The Big Bang in European Transition to Market Economies Following the Fall of the Soviet Union



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The Big Bang in European Transition to Market Economies Following the Fall of the Soviet Union


Jennifer Jura

Senior Thesis

University of Puget Sound

12 May 2006



Abstract: After the fall of the Soviet Union, Central and Eastern Europe were faced with massive reforms and restructuring of the political and economic systems. In terms of economic transition, countries either chose shock therapy, gradualism or a combination of both. These methods of transition deal primarily with the time frame in which reforms are made. In particular this paper looks at the method of shock therapy and the motives countries had in using it in reforming their economies. Within transitional economies, banking sectors are the most important and most difficult to reform. To illustrate the methods of transition this paper uses Germany, Poland, Russia and Hungary as case studies. This paper examines the experience of these countries to determine the factors that influence a country to employ shock therapy as well as the consequences of that decision.

Table of Contents
1. Introduction

2. Purpose of a Strong Banking Sector

3. Shock Therapy Theory

3.1 Reforms under Shock Therapy

4. Banking Sector

4.1 Pillars to Successful Banking

4.2 Soviet Planned Economy

4.3 Central Bank Reform

5. Theories of Transition

5.1 Policies of Shock Therapy

5.2 Shock Therapy Consequences

5.3 Gradualism

6. German Reunification

6.1 Pre-Reunification

6.2 Criticism of Shock Therapy in Germany

6.3 Decisions for the Government in Transition

6.4 East-West Monetary Union

7. Poland

7.1 Social Unrest Brings Economic Reforms

` 7.2 Balcerowicz Plan

8. Russia

8.1 Obstacles to Transition

9. Hungary

9.1 Model for Transition

9.2 Impact of Political Reforms on the Economy

10. Conclusion

1. Introduction

The collapse of the Soviet Union brought about a global change in the political and economic landscape which had been dominant for almost 50 years. Mikhail Gorbachev was the driving force behind the economic reforms that led to the demise of the Soviet Union. He proposed the ideas of glasnost and perestroika. Perestroika means economic restructuring which includes the liberalization and opening of the Communist command economy. By doing this, many of the economic failures that had plagued the economy for so long came to light. One of the motives behind Gorbachev’s reforms was to appease the public who were growing weary of the sluggish economy. He was hoping that by enacting liberalized reforms, the economy would respond and recover. Instead of jumpstarting the economy, Gorbachev’s reforms caused further deterioration which eventually led to the collapse of the Soviet Union. Upon the collapse, the Soviet satellite countries had to face transitioning from the Soviet system to a western-based democracy which included a market economy.

One of the areas within the economic sector that experienced an entire overhaul was the financial systems, in particular the banking sector. The banking sector, an important aspect because it finances not only the entire economy, but companies as well because it benefits individuals with saving and loans. This illustrates how influential banks are in every aspect of the economy methods. To ensure a smooth transition of the banking sector it is important to have these influences. There are two primary methods used by countries in transitioning: shock therapy and gradualism. The difference between the two methods deals with the time frame and to specifically address the policies necessary to make a successful transition. Debates center around which method is best. Although it is clear that both methods while achieving the same outcome, initiate different processes. Shock therapy tends to focus on a quick time frame which severely limits the type of policies a government can create. These policies usually focus on remedying a problem as quickly as possible regardless of the effect it potentially might have on the economy. Shock therapy focuses itself on the short term while gradualism is more concerned with the long term. Gradualism gives politicians a longer time frame to work with and allows for policies to address any items in a case by case situation. Choosing between shock therapy and gradualism became a hotly contested issue for many of the former Soviet satellite countries. In the end, some of these countries choose booth approaches. For example, Germany opted for in the reunification, while Hungary began to employ gradualist policies in the 1970's. Since the fall of the Soviet Union there has been quite a bit of discussion over the experiences of these transitional countries, due in part to the debate over which method is preferred.

This paper will examine in particular the method of shock therapy and its role in Central and Eastern Europe after the fall of the Soviet Union. Specifically, what is the appeal to the chosen method by governments and how they utilized it in their transitions from Soviet planned economies to Western market-based economies. This paper will also investigate the impact shock therapy has on the banking sector of the economy. In addition, four case studies will be used to illustrate the experiences and effects shock therapy has had. Its intent is to examine, the experiences in Germany and their decision to use this process during the reunification process. Russia in contrast is a good example of mix between shock therapy and gradualism and the potential disastrous results that can be associated. Poland on the other hand, will highlight how successful utilization using of shock therapy will benefit the transition process. Finally Hungary will be used to contrast shock therapy with a successful use of gradualist reforms. What accounts for these variations in the transition process? This paper sets out to discuss the theory of shock therapy and gradualism, as well as the experiences these countries have had in regards to determining the best course of action in reaching a market economy.



