Chapter Twenty-One: Notes -- Transition Economies

• The East Meets the West
• Socialism and Capitalism
• The Collapse of Socialism
• Macroeconomic Transition Issues
• Other Transition Issues
• Poland
• Russia
• Polish and Russian Transitions Contrasted
• Comparative Analysis of Transition Economies

The difference in living standards in just a forty-five year period is striking. As Table 1 illustrates, household income in West Germany was three times higher than income in the East. Even this statistic understates the true difference in living standards because a smaller percentage of production in the East was for domestic consumption. Perhaps more telling is that those in the East had to work six times as long as those in the West to purchase a shirt, and twelve times as long to purchase a color television set.

In the late 1980s the disintegration of socialist economies began in earnest and the Berlin Wall was torn down November 9, 1989. Although the merger of East and West Germany has gone relatively well, many problems were encountered. Indeed, Germany is still going through difficult adjustments more than a decade after the transition began. During the transition, output in eastern Germany collapsed because its economy produced noncompetitive, low-quality products that few wished to purchase. Eastern Germans flocked to the west in order to purchase higher quality products. With the output collapse came a surge in unemployment in the east. Unofficially, it was estimated that one in three workers lost their jobs, though the official unemployment rate peaked at 16.5 percent in 1992. Unemployment in the East has remained stubbornly high. Even as late as May 2000, eastern [Outside Econweb] Germany's unemployment rate was 16.9 percent, compared with western German unemployment of 7.5 percent. The poor employment performance comes in spite of massive government transfers from west to east.

Despite the hardships, the transition of eastern Germany to capitalism has been relatively easy. Western Germany imposed its political, economic and social institutions on the east, resulting in a stable democracy and macroeconomy. Other transition experiences--such as the Russian experience--have been much more difficult.

Socialism and Capitalism

The second question that all economies must answer is how to produce the goods and services. In socialist systems, managers and government officials plan the production process and the technology used. Individual plants may have some leeway to influence the production process, but as we discuss below, there is little incentive to do so. Capitalist economies leave the decision of how to produce up to private firms. In theory, firms produce in such a way as to minimize their costs of production. If machinery is relatively expensive, firms use more labor. Government may set some regulations on the production process, imposing environmental regulations for example, but firms still have much leeway in deciding how to produce their products.

The third question is to decide for whom the goods and services are produced. Socialist economies answer this in two ways. First, the government determines employee wages. The wages determine income and hence, consumption levels. Second, the government directly sets the prices for goods and services. In theory, a socialist government could set prices so that supply equals demand. If there are long lines for certain products, the price could be increased until the lines disappear. In practice, however, long lines are commonplace because governments keep prices of key products low for political and social reasons. Typically, energy and food staples are priced at a fraction of their production costs. Therefore, many goods are produced for those who are able and willing to wait in long lines. In the Soviet Union, for example, bread prices were unchanged for thirty years. Market economies also produce the goods and services for those who have income. However, income is not set directly by the government. Wages, like most prices, are set by the forces of supply and demand. One consequence of this is that capitalist economies tend to have more income inequality than socialist economies. West Germany, for example, had more income inequality than East Germany even though average income levels in West Germany were much higher.

After World War II, socialism spread from Russia to much of eastern Europe and parts of Asia. Initially, economic performance was somewhat respectable in these countries; growth rates were high. Recall from the production possibilities frontier that economic growth can result from an increase in the resource base (extensive growth) or from an increase in technology (intensive growth). Socialist economies primarily took advantage of exploitation of untapped resources, which resulted in extensive growth. Labor force participation rates for women increased dramatically as did the average number of hours worked per week. However, the good economic performance began to slow dramatically in the 1960s as socialist economies stagnated. The gap between the West and the East increased. Why did this happen?

