necessary enforcement mechanisms and develop appropriate forums for the settlement of disputes. The third such institution is a stable currency. Individual agents in a market economy must have a viable currency both as a means of making transactions as well as a unit of account and a store of value. In the absence of such money, some of the trade among enterprises has been conducted on the basis of barter arrangements, but this is an extremely inefficient way of making economic transactions, making it difficult for producing units either to obtain material inputs or to sell their products. The trade between enterprises that is not arranged on the basis of barter is being carried out in most circumstances under traditional supplier networks, with each enterprise building up debt to the others. This debt, however, must eventually be paid off by the government through increased subsidization, thereby fuelling the inflation. These old-style relationships have led to a huge inter-enterprise arrears crisis of overdue payments for goods and services that is severely undermining stabilization efforts.9 A stable currency must be the goal of monetary and fiscal policy. This goal would be facilitated by the establishment of an efficient system of tax collection and closer control of government expenditures and the money creation process.

Other public institutions that would facilitate the formation of a market economy include state legal and regulatory agencies to prevent corruption, monopolization and other criminal activities that are not only costly in themselves but that also undermine popular support for a market economy. It is also important to develop a social safety net to replace the social services that had previously been provided by state enterprises. Both of these institutions should be part of a new social contract to replace the earlier one. The earlier social contract called for unqualified support of the party in return for its provision of subsidized housing, food and fuel, and its direct provision of social services such as education, health care and pensions. There is not yet a new social contract, but it might involve the provision of a social safety net and protection from criminal activities in return for support of the current political-economic system. The establishment of a new social contract is important to gain public support for the transition to a market economy. In addition to these public institutions that are all the exclusive domain of government, there are several other institutions that are also essential to a functioning market economy. They are typically provided through the private sector in Western economies, but they could be provided by the government and are thus quasi-public institutions. While the history of Western economies suggests that these institutions could come into being through private initiatives, the fact is that it took centuries for their evolution in the West and the Soviet successor states do not have the time needed for their private formation. It will take governmental initiatives to foster their creation or, even better, to establish them directly, possibly to spin them off eventually to the private sector.


The first is a banking and credit system, which could finance new enterprises. Such a system of financial intermediaries is not provided by the current banks in the Soviet successor states. It may be easier to establish new entities to provide these services, including commercial and investment banks, rather than to try to change the existing ones in view of the traditional ways in which they operate and the problem they have of writing off their bad debts. Second is classified advertising, trade journals and other information systems that enable buyers and sellers to find each other. In their absence, transactions depend on traditional networks among established entities, fledgling commodity markets that help but are inadequate, use of computer networks that are innovative but inadequate to the task, and street bazaars among individuals. The government should help create markets by organizing information exchanges among potential buyers and sellers, such as publications advertising items for sale or purchase, including help wanted and jobs sought. Third is accounting, which plays a very different role in a market economy from the one it plays in a centrally planned economy. As in the case of banking, it may be easier to establish new entities to provide these services than to change the existing ones. Fourth is insurance, another quasi public institution that plays a key role in a market economy, and the government should establish organizations providing insurance services, including special guarantees for investment. These quasi-public institutions, once established, could eventually be privatized.



The official programmes of the Soviet successor states involve a continuation of some elements of the SLP approach as the strategy for reform and as a way of treating the steep declines in their economies. This approach, which has been endorsed by some Western governments and international organizations, includes further privatization and price liberalization, bankruptcy of non-viable enterprises, and control of government spending. However, this SLP approach has already had and will continue to have significantly negative results. There was no preparation for the rapid introduction of free markets and a consumer-driven social order in terms of the establishment of the basic institutions of a market economy.1O Furthermore, while the Communist Party hegemony has collapsed, much of its structure remains, including the social structure and culture of state socialism, the state apparatus, and the Communist Party members themselves. The managers of the state sector are resistant to change, believing that reform would undercut their position. Thus, the SLP attempt at a transition to a market economy both inherited many of the institutions of the prior system and did not create the institutions necessary for a market economy. The result was not transition to a market economy but rather the collapse of the economy and its criminalization.

The International Monetary Fund has proposed its standard solutions of governmental fiscal restraint and restricted growth of the money supply, with attention focused on stopping the ongoing inflation and on balancing the international accounts. These components of the stabilization part of the SLP approach were developed for Latin America, particularly to treat the structural inflation of that region, and they involve a totally different set of problems and a different history. In particular, the Latin American economies have the market institutions that are lacking in the Soviet successor states. The Soviet successor states, in fact, have much to build on to become successful economies in the international community. They have a skilled labour force, access to some advanced technologies, a complete infrastructure and an internal market. The question is how will the necessary investment incentives be created to convert these assets into marketable products and services and to convert decline into growth?



