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Shock Or Crawl The Transition To Market Economies Economics Essay

Almost seventy years ago, America and its allies put aside their philosophical differences and joined with the Russians to defeat Hitler’s repugnant ideology. After World War II, the West began to see how diametrically opposed to the Soviet government and economy they truly were; this lead to the Cold War. The Cold War is the long, none direct confrontational, war between the former Union of Soviet Socialist Republics (USSR) and the United States of America. The war started immediately after the end of World War II. This war was essentially a clash of two different ideologies; the Capitalism and the Communism. [1] The Collapse of the former Soviet Union and its formal states’ transition toward the free market economy established that capitalism and its principles is the best way to organize an economy. Capitalism's principles such as privatization, specialization, small state authority, property rights, individual rights, freedom, and free market economy became the model for nations to follow in order to reform. Nevertheless, in this context one question that should be analyse is which approach during the reform process has worked best for post communist states, shock therapy or gradualism? This paper will explore the outcomes of reforms in post communist Poland, a country that used the shock therapy approach, and Hungary’s slow and gradual transition to a managed market economy.

Although markets have many positives, markets also have many failures. Some major types of market-failures are natural monopoly, externalities, the unequal destitution of public goods, and asymmetric information. In any transitions to a market economy, authorities must make sure to guard against all these types of failure. A normative theory of market-failure predicts that regulation will be instituted to improve economic efficiency and protect social values by correction market imperfections. [2] Therefore policy measures taken by these governments in post communist states had to not only reform to a market economy, they had to simultaneously guard against market failures.

Transition means the process of change from a centrally planned economy towards a market economy, a progression that involves massive change at every level of society. [3] After the collapse of the USSR, the transition from a central planned economy to a market economy was considered as an effective means of solving social and economic problems in these former socialist states. As stated in the International Business Research, “A country that wished to change to a market base economy needed to restructure many things such as market liberalization, privatization, institutional development, structural adjustment, economic policy program of stabilization, deregulation and integration with the global economy.” [4] 

All communist countries attempted to implement industrialization, collectivization, and mass education policies and institute the state control over the economy in the form of central planning and the state ownership of enterprises. [5] The terms 'shock therapy' and gradualism refer to the speed with which reform measures should be introduced and implemented. One of the economic argument in support of shock therapy is that a rapid transition to a full scale market economy minimizes the period over which elements of mutually incompatible economic systems are required to coexist in a single system; this was the Washington consensus. The Washington consensus of rapid change initiative was conducive to Poland’s transition. Poland had virtually paralysed the party state on which the functioning of the whole economic system crucially depended a decade earlier. Also, Poland had a history of practising capitalism even during its communist era. According to Katchanovski, Private farming remained dominant in the agricultural sector in communist Poland. [6] Therefore when Poland applied the rapid change of “shock therapy” to place its economy on a fast track to complete economic transformation, it had some institutions in place to manage this swift transformation.

Poland was the pioneer of formal communist states. Poland had a freely elected parliament, with a large non-communist majority, approved the so-called Balcerowicz program in December 1989. [7] The program consisted of whole hosts of coordinated liberalization measures ultimately aiming at the restoring capitalism, the program--often described as "shock therapy became the first of the post communist reform schemes. Regardless of Poland’s conduciveness to shock therapy reforms, its transition was difficult. According to Grzegorz Kolodko, Poland started loosing its GDP at the beginning of its reform process. [8] Nevertheless, Poland stuck with it and they “recovered relatively rapidly.”

Poland’s transition went through a few faces. From, 1989-1993, it initiated shock therapy, with stabilization policy which disregard market-economy institution building, and excessive too fast trade liberalization. [9] From 1994-1997, the “strategy for Poland” for was implement, and this when the economy entered a fast growth. GDP per capita grew at an average annual rate of 6.4%, achieving a cumulative increase of 28%. [10] From 1998-2001, this period is considered the over-cooling of the economy, with the growth rate brought down from 7% during the last quarters of 1997 to a stagnant 0.2% in the fourth quarter of 2001. Then from 2002-2004, the economy returned to the path of rapid development, with a reorganization in the area of public finance and the accession to the EU. [11] 

Although Poland’s transition was not without bumps in the road, the transition to market economy had worked using the “shock therapy” approach. They made the transition from a planned economy to a market economy and acceptance into the European Union. According to Alan Smith, “By the middle of I990 the neo-liberal viewpoint, or 'Washington consensus', had become the dominant paradigm for analysing the transition to a market economy in Central Eastern Europe and was becoming a blueprint for other economies in transition.” [12] The reforms in Poland produced many positives. According to the International Monetary Fund (IMF), although sharp inequality has been nearly universal in the transition economies, with the differences being only in degree, research shows that Poland's experience is a striking contrast to this pattern. [13] The IMF also went on to state that Poland is also the only transition economy that has experienced substantial growth: real GDP was 28 percent higher in 1999 than in 1989. [14] In contrast, only a few other countries like Albania, the Czech Republic, and Hungary managed to keep GDP to within a few percent above or below their previous communist levels. According to Jeffrey Sachs, the early “shock therapy” like Poland, outperformed most of the other countries, but the idea of radical, comprehensive transformation to a market economy is increasingly being adopted in countries that earlier shunned the strategy. [15] 

