“How Capitalism Was Built” by Anders Aslund – Chapter 2: Shock Therapy v. Gradualism

“How Capitalism Was Built” by Anders Aslund – Chapter 2: Shock Therapy versus Gradualism

  • 28 countries totaling 400 million people were suddenly faced with a choice in political & economic systems
    • Many intellectuals were pushing a “normal society”, meaning Western-style Democracy with a market economy, predominant private property, & rule of law
    • East & Central Europeans didn’t care if it were a European-style social welfare state or a freer American market economy – either one was superior to what they had just been through
    • Central, Southeast Europe & Baltics wanted a return to Europe & membership in the EU & NATO
  • Radical Reform
    • Washington Consensus – IMF, World Bank & US Government recommendations for reform policies
      • 1 – Fiscal Discipline
      • 2 – Minimal discretionary expenditures, focus on health, education, public investment
      • 3 – Broad tax base with moderate marginal tax rates
      • 4 – Market determined interest rates – positive real interest rates
      • 5 – Competitive exchange rates
      • 6 – Liberal foreign trade policy
      • 7 – Foreign Direct Investment (FDI) is good but not the highest priority
      • 8 – Privatization is beneficial because private industry is more efficient than state run industry
      • 9 – Deregulation promotes competition
      • 10 – Need secure property rights
    • Poland was the first to start tackling these problems
      • Success was seen in Latin America in following them closely
    • Balcerowicz program was Polish policy in radical reform
      • 1 – Macroeconomic Stability
        • stop hyperinflation
        • reduction in budget deficit
        • centralized & controlled fiscal policy
        • tightened monetary policy
        • independent Central Bank
        • exchange rate & currency need to be convertible to be made for foreign trade
      • 2 – Deregulation
        • prices deregulated
        • price subsidies eliminated to allow supply & demand to determine prices
        • domestic trade liberalized
        • monopolies broken up
        • free foreign trade alleviates shortages, facilitates production & boosts living standards
      • 3 – Privatization
        • abolish restrictions on private sector
        • new entrepreneurs offered maximum freedom
        • small-scale privatization to start
          • followed by medium- & large-scale industries to be privatized over time
            • how to do this was unclear
      • 4 – Reinforcing the social safety net
        • targeted at groups in need: unemployed & pensioners
    • Key government functions needed to be introduced – central fiscal policy & monetary control
      • Minimize the role of old state aparatus
      • No social engineering
    • Reformers supported unemployment insurance because the new system was going to be volatile
    • Reformers agreed on much but split on other issues
      • Poland, Czechoslovakia & Estonia pegged exchange rates as nominal anchors for financial stabilization – others chose floating exchange rates
      • Poland & Czechoslovakia had strict wage controls as initial stabilization policy – others had little to none
      • Some wanted international financial assistance, others wanted none
      • Privatization meant so many things that it was hard to define
  • Importance of Speed & Comprehensiveness
    • Many measures would take a while, including full privatization, complex reforms (tax, social, civil service, legal) to develop a financial sector
      • 1 – Liberal economists had bad memories of failed Soviet reforms – mostly because they weren’t radical enough
        • Needed a strong degree of cohesion & consistency
      • 2 – Radical reformers were aware of the possibility government & market failure
        • They knew the market was imperfect but was less imperfect than government intervention
      • 3 – People’s expectations had to be changed to make the system credible & irreversible
        • People were more likely to change their attitudes if the reform & changes were radical than gradual
      • 4 – Public was prepared to make short-term sacrifices to ensure long-term benefits
        • This was purely out of idealism – packages proposed in newly minted parliaments
      • 5 – Quick changes transformed intellectual paradigm
        • Central Europe & Baltics changed very quickly, while slower reformers kept the old parochial paradigm alive
      • 6 – Theory stated that macroeconomic stabilization needed to be done quickly to preempt inflationary expectations
      • 7 – Liberalization of prices & trade had to create a critical mass of markets & provide credible incentives
        • Old prices were hopelessly distorted & any gradual reform would allow the continuation of distortions
      • 8 – Convince enterprise managers to change behavior
        • Had to be convinced through introduction of hard budget constraints (no state subsidies like before)
      • 9 – Corruption & rent seeking were enormous under Communism. Quick reform would mitigate distortions
      • 10 – Extremely little accurate information was available in the early part of transition because things were changing so fast
        • If nothing could be measured, no facts could be established
      • 11 – Bureaucracy had incentives to oppose radical changeds
        • It would lose its power & human capital would become obsolete
  • Gradual Reform Programs
    • Opponents of radical reform weren’t united as there was no clear concept of gradual reform
      • Gradualists in Hungary thought Polish shock therapy wasn’t applicable to Hungary
      • Some liked the Chinese-style of reform
      • Nostalgia for the old & rent seeking
    • Difference between Radicals & Graduals
      • View of market & government failure
        • Gradualists believed that government failure wasn’t as bad as the Radicals
        • Radicals believed that government failure was worse than the Gradualists
      • Gradualists downplayed the crisis after Communism
      • They refused to accept that the Communist state was corrupt or kleptocratic
      • They favored state intervention & believed in social engineering
      • They believed that the strength of the state would make the economy impervious to risks in transition
      • Wanted to stimulate output through demand management
        • Radicals saw supply as the weakness
    • Chines-style success was the strongest argument in reform style
    • European social scientists claimed the social costs of the upheaval in radical reform were too costly & gradual was more palatable
