European Affairs

“Shock Therapy” Worked for the Economies of the Post-Communist Countries     Print Email
Anders Åslund

Anders ÅslundAnders Åslund, a leading specialist on the Soviet Union and its satellites, gave a talk last fall about the massive changes in Russia and the new post-communist countries in Eastern Europe and Central Asia in the 1990s after the collapse of communism. His conclusions were incontrovertible – and they were stark. Economically, the process provided successful transitions to capitalism because most countries understood how to move to free markets and did so quickly. Economists, both in these countries and the West, have mastered the principles for this transition and they worked in practice. In contrast, political transformation has been disappointing in these nations – a failure that Åslund blames on the lack of blueprints for action that should have been developed over the years by political scientists.

Åslund’s work provides an important historical answer to the debate in policy-making and academic circles about how to proceed in replacing the command economies from the Soviet era. An expert on the communist system imposed by Russia, Åslund had predicted the collapse of the Soviet Union under Mikhail Gorbachev. When it happened, he was a leading advocate of rapid change – “shock therapy,” as this controversial approach was called. Opponents argued that a gradual transition from Soviet-style ways would provide a better path for these countries in a world ruled by free-market economies. The argument has sputtered on among economists in the former Soviet bloc, Europe and the United States.

But now the answer is in. Åslund’s magisterial work, built on thorough research, vindicates his predictions – and incidentally, adds substantially to our understanding of development – this book, the first of three on the subject, analyzes the economic performance (and the corresponding political evolution) of 21 ex-communist countries. It is the first-ever such sweeping survey.

In this monumental new book, How Capitalism was Built, Åslund documents sustained economic take-offs in almost all of the 21 countries that once comprised the Soviet bloc: Russia, the countries in East-Central Europe and those of the Commonwealth of Independent States, including some in Central Asia. His findings were consistent: all but three of the 21 embraced sound economic policies, with similar mixes of market reform with deregulation, macroeconomic stabilization, privatization and the creation of a new social safety net. This economic recipe has led to accelerating growth.

In the process of documenting this extraordinary historical transformation, Åslund debunks the main charges spread by critics of his approach. A widespread charge has been that “shock therapy” only benefited rent-seeking oligarchs in these ex-communist countries. Marshalling the economic data from across the region, he demonstrates convincingly that the economic achievements have been a success for whole societies, not just a corrupt elite. While critics contended that these countries were being looted by “the oligarchs,” Åslund shows that this pattern was, at worst, temporary. Historically, it proved part of a process that has led not only to general economic improvement but also helped pave the way to more democratic politics. Tellingly, only three countries of the 21 did not embrace the reforms needed to become successful market-based economies: this trio – Belarus, Turkmenistan and Uzbekistan – remain effectively dictatorships with State-dominated economies.

As Åslund underscores, free markets are integral to the formation of democracy and rule of law. But, as he also shows, there is no basis for the long-prevailing assumption among economists that market economies automatically foster democracy. They may lay an indispensable groundwork. But relative failure of political reconstruction in many of these 21 ex-communist countries shows that the national leaders there, however well-equipped they were to handle the economic challenge, had no viable theory that could have enabled them to implement thorough-going political and legal reforms. The countries that got help along these lines got it mainly from the European Union: meeting accession requirements for eventual membership has been a powerful institution-forming process in candidate countries and moved them in the direction of more pluralistic politics and legal integrity. But the shortcomings in this regard are a dramatic contrast to the demonstrable economic success that now seems rooted in this region. This picture – now clearly documented for the first time – holds not only historical interest but also lessons for policy-makers thinking about economic take-off and political progress in other parts of the world. Providing an introduction to his work, Åslund discussed his findings on September 19, 2007 at the Peterson Institute in Washington. Excerpts follow.

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Anders Åslund: My short message is that after the collapse of communism in Eastern Europe and the Soviet Union, things have worked out economically just about as well as we could have hoped. Now, after nearly 20 years, we have a reasonable perspective on the subject, and today I will discuss five topics: Which reforms worked best? What are the lessons from privatization? Does economic reform put countries on the road to democracy? What was the role of Western aid? Is there a tenable future now for high and sustainable growth in these countries?

Two theses run through my book. One, we know how to build a market economy. In my book, I discuss 21 post-communist transition countries (not former Yugoslavia and not China). Of these, 18 have become market economies and only three – Belarus, Turkmenistan and Uzbekistan, all effectively dictatorships – have managed to avoid it. So the message is that radical reforms work best in this process.

My other thesis is negative: we do not know how to build a democracy. Only ten out of these 21 post-communist countries are democracies. They are all in East and Central Europe, i.e. new European Union (EU) members plus Ukraine which, for the moment at least, is a democracy. I found that only the implantation of EU institutions has actually bred democracy. This is a miserable intellectual failure. In my view, the economists have done their job; the political scientists still have theirs to do.

