HANDOUT 4
The Economic Dimension of Transition
Part I: The Shock Therapy Model
Jeffrey Sachs - model of “shock therapy”: an economic theory of transition
Based on a globalised, unified capitalist world: this would be brought about by formulating
a policy of transformation in Central and Eastern Europe.
He created a model of behaviour of the revelant actors and of the ways in which they would
interact in certain circumstances faced with their particular constraints and incentives.
Various names for this model:
Shock Therapy/Treatment
Radical Economic Reform Plan
the Economic Big Bang
Initially supported by US and British policy-makers andmost East European economists advocating
reform.
The Shock Therapy Model Involved:
(Macro-Policies for Restructuring)
1) Breaking-up up of COMECON region, especially breaking-up the C/E Euro countries from the
USSR.
2) Making a “root and branch” switch to a particular form of capitalist institutional structure in each
state a precondition for normalising relations with that state.
3) Imposing, therefore, a “hub and spoke” structure on the relationship between the West and C/e Euro
with each target state in the region relating to the others principally vai its relationship with the
Western hub. (American policy between 1990-92 continued to favour the maintenance of a Moscowcentred economic sphere in the Soviet region, except for the Baltic Republics.)
4) Starting the process of regional transformation in the states with the most politically sympathetic
governments and then using both negative and positive incentives to extend the required mix of
domestic policies across the region as a whole.
5) Western states to provide, in the main through their multilateral organisation, the necessary positive
incentives for co-operative governments and constraints for unco-operative governments.
6) The revivial of economic activity in co-operative target states woulf take the form of trade-led
growth directed towards Western Europe compensating for COMECON’s collapse.
7) Co-operative states would gain full access to the market of the EC (partly through radically changing
some of its key institutional pillars, such as its trade regime and CAP), very substantial economic
assistance and eventual membership of an enlarged EU.
This approach:
a) urged the break-up and in effect the start of a competitive race by E Euro states to prepare
themselves for direct entry into the W Euro market;
b) rejected mixed or hybrid forms of socio-economic system on the grounds that market socialism had
already proved unworkable;
HOWEVER, this necessitated radical reform of the EC to accommodate an ‘export surge’ from C/E
Euro states and called for an unprecedented degree of funding from co-operative states in the West.
By 1990, this overall model was pushed forward as a comprehensive economic strategy for
the
region as a whole.
This was especially favoured because the model was already being used in Yugoslavia and
Poland:
“Poland will bring in the first comprehensive market-oriented reforms in Eastern Europe.”
“The Yugoslav outcome would differ from Poland’s for Yugoslavia would maintain, in
large measure, its self-management approach to corporate governance.”
(Sachs, 1990)
By 1990 this approach was adopted by the G7 states.
[Fr-Ger proposals to keep the USSR and C/E Euro linked via a free-trade regime were rejected; Fr
proposals for a strategy which would engage in large public infr-structure projects covering the former
USSR and C/E Euro were cut-short; a further Fr idea for a pan-European Confederation embracing
both the EC and the whole of the East were repudiated. Poland and Yugoslavia were used as examples
for a successful way forward.]
The path forward, seen by most C/E European supporters of ST lay through the gradual adsorption of
the states in the region into the Western economy institutionalised in the various multilateral
organisation, especially the EU. Because of this the desired out come was identified as:
- a unification of Europe in a single market;
- the regional development of prosperous capitalist democracies.
- the official projected outcome of ST was to be “democratically-based increased living
standards and freedom.”
At the base of this transformation was the idea that the post-communist world would have the potential
to grow more rapidly than the developed world and thereby narrow the gap in living standards, if the
states concerned “harmonised” their economic institutions and joined their economies to the global
economic system.
The Strategy of ST had:
1) A very paticular institutional “matrix” which included: open trade; currency convertibility; and the
private sector as the “engine of growth”.
