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Economic Transitions: Learning from Central Europe

Tuesday, October 2, 2012

What practical lessons can the experience of post-communist transitions in Central and Eastern Europe offer to countries that are attempting to overhaul their economic systems? With the Arab Spring, a window of opportunity has been opened in the Middle East and North Africa to put in place new institutions conducive to entrepreneurship, innovation, and economic growth.

To be sure, the world today offers very few examples of genuine centrally planned economies. Even the worst performing low- and mid-income countries do have sizeable private sectors and experience with open markets. However, despite the wide-ranging scale of reform challenges in different societies, many countries in the mid-income world, which are undergoing significant political changes at the moment, will also need to privatize, remove distortionary subsidies, stabilize their public finances, and create space for the growth of the private sector.

Egypt, for instance, is suffering from an acute public finance problem, which is driven mostly by the existence of a distortionary subsidy system, aiming to keep prices of certain commodities low in order to help people in need. But, of course, indiscriminate subsidies to commodities chiefly benefit the wealthy and place a strain on public finance. Many Arab countries have sizeable public sectors — roughly one third of Egypt’s economy is run by the military, for instance. As a result, a genuine transition to the market will necessitate privatizing state- and military-run enterprises — albeit on a smaller scale than in countries where the whole of the economy was owned by the government. As a rule of thumb, Arab Spring countries suffer from suffocating barriers to entrepreneurship and corrupt bureaucrats enforcing those rules. The revolution in Tunisia was, after all, sparked by the self-immolation of Mohamed Bouazizi, an aspiring entrepreneur who was selling fruit and vegetables illegally and was being harassed by the local authorities.

Many of the challenges facing the Arab world today are not that different from those facing Eastern Europe twenty years ago.

Context-specificity matters, and the Middle East in 2012 differs from Eastern Europe in 1990. Still, many of the challenges facing the Arab world today are not that different from those facing Eastern European economies twenty years ago. As a result, one may hope that there are some lessons from post-communist transitions that need to be kept in mind if the democratic transitions in the Middle East are to succeed.

Unfortunately, most current debates about economic and political transitions and desirable reform strategies are flawed, as they do not reflect the role played by dispersed knowledge in the economy and the incentive problems existing within the political sphere. It is not helpful to provide reform advice that is grounded in the assumption that reformers are omniscient and benevolent. After all, the central reason for the failure of planned economies was that they placed unrealistic epistemic and motivational demands on policymakers. In the same vein, many popular prescriptions for economic reforms implicitly assume that policymakers do not face cognitive constraints and that their motives are purely benevolent. This article, therefore, has the ambition to outline a few lessons that are more likely to pass the test of robustness with regard to less-than-ideal assumptions about policymakers’ knowledge and incentives.

This essay is partly an attempt to rehabilitate the “Washington Consensus.” By focusing policymakers’ attention on variables that they could directly control, and by providing a simple laundry list of policies that are necessary, though not sufficient, for the success of transitions, this approach provided a more solid platform for economic transition than its alternatives. Although one might question the soundness of its economic fundamentals, it is not clear whether systematic improvements upon its results were possible without requiring unrealistic assumptions about the knowledge and benevolence of policymakers.

This essay also calls for humility. Ultimately, success or failure of economic reforms does not depend on economic considerations alone. The success of transitions hinges mostly on how the undertaken economic reforms relate to the underlying informal institutions, culture, and expectations. In other words, ideas, culture, and rhetoric can go a long way in explaining the success or failure of economic reforms. Economists generally recognize the role of institutions but they seldom acknowledge that institutions cannot be changed at will. At the same time, as the experience of the past century shows us, ideas and rhetoric are not immutable. They do change, for worse and for better.

Finally, this essay is a call for action. It is the obligation of public intellectuals in free countries to foster free discussion and rigorous thinking about economic policy and political institutions, not only in our own countries, but also in places that still suffer, or have until recently suffered, under authoritarian rule. Although Egypt, Libya, and Syria are very different from post-communist Eastern Europe, their transitions away from authoritarian and heavy-handed government will not be successful unless they undergo a radical shift in the way their citizens think and talk about government, civil society, and economy.

What do we know about transitions?

For many in the economics profession, the fall of communism in 1989 came as a surprise. For decades, neoclassical economists maintained that centrally planned economies could perform just as well as market economies. In the famous “socialist calculation debate” of the 1930s, the mathematical economists advocating the theory of general equilibrium maintained that, in principle, a central planner could solve the problem of allocating resources and organizing production just as well as a competitive markets. As late as 1989, in their bestselling textbook, Paul Samuelson and William Nordhaus wrote,  “contrary to what many skeptics had earlier believed . . . the Soviet economy is proof that . . . a socialist command economy can function and even thrive.”

