Keynote Speech: Economic Developmentsand Reforms in the Partner Countries

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NATO ECONOMIC Colloqium, 
30 June, 1 and 2 July 1993, 
Brussels

ECONOMIC DEVELOPMENTS IN COOPERATION PARTNER COUNTRIES
FROM A SECTORAL PERSPECTIVE

EVOLUTION DE LA SITUATION ECONOMIQUE DANS LES PAYS
PARTENAIRES DE LA COOPERATION DU POINT DE VUE SECTORIEL

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Keynote speech:

ECONOMIC DEVELOPMENTS AND REFORMS IN THE PARTNER
COUNTRIES*
Leszek Balcerowicz

I. The Role of Initial Economic Conditions

The process and outcome of economic transformation depends
on the initial conditions, on the conditions which
accompanied the transition and on the adopted strategy of
transformation. The latter is defined by the vision of the
target system to be reached as a result of the
transformation process and is a sequence of steps intended
to bring the economy from its perceived initial state to
this desired end state. Without such a clear vision the
economic policy may easily follow a zig-zag course and
irreversible steps precluding the achievement of a
competitive market economy may be taken.

Identifying initial conditions may be compared to making a
medical diagnosis, which includes determining the illness
and other elements of the patients health. Without
this step it is hardly possible to tell what the
recommended therapy should be and what course it would
take.

Differences in the initial conditions greatly affect the
economic transformation. This is especially true of the
initial economic structure. For example, in China, in the
late seventies, close to 80% of the population was working
in technically simple, easily divisible agriculture.
Therefore, privatisation of the agricultural sector
started at that time could have represented a massive
positive change in the whole economy and it could have
been the first enormous stage in the self-stimulating
process of directing China towards a market economy. The
"Chinese way" cannot be, however, applied so easily and
effectively in Russia because agriculture plays a far less
important role in the economy as a whole and is
technically much less divisible. The "Chinese way" may be,
on the other hand, repeatable in Vietnam.

Other important types of initial conditions are: the
macroeconomic situation (hyperinflation or relative
stability) and the kind of economic system defined in
terms of the proportion of the public sector and the
related ease and speed with which one can obtain the
capitalistic structure in the economy. The initial type of
economic system also determines the supply response of the
economy to a stabilisation and liberalisation programme.

The initial conditions in Central and Eastern European
countries were, on average, much more difficult than those
in other cases of radical market oriented reforms (e.g. in
West Germany in 1948 or Taiwan and South Korea some 20
years later). I see three main differences, all to the
detriment of the Central and Eastern European countries.
First, the burden of the previous system was much heavier
in Poland, Hungary, Czechoslovakia, Bulgaria and certainly
in the Former Soviet Union. One part of this burden is the
proportion of output which is non-viable under market
economic conditions because it was closely linked to the
previous economic system or to the Comecon market that
collapsed. This proportion was on average rather high,
although it was higher in some of them, like the Ukraine
or Slovakia, than in Poland, Hungary or the Czech
Republic. Another kind of burden were the mental results
of 40 or more years of the existence of a centrally
planned economy, as reflected in certain habits or
attitudes towards income differentiation, towards private
economic activity, the labour ethic, etc.

The former socialist countries also suffered from a
DEFICIENT STRUCTURE OF HUMAN CAPITAL as reflected in the
lack of specialists in marketing, banking, finance, modern
accounting, i.e. in all the fields that are so important
for the proper functioning of a market economy. On the
other hand, one of the few positive legacies of socialism
was a fairly high level of GENERAL EDUCATION, which
enables quick learning of more specific skills and
positively distinguishes the Central and Eastern European
countries from many less developed countries. However,
this initially high stock of general human capital may be
depleted if proper economic reforms are not introduced.
For under such conditions, a deepening economic crisis
could ensue, and this in turn would induce the emigration
of the best specialists, an emigration made possible by
the political liberalisation.

