Shock Therapy versus Gradualism

The end of communism in Europe presented 28 countries with 400 million people with the challenge of choosing new political and economic systems.
A key problem was the lack of established guidance on transitioning from socialism to capitalism.
The transition was often compared to turning fish soup into an aquarium.
The high stakes led to heated debates about the future of a large part of the world.
Questions arose about integrating the former Soviet bloc into the Western world, avoiding armed conflicts, and minimizing economic and social hardship.
The overarching goal was to achieve a “normal” society, resembling an ordinary Western democracy with a market economy, private property, and the rule of law.
Central and Southeast Europe and the Baltics aimed for a “return to Europe” by integrating into West European organizations like the EU and NATO.
The era was marked by liberal triumph, with revolutions resembling those of 1848, emphasizing liberalization and checks on state power.
Market socialism and other “third way” ideas were largely abandoned.
The central debate focused on the speed and order of transition to a market economy, with radical and gradual reformers as the main contenders.
Radical reformers advocated for rapid liberalization, macroeconomic stabilization, and privatization to establish a market economy, enhance efficiency, promote economic growth, and improve living standards.
Gradual reform proposals were more diverse.
Rent-seeking activities during the Gorbachev reforms and early transition influenced the reform process.
Criticism against radical reform grew, especially after Russia’s financial crash in 1998.

The Radical Reform Program: A Big Bang

The radical reform program was supported by three main groups:
- Leading Western macroeconomists.
- Economists in the East.
- International financial institutions and major Western governments.
The Latin American experience with macroeconomic stabilization in the 1980s influenced the approach, leading to what John Williamson termed the “Washington Consensus”.
The Washington Consensus included:
- Fiscal discipline.
- Prioritizing education, health, and public investment.
- Broad tax base with moderate marginal tax rates.
- Market-determined interest rates.
- Competitive exchange rates.
- Liberal foreign trade policy.
- Openness to foreign direct investment.
- Privatization of state enterprises.
- Deregulation to promote competition.
- Secure property rights.
The intellectual shift in the East was rapid, with full-fledged market economic transformation not seen as a possibility until the late 1980s.
The publication of critical articles in the journal Novy mir in 1987 marked a breakthrough.
Poland presented the first market economic program proposing large-scale privatization in 1988.
Leszek Balcerowicz led an economic reform group in Warsaw, advocating for truly radical and comprehensive market reforms.
In May 1989, Balcerowicz proposed a reform program including privatization, liberalization of foreign trade, currency convertibility, and an open economy.
The last communist government liberalized food prices, resulting in significant inflation.
Jeffrey Sachs assisted in developing a financial stabilization program and promoted the Polish radical reform program in the West.
The radical reform program closely followed the Washington Consensus but was more specific and adjusted to Polish conditions.
The Balcerowicz program became the standard for radical, comprehensive reform, prescribing:
- Macroeconomic stabilization through fiscal policy centralization, tight monetary policies, and currency convertibility.
- Deregulation of prices and trade to allow market forces to determine prices and eliminate rents.
- Privatization of state-owned enterprises.
- Reinforcing the social safety net to support those affected by restructuring.
Radical reformers aimed to minimize the role of the old state apparatus while building a new democratic government.
Jeffrey Sachs summarized that governments should focus on core functions like law and order, public security, monetary stability, and basic social welfare.
Radical reformers supported unemployment insurance and higher pensions.
Radical reformers differed on exchange rate policy, wage controls, international assistance, and privatization. Some pegged exchange rates, introduced wage controls, and advocated for international aid, while others held opposing views.

The Importance of Speed and Comprehensiveness

Radical reformers believed that major market reforms should be undertaken comprehensively and swiftly.
They understood that transition would take at least a decade and that some processes have different maximum possible speeds.
Radical and comprehensive reform was seen as necessary for a real breakthrough, minimizing social costs and leading to an earlier and sharper economic upswing.
Failed and reversed reforms led to the conclusion that reforms must be radical enough to reach a critical mass of necessary changes rapidly to achieve cohesion and consistency.
Radical reformers were more fearful of state failure than market failure, advocating for a shock to break the hold of the old system and introduce a viable new market economy.
Radical changes were seen as necessary to change people’s expectations and make systemic changes credible and irreversible.
The public was prepared to make short-term sacrifices for long-term benefits during a period of “extraordinary politics,” which needed to be utilized to adopt a full package of reform laws.
Quick systemic change transforms the intellectual paradigm.
Macroeconomic stabilization had to be done fast to break inflationary expectations.
Liberalization of prices and trade had to go far enough to generate a critical mass of markets and provide credible incentives.
Enterprise managers' incentives had to be changed through hard budget constraints.
Quick and comprehensive reform could mitigate corruption, misappropriation of public funds, and rent seeking.
Due to the lack of accurate information during the early transition, a policy based on principle was deemed more appropriate.
The state bureaucracy had reasons to oppose radical reform, making it vital to disarm the old elite through radical reform.