2. Purpose of Strong Banking Sector

The European Bank for Reconstruction and Development (EBRD) sees, “a sound and efficient banking system [as] an absolutely fundamental element of a market economy” (Fries 1996) (22). To go a step further the banking sector can be seen as a window into the economic and commercial life of the country. The banking sector represents the activities of all the principle agents: consumers, savers, investors, firms and the government. Banks help to facilitate transactions between these agents, “in a way that combines confidence in their own financial strengths with the provision of products and services that people want” (Fries 1996) (22). A strong well functioning financial system is characterized as having a banking sector which has high domestic savings and private investment which will lead to growth of the economy. With a planned economy, growth is slow due not to the volume of investments but by the low quality. This is due to the government involvement in the financial sector of the economy. The EBRD refers to this as “passive banking” (Fries 1996) (4). Within the former Soviet Union all countries opted for a rapid abolishment of monobanks, however some countries such as Russia allowed for growth of new banks. This led to the creation of hundreds of banks virtually overnight. On the other hand, countries such as the Czech Republic, experienced more government control which helped to limit the number of banks that emerged. Whichever approach a country decides to take, the banking sector was the centerpiece of the transition.



3. Shock Therapy Theory

Shock therapy refers to the approach of quick implementation of reforms on monetary policy, privatization, and other sectors of the economy. Thus, proponents of shock therapy stress that by implementing reforms quickly more of the populace being awarded. The idea of the majority benefiting is not new to these economies. Under the communist regimes and planned economies one of the principles focused on trying to create these benefits for the majority of the population. Soviet planned economies were designed for the government to decide which products get produced and how much is supplied. The government had complete control over producers which helped the government exercises its control over the public. One consequence of a planned economy was shortages. This occurred because the government, not market forces were determining what products were provided, while the public was still able to determine the demand for products. For example, it was common for individuals in the Soviet Union and its satellites to wait a decade or longer for a vehicle. With a planned economy a system of incentives emerges, yet these incentives work against growth and efficiency. The incentives come from the state which keeps producers from over producing and instead following a strict quota system. With a system such as this, the state is contributing to the stifling of reforms and eventually the system will fail. This is exactly what occurred in the Soviet Union, it was inflexible to reforms for growth which lead eventually to its demise.


3.1 Reforms under Shock Therapy

Under the shock therapy approach there are both macro and micro economic reforms that occur to ensure a quick transition. Macroeconomic reforms emphasize, “restrictive fiscal and monetary policies, wage controls, and fixed exchange rates” (Svejnar 2002) (5). Microeconomics reforms focus on price liberalization as well as a rapid opening to international trade. By opening themselves up to international trade, these countries are ensuring efficient allocation of resources which is based on the world market prices and helps to bring about market economies. To ensure that the economic environment is conducive for macro and micro reforms, countries have to develop and enforce laws, regulations and institutions. This includes for example, privatization of large and medium sized enterprises and most importantly the banking sector. Besides restructuring, governments also need to develop the infrastructure for such changes such as labor regulations, unemployment, and retirement systems. Some of these reforms require the government to have some resources to help create an economic environment that can nurture the growth of a market economy. Some countries in Central and Eastern Europe found this difficult no matter which approach they initiated. Either method led to a disastrous attempt at shock therapy or a more gradualist approach.



4. Banking Sector

The banking sector is one of the most important areas of a transition economy. Bonin claims that, “financial markets are at the core of any well-functioning capitalist economy (Bonin 1994) (109). This illustrates the importance of the banking sector in the economy as well as shows the urgency for quick reforms needed to take place after the fall of the Soviet Union. It was necessary for financial institutions and banks to allocate resources within the economy in order to keep it strong.. Bonin describes the new role banks take on under such a process. They include settling payments between individuals and companies as well as providing financing to businesses and serving as an intermediary for savings and investments which in turn develops credit for individuals and businesses.



4.1 Pillars to Successful Banking

Elmar Koch outlines three essential pillars that need to be achieved to have a successful banking sector as, “the payment and settlement system, financial markets and financial institutions” (Koch 1998) (67). By achieving these pillars countries are ensuring a smooth transition as well as sound economic growth for the future. The OECD stated that, “the creation of transparent, flexible financial systems . . . is essential” (Koch 1998) (67). By having such financial systems these transitional economies can generate capital flows which will lead to economic growth. However, for most of the economies it has resulted in weak banking systems which have stemmed from a combination of bad loans, political interference and a lack of capital. Creating transparent and flexible financial systems should help to alleviate some of the issued that plagued these countries.



4.2 Soviet Planned Economy

According to Central Bank Reform in the Transition Economies, in 1991-1992 a, “two-tier banking system emerged with the creation of central banks and the transformation of the specialized banks” (Sundararajan 1997)(27). The two-tier banking system was unique following the monobank system from the Soviet Union. Under the Soviet planned system, “financial institutions and instruments were used mainly to record transactions and monitor compliance with plan directives” (Bonin 1994) (109). Basically the state was in complete control of all aspects of the banking sector. The state exercised its control through directives which included making investment decisions by allowing for households to only deposit savings into a national savings bank that was driven by the state. The control of the banking sector illustrates the role and influences the state had in all areas of citizens’ lives in the Soviet Union.

In some regards the monobank of the Soviet Union was not truly a bank due to its inability to actually be responsible for projects as well as loan enforcement. Instead it main purpose was to finance the planned economy that the government created. The two-tier banking system created a separation between the central bank and commercial banks, which never exists under the previous Soviet system. When instituting the two-tier system countries typically began by, “splitting the monolithic state bank under central planning into several large banks, which are specialized by activity, economic sector or geographical region” (Fries 8). With this separation came new function for both, which included minimizing the government control as well as increasing the autonomy for commercial banks. In addition, the two-tier banking system helped to create and strengthen regulations, supervision, recapitalization, and privatization which assisted in the creation of strong market reforms for the banking sector.