The second, and very important, difference referred to the
type of economic system that existed at the start of the
market-oriented reform. In Taiwan or in South Korea at the
turn of the fifties and the sixties there already existed
a weak form of capitalism, and the economic reform largely
boiled down to a shift from import substitution to export
oriented growth. In West Germany before 1948 capitalism
had been merely "suspended" through the introduction of
wartime economic mechanisms. Stabilisation (currency
reform) and liberalisation (removing the
"Bewirtschaftung") were basically sufficient to quickly
restore competitive capitalism and to obtain a positive
global reaction of supply to the
stabilisation-liberalisation package. The former socialist
countries faced a much more difficult situation, for
capitalism there had been destroyed, not merely suspended.
Apart from stabilisation and liberalisation it was,
therefore, necessary to introduce difficult and time
consuming fundamental institutional changes, including
massive privatisation. A stabilisation and liberalisation
programme had to be introduced in a yet largely socialist
economy.

The third difference was that public administration in the
former socialist countries was weaker, especially in terms
of competence, than in the previously mentioned cases of
radical market oriented reforms. The inherited socialist
administration was specialised in things that the state
should not be doing in the economy, i.e. detailed
intervention, and was weak in those things that are
necessary, e.g. macroeconomic management. Yet, it was
impossible, except in East Germany, which relied on
massive imports of specialists from West Germany, to
quickly have a completely new and much more competent
public administration. One could change some people at the
higher echelons, but essentially the economic revolution
had to be started with a basically unchanged army
of public servants.

To be sure the competence of the inherited public
administration varied across the former socialist
countries. It was certainly higher in countries that had
previously undertaken same decentralising reforms
(Hungary, Poland) than in those that had maintained a
rigid centralised system.

But this brings me to the issue of the DIFFERENCES IN THE
INITIAL CONDITIONS among the Eastern and Central European
countries. Apart from the above-mentioned difference I can
see four others.

First, one can distinguish between well-defined and
ill-defined states. The latter group included the
countries of the Former Soviet Union (and, as it later
turned out, Czechoslovakia). All these countries, on top
of enormous economic difficulties, had to face some
additional tasks: those of organising the state both
internally and externally. So the top decision-makers were
in this respect even more overburdened than those in the
relatively well-defined states, such as Poland.

The second difference refers to the economic system.
In none of the former socialist countries did there exist
a market economy, but their initial economic systems
differed nevertheless. On the one hand there were
degenerate centrally planned economies (in the Former
Soviet Union, in Czechoslovakia, Bulgaria, Romania), and
on the other hand, what Tamas Bauer called, "neither
planned nor market" economies. The latter was true
first of all of Hungary and to a lesser extent of Poland.
The countries that had some elements of the market
mechanism had a certain advantage over the others, as the
scope of the necessary changes, although still enormous,
was somewhat reduced.

However, this modest advantage was totally offset in
the case of Poland by the third difference, that OF THE
MACROECONOMIC SITUATION. Poland in the middle of 1989
belonged to a very rare category, that of a socialist
economy of shortage, struck by hyperinflation. This group
was later joined by practically all the countries of the
Former Soviet Union, while Poland successfully eliminated
hyperinflation and shortages.

On the other hand the initial macroeconomic conditions in
Czechoslovakia and Hungary were incomparably better. There
were relatively few shortages, and the annual inflation
rate in Czechoslovakia was about 10% and in Hungary around
30%. In Poland in August 1989 prices started to rise 40%
monthly, the market dollar exchange rate exceeded several
times the official one, shops were empty, and foreign
currency reserves declined dramatically.

The fourth difference had to do with FOREIGN DEBT. Poland,
Hungary and Bulgaria inherited a heavy burden of debt,
while Czechoslovakia and Romania were relatively free of
it. Countries of the former group had to face the
additional problem of negotiating with their former
creditors. This constituted an important element of
the overall economic strategy in Poland and brought about,
thanks to the radical economic reform that justified
unprecedented steps and intensive negotiation, an
agreement whereby the Polish debt with respect to the
Paris Club was to be reduced by 50%.

