Knowledge is power, and it can help you overcome any fear of the unexpected. When you learn, you gain more awareness through the process, and you know what pitfalls to look for as you get ready to transition to the next level.
Economic Growth in Developing and Transitional Economies
(Part D)
by
Charles Lamson
The Transition to a Market Economy
The reforms underway in the Russian Republic and the other formerly communist countries of Eastern Europe have taken shape very slowly and amid debate about how best to proceed. Remember, there is absolutely no historical precedent to provide lessons. Despite this lack of precedent, however, there is substantial agreement among economists about what needs to be done. Six Basic Requirements for a Successful Transition Economists generally agree on six basic requirements for a successful transition from socialism to a market-based economy: (1) macroeconomic stabilization; (2) deregulation of prices and liberalization of trade; (3) privatization of state-owned enterprises and development of new private industry; (4) establishment of market-supporting institutions, such as property and contract laws, accounting systems, and so forth; (5) social safety net to deal with unemployment and poverty; and (6) external assistance. We now discuss each component. Although we focus on the experience of the Russian Republic, these principles apply to all economies in transition. Macroeconomic Stabilization Virtually every one of the countries in transition has had a problem with inflation, but nowhere has it been worse than in Russia. As economic conditions worsened, the government found itself with serious budget problems. As revenue flows slowed and expenditure commitments increased, large budget deficits resulted. At the same time, each of the new republics established its own central bank. Each central bank began issuing "ruble credits" to keep important enterprises afloat and to pay the government's bills. The issuance of these credits, which were generally accepted as a means of payment throughout the country, led to a dramatic expansion of the money supply. Almost from the beginning, the expanded money supply meant too much money was chasing too few goods. This was made worse by government-controlled prices set substantially below market-clearing levels. The combination of monetary expansion and price control was deadly. Government-run shops that sold goods at controlled prices were empty. People waited in line for days and often became violent when their efforts to buy goods at low official prices were thwarted. At the same time, suppliers found that they could charge much higher prices for their products on the black market---which grew bigger by the day, further exacerbating the shortage of goods at government shops. Over time, the ruble became worth less and less as black market prices continued to rise more rapidly. Russia found itself with near hyperinflation in 1992.  To achieve a properly functioning market system, prices must be stabilized. To do so, the government must find a way to move toward a balanced budget and to bring the supply of money under control. Deregulation of Prices and Liberalization of Trade To move successfully from central planning to a market system, individual prices must be deregulated. A system of freely moving prices forms the backbone of a market system. When people want more of a good than is currently being produced, its price will rise. This higher price increases producers' profits and provides an incentive for existing firms to expand production and for new firms to enter the industry. Conversely, if an industry is producing a good for for which there is no market or a good that people no longer want in the same quantity, the result will be excess supply and the price of that good will fall. This reduces profits or creates losses, providing an incentive for some existing firms to cut back on production and for others to go out of business. In short, an unregulated price mechanism ensures an efficient allocation of resources across industries. Until prices are deregulated, this mechanism cannot function. Trade barriers must also be removed. Reform-minded countries must be able to import capital, technology, and ideas. In addition, it makes no sense to continue to subsidize industries that cannot be competitive in world markets. It is cheaper to buy steel from an efficient West German steel mill than to produce it in a subsidized antiquated Russian mill, the Russian mill should be modernized or shut down. Ultimately, as the theory of comparative advantage suggests, liberalized trade will push each country to produce the product it produces best. Deregulating prices and eliminating subsidies can bring serious political problems. Many products in Russia and the rest of the socialist world were priced below market clearing levels for equity reasons. Housing, food, and clothing were considered by many to be entitlements. Making them more expensive, at least relative to their prices in previous times, is not likely to be popular. In addition, forcing inefficient firms to operate without subsidies will lead many to go out of business, and jobs will be lost. So while price deregulation and trade liberalization are necessary, they are very difficult politically.  