Economic Reform in Eastern Europe and Russia:
(“The Commanding Heights” – Chapter #10)
(“Economics” – Chapter 15)
Eastern Europe and Soviet Union operated under
Command Planning after WW-II => drastic economic and
political reform throughout region starting in late 1980’s
Societies which embraced extreme forms of Socialism and
Command Planning often did so for two reasons:
1. to quickly bring a backward nation into the
modern world
2. to eliminate the inefficiencies and “wasteful
excesses” of Capitalism
#1: was accomplished to a degree in some societies (e.g.,
Soviet Union and China), but at an extreme cost
(acceptance of a totalitarian political system; recall,
between 1934-1953, 18.75 million people spent time in
forced labor concentration camps in the former USSR)
#2: not accomplished => particularly in the long term,
systems of planning operated much less efficiently than
market based systems (“The unexpected lesson of
Socialism was that planning was an easy word to spell, but
a hard word to spell out.”)
213
Lower living standards in systems of Command Planning:
 two “natural experiments” of Germany and Korea
Germany:
 1936: slightly higher standard of living in what would
become “East Germany” compared to what would
become “West Germany”
 1991: at the time of reunification, Per Capita GDP of
12,950 Deutsch Marks in East Germany versus 41,320
Deutsch Marks in West Germany (East German Per
Capita GDP only 31.34% of West German level)
 2000: Per Capita GDP in what was East Germany now
up to 65.3% of level in what was West Germany
Korea:
 1953 (at the end of the Korean War): Per Capita GDP
was slightly higher in North Korea than in South
Korea (South Korean level was about 85.8% of North
Korean level)
 2011: Per Capita GDP (PPP) was $32,100 in South
Korea versus $1,800 in North Korea (North Korean
level is only 5.6% of South Korean level)
In the late 1980s and early 1990s, the economies of
numerous societies which operated under command
planning collapsed, due in part to these failures.
We will focus on the transitions from Command Planning
to market based institutions which took place in Poland and
Russia.
214
Such institutional reforms had never been implemented on
such a large scale before => not obvious what the best
approach was…
Ultimately, in Russia and many of the Soviet Bloc
countries (e.g., Poland, Czech Republic, Slovak Republic)
economic reform was instituted by “Shock Therapy”
 Shock Therapy – the approach to transition from
socialism to market capitalism that advocates rapid
deregulation of prices, liberalization of trade, and
privatization
 Jeffrey Sachs (Columbia University Economist;
advisor to numerous governments in Latin America
and Eastern Europe during times of economic reform)
strongly advocated for these countries to use “Shock
Therapy” as opposed to “gradualism”
 Pragmatic approach for these countries, since political
freedoms were realized for the first time in decades
(and at the time nobody knew how long the “new
freedoms” would last) => reform as much as you can,
as quickly as you can
But, again, it was not obvious that “shock therapy” was the
ideal approach:
In 1992, only 57.6% of economists agreed: “As the USSR
moves toward a market economy, a rapid and total reform
would result in a better outcome than a slow transition.”
215
Poland:
“End of Communism” began in Poland => central figure
behind economic/political reform was Lech Wałęsa:
 Polish Labor leader throughout 1970’s; Co-founder of
“Solidarity”
 Won Nobel Peace Prize in 1983
 President of Poland from 1990-1995 (first freely
elected President)
Solidarity:
 trade union federation founded in 1980 at Lenin
Shipyards
 first independent trade union in a Soviet-bloc country
 membership peaked at 10 million in early 1980’s
(when population of Poland was around 36 million)
 gained political control in “semi-free elections of
1989” => Soviet leader Mikhail Gorbachev told Polish
Communist Leaders to accept the outcome of the
elections (start of the end of the Cold War)
 asked Jeffrey Sachs to prepare a plan for Poland to
“jump to the market economy” (wanted a quick move
to the market)
216
By the end of the 1980’s the Polish economy was
performing horribly => annual inflation rate of 17,000%
(14th documented case of hyperinflation in history)
Balcerowicz Group:
 group of Polish economists concerned with analyzing
the problems of Socialism and questions of how to
reform the Polish economy
 led by Leszek Balcerowicz, who would be Finance
Minister and Deputy Prime Minister in the new
Solidarity government
 supported “shock therapy,” not “gradual reform”
Sachs/Balcerowicz “shock therapy” plan implemented on
January 1, 1990:
 price controls lifted
 tax structure reformed
 currency devalued and switched to “floating exchange
rate”
 markets began to work by the end of January:
shortages disappeared, goods returned to markets,
prices started to come down
Solid economic performance since mid 1990’s: GDP
growth averaged 4.7% a year from 1990–1999 => became
known as “Europe’s New Tiger”
217
Russia:
Soviet Command Economy:
 did not evolve “gradually over time” (as did
Capitalism), but rather was created forcibly after the
Russian Revolution in 1917
 officially “no markets”: all resources allocated by
bureaucrats; government controlled whole economy
 “gos” is the Russian abbreviation for “government”:
 Gosplan determined the overall economic plan
 Gosten set prices
 Gossnab allocated productive resources
 Gostrud established labor and wage policies
 Gosbank was the Central Bank and only bank
whatsoever
Probably impossible for any of us to fully comprehend how
such an economic system would actually operate.
