Eastern Europe in Transition

Oldrich Kyn

INTRODUCTION

It has been said many times that the fall of communism in 1989 came to many as a big surprise. It was a surprise even to most experts on Soviet and East European politics and economics. What was really surprising - at least to me - was not just the fall of communism but the relatively peaceful way that the communists gave up power in most of the Soviet Union and Eastern Europe. Of course, Bosnia and Chechnya keep us aware that there were exceptions to this dictum.

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. Second, once we were finally convinced that the East European peoples had departed once and for all from that period of their history, they started to re­elect the former communists to power. Finally, at the same time as the arguments about the merits and weaknesses of shock therapy and privatization reached a climax, almost all the East European countries resumed economic growth irrespective of the strategy that they actually adopted.

All these surprises suggest that we may have misunderstood or misinterpreted the historical circumstances and conditions and that some reconsideration of conventional wisdom may be due. 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.

WHY COLLAPSE?

The first question which comes to my mind is 'Why did communism collapse?' This question was rarely asked, perhaps because the collapse and its abrupt arrival appeared ex post inevitable. The answer to this question may hold important clues for the understanding of the bewildering developments in today's Eastern Europe. Let me state three - not necessarily exclusive - hypotheses about the possible reasons for collapse.

The next set of hypotheses relates to the difficulties of economic transformation.

Several if not all of the B hypotheses may actually be valid at the same time. The point is not to accept or reject any of them but rather to show how much and in what time frame each of them contributed to the perils of transition. This knowledge is relevant especially for judging the appropriateness of various transformation strategies. The problem is, of course, that it might be impossible to separate the effect of the factors mentioned from the effect of the strategy itself. The hypothesis B7 states that wrongly chosen strategies may have been a significant cause of the economic decline during transition. This could also explain why different countries did not suffer equally. It is quite obvious that no country escaped a significant decline in GDP and industrial production, increase of unemployment and at least a temporary surge of inflation. It is, however, equally clear that the extent of these setbacks was quite different in different countries. For example the estimated fall in GDP amounted only to 20-25 per cent in Visegrad countries (Poland, the Czech Republic, Slovakia, Hungary) and Slovenia, while it reached 40-60 per cent in other East European countries and the successor states of the former Soviet Union. Even larger differences have been observed in rates of inflation and unemployment. Are these disparities owing primarily to different strategies used or do they have some other causes? Three additional hypotheses can be formulated to explain the differences mentioned.

Let us now look more closely at the individual hypotheses. The first hypothesis A1 corresponds to the old views of von Mises and Hayek. It had little support after World War II but became quite popular again after 1989. It is probably true, although I am not sure whether it can ever be proved independently of hypothesis A2. Maybe the centrally planned command economy could actually work if completely isolated from capitalism on some remote planet preferably outside the Solar system. It seems clear, however, that it has not been able to keep up in competition with the vigorous dynamics of capitalist economies as postulated by hypothesis A2. Of course, this is my personal view which is perhaps shared by some of my colleagues but other people may have different belief about the validity of these hypotheses.

For example Michael Ellman clearly rejected A1 when he wrote: 'it seems to me wrong to place the blame for the collapse on the system exclusively. In an earlier period, the system was quite compatible with rapid economic progress. I see the collapse of the Soviet economic system at the end of the 1980s as a contingent phenomenon, resulting from the interaction of the system, the economic policies pursued, and the domestic and international environment in which it found itself' (Ellman, 1993, p. 2). He then vehemently supports hypothesis A2: 'The former Soviet system collapsed, in my opinion, because of its inability to compete successfully with the OECD countries and because of the response of its leadership to this failure. The crucial spheres of this competition concerned personal consumption and technical progress' (Ellman, 1993, p. 3).

Grzegorz Kolodko also rejected A1: 'one should not oversimplify the conclusion drawn from the historical experience of the CPEs. It is not true, as recently and quite often suggested, that under a centrally planned economy allocation of resources was always inefficient and investment was largely wasted . . . One cannot negate the fact, that in several cases . . . the CPEs exercised firm economic growth' (Kolodko, 1993, pp. 44-5). He then seems to suggest that what appeared to be the economic collapse of communism, may have been - at least partly - explainable by cyclical fluctuations in rates of economic growth and by external shocks: 'During 40 years of their history there were some sort of growth cycles . . . For a more recent period, however, . . . the picture is less bright. The condition has clearly deteriorated in almost all CPEs . . . due mainly to the CPEs' lack of proper adjustment to the supply shocks of the 1970s' (Kolodko, 1993, p. 45). If I read it correctly Kolodko implies that the system might have not collapsed if it could only have been isolated from external shocks.