Gradual Reform Programs

Opponents of radical reform proposed more gradual approaches, lacking a unified conceptualization.
The discussion was dominated by contrasts between reforms in Poland and Hungary, with gradualists defending Hungarian methods.
The Chinese reform model was also a source of inspiration.
The fundamental difference between gradualists and radical reformers was their view of market failure and state failure.
Gradualists thought the old communist economy and state were more viable, downplayed the economic crisis, and favored state intervention.
They also retained a strong belief in social engineering.
Radical reformers considered the transition a risky task that could fail, while gradualists took the success of the market economy for granted.
Gradualists wanted to stimulate output through demand management, while radical reformers saw a systemic lack of supply as the prime problem.
Many gradualists retained more socialist views than they revealed.
The Chinese model was seen as an example of successful communist reform.
Some Western social scientists argued that radical reform would lead to a greater fall in output and be more socially costly than gradual reform.
Institutional economists wanted to postpone the introduction of a market economy until most institutional reforms had been undertaken.
Reform communists in the former Soviet Union turned against market reforms.

The Chinese Model

East Asia's economic success and particularly China was praised as a model for transition countries.
Some argued that Gorbachev should have started with economic reforms instead of democratization but this was rejected by the Communist Party of the Soviet Union.
Vladimir Mau argued that the Chinese path involved leaving power in the hands of the old Nomenklatura to preserve a one-party system.
Experimentation was advocated, but the Soviet Union had experimented extensively with economic reforms that were reversed.
It was suggested to start reform with agriculture and small enterprises, leaving large industrial enterprises in state hands, creating a dual economy,
Jeffrey Sachs and Wing Thye Woo objected that agriculture in China was dominant while it was a small part of the overindustrialized economy in Central Europe and the Soviet Union.
Proponents of the Chinese model favored gradual price liberalization and opening of the economy.
Far-reaching decentralization was favored, but Murrell and Olson argued that the decline of centrally planned economies could be explained by the devolution of power within the party and state hierarchy.
The Chinese Communist Party maintained some control over its bureaucrats, whereas the Soviet state fell apart.
Preconditions differed significantly between China and the Soviet Union when they launched market economic reforms.
The Soviet state and Party were too petrified to reform, while the Chinese state and its Communist Party were still reformable.
China was dominated by agriculture, but the Soviet Union by large-scale industry.
The Soviet Union collapsed in hyperinflation, whereas the Chinese leaders never lost control over macroeconomic stability.

Western Arguments for Gradualism

Four main arguments for gradualism are social democratic political economy, theoretical political economy, the concept of disorganization, and evolutionary or institutional economics.
Social democratic political economy, as argued by Adam Przeworski, posited that democracy must justify itself by material achievements and that people demand quick results.
Przeworski assumed that social cost is higher under the radical strategy and that the threat to democracy comes from a dissatisfied population.
Larry Diamond debunked Przeworski’s first postulate, showing that people see democracy as a value in itself.
Theoretical political economy, developed by Gerard Roland, Mathias Dewatripont, Phillipe Aghion, and Olivier Blanchard, assumed that radical reform leads to a sharper decline in output and greater social costs than gradual reform.
They suggested slow liberalization and privatization, as well as more social benefits and subsidies, to make reforms politically possible.
Olivier Blanchard and Michael Kremer developed an alternative model to explain the decline in output with disorganization. Under communism, a typical industry had fewer firms than in the West. During transition, old trade links were disrupted or became uneconomical.
Douglass C. North accused radical reformers of having “forgotten” institutions. Peter Murrell tried to develop an evolutionary theory for postcommunist economic transition. Insisted that market institutions should be established before the economy was liberalized to avoid market failures.

Reform Communists Opposing a Normal Market Economy

The starkest antireform opposition came from the old Soviet establishment in Russia.
Reform communists regarded “the real economy,” production, and investment as important while disregarding finance, money, and inflation
Leonid Abalkin reckoned: “the budget deficit cannot be diminished by tax increases. Their rise will lead to price hikes and the reduction of production and tax evasion”.
The state had to build the market, which could not develop spontaneously.
Aleksandr Rutskoi (1992) could not imagine the absence of price controls: “The liberalization of prices without the existence of a civilized market requires strict price control. . . . In all civilized countries such strict controls exist.”
The economic reforms must not be based on abstract and extremely simplified models, but on decisions derived from real life.
Five American Nobel Prize laureates in economics joined the whole Soviet economic establishment in what was a campaign effort for the communist presidential candidate Gennady Zyuganov in 1996
They demanded a higher progressive income tax, price controls, higher protective customs tariffs and industrial policy, including government subsidies and credits. Their key request was “the necessity to reinforce the role of the government in the process of transformation,” but the malfunctioning of the state was ignored.

