OK Economics

Economic Systems



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Joseph Stiglitz







This century has been marked by two great economic experiments. The outcome of the first set the socialist experiment ... is now clear. The second experiment is the movement back from a socialist economy to a market economy. ... As rapidly as the countries announced the abandonment of communism so too did western advisers march in with their sure-fire recipes for a quick transition to a market economy.

A decade after the beginning of the transition in Eastern Europe and the Former Soviet Union (FSU) and two decades after the beginning of the transition in China the picture is mixed. Each country started the course of transition with a different history a different set of human and physical endowments. ... the disparity between the successes and failures is so large that it calls out for interpretation and explanation and in any case the public debate has already begun.

The contrast between the strategies—and results—of the two largest countries Russia and China may be instructive. Figure 1 shows that over the decade beginning in 1989 while China’s GDP nearly doubled Russia’s GDP almost halved; so that while at the beginning of the period Russia’s GDP was more than twice that of China’s at the end it was a third smaller. Not only did Russia stagnate during this past decade but Figure 2 shows how ... in the process of shrinking its GDP Russia also doubled its inequality (as measured by the Gini coefficient). Recent data contained in the 1999 World Development Indicators paint an even bleaker picture with poverty—defined as $4 a day—rising from 2 million to over 60 million by the middle of the decade. ... While those who had advised Russia on its transition path constantly predicted that it was on the verge of success—virtually declaring victory just a short while before its recent crash—the shortfall should have been apparent. Yes Russia had succeeded in "privatizing" much of its industry and natural resources but the level of gross fixed investment—a far more important sign of a burgeoning market economy—has fallen dramatically over the last five years [EBRD 1998]. Russia was fast becoming an extractive economy rather than a modern industrial economy.


Figure 1: Russian and Chinese Gross Domestic Product*


Figure 2: Russian Growth and Inequalit

Source: World Development Indicators 1999.
The GDP is measured in constant 1987$US and
chart represents generated trendline between 1989 and 1996 data points


Standing in marked contrast with these failures has been the enormous success of China which created its own path of transition (rather than just using a 'blueprint' or 'recipe' from western advisors). It succeeded not only in growing rapidly but in creating a vibrant non-State-owned collective enterprise sector. While investment in manufacturing in Russia stagnated that in China was growing by leaps and bounds. ...

The question that we need to ask is why the failures? Not surprisingly those who advocated shock therapy and rapid privatization argue that the problem was not too much shock and too little therapy but that there was too little shock. The reforms were not pursued aggressively enough.


Other defenders ... argue that the failures were not in the design of the reforms but in their implementation. ... I want to argue here however that the failures of the reforms that were widely advocated go far deeper—to a misunderstanding of the very foundations of a market economy as well as a failure to grasp the fundamentals of reform processes. I will argue below that at least part of the problem was an excessive reliance on textbook models of economics. ... the typical American style textbook relies so heavily on ... the neoclassical model leaving out other traditions (such as those put forward by Schumpeter and Hayek) which might have provided more insights into the situations facing the economies in transition. ...

... In hindsight it is clear that many of the political forecasts of those involved in the reform process were far from clairvoyant; ... Policy advisers put forth policy prescriptions in the context of a particular society... Interventions do not occur in a vacuum. How those recommendations are used or abused is not an issue from which economists can simply walk away. .... It is time for the doctors to rethink the prescription....


Part I:
Misunderstandings of
Market Economies


In my book Whither Socialism? [1994] I argued that the failure of market socialism arose in part from a failure to understand what makes a actual market economy function—a failure arising in part from the neoclassical model itself. If the Arrow-Debreu (AD) model [1954] had been correct then market socialism might have fared far better. ... I want to suggest here that those advocating shock therapy with its focus on privatization similarly failed because they failed to understand modern capitalism; they too were overly influenced by the excessively simplistic textbook models of the market economy. ...

While Hayek and Schumpeter had earlier in the century developed alternative paradigms... by the time the post-socialist economies faced their transition the modern theory of information economics had shown the striking limitations of the AD model and used the tools of modern economic analysis to illustrate forcefully the problems of corporate governance that Marshall [1897] Keynes [1936 ] Berle and Means [1932] Galbraith [1952] March and Simon [1958] Baumol [1959] Marris [1964] and many others had written about over the course of the twentieth century. In the following paragraphs I want to review what I see as the major ways in which for want of a better term I shall refer to as the "Washington Consensus" doctrines of transition failed in their understandings of the core elements of a market economy. In the second section of this talk I shall focus more sharply on the reform strategy that is on views about sequencing and pacing.