Only a minority of economists believed that central planning was doomed to failure, and their arguments were not easily amenable to mathematical formalization. Partly because of that, their ideas did not get much traction until relatively late on. Friedrich von Hayek, one of the leading critics of socialist economic planning, maintained that neoclassical theorists left a crucial factor out of their models. In the real world, the knowledge needed for economic planning is to a great extent tacit and decentralized. In other words, the relevant knowledge that individuals use in their economic life consists not only of technical or scientific information but also of knowledge of “particular circumstances of time and place,” which is seldom articulated and, therefore, difficult to communicate explicitly. One of the key functions of market prices is to communicate that knowledge and use it to make economic decisions. When frost suddenly destroys the crop of oranges in Florida, the price mechanism induces consumers to adjust their behavior, without them having any idea about the reasons for the sudden change in the supply of oranges. Price signals thus enable people to act on knowledge which they do not possess and which they could not reasonably be expected to collect. This feature of private markets does not depend on whether they are “efficient” in the neoclassical sense — if anything, disequilibrium makes the role of price signals even more relevant than a situation of stationary equilibrium. By eliminating this mechanism, socialism placed unreasonable epistemic demands on the planners who were expected to make economic decisions without being able to use the condensed bits of decentralized knowledge embodied in market prices.

In economic transitions, macroeconomic stabilization is a necessary though not a sufficient part of any reform strategy.

Hayek’s point about tacit knowledge was subtle. There was also a more mundane reason for the failure of socialism, which had not been fully internalized by the economic profession until recently. A system where economic decisions were based on a process of bargaining over output and resources between factory managers and planners created perverse incentives. Even if we agreed that socialist planning could, in principle, deliver efficient outcomes, it remains unclear whether the individual conduct needed to attain such outcomes is incentive-compatible. In planned economies, factory managers were motivated to provide planners with information that led them to either increase the factors of production given to companies and/or decrease the level of output relative to what it would otherwise have been. This public choice also led the planners to set prices artificially low, in order to induce shortages in product markets, because shortages created rents for those involved in the supply chain.

These two considerations — the problem of local knowledge and the problem of incentives in the government sector — are central to our understanding of the economic problems of socialism. On a general level, problems of dispersed local knowledge and perverse incentives existing in the political sphere go a long way towards explaining the deficiencies of the political economy of the Arab world — albeit the particular manifestations of these problems are different from those of centrally planned economies. Unfortunately, those two considerations were missing from most models that the economic profession had relied on, and the fall of communism caught many economists off guard — just as the events of the Arab Spring caught off guard many observers of Middle Eastern politics. Yet, economists were then expected to provide practical solutions that would guide the transition of formerly communist countries to market economy. Did they do a good job? With the benefit of hindsight, what economic lessons can one safely draw from the experience of post-communist countries in Central and Eastern Europe?

Macroeconomic stabilization

Unsurprisingly, when asked for advice, economists turned their attention towards a subject they knew and understood: macroeconomic stabilization. Economic structures that emerged after decades of socialism were bound to produce sizeable macroeconomic imbalances once exposed to genuine market forces. Prices of consumer goods, which had been kept below equilibrium at the time of the planned economy, needed to increase in response to liberalization, creating upward pressure on inflation. At the same time, countries could expect current account balance crises to materialize, as the markets existing under the Council of Mutual Economic Assistance disintegrated. The restructuring of national industry, including the closing down of large and wasteful heavy industries, was likely to increase unemployment, and, therefore, to apply pressure on the social safety net and on public budgets.

From whatever perspective one approaches economic transitions, it is clear that macroeconomic stabilization was a necessary — albeit not a sufficient — element of any successful reform strategy. With this understanding, a leading group of economists was prescribing a strategy of rapid, systemic changes to the post-communist countries, with a strong focus on restoring macroeconomic stability. This approach was dubbed the Washington Consensus, because at the time it reflected the dominant view of the U.S. Treasury, the imf, and the World Bank on the policies that either were or should have been adopted by Latin American countries in the 1980s. Very quickly, partly through the work of Jeffrey Sachs and others, the idea that rapid macroeconomic stabilization is the key to success in economic transitions was translated into policy practice in the transitional world.