SYSTEM DESIGN

The relative inefficiency of the Soviet-type system has been documented many times. One of the striking pieces of evidence - quoted in Niels Mygind's chapter - is the finding (Dellebrant, 1992) that Estonia and Finland were at about the same level in 1940 and that in 1990 Estonia had only around 40 per cent of Finland's GDP.

The question about the causes of the collapse of communism is closely related to another question, namely why the capitalist market economy proved to be more efficient and dynamic than the centrally planned command economy. There are several and again not necessarily mutually exclusive answers.

Depending on their perceptions of these causes, different people may regard different target systems and different transitional strategies as desirable.

The important questions to decide are:

Answers to these questions may be important for understanding the motives of post-communist politicians. Do they aim for the free capitalist market economy based on private property and minimal government intervention, or for some kind of third way 'social market economy' with government 'guiding' the market by enforcing strong social policies and possibly maintaining a large chunk of the economy in state ownership? The reluctance to liberalize markets rapidly and to privatize state­owned firms may be an indication of the latter position.

THE THIRD WAY

Probably only a minority believes today in hypothesis A3. Hardly anybody would openly ask for the restoration of Soviet-type communism, but some may still believe that market socialism or some kind of the 'third way' rather than the return to capitalism should be the target.

Immediately after the 'Velvet Revolution' in 1989, Ota Sik, the father of the 'Third Way' concept, returned to Prague with the hope of implementing his ideas there. According to his own description (Sik, 1990), the target system was not to be much different from some versions of Western capitalism. Markets for goods, labour and capital were supposed to be almost completely free and government was supposed to avoid discretionary interventions as much as possible. The main role of the government was to set the institutional framework for the economy and to use the tools of economic policy for achieving social goals. Sik did say, though, that he favoured some forms of 'macroeconomic programming'. Some remnants of socialism would be encountered in combining various forms of property rights: private, cooperative, state and employee co-ownership in private firms. Employees would be able to participate in management and profits. Sik claimed that such a system - he was not sure whether to call it socialist or not - would guarantee full employment, economic efficiency and elimination of the conflicts between labour and capital. But even that was too much for the post­communist generation.

They refused to listen to him and set the country on the path leading directly to a highly liberal form of capitalism. Their idea is succinctly summarized in the following recent statement of Vaclav Klaus:

The fashionable ideologies of the fifties and sixties suggesting the crucial role of governments, state ownership, planning, development agencies and development aid are over. The old utopian dreams of social engineering are forgotten and it has been more and more accepted that everything starts with an individual human being, with his or her behavior and activity, with free markets, private property, and private initiative. The collapse of communism gave a final blow to the previous etatist thinking (Klaus, 1995).

Mario Nuti believed that market socialism was feasible and would have been an improvement over the traditional Soviet-type system. He blamed communist politicians for their inability to implement the appropriate reforms:

speculation about a possible alternative model of "market socialism" - a "Third Way" - is a purely intellectual exercise . . . It cannot possibly involve claims to superiority over the capitalist system but it might well have been an improvement over the half measures taken in the name of reform. However, market socialism today cannot be regarded as a blueprint for action in Central Eastern Europe: obtuse procrastination on the part of past and present socialist leaders . . . has made it impossible for anything but a version of capitalism to be the target model for Central Eastern European countries: when a boat is sinking, it is no time to experiment with the floating properties of alternative rafts (Nuti, 1992, pp. 19-20).

Historical developments also forced John Roemer to revise considerably his idea of market socialism. It now differs from pure capitalism mostly by using 'coupons' to simulate popular ownership of capital.

My intent is to propose an economic mechanism that differs quite modestly from the successful capitalist market economies: a lesson of the Bolshevik experience is that one is ill-advised to redesign too many moving parts in a complex machine at the same time. . . . The market socialism that I have outlined is a pale shadow of what Marx thought possible, or of the Bolsheviks' utopian dream. It is a society in which many of the conflicts of capitalist society would remain (Roemer, 1993, pp. 105-06).

Niels Mygind pointed to the importance of a 'value system'. He is certainly right about that, but he also seemed to imply that people of Eastern Europe with histories, cultures and value systems different from the West should aim for target systems that are more akin to them, that is for systems that presumably lie somewhere in between the decentralized individualist capitalism of the West and the former centralized collectivist system of the East. I disagree. What is here perceived as the value system of East Europeans may have been just the value system of their rulers. In a totalitarian society it is impossible to determine what people really want, because their will cannot be manifested, and because they are subjected to intense ideological manipulation. But let us admit that people - whether this was their 'natural' preference or not - actually embraced the collectivist values imposed on them by past propaganda. Does it mean that some mix of market and planning will be better suited for them than the pure market economy? I do not think so. I doubt that any combination of (command) planning and market forces is appropriate. Certainly, market systems have had variations relating to diverse cultures and historical traditions; however, not all of these variants were equally efficient. Any large interventions by the government that severely restricted or deformed private property rights, free pricing and competition always resulted in reduced performance by the market system. It is a misconception to believe that owing to different cultures and historical traditions the optimal arrangements of, for example, Asian markets should be substantially different from the optimal arrangements of European or American markets. Similarly, it is bad advice to tell East Europeans that because of their values and traditions they should preserve a higher degree of planning and collectivism in their economic system.