Competition and Privatization


Standard neoclassical theory argues that for a market economy to work well (to be Pareto efficient) there must be both competition and private property ... The issue however concerns choices: if one cannot have both should one proceed with privatization alone?

While those pushing for privatization pointed with pride to the large fraction of state enterprises that were turned over to private hands these were dubious achievements. ... it is easy to simply give away state assets especially to one's friends and cronies; ... Indeed if privatization is conducted in ways that are widely viewed as illegitimate ... the longer-run prospects of a market economy may actually be undermined. ... Thus the failure of privatization to provide the basis of a market economy was not an accident but a predictable consequence of the manner in which privatization occurred.


Privatization Alternatives


Those advocating rapid privatization faced the quandary that there were no legitimate sources of private wealth within the country with which privatization could be accomplished. Governments thus faced essentially four alternativesa sale of national assets abroad; voucher privatization; taming "spontaneous" privatization; or what I shall call for want of a better term "illegitimate" privatization.
The latter was the route Russia chose
after 1995 in the notorious "loans-for-shares" scheme. The government can allow private entrepreneurs to create banks which can lend these private parties money with which to buy the enterprises ... While the corruption was somewhat roundabout—and the process was less transparent than if the government had simply given the nation's assets to its friends—there is in fact little distinction between the two processes.

Since the whole process was widely viewed as illegitimate this "robber baron" privatization put market capitalism to even greater disrepute than perhaps the indoctrination of the Communist era. And since there was no presumption that those who thereby acquired the assets were particularly good managers there was no reason to hope that the assets would be better deployed than they had previously been.... the declining confidence in the economy and the government made the country even less attractive to foreign investors. The oligarchs found that they could extract more wealth from asset stripping than from redeploying assets in way that would provide the foundations of wealth creation.
The voucher schemes proved little more successful with the Czech Republic (at first taken as a model) providing the clearest illustration of the underlying problem of corporate governance ...


Creative Destruction


An essential part of the transition to a more efficient economy is the redeployment of resources from less productive to more productive uses. Moving workers from low productive employment to unemployment does not by itself increase productivity. ...  But any student of the process of enterprise creation and entrepreneurship would have expressed concerns especially in regions like FSU where there was little history of market-oriented entrepreneurship. For entrepreneurship to succeed certain skills need to be developed in practice skills which those in the FSU had no opportunity to develop. ... Entrepreneurship also requires capital. ... few had the necessary capital—especially after inflation eroded what little savings people had accumulated. The banking system had no experience in screening and monitoring loans it was wrong even to think of these banks as "banks" in the western sense...

Bankruptcy or the credible threat of it is a crucial part of a market economy. The institution of bankruptcy like its inverse of entrepreneurship had little or no precedent in the socialist countries. The institution of bankruptcy had to be created. A variety of available models for bankruptcy codes had evolved over centuries in the market economies and each was integrated into the specifics of its economy. A transplant to an alien environment could hardly be expected to quickly take root ... Those who hoped that newly drafted and "installed" bankruptcy codes would drive industrial restructuring have been much disappointed. .. we should not think that much industrial restructuring will come out of bankruptcy courts; the real restructuring is usually done to keep companies out of formal bankruptcy. Entrepreneurship and bankruptcy entry and exit must be seen as two sides of the same coin of economic change. ... Both parts of Schumpeter's phrase "creative destruction" must be remembered....


Social and Organizational Capital


It has long been recognized that a market system cannot operate solely on the basis of narrow self-interest. The informational problems in market interactions offer many chances for opportunistic behavior. Without some minimal amount of social trust and civil norms social interaction would be reduced to a minimum of tentative and distrustful commodity trades. Behind these social norms stands the machinery of the law which itself stands apart from the market.