Dynamic growth incentives were weak in socialist economies. Recall from Chapter 19 that economic growth requires institutions that foster the process of creative destruction in which new technology destroys the old. This process requires supply-side competition and profit-seeking behavior. Socialist economies by their very nature did not promote competition. Proper dynamic incentives also require capital markets that respond to the potential for earning a return, not to the whims of state bureaucrats. In socialist economies, funds were rationed based on how they were rationed the previous year and on who was the most influential in the political process. For example, East German workers, in contrast to their counterparts in the West, had no incentive to improve the products that they produced. Even if the technology reduced production costs, the employees did not receive higher wages. Quality-enhancing technology was also unimportant because prices were set by the state and consumer demand was guaranteed. Consumers had to buy the inferior product since there were no alternatives available. Moreover, if a firm found a way to produce the output quota using fewer resources, then the quantity of resources allotted to the firm the following year may have fallen. These incentives are analogous to a government agency that must spend all of its budget in a given year even if it does not need all of the funds, in order to avoid cuts during the following year. For these reasons, dynamic incentives were weak and technology, productivity and wealth lagged behind Western economies.

Key macroeconomic issues arise as well. The most important of these are to achieve price, output and exchange rate stability in the short run and high rates of growth via high levels of savings and investment in the long run.

Former socialist economies typically experience high rates of inflation in the early transition years. Price liberalization, declining output, and rising velocity account for much of the inflation.

Price liberalization abolishes price controls set by the former socialist government; prices now float in the market. This process touches off an initial burst of price increases because many key goods and services such as food staples and oil were purposely underpriced in the socialist economy. As the figure titled "Removal of a Price Ceiling" illustrates, the price level rises from P_C to P_E when the price ceiling is removed. Rather than keeping prices artificially low and generating waiting lines, firms exercise their new power and increase the prices of goods and services. As the price level rises, consumer demand declines.

A second inflationary force is the negative supply shock that transition economies experience. Five-year plans coordinated production under socialism. With the conversion to a market economy, the plans become increasingly irrelevant. In the confusion, output declines as state-owned firms are cut off from funding or necessary intermediate inputs fail to arrive to allow other firms to produce their products. As the figure titled "Negative Supply Shock" illustrates, the Aggregate Supply curve shifts to the left, resulting in lower output and a higher price level.

The third inflationary force is monetary overhang--a situation left over from the socialist era in which there is ample currency in consumers' hands because there were few goods and services to purchase. With the transition to capitalism, consumers begin to spend their cash rather than see it erode with inflation. Large sums of currency compete for the limited supply of goods. Consumers who were forced to wait in lines before to purchase goods now compete for goods with their money. In Monetarist language, the velocity of money increases as money demand declines. Recall from the equation of exchange (M x V = P x Y) that an increase in V leads to an increase in nominal output (P x Y). Because output is essentially fixed in the short run, the higher velocity leads directly to an increase in the price level.

To prevent the rising prices from becoming permanently high inflation (and possibly hyperinflation), the government must avoid printing large sums of currency to finance expenditures. However, budget pressures make the printing of money tempting. The budget deficit (G + TR - T) typically increases significantly during transition as government expenditures decrease slowly while tax revenues decline rapidly. Two budget priorities in particular strain the budget. First, socialist governments directly provide operations funding to state owned enterprises (SOEs). For political, economic, and social reasons, governments are reluctant to reduce or eliminate this funding. To do so means that employees are laid off, potential voters become very angry, and poverty and homelessness increase. So SOEs continue to operate despite large losses. Even if the SOEs are semi-private after the transition, they often operate under what is called a soft budget constraint. This is a situation in which the government is the underlying source of funding if an organization experiences negative net income. The firm need not change organizational behavior to cut losses or turn a profit because the firm knows that the government will make up the loss. Second, the social safety net must expand (or be recreated) to take care of the newly unemployed and the expanding poor class. This entails additional government spending for social programs.

These budget priorities occur in the context of falling tax revenues. As demonstrated by Russia, tax collection can pose a severe problem for transition economies. Under socialism, the state simply kept the profits from their enterprises. But with wages determined by the private sector, an income tax must be established. This tax system requires accurate recording of workers' incomes, tax laws to specify tax levels, and an enforcement agency with the power to detect and punish tax evaders. An income tax takes time to create and establish. In the mean time, tax revenues decline.

