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.”)

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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.

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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.”

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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)

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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”

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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

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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…

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?...”

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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

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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”

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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.”

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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%, 1999-2001; 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).

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Military Output

Non-Military Output

After “Gaidar Reforms”

Before “Gaidar Reforms”

0

0

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”

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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

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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

Annual GDP Growth

1990-1999

Annual GDP Growth

2000-2004

Unemployment Rate

2000-2010

Inflation Rate

2000-2010

Misery Index

2000-2010Czech Republic 0.9% 2.9% 7.2% 2.7% 9.9

Hungary 1.0% 3.5% 7.4% 6.0% 13.4Poland 4.7% 2.8% 14.4% 3.4% 17.8

Romania –1.2% 5.5% 7.3% 15.4% 22.7Russian Federation –6.1% 6.1% 7.7% 17.3% 25.0

Slovak Republic 1.9% 4.8% 15.3% 4.8% 20.1

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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?

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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”):

1990 1995 2000 2005 2010

% increase 1990 to

2010

% increase 2000 to

2010Czech Republic 5,351 5,102 5,522 6,658 7,381 37.94% 33.67%

Hungary 4,359 3,884 4,543 5,639 5,634 29.25% 24.01%Poland 1,694 3,603 4,454 7,963 12,294 625.74% 176.02%

Romania 1,896 1,741 1,651 2,260 2,637 39.08% 59.72%Russian Federation 2,602 1,618 1,775 2,443 2,923 12.34% 64.68%

Slovak Republic 5,316 4,532 5,330 6,775 8,446 58.88% 58.46%United States 28,274 30,025 35,082 37,732 37,491 32.60% 6.87%

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