 More generally, it would likely be difficult for anyone
to grasp the workings of an economic system
(drastically different from their own) which they have
not experienced firsthand…
218
Part of 2007 Stanford Commencement Address by Prof.
Michael Boskin (Stanford Univ. economist; served on
Council of Econ. Advisors to Pres. George H.W. Bush):
www.stanford.edu/~boskin/Publications/COMMENCEMENT%20ADDRESS%202007.pdf
“…I never imagined as an economics undergrad that a couple of decades later
President Bush “41” would dispatch this grandson of Russian immigrants to Moscow
to help Gorbachev with Soviet economic reform! When I arrived in Moscow, in
addition to Gorbachev, who knew very little economics, I met with the head of the
state planning agency, (Gosplan), the Finance Minister, and the head of the Central
Bank.
The head of Gosplan was presiding over price reform in the Soviet Union.
Instead of administered prices, there was supposed to be a move to a free market. At
our first meeting he asked me, “Who sets the prices in your economy?” Flabbergasted
at this remark, I explained that, while we have a few industries that are regulated by
government, for the overwhelming bulk of products, the interaction of numerous
producers and still more numerous consumers determine prices in our economy, and
furthermore, repeating Adam Smith’s famous dictum, this invisible hand of the
market produced the greatest good for the greatest number. The head of Gosplan
repeated “So who sets the prices in your economy?” It was clear he could not think
of an economy in which somebody in the government did not set the prices. He
pulled out a 1960s-style giant computer printout which was the price list for every
product in the Soviet Union. America had a market economy, I was the American
President’s economic advisor, he had been told by Gorbachev that I would help, so
who, he thought, was better able to decide the new prices?...”
This presumably intelligent and educated Soviet official
could not conceive of an economic system in which prices
weren’t “set” by “someone” – simply because he had never
experienced it firsthand
219
Failures of “planned system” (“lack of incentives,” “no
rewards for innovation,” and “difficulties allocating
resources”) became clear in 1970’s
 Industrial Sector was highly inefficient – took Soviet
paper industry 7 times more timber than Finnish industry
to make a ton of paper
 Price Controls led to bizarre prices – airfare from
Vladivostok (on Pacific coast) to Moscow (over 4,000
miles away) was $7, while taxifare from Moscow airport
to Red Square was $10
Mikhail Gorbachev – leader of USSR from 1985 until
collapse in 1991
 came to power intent on promoting political/economic
reform
 instituted perestroika (“restructuring,” referring to
restructuring of the Soviet economy) and glasnost
(“openness,” referring to a shift toward openness and
transparency in governmental decision making, along
with freedom of access to information, in Soviet society)
 aimed to “modify a socialist economy” and did not want
to “shift toward a true market economy”
 Overall, his economic reforms failed: he “dismantled the
machinery of central planning…but he did not replace it
with anything”
220
Gorbachev’s gradual, partial reforms did not work =>
Gorbachev’s successor Boris Yeltsin (President of Russian
Federation from 1991-1999) initiated the Gaidar Reforms:
 Economic reforms launched on January 2, 1992
 Russia’s version of “shock therapy”
 similar to Sachs/Balcerowicz reforms implemented in
Poland in 1990
Four components of “Gaidar Reforms”:
1. Market Liberalization – policies aimed at creating a
functioning market, including: decontrolling prices,
allowing free entry into markets, decreasing share of
output absorbed by government, and establishing a legal
system to support market activity.
2. Privatization – privatization of state owned enterprises to
increase their efficiency, reduce/eliminate fiscal burden
of state subsidization, and make economic reform
irreversible.
3. Constructing a Social Security System – previously no
unemployment compensation (since none is needed
when unemployment is illegal); economic reform would
temporarily lead to massive unemployment, creating the
need for a “social safety net.”
221
4. Converting Defense Sector – military spending more
than 30% of GDP by end of Cold War [U.S. military as
% of GDP: 4.7% in 2010; recent low of 3.0%, 19992001; post-Vietnam high of 6.2%, 1986]
 Gorbachev: “A country that was in outer space, that
had this kind of defense, could not make enough panty
hose for women, not enough toothpaste or the simplest
things for people’s lives.”
 The country did not have enough resources
remaining to produce high levels of high quality
“basic necessities”
 Angus Young (lead guitarist of AC/DC): “I could
always tell a country was more left wing by how
rough the toilet paper was. Every band I ever knew
that went to Moscow, the first item on the list was
toilet paper. They can say what they like about
Capitalism, but they sure know what soft tissue is.”
 the most highly skilled workers were employed in
defense sector
 increases in “non-military output” expected as
resources shifted to peaceful purposes (illustrated
below by way of PPC).
Military
Output
Before “Gaidar
Reforms”
After “Gaidar
Reforms”
Non-Military
Output
0
0
222
Privatization in Russia:
In 1992, 73.5% of economists agreed: “In the movement
from a non-market to a market economy it is important that
the ownership of productive resources be privatized at the
onset.”
