Creating Market Economy in Eastern Europe

dependence on competition from abroad.

If a seems very likely, the post-privatization industrial structure

turns out to be highly over-concentrated and inefficient, then the main

effect of threatening foreign competition will be to unleash a powerful

confluence of political forces in favor of protectionism. Owners of the

domestic enterprises will lobby to defend their rents, managers will lobby

to defend privileges, and workers will lobby to defend their jobs. Because

the problem of unemployment never really arose under communism, the potent

tension between introducing free trade and maintaining employment levels

never became apparent.

2.2. Poland and Hungary as the best example of transition in the East

Europe

Economic Reform in Eastern Europe: The Background

The background of economic reform in Eastern Europe is not unlike that

in the Soviet Union, even though, as I have emphasized, the setting is

rather different. The brief political thaw following the death of Stalin in

the early 1950s did permit a freer discussion of ideas, which, along with

growing problems of economic performance, led to limited attempts to

develop and implement economic reform. Initially, these changes were modest

in scope, and they typically followed the Soviet reform pattern: Try to

improve decision making while preserving socialist objectives and the

essence of the planning system. This was the focus of the New Economic

System in the GDR and of the New Economic Mechanism introduced in Hungary

in 1968. The potential for genuine economic reform was certainly limited by

Soviet influence. Indeed in some cases (such as Czechoslovakia in 1968),

reform was abruptly forestalled by Soviet intervention. In other cases,

such as Hungary, reform attempts dating from the late 1960s were sustained

on a limited basis, to become the background for more serious reform in the

present era. There were, then, numerous attempts at reform in Eastern

Europe. What were the major forces promoting these efforts?

First, as was the case in the Soviet Union, rates of economic growth

in Eastern Europe have undergone a long-term secular decline. The magnitude

of this decline (see Table 1) has varied from case to case, but overall it

has been pervasive. Moreover, these countries had taken pride in being high-

growth economies, even if the costs, such as little growth of consumer well-

being, were also high. At the same time, growth in productivity slackened,

especially in the late 1970s and 1980s. And inflation quickened, though it

was most serious in Poland and Yugoslavia. Repressed inflation, though

difficult to measure, grew in importance in the 1980s.

Second, East European countries relied heavily on foreign trade as a

means of stimulating economic growth in the 1970s. Their strategy was to

promote exports in Western markets so that the imports required both to

stimulate technological change in industry and to enhance consumer well-

being could be obtained without the growth of hard-currency debt.

Unfortunately, this strategy was not successful. The energy crisis led to a

significant slackening of Western markets at the very time when East

European nations were becoming more aggressive in these markets. East

European imports were sustained, but largely by means of building a

substantial hard-currency debt. The magnitude of debt repayment

subsequently led to considerable internal belt-tightening for these

countries in the 1980s — precisely the opposite of what had been intended.

Third, one could argue that in Eastern Europe, the possibilities for

economic growth through extensive means had initially been less promising

than in the Soviet case and had been exhausted more quickly. In light of

the level of economic development in Eastern Europe compared to that in the

Soviet Union, it is not surprising that the imperative for reform was

strong and that developments of the Gorbachev era quickly spilled over into

Eastern Europe. In the absence of Soviet backing, interest in the

administrative command model faded fast.

Table 1. Economic Growth and Performance in Eastern Europe:

The Background to Reform

| |1961-70 |1971-80 |1981-85 |1985 |1986 |

|Eastern |3.4 |2.4 |1.0 |.2 |2.2 |

|Europe | | | | | |

|Bulgaria|5.0 |2.3 |.1 |-3.2 |4.7 |

|Czechosl|2.4 |2.3 |1.0 |.4 |1.9 |

|ovakia | | | | | |

|East |3.2 |3.5 |1.7 |3.3 |1.6 |

|Germany | | | | | |

|Hungary |3.1 |2.5 |.6 |-2.3 |2.4 |

|Poland |3.3 |3.0 |1.0 |.2 |2.1 |

|Romania |4.2 |3.5 |-.6 |-1.4 |3.1 |

East European Reform Programs: Similarities and Differences

In this chapter we pay special attention to Poland and Hungary. We do

so because these countries are both examples of aggressive reform but have

employed different strategies. However, before we consider these cases in

greater detail, it is useful to summarize the East European reform

experience, noting important similarities and differences among the various

cases. To do so will entail some repetition of basic themes.