If the government cannot pay its debts with existing tax revenue, it may print money in order to pay off debts. Soon, the price increases are built into people's inflation expectations and quickly turn into a wage-price spiral. Recall from the Phillips Curve that in the long run, inflation expectations determine the inflation rate, or = P^e. When an economy experiences hyperinflation, transaction costs become extremely high. The monetary system, whose function it is to facilitate exchanges by eliminating the need for a double coincidence of wants, becomes increasingly irrelevant. It is difficult to experience economic growth in this environment. Successful transition economies such as Poland and the Czech Republic reduced their inflation rates over the period of a couple years by managing their deficits through reduced expenditures and rising tax revenues.

Another macroeconomic issue is currency stabilization in the foreign exchange market. The stabilization process typically requires a large initial devaluation because of past government support of an overvalued currency. As the figure titled "Pressures for Exchange Rate Devaluation" illustrates, downward pressure on the currency continues even after the initial devaluation because demand for foreign exchange rises and supply of foreign exchange falls.

New consumer freedoms lead to a surge in imports and capital flight--the transfer of domestic wealth to other nations' assets--increases as citizens seek to harbor their savings in other countries. Both of these effects shift the demand for foreign exchange to the right, devaluing the domestic currency. The supply of foreign exchange decreases as exports fall with the collapse in output and the disintegration of the socialist trading blocks. In addition, high inflation rates make the nominal domestic currency less valuable, resulting in devaluation. Measures that restrict imports and capital flight can ease downward pressure on the currency in the short term, but long-term success requires a healthy and growing export sector.

Transition economies must choose the type of exchange rate policy that they wish to follow. In Chapter 20, three possibilities were discussed. First, the nation could follow a fixed exchange rate policy in which the value of the domestic currency is tied to a foreign currency (or a basket of currencies) whose value is stable. This allows the exchange rate to serve as an anchor for inflation expectations. If the value of the Polish zloty, for example, is tied to the dollar, then to avoid devaluation, the rate of inflation in the Polish economy must be similar to that in the United States. If Polish inflation rates continually surpass those of the U.S., then devaluation is inevitable. Therefore, a fixed exchange rate provides the economy with a measure of inflation expectations in controlling inflation. However, there is little room for error. Just one devaluation reduces or eliminates the credibility of the government's desire to control inflation. Citizens no longer believe that the government will maintain its promise of fixing the exchange rate.

The opposite extreme is a flexible exchange rate policy. In this case, market forces determine the international value of the currency. The advantage of this system is that monetary policy can be conducted with less regard for effects on the currency. Moreover, the exchange rate adjusts to keep exports competitive and trade deficits at reasonable levels. The opportunity cost of this policy is the chance to more aggressively reduce inflation because there is no foreign currency to serve as an anchor for inflation. Reliance on the market can also lead to highly variable exchange rates in the short run, making foreign transactions more difficult.

A third possibility is a crawling peg. This strategy has the advantage of serving as a moving anchor for inflation expectations, and it is more realistic in situations in which inflation cannot be brought to low levels immediately. The government is not put in the position that, with one devaluation, its inflation fighting credibility is lost.

Over the long run, transition economies must stimulate foreign trade and attract foreign investment. Both of these measures help to stabilize the domestic currency. In addition, foreign investment can provide needed capital, technology and management expertise. Since transition economies typically have low levels of saving and need to play catch-up in the technology game, foreign investment becomes particularly important. In general, transition economies have done a poor job at attracting foreign investment. The reason is that foreign investors want essentially the same things they desire in their host country: secure property rights, macroeconomic stability, and an institutional framework that treats foreign firms fairly. Transition economies have often had a hard time delivering these things.

Should the transition occur slowly or quickly? Unfortunately, economic theory provides little guidance to addressing this question. Poland and Russia adopted a rapid process called shock therapy. Major institutional changes were implemented immediately. China, on the other hand, has been in transition for more than 25 years--a process called gradualism. China has yet to make the radical political changes that many former socialist nations have made and they have openly repressed calls for more democracy.

Probably the most important factor in determining the speed of transition is the political environment of the transition country. Because Poland was the first nation to begin the transition, shock therapy was implemented for fear that the socialists might use force or public persuasion to dramatically slow or reverse the conversion to capitalism.

Whether transition occurs slowly or quickly, most price controls must be lifted and property must be privatized. Price liberalization is perhaps the easiest to accomplish since it involves removing controls rather than imposing new ones. Price liberalization reduces the inefficiencies involved in resource allocation; resources are priced closer to their opportunity cost.

