Evgeniy Chernov, Elina Severe
The Economic Transformation in East-Central Europe since 1989
The last decade of the 20th century was eventful not only from the political and historical, but also from the economic point of view. Before 1989, all East-Central Europe countries had planned economies and they were tied to the Soviet Union by a variety of economic and political bonds. Their economic systems were comparable to Soviet ones: the Soviet planning bureaucracy determined prices, allocation of resources, and distribution of goods and services. Private property was legal but limited, people could own property for personal use, but not for commercial use.
The break-up of the Soviet Union brought plenty of changes, also in our casual ways of life – we no longer spend hours in tiresome lines at the market to get our share of salami and we no longer work in quandary over the cause of our labor not knowing the destination of our produce. We have the salami available at the markets, and the question is now how to earn enough in order to buy it rather than where to find it. The dissolution of the Soviet Union cut also subsidies to money-losing farms and industries, decontrolled prices, moved toward convertibility of the rouble, and moved toward restructuring the largely state-owned economy.
For the East-Central Europe countries this new situation was a shock, because there was no longer the hand of solicitous father, who told, what to do. The countries had to cope with the situation alone and one of the first tasks was setting the economic policy. It wasn’t easy for countries, which had never made and even hadn’t had an impact on the economic policy. As we see today, the countries managed setting economic policies, but the question and the aim of the research paper is, whether the economic policies of the East-Central Europe countries were successful.
For testing it, following methods of research will be used: descriptive and empirical. At the beginning authors are going to examine the incorrect approach of modern scientists to evaluate the process of economic transition as the cause of economic collapse in the Soviet Union. In order to understand, whether there is or is not development of economies in East-Central Europe, there will be viewed the causes of economic growth. Starting the empirical analysis, authors are going to take a look at the results of 2 researches on economic transition successes in East-Central Europe. Because of the broad amount of data and the limited size of research paper, there are going to be analyzed the economies in the three randomly selected countries (the Czech Republic, Hungary and Poland) at the end of the empirical part.
The hypothesis of this paper is: “The economic growth in East-Central Europe since 1989 has proven that the economic policies put in place have been successful”.
Myth about Economic Collapse
Much of the literature about the slump in output discusses it as a sheer tragedy, and many draw parallels with the Great Depression of 1929-33. However the words “depression” and “recession” evoke the images of a business cycle gone awry, whereas this was a profound systemic change. Anders Åslund mentions following arguments, why there exists a myth about economic collapse in the countries of East-Central Europe (ECE):
1) The purported tragedy of universal output loss after communism is a myth, though the region suffered from stagnation during the first half of the 1990s. this helps to explain the mysterious absence of social unrest and of electoral backlashes against reformers. Nor is it possible to understand the sharp rise of social expenditures in most postcommunist countries in the first half of 1990s, if an output collapse had taken place.
2) The socialist economies were in far worse shape than most Western observers believed at the time of its demise. The alleged misery in postcommunist transformation is primarily the delayed revelation of the time costs of communism.
3) Even after most effects of adverse “initial conditions” have been deducted, the differences between failures and successes remain almost as large as in the flawed official statistics. This indicates that economic reform policies have been even more positive for economic performance than previously understood.
In other words, the main problem of transition was that value detraction was not impeded quickly enough. Therefore, underutilized or wasted resources were not reallocated to facilitate supply. In the radical early reformers, Poland and the Czech Republic, a positive supply effect was in evidence early on.
4) Distorted official statistics have been a major cause of bad policies, as they did not reveal the strong, early supply effects shock reforms brought about. Consequently, the successful Polish model was not widely adopted, and many started calling for fiscal and monetary stimulation instead. The distorted official statistics have disinformed policymakers in postcommunist transformation, inciting them to adopt inefficient gradual reforms, which reinforced rent seeking and prolonged stagnation.
The overall lesson is that radical reforms, involving liberalization and financial stabilization, were both economically effective and socially desirable. The real social concern of postcommunism was not initial decline in output but lasting stagnation in many countries.
Causes of Economic Growth in Transition
Understanding that the sharp economic decline in the ECE countries in the early 1990s was only the product of incorrect economic indicators’ evaluation, there must be analyzed the current situation in ECE. In order to understand the successes of economies, there are going to be examined following spheres:
1) Controlling inflation.
All East-Central European countries successfully took the high level of inflation under control, but no country returned to economic growth until inflation had fallen below 45% a year.