The preference for a 'third way' solution is even more visible in the chapter by Hans Aage. He pleads for a partial retention of state ownership and claims that 'the requirements of restructuring are so overwhelming that they can hardly be fulfilled by the invisible hand of the market, unless it receives some badly needed assistance from a firm and visible government policy'. How does Aage support this position? First, he says that 'a well functioning market economy . . . is not an original, natural state of economic life' and that 'it requires a complex system of legal, political and social structures that took five centuries to establish in Western Europe, and a further 200 years to establish a civilized, socially acceptable system'. Second, he says that high taxation restricts private property rights anyway: 'a 50 per cent profits tax that has full loss offset corresponds to a 50 per cent state ownership concerning the right to income. A tax on capital gains is similarly the equivalent of state ownership of part of the right to the capital value.' Third, he brings forward a frequently repeated example of some Asian growth economies (Japan, South Korea, China) that used 'comprehensive state intervention' to achieve fast growth. Fourth, he mentions the case of some Polish state enterprises that were reported to improve their efficiency during transition. Finally, he suggests that 'there is growing scepticism, for both theoretical and empirical reasons, towards unregulated market forces and trade liberalization.'

I am not impressed. Should we believe with Aage that because the East European countries missed seven centuries of the development of market institutions they would be better off retaining some state ownership? This is ridiculous. Eastern Europe missed at most 50 years of those seven centuries (70 years in the case of the former Soviet Union), and the economic implications of the difference between private and state ownership goes far beyond the 'taxation equivalence'. The crucial thing is who makes decisions. It is true that 50 per cent taxation restricts private property rights somewhat, but the decisions are still made by owners and managers of private firms. If state ownership were to be retained, decisions would remain in the hands of state bureaucrats who would most likely continue to produce negative value added. It may be true that under the pressure of hard budget constraints some managers of state­owned enterprises began to behave in a more business-like manner, but there is also plenty of evidence to the contrary. In any case managers of state enterprises would probably need strong guarantees that their enterprise would not be privatized in the foreseeable future to prevent the 'pre-privatization malaise'. Pavel Pelikan showed in his chapter quite well why China may not be a good model for Eastern Europe. I want to add just one point here: political freedom and democracy were among the main goals of the recent revolutions of East European people. I do not think they would welcome our suggestion that in a Chinese manner they should postpone the achievement of these two goals until after the economic transition was accomplished in a well­organized way under the firm hand of the government.

Michael Intriligator came out with another version of 'historical tradition' and 'third way' solution. Not unlike Ellman or Kolodko, he believes that Soviet planning played a positive role at low levels of development and became a burden only in recent years. 'Thus, one must give at least some credit to central planning, which, despite its well-known deficiencies and excesses, "worked" in the Soviet context.' He also makes a reference to the controversial view of Dyachenko that 'the need for central planning is inversely proportional to the level of development'. Intriligator believes that sudden liberalization and privatization is a bad policy. At least for the foreseeable future, the goal should have been not a laissez­faire system, but a mixed economy with strong activist government that would concentrate on institution building and reorganization of the economy. The inefficient state­owned gigantic firms should not have been privatized but rather either left to wither away or to be privatized at some future date, when their efficiency improved. The new efficient enterprises should be created by state, local administrations, investment banks, foreign firms and international organizations.

        B #############

Now I move to the B hypotheses. Again, 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 ROAD TO ECONOMIC GROWTH

When the Iron Curtain was raised, and people were allowed to travel more freely, they immediately noticed the significantly higher standards of material consumption in Western Europe. Naturally they attributed the discrepancy to the higher efficiency of the market system and believed that the transition to a market economy would allow them to attain Western consumption standards. As Niels Mygind puts it: 'some people in the euphoria of freedom had expected that their country would take a jump into the Western market economy and the Western standard of living'.

In terms of economic theory, this is a question of an efficiency or welfare gain owing to improved allocation of resources. It was presumed that owing to distorted prices and faulty incentives, central planners and firm managers misallocate resources and therefore Pareto optimality could not be reached under a command economy. Transition to the market would remove price distortions and lead to a more efficient allocation of resources. A welfare gain would be noticeable almost immediately.