One obstacle that arose when trying to institute the two-tier system was the awareness of bad loans that had occurred under the Soviet system as well as trying to rid the banking sector of low quality investments. These both became extremely difficult to judge and identify. Reforms that were enacted to combat these problems were modeled after international standards. For many of the transition countries, European Union membership was seen as a goal for the future. To ensure compliance with EU many countries drew upon the Basle Committee, which helped in, “classifying assets and for making specific provisions against doubtful and unrecoverable loans” (Fries 1996) (5). While many countries have embraced reforms based on EU standards, there is still a long way to go in securing the banking sector.

Another challenge that has plagued the banking sector is supervision. Without the proper supervision a country’s banking sector will be unstable and will lead to unsound financial system. One of the biggest issues is the rampant asymmetrical information practices which are a hold over from the Soviet banking system. The problem arises when banks do not disclose potential issues to the investors and savers. This practice was used frequently under that Soviet system, partly due to the government control over the banking sector. The government did not want the public to discover the pitfalls of the Soviet system, which led to banks to become very underhanded in their practices. Yet with a market economy it is vital that banks are transparent. This became a challenge in ensuring sound banking practices. One major change had to deal with banking personnel. Bankers had to change their approaches to banking which required a massive retraining of these individuals. Part of this is due to the potential of former Soviet sympathizers infiltrating the banking sector and derailing reforms.

With the banking reforms that occurred after the fall of communism many transitional countries experienced a dramatic increase in the number of banks. For example, in Russia, by, “January 1996, the number of banks was 2,268" (Sundararajan 1997) (55). This increase in banks illustrates the quickness banking reforms took place in many of these countries. One of the explanations for this is that under the Soviet monobank system individuals were forced to go to the state owned bank to perform any banking activity. This severely curbed individual banking activity. Individuals instead kept their money in their individual possession and therefore refrained from participating in any financial activities. With the creation of private branch banks individuals had easier access to invest their money into a bank. In addition, having access to banks helped encouraged individuals to participate in the financial sector by taking out loans and in hand promoted savings. For many of these transitional countries the World Bank and International Monetary Fund, as well as other governmental and non-governmental organizations assisted in the first phases of banking reforms.



4.3 Central Bank Reform

One of the ways financial stability can be achieved is through the creation of a strong central bank. The goal of central banks is financial stability which includes the strengthening of the payment and settlement system. These provisos according to the report prepared by the Committee on Payment and Settlement Systems are, “the transfer of money and financial instruments” (Bank for International Settlements 2005) (1). This Committee has identified the Central Bank as a way to help oversee and ensure that the financial infrastructure which includes these systems are in keeping with the stabilization of the economy . The Committee recognizes that many of the systems also satisfy a certain criteria which helps bring about stability. It also makes recommendations that Central Banks need to be transparent in their payment and settlement systems. By being transparent the central banks can ensure that approach to all payment and settlement systems are uniformed.

Koch writes that, “macro- and micro-environment will have to be taken into account when assessing bank restructuring” (Koch 1998) (68). This exemplifies the interdependencies of macro- and micro-economic necessary for successful banking reforms. By influencing both macro- and micro-economic aspects of the economy it shows apparent the importance of a strong stable banking sector. It also demonstrates the need for appropriate reforms to be installed which ensured that transition occurs as smoothly as possible.

5.Theories of Transition

Clague and Rausser write that transitions from command economies to market economies are difficult because, “markets do not need to be painstakingly constructed by government-they emerge spontaneously . . . a communist economy, by contrast, has to be centrally planned and implemented” (Clague and Rausser 1992)( viii). As I mentioned before, there are two main strategies for transition into a market economy: shock therapy and gradualism. Vladimir Popov writes, “shock therapists advocate radical reforms and rapid transformation, and gradualists, justifying a more cautious and piecemeal approach to reforms” (Popov 2000). Shock therapy advocates argue that by having a quick transition, a long and costly period is avoided. With the collapse of the Soviet Union there have been many discussions about the correct course of action for the newly created countries to use in their transition from a Soviet command economy to a market based economy. One of the most prominent advocates of shock therapy in Central and Eastern Europe is Jeffery Sachs. Sachs sees the shock therapy as the appropriate course of action because, “the existing structures are the problem” (Clague and Rausser 1992) (44). Pairing this belief of current institutions with the concept of a rapid straightforward economic transition, the entire system is seen as inadequate and needs to be completely overhauled in hopes of minimizing the long term effects.



5.1 Policies of Shock Therapy

Those who are proponents of shock therapy see the transition to a market economy as mostly the destruction of the current system and the building of an entirely new one. This new system includes the creation of, “the Central Bank and the Ministry of Finance, as well as the payment mechanisms and tax collection systems” (Clague and Rausser 1992) (35). Sachs is not the only economist that has proposed or discussed the theories associated with transition; Popov’s article in Comparative Economic Studies discusses that with the transition of the former Communist states, “many studies were undertaken with the intention to prove that fast liberalization and macro-stabilization pays off and finally leads to better performance” (Popov 2000). According to Mark Kramer there are six policies that were adopted by many of the Central and Eastern European countries during their big bang transition. They include, “macroeconomic stabilization, liberalization of prices and commercial transactions, privatization of small firms, removal of barriers to small business formation, restructuring and liquidation of large state-owned enterprises (SOEs) and the development of market institutions and infrastructure which includes commercial banks” (Kramer 1999). These policies are seen by many to help lay a sound foundation in which growth and reforms can take place quickly. Some of these policies have been discussed previously in this paper and illustrate their importance in the transition process.