The China example might be a model for creating the necessary investment incentives. While the Soviet successor states have been experiencing declines in output, employment, investment and so on, China has been growing at one of the fastest rates of any major economy in the world. It experienced a 13 per cent growth rate in both 1992 and 1993 and, while its growth may be declining, it will probably remain at or near the double-digit level for the next few years.12It is a mistake to dismiss the China model owing to perceived and valid differences with Europe. The fact is that much can be learned from this example.

China achieved a high growth rate by following several principles. First, it avoided political risk by postponing political reform until after economic reform had taken place. Second, it started its reform in the rural regions, thereby making the peasants rich and creating an internal market that had not existed earlier. Third, it then set up special economic zones in coastal areas, particularly in south China near Hong Kong, and in east China across from Taiwan. These zones have attracted export-oriented industry and have helped make China a leading exporter, thereby earning needed foreign exchange. The rest of the world assisted China through granting it Most-Favoured- Nation (MFN) status, helping it to create a huge export sector. Fourth, and often overlooked, China focused on the creation of new enterprises, particularly those oriented to exports, rather than on privatizing existing old enterprises. Instead of wasting scarce resources on privatizing the old economy, it concentrated on building a new economy of mainly state-owned enterprises, many of which were established by the local governments (provinces) and townships or villages. China was much more pragmatic and flexible than the other economies undergoing the transition, not insisting on changing ownership or on private enterprise, but instead requiring that the new firms be modem and export-oriented, using current technology, having good managers and workers and so on. The result has been stunning, with not only very high growth rates but also tremendous flows of capital into China from all over the world. China's competence in managing the transition has had an enormous pay-off. This is a model that could be followed in other nations, including the Soviet successor states, that have focused on the 'old economy' , keeping old establishments going through privatization.



There is an alternative to privatization as the route to a market economy. This alternative is to focus the programme on the 'new' economy rather than the 'old' economy, establishing new enterprises, as in the case of China, rather than concentrating on privatizing old enterprises. The contrast between these two routes to a market economy is a stark one. Consider the various aspects of enterprise involved in privatization versus the creation of new enterprise. As to managers, privatization retains the old incompetent or corrupt managers, while the creation of new enterprises leads to a search for competent and honest managers. As to workers, privatization retains the old poorly motivated, low productivity workers, while the creation of new enterprises leads to a search for the best workers. Similarly for capital, technology, distribution channels and so on.

The first step in the transition to a market economy should be the creation of the institutions on which such an economy is based, as without them a market economy cannot exist. The second step should then primarily be that of the creation of new enterprises and secondarily the reorganization of old enterprises into viable and profitable firms, which have competent managers, productive workers, modem capital and technology, secure sources of inputs and markets and so on. These firms can be state-owned or private. The third step is then that of privatization of those firms that are state owned by spinning them off to the private sector. By delaying privatization to this point, the enterprises, including newly created state owned enterprise, will be viable and valuable, making use of both the financial and other institutions of the market economy that can facilitate such a transition.


The system of privatization adopted by the Soviet successor states represents an attempt to salvage existing enterprises, which are uneconomic and thus amounts to a waste of resources, throwing 'good money' after 'bad'. By contrast, the alternative approach, based on the Chinese model, is that of focusing resources on building a 'new' economy through the creation of new enterprises, many of which are state-owned enterprises. It is at best wishful thinking to believe that these enterprises could be created from the old state enterprise~, given the incompetent managers, obsolete capital, use of outmoded technologies, inappropriate scale, and so on in such enterprises. Equally, it is wishful thinking to believe that they would be created spontaneously as new firms, given the lack of management skills, the scarcity of capital, the huge risks involved, and the policy of the state to tax profits in every way possible.

It is more realistic to base the creation of these enterprises on the actions of interested parties, including the same parties that might play a role in the development of the institutions of the economy. The state itself or local governments could play the role of a catalyst. Another possibility is investment banks, one of the financial institutions that should be created for this very purpose. External bodies might also help in the creation of the new enterprises, including foreign multinational firms; Western governments and consortia of governments such as the G7 and the Organisation for Security and Cooperation in Europe; and international organizations, including the International Monetary Fund, the World Bank, the European Bank for Reconstruction and Development, and the Organization for Economic Cooperation and Development. They could provide the Soviet successor states with the technical assistance. needed to establish and to develop the basic institutions of functioning markets. A sister nation approach might also be valuable, pairing nations or groups of them with Western nations that would assist their formerly centrally planned partners in creating the modem enterprises that would form the production base for a market economy.