  • Chinese Model
    • Many blamed on the collapse of Communism on Gorbachev’s focus on democratization before economic reforms
      • The Communist Party blocked him on any economic reform proposed
    • He pushed for democratization to undermine the Party’s block on economic reform
    • Chinese reforms were launched after the Cultural Revolution which had brought dramatic economic decline
      • The Chinese Communist Party was terrorized & wasn’t going to block any reform proposed
    • There was an argument for experimentation rather than full reform
      • But no communist country had ever done that before
      • Any reform started was immediately reversed
      • No answer of why it worked in China but failed in the Soviet Bloc
    • Proponents of Chinese reforms believed that Agricultural & small enterprise reform was better, leaving large enterprises to the state, establishing a dual economy
      • New private sector could grow without antagonizing the old state sector
      • Proportions of Agriculture were way higher in China than in Soviet Bloc – wouldn’t have had much of an effect
      • Soviet agriculture was industrialized & difficult to privatize
        • Any attempt at reform in USSR failed
    • Chinese proponents pushed for price liberalization & opening of the economy
      • When the USSR did this it created large rent seeking by the Nomenklatura
    • Some said the Chinese succeeded in actual decentralization but the USSR failed to do so
      • Bureaucratic Aristocracy was form of powerful elites – antithetical to Communist Theory
        • Chinese government maintained control over its elites
  • Western Arguments for Gradualism
    • Przeworski’s Political Economy
      • European Social Democrats were uncomfortable during the Communist collapse
        • They’d argued it would never happen
        • Left wingers drew parallels to the Great Depression
      • 1 – Democracy had to justify itself by material achievements
        • It was there for the sake of economic welfare, not political reasons
      • 2 – People demanded quick results
        • Transient deterioration of material conditions would be sufficient to undermine democracy
      • 3 – Social Cost is higher under radicalism
      • 4 – Threat to Democracy come from a dissatisfied popluation
      • These assumptions didn’t square with reality
        • Economic reform & democracy were positively correlated
    • Theoretical Political Economy
      • Small group of Western economists made assumptions similar to Przeworski
      • Radical reform leads to sharp decline in output & greater social costs than gradual reform
        • Population wouldn’t tolerate more than a certain decline in output or a certain degree of unemployment
      • Gradualism may allow for “divide & rule” tactics
      • Radical reform might lead to higher taxes & slower growth in private sector
      • All major assumptions contradicted reality
    • Disorganization
      • Under communism, typical industry had fewer firms than in the West
      • Firms only knew 1 supplier for certain inputs
      • Old trade links were disrupted or uneconomical
      • With asymmetric information, incomplete contracts, initial results of bargaining might have been inefficient => maybe market failures are causing output to fall
      • Shortages persisted because adjustments took time
        • Needed subsidies to avoid immediate collapse
      • Only valid in the short-term
    • Institutions First
      • Radical reformers forgot about the importance of institutions
      • Rules may change overnight but they need to be gotten used to by economic agents
      • Privatization might not be a panacea
        • No evidence of this
    • Evolutionary Theory
      • Peter Murrell say that Central Europe had organizations that were expected to change behavior in response to changes but have failed to do so – especially large state enterprises
      • Agreed there needed to be a coherent economic environment but little evidence provided that it would work
        • Old systems can’t just simply be destroyed – will cause problems of coherence
      • State was seen as omnipotent in spite of the crisis & the real issue was political will
  • Reform Communists Opposing A Normal Market Economy
    • Old Soviet establishment was largest anti-reform opposition
      • New reforms were attacked with a mixture of Marxism, populism, & vested interests
      • Regarded the real economy production & important but ignored finance, money & inflation because they saw money as a free utility
      • Saw hyperinflation-based monetary policy as the only way to combat falling output
    • Said Russia was unique & can’t be governed by general rules
      • Reform can’t be based on abstract models but real life decisions based on the real situation of the economy, the population & the country’s political & economic history
    • Cautioned that reform should be pragmatic, common sense, consensus & moderate
      • But no desire to return to the Soviet system
  • Rent Seeking
    • State enterprise managers & Soviet officials resisted reform because they benefited from the inconsistencies of the transitional system & wanted to perpetuate them
      • They favored a market economy but they wanted to prolong & distort the transition to maximize their own personal gain from it
    • Liberal reformers won in Central Europe & Baltics but Rent seekers won in CIS countries
    • Gorbachev’s reforms in the 1980s seemed designed to create a rent-seeking machine
      • Deregulations were mostly minor but some were very liberal
      • They only succeeded in being implemented because they facilitated rent seeking behavior
      • 1 – Partial liberalization of foreign trade
        • allowed powerful state bodies to make money off of foreign trade by arbitrage from low international prices & high domestic prices
      • 2 – Early foreign trade reforms introduced currency coefficients to allow for arbitrage opportunities
      • 3 – Soviet Law on State Enterprises in 1988 was a halfway attempt at economic reform
        • USSR’s economy was neither a plan nor a market
        • Plan targets were abolished & enterprises were given more freedom in prices & wages
        • Wages & prices began to skyrocket
      • 4 – With the new Law on State Enterprises, industrial ministries lost control over state firm managers, giving them freedom with no accountability making them effective owners of their enterprises
      • 5 – Law legalized private enterprises with minimal regulation.