In 1996, the World Bank released the World Development Report From Plan to Market, which looked at the economic performance related to the transition countries of Central and Eastern Europe from a command economy to a market economy. Specifically, the report looks at the progress of the countries in the areas of liberalization and macroeconomic stability. The report discovered that, “consistent policies, combining liberalization of markets, trade, and new business entry with reasonable price stability, can achieve a great deal even in countries lacking clear property rights and strong market institutions” (WDR 1996 p142). Even though this report illustrates that it is possible to have a successful transition without strong market institutions many economists agree that the lack of strong institutions actually contributed to the struggles faced by many economies.

5.2 Shock Therapy Consequences

When shock therapy is applied to an economy, it leads to the immediate release of price and currency controls, as well as the rapid liberalization of trade and withdrawal of the state subsidies. Shock therapy is usually graphically illustrated by a J-curve with a sharp initial fall in economic activity, yet recovery will follow relatively rapidly (Hoen 1998)(7). The other alternative is gradualism, which has a J-curve with a moderate initial decline with the recovery following at a slower pace. With gradualism, institutions are seen as a way to assist in the transition. By making them an integral part of this process, it ensures that the market forces that work within the confines of the institutions are not reinforcing an economic crisis. The importance of market forces working properly within these institutions can be seen not only in Europe, but also the United States. While many European countries have only recently experienced economic hardships, the United States experienced its hardship during the Great Depression. With the onset of the Depression the U.S. government had to implement economic reforms which included a significant amount of banking reforms. To combat the economic effects of the depression, the United States realized that it had to put into place banking safeguards and regulations to help ensure the eradication of future economic failures.



5.3 Gradualism

As discussed briefly before, gradualism refers to a slower speed of implementation of reforms in comparison to shock therapy. By taking a slower pace of implementation gradualism allows for, “the highest expected outcome for a majority and to delay the reforms that are expected to hurt most” (Roland, 1994) (1163). For many individuals they, “do not know before the reform whether they will be winners or losers” (Wei, 1997) (1237). This asymmetrical information effect makes gradualism more appealing to those individuals who are unsure about the consequences reforms could have on them. For example, if you were to restructure an entire sector of the economy which required a large relocation of the workforce, and you decide to take a gradualist approach. I t could result in a relocation of a third of the workforce rather than the entire populace. This would allow for the workforce to be compensated and relocated without shocking other sectors of the economy. In comparison with a shock therapy approach, the economy would be unprepared to handle compensating all workers as well as absorbing them in other sectors of the economy. When restructuring sectors of the economy there is an increase of uncertainty about the consequences of reforms. To combat the unknown effects, a gradualist approach could be beneficial in allowing for alteration of reforms if it is discovered they are not going to be effective. Gradualism allows for if the public to either accept or reject reforms which will allow for the government to determine if there is a need to implement further actions. If the public rejects reforms the gradualist reforms approach, it then allows the government to either abandon the actions or restructure it to decrease the loss of monetary investment.

When creating financial institutions a gradualist approach could be beneficial due to the potential asymmetrical and moral hazard problem. With the amount of intermediaries that exist in the economy the potential of problems is increased which makes gradualism an attractive approach. When creating a financial system gradualism, it can allow for, “the establishment of a screening mechanism, the emergence of a sound private financial system, a credible policy of gradual restructuring and hardening of budget constraints in the state sector” (Roland, 1994) (1164).

6. German Unification

After the fall of the Soviet Union, Germany was the only country that experienced a reunification with a democratic counterpart, which made the transition process unique compared to the other former Soviet satellites. That transition for the GDR had huge political implications that affected the economic landscape. For both East and West Germans the reunification was both a blessing and a burden. One of the hardest decisions made after the fall was how best to merge two separate and different economies which were both German. The reunification needed to find a way to integrate a broken planned economy with a successful global trading system without disrupting the economic vitality of both nations as well as the global market as a whole. The reunification and complete dissolution of the East German State took place in less than twelve months. Many East Germans advocated for a swift incorporation to West Germany. The Berlin Wall came down November 1989 and by May 1990 a treaty establishing a monetary and economic union was drafted. By July of 1990 the treaty was in full effect with the introduction of the Deutschmark to the East Germans.



6.1 Pre-reunification

Prior to reunification West Germany was “ranked among the top global exporters, and its inflation rate was among the lowest in the world” (Smyser 1992) (1). West German products were held in high regard as well as its Central Bank, the Bundesbank, which served as a model for European Central Banks. In addition to serving as a banking model to the rest of Europe, the Deutschmark “was second in rank only to the U.S. dollar as a reserve currency” (Smyser 1992) (1). These achievements coupled with a high standard of living and financial security, made West Germany one of the most successful economies in the western world. Smyser describes the West Germany approach to the economy as, “a distinctive mix of drive and caution of competition and self-restraint, of a market economy functioning within a framework established by theory and custom” (Smyser 1992) (1).