2) Core reforms that needed to be achieved for the model as a whole to be viable:
a) open international trade
b) currency convertibility
c) private ownership as the main force for economic growth
d) corporate ownership as the dominant organisational form for large enterprises
e) opneness to foreign investment
f) membership of key international economic institutions, including the IMF, World Bank and
GATT
[Reforms a/b/e/f - were about changing a state’s external politico-economic relations; reform d - was
about a particular form of ownership; and reform c - was about what is generally seen as capitalism.]
It was argued by the advocates of this strategy that:
by joining the rest of the global economy the states of C/E Euro would be able to import some
of the prosperity from the rest of the world, usually through the importation of new technologies,
organisational patterns, managerial methods and financial capital. Only these could overcome the
economic legacy of the previous 40 years.
Another core requirement for the success of economic transition was foreign direct
investment. In order to get this the strategy called for the creation of a free trade regime and the right
institutional and economic conditions in C/E Euro.
It was claimed that failure to implement this style of economic strategy (aimed at making a
connection with the world economy) would lead to problems such as: an unconvertible currency. an
unreformed industrial structure; and a hostile investment climate.
[Generally this approach and vision of joining the global economy was a powerful motive for C/E Euro
reformers - here again we can look at the examples of Poland and Yugoslavia; also the adapted version
used in Hungary and the Czech Republic, and in the early 1990s (1992-93) in Russia through Gaidar’s
reforms.]
It was explained that such an opening-up of the C/E Euro economies to global capital was the
necessary first step for government policy. This kind of policy justified sudden switches to free trade; it
justified early convertibility as a means to anchor world prices in the domestic context - thus
promoting economic revival through trade; it justified foreign direct investment as indispensible for
privatisation and structuring.
SHOCK THERAPY
It is usually referred to as the 3 “izations”:
1) Liberalization
2) Stabilization
3) Privatization
Recently a 4th has been added - Institutionalization
As it has turned out in practice - these “izations” progress in a very partcular pattern, covering the
interaction of actors with each other and with their environment:
1) the liberalizing/stabilizing shock
2) the international shock
3) privatization and foreign direct investment
4) trade-led growth
5) political/institutional consolidation and growth
Shock Therapy, Democracy and ‘Civil Society’
Cardinal goals of ST have been the achievement of democracy and freedom. Although the
building of a civil society has not been emphasized, this has been a constant theme of ST supporters.
Yet these goals have been treated as ends and not means. As ends, they have been discursively very
important because they have been used as core justifications of the means of ST. However, the liberal
principle that ends should govern means has been operationally rejected within ST in favour of a more
“dialectical” approach: the existing social, legal and political institutions are likely to be resistant to ST,
but ST is the only, or best, path to truly democratic, legal and civil institutions, so the existing
institutions must be negated from above and outside in order to realise true democracy and civil
society.
Between 1990-1995
Most governments in post-communist C?E Euro have to some degree tried to lock themselves
into the strategy envisaged by ST (especially in terms of the relationships with the global economy)
and have tried to combine the demands of the international financial institutional and the EC/EU with
often comflicting domestic pressures.
Some governments have drifted, without any coherent policy, and only a few, such as
Romania, have consciously sought a different road to another form of capitalism.
By the mid-1990s
The path of progress for ST has proved unstable and many analysts are now criticising this
model of economic transition. Although by the beginning of 1996 many analysts do begin to identify
an up-turn in the economic climate within the region (things are beginning to stabilise - but is it already
too late, politically.
So far, 5 major charges are levelled against ST and what it has created in C/E Euro:
I
that its macro instruments of regional fragmentation and domestic shock change have been
immensly costly in the short and medium terms;
II
that ST free trade-led policy for economic revival was largely misconceived;
III
ST’s macro policies for sustained economic revival have tended to weaken rather than
strengthen
long-term revival;
IV
the practice of ST on the part of Western actors has sharply diverged from the theory in ways
that have damaged C/E Eruo states;
V
in terms of its own criteria, ST has been a failure.
The implementation of ST has brought about a “double-depressive-shock” in the region:
- part of this has been the result of the ST model’s insistance on the break-up of the
COMECON
area, rather than maintaining regional trade and production linkages through a customs union
and new payment arrangement . . .