Property systems are in general not completely self-enforcing. They depend for their definition upon a constellation of legal procedures both civil and criminal. The course of the law itself cannot be regarded as subject to the price system. ...  The price system is not and perhaps in some basic sense cannot be universal. To the extent that it is incomplete it must be supplemented by an implicit or explicit social contract. [Arrow 1972 357]

The information requirements for and transactions costs involved in implicit and explicit contract enforcement are typically different so that the two should best be thought of as complements rather than substitutes. The problem in the economies in transition was that both enforcement mechanisms were weak: .... Thus even if institutions did not need to be created the very process of transition provides impediments to the workings of a market economy.


Arrow, Hirschman [1992] Putnam [1993] Fukuyama [1995] and others have argued that the success of a market economy cannot be understood in terms of narrow economic incentives: norms social institutions social capital and trust play critical roles. It is this implicit social contract necessary to a market society that cannot be simply legislated decreed or installed by a reform government. ... One of the most difficult parts of a transformation such as the transition from socialism to a market economy is the transformation of the old "implicit social contract" to a new one. If "reformers" simply destroy the old norms and constraints in order to "clean the slate" without allowing for the time-consuming processes of reconstructing new norms then the new legislated institutions may well not take hold. ...

One variation on this theme is to blame the failure of the shock therapy reforms on corruption and rent-seeking at every turn (e.g. Aslund 1999 this conference). But while rent seeking and corruption were important there was more to the failure than that... The social and organizational capital needed for the transition cannot be legislated decreed or in some other way imposed from above.  People need to take an active and constructive role in their self-transformation;...

In market economies firms may be seen as local non-market solutions to collective action problems where transaction costs inhibit coordination by market contracts [Coase 1937]. In the new post-socialist market economies as in the established market economies the primary example of extensive (i.e. beyond the family) social cooperation in daily life is found in the workplace. Thus entrepreneurial efforts that arise out of or spin off from existing enterprises may be particularly effective in post-socialist societies in preserving "lumps" of social and organizational capital. Once dissipated organizational capital is hard to reassemble particularly in environments with little entrepreneurial experience. ...


The Post-Socialist Separation of
Ownership and Control


In retrospect one of the remarkable features of the body of western advice given to post-socialist economies ("Washington Consensus") especially as they approached the issue of privatization (see above) is the absence of attention to the separation of ownership and control. The intellectual framework often seems to be a curious pre-Berle-Means  world where "private ownership" and control of the enterprise are essentially the same thing—as if the small or medium-sized closely-held corporation was the norm. Yet the salient feature of the large companies in the Anglo-American economies has been what Berle and Means called the "separation of ownership and control." Keynes even earlier made the same point.

One of the most interesting and unnoticed developments of recent decades [written in 1926] has been the tendency of big enterprise to socialize itself. A point arrives in the growth of a big institution—particularly a big railroad or big public utility enterprise but also a big bank or a big insurance company—at which the owners of the capital i.e. the shareholders are almost entirely dissociated from the management with the result that the direct personal interest of the latter in the making of the great profit becomes quite secondary. [Keynes 1963 314]

The divergence of interests between the managers and shareholders in large publicly-traded corporations has been a major source of the economics of agency contracts. Yet the hard lessons of the separation of ownership and control and the resulting agency problems have received insufficient attention in the standard western advice in spite of much discussion of "the corporate governance problem." Let me give you a few examples of "fine phrases."


"Clearly Defined Private Property Rights"


Instead of trying to control managers in state-owned companies with better incentive contracts the standard advice is to privatize and let "private property rights" provide the natural incentives—"like in the West." Yet the separation of ownership and control in large western companies means that the control function is not allocated on the basis of "clearly defined private property rights." The ownership of shares like the ownership of bonds is indeed clearly defined; the shareholder can buy sell or hold those rights. But those rights do not "add up" to a real ownership-based control of the company when the shareholders are atomized and dispersed. One way to express this point is to recognize that the management of a publicly held company with disperse ownership is a public good  ... Another way of putting the same point is that the market for managers...is highly imperfect and does not in general ensure that the company will be managed by those who will ensure that the assets yield the highest returns.


"Controlling Private Owner"


When the problems of dispersed shareholding were recognized in operating companies then the suggested solution was usually to have a "controlling private owner" in the form of an investment fund—as in the standard form of voucher privatization promoted by the Washington Consensus and modeled essentially on the Czech voucher privatization program. One obvious problem with this "solution" is that the voucher investment funds had an even greater "corporate governance" problem than the companies in their portfolio. The funds' shares were held by a broad cross-section of the entire population of citizens. Thus the shareholders' influence on the fund management was essentially nil. Yet the controlling investment fund idea was "sold" by the standard Washington Consensus as a "solution" (rather than a worsening) of the corporate governance problem.