First, economic reform in Eastern Europe (at least in Poland, Hungary,

and Czechoslovakia) is generally described as a transition in that these

countries seek to replace the planned economy with a market economy rather

than attempting merely to modify the former.

Second, transition programs have varied in speed and intensity. Some

countries have pursued reform on a "gradual" basis, whereas others, like

Poland, have pursued what is often termed a "big bang," or rapid, approach

to reform. However, we must remember that even in those countries not

pursuing a "big bang" or "shock therapy" approach, the process of

transition in Eastern Europe has been relatively rapid, especially when

compared to reforms of the past - and notably so when compared to the

recent Soviet record. It is important, therefore, to be aware of the basic

issues associated with transition and of the extent to which the attempted

speed of transition alters the overall reform experience.

Third, although it is possible to examine and understand the basic

elements of economic reform and even of transition from one system to

another, we really do not have a general theory of change in economic

systems. In some cases — for example, during such a period of rapid change

as the 1990s — it is difficult even to develop a way to classify the issues

involved in transition.

Fourth, important differences exist from one country to another. Our

view of the socialist transition process is heavily influenced by our image

of the best-known and most advanced reforms, such as those of Poland,

Hungary, and Czechoslovakia. We know much less about, and tend to pay less

attention to developments where reforms are proceeding at a slower pace, as

in Romania and Bulgaria. Figure 1 offers a simple, stylized view of

contemporary political and economic reform (transition) in Eastern Europe.

Figure 1. Reform in Eastern Europe

POLAND: FROM PLAN TO MARKET VIA SHOCK THERAPY

Until Solidarity won the parliamentary elections in Poland in the

summer of 1989, the Polish economy had been, since the end of World War II,

a rather typical planned socialist economic system. State ownership

predominated, and though economic reform was attempted in varying degrees

at different times, little real systemic change had taken place. Moreover,

as Table 1 shows, the rate of economic growth continued to decline, and the

period saw recurring shortages, increasing inflation, and an understandably

declining work ethic.

Beginning in 1990, Poland took decisive steps toward a market economy.

This "shock therapy" approach was to be sudden, and in this it differed

significantly from the gradualist approach being discussed in other

socialist systems. In addition to treeing prices, Poland implemented

monetary controls, the zloty was made convertible into hard currencies, and

steps were taken to control wage increases.

As we shall see, the "shock therapy" approach has not been without

critics. Moreover, although the Polish case quickly attracted the interest

of those who study the problems of socialist transition, it was viewed as

unique. Thus it was argued that. for a variety of reasons that were

discussed earlier, reform was much more likely to succeed in Poland than in

a case like the Soviet Union. But before we examine the Polish reform

experience in greater detail, we must review what brought the Polish

economy to the reform phase and how, at that point, it might be different

from other socialist countries.

I begin our discussion of Poland with a brief examination of the

setting. Then I discuss the Polish command system, considering the extent

to which this system led to distortions in the Polish economic structure.

Finally, I turn to the issue of transition and examine the mechanisms

utilized and the results achieved thus far.

1) Poland: The Setting

By European standards, Poland is a relatively large country. With a

land area of just over 300,000 square kilometers, it is just over half the

size of France. Moreover, with a population that approached 38 million in

1990, Poland is some 68 percent of the size of France in terms of

population.

Poland is frequently viewed as having a homogeneous society, a factor

that facilitates economic reform. Although social homogeneity is difficult

to measure and may well be overstated in the Polish case and in other cases

(for example, there are regional differentials, urban-rural differentials,

and the like), the basic statistical evidence is strong. In terms of

religion, 95 percent of the Polish population is Roman Catholic. From a

stannic standpoint, 98.7 percent of the population is Polish, and only a

few minority groups occur.

Urbanization and industrialization have changed the nature of Polish life

and customs, but the church, family, and folk ties that have sustained

Poland for a long time remain strong. Thus, although Poland must deal with

problems of modernization, it also has valued traditions and a clear

identity. These qualities make implementing change more manageable here

than in many other countries.

In terms of natural resources, Poland is a country of considerable regional

diversity, though major portions of the land area are not especially

fertile.