The variation of the above neoclassical view is represented in the chapter 'Structural Adjustment, Efficiency, and Economic Growth' by Torvaldur Gylfason. Although he analyses the efficiency gains from the liberalization of international trade rather than from the liberalization of the domestic market, the basic logic of the argument is the same. According to his estimates based on 'plausible parameter values', the liberalization of international trade can increase efficiency by 7- 40 per cent. Using the same resources every year, the country's output may be increased by that proportion now and every year thereafter. Gylfason concludes that the present value - at a 5 per cent discount rate - of the infinite stream of increased production amounts to 1.4-8 times the GDP of the country. And this is only the external trade liberalization effect. The effect would be much greater when domestic market liberalization is taken into consideration. But even this is not all. A more efficient market economy would lead a more rapid rate of economic growth increasing even further the present value of future economic gains.

Gylfason's figures of 1.4-8 times GDP look really very impressive. But what does a present value of the future stream of GDP mean? Drawing the parallel with a single firm, it ought to be the market value of its assets. At a 5 per cent discount rate, the present value of the constant annual GDP of size 1 would give us a market value of assets equal to 20. The annual size 1.07 would give 21.4 and the annual size 1.4 would give the asset value 28. We are back to more realistic figures of 7-40 per cent increase of national wealth. This looks more moderate but it is still not what happened in Eastern Europe. GDP has been declining for at least three to four years and the market value of economic assets decreased if anything. This example epitomizes the problems with allocative efficiency hypothesis B1. Neoclassical economics need not be wrong about the allocative efficiency of markets, but Gylfason's type of analysis disregards the cost and the time needed for transformation. Here hypothesis B4 becomes relevant. It is naive to think that the new system can use the same resources and just allocate them more efficiently. Some of the old equipment is so obsolete that it has to be discarded. The restructuring of the economy is costly. People need to be retrained and need time for adjustment. Certainly Gylfason does talk about temporary disequilibriums and a decline of output before 'resources are drawn into more productive employment than before and the decline of aggregate output is gradually reversed'. But he does seems to imply that eventually all the resources will be reallocated into more productive uses. 'Output continues to rise until all profit opportunities have been exploited in full and full employment has been restored at a higher level of output than initially'. He must also be thinking about relatively rapid adjustments, because in his present value calculations, everything happens within the first year.

Let me give a counter­example. Assume a middle case in which the efficiency is permanently increased by 20 per cent. I will use, however, a 10 per cent discount rate to reflect a higher level of risk. (Note that the average stock market risk premium in the USA has been around 9 per cent.) Using Gylfason's approach with an immediate increase of efficiency, we obtain a 20 per cent increase in present value. If we assume more realistically that output will first decline and only later increase, we will achieve a very different picture. For example the time path of output may look as follows: 90 per cent, 70 per cent, 60 per cent, 70 per cent, 80 per cent, 90 per cent, 100 per cent, 110 per cent, 120 per cent, 120 per cent . . . This pattern of transition will give us a decline of present value by 5 per cent. Note that from year nine onwards output is always 20 per cent above the initial state, although the temporary decline in the first three years combined with a high risk premium still results in a 5 per cent decline of the market value of economic assets. Even less favourable results would be obtained if we acknowledged that some of the resources would be lost or expended in transition so that the final increase of output would be less than 20 per cent. Strangely enough this indicates that the transition from command to market economy might never have been accomplished as a private investment venture since it is too costly and too risky. This may explain why the promises of massive financial aid by Western governments never really materialized. As Gunnar Eliasson puts it: 'When the former Soviet empire collapsed, it was believed, quite plausibly that enormous investment resources would be needed to restore run-down communist economies to industrial nations. This massive investment boom would be privately and socially profitable. . . . This scenario has failed to materialize, at least so far.'

The misdiagnosis hypothesis B2 surfaced soon after the data began to show that the popular expectations of quick efficiency gains were not materializing. Probably the most outspoken proponent of this hypothesis was Jeffrey Sachs who in numerous Lectures, discussions and publications claimed that the observed fall of output and real consumption in Poland immediately after the Big Bang in January 1990 was mostly imaginary.

The usual listing of the costs is well known, because it is almost a mantra repeated by reporters and political opponents of the reforms: living standards down by a third, unemployment soaring, and real output down by 30 percent. All of that sounds rather dreadful, but fortunately it reflects an exaggeration of the costs of transformation, rather than real disaster. There has been no significant fall in living standards. Real incomes did not plummet. Unemployment, while high, is not soaring to the levels that were feared. And the lost production reflects the cutbacks in production of enterprises that lack customers, mainly the cutback of Poland's excessively large heavy industrial sector (Sachs, 1993, p. 67).