"Natural Incentives of Private Ownership"


In economics as in politics it is a good idea to "follow the money." Who has the economic interests ("cashflow rights") normally associated with corporate ownership? The standard theory is that the economic interests are attached to share ownership. .... But when there is a separation of ownership and control then the controlling agent is partly or almost wholly disconnected from those "natural incentives of ownership."...

An actual case is ... the Czech voucher privatization scheme. The voucher investment funds were limited to at most a 20% stake in a portfolio company and the funds were controlled by fund management companies receiving 2% of the asset value under management. That fund management company's economic interest in the portfolio company is 0.4 % (20% x 2%). ... Moreover these returns are gross to the fund manager. ...

Let me ask you. If you had control of an economic asset but could only extract say 0.9% through a certain channel would you tend to use that channel or to find a more "efficient" channel for extracting value? At least in retrospect no one should be surprised that the Czech investment funds found other channels to extract or "tunnel" value out of the portfolio companies. ...


"Better Management Contracts"


It will be said perhaps the answer lies with better regulations and well-designed incentive contracts for the controlling fund managers. But let us now step back and take stock. If a government had such incredible monitoring and enforcement powers to overcome such disincentives why not apply those powers directly in corporatized state-owned enterprises and then privatize later in a better thought-out way?

One of the main points of "privatization" was to use the "natural incentives of private ownership" instead of the more contrived incentives of management contracts (e.g. in SOEs). Yet we have come full circle. We have seen that the rapid privatization schemes promoted by the standard western advice (voucher privatization with investment funds) did not establish or lead to controlling owners motivated to restructure enterprises towards long-term economic success.

The current advice has ended up focusing on better regulations and management contracts to try to get those in control (e.g. the Czech fund management companies) to act like "private owners"—since the standard form of privatization didn't do that job. It is time to rethink that "standard" type of privatization.


Reducing Agency Chains:
Stakeholder Privatization


A modern market economy is based on highly developed agency relationships. One of the most important ways in which real economies diverge from textbook models is in the problems of asymmetric information imperfect monitoring and opportunistic behavior. Accordingly some of the most important economic institutions arise to alleviate agency problems .... In the more stable and developed market economies long multi-stage chains of agency relationships have developed (e.g. workers are agents for managers who are agents for shareholders such as mutual funds whose shares are held by pension funds which act as agents for their beneficiaries such as workers). But in earlier stages of development market economies had much shorter agency chains.

These agency institutions need to incrementally grow and evolve over decades. If one tries to just set up a market economy overnight with such extended and concatenated agency relationships then the superstructure may collapse in dysfunction. That is what has happened in Russia and the former Soviet Union. ...

That is why it is time to rethink the elaborate agency chains we have been trying to "install" in the former Soviet Union. Think for a moment why we condemn oligarchs and managers for asset stripping and looting that leads to the demise of an enterprise. One might say that they are within their legal rights as shareholders. Yet we nonetheless condemn them because of the direct impact on the livelihoods of workers and indirect impact on the economic life of the local community and on the prospects for related parties such as suppliers and customers. By bringing in the interests of these other parties in evaluating the looting we are in effect identifying these other parties as stakeholders in the enterprise. The stakeholders all have implicit contracts signifying long term relationships with the enterprise. ...

If the pyramided agency relationships are not functioning a... then perhaps it is best to shorten the relationships so that those who are monitoring are the ultimate stakeholders who are hurt by the looting and malfeasance. ...  In general we might reason that the shorter the agency chain the easier it is to resolve the corporate governance problem.

This is a strategy of privatization to stakeholders which could be seen as a way to generalize the owner-operated business or family farm to medium-sized and larger firms... Since the stakeholders by definition have a long-term economic relationship to the enterprise they have broader interests in the firm and another channel through which to exert their corporate governance on the management. ...

This general strategy would push towards decentralization. The idea is to push decision-making responsibility down to the levels where people can more directly control their agents or where peer-monitoring can operate—without presupposing the elaborate institutions of monitoring and enforcement that will take many years to develop. ....