To simplify comparisons, I have divided the 21 countries into a few categories. One group is “Central Europe” covering Poland, the Czech Republic, Slovakia and Hungary; “Southeast Europe” means Bulgaria and Romania; there are “the Baltics” – Estonia, Latvia, Lithuania. They are the star performers, and, if you want to pick one country as the best transition country, it is Estonia. It is the smallest, but it has pursued the best economic policies. Taken together, these nine countries comprise “East-Central Europe” for my purposes. The remaining 12 countries belong to the Commonwealth of Independent States (CIS): Russia, Belarus, Ukraine, Moldova, Armenia, Azerbaijan, Georgia, Kazakhstan, Kyrgyzstan, Tajikistan, Turkmenistan and Uzbekistan. This group includes the three non-reformers: Belarus, Uzbekistan and Turkmenistan.

GDP Growth in Post-Communist Countries -- 1990-2006Figure 1 illustrates an overall picture of how economic growth happened for the whole region. Initially, collapse bred misery, but then capitalists brought about economic growth. Even in the nine reforming nations in the CIS, since the Russian financial crash in 1998, we have seen stellar growth performance.

How much did overall output fall in the initial shock of liberalization? We will never know because we have such bad statistics about the economic conditions at the end of communist rule, including information about the pervasive shortages and big output falls that helped breed the collapse. And the process of gradual reforms under Gorbachev had the perverse effect of breeding an extraordinary “rent-seeking machine” by people in gatekeeper positions, and this was a cause of massive costs.

The cure was radical-comprehensive economic reforms. This confirms a formula that we know works: quick deregulation, a grip to defeat inflation, and extensive privatization. The sooner you get it done, the better it is. Of course, there are political questions about how fast a country can manage to get all of this done.

Structural Reform Index -- 1990-2006Figure 2, Structural Reform Index, produced by the European Bank for Reconstruction and Development (EBRD) shows that East-Central Europe did extremely well from the beginning and has stayed there. The nine reformers in the CIS started slowly, but once they reached a certain level of market economy, they have not fallen back. This shows that there was no growth until inflation was under control. Hyper-inflation was running 4,500 percent in 1993. Early privatization leads to early growth: the same countries that are the leaders in reform today have also privatized the most.

Privatization has a bad name and I think this view is totally and utterly wrong. The predominance of the private sector is a precondition for market economy, and it’s also a precondition for democracy. Contrary to what many people say, it limits corruption.


And in Figure 3 we see the strong correlation Democracy and Privatization, 2005, Political Rights and Civil Liberties Ratingsbetween all the good factors. Democracy and privatization go together: more property pluralism breeds more political pluralism. Similarly, more privatization breeds less corruption. Using data from Transparency International, Turkmenistan, Belarus and Uzbekistan are among the worst; and the best is, as I already indicated, Estonia. Democracy is indeed the best weapon against the risk of seeing the elite take all the money in rent-seeking that despoils the people. So democracy and market reforms are positively correlated, as are democracy and privatization. Democracy reduces corruption because it means more transparency and more checks and balances.

A fourth issue is Western aid. There was a discussion about whether the United States, for example, wasted too much money on these transition countries. Looking back now, that debate seems rather odd because Western aid barely existed. Western governments received more in debt service on old communist loans than they gave in loans and grants to the post-communist countries from 1993-1996. The capital flows of those countries in the midst of their transition were negative official flows from 1994, 1995, and 1996, according to statistics from the International Monetary Fund. And if you look at the grant assistance to the region, it was a couple of billion dollars each year. Compare that with the $80 billion a year that Germany has steadily spent on its new Länder in former East Germany.

Let’s put this in the context of the total U.S. “peace dividend” from the cold war’s end. During the Reagan administration, the U.S. spent six percent of gross domestic product on defense, but by 1999 U.S. defense expenditures had fallen to three percent of GDP. The difference over the period generated a peace dividend amounting to $1.4 trillion by the end of the Clinton administration in 2000. So, you can say that the strongest force in reducing the U.S. budget deficit during the Clinton administration was the Soviet Union or rather its absence: its disappearance as a threat meant the U.S. could save so much on defense expenditure. [Incidentally, that saving did not show up as U.S. development expenditure for Russia and the countries in the ex-Soviet sphere. As you know, gratitude is no force in foreign policy.]

A point is often made that the EU was the key in solving the transition of [these] countries. I think that is correct. The EU provided the standard of a normal society in terms of a market economy, rule of law and democracy, and it offered an open market to the accession countries at an early stage.

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Now let me turn towards the future. Has sustainable economic growth been achieved in the region? I would argue that it has. Since 2000, the former Soviet region has had an average growth of eight percent a year because of strong macroeconomic policies, a lot of structural reforms, sharp cuts in public expenditures, low exchange rates after the Russian financial crash of 1998 and a commodity boom. I would emphasize the first three factors and cite as the star performers the Baltics, Armenia, Azerbaijan and Kazakhstan. It is not true that oil wholly explains their success although Azerbaijan and Kazakhstan are, of course, benefiting greatly from their oil.