- part of the shock has come from the implementation of the ST domestic policy cycle . . .
All commentators on the region now know about these effects:
1) increased unemployment
2) reduction in real incomes
3) reduction in levels of production
IMPORTANTLY, an OECD study entitled “Integrating Emerging Market Economies into the
International Trading System” (1994-96) - analysed the state of economic transition in the region,
specifically the depression being experienced by the mid-1990s. It pin-points the major causal factors
(all deriving from the short-term consequences of ST):
I
It states that the “stabilisation” aspect, especially the credit squeeze via credit ceilings, was
“indentified as the emportant element contributing to the recession, especially at the beginning of the
reform process”.
II
The fragmentation of COMECON-regime trade had a disastrous impact on industrial outpu:
“according to some calculation, this volume effect alone can explain most of the fall in output in
Hungary and the CSFR and about one third of the decline in Poland”.
III
Key institutional vacuums, as pointed out by the critics of ST, such as the absence of a
financial system, meant that “all countries suffered from an inadequate supply-side response”, in other
words a downward spiral into protracted depression.
This study, along with others, concluded by the mid-1990s that, dispite a host of arguments presented
by ST supporters, the then contemporary situation, the simple undeniable fact, was that the entire ST
programme held the depression as its core feature.
Similar critiques have also focussed concern in the following areas:
1) the failure of the ST trade regime
2) the failure of the transition economies to gain full acess to the EU market
It has been concluded that the tragic result of these politico-economic interactions has been that the
domestic depressive shocks, policed by the IMF and designed to lay the basis for an export-led revivial,
have largely led these countries up a “blind alley”, prolonging the depression. The origins of the
revival, in so far as it has come, has not been led by foreign trade but by domestic consumption. Yet the
policies of the international financial institutions have been overwhelmingly directed at reducing
domestic demand pressures, stamping out inflation, lowering wages and reducing government deficits
through spending cuts.
CONSTITUTIONALITY VS SHOCK THERAPY IN RUSSIA
The most direct and brutal test of the relationship between liberal principle and ST ocurred in
Russia in 1993. The Yeltsin government derived its authority from parliamentary elections held in 1990
during the Gorbachev period. The Russian parliament elected at that time had then elected Yeltsin as
president and, in the autumn of 1991, voted hm emergency powers for a year to give him a free hand
with econmic transformation. By the autumn of 1992, with real wages down to 40% of their levels at
the start of the year, the majority in parliament began to swing against the Gaidar reforms. By the
spring of 1993 Yeltsin was on a collision course with the deputies.
From the spring of 1993 Yeltsin embarked upon a drive to flout the constitution in order to
crush erstwhile supporters within the Russian parliament. The parliament’s powers were not, in fact,
very extensive. It could not vote on the government’s programme or pass a vote of no confidence in the
PM. It could not approve individual ministers. But on the other hand, it could not be dissolved by the
president and it has substantial power over budgetary matters.
Faced with parliamentary opposition to his economic programme, Yeltsin decided to
announce the dissolution of parliament, an act expressly prohibited in the constitution. When the Mps
sought to resist this act by occupying the parliament building, Yeltsin had them surrounded and cut-off,
and this led to an ill-judged but constitutionally legitimate effort by the parliament to strip Yeltsin of
power. Yeltsin responded to a march on a radio station with a military assault on parliament building.
After the defeat of the opposition, Yeltsin also imposed censorship and closed-down hostile
newspapers. Mps who had participated in the occupation of the Whitehouse were thrown out of their
flats within 3 days of the victory.
Western governments ans ST supporters supported Yeltsin’s unconstitutional acts. The
parliament leaders were branded as the “Old Guard”. “Yeltsin was faced with the alternative of
surrendering to the Old Guard or breaching the constitution” he was reported in the West. This is
propagandistic: the parliament had not been asking Yeltsin to surrender; they had been opposing his ST
policy.