Liberalization is usually divided into internal and external liberalization. Internal liberalization comprises the freeing of domestic prices and the abolition of state trading monopolies. External liberalization refers to the unification of the exchange rate and currency convertibility, the elimination of export controls and export taxes, and the substitution of moderate import tariffs for import quotas and high import duties. There are a number of liberalization indexes, but all they show that ECE and the Baltic states have high values of liberalization. Scientist Berg found that liberalization helps all countries in the later transition and most of them even in the early transition. From the fourth year after the transition, mainly structural reforms, also including privatization, determined growth, and they are the driving force behind economic recovery.
There is a strong positive correlation between the share of Gross Domestic Product (GDP) arising from the private sector and output. Berg found that privatization and private sector conditions had significant effect on growth in the ensuing period.
4) Export increasing.
Exports have started increasing before output in almost all countries, and their increase has been considerable, swiftly expanding as a share of GDP, and growth has clearly been export-led. Christoffersen and Doyle found that export market growth is strongly associated with output growth. A considerable restructuring of foreign trade has occurred. All the former communist countries reoriented their trade from one another to the West, and growth in postcommunist countries has depended on access to Western markets. The most reformist countries have seen an impressive and steady increase of their exports. As exports grew, the successfully exporting countries received more money for imports, and imports have largely followed exports. To begin with, most countries went from a current economic crisis to a trade surplus. Exports have been the dominant engine of early economic growth, and the restructuring of foreign trade has been truly amazing in both speed and quality, especially in the most fortuitous reform countries.
The Analysis of Transition by Anders Åslund
The American economist A. Åslund based his analysis of the ECE transition economies on the following criteria:
The focal point was building a market economy, and there was chosen a certain value of structural reform index as a benchmark. All ECE countries comply this standard. [at least 0.70 on the structural reform index 1999]
Another criterion is macroeconomic stabilization. Regressions have shown that an inflation of 40 per cent a year is a critical threshold for economic growth. In 1999 all ECE countries apart from Romania had inflation below that hurdle. Stabilization is the big task that has been carried out most successfully.
A third standard of transformation is privatization. If the required level is chosen as 60 per cent of GDP arising in the private sector, all ECE countries comply.
The ultimate goal is sustainable economic growth. There was chosen a relatively low level of 4 per cent a year GDP growth for at least 3 years as the forth criterion. Five ECE countries in region had surpassed this hurdle by 1999 – Poland, Slovakia, Hungary, Estonia and Lithuania.
Clearly, some malfunctioning of the economic growth is not properly reflected in first three criteria of transformation. The predominant suggestion is corruption and poor governance. According to the Transparency International (1999) Corruption Perception Index, only two transition countries, Estonia and Hungary, are perceived as less corrupt than the most corrupt West European countries (Greece and Italy). Corruption or state failure, as opposed to market failure, appears to be the fundamental problem of the transition countries.
Democracy is a vital indicator of the quality of the state and thus important for market reform. Freedom House draws a sharp territorial line between ECE, where all countries are free, and the CIS countries – partly democracies and dictatorships. For democracy, we find a much stronger geographical subdivision than for market economic criteria. This might reflect greater peer pressure with regard to democracy than market reform. In Europe, it is perceived as a great shame to be undemocratic.
The Analysis of the European Bank for Reconstruction and Development
At the beginning of a new decade of transition, progress in reform in East-Central Europe and the Baltic States has regained momentum. In 2000 progress has been achieved across most countries and dimensions of reform, as several countries at the early stages of transition have taken significant strides towards a market economy, particularly in the areas of privatization and liberalization.
The European Bank’s for Reconstruction and Development (EBRD) Transition Reports have provided assessments of progress in transition for 26 post-communist countries since 1994. These assessments are made for a number of core dimensions of reform that correspond with the main elements of a market economy – markets and trade, enterprises and financial institutions. Progress in each of these dimensions represents an improvement in how well markets, enterprises and financial institutions function. Progress is measured against the standards of industrialized market economies, recognizing that there is neither a perfectly functioning market economy nor a unique endpoint for transition. The measurement scale for the indicators ranges from 1to 4+, where 1represents little or no change from a rigidly planned economy and a 4+represents a standard that would not look out of place in an industrialized market economy.
The transition indicators measure specific aspects of transition.