Apart from the emphasis on containing inflation and budget deficits, and tackling external imbalances, this perspective argued that rapid privatization and liberalization — both on the domestic, microeconomic front and also with regard to external trade and capital flows — were of the essence. This approach emphasized the existence of complementarities between various elements of economic reform. Plausibly, price liberalization, without prudent monetary policy, would result in rampant inflation rates. Similarly, without the imposition of hard budget constraints, liberalization would not induce the right behavioral responses on the part of the firms. And speed was essential because the fall of communism provided a window of opportunity for reforms, which was likely to close once the initial euphoria dissipated.

These rapid reforms, accompanied by macroeconomic stabilization, worked. Sure, in all countries, output contracted in response to liberalization and the collapse of the Comecon markets. As a rule of thumb, this contraction was related to the initial conditions of the economy — the less agile economies, more dependent on the production structures of the Soviet-run economic cooperation, suffered more than those able to reorient trade and economic activity towards Western markets. The Baltic and the Visegrad countries were able to make that transition very quickly and very effectively. In contrast, most countries of the former ussr have had serious troubles along the way. But that is not, by itself, an indictment of the “shock therapy.” It is rather an unfortunate result of the distortions created by the logic of Soviet-style central planning. After all, the slump was deepest in countries that can hardly be accused of following a radical program of economic reforms — such as Ukraine or Moldova.

Is seems naïve to think that privatization should be postponed until a complex legal and judicial framework is in place.

Even in Russia, the failure to transition fully towards democratic capitalism cannot be blamed on the radical reforms package put forward by Yegor Gaidar and his “kamikaze” team in 1992. For instance, the price liberalization of 1992 was far from complete and the overall program lacked credibility. That was not Gaidar’s fault. Russians had seen numerous failed attempts to fix the economy, and had little reason to believe that this time was any different. The Russian liberalization program was accompanied by an extremely accommodative monetary policy. As a result, the hard budget constraints that the reformers were trying to impose on Russian enterprises were quickly relaxed by the inflow of cheap credit, resulting in a catastrophic inflation rate of 2,500 percent in 1992.

Numerous other pitfalls occurred on Russia’s way towards a market economy — the uncanny alliance between big businesses and regional governments is probably the single most striking one. It resulted in an economic structure that fostered local monopolies and prevented the exit and entry of various industries, thus hampering economic growth. It also had unfortunate political repercussions, resulting in the persisting one-and-a-half-party rule. But none of those unfortunate outcomes can be blamed on radical economic reforms — most importantly because Russia’s reforms were not all that radical.

All things considered, it would be ill-advised to label the “shock therapy” as a failure. Its proponents — such as Jeffrey Sachs or Stanley Fischer — were not claiming that rapid and wholesale reforms would solve all economic ills. They were merely pointing out that macroeconomic stability was a prerequisite for successful reform, a belief that was largely confirmed by the events of the 1990s and the 2000s. It is true that the Washington Consensus has often been blamed for ignoring the problems of the institutional framework within which market economies operate. Privatization, liberalization, and macroeconomic stabilization, by themselves, are not always going to create an environment where private enterprise can flourish. But the relevant question is whether any quick fixes were available to address those problems.

Privatization v. restructuring

Rapid privatization, which was an integral part of the radical reform packages implemented in Central and Eastern Europe, has probably been the most contentious aspect of the post-communist transitions, partly because of its perceived unfairness. In many countries, shrewd individuals with political connections found themselves in possession of large companies employing thousands of people and worth billions of dollars. Worse yet, many of the new owners were arguably not in an ideal position to restructure the companies they purchased, and neither was the legal environment always conducive to the smooth functioning of the private sector.

Was there an alternative to rapid privatization? The idea that privatization should have been postponed until a complex legal and judicial framework was ready to fully accommodate private enterprise has become dominant in certain circles, both in the economic profession and among the general public. Yet that belief seems naïve at best. Effective legal rules cannot be created instantly by government fiat. And, even if they could, they would require informed judges and lawyers to enforce them.

Practical issues aside, there was one central reason for rapid privatization: credibility. Historically, communist economies were subjected to numerous reforms. In the ussr alone, significant reforms occurred in the 1920s, 1950s, 1960s, and 1980s. All of them either failed and/or were reversed at some later stage. In such circumstances, the commitment of reformers to a market economy, especially if they were connected in any way with the previous political elite, was contestable, and piecemeal reforms would have been perceived as reversible and lacking credibility. The only way the new political elite could signal its durable commitment to the new economic and political order was to use the brief window of opportunity for rapid and encompassing reforms, including privatization. It is beside the point whether an “optimal” sequence of small-scale reforms and restructuring could have, in principle, worked better. In a situation where commitment to the emerging market order was in doubt, wholesale and rapid reforms were necessary. The large scale of the newly created private sector and its mass character were thus seen as a greater constraint for potential re-nationalization.