        • Cooperatives were trading with State-run companies at low prices & profiting off the high prices in the market
      • 6 – Commercial banks were a part of these cooperatives & had no regulation
        • They demanded unlimited access to state credit at minimal interest rates & usurped inflation tax of hyperinflation
      • 7 – Ministry of Finance & Central Bank were weak & subordinate to State Planning Committee
        • Because of lack of fiscal or monetary restraints, money flooded freely, causing the inevitable hyperinflation & collapse of the Soviet economy & then politic system
    • By 1991, the writing was on the wall & bureaucrats were no longer on board with the regime
      • This helped explain the failure of the August 1991 coup
        • State enterprise managers had too much to lose by going back to the old ways
    • In 1988, Soviet citizens were finding all kinds of ways to make money, most of which violated Communist principles
      • Fixed exchange rates at home & abroad were different giving arbitrage opportunities
      • Foreign trade rents increased with the purchase of computers
      • Soviet managers sold oil & metals abroad & kept the profits to themselves
        • This caused major volatility in domestic & foreign commodities markets
      • Subsidized imports allowed for arbitrage opportunities in domestic & black markets
      • The government subsidized state enterprises to the tune of approximately 10% GDP
  • Criticisms of Radical Reform after Russian Financial Crash
    • Early successes were cheered in Central Europe & the Baltics
    • Russia & CIS countries were starting to reform
    • 1996 – World Bank’s conclusions on radical reform
      • 1 – Consistent policies, liberalization of markets, trade & new enterprises, with price stability are powerful even in countries with poorly defined property rights & market institutions
      • 2 – Market processes require property rights & widespread private property
      • 3 – Social policy changes will move the market
      • 4 – Institutions that support markets arise by design & demand
      • 5 – International integration can lock in these reforms
    • Russia’s growth failed in spite of privatization
      • Inflation cooled & new stock market succeeded
      • Oligarchs were able to buy oil & metals companies
        • Country seen as corrupt & filled with organized crime
    • 1998 – Russian government defaulted on its domestic debt & ruble exchange rate dropped
      • All bank accounts were frozen & half the banking system went bankrupt
      • Russian middle class lost all of its savings, inflation rose & output fell
    • Stiglitz argued that the Washington Consensus couldn’t work in Russia & it should follow the Chinese model instead
      • Blamed collapse on Market Fundamentalism
      • He praised the gradual reforms of tyranny of Uzebekistan
      • He praised Gorbachev’s reforms
        • Forgot to mention that they caused the collapse of the Soviet Union
    • Reformers forgot to emphasize institutional infrastructure of a market economy
      • Stiglitz criticized the blaming of the failure on organized crime & corruption
        • Should have focus on institutions destroying but not replacing social norms
    • Stiglitz was concerned with Russian privatization
      • Russian loans-for-shares scheme which allowed oligarchs to own oil & metals enterprises
      • Privatization didn’t provide the incentives for wealth creation but did for asset stripping
      • Ignored macroeconomic crisis
    • Interestingly, Russia’s transformation was called a failure even though it was boasting 7% GDP growth 8 years in a row
      • Other economists blamed the second collapse on Gradualism
        • Saying institutional reforms & privatization should have happened first & then political liberalization
      • Most conditions of IMF conditions were made in Moscow, not Washington
    • Despite of 2 collapses within 10 years, Russia is a middle-income country
      • Democracies in these countries are “rough around the edges” with income inequality, politicized courts, corrupt governments & unfree press
      • Oligarchs have not stripped their companies of assets but maintain investment in them in the $100 millions range.

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