By contrast to past and current governmental and international organization policies, which involve some or all of the elements of the SLP approach, the analysis presented here implies that there may be a better route to a market economy. This alternative would entail a radically different type of policy that reconstructs the very structure of the economies of the Soviet successor states. This approach requires more activist governments than those found in the Soviet successor states after the dissolution of the Soviet Union, governments that would take major initiatives and not rely entirely on delegating economic matters to the private sector. These governments must playa major role in the transition between the centrally planned economy, which now no longer exists, and a market economy, which still does not yet exist. Activist governments should be establishing those institutions of a market economy that could not be provided by the private sector, including a system of property rights, a legal system and a sound currency. They should also be establishing and enforcing a legal code and establishing regulatory bodies to prevent asset stripping, monopolization of markets, extortion and corruption. The governments should also be establishing those quasi-public institutions that could be provided by the private sector but would take too long to develop, including entities providing accounting, advertising, banking, insurance and other services. The governments should also help in the establishment of new producing and other entities that would make use of such institutions. Finally, they should be establishing social safety nets as part of a new social contract.

As to the rest of the world, the issue is not simply that of providing foreign  aid. The amounts that have been proposed are much too small to be meaningful and the Soviet successor states could well be sieves for these funds, which end up in private offshore bank accounts. It must be recognized that there are limits on what the West can do, but that the West can definitely help. It can provide technical assistance to help establish those institutions needed for a market economy to function. National governments, international organizations and consortia of governments should provide the Soviet successor states with the technical assistance needed to develop functioning markets. Such governmental or intergovernmental technical assistance should ideally be augmented by assistance from the private sector. For example, professional associations of lawyers, bankers, accountants, advertising executives and so on in the West might furnish groups of volunteers, such as recently retired professionals, to provide advice and assistance at nominal cost. Such public and private assistance should be channelled through new activist governmental programmes and new non-governmental organizations in the Soviet successor states. Equally important, Western nations should open their markets to goods from the Soviet successor states, facilitating increased international trade with these states. They should also provide information and insurance and other forms of protection to encourage foreign direct and portfolio investment in these states and joint-ventures. They should also encourage visits by managers and students to Western institutions so they can appreciate what is meant by a 'market economy', which remains a mystery to many in the former Soviet Union. Access to foreign markets; to what can be provided by foreign firms in terms of capital, management, marketing skills and so on; and to learning how markets function are all of basic importance to the rebuilding of the economies of the Soviet successor states and their transition to a market economy.

Private capital markets would be prepared to provide fmancing, provided there is a reasonable prospect of profit at an acceptable level of risk. An example is China, where huge sums are flowing in trom throughout the world, demonstrating that there is a global capital market. Indeed, a market test of reform is precisely whether such capital is forthcoming, whether from internal or external sources. Assuming there is market access, the forward and backward linkages trom international trade could assist in establishing institutions and markets, particularly those involved in exports and imports of the Soviet successor states. Another market test of reform is whether the economies of the Soviet successor states are able to capitalize on those products that have potential markets in the West. These include not only the traditional natural resource exports, especially oil and gas, but also the products of advanced technologies that have been developed for military or space use but that have commercial potential in Western markets. Ideally, high technology products would be produced by new firms established in the Soviet successor states for export to distributors in the West, who would market them throughout Western markets. This approach would combine the high technology products and production facilities in the Soviet successor states with the marketing capabilities offll111sin the West.



This paper builds on Michael D. Intriligator, 'Reform of the Russian Economy: The Role of Institutions,' Contention, Winter 1994. The author acknowledges, with appreciation, the research assistance of Kenneth Serwin and the comments and suggestions of Fuad Aleskerov, Michael Barnes, Vladimir Keilis-Borok, Axel Leijonhufvud, George Murphy and Slava Tchoudinov. Support from the UCLA Office of International Relations and Overseas Programs is gratefully acknowledged.

See, among others, Milner and Lvov (1991), Aslund (1991), Marer and Zecchini (1991), Alexeev et aI. (1992), Wolfson (1992), Fischer and Frenkel (1992), Sachs, (1992), Abalkin (1992), Fischer (1992), Summers and Nordhaus (1992a), Ellman (1992), Dyker (1992), Clague and Rausser (1992), Eberwein (1992), Leijonhufvud (I 993a).