Shock therapy seems to have succeeded quite well in Poland. Obviously the course and outcome of the reforms were strongly influenced by local circumstances. Nonetheless, a few observations may be helpful in understanding the impact of the shock therapy. Of the transition countries, Poland has achieved the highest rate of GDP growth along with the smallest increase in inequality. [16] Research has shown that Poland implemented market liberalization at a more rapid pace from a planned economy to a market economy then other formal communist states. The IMF concludes that, Poland’s transition process did lead to great increases in labour earnings inequality and significant job destruction. But, through a well-targeted system of social transfers, the government mitigated the rise in income inequality and facilitated enterprise restructuring and other market-oriented reforms. [17] 

Like almost every answer to a problem, reasonable people seem to disagree on the best possible solution. Therefore, economists who otherwise agree that a market economy is the best ways to organize an economy, do not agree with the notion that shock therapy is the best approach to transition. Some argue that the degree of severity and speed with which economic transitions ought to be pursue should take into consideration the human costs that would result from this process in terms of the growth of unemployment and poverty, and the willingness and ability of the population to tolerate it; the ability of domestic industry to withstand foreign competition and other more technical questions concerning how best to implement these measures and precisely how reform measures should be adapted to meet the specific circumstances facing each country. [18] Finally, there is major disagreement about the ability of pure market forces alone to stimulate economic recovery during the transition and whether the policies pursued in the initial stages of the transition will help or hinder economic recovery in the long run. This is why some transitional countries chose the gradualism to market reforms.

One of the formal communist countries that chose to reform gradually is Hungary. The first change was a significant reduction in the number and complexity of the directives firms. Privatization in Hungary was slower and more difficult In addition to privatization itself, Hungary had to address the creation of infrastructure. For example, a stock market and new rules designed to change the guidance of enterprises. [19] Accounting procedures had to first be refined and bankruptcy laws strengthened so that state subsidies can be curtailed and hard budgets introduced into large state-owned enterprises. This went against the Shock therapy approach to reform that the west wanted and Poland followed.

Hungary has also pursued a variety of stabilization measures and has liberalized policies in the sphere of foreign trade, though to a lesser degree and certainly more gradually than Poland. Although domestic price controls were removed in Hungary, and enterprises were permitted to enter into and benefit from foreign trade transactions, there were still limits on the holding of foreign exchange. [20] The Bank of Hungary maintained controls over access to foreign exchange earning to focus on stability before full liberalization of their economy. According to Paul Hare, Hungary followed a tight monetary policy designed to create a balanced budget and also to exert financial pressure on enterprises. Hungary decided to lay down the ground work before they fully embracing the free market system. As a result, Inflation was less serious in Hungary than in Poland. The annual rate of inflation during the early 1990s was estimated at roughly 17 percent. [21] Hungary also had increases in wages, and Hungarians experienced growth in exports to Western markets. [22] . These data shows that Hungary’s market reforms worked.

In comparing these two countries, one must recognize the complexity of a systemic overhaul and the internal dynamics of each countries, and theories nor did practical experience offer any guidance regarding the transition from a planned economy to a market economy. Necessarily, the great project of overhauling an entire economic system, one that was completely managed from the top, to one that was open and free, has never been done before. The choice between the two strategies was further complicated because many relevant considerations involved psychological, sociological, and cultural dimensions that do not lend themselves easily to analysis, in particular, to quantifiable analysis and prediction. [23] This means that there was no exact science to how economies should transform.

Moreover, apart from any intrinsic complications, the choice of strategy and its implementation was to a great extent a matter of politics. It depended on the configuration of political forces in each country. In Poland the goal was to remove once and for all the organizational and economic basis of the Communist Party state, and it already had a history of doing this. The reformers, who have already ended the communist party rule, wanted to create an irreversible situation. Therefore, the shock therapy approach suited them perfectly.

On the other hand, Hungary’s more gradual changes also added up to creditable progress towards a market economy. Before the implementation of their gradual approach, changes in the nature of rural landholdings, and the beginnings of nationalization had to first be accomplished. The first plan was designed primarily to bring the economy up to pre-war levels of economic activity. During this time, a planning mechanism was created and the share of national income going to investment increased sharply. Therefore, Hungary was not ready for the shock therapy.

There is no doubt that shock therapy is painful in the short run. The high, declining living standards, increasing unemployment was judged excessive. Instead, a purportedly less painful exit route for reform was gradualism. Which model was more successful? There is no clear answer. Each country has to evaluate their own economy situation and what area of their reform they are currently in, and for there, they can determine the best approach to their economy reform. Both, shock therapists and gradualists, have their positives and their drawbacks. Poland has shown more success with the shock therapy, but they were further along than Hungary after the USSR came down.

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