REACTIONS IN CENTRAL/EASTERN EUROPE
By the mid-1990s the populations of the region have not only suffered hardships but have
elected governments on political platforms that have subsequently been blocked, in Hungary, Poland
and Slovakia, by Western pressure. Attempts at ultr-nationalist backlash by the Christian Nationals in
Poland, the Republicans in the Czech Republic, the Slovak Nationalist Party or the Csurka breakaway
from the MDF in Hungary have all been repudiated by the electorates in the region. In general, the
extreme right has been far weaker electorally in Eastern Europe during the 1990s.
Instead voters have turned back to the one political current in the region that has received no
support whatsoever from the West: the ex-communist socialist parties. These have achieved victories in
Poland, Hungary, Bulgaria, Lithuania, Estonia, Ukraine and have become important also in the former
GDR.
ROMANIA: A DIFFERENT WAY FORWARD
A stark contrast in the policy field would be that between Hungary, Poland, the Czech
Republic on the one side and Romania on the other. The Romanian case may be taken as a paradigm of
an alternative, national, capitalist strategy of transformation counterposed to the ST cycle of “opening
to globalism”. The Iliescu regime rejected a sweeping liberalisation of prices, avoided bankruptcies and
large lay-offs of workers, sought to maintain the big industrial enterprises and directed its privatisation
efforts towards management and worker buy-outs, largely excluding foreign capital. The government
was also cautious about liberalising its trade regime. As a result of these policies it was largely rebuffed
by the major international economic organisations.
Romania initially suffered from acute internal tensions as a result of the form of transition
from the Ceaucescu regime. It also suffered from an acute hard-currency shortage. Nevertheless, like
Poland, the Romanian economy returned to growth by the end of 1993 with a 1% rise in GDP, and
grew by a further 1% the following year. By 1995 it was reported “Romania, little noticed by the West,
delivered last year probably the most impressive performance in Eastern Europe”.
This does not mean that the Romanian experience should be erected as some sort of superior
strategy to that of Poland, for example. Since 1989 the Romanian people have probably suffered more
than the Poles. It does suggest 2 possible lines of investigations:
1) Romania had no significant foreign debt and this makes it similar to Poland with its debt reductions;
2) ST opening to global forces is at the very least no panacea if recent growth records are the standard
of judgement: Romania has revived far more strongly than wide-open Hungary or the Czech Republic.
SOME CONCLUSIONS
However it was introduced, capitalism was bound to come as a bit of a shock to the peoples of
C/E Euro. Illusions about capitalism were very widespread. Workers did not realise that it would entail
a radical drop in their living standards, a great intensification of the work process and chronic
insecurity, as well as destitution for a minority. There is a danger of blaming ST for capitalism as such.
There were also widespread illusions about what kind of capitalism was on the market from
the West. Many East European intellectuals, long disillusioned with dialectices, wanted Swedish-style
social-democratic capitalism, not appreciating that if the communist world abandoned state socialism
for postwar social-democratic captialism, this very choice would destroy the possibility of realising it:
without communism, social democracy would be taken off the menu. It could also be said that official
opinion, at least in the Visegrad states, continued, despite mounting popular opposition in Poland and
Hungary, to be resolutely committed to the ST course and that this was not only due to Western
structural power and pressure.
While this is both true and important, it is also important to see why this commitment by these
post-communist elites has been so strong. In the Visegrad states the idea of rapid, systematic change
has been discursively pakaged as a quick “entry into Europe”. In this form it has been the legitimating
discourse for the transformation towards capitalism as such. It has been the way for legitimising
privatisation, unemployment, social differentiation and the impoverishment of large sections of the
population. Those who have questioned this discourse have been marked as opponents to capitalism as
such. Thus to have abandoned the set of Western policies and condition entailed by ST would have
required an alternative means of legitmating the social transformation.
Yet attempts to hail this country as a success on the basis of current growth tables are a facile
way to judge the outcome of ST. The real test is the one proposed by Sachs himself: will ST
provide higher living standards than those which prevailed in 1989, as well as democracy and
freedom? We do not, of course, yet know!