II. The Choice of Economic Strategy

Disregarding the above discussed differences, one may say
that all the post-socialist countries have to overcome two
problems:

- a deep structural crisis, which could be seen in the
faulty inherited economic structure (large and ineffective
heavy industrial sector, strong dependence on the Former
Soviet Union market, etc.) and in a low and failing
overall economic efficiency. The latter led to a low
living standard when compared to countries that once had a
similar level of development, e.g. East and West Germany,
Czechoslovakia and Austria, Poland and Spain, and others;

- MACROECONOMIC IMBALANCE, which ranged - as mentioned -
from macroeconomic catastrophe (as in Poland) to a
relatively mild disequilibrium (Czechoslovakia, Hungary).

Economic strategy had to be the answer to these two
major inherited problems.

In order to remove the macroeconomic imbalance, a
programme of macroeconomic stabilisation was necessary.
The more advanced the macroeconomic illness, the more
rigorous such a programme had to be. In Poland in 1989,
plagued with hyperinflation and massive shortages, a far
more radical therapy was necessary than in Hungary, where
the imbalance was much smaller.

In order to eliminate the shortages, it is necessary,
besides macroeconomic changes, to introduce
liberalisation, especially with respect to prices and
foreign trade. An obvious step towards liberalisation is
removing constraints in the creation and development of
the private sector.

The deep structural crisis had at its foundation a faulty
system of a non-market economy, dominated by the
state-party. Therefore, the building of a new economic
system (an economy driven by market forces, where various
forms of private ownership are predominant, open to the
world, and with a stable currency, etc.) had to
become a priority. The creation of a new economic order
involved two kinds of steps, the already mentioned
liberalisation, i.e. increasing economic freedom, and a
comprehensive transformation of economic institutions: of
enterprises (privatisation), the tax system, banking
sector, local government, as well as the creation of new
ones, e.g. stock exchange, etc.

The right strategy does not only mean determining the
range of activities, but also the speed of its
implementation. A key issue is to realize that decisive
stabilisation and liberalisation takes much less time than
a large-scale institutional restructuring.

The leaders of the economic reforms had to choose between
a radical strategy and various gradual strategies.

A radical strategy is based on expeditious and strict
stabilisation and liberalisation and, as speedy as
possible fundamental institutional restructuring. As
mentioned before, these first two changes could be
implemented much faster than the third one. Thus, if the
process of transition begins in these three areas at the
same time, then the radical strategy means that the
stabilisation and liberalisation must take place in
basically unchanged institutional structures. This is the
source of this strategy's danger: it is far more difficult
to foresee the reaction of the economy to the tough
stabilisation and liberalisation measures; this
reaction is usually worse than in an already restructured
economy. This risk, however, must be compared to the
dangers inherent in alternative strategies.

One of the gradual strategies is GRADUAL stabilisation.
If, in the beginning, a country experiences
hyperinflation, then taking such action resembles putting
out a fire slowly. So, this strategy is not risky, it is
hopeless. Postponing the struggle against hyperinflation
until a time when the economy has been basically
privatised could only be compared to abandoning a fire for
the sake of trying to rebuild the house, the inside of
which was still burning. A gradual liberalisation of
prices, access to international trade, etc., would
preclude a quick elimination of massive shortages as well
as a definite improvement of the price structure. It would
be a mere repetition of the previous partial reforms, all
of which ended in a fiasco.

A "gradual" reform would also mean wasting the political
capital existing in people, in the form of increased
readiness on the part of the people to accept difficult
radical steps in the economy. Such capital is usually the
benefit of a large scale political breakthrough, but it
also vanishes quite quickly, giving way to "normal"
politics conducted by political parties and a game of
particular interests. Finally, social psychology tells us
that people are more prone to adjust their attitudes to
the surrounding environment when this environment has
undergone a radical change, than when it is gradually
changing.

Consequently, in countries in the situation of a
macroeconomic catastrophe and a deep structural crisis,
THERE ARE NO SOLUTIONS THAT ARE RISK-FREE. The least risky
and having the best chances for success is a properly
structured radical strategy, supplemented withstrictly
limited and market oriented state policy towards selected
sectors of the economy (e.g. energy, transport, mining,
agriculture) and with carefully considered foreign policy
aimed an opening foreign markets.

