Central Europe and the Former Soviet Union: a survey

Business Economics, July, 1995 by Byron Brown

Five years after the collapse of state socialism in Central and Eastern Europe and the consequent dissolution of the Soviet Union, democracy and free enterprise are spreading sporadically throughout the region. More than a third of economic output is now produced by the private sector, shortages have virtually disappeared, and fortunes are being accumulated by a new class of entrepreneurs. The casual outside observer may be forgiven for assuming that it will be only a matter of time before these initially disadvantaged countries achieve sustained rates of economic growth and acquire the political and economic characteristics of the richer European nations.

A closer look reveals disquieting phenomena. Among the population at large in the transition countries, enthusiasm for change has greatly diminished. Most are convinced that the economic situation in their countries is deteriorating. People are angry about rising unemployment, falling living standards, growing poverty and inequality, the erosion of social services, and soaring crime rates. Ominously, once disgraced communist leaders have been recalled to power. The transition process is more complicated than initially presumed. Two distinct processes of transition are under way: one from dictatorship to democracy, another from socialism to capitalism. They do not necessarily proceed in tandem. History has shown that it is possible to have capitalism without democracy; whether one can have democracy without capitalism has yet to be demonstrated (Berger, 1994).

No one expected the social costs of transition to be so high. The massive decline of measured GDP in the transition economies was greater than the output and income loss of the United States and Germany during the Great Depression. The proportion of the poor has increased from about 3 percent to 18 percent, or 50 million people. About 60 percent of them live in Russia, with another 20 percent in the other Slavic states of the FSU, not counting the Transcaucasian countries at war or under blockade where the poverty incidence is probably even higher. Poverty rates are unevenly distributed: almost 30 percent in the Baltic countries, around 17 percent in Poland, and much lower (around 1 percent) in the Czech Republic, Hungary, Slovakia, and Slovenia. Income distribution throughout the region has become increasingly unequal as private entrepreneurs and professionals have gained relative to the rest of the population. The increase in inequality, coupled with the decline in overall income and the reduction of social services, explain the large increase in poverty and go far toward explaining the increasing cynicism and displeasure that pervades the region (Milanovic, 1994).

It is interesting to note that the sharp increases in poverty in the United States and Germany during the Great Depression were met with active government policies to counter the problem. In the transition economies, however, the policy prescription - enforced by the International Monetary Fund and the World Bank - has been free-market shock therapy. In spite of sound economic arguments for this approach, its side effects are harsh. In practice, shock therapy has produced significant inflation, has promoted stagnation, and has had the effect of deindustrializing large segments of the economy. As high rates of inflation have eroded the social safety net, social costs have been reflected in unemployment, poverty, and inequality (Amsden, Kochanowicz, and Taylor, 1994). High interest rates as well as high rates of taxation on profits and wages, made necessary by IMF conditionality requirements, have directed entrepreneurship away from long-term productive investment and into arbitrage and speculation.

It is not only the IMF and World Bank that are responsible for shock therapy. Reacting to the recent history of central planning and tight state controls, the political leaders of the transition economies turned to textbook laissez-faire policies long abandoned in western economies. Much of the impetus to these policies stemmed from the newly elected leaders' conviction that rapid, radical economic reform was necessary in order to make the transition process irreversible. In the euphoria of the period, anyone who suggested even minimalist long-range government planning was subject to being labeled a crypto-Stalinist. It was genuinely felt that the rapid introduction of economic and institutional changes would act as policy constraints on future governments, whatever their ideology and value systems. These assumptions were logical but failed to take into consideration the difficulty of modifying institutions built up over decades of central planning to make them appropriate for a market economy. They were, however, sufficient to forestall the adoption of more gradualist policies in most countries.

Free-market policies have been relied upon to integrate the transition economies into the global economy, in sharp contrast to the planning requirements imposed by the Marshall Plan after World War II. In spite of the fact that the West has been relieved of the defense expenditures associated with the Cold War, only a pittance has been redirected to speed the transition process of its former antagonists. Exacerbating the difficulties, import barriers have been erected by the West to protect their relatively rich economies from low-wage competition, thus depriving the transition economies of full utilization of their comparative advantages. An objective observer would have to conclude the future is still uncertain for many of these countries, and that the chances of "stalling out" are at least as likely as "takeoff."