Looking at East Germany is more difficult according to Smyser. The economic statistics, “ha[ve] always been questionable, in part because of widespread statistical juggling and in part because it was difficult to determine what production could or could not be justified economically” (Smyser 1992) (3). Ghaussy and Schafer characterized Soviet planned economy as, “collective ownership of the means of production and central quantity-based planning” (Ghaussy and Schafer 1993) (18). This system suppressed market forces which dictate how much should be produced in the economy. Without these forces companies had little motivation to produce higher than the quota provided by the government. However, an effort to translate East German economic statistics to their Western counterparts proved to be nearly impossible. Yet even with the difficultly comparing the East and West, Smyser determined that, “the sector composition of the East German economy before its collapse was very much like that of West Germany” (Smyser 1992) (3). The issue soon became how to integrate these two economies and at what speed.

6.2 Criticism of Shock Therapy in Germany

Some critics, like Ghaussy and Schafer point out that by choosing a rapid transition, “extensive literature was ignored, [and] the establishing of a market-economy system was carried out in a frantic rush and unscrupulous election promises were made” (Ghaussy and Schafer 1993) (20). By using a shock therapy method, officials were abolishing the GDR’s economy before the new unified system was fully operational. Officials were gambling on the fact that rapid transition would minimize the long term effects and that the benefits would far outweigh the costs. With a crisis on the horizon many German politicians claimed that no one realized how bad the economic situation really was in East Germany. The transition crisis that arose was due in part to asymmetrical information. It soon became apparent that many were oblivious to, “the fact that research on the GDR existed [and] even maintained that this research had failed to provide correct information” (Ghaussy and Schafer 1993) (22). As noted earlier it was a difficult process to translate East German economic statistics into Western standards. By not being able to accurately make comparisons the resulting transitional policies becomes difficult.

Ghaussy and Schafer continue to criticize the German decision of shock therapy in their reunification. They denounce German politicians for not being aware of the consequences of a quick reunification. Also, they charge the politicians with being irresponsible to the public, “wrong decisions [were] made on a grand scale [and] were covered up with official calculated optimism” (Ghaussy and Schafer 1993) (23). Ghaussy and Schafer illustrate how contested the transition process was for Germany. It became apparent that either politics or economics was going to suffer in the transition. With shock therapy Germany would be unified quickly which would hopefully lead to a cohesive national identity. Yet economically that reunification could have dismal results which could alienate East Germans further and thus widen the gap between East and West. On the other hand, with gradualism, differences between the two nations could continue for years and the economic shock of reunification would be less dramatic and most likely lead to a more evenly distributed wealth between the East and West. In the end Chancellor Helmut Kohl initiated policies for a complete political reunification in which the economic aims would have to be adjusted to fit.

6.3 Decisions for the Government in Transition

Germany’s decision to implement shock therapy reforms could indicate that German politicians saw the priority to bring together people under one unified identity. This concerned many, as they saw political leaders elevate political ambition over economic necessity. The European Community expressed many fears with the neglectful nature the German politicians were taking with economic concerns. Their fears stemmed from the fact that Germany is one of the engines of the then European Community. If the engine was to experience dramatic economic change that could potential lead to economic disaster and the repercussions could extend to all the members of the community. Specifically, some European governments were concerned of higher inflation and interest rates as well as the devaluation or revaluation of the Deutschmark. Those concerns of the Deutschmark were fueled by its place as a dominant global reserve currency that could have a ripple effect. The European Community wanted the German government to not only think about the consequences for German citizens but for the European Community as a whole. In the end, the German government integrated both economic and political aims together which calmed the fears of other European members.



6.4 East-West Monetary Union

One of the biggest aspects of the transition and reunification of East Germany is the monetary union created between East and West. The goal behind this union was to not only create a unifying currency but also to reduce migration from East to West. By July 1990, the West German Deutschmark became the legal tender in East Germany. This shift led to considerable changes within East Germany. For example, “the Deutschmark is fully convertible . . . [which] allows unlimited freedom of exchange with West Germany and the outside world” (Giersch 1991) (155). In addition the citizens of East Germany were no longer under state control of their assets and monetary transactions. The East Germans had to turn over all banking authority to the Deutsche Bundesbank (German Central Bank) whose main goal was to ensure that the currency remained stable as well as remaining independent of the political reunification that was occurring simultaneously. To ensure stability, the Treaty on the Creation of a Monetary, Economic and Social Union declared that not only was the Deutsche Bundesbank the only central bank, but that the Deutschmark will be the only currency. It also outlined the day to day tasks of the Bundesbank. These included price stability as well as independence from the government. The Bundesbank is in charge of, “issu[ing] currency, decid[ing] upon discount and other interest rates, which [creates] open market policy, conducts open market transactions, and establishes minimum reserve requirements” (Smyser 1992) (48). Within Germany the Bundesbank has significant power in implementing policies due to its independence from the government. By having a strong central bank, the transition and reunification of the East German economy with the West was minimized. To help ease the transition the monetary union allowed for East Germans to exchange their savings at a rate of 1:1, even though the currency should not have been exchanged equally for West German Deutschmarks. The focus was not on sound economic principles but what would be the quickest and most painless way for the citizens. One obstacle that the union faced was the asymmetrical information from the East. Once again the German government had a difficult time finding the clarity in statistical data from the GDR. Some critics today have claimed that by not only using shock therapy but by exchanging currency at equal value the economy suffered. One of the reasons is that once East Germans exchanged their currency they had no incentive to stay in the East, but instead migrated to the West. The government did very little to try and entice East Germans to remain and help to strengthen the local economy. Some criticized the government’s neglectfulness of the economic repercussions of making both the East and West currency equal to one another. West Germans were penalized in that their money was not worth as much as the East German currency. The currency exchange gave purchasing power to the East Germans which without the equal exchange rate would have led to a loss of competitiveness in the East. Without both sound economic institutions such as the Deutsche Bundesbank and a competitive market needed to fuel an economy, the East would collapse.