Rent Seeking: The Scourge of Transition

The most important gradualist group consisted of those who wanted to make money on the very transition to a market economy.
Postcommunist transformation is the history of the war for and against rent seeking. Reformers wanted to establish a normal market economy, but rent seekers desired to make money on both market and state failures.
Anne Krueger (1974) introduced the term “rent seeking” in modern economic inquiry in reference to the costs of government regulation.
Liberal reformers won in Central Europe and the Baltics, while rent seekers dominated in the CIS countries.
The rent seekers’ strategy involved a confusing mixture of freedom and regulation because they aspired to a maximum of economic freedom for themselves but severe regulations for others.
At the collapse of communism, the opportunities for rent seeking were probably greater than at any other time in world history. Huge resources lay unguarded. Large rents arose from arbitrage between free market prices and state-controlled prices, aggravated by multiple exchange rates.
The explanation for why these reforms, later so obviously a result of trial and error, provide such a clear pattern is that certain reforms were accepted because they facilitated rent seeking by Soviet officials, but they refuted other reforms that contradicted their interests.
Seven changes in economic policy provided the preconditions for extraordinary rent seeking.
In late 1990, the standard assessment of both Soviet and Western economists was that Soviet hyperinflation was virtually inevitable.
This division of the elite helps to explain the pathetic abortive August 1991 coup.
From 1988, the Soviet Union displayed an incredibly innovative spirit. Soviet citizens made money in every conceivable way.
The basic method of rent seeking was arbitrage between fixed state prices and private market prices, preferably abroad. Western computers were imported and sold at high prices on the domestic market, because of extreme shortage and high domestic sales taxes.
Total Russian exports outside of the CIS amounted to $42.2$ billion. The collected export tariffs amounted to some $2.4$ billion, while GDP was only $79$ billion in 1992, because of the very low exchange rate (World Bank 1996b). That means that the total export rents were no less than $24$ billion, or 30 percent of GDP.
Another major source of rents was subsidized imports. The IMF (1993, p. 133) calculated total Russian import subsidies at 17.5 percent of GDP that year.
A third source of rents was the emission of subsidized state credits. The Central Bank of Russia issued new credit equivalent to 31.6 percent GDP in 1992
From these four sources, total gross rents amounted to almost 90 percent of Russia’s GDP in 1992.
Confusingly, they were reformist and progressive as long as communism lasted.
Examples are price liberalization, the abolition of import subsidization or subsidized credits, the deregulation of exports, cuts in enterprise subsidies, and the transition from soft to strict monetary policy in most post-Soviet countries.
Rents ended with privatization.
The course of postcommunist transition was determined by what means policy makers chose to deal with rent seeking, and that choice depended on the political regime.
We can define postcommunist transition as the period of this extraordinary rent seeking. In the former Soviet Union, it started in 1990 and ended on August 17, 1998, the day of the Russian financial crash, which disciplined the prime rent seekers of the day, the Russian oligarchs.

Criticism of Radical Reform after the Russian Financial Crash

As the years passed, however, Russia’s economic growth failed to take off, although mass privatization had been carried out. The Russian loans-for-shares privatization in late 1995, which transferred a dozen of Russia’s most valuable oil and metals companies to a handful of new oligarchs aroused an outcry about “original sin” in both Russia and the West.
On August 17, 1998, the Russian government defaulted on its domestic debt, let the ruble exchange rate plummet, and froze all bank accounts, and roughly half the Russian bank system went bankrupt.
Had the attempts to build a market economy in Russia failed?
Joseph Stiglitz attacked IMF policy on Russia, arguing that the Washington Consensus model did not work there. He reckoned that Russia should have followed China’s example Logically, Stiglitz (1999b, p. 4) praised the gradual reforms in truly tyrannical Uzbekistan.
It was criticized institutional, that the reformers had ignored the importance of the institutional infrastructure of a market economy and dissipated the communist organizational capital.
Stiglitz’s third and greatest concern was the Russian privatization. He condemned the Russian loans-for-shares scheme as the main source of corruption. He wanted to give away state enterprises to the old elite. “Perhaps trying to discipline spontaneous privatization might have offered the greatest hope” (Stiglitz 1999a, p. 6).
He concluded: “Prospects for the future are bleak” (p. 133).
A nearly unison choir of macroeconomists argued that the problems with Russia’s stabilization was not shock therapy but gradualism.
They emphasized that early and fast privatization with some order was the best option to create a stratum of private owners as a base for a market economy.
Andrei Shleifer and Daniel Treisman (2004) in Foreign Affairs defended the economic performance of the oligarchs in the loans-for-shares companies. “Have the oligarchs stripped assets from the companies they acquired in privatization, rather than investing in them? The audited financial statements of these companies suggest that their assets have grown dramatically, especially since 1998.