Transition economies

From 1989 to 1991, COMMUNISM foundered throughout the former Soviet bloc in
Europe and Asia. From Prague to Vladivostok, twenty-eight countries in the former
Soviet Union and Eastern Europe abandoned similar political and economic
systems.
The Collapse of the Socialist System
At the end of communism, all these countries were experiencing great economic
problems. The old, highly centralized socialist economic system had become
ossified. Although it had mobilized labor and capital for industrialization, it failed
to keep up with modern economies. Its chronic shortcoming was shortages, as the
centralized allocation system failed to balance SUPPLY and DEMAND for the
millions of goods and services characteristic of a modern economy. It was
incapable of promoting EFFICIENCY or quality improvement because it focused on
gross production, encouraging excessive use of all inputs. Its ability to innovate
was very limited, too. The socialist economy suffered from a dearth of small
enterprises and creative destruction (the destroying of the outdated by new and
better products and services; see CREATIVE DESTRUCTION). As free resources dried
up, growth rates started stagnating. In addition, an ever-larger share of the Soviet
economy, about one-quarter of GDP in the 1980s, was devoted to military spending
in the arms race with the United States. The stagnation of the standard of living
bred public dissatisfaction, which in turn prompted excessive wage increases and
held back necessary price rises. In Poland and the Soviet Union, budget deficits
and the MONEY SUPPLY grew rapidly toward the end of communism,
causing HYPERINFLATIONmore than 50 percent INFLATION during one month
drastic falls in output, and economic collapse (Kornai 1992).
Market economic transformation was initiated mainly by peaceful political
revolutions heralded by a cry for a normal society, meaning a democracy and a
market economy based on private property and the rule of law. The causes of the
collapse of communism were multiple, and their relative importance will remain in
dispute. The economic failure was manifold and evident. Political repression and
aspirations for national independence also helped cause the collapse. The
multinational statesthe Soviet Union, Czechoslovakia, and Yugoslaviafell

apart. The Soviet Unions inability to keep up with the United States in the arms
race and in high technology was also a factor. The EUROPEAN UNION attracted the
East-Central European nations, which demanded a return to Europe.
Differing Programs of Economic Transformation
At the beginning, the transitions direction was clear, but its final aims were not.
Overtly, everybody advocated democracy, a normal market economy with
predominant private ownership, a rule of law, and a social safety net, but their
eventual goals ranged from the American-style mixed economy to a West
Europeanstyle WELFARE state to market socialism. Instead of arguing about aims,
people argued over whether the transformation to a market should be radical or
gradual.
A radical program, shock therapy or the Washington consensus, became the
main proposal for how to undertakethe systemic change. It amounted to a
comprehensive and radical market reform. Key elements were swift and farreaching liberalization of prices and trade, sharp reduction of budget deficits,
strict MONETARY POLICY, and earlyPRIVATIZATION, usually coupled with
international assistance conditioned on reform measures. The programs main
advocate was Jeffrey Sachs of Harvard University, but mainstream AngloAmerican macroeconomists; the International Monetary Fund (IMF); the World
Bank; the Ministries of Finance of the G-7; and leading policymakers in Poland,
the Czech Republic, the Baltic states, and Russia also supported it. Radical reform
became the orthodoxy. Advocates used many arguments. The success of reform
was in danger if a critical mass of market and private enterprise was not formed
fast enough. A semireformed system would maintain major distortions that would
cause people to seek privileges and subsidies, and would deter INVESTMENT. The
social and political costs of slow reform would be much greater because a
semireformed system could not perform well. People were prepared to accept only
a limited period of suffering (Fischer and Gelb 1991; Lipton and Sachs 1990;
Shleifer and Vishny 1998). Shock therapy was applied in Poland, the Czech
Republic, and the three Baltic states (Estonia, Latvia, and Lithuania).