Restructuring and Bankruptcy


Industrial restructuring to improve competitiveness has proven one of the most difficult and intractable parts of the transition process. Hopes that privatization would lead to restructuring "by the market" have been widely disappointed. .... But part of the blame should also be assigned to a failure to understand the nature of the restructuring process in the context of economies in transition.

One fundamental error ... is a failure to distinguish between what is required in the case of restructuring a single firm within a well functioning market economy and restructuring virtually an entire economy or at least the manufacturing sector of an economy. .... When a single firm is restructured ... firing underemployed workers has beneficial effects partly because those workers get quickly redeployed to more productive uses. When however there already is massive unemployment firing workers moves them for a situation of underemployment to no employment...

...  finance under the socialist regime played a completely different role. Banks did not have the job of screening and monitoring. A high debt-equity ratio—leading a firm to a situation where it could not meet its obligations—thus had no informational value; ...

By the same token when there is systemic bankruptcy selling off assets may make little sense: who is there to buy them? And even when it is possible that some firm could more effectively utilize the asset if capital market imperfections are rampant...it may not find it possible to obtain the funds to purchase the asset. ...


Restructuring through Decentralization Reconstitution and Recombination


There was a form of restructuring that was important...and that is restructuring to decentralize decision-making.  Decentralization means vertically and/or horizontally dis-integrating a large firm into separate semi-autonomous teams or profit centers within a federal structure  —or perhaps a split into more independent business units (e.g. spin-offs which could be confederated and/or partly owned by the mother firm).

Decentralization can improve incentives (by linking actions of individuals and smaller units to rewards) and accountability and harden budget constraints—eliminating the cross subsidies that often exist in large organizations.

New managers are needed in the decentralized parts. This devolution is the hardest part of the process since it entails the central management giving up a good part of its power to the decentralized or spun off units under younger middle managers. Yet it is key. Restructuring for a market economy entails a sea-change away from the strategy of keeping or conglomerating together the largest units possible to be more successful in lobbying for subsidies. ...

One can argue that it is best if the pressure for the center to cede power to the decentralized units to begin the process of re-constitution come from the constituent stakeholders ...

... much of the relevant knowledge is in fact decentralized; that the well recognized failures of central planning—having at least in part to do with the inability of the central planner to gather and disseminate relevant information—can apply with equal force within a large organization; and that simply calling the organization a "firm" does not by itself provide the constituent parts with incentives to transmit information to the center nor does it endow the "firm" with the ability to process that information nor does it provide a clear mechanism for the central headquarters to convey instructions to its constituent parts nor does it provide the incentives for those parts (and the individuals within them) to respond in the desired manner....

Thus decentralization along with the benchmarking and outside competition ... could be seen as social learning mechanisms to drive the process of recombination and restructuring. ....

We have so far illustrated the general model of restructuring through decentralization reconstitution and recombination by applying it to a large and presumably distressed firm. The model helps to explain why successful restructuring is so rare in post-socialist countries (as well as elsewhere). The center refuses to decentralize power to start the new process of learning and reconstitution. The center clings to the hope that some new master restructuring plan (coupled no doubt with "new machinery" as a technological fix) will solve the problem. ...


Part II:
Misunderstandings of
the Reform Process


Early in the decade there was much discussion about the proper pacing and sequencing of reforms in the transition economies. In both cases political and economic considerations were invoked to justify alternative strategies. ... traditional economic theory has even less to say about the dynamics of transition than it has to say about equilibrium states; and yet it was issues of dynamics of transition that were central to the debate over pacing and


Sequencing and Pacing of Reforms


There was always the facile recommendation that "everything is important" and "everything should be done at once." But real choices are always necessary given the real limitations on any government's time focus and resources. One of the theories was to start with the "low hanging fruit"—the easy pieces—to build up the momentum of reform before taking on the harder pieces. ...


... The particular context in which I will look at the issue of sequencing is privatization. There were three different perspectives: (a) Proceed with privatization as fast as one can; it is more important that privatization occurs than how it occurs; (b) Proceed with privatization as soon as one has put into place an appropriate framework for privatization itself but do not wait for an appropriate legal structure including a regulatory and competition framework to be in place (since government failure is much more important than market failure); and (c) Only proceed with full privatization when there is the appropriate legal framework in place.