A large body of economic literature has tried to map the effects of privatization on economic performance. On a superficial level privatization has improved the economic performance of companies. Of course, the relevant question is whether the counterfactual to rapid privatization was more likely to produce good economic outcomes — and that question is more difficult to answer unambiguously. The general conclusion of the literature on the economic effects of rapid privatization is that privatization of a company guarantees a genuine transfer of ownership only if specific institutions are in place. Thus, when privatization occurred in a good institutional environment, it had a positive effect on corporate performance. Conversely, most studies fail to demonstrate a strong negative effect of privatization on economic performance of enterprises when institutional conditions are adverse. Overall, it appears that privatization was a winning strategy, although its results were better in some contexts than in others.

Sure, in institutionally weak countries privatization has led to stagnation and the decapitalization of companies, instead of better financial results and increased efficiency. However, renationalization or postponement of further privatization was unlikely to provide any major gain. As John Nellis, a former World Bank economist observed, “governments that botch privatization are equally likely to botch the management of state-owned firms.” So while rapid privatization in Central and Eastern Europe did not always live up to people’s expectations, we’ve yet to see convincing evidence that its alternatives would have been any better.

Institutions and economic transitions

It is undeniable that the key problem of economic transitions was institutional. Market economies do not exist in a vacuum, and their performance depends on the presence of a complicated network of formal and informal norms, legal rules, and also trust and cultural expectations. Numerous economists were therefore quick to point out that reformers and policymakers who ignore those factors are unlikely to provide sound reform advice. The Washington Consensus has therefore quickly become a subject of harsh critique and ridicule.

But what reform advice — informed by a more thorough understanding of the role of institutions — could one have given to prospective reformers in post-communist countries? The practical lessons of the “neo-institutionalist” approach, pioneered by University of Maryland economist Peter Murrell and Gerard Roland of uc-Berkeley, are limited to questions of timing and sequencing, where the approach advocates implementing more popular reforms first, in order to build political support for further reforms. These economists also emphasized the creation of a robust legal and institutional framework before privatization and liberalization take effect and a potentially large role for the government in the process of control and restructuring of state-owned enterprises. On a more general level, the neo-institutionalists were worried by the existence of externalities in the creation, design and destruction of large organizations. Clearly, new companies do not emerge out of thin air, and bad, inefficient companies do not disappear without imposing significant social costs. One corollary of this was the belief that there existed a trade-off between the creation of a new private sector and the decentralization and privatization of the government-run economy.

One has to wonder whether the neo-institutionalist perspective does not ask too much from policymakers. Back in 1990, Václav Klaus famously observed that we can

compare the transformation process with chess playing. If we want to play chess, we must know how to play. We must know how to move various pieces on the chessboard. We must know the basic opening strategies. But it’s not possible to know the situation on the chessboard after the 15th or 25th move.

Arguably, economic transitions are even more complex than that. Unlike in a chess game, in the real economy the chess pieces have a volition of their own.

If Washington Consensus-style policies were seen as “societal engineering,” to use Roland’s characterization, it is not clear what we can call the institutionalist approach to economic reform. Not only does it require that policymakers are able to identify the measures that are the most likely to elicit popular support at the beginning of the transition, but also that they are able to sequence the reforms in a way that leads to the desired outcome. Even the question of identifying winners and losers from particular policy moves is a more complex task than first meets the eye. Counterintuitively, the World Bank economist Branko Milanovic demonstrated that the biggest winners of the post-communist transitions were pensioners — a finding that is at odds with the popular perception of pensioners as the most vulnerable victims of the allegedly ruthless transition towards capitalism.

More fundamentally, it is a mistake to expect the progress in the creation of functioning and well-enforced property rights in transitional countries to come primarily from the perfection of the legal system. Particularly in the case of more complex assets and more intricate market relationships, it is essentially impossible to identify the desirable legal mechanisms in advance, without actually observing the practices that emerge on the markets. Of course, institutional order is key to the functioning of the market economy. However, the rules of market order are not something that can be designed and imposed on market participants from above in no time.