Private ownership of property is essential in providing solid dynamic incentives for profit-maximizing behavior. Individuals must be assured that they will earn a return on their capital and labor, otherwise they have little incentive to invest in businesses or create new businesses. With secure property rights, people are more willing to work hard to succeed. But the process of privatization has not been easy for most transforming economies because it requires the government to relinquish control of power and often economic profits. In addition, the sale of a state-owned enterprise typically leads to worker layoffs. The most common methods of privatization are restitution processes, sale of state property, mass voucher systems, and formation of new privately owned enterprises.

Transition governments must promote competition. They face the challenge of demonopolizing their SOEs. The process of creative destruction requires a competitive economy in which organizations battle one another for supremacy. Stalinist socialist economies were based on large industrial enterprises designed to fully exploit economies of scale. Not only was competition eliminated, it was looked down upon as one of the pitfalls of capitalism. Demonopolization of the large firms is crucial to fostering the privatization process.

The final key transition issue is the development of a legal system that specifies and enforces property rights. A primary role of government in a market economy is to arbitrate economic disputes. Disputes and disagreements invariably arise when goods and services are exchanged. It is no accident that the United States, Germany and Japan--three of the world's wealthiest nations--also have the highest ratios of lawyers per capita. Getting government to behave as an unbiased third party in resolving disputes is perhaps the biggest challenge to a successful transition. Many developing nations remain poor precisely because the government is not able to create a level playing field in which the majority of organizations play by the same rules and are treated somewhat fairly.

We have much to learn from the experiences of those economies that have undertaken the transition to capitalism. We turn our focus to a brief analysis of transition issues in Poland and Russia.

During the 1950s and 1960s, macroeconomic performance in Poland was typical of socialist nations. Growth rates were fairly high as the economy exploited natural resources and increased its industrial base. But beginning in 1970, growth rates plummeted, bottoming out in 1980. The government responded by scaling back state planning and it gave firms more managerial and price setting control. Poland's debt increased significantly in the 1980s, however, and inflation increased to over 250 percent in 1989. The economic chaos led to new strikes, a new non-Communist government, and finally democratic elections whose leaders began the transformation to capitalism.

Poland imposed shock therapy. The first major reform, known as the Balcerowicz Plan, was implemented in January 1990. This plan abolished remaining price controls, lifted foreign exchange restrictions, devalued the Polish zloty and pegged it to the U.S. dollar, legalized ownership of private assets and enterprises, reduced subsidies to SOEs, and--to slow the wage-price inflation spiral--taxed firms whose wages increased more than 30 percent above the rate of inflation.

As Table 2 illustrates, Poland's level of output fell sharply in 1990 and 1991 but rebounded quickly. Growth has been positive and strong in every year since 1993. Unemployment has been more of a concern, peaking at 16 percent in 1994. The inflation rate declined quickly after 1990, and budget deficits were reduced to reasonable levels after 1993. Exports surged with the new economic freedoms, increasing nearly four-fold between 1989 and 1999. Part of the long-term success of Poland's economy lies in its ability to compete internationally and fully employ its citizens; these are both objectives that Poland seems well on its way to accomplishing.

After the collapse of the Soviet Union in 1991, President Yeltsin had the daunting challenge of leading the independent Republic down the road to capitalism. Under the direction of finance minister Yegor Gaidar, Russia implemented a shock therapy plan in January 1992 similar to that carried out in Poland. Prices on all but fifteen basic commodities such as bread and gasoline were decontrolled. Prices rose 200 to 300 percent. State spending on the military and subsidies was slashed in an attempt to reduce the budget deficit to three percent of GNP. A privatization plan was instituted, and the ruble was made partially convertible.