Sachs cited the inability of official statistical methodology - which was developed for the purposes of central planning - to capture vigorous growth of the small­scale private sector. He also argued that the reported decline of real wages resulted from overestimation of real wage growth in the year preceding Big Bang. 'This alleged drop in living standards was largely illusory, since back in November 1989, Poles faced crippling shortages at the official prices, so that living standards on the eve of reform were much lower than the official statistics had suggested' (Sachs, 1993, p. 62).

Niels Mygind also provides at least partial support for hypothesis B2:

In all Eastern countries in transition, production has fallen sharply in the first years after the start of the transition. This has also been the case for the three Baltic countries. In 1990-92 GDP fell nearly by 40 per cent in all three countries. Part of this fall can be explained by lack of registration of the new growing private activities and under reporting of the results in state­owned firms. The new private firms and some state­owned firms may have an incentive to underreport to avoid taxes. For firms facing privatization the managers might want to give a bad picture of the results, if they have an interest in a low price for the enterprise.

My position is that although the official statistics may have overestimated the extent of decline in output it would be very difficult to argue today that all that decline was in fact compensated by the unrecorded growth of the private sector. It is also indisputable that there was a significant actual and not just imaginary decline in the standard of living of the population in all the countries in transition. The misdiagnosis hypothesis cannot be the main explanation for the observed setbacks.

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 guide in this field.

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).

Similar views reappeared in the 1980s during 'perestroika' in the Soviet Union and other East European countries. They were expressed in slogans of the type: 'You cannot jump over the abyss in two steps'. On the other hand some Soviet economists, for example Shatalin, Zaslavskaya and Gaidar, dismissed the model of centralized hierarchical coordination in favour of a 'bargaining model' (Sutela, 1991, pp. 139-47). The 'bargaining model' is based more on decentralized decisions and lateral communication channels and, therefore, may not appear to be as incompatible with the market mechanism as the centralized command model. 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)

THE ROLE OF INSTITUTIONS

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, p. 9).

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.

The point I tried to make above can be documented by comparing Polish and Czechoslovak privatization schemes. Mutual funds played an important role in both designs. The Polish proposal assumed that government would create and run a small number of large mutual funds through which all the citizens would acquire diversified ownership in the formerly state-run firms. This was a social engineering scheme to be implemented by government bureaucrats from the top. No room was given to the preferences of people and to the initiative of private entrepreneurs. Although originally already developed in 1989 it has not yet been implemented. The Czechoslovak design did not originally involve mutual funds. The laissez­faire rules of the game allowed a rapid spontaneous increase in hundreds of mutual funds, which contributed immensely to the success of the privatization process.

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.

THE BALTIC TRANSITION

Many Western experts judge the success of East European transformation strategy quite differently from Michael Intriligator. This can be documented by the following excerpts from the recent article in The Economist:

The fastest-reforming economies, by the EBRD's and most other reckonings, are to be found in Central Europe. They include Poland, the Czech Republic, Slovakia, Hungary, Slovenia and the Baltic states of Estonia, Latvia and Lithuania. All have the foundations of a market economy securely in place. Poor as the post-communist countries may be, their economies compare promisingly with those of Western Europe. The Czechs, for example, fulfil the Maastricht-treaty criteria for sound public finances better than most present EU members. Despite the economic upheaval, unemployment rates are generally lower than, say, that of Spain . . . If the success of these efforts is far from assured, they do indicate that a watershed has been passed. Across the whole region, the possibility and desirability of creating capitalism has now been accepted, even by the laggards. . . . countries escaping from communism have shown that they can indeed change the economic structure of their societies in as little as three years. What is more, they have done so with little outside help. (The Economist, 3 December 1994)

This evaluation is well complemented by the following two tables: 1) EBRD ranking of the East European countries' progress on the way towards market economy and 2) the dynamics of real GDP in the transition period. The first six columns of Table 11.1 give scores - from 1 (little or no progress) to 4 (a lot of progress) - on essential aspects of the systemic change. The last column is my calculation of the unweighted average of these scores. Table 11.1: Marking to market

LSR PFBA
Czech Rep. 44 33433.5
Poland 34 33433.33
Hungary 34334 33.33
Slovakia 3 433433.33
Estonia 34 33433.33
Slovenia 2 433433.16
Croatia 34234 33.16
Lithuania 34 23423.0
Latvia 23 23432.83
Macedonia 2 423422.83
Kirgizstan 3 423322.83
Romania 2 323422.83
Russia 3 323322.66
Bulgaria 2 223422.5
Albania  132 34 22.5

Note: The meaning of columns: L=Large privatization, S = Small privatization, R = Restructuring of companies, P = Prices, competition, F = Trade - foreign exchange, B = Banks, A = Average. Score: 4 = market economy, 1 = little progress.