7. Shock Therapy in Poland

Poland was one of the first countries after the fall of the Soviet Union to implement market reforms. Poland opted for the shock therapy method of implementing reforms and was soon seen throughout Europe as one of the most radical of transitional countries. While it seemed that Poland’s experience with shock therapy was going to be a success, many obstacles tried to derail reforms.



7.1 Social Unrest Brings Economic Reforms

For Poland, social upheaval in 1956 help to induce economic reforms. It began with railroad workers striking against poor economic conditions and government policy. Soon the strike spread to mass demonstrations which prompted the government to use force which did not ease the conflict. Eventually the government conceded to the protests and brought back from exile Wladyslaw Gomulka. Gomulka, who was the former head of the Communist party, was reinstated as the head of the Communist Party (Hoen 1998) (105). Gomulka helped to institute economic reforms even with political pressure from Moscow against him. The economic reforms occurred in three parts: “Firstly, independent worker’ councils were installed to check managerial decision making. Secondly,...Polish agriculture was not collectivized. Finally,... a substantial societal influence of the Catholic church was brooked (Hoen 1998) (105). After 14 years however, the public lost confidence in Gomulka and his reforms and the country once again experienced violent social upheaval.

Edward Gierak succeeded Gomulka and instituted an import-led economic strategy. This approach was used by many Central and Eastern European countries and relied on, “capital investments financed by foreign loans” (Hoen 1998) (106). It also relied on using external financing to reform the economy. By using external financing the hope was the government could increase investments without sacrificing the current state of the economy. However, by 1976 it became clear that Poland was living beyond its means of capacity. This led to an increase in food prices which ultimately led to decrease of public support for Gierak’s economic policies. By the 1980's it seemed that Poland was going to fail in its attempts for successful economic reforms. This once again brought protests which eventually led to the resignation of Gierak. Following Gierak’s resignation the Polish parliament accepted a proposal for economic reform that resembled that of Hungary’s. The reforms resembled Hungary’s approach in that they opted for a more gradualist position which focused: “Firstly, [on] decentralization in economic decision making. Secondly, in order to fulfill the plan, financial regulations were introduced. Thirdly,...workers’ councils were given wider powers” (Hoen 1998) (108). These reforms were scheduled to be implemented in January 1982. However, once again social unrest erupted and led to the implementation of marshal law. Yet even with the introduction of martial law the reforms were implemented on time. By 1984 the Polish economy began to stabilize and recover. As the Soviet Union began to dissolve Poland also realized the need for further reforms due to the lackluster success of the gradualist approach during the 1980's. These reforms included: “price corrections to fight chronic shortages” (Hoen 1998) (108). However with the liberalization of prices, disequilibrium occurred which caused an increase in inflation rate. According to Herbert Giersch, “historical evidence on fighting hyperinflation seemed to indicate that shock treatment stood a better chance of success and on the whole,promised to be less costly in terms of social hardship” (Giersch 1991) (95). The government was then forced to once again alter reforms due to mass protest which arose in response to the increase in prices. For the government stopping inflation quickly was the main focus to not only lay the groundwork for more intense reform but to also silence the protests.

7.2 Balcerowicz Plan

With the help of Jeffrey Sachs, an economist who is a proponent of shock therapy, Poland implemented the Balcerowicz Plan. The plan liberalized prices, production and trade. By liberalizing prices the government was hoping to eliminate the monetary overhang and have prices reflect the scarcities of the market. In addition the plan looked at wage rates and implemented a system of tight wage control. The plan also attempted to balance the budget as well as creating a more restrictive monetary policy. Finally the plan devalued the currency and pegged it to the dollar. The success of the Balcerowicz plan relied heavily on the public embracing the proposed reforms. By the mid nineties Poland was seen as an economic tiger in Central and Eastern Europe. By 1994 Poland had applied for European Union membership which was granted in 2004. By achieving EU membership Poland has come full circle in the transition process. Poland has gone from Soviet planned economy to being part of an union with the economic powers of Europe. Poland applied both gradualist and shock therapy reforms which allows for a comparison of both approaches. It is apparent that for Poland, shock therapy was a more effective approach in transitioning to a market based economy.



