Chapter Twenty-one: Module Summary -- Transition Economies

Transition economies are those undertaking the transformation from socialism to capitalism.

Every nation must answer three fundamental economic questions: What will be produced? How will it be produced? For whom will it be produced?

Socialist economies ration resources by detailed government planning. Capitalist economies, on the other hand, mainly ration scarce resources based on consumer demand and the producer profit motive.

In socialist systems, managers and government officials plan the production process and the technology used. Capitalist economies leave the decision of how to produce up to private firms.

In both economic systems, the goods are produced for those with income. The difference is that the government determines income in socialist economies while the market determines incomes in capitalist economies.

Socialist economies relied primarily on extensive growth, which worked fairly well until the 1960s. Economic performance slowed thereafter because dynamic growth incentives were weak. The process of creative destruction was absent.

The most important macroeconomic objectives for transition economies 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 due to price liberalization, declining output and rising velocity.

Budget pressures make the printing of money tempting for transition governments. Tax revenues fall rapidly as output collapses and a new tax system is implemented.

A soft budget constraint is a situation in which the government is the underlying source of funding if an organization experiences negative net income.

Currency stabilization typically requires a large initial devaluation because of past government support of an overvalued currency. A surge in imports and capital flight--the transfer of domestic wealth to other nations' assets--increase the demand for foreign exchange, and a drop in exports decreases the supply of foreign exchange, leading to further devaluation.

Transition economies must choose the type of exchange rate policy that they wish to follow. Three possibilities are fixed exchange rates, flexible exchange rates and crawling pegs. Each has certain advantages and disadvantages.

Over the long run, transition economies must stimulate foreign trade and attract foreign investment. In general, transition economies have done a poor job at attracting foreign investment because they fail to provide a safe environment for foreign funds.

The optimal speed of transition is an open question. Poland and Russia adopted a rapid process called shock therapy, a process where major institutional changes were implemented immediately. In contrast, China has opted for a slower process termed gradualism.

Private ownership of property is essential in providing solid dynamic incentives for profit-maximizing behavior. The most common methods of privatization are restitution processes, sale of state property, mass voucher systems, and formation of new privately owned enterprises.

Perhaps the most important transition issue is the development of a legal system that specifies and enforces property rights.

Poland's transition has gone quite well. The first major reform, 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 and reduced subsidies to state-owned enterprises (SOEs). Poland's level of output fell sharply in 1990 and 1991 but rebounded quickly. In addition, the inflation rate declined quickly after 1990, and budget deficits were reduced to reasonable levels after 1993.

The Russian transition has been very different and more problematic than Poland's experience. Russia implemented a shock therapy plan in January 1992 similar to that carried out in Poland. The country has not been able to stop the spiral downward and begin the process of economic reconstruction. Its GDP declined every year but one between 1990 and 1998.

Poland's transition has been much smoother than Russia's because 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 government is constantly strapped for cash because the tax system is an utter failure. 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

Performance of many other nations in transition lies somewhere between the performances of Poland and Russia. Generally, Eastern European countries are faring better than the Former Soviet Republics.