There were in fact arguments put forward in favor of each of these strategies. Consider the first approach. Underlying it was the Coasian idea that the initial private owners didn't matter too much as "the market" would soon reallocate the assets to the efficient owners. One of the strong arguments for rapid privatization was that it would create powerful political forces that would move forward the broader agenda of economic reform. Fearing a reversion to a Communist state one needed not only to lock up what successes one could but to create a political force in favor of the market economy. Still another argument was that waiting until a legal structure was in place would result in long delays. Privatization at least in a formal sense can be done quickly while it will take years to build up the regulatory framework for competition and the legal system to enforce it. One needed to "grab" the low hanging fruit "take advantage of the window of opportunity" in every way that one could.


In contrast ... is the view that reforms have strong complementarities. Privatization is no great achievement—it can occur whenever one wants—if only by giving away property to one's friends. Achieving a private competitive market economy on the other hand is a great achievement but this requires an institutional framework a set of credible and enforced laws and regulations. Do this and the larger politically-sensitive privatizations can be attended to when the needed institutional infrastructure was ready while in the meantime stakeholder-oriented privatization of small and medium-sized firms (which have less potential for abuse and require simpler regulatory structures) could go forward apace.

Those who worried about the sequencing and pacing of reforms were also concerned that without the appropriate reform strategy the likelihood of success was limited; and a failure of reform could indeed undermine its sustainability. Success rather than speed was of the essence. Indeed failures could be reinforcing: if reforms were not viewed to be sustainable then investors would not have an incentive to make the long term commitments required for growth; one could get caught in a low level equilibrium trap. Successful transition strategies had to have the property of time consistency including political sustainability.


What have we learned? Some of the most telling lessons relate to the political process itself. One of the problems in the theory is that the interest groups do not sit still in the midst of the reform process. And the reform can create new political forces. The early reforms the "low hanging fruit " can—and in many cases did-- create new interest groups often associated with the "reformers " that would then add their decisive weight to block the later reforms. Several examples might be cited.

· It is not doubt easier to start the process of privatizing banks by privatizing the early ones to domestic groups. The new domestic private banks would then be able to stabilize themselves before allowing foreign competition by selling other banks to foreigners or by allowing direct entry of foreign banks. The problem in the strategy is that the private groups owning the first privatized banks will use their political clout to prevent the foreign sales or entry.


· Many countries in effect adopted the policy to "privatize now regulate later." Here again the early privatizations into an essentially unregulated environment created a strong vested interest to block the later attempts at regulation in the case of natural monopolies or to create a competitive market in the case of those industries where competition was viable. While privatization was supposed to "tame" political intrusion in market processes privatization provided an additional instrument by which special interests and political powers could maintain their power. ...

The Coasian argument that there would quickly be a reallocation of assets to "efficient" producers failed in part because there was no genuine secondary market for the same reasons that there was no real primary market—so the assets were more "looted" than resold.

But there was a further problem in the "Coasian" approach. It is not only important for sustainability that property rights are clarified but how they are clarified. Suppose there are several parties with ill-defined claims on "pieces of a pie." One strategy would be assign "clear property rights" to some party (probably on political grounds) and then let them trade. But the other parties would probably reject the assignment and sabotage the "solution." .....


The Grabbing Hand of the State; the Velvet Glove of Privatization


One of the theories that promotes privatization independently of a competitive or even regulated environment is the "grabbing hand" theory of the government. The state is seen as the primary source of the problems: interfering in state firms and preying on private firms. The emphasis is on government failure not market failure. Privatization of enterprises and depoliticization of economic life are the overarching policy goals.

The architects of the Russian privatization were aware of the dangers of poor enforcement of property rights. Yet because of the emphasis on politics the reformers predicted that institutions would follow private property rather than the other way around. [Shleifer and Vishny 1998 11]

Not only were regulatory and corporate governance institutions supposed to arise on their own account but the proponents of this theory even saw it actually happening in Russia. "Institutions supporting corporate governance such as the banking sector and capital markets are also developing rapidly in part because of the profit opportunities made available by the privatized firms." [Shleifer and Vishny 1998 254 note 4]


Historians may well wonder how the programs implemented by the architects of the Russian privatization could have led to the present system of economic oligarchy and disorganization. The grabbing hand theory sees the state as being irredeemably corrupt—while the private sector is viewed through rose-colored glasses. Yet the resulting program of transferring assets to the private sector without regulatory safeguards ("depoliticization") has only succeeded in putting the "grabbing hand" into the "velvet glove" of privatization. The "grabbing hand" keeps on grabbing with even less hope of public restraint. The rapid liberalization of capital accounts allowed the aforementioned "banking sector" to spirit tens of billions of dollars of loot out of Russia each year while the architects of capital account liberalization negotiated more billions of international debt. ...