The Economic Dimension of Transition
Part II: Attitudes Towards the Market and Government in the Post-Communist
States
In the aftermath of the anti-communist revolutions of 1989-1991, the new governments in
Eastern Europe faced the great task of attempting simultaneously to build market economies and
democratic political institutions. Though capitalism and democracy are often considered to be natural
allies, in the cases of thesenew states they some-times pull against each other. The costs of the
economic transition, in terms of growing unemployment, inequality and inflation, may erode support
for the new governments and lead to calls for a “strong government” or leadership to cope with
economic dislocations. To a large extent, the success of econmic transitions is dependent on the
continuing popularity and legitimacy of new governments. Democratic legitimacy and stability can
probably be maintained only if the governments remain broadly responsive to and representative of the
opoulations - or at least be perceived as such.
Attitudes Towards the Market and Government
After the revolutions of 1989 citizens in the post-communist states demonstrated a remarkable
ambivalence towards the theory and practice of socialism. The overwhelming majority agreed with the
statement that “a free market economy is essential to our economic development.
With the revolutions, the countries of C/E Euro left behind systems in whichc state and party
dominated the economies and most other aspects of society. The state provided jobs and housing, set
prices and wages, owned industries, schools and farms and subsidised basic necessities. The
omnipresence and mnipotence of the state aggravated many people and contributed to revolutionary
ferver. But many people also came to rely on the benefits provided by the state: under the communist
systems, they may not have had freedom or affluence, but they did have basic economic security. The
current reforms promise to deliver the former but threaten the latter.
Now by the mid-1990s, as the East Euro countries move towards free enterprise and the
market, economic inequality will grow sharply as the governments relax restrictions on wages and
wealth, and abandon their commitment to full employment. A major task of the new governments is to
convince their opoulations to accept greater economic inequality in their societies. This may be
difficult given the prevailing attitudes. But in assessing the likely success of market-oriented reforms in
the region, it is necessary to consider whi it is that supports and opposses these reforms. It would be
helpful for market-oriented governments, of course, if a majority of the population supported the kinds
of policies they are implementing. This, however, is not an easy task: many people in the postcommunist states still have a basically egalitarian and statist orientation that works against the laissezfaire and decentralising reforms being implemented.
The bad news for the reforming governments has been that opposition to reforms has become
mobilised and politically active. Silent majorities could safely be ignored as long as they remained
silent. But as the transitional period has become more painful and taken more time, skepticism about
the principles of reform has been reinforced by very real economic hardship. The combination of these
circumstances has led to opoular upheaval and to electoral defeat for the reforming governments and
strong electoral support for the newly revived post-communist parties in Lithuania, Poland and
Hungary, and in Russia.
RESHAPING CULTURE AND IDEOLOGY
This kind of evidence points to some of the social and political obstacles to the transition to
market democracies in C/E Euro. It is unlikely that the governments of the region will be able to work
against this political culture in the short term: either the governments or the culture will have to change.
Given the overwhelming consensus among both the post-communist political elites and Western
financial institutions that they should push ahead with reforms, the governments will not lightly change
their market-oriented reforms. What they need to do, in that case, is to work on reshaping popular
values and political culture.
There are those who argue that changes in popular orientations are already beginning to take
place and that a shift in favour of the market and capitalism will accelerate as the economic reforms
begin to improve the economies and deliver jobs, wealth and consumer goods. Indeed, most of the
post-communist states show some shifts away from the radical egalitarianism and hostility to private
enterprise that characterised the communist and early post-communist period. As was seen, however,
even by 1993, 4 years after the revolutions, attitudes still remained much more egalitarian and statist
than in the Western countries.
ECONOMIC STATISTICS 1994-95
Basic categories applicable (see notes on 1990-93 in week 6).
(Sources: European Bank on Reconstruction and Development - Transition Report (1994).)
IMPORTANT:
1)
HUNGARY
POLAND
See figures in Handout week 7 (Shock Therapy) - last page for 1995 figures.