Radical strategy must be complemented by clear EXTERNAL
SUPPORT manifested by better access to foreign markets,
favourable terms of foreign debt servicing, foreign,
investment, technical assistance in building new
institutions, and improving skills and know-how. The
success of reforms in Central Eastern European countries
is also dependent on the INTERNAL ECONOMIC POLICY of the
biggest Western countries. For example, the lack of budget
discipline in the West, which results in higher interest
rates in the financial markets of the world and decreased
access to funds, represents a severe set-back for the
countries undergoing the reform process. Even more harmful
are the protectionist tendencies in the West. I will
return to this subject later.

III. Conditions during the Economic Transformation

Before I start discussing the results, let me mention the
conditions which accompanied the reforms in Central and
Eastern Europe. One can safely say that they were
extremely difficult, much more difficult than those
that prevailed during previous transitions to a market
economy. West German reforms after 1948 were accompanied
by the Korean boom, and economic reforms in Taiwan and
South Korea at the turn of the 1950s and 1960s were
implemented when world trade was booming. In contrast, the
reforms in Central and Eastern European countries were
accompanied by the collapse of their exports to the Former
Soviet Union and a sharp deterioration of their terms of
trade.

There were also important differences among the
post-socialist countries with respect to the conditions
which prevailed during their economic reforms. Smaller
countries and those which were especially dependent on the
Soviet market for exports and imports (the twogroups
largely overlapped) were hit especially hard by the
collapse of this market and the transition to world prices
for importantraw materials. This applies e.g. to all the
Baltic countries, and - outside the Former Soviet Union -
to Bulgaria and Slovakia.

There had also been important differences in internal
political developments, i.e. the level of conflicts within
the political system, the frequency of elections and the
related changes of governments, etc. These political
factors are important for the economy, as they influence
the expectations of the economic agents and, therefore,
their willingness to engage in longer-term investments,
and the propensity to take difficult decisions aimed at
the restructuring of enterprises. On this political scale
Hungary can be singled out as the country with the most
stable political system so far, followed perhaps by the
Czech Republic. Poland has displayed much more political
instability. The positive results of the Polish economic
programme have been achieved in spite of this instability
and thanks to the fact that most of the radical changes
were introduced during the first two years, when the
political situation was much more stable than later, and
when there was continuity in the economic leadership. Most
other Central and Eastern European countries have an even
more difficult political situation than Poland.

IV. The Economic Outcome

As already explained,the economic developments in the
Central and Eastern European countries depend on (1) their
initial economic situation; (2) the conditions during the
economic transformation (if any); (3) the adopted economic
strategy. The differences in each of these factors have
influenced the economic outcome. I would think that the
adopted economic strategy was probably the variable that
influenced the economic outcome the most. Of great
importance were also the initial economic conditions.

Before discussing the economic outcome, a note of caution
concerning the statistical data seems to be in place. The
inherited statistical system is not capable of giving an
accurate description of the economy undergoing a dramatic
change. It focuses on the public sector which is shrinking
and it cannot capture fully the private sector which is
growing very fast, at least in those countries that
introduced a radical economic strategy. As a result, the
official data may overstate the decline in GDP during the
economic transition. For example, the official data for
Poland for the years 1990-91 registered a decline of about
18% in GDP while the newer estimates carried out at the
Research Institute of the Main Statistical Office in
Poland put that decline at 5-10%. And it should be
remembered that even these estimates do not capture the
effects of a radical elimination of shortages and of the
improvements in the range and the quality of goods.
Besides, a substantial part of this decline was due to the
collapse of trade within the former Comecon.