On markets and trade, the indicators capture the liberalization of prices, trade and access to foreign exchange as well as the extent to which utility pricing reflects economic costs. The indicators also access the effectiveness of competition policy in combating abuses of market dominance and anti-competitive practices. The highest indicators in this field have the two East-Central European countries: Hungary and Poland plus Slovenia (average 3+).
On enterprises, the indicators measure the extent of small-scale and large-scale privatization and of enterprise reforms, such as the elimination of production subsidies and the introduction of bankruptcy procedures and of sound corporate governance. In this aspect the biggest progress was made in the four East-Central European countries: the Czech Republic, Estonia, Hungary and Slovakia (average 4)
On financial institutions, the indicators capture the extent to which interest rates have been liberalized, twotier banking systems established and securities markets created. They also assess whether prudential regulations have been raised to international standards and if procedures exist for resolving the failure of financial institutions. According to these indicators the highest degree shows the three East-Central European countries: Hungary, Poland and Estonia (average 3+).
The Czech Republic
With the collapse of Soviet authority in 1989, Czechoslovakia regained its freedom through a peaceful “Velvet Revolution.” On the 1st January 1993, the country underwent a “velvet divorce” into its two national components, the Czech Republic and Slovakia. As the World Bank reports, until 1996 it was perceived as the most successful transition economy in Central and Eastern Europe by achieving economic transformation with minimum unemployment and no hyperinflation.
The “Velvet Revolution” in 1989 offered a chance for profound and sustained economic reform. Signs of economic resurgence began to appear in the wake of the shock therapy that the IMF labeled the “big bang” of January 1991. Since then, astute economic management has led to the liberalization of 95% of all price controls, annual inflation in the 10% range, modest budgetary deficits, low unemployment, a positive balance-of-payments position, a stable exchange rate, a shift of exports from former communist economic bloc markets to Western Europe, and relatively low foreign debt.
However, not everything was so good at the beginning. In 1991 with the disintegration of the communist economic alliance the GDP growth rate dropped to -11.5%, Czech manufacturers lost their traditional markets among former communist countries to the East, some of which still owe the former Czechoslovakia sizable debts. The only way-put was shifting emphasis from the East to the West and restructuring existing facilities in banking and telecommunications as well as adjusting commercial laws and practices to fit Western standards. Thereby the Republic made progress toward creating a stable investment climate.
At the end of 1995, macroeconomic policy seemed to be well supported by important structural reforms including the liberalization of wages, prices, and foreign trade and the real GDP growth reached 6.4% 1995. This result was very impressive in comparison with the year 1994, when the real GDP growth was 3.2%.
Several years of successful growth were followed by a setback in the Czech economy in 1996, where the growth of GDP slowed down to about 3.9% from 6.4% in 1995, due to the deterioration of the foreign balance caused by disappointing export growth and continuing strong import demand. In the year 1997 the rate continued to decrease and in 1998 it reached -2.2%, which was the result of a Russian rouble crisis.The economy started to grow in 1999 by reaching GDP growth at 3.1% in 2000. The growth in 2000 following significant and costly financial and enterprise reforms and was characterized by considerable FDI inflows. In the following year it continued to grow and reached 3.3%. In the year 2002 the GDP growth was slower – only 2.6%, because of giving weak external demand and somewhat subdued investment. There has to be mentioned that in the year 2002 all Europe had a decline and as we see – the Czech Republic wasn’t an exception. The difference is that in the following years Czechs were able to resume the economic growth and, as the World Bank reports, in 2003 the growth was 3.1% and the growth is projected to rise to 3.5% in 2004 as exports recover. But if we take a wider look at the GDP growth, we see that the rate within last 13 years has grown from -11.5% till 3.5% and the compound annual growth of the real GDP in the period from 1991 till 2000 was 1.4%.
Hungary was one of the few socialist countries where significant reforms were enacted under the old regime. The use of market mechanisms, in particular, a reduction in the use of planned indicators and the implementation of a more rational price mechanism, was adopted in Hungary in 1968, with the promulgation of the New Economic Mechanism under the Communist Government of János Kádár. The last Communist administration (1987-89) introduced legislation, such as a Companies Act in 1998, which effectively initiated the privatization process. There were also major advances in the creation of a two-tier banking system and in the extension of foreign trade rights.
However, the real changes came in the 1990s with the adoption of series of measures aimed at instituting a market economy. In the early 1990s Hungary was criticized for not having utilized a “shock therapy” method of transition – that is, the introduction of a complete set of radical reforms containing the by now classic elements of transition economics: macroeconomic stabilization control of public finances; extensive new legislation designed to promote the private sector; liberalization of foreign-trade activities; and moves towards currency convertibility. However, all of these elements of the transition process could be found in the various stabilization packages adopted by successive Governments. This was achieved despite the poor economic legacy inherited by the new democratic Government.