These declines in the economies of the Soviet successor states, particularly those in Russia and Ukraine, and their consequences for political and social instability represent perhaps the greatest threat to global security today. To appreciate their significance, one must take account of the size and population of Russia and Ukraine, their geo-strategic position, their arsenals of nuclear and other weapons, their relations with the near abroad nations that had been part of the Soviet Union, and the possibility of Bosnia-type wars within or between these nations. There is a potential in these countries for the advent of neo-communist, fascist or militaristic governments, with adverse consequences for the world that world leaders have generally ignored. The potential threats to global security stemming from these nations are, for example, of far greater potential consequence than such issues as proliferation, the arms trade, terrorism, local conflicts and so on. See Intriligator (1994).

See Murrell (I992, pp. 79-95). As to the contribution of economics, while there had been a debate among economists over centrally planned versus market economies in the 1930s, there has been remarkably little discussion of the transition from one system to the other. On the transition and economic theory, see Fischer and Gelb (1991, pp. 91-106), Winiecki (1992, pp. 171-90) and Nove (1993, pp. 20-33). On the lack of applicability of the previous transition literature, which concerns mainly the transition from right-wing authoritarian regimes, to the post-Communist transition, see Meiklejohn Terry (1993).

For discussions of the role of institutions in the transition to a market economy,  see Oppenheimer (1992, pp. 48-61), Koslowski (1992, pp. 673-705) and Nagy (1992).

6 See Cooter (1992). The Role of Institutions 227

An estimated $23 billion left Russia in 1993 alone to go into private offshore accounts in Cyprus, Bermuda, Switzerland and other locations, dwarfing the amounts that the IMF and other nations have delivered to Russia. For discussions of property rights and economic reform see (Winiecki, 1992) and (Koslowski, 1992).

The naive belief that 'hard budget constraints' could simply be applied to the old enterprises is directly responsible for this inter-enterprise arrears crisis. No one now believes that hard budget constraints will work, but the crisis is one of enormous proportions. See Whitlock (1992, pp. 33-8) and Ickes and Ryterman (1992, pp. 331-61).                                

10 By contrast,Polandwasfar morepreparedfor a policyof shocktherapyowingto the prior existence of some market institutions, a strong corporatist relationship between the government and unions, and a healthier overall economic condition at the time of implementation. For discussions of the economic reform in East Europe and in other Soviet successor states see Komai (1992, pp. 1-21), Koslowski (1992) and Ellman (1992) regarding Poland; Leijonhufvud (1993), Simonetti (1993, pp. 79-102), regarding Hungary, Poland, the Czech and Slovak Federation, and East Germany.

11 SeeWiniecki(1992).

12 Thecontrastbetweenthe steepoutputdeclinesin the Sovietsuccessorstatesand the huge output increases in China is a stark one. If economists had been ," predicting the effects of the attempted transitions to a market economy in the Soviet Union and in China as of the late 1980s, they could well have concluded that the attempt would succeed in Russia but would fail in China, given the contrast between their levels of output, particularly on a per-capita basis; given the presence of a huge internal market in the Soviet Union but its absence in China; given the presence of communications, transportation and other infrastructure in the Soviet Union but their absence in China; given the presence of a highly trained workforce in the Soviet Union but its absence in China, and so on. In fact, the outcome was just the opposite, with great increases in China and great decreases in the Soviet Union. The major explanation for the differences between the outcomes in these formerly centrally planned economies must be the differences in their approaches to economic reform.

13 For a discussionof how aid distributedto the governmentshouldbe conditioned on the implementation of institutional reforms and how aid should be directed towards the firms and individuals actualIy making the transition, see (Leitzel 1992, pp.357-74).




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Murrell, P. (1992), Evolutionary and Radical Approaches to Economic Reform, Economics of Planning, vol. 25, pp. 79-95.

Nagy, A. (1992), Institutions and the Transition to a Market Economy, in C. Clague and G.C Rausser, eds, The Emergence of Market Economies in Eastern Europe, Blackwell, Cambridge, MA.

Nove, A. (1993), Transition to the Market and Economic Theory, Problems of Economic Transition, vol. 35, pp. 20-33.

Oppenheimer, P.M. (1992), Economic Reform in Russia, National Institute Economic Review, vol. 82 (August), pp. 48-61.