Poland's main energy resource is coal; basic minerals and some deposits of

oil and natural gas also exist. Both basic data and methods of computing

economic aggregates of socialist systems are currently under scrutiny. New

evidence that will make it possible to do different kinds of computations

may well lead to important adjustments. With these reservations in mind,

however, we note that Poland was reported to have a per capita gross

national product of approximately $4500 measured in 1989 U.S. dollars. This

figure places it between the high-income countries of the region (Hungary

and Czechoslovakia) and the low-income countries (Bulgaria, Romania,

Yugoslavia) and at one-quarter that of the United States. Prior to the

onset of major economic reform, the bulk of Polish industry was state-owned

and planned. Agriculture (representing roughly one-fifth of total Polish

output) was a mixed system wherein the private sector produced about three-

quarters of the total agricultural product. Foreign trade turnover — that

is, exports plus imports — represents roughly one-third of Polish product,

again using U.S. dollar measures.

2) Poland: The Command Economy

The organizational arrangements of the Polish command economy were

established immediately after World War II and closely resembled those

prevailing in the Soviet Union. There was widespread nationalization of

property, central planning mechanisms were established, and agriculture was

socialized. In addition to organizational arrangements, Polish economic

policies of the era, such as those on investment, sectoral development, and

the like, closely mirrored the Soviet model.

Although Poland attempted modification of the command system as early

as 1956 when collectivization was abandoned, little actually changed. Over

time, private agriculture was neglected by the state, and continuing

political protests, especially in the early 1970s, signaled both political

and economic difficulties.

The 1970s was a difficult decade for many countries, especially those

that rely on imported oil. The Polish strategy in the 1970s and later was

to stimulate the domestic economy through the importation of foreign

technology. This was not an unreasonable strategy in theory, but Western

economies were themselves in the midst of the energy crisis and the

recession it caused. Poland's effort to expand exports failed, hard-

currency debt accumulated, and the projected impact of Western technology

on the Polish economy was minimal. As the 1970s came to an end, it was

evident that domestic retrenchment would be essential — a difficult path in

light of the continuing unrest among Polish workers. The 1980s began with

roughly three years of martial law and an attempt to achieve economic

stabilization.

After half-hearted economic reforms in the early 1980s, the rise of

Solidarity (which had been outlawed in 1982) proved that major systemic and

structural reform was necessary. Even so, and despite the fact that Polish

economic performance was deteriorating badly, serious economic reform did

not begin until the late 1980s.

3) The Polish Transition: The "Big Bang" in Practice

The Polish transition from plan to market has been watched closely by

a variety of interested observers. Although many of the policy and systemic

changes introduced in Poland are familiar hallmarks of the general reform

scene, the speed of implementation in the Polish case is unique.

There had been attempts to decentralize decision making in large state-

owned Polish enterprises in the 1980s, but these reforms failed to change

outcomes (a possible exception is their contribution to the wage explosion

that took place toward the end of the decade). Moreover, on the eve of

reform in Poland (the reform program began officially on January 1, 1990),

macroeco-nomic conditions there were in a state of severe disequilibrium.

Although the exact nature of monetary overhang in Poland (as elsewhere) has

been the subject of debate, there was a significant budget deficit, wage

increases were out of control, and hyperinflation had resulted. Poland's

hard-currency debt position was better than that of Hungary, but the debt

that had been accumulated did little to stimulate the Polish economy, the

zioty was overvalued, and no debt relief from external sources was in

sight.

In the fall of 1989, most price controls were lifted (on both producer

and consumer goods), public spending was reduced, and the zioty was

devalued. In the second stage of major reform, begun in 1990, the budget

deficit was sharply cut, largely through a reduction of subsidies to state

enterprises. A positive real rate of interest was to be implemented, and

the market was to be used to signal changes in the value of the zloty. The

latter was a critical measure, because foreign trade and the impact of this

trade on the Polish industrial structure was to be a key component of the

overall reform strategy. In January of 1990, the government set the

exchange rate of the zloty at 9500 to the dollar (this represented a

devaluation from 1989), a rate roughly approximating its value on the black

market, and it established convertibility of the zloty for international

trade. Many trade restrictions were eliminated, and internal exchanges were

set up to handle the buying and selling of hard currencies. Although these

changes resulted in domestic inflation, the initial increases proved to be

short-term and the exchange rate of the zloty has proved to be realistic.

Finally, wage increases were to be controlled partly through wage

indexation and partly through a new tax on wage increases that exceeded

established guidelines.

Privatization is a major element of the Polish strategy of transition.

In 1990 the Polish government passed a law creating a Ministry of Ownership

Change, a mechanism to supervise the process of privatization.