Source: European Bank for Reconstruction and Development as published in The Economist, 3 December 1994. Ranking of the remaining countries by average score: 2.16 Moldova, 2 Uzbekistan, 1.83 Armenia, 1.66 Belarus, Kazakhstan, and Tajikistan, 1.33 Azerbaijan, Georgia, and Ukraine, 1.16 Turkmenistan.

Table 11.2: Index of real GDP 1988 = 100

 198919901991 19921993 19941995**
Czech Rep.*101.40 100.9986.65 80.5080.50 82.9287.06
Slovakia*101.40 100.9986.65 80.5077.28 81.1484.39
Poland100.20 88.5882.38 83.2086.53 90.8595.40
Hungary99.80 95.8184.31 80.4378.82 80.4082.81
Slovenia98.20 93.5884.88 79.3680.16 84.1789.22
Estonia103.30 99.1786.28 63.8461.93 65.0368.93
Latvia106.80 109.90100.78 56.4349.66 51.1552.69
Lithuania101.50 96.4383.79 54.4745.75 46.6748.53
Moldova108.80 107.1794.42 74.3067.62 50.7150.71
Romania93.10 86.2174.40 62.9463.57 65.4867.44
Bulgaria98.10 89.1778.74 72.6863.96 49.8946.39
Albania109.80 98.8269.27 63.8770.90 75.8679.65
Russia101.90 98.2387.43 69.9461.55 52.3248.65
Kirgizstan103.80 107.12101.77 76.3264.11 57.7058.86
Belarus108.00 104.76101.51 90.3579.50 62.0157.67
Ukraine104.10 100.5686.98 74.8164.33 49.5450.53
Kazakhstan98.00 90.1678.71 66.9058.87 44.1638.86
Tajikistan93.50 92.9484.85 58.5542.16 31.62n.a.
Turkmenistan93.10 94.5093.93 89.2380.31 64.2561.04
Uzbekistan103.10 107.53106.57 91.6589.81 87.1283.63
Armenia114.20 104.4992.16 87.5574.42 74.4274.42
Azerbaijan99.40 87.9786.30 60.4152.56 40.9936.89

Note: * Czechoslovakia before 1993. ** Forecast.

Sources: EBRD and WIIW.

In his chapter, Niels Mygind produced an enormously rich base of empirical facts. They may be quite useful for getting an insight into both general and specific aspects of the transformation process in the Baltic countries. I would disagree with only a very few statements and conclusions of his chapter. However, this is partly because they mostly conform with conventional wisdom on the transition.

His initial attempt to construct a general model of interactions among various economic, social and political factors in the transformation process is somewhat disappointing. Although I do think that it is impossible to fully understand the complexities of the transformation process without having such an interaction in mind, I could not see from the brief presentation at this conference what kind of conclusions one could draw from it. A quick look into his book Societies in Transition (Mygind, 1994) revealed the problem. It appears that Mygind is aiming for some grand synthesis of at least five different paradigms: 1) Marxian 'historical materialism'; 2) the 'decision-information-motivation' (DIM) approach to the theory of comparative economic systems, (Neuberger, 1971); 3) neoclassical economics; 4) new institutionalist economics of Williamson, North and others; and finally 5) 'the cultural approach' of Gollestrup (Mygind, 1994, p. 13). This is not only a very difficult, but also a very dangerous path. I cannot keep myself from making a comparison with the past theories of 'optimal mix' of capitalism and socialism, or at least of some of their ingredients, plan and market, public and private ownership and so on. It seemed to some that if those systems had different drawbacks, some combination of them ought to be better than any of the pure types. But, as discussed above, if the distinct systems are based on incompatible 'rules of the game' or incompatible coordinative mechanisms, their mixing would worsen the performance, not improve it. Similarly historical materialism, neoclassical economics, the DIM approach or new institutional economics have their own drawbacks and limitations, but you do not necessarily get better theory by mixing them together. They are based on distinct paradigms, start from quite different assumptions and often use very different methodological tools.

Mygind's 'model' is flawed because 1) it is not clear what the underlying assumptions are; 2) the individual elements of his 'model' are defined only vaguely; 3) it is hard to see how some of these elements would respond to changing inputs from the rest of the system; 4) the overall interactive structure of the model is not very convincingly specified. Analysis of this kind of model can hardly lead to firm conclusions about the resulting processes. In some cases Mygind formulates 'results' that seem to be verified by what has been actually happening in many transitional economies. The problem is, however, that these 'results' do not clearly and necessarily follow from the behaviour and interactions of elements of the model as he has formulated it. Mygind's language with statements like 'this will result in . . . ' or 'it will have positive (or negative) effect on . . .' is misleading because it presents what has been observed to happen as if it followed necessarily from the assumptions of the model, but it does not.