Sachs, J.D. (1992), Privatization in Russia: Some Lessons from Eastern Europe, American Economic Review, vol. 82 (May), pp. 43-8.

Simonetti , M. (1993), A Comparative Review of Privatisation Strategies in Four Former Socialist Countries, Europe-Asia Studies, vol. 45, pp. 79- 102.

Summers, L. and W. Nordhaus (1992), Stabilization and Economic Reform in Russia, Brookings Papers on Economic Activity,.pp. 112-26.

Whitlock, E. (1992), A Borrower and a Lender Be: Interenterprise Debt in Russia, RFE/RL Research Report, vol. 1 (October), pp. 33-8.

Winiecki, J. (1992), The Transition of Post-Soviet-Type Economies: Expected and Unexpected Developments, Banca Nazionale del Lavoro Quarterly Review, vol. 181, pp. 171-90.

Wolfson, M. (1992), Transitions from a Command Economy: Rational Expectations and Cold Turkey, Contemporary Policy Issues, vol. 10 (April), pp. 35-43.


Excerpts from the Introduction to the book The Transition to a Market Economy by Haavisto:

Chapters 9, 10 and II can be considered as reflections on the paper discussed above. All three authors participated the seminar in Bergen. The first of these three chapters is written by Michael D. Intriligator of UCLA, who comes with a critical view on the Big Bang approach to the transformation process. He discusses alternative paths for the former planned economies. Chapter 10 is by Tadeus Rybczynski of City University, London, who examines the emerging financial markets as a part of the transformation process in the Baltic countries. And finally, we have the chapter by Oldrich Kyn, of the University of Boston, dealing with the role of the SLP approach (stabilization, liberalization, privatization) in the successful transition to the market economy.

The point of departure is of course the role of the missing institutions. It seems that there is some confusion about what is meant by institutions. In some circumstances 'institutions' is used in the sense of actors in markets as with 'financial institutions' meaning banks, insurance companies, mortgage lenders and so on, while in some other circumstances, 'institutions' refers to institutions in the sense used here by Pelikan and Eliasson: the fundamentals of the market economy, such as property rights. There is of course a linkage between the fundamentals of the markets and the actors in the market: the fundamentals define the actors. However, it is clear that we should try to avoid confusion when discussing this issue. Intriligator points out that the lack of institutions, in the sense of certain market actors, is a reason to hasten slowly when introducing the market economy. Indeed, he goes so far as to recommend some type of 'third way approach' to avoid a collapse of the economy. Intriligator argues that there is a risk that the pace of destruction of the established structure of the former planned economies may be fast, while it may be a long time until the new market actors emerge. As a result, the economy will tend to slide into a chaotic state. Furthermore, it seems that authors like Intriligator believe that certain functions of the planned economy are vital and should be adopted in the new structure taking form in those countries. Thus, Michael Intriligator concludes that the Big Bang approach should be replaced by a third way approach.

This conclusion is in sharp contrast to the conclusions of several other chapters in this volume. A common conclusion reached in several papers is that only a simple framework is required to carry out the most basic functions of the market economy. Once those basic functions are implemented, the dynamics of the market economy are going to work in the same manner as they do in the Western market economies. The paper by Oldrich Kyn argues strongly for this latter view. We have both theoretical and empirical arguments to make us believe that the market economy and the Western type of democracy are the main reasons for the huge gap between the standard of living in the Soviet successor states and the market economies in the West.

Thus, the conclusions made by Kyn support a rapid implementation of the institutions of the market economies. The third way approach implies that certain functions of an economic system that never worked remain in force. A part of socialism is maintained in those countries to ease the hardships related to the restructuring of the economy. The problem here is obvious. The medicine recommended to alleviate the symptoms is in fact a part of the disease! It is easy to agree with Michael Intriligator that the lack of institutions is a huge problem in the process of transformation from socialism to capitalism, but as pointed out by Pelikan, Eliasson and Kyn, the maintenance of the old institutions of socialism is a greater threat to the successful transformation of those economies than are those temporary hardships arising from the transformation process.


Excerpts from

Eastern Europe in Transition

Oldrich Kyn

in:  The Transition to a Market Economy

Tarmo Haavisto ed.