Clothing the grabbing hand in a velvet glove does not solve the underlying problem of irresponsible power public or private. That is why I have urged a strategy of decentralization to push power down to the levels where people can use local institutions (e.g. enterprises associations unions and local governments) to protect their own interests and marshal their resources to incrementally rebuild functioning institutions on a broader scale.

This brings us to the larger debate about the methods and pace of institutional change.


The Modern Debate:
Shock Therapy versus Incrementalism


The standard western advice such as what I have called the "Washington consensus " took what Hirschman [1973 248] called an ideological fundamental and root-and-branch approach to reform as opposed to an incremental remedial piecemeal and adaptive approach. I have no great quarrel with "shock therapy" as a measure to quickly reset expectations say in an anti-inflation program. The controversy was more about the attempted use of a shock therapy approach to "install" institutions—where it might more aptly be called a "blitzkrieg" approach.

Historically the shock therapy approach to changing institutions is associated with Jacobinism in the French Revolution and (ironically) with Bolshevism in the Russian Revolution. There is an "Austrian" tradition of criticism of the Jacobin-Bolshevik approach to institutional change. Karl Popper's criticism [1962] of utopian social engineering and Friedrich Hayek's critique [1979] of the Jacobinic ambitions of scientism gave this tradition its modern Austrian flavor but the roots go back at least to Edmund Burke's [1937 (1790)] attack on Jacobinism in the French Revolution. Peter Murrell [1992] has explicitly used that tradition in his critique of the shock therapy approach. ...

... One deeper origin of what became known as the "shock therapy" approach to the transition was moral fervor and triumphialism left over from the Cold War. Some economic cold-warriors seem to have seen themselves on a mission to level the "evil" institutions of communism and to socially engineer in their place (using the right textbooks this time) the new clean and pure "textbook institutions" of a private property market economy. .... Since for better or for worse much of the "great debate" has been carried on in metaphorical terms I will summarize the "battle of the metaphors" in the following table 1.


Table 1: "Battle of Metaphors"

  Shock Therapy Incrementalism
Continuity vs. Break

Discontinuous break or shock—razing the old social structure in order to build the new.

Continuous change—trying to preserve social capital that cannot be easily reconstructed.

Role of Initial Conditions

The first-best socially engineered solution that is not "distorted" by the initial conditions.

Piecemeal changes (continuous improvements) taking into account initial conditions.

Role of Knowledge

Emphasizes explicit or technical knowledge of end-state blueprint.

Emphasizes local practical knowledge that only yields local predictability and does not apply to large or global changes.

Knowledge Attitude

Knowing what you are doing.

Knowing that you don't know what you are doing.41

Chasm Metaphor

Jump across the chasm in one leap.

Build a bridge across the chasm.

Repairing the Ship Metaphor

Rebuilding the ship in dry dock. The dry dock provides the Archimedian point outside the water so the ship can be rebuilt without being disturbed by the conditions at sea.

Repairing the ship at sea. There is no "dry dock" or Archimedian fulcrum for changing social institutions from outside of society. Change always starts with the given historical institutions.

Transplanting the Tree Metaphor

All at once transplantation in a decisive manner to seize the benefits and get over the shock as quickly as possible.

Preparing and wrapping the major roots one at a time (nemawashi) to prevent shock to the whole system and improve chances of successful transplantation. 42


The Chinese were not historically immune to this mentality but they seem to have "got it out of their system" in the Great Leap Forward and the Cultural Revolution. They learned the hard way where that Bolshevik mentality would lead. When they came to choose a path to a market economy they chose the path of incrementalism (crossing the river by groping for the stones one at a time ) and non-ideological pragmatism (the question is not whether the cat is black or white but whether or not it catches the mice). They had the wisdom to "know they didn't know what they were doing" so they didn't jump off a cliff after being assured by experts that they would be jumping over the chasm in just one more great leap forward.