8. Russia

It is also necessary to discuss these issues from a Russian perspective. However it is interesting to point out that some believe that Russia adopted a shock therapy approach while some see it as more a gradualist approach. I am going to discuss this confusion as well as outline similarly their experience in comparison to Germany and Poland

Russia’s transitional experience is unique due to its power as the leader of the Soviet Union. Once the Soviet Union dissolved Russia was thrown into turmoil both economically and politically. In addition, Russia is a large country which has poor infrastructure in terms of financial institutions. Yet even with these obstacles there was a glimmer of hope for Russia’s transition. Russia seemed to be on a smooth path with the implementation of privatization and stabilization reforms throughout the mid-90's. Quickly that glimmer disappeared with the inability of the Russian government to implement structural reforms that would assist in transitioning to a market based economy. The election of 1996 also proved to be an obstacle to this fragile economy. From the beginning the inflation rate was one of the biggest financial issues that Russia faced. For example, between 1991 and 1992 the inflation rate increased by 1353.0, compare this to Czech Republic whose inflation rate increased by 11.0 for the same year (Michelman 58).

8.1 Obstacles to Transition

Another unique problem that plagued Russia was its wealth of natural resources. Under the Soviet system natural resources such as gold, silver, oil, gas, and diamonds sustained part of the economy. Yet with the movement toward a market economy the country struggled to incorporate its rich natural wealth into a new economy. The biggest concern was the ownership of these precious natural resources. Under the Soviet system the state owned the companies but during the transition process many of these companies were privatized in some capacity, which many thought would bring about a market system. However, Russia discovered that it is more difficult to turn back the clock on seventy years of a command economy. Michelman claims that because of the years with a command economy Russia needs gradualist reforms for, “capitalist standbys as bankruptcy for failed or redundant firms, employee layoffs and relocation, unemployment insurance and re-employment training”(Michelman 1998) (7). Under the Soviet system the state was in control of ensuring that firms were supported and that there was no unemployment. Yet with the diminishing role of the state in a market economy, the economy has to adjust by creating institutions to help alleviate problems. Many international organization such as the European Bank for Reconstruction and Development have tried to bring about a stable banking sector in Russia. One of the most comprehensive projects was between the EBRD and the World Bank. The project had three aspects of implementation which included: “strengthening of a core of thirty to forty commercial banks... the building up of bank supervision...and the improving of bank accounting” (Fries 1996) (10). The ERBD saw these reforms as the most crucial with the potential of deeper reform to occur afterwards. Even with ideas presented today about how to most efficiently transition these reforms the Russian government continues to struggles.

Similarly to the other transitional countries of Central and Eastern Europe, Russia had difficulty with the openness associated with a market economy. As previously discussed under a Soviet planned economy there was an asymmetrical information problem. Under the Soviet Union budget deficits these economic indicators were not recognized and therefore never recorded. This makes it difficult to understand the economy and apply the appropriate reforms. Without strong financial institutions such as a strong banking sector the economy will continue to struggle.

For shock therapy to work there need to be some market compatible institutions which assist in making the transition to a market economy. Russia did not have institutions that were compatible to the market and consequently they faced difficulties. On the other hand, countries such as Poland, had some market compatible institutions. It seems that Russia saw the success of shock therapy in Poland and automatically assumed that the outcome would be the same for them, however, Poland had areas of its economy that were already privatized while Russia’s economy was almost entirely collective. In addition to the lack of market compatible institutions, Russia did not have the experience required to implement smooth market reforms. How can a country try to implement market reforms when very few individuals have ever lived in a market economy? The lack of experience was quite evident in the sense that Russian officials were unaware of the ramifications certain policies would have on the transitional process. Once again, Russia saw the success of other countries that used shock therapy, yet most of them had officials who had experienced a market based economy. It can be inferred that through the experience of living in a market economy one has acquired knowledge which is invaluable to the transition process. Finally, the spirit and mentality of the people of Russia had an affect on the success of market reforms. For many the ideology and beliefs of the Soviet Union were strongly integrated even after 1990.

In terms of economic reforms private trade was seen as an economic crime which thought helped to deter Russia from embracing it. Not only did the government have to struggle logistically with the implementation of reforms, but they also had to work to change the attitude of the people towards those reforms. While the younger generation seem receptive, older generation seem less willing to embrace a new economic system. It seems that Russia should have thought about using a gradualist approach similar to Hungary to model their transition reforms. However, as said before, one of Russia’s problems stems from its belief that it would have the same success as Poland. Michelman suggests that Russia’s problems in transition have to do with being, “too large a country; too long under Communism; too weak the presidential powers; too much crime and corruption; too large an entrenched bureaucracy” (Michelman 1998) (73). With these sorts of obstacles Michelman sees a more gradualist approach as the answer, however, it could be argued that using a gradualist approach would have been detrimental as well. While it is unclear whether a gradualist approach would have benefited Russia, all that is clear is that Russia remains in transition.

9. Hungary

In comparison to the previous three countries, Hungary was the model for a successful implementation of gradualism. As mention before, other countries, such as Russia looked to Hungary and its success to shape its reform policies. One of the triumphs of Hungary’s transition experience was its ability to escape hyperinflation which plagued most of the other transition countries. Part of this can be explained by Hungary’s, “background of market-freedom achieved during the Communist period, under the 30-year regime of Janos Kadar” (Michelman, 1998) (64). Some of the freedoms that were pursued during this time included: consumer prices comparable to those of the world outside of the Soviet Union, the privatization of both the retail and agricultural sectors, and a market inspired tax system. All of these freedoms came at a price. In 1956 there was a social uprising that was crushed by the Russians, yet helped to influence the economic reforms that would be needed later for a smooth transition to a market based economy. After the tumultuous events of the 1950's Hungary has been able to sustain market reforms since their conception in the late 1960's.