Edward Elgar, Cheltenham, UK;  Brooksfield, US 

... [T]he fall of communism in 1989 came to many as a big surprise....
....It was not long after 1989 that the international community was exposed to additional surprises. First, we learned that the transition from a totalitarian system to political democracy and from central planning to the free market economy is much more difficult than anyone could have believed. It has taken longer than expected and all the countries in transition suffered unparalleled economic setbacks. ...
....I shall start by formulating alternative hypotheses and then reflect on the evidence from the Baltic and other East European countries as presented in the papers and discussions of this conference and in various other publications.....
....The vacuum or discoordination hypothesis: according to this hypothesis, market economy and command economy are two distinct coordinative mechanisms that work on completely different principles. During transition one has to be dismantled before the other can be created, leading to a temporary discoordination....
...I want to draw attention to the difference between what has actually been happening and what may have been perceived by people or politicians. At the very beginning, that is in 1989 and 1990, people mostly expected a relatively short period of economic adjustment, a quick increase of efficiency and resumption of economic growth. This was partly based on casual observations and partly on neoclassical economics.
...The vacuum or discoordination hypothesis B3 was probably first formulated by Hayek in The Road to Serfdom:
"most people still believe that it must be possible to find some middle way between 'atomistic' competition and central direction. Nothing, indeed, seems at first more plausible, or is more likely to appeal to reasonable people, than the idea that our goal must be neither the extreme decentralization of free competition nor the complete centralization of a single plan but some judicious mixture of the two methods. Yet mere common sense proves a treacherous

"Although competition can bear some admixture of regulation, it cannot be combined with planning to any extent we like without ceasing to operate as an effective guide to production. Nor is 'planning' a medicine which, taken in small doses, can produce the effects for which one might hope from its thoroughgoing application. Both competition and central direction become poor and inefficient tools if they are incomplete; they are alternative principles used to solve the same problem, and a mixture of the two means that neither will really work and that the result will be worse than if either system had been consistently relied upon" (Hayek, 1944, p. 42).