Let us now inspect Mygind's chapter from the point of view of transition hypotheses. He attributes the major part of the economic setback to economic fragmentation (hypothesis B5) and to the decline of aggregate demand (hypothesis B6). Mygind acknowledges certain aspects of the cost of transition hypothesis B4, but does not seem to give it a prominent place in the explanation of transition difficulties.

Mygind points out that the disintegration of the USSR and COMECON between 1990 to 1992 led to a sharp fall in demand for Baltic products from Russia and the other republics of the former Soviet Union as well as from other countries in COMECON.

The disintegration of the former Soviet Union, and the transition to world market prices have led to a disruption of former trade links and serious problems on the supply and the demand side for the industry. . . . Trade with the former Soviet Union fell by more than 50 per cent in 1991, and this trend continued in 1992.

Furthermore,

The general development in 1990-92 was a sharp fall in the demand from Russia and other republics in the Former Soviet Union and also from other countries in COMECON. Most of the trading partners, especially in the Former Soviet Union could simply not pay for the goods. This resulted in increasing interfirm arrears and a change to barter trade, but first of all it resulted in a sharp fall in trade. All three Baltic countries were seriously hit by this development.

It started with the politically motivated economic blockade of Lithuania in the spring of 1990, spread to all three countries when the blockade began to disintegrate, continued when Baltic currencies were removed from the rouble zone, and reached a peak in 1992 after Russia liberalized its own prices and allowed the prices of exported raw materials to jump to world market levels. This was a severe shock for the Baltic economies which resulted in hyperinflation, and a sharp reduction in the supply of energy and other essential raw materials so that 'many firms had to stop or drastically cut production, and in most houses and official buildings the temperature was much lower than normal'. The desperate attempts to redirect trade away from the countries of the former Soviet bloc did not work sufficiently fast, because Finland the closest and most natural partner of Baltic countries was also affected by the Soviet disintegration. A peculiar brief interlude occurred in 1991 because the Baltic countries started price liberalization before Russia while still being in the rouble zone. Russians, who faced empty shops in their own country, generated an extra demand for Baltic products.

In a more or less standard way, Mygind also attributes the decline in aggregate demand in all three Baltic countries to the very strict stabilization policy. Not only did declining real incomes reduce household demand but also 'the credit squeeze made it difficult for the firms to cover their deficit by bank loans. They had to cut down production that could not be sold at prices covering costs'.

Niels Mygind's chapter also adduces some evidence that suggests that all three hypotheses, C1, C2 and C3 claim to explain the differential success of individual countries in transition may be true. This holds both for the group of all three Baltic countries in comparison with other East European countries and the rest of the former Soviet Union as well as for the differences within the Baltic group itself. The Baltic countries as a whole are clearly more successful than the rest of the former Soviet Union but not as successful as Visegrad countries (Poland, the Czech Republic, Slovakia and Hungary). Within the Baltic countries, Estonia seems to be ahead of the other two. The comparison of Latvia and Lithuania is much less clear.

This can be explained partly by geographic proximity (hypothesis C1). Baltic countries, and specifically Estonia, are very close to Finland and Sweden but not as close to the rest of Western Europe as Visegrad countries and Slovenia. Geographic proximity has made the reorientation of trade links from East to West much easier and with fewer transaction costs. As long as East European communication (telephone, fax, mail and so on) and banking services (slow transfer of funds) remain backward, the advantage of reaching the country in a few hours by car, train or boat unquestionably helps not only trade but direct foreign investment as well. Geographic proximity also allows much more frequent commuting by East Europeans for shopping or work to West European countries or at least to watch West European television and thus get better information about the workings of the Western free market democracies.

The geographic proximity is closely related to the 'historical and cultural traditions hypothesis' C3. In their histories, the neighbouring countries may have mutually exchanged portions of their populations and almost certainly have had a need for frequent communication. As a result, at least part of the population usually knows the language and idiosyncratic national characteristics of their neighbour. This certainly facilitates the transition both because Westerners can present their business proposals in a more understandable and acceptable form while Easterners may learn faster from the West about how to operate in the market economy.

CONCLUDING REMARKS

The fact that Poles, Czechs, Slovaks, Hungarians and Slovenes have had for more than a thousand years permanent political, cultural and commercial interactions with German­speaking neighbours certainly made the resumption of commercial ties with Germany and Austria after 1989 much easier. For Baltic countries, however, it works in two ways. On the one hand they had strong historical links to Finns and Germans which greatly facilitates reorientation to the West. On the other hand, the traditional links to Russia and the significant presence of a Russian population somewhat complicated the transition process. The historical and language differences also contributed to the greater success of Estonia as compared to the other two Baltic countries.

