THE LONDON ECONOMIST, June 29, 1996 Why are some formerly centrally planned economies doing so much better than others? Only a few years ago western visitors to Bucharest and Bishkek would have been struck more by the cities' similarities than by their differences. Communism's central planners created a depressing uniformity that defied culture and geography. Not these days. From Central Europe to China, the transition from communism to capitalism has had strikingly different results. The fast reformers of Central Europe, such as Poland and the Czech Republic, suffered deep recessions in the early 1990s. Now, though, their economies are growing apace and have the basic look of a market economy. In Central Asian countries, such as Tajikistan and Uzbekistan, reform has been slow and piecemeal, and output has continued to decline. China is different again; there, gradual market reforms have brought a booming economy, but one still firmly run by the Communist Party. This year's World Development Report published by the World Bank on June 27th, studies this variation in economic performance. Although this topic has already generated stacks of academic studies the Bank's report is the first comprehensive attempt to compare Chinese, ex-Soviet and East European experiences and to sort out which strategies have worked and which have not. One such strategy, best exemplified by Poland, the Czech Republic and Estonia, is "shock therapy". Prices and trade were liberalised fast, inflation was choked by tight monetary policy, and the privatisation and demonopolisation of industry was started (if not finished) quickly. China, on the other hand, epitomises gradualism -- it freed one or two areas of the economy first and is exposing the rest only slowly to market mechanisms. At first sight the Chinese way looks much the more successful. Since 1978, when the first reform experiments began in agriculture, China's GDP has grown by an average Of 9.7% a year; throughout the former Soviet Union and its ex-satellites, in contrast, output dropped dramatically in the first years of reform. As the report points out, however, China stands apart. When liberalisation began, 71% of its workers were in agriculture, a sector long crippled by artificially low prices and poor productivity. Reform led to big rises in productivity, boosting incomes and growth. The former Soviet Union and its ex-satellites had huge and inefficient industrial sectors. China's financial system was also underdeveloped: rising incomes increased bank deposits and the demand for money. This in turn allowed the government to print money to finance state firms without causing rampant inflation. Former Soviet economies were more monetised. Indeed, they had a "monetary overhang" because their government had been printing money while keeping prices fixed; so once prices were freed, subsidising state firms through the banking system sparked high inflation. Moreover, the Soviet and East European transitions combined political with economic collapse; in China the Communist party stayed in full command. Still, the report concludes that in the 26 economies of Eastern Europe and the former Soviet Union, quick reform and faster growth have gone hand-in-hand. The chart compares these economies' growth rates with the Bank's ranking of them as liberalisers. Speedy reformers suffered smaller falls in output and returned to growth more quickly than the slow coaches. Those that controlled infla- tion more effectively also grew faster. If there is such a strong link between the speed of transition and economic success, why did some countries in the former Soviet Union and Eastern Europe reform rapidly and others not? This is a question the World Bank does not address. But in a new paper three economists, Anders Aslund of the Carnegie Endowment for International Peace, Peter Boone of the London School of Economics and Simon Johnson of Duke University, tackle it.* They argue that the choice depended on political forces: post-communist struggles for power determined a country's pace of reform and thus its eco- nomic performance. It's the polity, stupid. Many ex-communist countries had no clear process for choosing leaders and few checks on their actions. The economists argue that this allowed the timing and intensity of reform to be determined by the vested interests of the former communist elite. In slow-reforming countries, elites who benefited from con- tinuing controls and subsidies were able to delay change and ac- quire huge resources. Some of the authors' evidence is staggering. in Russia in 1992, for instance, subsidised credits, import subsidies and export controls were worth between 55% and 75% of GDP, much of which went to former communist bigwigs. Fast-reforming countries, particularly in Central Europe did not suffer the same paralysis. Moreover, other factors reduced the potential power of vested interests: usually such countries were smaller, had fewer natural resources and relied more heavily on foreign financial assistance (especially from the IMF), which was often conditional on speedy reform. Combine the economic analysis provided by the World Bank with such a political perspective and you begin to get a clearer picture of why some post-communist countries have done better than others. But to address only one dimension -- as the World Bank, a statutorily apolitical institution, has to do-is to disregard one of the most basic features of post-communist economies. * "How to Stabilise: Lessons from Post-communist Countries," BROOKINGS PAPERS ON ECONOMIC ACTIVITY, March 19, 1996 SHOCK THERAPY VERSUS GRADUALISM From Martin C. Schnitzer, COMPARATIVE ECONOMIC SYSTEMS, 7th ed., South-Western Publishing Co., 1997, pp.220-221 There are two main approaches to economic reform of a centrally planned economy, shock therapy and gradualism. Shock therapy involves an immediate scrapping of the old system in order to build a completely new one. A basic rationale for junking the old system is to lessen the opportunities for the nomenklatura elite to get their hands on the new system. One way to do this is to create a democracy. At the core of shock therapy is a set of short-term policies designed to create a free market and to achieve macroeconomic stabilization and control through government fiscal and monetary policies. Shock therapy would simultaneously do the following: 1. Prices would be freed to achieve market-clearing prices determined by supply and demand, and to eliminate hoarding by transforming an economy from a seller's market to a buyer's market. This would induce a supply response. 2. Money wages and income would be frozen to cause real wages and incomes to fall. This is designed to prevent a wage-price spiral and to reduce real production costs. 3. Government expenditures would be reduced by cutting subsidies and entitlement and reducing defense expenditures. 4. Aggregate demand would be reduced by reducing deficit spending and raising taxes, in particular a value-added tax, which is a tax on consumption. This would cause unemployment to rise and induce employers to make a more rational choice in their use of labor. 5. Bank credit would be tightened, the money supply would be controlled, and a two-tiered banking system headed by a new central bank would be created. 6. The economy would be opened up to world markets by replacing the exchange rate mechanism, in which the ruble was inconvertible into foreign currencies and the supply of foreign currencies was held by the state, with a floating exchange rate in which the ruble is convertible into other currencies. A more gradual approach would take into consideration that American-style monetarist macroeconomic stabilization policies are not particularly applicable to a socialist economy having different institutional, social, and cultural variables. For example, after the American and French Revolutions were over, the legal systems of common law and code law remained in place as a part of the new building blocks. Seventy years of the communist ideal, based on abstract nineteenth-century ideas, were imposed on the economic and political system of the Soviet union. Critics of shock therapy claim that it too is based on abstract monetarist principles. Gradualists would argue that it is better to use a more pragmatic approach that would, for example, rely on experience gained from the use of the Marshall Plan after the end of World War 11. It was designed to achieve political stabilization in postwar Europe by achieving economic stability. Grants were made to specific countries, including Germany, to be used to develop their own development strategies. In January 1992 the Russian government embarked on a shock therapy policy of economic reform. Prices were decontrolled on most producer and consumer goods. Steps were made to reduce the deficit through cuts in government spending, including defense spending and subsidies to industry and agriculture, and to impose a new tax system. Foreign trade was liberalized although certain restrictions were retained, such as export and import licensing and a requirement that a large portion of foreign exchange earnings be sold to the government. The initial impact of shock therapy was an increase in unemployment and a fall in living standards. The tight fiscal and monetary policies were relaxed, and easy credit and subsidies to industry were introduced. A continuous struggle occurred in Moscow over the pace of reform.