In contrast the Russians have tended towards a more Jacobinic reform regime guided by prophets armed with clean textbook models. They have learned the hard way to appreciate the old saying: "It's not so much what you don't know that can hurt you—but what you know that ain't so."


The CDF and The Presumption for Participation


What is the alternative strategy for change? As social and organizational capital turns out to be so fragile and like Humpty-Dumpty "hard to put back together again " one can argue that it is best to start with existing social institutions and try to induce their incremental transformation—rather than trying to eliminate them "root-and-branch" in order to start with "a clean sheet of paper."....

Why were the reformers so unwilling to start from where they were? Perhaps the simplest explanation is that the post-Soviet reformers saw anything that grew organically out of Soviet or Russian reform attempts as still bearing the stigma of communism. They wanted to make a clean break by using the "window of opportunity" to jump over the abyss to an "advanced model" like in the western textbooks.

We should be clear: there were risks everywhere. The critics of gradual reform worried that the forces at play—the old vested interests—would somehow manage to reassert themselves unless their power was broken. They worried too that the momentum—and the people’s taste—for change was limited and one had to seize the opportunity while one could. Alternatively there is a long history of gridlock in democratic societies and for a society in desperate need for change such gridlock too would prove disastrous.


Perhaps nowhere did these conflicting fears and anxieties play out so much as in the debate over stake-holder (local) privatization sometimes referred to as “spontaneous” privatization. The term spontaneous might have suggested a natural evolutionary process; a Hayekian might have seen these privatizations as a natural (efficient?) social response to the unfettering of central controls. For decades prior to the actual collapse of communism in 1989-90 reformers had worked in East Europe and in the Soviet Union itself to decentralize power away from the state. Various models of decentralized socialism were promoted starting in Yugoslavia in the early 50's and eventually in many of the countries within the Soviet bloc to a lesser degree. In the late 80's the "destatization" and decentralization spread to the Soviet Union. Some measures of independence and "self-accounting" were extended to state enterprises. New ownership forms such as cooperatives and collective ownership by work collectives were legalized. "The Law on Leasing set up a legal basis for gradual evolution of state ownership: work collectives could now lease enterprises from the state and run them as more or less private entities according to the market logic." [Plekhanov 1995 38]

These ownership forms were not imposed on managers and workers by the state. They represented the results of experimentation and collective efforts to wrench more control over their lives from the state. By the beginning of 1992 some ten thousand enterprises had become leasehold enterprises. Reformers who recognize that real transformation requires participation and involvement would have welcomed this reform momentum and would have helped it push all the way to full privatization. Yet the western-oriented reformers took the opposite course. In Russia the leasing movement was stopped dead in its tracks in favor of voucher privatization. Throughout the countries of the former Soviet Union official announcements emphasized that voucher privatization was necessary to speed up the process— while there were unofficial and private admissions that the leasing movement had to be stopped in order to have something left to go into the voucher auctions....




I remarked at the beginning of this paper that the century coming to a close has been marked by two great economic experiments. The outcome of the first—the socialist/communist experiment that dominated much of the world scene during the century—is now virtually over and the lessons from that experiment appear clear.

We are in the midst of the second great experiment—the transition from the socialist/communist economies to a market economy. That experiment has not proceeded in the way that many economists had predicted a short decade ago. To be sure the process of transition is far from over. But it has not been an easy decade for most of the countries and even China with all of its successes faces hard challenges ahead. Russia is a resource rich country with enormous potential. We know that for societies to function the State must provide a certain basic minimal level of services and that it takes resources to provide those services. In all societies taxes are collected only because governments enforce tax laws through the right to seize property in the event of a failure to comply. Russia and the other countries must show a resolve to enforce the tax laws and to provide the basic services of the State. With compliance government revenue problems will be resolved—and in doing so one of the main challenges facing the countries would be effectively addressed. Without compliance having through bankruptcy and other legal means taken control of assets previously privatized the governments would face a new opportunity to address some of the key issues e.g. associated with privatization once again. Hopefully this time those issues would be faced with a better understanding of the broader principles of the market economy and the reform process. Hopefully the countries—and their advisors—will have learned from the many bitter and disappointing failures—and the few successes—of the past decade.


100 % = 1989













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