The higher degree of market-orientated values in Estonia can also be connected to influences from the surrounding world. The close linguistic relationship with Finland made the Estonians able to follow Finnish television and radio. Many Estonians lived in exile in Sweden, Finland and North America. This was to a certain extent also the case for Latvians and Lithuanians, but the language barrier implied that the influence of the Western style of living was smaller in these countries. . . . Latvia did not have such close links to the West as the Estonians did in relation to Finland. (Mygind)

The level of development hypothesis C2 seems to have some explanatory power as well. The Visegrad countries, and especially the Czech part of the former Czechoslovakia, were traditionally the most industrially developed part of Eastern Europe. Baltic countries and specifically Estonia and Latvia were not very far behind.

Both Estonia and Latvia were industrialized before the Soviet occupation. Tallinn and especially Riga were already important trade centres at the beginning of the century. Lithuania on the contrary had a large population in agriculture after World War II. Therefore the industry here was mainly built up under Soviet rule (Mygind).

The last observation is particularly important. For the countries that achieved a significant level of industrial development before the communist takeover, the transition process may be easier because it means rebuilding something that had already been there. There are three areas in which the previously achieved level of development may by crucially important.

First, there is a good deal of evidence that the industrial structure can itself be adjusted with more ease in a country where communist industrialization was built upon an industrial base created under capitalism. In such situations at least some of the huge socialist 'dinosaur' enterprises were created as amalgamations of previously existing smaller capitalist firms, whose skeletons and 'DNA' may be at least partially recovered even after half a century. It is much more difficult to restructure 'dinosaurs' that have been entirely newly created by socialist industrialization.

Second, the country that was already industrialized before communism must have had a stock of managers, entrepreneurs and people with skills needed in the capitalist market economy. A lot of that must have been lost as I have already mentioned above. Nevertheless, the recreation of these skills and professions may be easier than creating them anew in a country which has had very little business tradition.

Third and probably most important is the 'institutional memory' of such a country. It is much easier to recover and modernize the old economic and legal institutions in a country that once had a well­developed system of property rights, commercial law and so on than in a country that has little or no tradition in that area.

REFERENCES

Brus, W. (1972), Ogolne problemy funkcjonowania gospodarki socjalistycznej, Warsaw, PWN, 1961, translated into English as: The Market in a Socialist Economy, London and Boston, Routledge & Kegan Paul.

Counter-revolution, The Economist, 3 December (1994).

Dellebrant, J.A. (1992), Estonia's Economic Development 1940-1990, in A. Åslund, ed., Market Socialism or the Restoration of Capitalism, Cambridge University Press.

Dornbusch, R. (1991), Strategies and Priorities for Reform, in Transition to a Market Economy, OECD, Paris.

Ellman, M. (1993), General Aspects of Transition, in M. Ellman, Gaidar and G.W. Kolodko, Economic Transformation in Eastern Europe, Basil Blackwell.

Hayek, F.A. (1944), The Road to Serfdom, The University of Chicago Press,

Klaus, V. (1995), Speech for the World Summit for Social Development, Copenhagen, 11 March.

Kolodko, G.W. (1993), Recession and Growth during Transition to a Market Economy, in M. Ellman, Gaidar and G.W Kolodko, Economic Transformation in Eastern Europe, Basil Blackwell.

Kyn, O. (1975), Czechoslovakia, in H.-H. Hoehmann, M. Kaser and K.C. Thalheim, The New Economic Systems of Eastern Europe, C. Hurst & Company, London.

Mygind, N. (1994), Societies in Transition, Institute of economics Copenhagen Business School. This is a draft of the English version of the previously published book: Omvaeltning i Ost", Samfundsletteratur.

Neuberger, E. (1971), Classifying Economic Systems, in M. Bornstein ed., Comparative Economic Systems, Irwin, Boston.

Nuti, D.M. (1992), Market Socialism: The Model that Might have Been - But Never Was, in A. Åslund, ed., Market Socialism or the Restoration of Capitalism? Cambridge University Press.

Roemer, J.E. (1993), Can There Be Socialism after Communism?, in P.K. Bardhan and J.E. Roemer, eds, Market Socialism: The Current Debate, Oxford University Press, New York.

Sachs, J. (1993), Poland's Jump to the Market Economy, The MIT Press.

Sik, O., ed. (1990), Socialism Today, Macmillan, London.

Stiglitz, J.E. (1994), Whither Socialism?, The MIT Press.

Sutela, P. (1991), Economic Thought and Economic Reform in the Soviet Union, Cambridge University Press.

 

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