9.1 Model for Transition

The reforms of the 1960's were unique in that they did not seek to substantial increase the private sector of the economy, but instead the creators believed that, “a market economy could operate on the basis of state and cooperative ownership” (Giersch, 1991) (110). This belief seems to be incorporating Soviet aspects into a market based economy. Cooperative ownership that involves that state is a trait of the Soviet system. It is interesting that the creators of the reforms saw that there were flaws in the Soviet system yet they created reforms which kept certain fundamental aspects of the system they were trying to abolish. The gradualist nature of Hungary’s reforms illustrates that instead of eradicating a system quickly and starting without a foundation, it could be more beneficial to build on the already existing system. This seems to be the approach Hungary took when implementing its reforms. The government did not destroy the Communist system but instead built upon it.

Eventually, in the 1980's though the government realized that to create effective reforms they would have to endorse a privatization approach. The government did not have the intention to create a western style market economy, instead they proceed under the assumption of implementing partial reforms. These reforms primarily affected ownership, banking and taxation. Yet the reforms ended up taking a western inspired framework. In 1987 the banking sector underwent change in the form of turning the National Bank into a central bank and creating five business banks. By 1988 the business banks begin market based activities such as collecting deposits of private individuals and selling of bonds. Banking reform continued even after the fall of the Soviet Union with the government introducing the Law on Commercial Banks. This law reduced state ownership in all banks to less than 25 percent in a move to become more aligned with western market banking practices. Primarily the banking act also became more restrictive on companies. It helps to create an effective bankruptcy legislation which at first caused an increase in the number of bankrupt companies but eventually helped in decreasing the number. By creating a market based banking system Hungary was creating sound institutions which are crucial for a smooth economic transition.

9.2 Impact of Political Reforms on the Economy

In addition to economic reforms, 1988 brought about a new political situation. The Communist party conference accepted the multiparty system, free elections, and civil rights. This would result in the beginning of the end for the Communist party in Hungary. By 1990 the Communist party fell from political power and a western political framework appeared. With the political sphere transitioning to a western democracy it was inevitable that the economy would soon follow. Overall Hungary’s transition experience was successful due to the proactive nature of the government. By instituting reforms in the 1960's the government was setting itself up for a gradual movement to market reforms and ensuring that painful steps were minimized. As discussed previously gradualists reforms can benefit economies in allowing for the government to find the reforms that benefit the most people. Hungary also differs in that its political transition influenced its economic transition. The political reforms of the 1980's served as a nice backdrop for economic change. Gradualism seemed to be the best approach for Hungary and it allowed for the reforms to come from within the government which made them more influential. Hungary’s initatives were not induced by massive demonstrations or protests like Poland or the Czech Republic but instead induced from individuals within the government who recognized the need for reform.



10. Conclusion

Transition is a country by country experience which can be influenced by a host of other factors. For example, change for many of these countries was influenced heavily by the political situation at the time. Gradualism and shock therapy are two general approaches that have been identified as acceptable methods of transition. Many of the former Soviet countries of Central and Eastern Europe have either attempted one method or the other. Some countries have tried throughout the transition process to implement a combination of both gradualist and shock therapy reforms. The shock therapy approach is not seen as the natural progression in restructuring an entire economy. For most when making massive overhauls of an economy the more gradual the better so that all participants can adjust. However, the attractive to shock therapy lies in the hope of minimizing the cost bore by the government and the public. Finding which method is going to be the most successful is dependent on many factors politically, economically and socially. Each country is different which requires them to evaluate their own political, economic, and social spheres to determine which method will benefit most of the population. Looking at the studies outlined in this paper suggest that both approaches have been attempted and neither one seems to be the more successful option. From Hungary’s gradualist reforms to Poland’s shock therapy neither one is the obvious choice. For Poland shock therapy was the right choice at the time, while in Hungary gradualism was the right path at the time. It is hard to determine for a country which method will be in the end successful.



All the countries of Central and Eastern Europe had different transitional experiences. For some political issues threatened the transition process while for others the lack of financial institutions created obstacles. Transitioning economies is not a new concept but after the fall of the Soviet Union an entire region underwent a massive political and economic restructure which had effects around the world. It was important for the global community that these countries did not fall into a political and economic vacuum in which they turned to another authoritarian regime.

For the transitional countries, financial institutions primarily related to the banking sector were some of the most difficult to create and reform. The banking sector had to overhaul not only the institution of what a bank does but also had to overhaul the public perception of banks and related activities. Primarily these counties had to move from a monobank to creating a multi bank system that promotes lending, saving and investing. All the transition countries faced the same issue of overhauling the banking sector which makes it particularly interesting to compare the different methods. Ultimately the choice over the method used in transitioning is dependent on many factors and comes down to the right time, place and individual in power. Both methods hold positive and negative consequences that have to be weighed to bring about the best path for the country’s particular situation. Most of the countries in Central and Eastern Europe will continue to pursue transitional reform policies for many years to come and it will be anyone’s guess as to what approach will be most successful.


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