Russia's transition thus far has been difficult at best. Table 3 lists key data for the Russian economy between 1990 and 1999. Despite fiscal austerity, inflation rates exceeded 100 percent on an annual basis through 1995. Only in 1996 did Russia reduce its inflation rate under the 50 percent level that many economists view as crucial for economic growth to occur. Budget deficits were significantly lowered in 1995 and 1996. The ruble continues to devalue, going through another sharp devaluation in 1999. Finally, the export sector has performed dismally, dropping substantially through 1992 and then recovering between 1994 and 1996. This contrasts sharply with Poland, which tripled its exports between 1989 and 1996. Unemployment has been difficult to gauge in Russia. Officially, unemployment rates have been between two and three percent of the labor force. However, these figures only count those who claim unemployment insurance or job training. Credible estimates of Russian unemployment in 1996 ranged between nine and twenty percent.

Poland is well on its way to good economic performance as a capitalist economy; Russia is not. Why is this? There were many similarities in Russian and Polish transition. Both used shock therapy to liberalize prices and privatize assets in a rapid manner. Over time, the majority of subsidies to the SOE's were eliminated, and both countries have achieved macroeconomic stability. Democratic processes were implemented in both countries and peaceful elections have been held. What accounts for the divergence of performance?

Poland has managed to create an environment in which the rules of the game are spelled out in an adequate way and most people follow the rules. Russia has an economy plagued by tax evasion, crime and corruption.

The roots to the differences in post-transition economic performance in Poland and Russia probably lie in the culture and historical experiences of each country. Before transition, Russia was a poor agricultural economy with dictatorial rule and little experience with private ownership of resources. Stalin's rule of the Soviet Union only reinforced those trends. In contrast, communism never had a firm hold in Poland after World War II. Even during the height of the Cold War, Poland was more rebellious and more difficult to control than other Soviet Republics. Hence, it is not surprising that the collapse of the Soviet Union began with the Polish move to a Western, democratic society.

This difference in history and culture fundamentally affected attitudes towards transition to capitalism and democracy. Poles were eager to cast off Communism and they had experience with private ownership of production. Poles were willing to take the risks involved in establishing private businesses. Indeed, Poland has outpaced its transition counterparts in new business formation. In such an environment of guarded optimism, most people would be willing to follow the rules even if they did not necessarily like them. Russians, on the other hand, were very fearful of change, not having any experience with private ownership or democratic rule.

Russia has an economy plagued by crime and corruption. Estimates are that the Mafia controls more than 40 percent of the total economy. They have infiltrated the banking sector and financial markets. They force legitimate businesses to pay protection fees to continue operations. Most firms have no choice but to cooperate. The Mafia also influences and bribes government officials directly. In this situation, the government loses the ability to adequately protect consumers and businesses. The result is unstable property rights and dampened incentives for organizations to produce and advance technology.

In addition, the government is constantly strapped for cash because the tax system is an utter failure. Most Russian firms and individuals do not pay taxes. Part of the reason is that the Mafia collects taxes indirectly. Moreover, many Russians do not perceive that the government would spend the tax revenues fairly so they simply do not pay. Punishment of tax evaders is inadequate given the magnitude of the problem.

Russia has a long way to go; there is no reason to suspect that a true turnaround will occur in the near future. New leadership under President Putin may help, but Russia's economic and political future remains in doubt.

FIGURE 4

Figure 4 plots growth rates of real GDP for [Outside Econweb] selected countries. Croatia, Russia and Ukraine have fared far worse than Poland and the Czech Republic. Despite the good transition experience of the Czech Republic, their economy has been in recession since 1998. Inflation has also been highly erratic across transition countries. Of the four countries illustrated in Figure 5, the Czech Republic was the only one to avoid hyperinflation. Ukraine in particular had an inflation rate exceeding 5,000 percent in 1993.

By 1996, all of these nations managed to eliminate hyperinflation. The right-hand panel of Figure 5 shows that inflation never exceeded 90 percent between 1996 and 1999. Russia had a set-back in 1999 due to their debt default and steep currency devaluation in 1998.

FIGURE 5

In sum, many transition economies such as Poland, Hungary and the Czech Republic have made excellent progress in adopting the capitalist system. Most of the Former Soviet Republics have been less fortunate. The capitalist system has provided enormous opportunities for those with skills valued by the market. However, many older people who lived all their lives under a socialist regime are left behind. Underfunded welfare transfers sustain this population.

Transition to capitalism is an extremely complex process. Some nations are faring well while others are floundering. Time will tell if the struggling nations can implement the policies necessary to raise standards of living for their citizens.