By the time of the 1994 general election of the Government had implemented legislation designed to radically transform the Hungarian economy, although the social consequences of the transition placed it in a vulnerable position. However, the implementation of a new market-orientated business legislation, including the establishment of a stock exchange and new securities and investment legislation, greatly contributed to the creation of a new market economy.
The adoption of market-based measures initially resulted in the massive declines in GDP, but from mid-1990s, GDP began to increase. In the 1991 the real GDP growth was -11.9%, but in 1996 the growth reached 4.6%. In 1997 growth was estimated at 4.4% and at 4.6% in 1998. A figure of 4.5% was recorded in 1999, with an increase to 5.2% in 2000. In the following years there was a small drop back (in the year 2002 the rate was 3.3%), as in all Europe. It’s obvious that Hungary didn’t have as impressive 7% increase as Poland, but once the negative impact of the Russian financial crisis of 1998 and the war in neighboring Yugoslavia in 1999 were taken into account, economic performance in Hungary was impressive: from the year 1991 when the GDP growth was -11.9%, within 11 years it has grown and in 2002 it reached 3.3%. And as the United Nations Economic Commission for Europe reports, the compound annual growth of the real GDP in the period from 1991 till 2000 was 2.1%, what means that the economic policy had been successful.
The post-second World War settlement between the victorious powers not only dismembered Germany, but also resulted in a significant movement of frontiers in Central Europe. The Poland that emerged from the War looked, in a geographic sense, substantially different from the independent Poland of the inter-war years. Mass movements of population accompanied the changes to the political map of Europe. All this meant that early post-war Poland could not easily be compared in an economic sense to be pre-war Republic.
In terms of its economic system Poland inherited Soviet-style central planning, with all its characteristic features and defects. The relatively poor and weakly developed economy of Poland was about to embark on a great wave of forced industrialization, promising badly needed economic reconstruction and modernization. Throughout the 1950s, 1960s and even in the mid-1970s this modernization had a great impact. Urbanization also proceeded at a fast pace and welfare states brought health care, education and generally better living conditions to the bulk of the population. In August-September 1989, the Solidarity (Solidarność) protest movement was suddenly thrust into power. Meanwhile Leszek Balcerowicz was invited to become finance minister of Poland and to devise a means of moving from a planned to a market economy, from a state- to privately-owned economy, from Communism to capitalism.
L. Balcerowicz chose the “shock therapy” to stabilize economy and was also intent on liberalization (removing barriers to price movement, to entrepreneurship and to foreign trade) and privatization. Stabilization was achieved fairly quickly but at a high cost, with a much deeper than expected post-transition recession, which was partly the result of the shock-therapy approach and partly owing to the collapse of the socialist bloc’s trading arrangements. Between 1989 and 1991 GDP fell by almost -18% and reached -7% in 1992, however, from 1992 the economy began to grow. After expanding by 2.6% that year, the real GDP growth accelerated steadily, reaching an average 5.4% per year in 1993 - 95. The growth rate peaked at 7.0% in 1995, followed by slowing in 1998 and 1999. Also in the following years (2000, 2001 and 2002) the rate continued to decrease and in the year 2002 it was only 1.3%. This fall is connected to a general slow of economics in the Europe. But despite fluctuations, Poland was the first post-Communist economy to recover from the shock of transition when, in 1996, it regained the 1989 level of national income and nowadays the rate is increasing and reaches 3.7% in the year 2003. But generally the rate grew from -7% in 1991 till 3.7% in 2003. Also the compound annual growth of the real GDP shows that in the period from 1991 till 2000 GDP increased for 4.4%. It was one of the best results in Central and Eastern Europe!
In the early to mid-1990s, recovery was given considerable impetus by domestic consumption, with exports playing a subsidiary role. By the second half of the 1990s foreign direct investment inflows began also, after a slow start, to increase. Foreign investors came to appreciate Poland’s dual appeal as a low-cost export base with a relatively strong physical and skills infrastructure and a thirsty domestic market. Inward investment flows accelerated sharply in the mid-1990s: as the inward investment agency Panstwówa Agencja Inwestycji Zagranicznych reported, foreign direct investment inflows increased from US $2.500m. in 1995 to $10.600m. in 2000.