For about two decades after the end of the World War II, a fairly different concept of optimal mixture of market and planning prevailed, at least in the West. Many economists believed that the decentralized market system and centralized command economy are only idealized limiting cases with a continuous spectrum of real 'mixed systems' in between. An optimal combination of market and central planning was supposed to eliminate the deficiencies of both pure systems and significantly improve economic coordination and efficiency.
The idea of incompatibility was resurrected during the economic reforms of the 1960s especially in Czechoslovakia. "The Czechoslovak economists believed that the market and command principles are two radically different forms of economic organization which do not easily mix together. Their view of this dichotomy was derived partly from their own historical experience and partly from Wlodzimierz Brus's (1972) influential book which contained an excellent analysis of the differences between centralized (i.e. command) and decentralized (i.e. market) models of socialism" (Kyn, 1975, p. 141).
Ota Turek (1967) analysed an 'intermediate model' based on a mixture of command planning and elements of the market economy. He concluded that such a model is organizationally unstable and sooner or later would degenerate back to a directive system.
"This opinion was also shared by other economists who believed that both a command economy and a market economy were, in a certain sense, 'stable' organizations, while the intermediate forms containing mixtures of command and market elements were unstable, and would tend to move either toward a command system or toward a complete market system. To use an analogy from physics, it looked as if the command and market systems each had its own 'gravitational pull' which could cause a return to the original system when only a small deviation from it was made. Once, however, steps in the direction of the other system reach a certain border line, the gravitational pull of the other system prevails and the transformation could be accomplished (Kyn, 1975, p. 142).
After the collapse of communism the vacuum hypothesis reappeared again. For example Kolodko wrote: 'the planned mechanism of allocation has been dismantled, but the market one is not yet in place, so one has to see a sort of systemic vacuum' (Kolodko, 1993, p. 58). Vacuum hypothesis is in the core of Dornbusch's argument against gradualism: 'If reform proceeds hesitantly, economic collapse is certain and the market economy experiment becomes discredited before it even had a chance to be born' (Dornbusch, 1991, p. 181)
In his chapter Michael Intriligator formulates a version of the vacuum hypothesis:
The fundamental problem is that the Soviet successor states have disbanded the institutions of central planning but they have not yet established the institutions of a market economy. In the vacuum that resulted from the absence of those bodies that enable an economy to function, whether it be a centrally planned or a market economy, there have been unprecedented economic declines in the Soviet successor states. . . . a functioning market economy remains a rather distant prospect.
Intriligator's interpretation differs from the previous interpretations of the vacuum by identifying it as the lack of institutions. This is very much in line with the recently growing recognition of the importance of property rights and other economic and legal institutions for the efficient operation of a market economy. Certainly, the full significance of private property had not yet been recognized by the Czech reformers in the mid­1960s. Their idea was that Western-style economic efficiency could be attained by moving from a command to a socialist market economy while still preserving some form of public - although not necessarily state - ownership.
A similar delusion also existed among Western neoclassical economists. This is confirmed by the following quotations from the recently published book by Joseph Stiglitz:
The idea of market socialism was a powerful one. It suggested that it was possible to have all the advantages of market economies without the disadvantages attendant to private property and the frequently associated large concentrations of wealth. Market socialism, it was thought, could at the same time avoid the major pitfalls facing Soviet-type socialism (Stiglitz, 1994,
The neoclassical paradigm, through its incorrect characterization of the market economies and the central problems of resource allocation, provides a false sense of belief in the ability of market socialism to solve those resource allocation problems. To put it another way, if the neoclassical paradigm had provided a good description of the resource allocation problem and the market mechanism, then market socialism might well have been a success. The very criticisms of market socialism are themselves, to a large extent, criticisms of the neoclassical paradigm (Stiglitz, 1994, p. 13).
Although I think that such a stark denouncement of the neoclassical paradigm is exaggerated I do agree with most of the contemporary economic community that the market economy cannot operate efficiently without clearly determined rules of the game, that is, without well­established property rights and other institutions. I do, therefore, wholeheartedly agree with the main proposition of Michael Intriligator's chapter, namely that the successful transition to the market economy requires fast creation of the relevant economic, legal, political and social institutions. The importance of speedy change in property rights with related legal norms, civil and business laws, codes, contracts, and regulations cannot be overestimated.
What I do not understand, however, is that from this premise Intriligator arrives at bitter criticism of the existing strategies of transition. He blames Western advisers, IMF and the World Bank, for not recognizing that East European countries are different from other nations and for imposing a faulty strategy of stabilization, liberalization and privatization (SLP) on them. He regards this strategy and particularly its radical version nicknamed 'shock therapy' the main contributor to all the transition troubles (hypothesis B7). He claims that because central planning was abandoned while the institutions of a market economy had not yet been created no one except for criminal elements was in charge. He concludes that such a transition is not a transition to market economy as known in the West but, rather, to an economy riddled with crime and corruption with economic disarray and collapse.
It appears that there is some misunderstanding in the use of the term 'institutions'. While this term now usually means formal 'rules of the game' that impose constraints on economic decision­making - such as laws, customs and so on - Intriligator uses this term in a much broader sense which also includes actual organizations and even some other economic phenomena. His list of institutions of a market economy includes not only property rights, civil and commercial laws and so on, but also banks, insurance companies and other organizations of the financial markets. This has very important implications. Many of us would agree that the major role of the government in the transition process is the creation of institutions in the narrower sense of the rules of the game. Michael Intriligator wants, however, much more; he wants the government to take full responsibility for the actual creation of banks, insurance companies, advertising companies and even the new 'more efficient' industrial firms. He has not given up the idea of social engineering.