If you look at the growth picture in Figure 4, Central and Southeast Europe performed comparatively poorly. They had a shockingly low growth rate of only six percent last year while the Baltics and the CIS countries had a more acceptable growth rate of ten percent. You can’t really complain about this. If we look at the world more broadly, it is apparent that the former Soviet Union has joined the growth club that has proliferated through China and India. This growth club is now spilling over onto the previously stagnant EU.

GDP Growth in Post-Communist Countries -- 1999-2006We are also seeing competitive tax cuts and deregulation, so tax rates are dropping like stones. We are seeing lower corporate taxes and ever-lower flat income taxes. So the transition is really reforming Europe now, especially since EU enlargement has incorporated some of these countries. In fact, you can argue that the current growth that we can see in Europe as a whole comes very much from the eastern part of the continent and is affecting the whole EU through many different positive impacts.

(It is worth noting that growth rates in these new democracies are twice as high as in Latin America, where there are good macroeconomics but no structural reforms. So we see that the transition countries are getting the benefits of doing it all and accepting the whole package for economic change.)

How is this happening? Exactly as you would expect. Exports are driving growth everywhere, and in this part of the world – the ex-Soviet zone, where economies are today extremely open by any measure – we are now seeing the blessings of globalization more than ever.

Moreover, gross fixed investment is rising with growth – not before, only after growth has taken off. People should notice that some transition economies have investment ratios of 35 percent of gross domestic product, notably Estonia and Latvia. This is just as it should be. And, of course, foreign direct investment is also growing sharply.

Is everything fine? Not quite. Even here, you have some concerns. One part of the concern is relatively low growth in Central Europe, even though it is showing signs of being considerably amended. This region has three shortfalls: high taxes and large budget deficits; large social transfers; and over-regulation of labor and agriculture markets. But with new competition in regulation and taxes, this is improving. In the CIS countries, of course, the problem is poor law-and-order, corruption, uncertain property rights and the risk of re-nationalization. But with so many other positive things going for them, they still have substantial economic growth.

The fiscal balances, which are stellar for the Baltics and the CIS countries, are only a problem in Central Europe. Public expenditures are still too high, but thanks to their collapse in revenues, the CIS countries have ended up with public expenditures on average below 30 percent of GDP. Given that these countries are pretty corrupt, this is a fundamental precondition for their economic growth. The freest labor markets are – this may sound counterintuitive – the ones furthest to the East. Central Europe, which has imposed all of the EU regulations, has the most regulated labor markets and therefore the highest unemployment while the CIS countries have – at least in reality if not always according to the law – pretty liberal labor markets.

One threat to growth is a declining population. This is not, as it is normally presented, a Russian problem. Half a dozen countries – including Russia and Belarus but also Central Europe – have pretty constant populations. The Central Asians have big population growth. But the other countries have had declines in their populations since 1989 of ten to 30 percent. If you have a 30 percent decline in your population – as is probably the case in Armenia, Georgia and Moldova – then that is your main concern. So my conclusions are that capitalism has been successfully built and that it is likely to last. It’s generating more growth and more structural reform than in Latin America. I don’t see any reason to believe that this will be seriously shaken, given the fact that we are seeing it in so many different countries that the politics of one country or the other does not matter.

But the sad corollary is that democracy building has been deplorable, and that is primarily an intellectual shortfall. If you don’t know how to start the process, it doesn’t matter what you do further on. Democratization assistance is what we should really emphasize in the future. We need a Washington consensus on how to build a democracy because, in my economic story, the Washington consensus comes out pretty well – at least the version of it that we have seen at work in the ex-Soviet empire.

Anders Åslund is a senior fellow at the Peterson Institute for International Economics and an adjunct professor at Georgetown University.

 



The Sequel: Åslund’s Latest Book Focuses on Russia

Anders Åslund’s new book, Russia’s Capitalist Revolution: Why Market Reform Succeeded and Democracy Failed, explores for the first time Russia’s economic and political transformation from 1985, when Mikhail Gorbachev launched his reforms, until the present and looks at where Russia might head in the future.

Russia’s “capitalist revolution” has produced an unusual combination of a reasonably free market economy and increasingly authoritarian politics reminiscent of the tsarist period, according to Åslund, a Peterson Institute Senior Fellow. He predicted the fall of the Soviet Union in 1989, and now concludes that the current situation is not likely to hold. Russia is too wealthy, educated, pluralist, and open to be so authoritarian. Either the market economy or the authoritarian rule will have to give in the not-too-distant future: the market economic system appears much stronger than the authoritarianism, which is still relatively mild.

 

This article was published in European Affairs: Volume number 9, Issue number 1-2 in the Winter/Spring of 2008.