Privatization has proceeded rapidly, though it has been achieved mainly for

small enterprises in the trade and service sectors. Industrial output in

the private sector grew by 8.5 percent in 1990 and is reported to represent

roughly 17 percent of total Polish industrial output

Though privatization has been very successful for small-scale enterprises,

the picture for large state enterprises is quite different. For reasons we

noted earlier, privatization of these enterprises has proceeded very

slowly. In addition, the economic position of these enterprises worsened as

the state took decisive measures to introduce a hard-budget constraint. In

addition to price changes and wage limitations, subsidies have been ended

and protection from foreign competition has been sharply reduced. This new

setting has encouraged enterprise managers to reduce costs by restricting

unnecessary output and reducing the labor force. However, the strong

commitment to rapid privatization was reinforced in June of 1991, when it

was announced that a major portion of state industry would be privatized

through creation of stock funds, with the population receiving vouchers.

Beyond these changes in the state sector, new guidelines have been

introduced to monitor enterprise performance. Furthermore, a new Industrial

Restructuring Agency will consider how remaining state enterprises should

be handled, to what extent privatization is possible, and what

restructuring should take place for those enterprises that are not viable

in the new setting. These new arrangements are designed to ensure a rapid

transformation of the Polish industrial structure, to make it similar to

and competitive with market economic systems, and to achieve this result

quickly and as openly as possible.

Note that these comprehensive reforms in Poland cover all the critical

areas discussed in Chapter 4 and earlier in this chapter. Moreover,

beginning from very precarious economic circumstance in 1989, these changes

were introduced simultaneously and rapidly. We will now do our best to

assess the early results.

4) The Polish Economy in the 1990s

It is clear that economic reform in Poland has been radical and has

moved sharply and swiftly away from the plan toward the market. In addition

to the expanded influence of market mechanisms, decision making has been

decentralized, private property introduced, and incentive arrangements

changed. By most standards, the initial results have been encouraging.

First, stabilization measures cut the rate of inflation sharply from a

reported 40-50 percent per month at the end of 1989 to roughly 4-5 percent

per month in 1990. At the same time output fell, though supplies of

consumer goods in stores increased. Employment in industry declined by 20

percent during 1989 and 1990, although it is reported that only a

relatively small portion of this reduction in the labor force was caused by

forced layoffs. The unemployment rate was reported to be 6.5 percent at the

end of 1990.

Another major positive facet of the Polish reform experience has been

the foreign trade sector. There has been a significant expansion of

exports, especially to hard-currency markets. This expansion resulted in

part from the devaluation of the zloty to market-clearing levels and in

part from the reorientation of trade away from the Soviet Union and other

East European trading partners. At the same time, as a result of

restrictive policy measures and the higher domestic cost of these imports,

import demand declined.

A third qualified success has been privatization. Although the initial

pace of privatization was rapid, this early privatization was largely that

of small-scale enterprises in the area of trade and services. Although

Polish reformers take seriously the need to pursue privatization of major

state enterprises, bringing this about will remain a critical task for the

next several years.

Can these achievements be sustained in the coming years? We discuss

this issue more generally in the next section, but the Polish case deserves

specific comment. Quite clearly, the continued success of the Polish

transition will depend on the continuing implementation of appropriate

stabilization measures. Although this may seem relatively straightforward,

it requires cohesion and commitment among policy makers and willingness

among the populace to pay the costs of the transition. Pressures for wage

increases must be resisted, and the process of privatization must proceed.

To the extent that the latter can be achieved, the contours of new market

arrangements can be defined. Finally, although uncertainty in foreign

markets remains, relief of hard-currency debt will unquestionably add a

measure of flexibility.

Another issue is the extent to which the Polish "success" (if we can

call it that) was promoted by Western assistance. In light of the Polish

leadership's commitment to rapid transition, the West has provided

considerable assistance in the form of exchange-rate stabilization funds,

debt restructuring, and government guarantees.

HUNGARY: THE NEW ECONOMIC MECHANISM AND PRIVATIZATION

Early works in comparative economic systems devoted little attention

to the Hungarian economy. Over the last twenty years, however. Western

economists have begun to pay more attention to Hungary.

As one prominent observer of Hungary and other East European systems

has noted, "The Hungarian reform experience says as much about central

planning as it does about Hungary, and therefore an understanding of that

experience is important for those interested in the prospects for reform in

all of Eastern Europe, and indeed, in the Soviet Union. In other words,

Hungary is a prototype of economic reform for the former planned socialist

economic systems of Eastern Europe, and presumably elsewhere. These

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