Transition: Changes after Socialism (25 Years Transition from Socialism to a Market Economy)

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1 Transition: Changes after Socialism (25 Years Transition from Socialism to a Market Economy) Summary of Conference of Professor Leszek Balcerowicz, Warsaw School of Economics at the EIB Institute, 24 November 204 Leszek Balcerowicz The subject of this lecture is to take stock of the experience of Poland and other countries that have moved from socialism to a free market economy. First, we must define socialism. I use the term as it was used by Marx, who defined its characteristics, although it was also known as communism. The main institutional characteristics of socialism are: ) A monopoly of the public sector on all economic activity; there are no private firms. 2) Resource allocation takes place through a command and control system; there is no room for the market. As a result there can be no democracy, defined as a political system where competitive elections are held regularly. Equally there is no freedom of expression. This makes necessary a set of repressive institutional arrangements, symbolised better than anything else by the KGB (the Soviet security agency). Socialism had a dreadful impact on societies where it was adopted. As a socialist system provides incentives for waste and inefficiency and lacks checks and balances it has led to catastrophic policies which produced deep declines in income and at times sharp falls in population ( e.g. the famines caused by Stalin s and Mao s policies). Compare for example the performance of two countries with a free market economy, Spain and Austria with two socialist countries, Poland and Hungary. Between 950 and 990 a very wide gap developed in living standards. (See table below). A similar gap developed between East and West Germany and many other cases. Most tragic is the case of the two Koreas. North Korea is a gulag, while South Korea is a dynamic capitalist economy. In 950 both countries had the same per capita income, while in 2003 that of North Korea was only 7% of that of South Korea. When political power is very concentrated it falls at time in hands of psychopaths whose policies are not only detrimental to the economy, but can also lead to genocide (e.g. Mao, Stalin, the Khmer Rouge).

2 Countries under socialism lost a lot of distance to Western European economies. Per-capita GDP (in 990 international dollars) in 950 and 990: 4000 Poland vs. Spain (239%) Hungary vs. Austria. (26%) (02%) (98%) (42%) Poland Spain (38%) 647 (49%) (67%) Hungary Austria Source: Maddison Database. But, you may ask, what about the performance of China? There have been two phases in Chinese development. Until the late 970s the adoption of Maoist socialism caused growth to lag behind that of developed economies. Thereafter the command economy was largely abandoned in favour of market economy principles. China is still not a democracy, but the economy started growing fast. Exports and foreign direct investment are now five times those of India s, and several hundred million people have been lifted out of poverty. Against this background, the collapse of socialism and of Soviet bloc is the most positive event that has occurred after the Second World War. Initially all countries of the former Soviet Bloc seemed to be moving along the path leading to democracy i.e. political competition and the rule of law- and a capitalist market economy. But after two or three years, paths began to diverge. Let us look first at democracy: the diagram below shows that according to an index of political freedom, Centre and Eastern European countries have become fully institutionalised democracies. Democracy means that accession to political power happens through elections and not through other mechanisms like revolutions or coups d'état. Centre and Eastern European countries are democratic in that sense, along with Mongolia, which may be of interest. Under Yeltsin, a great reformer, Russia also began heading towards democracy. But then Yeltsin made a mistake and appointed Putin as his successor, who engineered a reversal of all political and economic reforms. 2

3 0 Political freedom 202 (Polity IV) 5 5< fully institutionalized democracies -5< mixed, or incoherent, authority regimes < < mixed, or incoherent, authority regimes <5-5> fully institutionalized autocracies -0 Source: Polity IV Project Now look at the economic regime. As socialism meant the monopoly of state ownership, it would seem logical to measure the transition to a market economy by looking at the share of the private sector in GDP. Some former Soviet bloc countries like Belarus or Turkmenistan still have a predominant public sector. But at first glance in most other countries private sector shares are between 65% and 80% Private sector share in GDP (%) Source: EBRD - Structural and institutional change indicators But this indicator can be misleading as nominal private ownership can hide very different political and institutional set ups. In most Central and Eastern Europe private firms operate on a level playing 3