Almost everybody has now abandoned the idea that the economy can be efficiently coordinated through the centralized hierarchical organization of the decision­making process. The superiority of the market economy lies not just in its decentralized organizational structure, but also in the fact that decisions about changes in the organizational structure are themselves decentralized. Market is a self-organizing mechanism in which spontaneously created new structures only survive if they are economically viable. Private ownership is an essential precondition of the self­organizing function of the market. This is because correct decisions lead to the growth of capital and consequently of the decision­making power of the owner. Intriligator seems to believe that government bureaucrats can design and implement the optimal reorganization of the economic system from the top. I believe that the successful transition strategy requires to start up the self-organizing function of the market as early as possible. This also implies that private owners rather than government bureaucrats should select managers of firms as Pavel Pelikan shows convincingly in his contribution on allocation of competence.
It is not that I disagree with the vacuum hypothesis, but I think that Intriligator is drawing the wrong conclusions from it. My conclusions would still be similar to the conclusion of the Czech economists in the mid-1960s, namely that the existence of the vacuum calls for rapid, comprehensive change rather than the piecemeal gradualist approach. My disagreement with Intriligator's interpretation is also based on the belief that the vacuum is not just in institutions. A market economy needs substantially different skills and decision-making behaviour. These cannot be decreed by government or imported from abroad. When I returned in 1990 to Czechoslovakia after 23 years' absence, I came to the conclusion that the greatest damage that the communist system did was to human capital. In the 1960s, there were still many who were trained before the communist takeover. In 1990 there were only a few. An entirely new generation with distorted work attitudes dominated. Newly emerging private firms commonly tend to avoid people with experience in the field because of their acquired bad work habits. Institutions are enormously important but the smooth operation of the market requires that people also learn how to make decisions in new situations. Most of this will be necessarily learning by doing. It is unrealistic to think that people could learn just from textbooks without real life experience. Prices must be liberalized for people to learn how to react to price movements. Property must be privatized for people to learn how to exercise their property rights.
Michael Intriligator's arguments are inconsistent. He criticizes stabilization policies but lists stable currency among the institutions that government should create first. He wants a market economy but attacks domestic price and foreign markets liberalization. He pleads for the preferential establishment of property rights but denounces privatization. Does he really believe that government can create a stable currency by decree without imposing a strict control over the supply of money and budget expenditures? Does he believe that government can create market institutions without letting the market operate? Does he have no doubts about the attempts to establish property rights with virtually no private enterprises?
Michael Intriligator says that the current privatization campaign will not change things significantly because it just changes the labels on existing entities. The same managers are running the same 'institutions' (!) with the same workers he says, implying that the privatized enterprise will continue to be inefficient. My response is that this may be true only when the government continues to pay subsidies to inefficient firms. Private property rights mean responsibility for one's own losses. Without subsidies or unlimited credits guaranteed by government, inefficient firms would go bankrupt. Only those privatized firms would survive whose managers and workers learned and adjusted their behaviour to the new environment. Bankruptcies are crucial. Monetary and fiscal restriction is needed to eliminate subsidies and skyrocketing credits to inefficient firms. Pressure of the market and the threat of bankruptcy or unemployment is the most effective way to change the behaviour of workers and managers. Certainly, it will take some time. Certainly, many old dinosaur enterprises will not survive. Why not close them without privatization? Because no government bureaucrat or even economic adviser can predict with sufficient accuracy which firms will remain inefficient in the future. Only competitive markets can solve this problem. Why not let them wither away without privatization? Because it is much more difficult for government to stop subsidies to state­owned enterprises than to private firms. Certainly new firms and organizations need to be created, but I would not trust government bureaucrats or even foreign economic advisers if they told me that they knew the right products and technologies and that they could improve economic efficiency before the market starts functioning in full.
Michael Intriligator seems to believe in optimal sequencing of reform measures. Vaclav Klaus lost such a belief when he became a politician and discovered that political forces and events are unpredictable and hardly controllable. For what is the optimal design worth if you cannot get crucial bills through the parliament in the desired time? Klaus likened the reform process to the game of chess. You must make your moves conditional on the moves of your opponent. The reality of vicious partisan fights in political democracies should cure us from the naive presumption that it is possible to prepare all the market institutions ahead of time before starting the liberalization and privatization process. Frequently you cannot convince politicians about the urgency of certain legislative action before they actually witness the approaching emergency. In the Czechoslovak parliament, the bill on investment privatization funds was sidestepped for months and quickly rushed through only when it became obvious that the Harvard Fund and a few others might acquire an exceedingly large share of privatization vouchers. The fear of concentration of economic power was what finally worked.
Michael Intriligator's severe criticism of the SLP strategy is based almost solely on the Russian experience. However, in many East European countries, the SLP strategy worked with far fewer negative repercussions than in Russia. Particularly in the Visegrad countries, the decline of output and the accompanying inflation were much milder. The Czech government took all the supposedly wrong steps and completed the transformation process more rapidly than any other country and with the massive support of the population. Poland which initiated the big bang strategy has now quite a vigorously growing economy. Both the Czech Republic and Hungary are attracting billions of dollars of private foreign investment. Although Baltic countries suffered much deeper setbacks than the Visegrad countries, they also seem to be already close to a recovery path. In none of these countries have criminal elements had such an extreme role as in Russia. Intriligator's suggestion that SLP would be likely to cause a complete economic collapse and his slogan 'privatization leads to criminalization' are highly inaccurate and misleading.
Intriligator's claim that the SLP strategy was imposed on East European countries by the IMF, World Bank and foreign advisers is false. There is a good deal of evidence that at least in some countries domestic reformers arrived independently at similar proposals. I am convinced that it is the only workable strategy, although ex post we always find out that many things could have been done differently. Foreign advisers and international organizations were well aware of the importance of education, training and institution building. In democratic countries institutional changes have to be implemented through the internal political process. It helps to have a stable well­functioning government, but it should restrict its activity primarily to the creation of clear and consistent rules of the game and leave most of the rest to private business.





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