Taking as the criterion the initial macroeconomic
situation we note that the two countries, Czechoslovakia
and Hungary, which had a relatively favourable position in
this respect, managed to maintain this position after
having liberalised their economies. Hungarian
liberalisation and stabilisation was much more gradualist
than the Czechoslovak one. Despite their relatively
favourable initial macroeconomic situation and the
differences in economic strategy, BOTH countries
registered (at least according to official statistics) a
deep decline in GDP in the years 1990-1992. A good part of
it was undoubtedly due to the collapse of trade with the
Former Soviet Union. In addition Hungary appears to have a
serious fiscal and, therefore, macroeconomic problem, while
in Czechoslovakia, as distinct from Hungary or Poland,
very little industrial restructuring in the state sector
appears to have occurred so far.

Countries which faced at the start a much more serious
macroeconomic situation are now in a very different state,
depending primarily on the adopted economic strategy.
Poland had to face in 1989 a macroeconomic catastrophe and
swiftly introduced a radical stabilisation-liberalisation
programme accompanied by the comprehensive institutional
change. As a result hyperinflation was quickly eliminated,
shortages were abolished, the private sector grew at a
very fast pace, some state enterprises started to adjust,
and Poland turned out to be the first post-socialist
country that recorded growth in GDP since about the middle
of 1991. Among the remaining economic problems the deficit
of the state budget and the related inflation, which is
still too high, are the most serious ones. At the other
extreme there is the Ukraine which, fearing the "shock
therapy", increased budgetary expenditures at such a pace
that a huge budget deficit and a related hyperinflation
ensued. This is accompanied by a continuing fall in GDP.
Russia started in early 1992 a radical stabilisation
programme accompanied by a modest liberalisation (as
compared to the Polish one). But Russia interrupted the
stabilisation in mid-1992. As a result very high inflation
returned. On the other hand it appears that Russia is
reasonably successful with the voucher privatisation
programme. It remains to be seen, however, how efficient
the newly privatised enterprises can be in the inherited
environment of "soft" budget constraint and pervasive rent
seeking.

Other countries that started under serious macroeconomic
imbalance fall somewhere in between these extremes. For
example, Estonia and Latvia seem to be close to
macroeconomic stability, thanks to their tough monetary
reforms. On the other hand Lithuania, Bulgaria and
Romania appear to be much further from it.

Generally speaking, countries which started under
conditions of dramatic macroeconomic instability and for
some reasons delayed or interrupted a radical
stabilisation-liberalisation programme are incurring
continuous social costs due to the decline in the real GDP
and to the macroeconomic chaos. Serious social costs, in
the sense of the worsening of some aspects of the economic
situation (i.e. growing open unemployment), are also
related to the radical economic reforms. However, these
reforms as distinct from the former approaches, if
implemented consistently, can bring about a gradual
improvement. The social costs of the radical reforms are,
therefore, "productive", while those of other strategies
are largely "unproductive".


V. The Role of External Factors

It is a truism that there is no substitute for the proper
economic reforms in the Central and Eastern European
countries. But it is also true that the chances for
success of such reforms are greatly affected by external
factors, and especially by the economic policies in the
West.

The Western governments seem not to realize their own
potential to harm or to increase the chances for success
of economic reforms in the former socialist countries
through - what to Western countries are - quite marginal
actions. This is especially true of measures determining
the access to their own markets for exports from the
Central and Eastern European countries. Given that the
share of these exports is at about 2% of total Western
imports, but that those exports account for about 50% of
the total exports of the former socialist countries, there
is an enormous leverage, which may work either way. What
is for the Western countries a marginal restriction of
access to their markets, may cause great harm to the
countries undergoing radical economic reforms, thus
affecting the complicated economic, social and political
dynamic and reducing their chances for success. No amount
of verbal encouragement from the Western governments can
compensate for the damage inflicted by these steps.


* This paper is partly based on the lecture to be
published by the School of Slavonic and East European
Studies of the University of London.

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First edition 1993
ISBN 92-845-0079-6

This is the latest in a series bringing together papers
presented at the NATO colloquia organised by the NATO
Economics Directorate and Office of Information and Press
on economic issues in the former USSR and Central and
East European countries. For further information please
write to the Director, Office of Information and Press,
1110 Brussels, Belgium.

The articles contained in this volume represent the views
of the authors and do not necessarily reflect the
official opinion or policy of member governments or NATO.