Plan&Market  Eastern Europe in Transition

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.


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 from the improved allocation of resources. It was presumed that because of 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 to 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 disequilibria 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, but 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 favorable 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 favor 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)

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.



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