 Massive privatization from 1992 to 1996. By 1996:
 18,000 industrial enterprises privatized
 More than 75% of all large/midsize industrial firms
 Over 80% of workers employed in private sector
 Over 70% of GDP was generated in private sector
 State still owned much of the “Commanding Heights”
 Critical question: What share of an enterprise should go
to current managers/employees versus what share should
be available to the general public?
Three Distinct Privatization Programs in Russia:
1. Voucher Privatization: privatization of large-scale
industry though “voucher auctions”
 “Vouchers” that could be used to buy shares of
enterprises via “auctions” given to all citizens
(including children)
 First major privatization in Russia: Bolshevik Biscuit
Factory (producer of Russia’s favorite cookies)
privatized via voucher auction in late 1992
 Dec. 1992 to June 1994: 15,779 enterprises with about
18 million employees privatized via voucher auction
 Market for vouchers emerged => enterprise ownership
was “much more concentrated” among a “narrow
group of insiders” than was initially anticipated,
creating a “class of wealthy tycoons”
223
2. Small-Scale Privatization: transfer of small shops
(usually to current managers); agricultural land
“decollectivized”; apartments sold to current occupants
3. Privatization for Cash: in 1995 the Russian government
shifted focus to “privatization for cash” to dispose of
remaining assets (mostly utilities, natural resources, and
high-tech defense enterprises)
 “Loans-for-Shares” – program under which the
government used shares in public enterprises as
collateral for loans from the private sector, with no
intention of ever being able to repay the loans
 Primary motive was probably to solidify support for
Yeltsin before 1997 election
 Potential for corruption => billions of dollars of state
enterprises would end up being in essence “sold” to
private individuals for a fraction of their true value
 e.g., Norilsk Nickel, with annual revenues of $1.5
billion, acquired by Vladimir Potanin for $180 million
224
Summary of Transition to Markets:
The transition to markets in many of these countries was
not very smooth
 high levels of corruption hindered growth in several
countries => recall the description of present day Russia
as “an ill-governed kleptocracy” in which “corruption
is…the core of the system”
 several of these countries still suffer from either high
inflation or high unemployment
Czech Republic
Hungary
Poland
Romania
Russian Federation
Slovak Republic
Annual GDP Annual GDP Unemployment Inflation
Misery
Growth
Growth
Rate
Rate
Index
1990-1999
2000-2004
2000-2010
2000-2010 2000-2010
0.9%
2.9%
7.2%
2.7%
9.9
1.0%
3.5%
7.4%
6.0%
13.4
4.7%
2.8%
14.4%
3.4%
17.8
–1.2%
5.5%
7.3%
15.4%
22.7
–6.1%
6.1%
7.7%
17.3%
25.0
1.9%
4.8%
15.3%
4.8%
20.1
225
Three potential difficulties in the transition to capitalism:
1. problems related to the transfer of political power
 to move from planning to markets, decision making
power must be transferred from government
officials to a new class of capitalist entrepreneurs
 the reformers of today want to accomplish this
quickly and peacefully, something which has never
been accomplished previously in history
2. long term benefits, but short term costs
 the “positive aspects” of market outcomes (e.g.,
efficient use of resources) are realized in the long
term
 however, transitioning to a market system often
brings about “negative realizations” (e.g.,
abnormally high rates of unemployment or
inflation) in the short term, as the use of resources
adjusts
 as noted in the textbook, the “unavoidable side
effects of a transition to capitalism are likely to
make their unwelcome presence felt long before
economic growth and well-being arrive.”
3. complications in creating institutions and laws
 property rights and laws relevant for the functioning
of a market economy must be created. How will
this be done? Who will undertake these tasks?
 how will state owned property be transferred to
private ownership? (noted potential for corruption)
 it may take time for private supporting institutions
(such as banks, law firms, accounting firms) to
emerge => how well can a market be expected to
function in the interim?
226
Realized outcomes:
 while several of these countries had disruptive transitions
(and some are still plagued by high levels of
unemployment or inflation), most have adjusted to
stable, market based systems
 as noted in the textbook, “by the mid-2000s, many of the
major East European countries, including Hungary,
Poland, and the Czech Republic, were growing rapidly,
competing internationally and becoming well integrated
into global capitalism.”
 in particular, the increase in per capita GDP over the past
decade (once solid, stable market institutions were more
well established) is substantial (all values are “2000 U.S.
dollars”):
Czech Republic
Hungary
Poland
Romania
Russian Federation
Slovak Republic
United States
%
%
increase increase
1990
1995
2000
2005
2010
1990 to 2000 to
2010
2010
5,351 5,102 5,522 6,658 7,381 37.94% 33.67%
4,359 3,884 4,543 5,639 5,634 29.25% 24.01%
1,694 3,603 4,454 7,963 12,294 625.74% 176.02%
1,896 1,741 1,651 2,260 2,637 39.08% 59.72%
2,602 1,618 1,775 2,443 2,923 12.34% 64.68%
5,316 4,532 5,330 6,775 8,446 58.88% 58.46%
28,274 30,025 35,082 37,732 37,491 32.60%
6.87%
227