Institutions matter. But just affirming their importance is unlikely to be enough. If creating the right legal and regulatory setting for a market economy to exist appears complicated, one should recall that there are essentially no known ways of creating, through the means of public policy, the informal and cultural norms that typically support a market economy. At the same time, the interaction between economic reforms and the underlying set of informal norms, cultural environment, and the local set of expectations — which are sometimes called “metis” by scholars such as Peter Boettke of George Mason University — is critical for the success of the transition. In countries where metis was receptive to a radical turn to a market economy and representative government, this transition seems to have occurred successfully. Not only did voters in the Czech Republic, Poland, and Slovenia not punish the reform governments for the pain of the reform, they have continually supported the change, even when it came at a cost. Backlash and unintended economic outcomes occurred in places where the underlying metis was not congruent with the institutional change that the reformers were trying to impose. In Russia, for instance, the efforts of Gaidar’s government were not met with much sympathy, either from interest groups or the electorate, neither of which had a deep appreciation of the need for institutional change.

Economics cannot really capture the underlying sources of social change that determine whether reforms succeed or fail.

The differences in metis might have to do with geopolitics and geography. In Central European countries, populations shared a clear sense of direction — they wanted to be part of the democratic and capitalist Europe. In many places, there was still a memory of pre-war years when those countries had been reasonably well-governed and prosperous. In Russia, perceptions were different, as many saw the collapse of the Soviet Union as a defeat for the Russian nation at large. While the Czechs and the Poles embraced the prospects of eu membership and the legal reforms that accompanied it, no similar prospects existed in Russia. No wonder that no significant momentum for reforms developed there.

Although geography matters, it hardly tells us the whole story. Even among the relatively successful countries of Central Europe, we saw substantial differences in metis, which affected the results of transitions. In Czechoslovakia, for instance, there existed a stark difference between the perceptions dominant in the Czech and the Slovak parts of the country. Slovaks believed that the radical transition package embraced by Klaus’s government did not suit Slovak economic interests, which would have been better satisfied by a milder reform program. This divergence of views, fueled by decades of Slovak nationalism, resulted in the Velvet Divorce of 1993. In subsequent years, Slovaks had to discover capitalism and create a free market on their own, through an iterative process, which first involved cronyism and reckless corruption but later brought about some bold reforms, turning the country into one of the fastest growing economies in Europe.

The Czechoslovak example shows that metis is not something immutable. Ideas change, and so do the prevailing sets of cultural norms and expectations. Unfortunately, economists are not particularly well equipped to explain and understand these shifts. And the economic profession is even less well suited to forecast, manage, or mastermind such shifts in advance. This means that humility is of the essence, whenever we discuss institutional and economic shifts in the world — especially in countries that we do not have an intimate knowledge of, such as those of the Arab world.

Although there are not many genuine planned economies left in the world today, there are a great many countries, especially in the low- and mid-income world, which have yet to create space for private enterprise and human flourishing. For those who are thinking about ways in which the West could foster successful transitions towards free market economy in places that are suffering from bad governance and massive government involvement in the economy, the central lesson from post-communist transitions is probably the importance of the metis, and the impossibility of altering it through policy interventions. Rather, freedom-loving people in the West need to invest in ideas and enable the elites and public in the emerging economies to see for themselves that there are no credible alternatives to free- market economy and representative government. This investment might bear fruit only in an uncertain and possibly distant future. But once an understanding of the role of the market and limited, representative government is established and translated into the way people think and talk about their country, then it will be very easy to solve the technocratic question of which reforms should come first and which should come second.

Fatal conceit

Economics can provide a willing reformer with a list of measures that are needed for a successful transition to market economy. In this respect, the old-fashioned laundry list of macroeconomic stabilization, liberalization, and privatization, implemented credibly and in a short time frame, gives as good a policy prescription as any other. Indeed, there is not much else that the prospective reformers are in a position to do. The idea that policymakers ought to design a perfect set of working institutions and legal norms ahead of the reforms, and that they carefully plan the sequence of gradual transitional steps, is a display of fatal conceit. To achieve that would require the policymakers to be at the same time omniscient and benevolent.

Concurrently, economics can’t really capture the underlying sources of social change that determine the success and failure of economic reforms. This should not come as a surprise, unless one adheres to a materialistic vision of society, in which institutions, culture, and ideas are mere by-products of its productive forces. After 1989, a change in ideas and rhetoric transformed much of Central and Eastern Europe into normal, prosperous countries. The same can happen again in the Middle East and North Africa.