4 field and there is no systematic patronage by politicians and bureaucrats. In some other countries, however, you have what I would call temporary private ownership. This is particularly the case of Russia under Mr Putin. Here the success of private enterprises, particularly large ones, depends very much on political connections and connections with the KGB rather than on management skills and innovation. If you have very good political connections you can destroy your competitors. If you do not, you might be the one to be destroyed. And uncertainty on how long a firm can survive in such an environment diverts the energy of entrepreneurs from managing their firms efficiently into seeking political connections. Whenever I am in Moscow I am struck by how much more expensive everything is than in Poland while it should be cheaper. Why is that? It is because of the system of private ownership based on patronage which makes everything more expensive. This increasingly politicised system leads to the destruction of private sector companies like Yukos and support to those whose owners are close to Mr Putin. It encourages capital flight rather than investment and hence foreign indebtedness as in the case of Gazprom and contributes to making the financial sector fragile. Furthermore Russia s economy is fragile as it depends increasingly on oil and gas exports to Europe and cannot easily switch exports to China. From all this we can therefore conclude that: - Democracy was introduced and maintained in the countries of Central and Eastern Europe which introduced capitalism - Non-democratic political systems co-exist with quasi-capitalist economies such as Russia and China and quasi-socialist economies such as Belarus and countries in Central Asia. Hence it is clear that you can have forms of capitalism without democracy, but you cannot have socialism and democracy. Let us now look at what happens after the transition from socialism. Here we have huge differences in outcomes, most importantly for economic growth. By the way, it is fashionable nowadays to say that economic growth is not important, but this is what rich people say, who can afford not to care about economic growth. But for poor people economic growth means apartments, better clothing and health care, etc. It is convenient to split the period after socialism in two: from 989 up to the financial crisis of 2008 and afterwards. The diagram below shows that between 989 and 2008 there was wide variation across former socialist countries in the growth of GDP per head. Poland was best performer, while Georgia, Ukraine and Russia were the worst - Georgia mostly because of the civil war in

5 (GDP per capita growth in 2008 in relation to 989 level) Source: EBRD Transition Report 2008; WB WDI, IMF WEO My conclusion is that it pays to move fast with reforms. If you have hyperinflation, you don't wait; you must cut the budget deficit. You must liberalise a centrally planned economy in a massive way, as was the case for Poland, the Baltics and Hungary initially. You must dismantle state monopolies - one of the most important features of Poland s program in 990. And you have to open up to world trade. Institutions need to change. Here I would draw a distinction between the enterprise sector and other sectors. In the enterprise sector, the necessary changes are clear: you have to privatize and to introduce competition. As a rule, all enterprises should be private. You may have exceptions from this rule, but the burden of proof should fall on those who want to make an exception. Reforming the public sector is much more complex. In Poland you have the challenge of making the justice system work faster and fairer or making the health service more efficient and better suited to the needs of patients. So the true challenge I think is in reforming the public sector, not only in Poland, but also in other countries. The key is that reforms should be sustainable. For that to succeed you will need a very active civil society that believes in limiting the role of the state. During the second period after the financial crisis of Poland avoided a recession thanks mainly to prudent macroeconomic policies that prevented a boom and bust cycle. We never dreamed of emulating the policies of Mr Greenspan. More generally, countries that did not experience a boom Germany, Sweden and Switzerland also avoided a bust. But even the Baltic countries, who could not avoid a boom and bust cycle, recovered quickly because they took appropriate action. They bit the bullet and did not delay painful fiscal adjustment mainly through expenditure cuts and sound reforms. But other countries, like Italy, Spain, Portugal, Cyprus and Greece have struggled to recover because they did not take appropriate action. Greece, in particular, relied instead on tax increases rather than expenditure cuts and reforms where not followed through. Greece has not suffered because of austerity, but because of the composition of the policy programme. 5

6 25% 20% GDP per capita (constant US$) change between 2007 and 202 (in %) 5% 0% 5% 0% -5% -0% -5% -20% -25% Source: World Bank, WorldDevelopment Indicators In any case, it is clear that fiscal stances are very important for longer term economic growth. If you have a chronically ill public finance, with high spending, persistent deficits, cumulative public debt, it is a drag on economic growth. And when I look at Hungary and compare it to Poland, I am comforted in my opinion: Polish fiscal policies have been far from ideal, but perhaps not as bad as in Hungary. Finally, let me elaborate on some issues concerning public sector spending, in particular welfare expenditure. I am not saying that welfare spending is good or bad: that is an ideological issue. Welfare spending should be guided by a few underlying principles. First, it should not undermine the health of public finance. Second, it should not discourage people from working and third, it should not discourage people from saving. So if your welfare state complies with these three conditions that is fine. But in most countries it does not and welfare spending is excessive and badly structured. This was clear even before the crisis and now public debt is much higher. In this connection, the largest public expenditure item in Poland is pensions. If you do not have funded pensions but a pay as you go system, the obvious measure is to increase the retirement age, especially for women. Why is that? Because women, on average, have a longer life expectancy. I am only half joking when I say that feminism would require women to retire later than men. If it is equitable that we should all live approximatively the same amount of years on a pension, who should retire later? I am very surprised that so far no feminist movement has set this as one of its main goals. Health is also a major expenditure item. And I think that one can combine the protection of poorer people with more efficiency. This can and should be done by scrutinising hospitals that currently absorb between 50 and 60% of health expenditure in Poland. So I think that these are the main areas that require further reforms in Poland. And I think probably in some other countries too. 6

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