Some reform 1968
but especially from 1988 onwards
50% GDP private
privatisation especially focussed on small scale
90% + prices free/also trade
currency pegged to different international currencies 70% to ECU 30% to Dollar
allows for profits accrued to foreign firms to be repatriated
Similar except there had initially been reform in 1981 and 1989
some tariffs on trade
currency pegged to a “basket” of external currencies
CZECH REPUBLIC
60% GDP private
comprehesive sale of state assets
85% prices free
currency pegged to different currencies 65% Deutsch Mark 35% to Dollar
SLOVAK REPUBLIC
50% GDP private
same as above
2)
BALTIC STATES
50% GDP private
privatisation progressing at a steady pace but not as advanced as in above
examples
prices and trade proportionally well liberated
full exchange rate convertibility (Estonia pegged to DM)
3)
BULGARIA/ROMANIA Some small-scale liberal reforms in 1987, more in 1990s
35% GDP private
prices liberated
Bulgarian currency freely convertible
Romanian currency pegged to a “basket”
ALBANIA
50% GDP private
liberalised prices
actual privatisation less advanced
RUSSIA
1987 perestroika but not real comprehensive econmoic reform, by 1992
fuller moves to economic model along lines of ST
50% GDP private
75% privatisation
most prices free
trade - organisated predominantly through bilateral relations with CIS
ruble floats
One major problem - the “shadow economy”
CIS
Except Kyrgystan - relatively little progress
Inflation:
Czech Repub:
Hungary/Poland/Sovakia:
Romania/Bulgaria:
Russia:
Ukraine:
less than 10% p.a
less than 35% pa.
51% p.m
51% p.m
(previously 13-20%)
10% p.m (previously 40-70%)
Growth:
Most E. Euro countries and Baltics - increased growth
Most CIS states - falling growth, although bottoming-out
All countries are probably starting to get growth - see especially this years economic figures
Problem in that some are not growing as much as expected
Foreign Investment:
All E. Euro and CIS countries - experience less foreign direct investment than either
China/Mexico
These countries have similar levels as Argentina and Malaysia
Hungary:
Hungary/Czech Repub/Slovak Repub:
44%
two-thirds
Most aimed at manufacturing industries (Hungary at some service industries)
Opportunistic moves in the area by the LARGE foreign firms
Some are there to gain access into domestic markets; some there because they see in generally as a way
into the regon as a whole (first on the scene).
Smaller firms more wary of investing: see it as an unstable region with unstable regimes; some small
firms can not afford to take the risk of the high cost of creating new infrstructures.
See also the “rouble zone” initiative of 1992-93 for the former Soviet space - initially accepted by CIS,
later rejected, all republics now have their own currencies.
Trade:
Trade between the CIS states is down by 50%
Fast reformers in C/E.Euro have been relatively successful in re-orienting trade towards the West,
especially the EU
European Agreements:
Copenhagen Council of EU 1993
Bulgaria/Romania/Czech Repub/Hungary/Poland/Slovakia
Enginered towards a progressive and asymmetrical joining with the EU - later full membership
EU and Baltics Republics: Free Trade Agreement 1995
Central European Free Trade Agreement 1993: Czech Repub/Slovakia/Hungary/Poland
Russian/CIS - rejection of “rouble zone” - replaced by bilateral agreements among the CIS states
Bankruptcy Laws - initiated in varying degrees with varying powers of enforcement
Divergence:
Advanced group has some structural reforms and have stabilised relatively well
Intermediate group is progressing at a slower pace but is gradually stabilising
Weaker group is still faced with major short- and medium-term problems
Reasons for this:
1) geographical position (E vs W)
2) different levels of enthusiasm politically
3) relative degrees of political stability
4) what are the motivations behind Western involvement
5) general uncertainty within the region reflected in Western reluctance
6) structural problems left-over by communist system need to be overcome
7) evaluating the possible outcome is difficult - gradualism vs shock therapy
8) Russian and CIS particular problems separating them from rest of C/E.Euro