Privatization One problem with a system of central ownership is a lack of accountability. Under a system of private ownership, owners reap the rewards of their successes and suffer the consequences of their failures. Private ownership provides a strong incentive for efficient operation, innovation, and hard work that is lacking when ownership is centralized and profits are distributed to the people. The classic story to illustrate this is called the tragedy of commons. Suppose an agricultural community has 10,000 acres of grazing land. If the land were held in common so that all farmers had unlimited rights to graze their animals, each farmer would have an incentive to overgraze. He or she would reap the full benefits from grazing additional calves while the costs of grazing the calves would be born collectively. The system provides no incentive to manage the land efficiently. Similarly, if the efficiency and benefits of my hard work and managerial skills accrue to others or to the state, what incentives do I have to work hard or to be efficient? One solution to the tragedy of commons attempted in 18th century Britain was to divide up the land into private holdings. Today, many economists argue, the solution to the incentive problem encountered in state-owned enterprises is to privatize them and let the owner compete. In addition to increasing accountability, privatization means creating a climate in which new enterprises can flourish. If there is market demand for a product not currently being produced, individual entrepreneurs should be free to set up a business and make a profit. During the last months of the Soviet Union's existence, private enterprises such as taxi services, car repair services, restaurants, and even hotels began to spring up all over the country.  Like deregulation of prices, privatization is difficult politically. Privatization means many protected enterprises will go out of business because they cannot compete at world prices. Resulting in a loss of jobs, at least temporarily. Market-Supporting Institutions Between 1991 and 1997, U.S. firms raced to Eastern Europe in search of markets and investment opportunities and immediately became aware of a major obstacle. The institutions that make the market function relatively smoothly in the United States do not exist in Eastern Europe. For example, the capital market, which channels private saving into productive capital investment and developed capitalist economies, is made up of hundreds of different institutions. The banking system, venture capital funds, stock market, bond market, commodity exchanges, brokerage houses, investment banks, and so forth, have all developed in the United States over hundreds of years, and they will not simply be replicated overnight in the formerly communist world. Many market-supporting institutions are so basic that Americans take them for granted. The institution of private property, for example, is a set of rights that must be protected by laws that the government must be willing to enforce. Suppose that the French hotel chain Novotel decides to build a new hotel in Moscow. Novotel must first acquire land. Then it will construct a building based on the expectation of renting rooms to customers. These investments are made with the expectation that the owner has a right to use them and the right to the profits that they produce. For such investments to be undertaken, these rights must be guaranteed by a set of property laws. This is equally true for large business firms and for Russian entrepreneurs who want to start their own enterprises.  Similarly, the law must provide for the enforcement of contracts. In the United States, a huge body of law determines what happens to you if you break a formal promise made in good faith. Businesses exist on promises to produce and promises to pay. Without recourse to the law when a contract is breached, contracts will not be entered into, goods will not be manufactured, and services will not be provided. Another seemingly simple matter that turns out to be quite complex is the establishment of a set of accounting principles. In the United States, the rules of the accounting game are embodied in a set of generally accepted accounting principles (GAAP) that carry the force of law. Companies are required to keep track of their receipts, expenditures, and liabilities so their performance can be observed and evaluated by shareholders, taxing authorities, and others who have an interest in the company. If you have taken a course in accounting, you know how detailed these rules have become. Imagine trying to do business in a country operating under hundreds of different sets of rules. This is what has been happening in Russia. Another institution is insurance. Whenever a venture undertakes a high-risk activity, it buys insurance to protect itself. Social Safety Net In a centrally planned socialist economy, the labor market does not function freely. Everyone who wants a job is guaranteed one somewhere. The number of jobs is determined by a central plan to match the number of workers. There is essentially no unemployment. This, it has been argued, is one of the great advantages of a planned system. In addition, a central-planning system provides basic housing, food, and clothing at very affordable levels for all. With no unemployment and necessities available at very low prices, there is no need for unemployment insurance, welfare, or other social programs.  Transition to a free labor market and liberalization of prices means that some workers will end up unemployed and everyone will pay higher prices for necessities. Indeed, during the early phases of the transition process, unemployment will be high. Inefficient state-owned enterprises will go out of business; some sectors will contract while others expand. As more and more people experience unemployment, popular support for reform is likely to drop unless some sort of social safety net is erected to ease the transition. This social safety net might include unemployment insurance, aid for the poor, and food and housing assistance. The experiences of the developed world have shown that such programs are expensive. External Assistance Very few believe the transition to a market system can be achieved without outside support and some outside financing. Knowledge of, and experience with, capitalist institutions that exist in the United States, western Europe, and Japan are of vital interest to the Eastern European nations. The basic skills of accounting, management, and enterprise development can be taught to Eastern Europe; many say it is in everyone's best interest to do so.  *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 744-748* end |
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