As in the book “Central and South-Eastern Europe 2002” by Imogen Bell reported, throughout the 1990s, despite political tremors, and the coming and going of numerous prime ministers and finance ministers, macroeconomic policy of Poland enjoyed substantial continuity. The Commitment to building a market economy remained intact, banking and tax reforms were introduced, privatization proceeded, and trade remained firmly fixed in its new Western direction. Even as early as the mid-1990s foreign debt had been successfully rescheduled, International Monetary Fund (IMF) endorsement of macroeconomic policy gained, an EU Association Agreement was in place and the Organization for Economic Cooperation and Development membership had been approved.
The fall of the Berlin Wall in November 1989 was an occasion for hope. It also inspired a sense of euphoria and triumphalism, and – for some – a belief that the transition to a market economy and democratic society would be simple and short. But fifteen years of experience has demonstrated that the transition is complex and long and that the upheavals and stresses can be harsh.
It was clearly shown that the transition from socialism to capitalism has not come without costs. However, most of the big recorded decline is not real but can be explained with an expansion of the unregistered economy and the elimination of value detraction. In addition, many countries lost substantial implicit trade subsidies. The alleged universal output collapse after communism is a myth, while the overall problem was rather stagnation. A strong early supply effect was apparent in the most radical reform countries, especially Poland. Output development is closely correlated with radical reform policies, and the revised statistics single out the nonreformers as failures.
The evidence is overwhelming that early, radical and comprehensive reforms constituted the best option for the whole region. Fast and comprehensive stabilization and liberalization have proven better than slower or partial reforms. Radical reforms have led to less overall decline in output, and seemingly to greater economic welfare of the population than partial reforms. The countries that have undertaken the most radical and comprehensive structural reforms have also implemented the most far-reaching institutional reform!
The common analysis of Anders Åslund and the analysis of the EBRD transition indicators confirms the fact that it is possible to divide the ECE states into 2 groups: successful reformers and unsuccessful partial reformers. The first group includes Central Europe and the Baltics, which largely enjoy high and seemingly sustainable growth. Most of these countries have undertaken substantial reforms of all kinds. The second group of partial reformers has experienced growth setbacks and stagnation – Bulgaria and Romania. The biggest problem of the ECE countries seems to be an incorrect economic policy by government at the early stage of transition plus corruption phenomenon, which disturbs the implementation of market rules also in the present time.
The driving force behind economic recovery has overwhelmingly been structural reforms, which include the introduction of liberalization and privatization ahead of the development of market-supporting institutions and the significant influence of economic, social and political conditions at the start of transition on the future progress of reform. Where sustained liberalization and comprehensive privatization have taken root, with countries open to international trade and investment, and with democratic political systems functioning freely and fairly, the foundations appear to have been laid for sustained progress in transition and strengthened institutional performance. This combination of factors helps to accelerate the establishment of a well-functioning market economy.
Analyzing three ECE states authors concluded that the economic policy was successful in long-term, not in short-term period. Even the shock after collapse socialist bloc’s trading arrangements and the Russian rouble crisis in 1998 didn’t have a big impact on the economic development of these three states, which proves the power of their economics. Overall, Hungary and the Czech Republic are considered to be the most successful in introducing a market economy among the East European countries in transition. They have implemented a successful macroeconomic stabilization policy and attracted foreign investors.
The results of the research proves our hypothesis: The economic growth in East-Central Europe since 1989 has proven that the economic policies put in place have been successful. At the same time, it is important to recognize that evolutionary process of economies is not automatic. Economic and political liberalization must be sustained, in part through complementary reforms, such as forms of privatization that help to build competitive markets and the protection of property rights and that strengthen the performance of enterprises following privatization. Governments must adapt to the requirements of a market economy by providing institutions that are necessary for a well-functioning market economy. They must also provide a social safety net that helps people adapt to the market. The international community also has a vital role to play in fostering international integration through the process of accession to the EU and the WTO.
In conclusion authors want to note that despite on the defects and differences in the national economies many ECE states have successfully fulfilled so-called “Copenhagen criteria” and in 2004 the seven of them joined the European Union: Estonia, Latvia, Lithuania, Hungary, the Czech Republic, Poland, Slovakia and the one South-Eastern European state, the part of former Yugoslavia, the Republic of Slovenia. The fact of accession confirms the significant progress made in economies and states’ readiness to join the European “common market”.
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