The Transition Economies

The Transition Economies

Some of you might remember the Berlin Wall falling down late in 1989, and along with it the concept of communism throughout Eastern Europe and the Soviet Union. The driving force for this change was people power. They were sick of being dictated to and wanted to have the chance to vote and have a say in the running of their country, like their democratic neighbours in the rest of Europe. But at least part of the dissatisfaction with these communist political systems must have been down to economics.

These economies were struggling. The ideal of the central plan was breaking down. People's standard of living was declining. One of the reasons for the mess was that the state owned enterprises began to ignore instructions from the government. This caused chaos as the output levels were not as planned, and this had knock on effects for other enterprises that relied on this output.

Unsurprisingly, investment from abroad was non-existent. More importantly, there was little investment from within these economies. The capital stock was old, obsolete and falling apart. Inevitably, the quality of the goods produced was low, and yet consumers still had to queue at the shops to buy them.

One of the supposed advantages of the command economy was the fact that the planning authorities could keep pollution low through their control of the production process. Even on this measure these economies were failing. The old factories with their out-of-date and dirty machinery were creating an unacceptable level of air and water pollution.

All of the transition economies experienced pain during the transition. Output fell dramatically, inflation rose (hyperinflation in some of the countries) and unemployment levels rose. The next section will look more closely at a couple of countries; one that recovered from this mess quite well and one that did not. For now, we need to look at the reasons why the transition process was so difficult.

One of the key problems was that the old command economies had no labour, capital or goods markets. Everything had been directed by the state. The creation of these markets from scratch was very difficult.

Also, the governments had never had to use fiscal policy and monetary policy in the way that developed economies understand. They had to set taxes in order to pay for defence, a legal system and a welfare state for those who were to inevitably suffer during the transition process, but the newly formed private enterprises were struggling in their early days, and so often could not afford the taxes, so they just didn't pay. If the government raised taxes to allow for this, even more businesses left the formal economy and joined the informal economy (or black economy).

So the tax base was very small. How else could the government raise money? In western economies, the government can sell bonds and bills to the public through the stock market. In the transition economies, the stock markets were under developed, so there was only one other way to raise money - print new notes. Of course, this caused the money supply to grow enormously, which is the main reason for the hyperinflation experienced by some of the countries.

Why did output fall so dramatically? One has to remember that the workers were used to working in a state owned enterprise when all production decisions came from above. The sudden switch to private enterprise was a shock. These new entrepreneurs were cautious in their decisions. They did not want to make lots of goods that might not be purchased by consumers. They were not keen on investing in new machinery. So not only was the quality and quantity of their output low, but this had a knock on effect. Businesses that supplied machinery, or the materials required, for the production of the good would suffer too. It was a negative multiplier effect. Low output led to low employment, which led to less consumer spending power and so an even lower output. Prospects did not look good.

Do you remember the most important characteristics of a free market economy? Without the establishment of property rights through an appropriate legal system, the whole economy can break down.

The economy

All the transition economies set up a system, but they were often unclear or contradictory. In some countries, businessmen took advantage of the unclear property laws by signing land and factories over to themselves during the privatisation process. The laws were also muddled for foreign investors. It was essential to attract foreign money if the economies were to grow again.

Generally, ten years on, the Central and Eastern European economies (like Poland, the Czech Republic and Slovenia) have recovered from the disastrous early years, whereas the states from the former Soviet Union (now called the Commonwealth of Independent States, or CIS) have stayed in the depths of depression.

Russia's official real GDP, for example, is still only about half the size it was before the transition began. This does mask the fact that many of the struggling economies have huge black economies. In Russia it is almost as big as the formal economy! In recognition of the fact that the high tax revenues were forcing businesses underground, the Russian parliament voted for a large cut in income tax rates in the summer of 2000. Although the tax rates are low (around 10%) the government are hoping that more businesses and individuals will be willing to pay, and so total tax revenue may even rise.

Poland

The example of a success story is Poland. To be fair, they did start the transition process a bit earlier than the other economies, but nevertheless, one has to say that Poland is now a recognisable mixed economy. The important fundamentals are there: a good legal framework, a wide tax base and even the currency is relatively stable. Obviously, they had their problems. Growth in real GDP was briefly below -10% in 1990. The unemployment rate (as a percent of the labour force) was just over 15% in the early 90s, and the inflation rate was over 500% in 1990. Now they are growing at the same rate, or slightly faster, than most western economies, the unemployment rate is down to 10%, which is not a dissimilar rate to most of Western Europe and their inflation rate has finally fallen below 10% (a relatively large figure for an EU country, but a real achievement for a transition economy).

At the other end of the spectrum, the Ukraine got it all wrong. The real growth rate has been negative for every year in the 90s, the worst year being 1994 when growth was less than -20%. The inflation rate was almost 5000% in 1993 (the government was simply printing money to get by). Things are better than they were but the growth rate still averages at -2% and inflation is still in the 10-20% range. We said earlier that a robust legal framework is a vital building block for these transition economies. This was missing in the Ukraine. The businesses were 'taken' by politicians and ex-factory bosses. Even criminals were involved.

Criminals

Businesses struggled to make any money, so they just didn't pay taxes or wages. The poor worker suffered, as did pensioners who relied on the state (who had little money) for their income. As with Russia, the informal economy is large to make up for the formal economy only being a third of the size it was before the changes. But much of this is criminal based. Unsurprisingly, investment form abroad is virtually non-existent. Without this, it is difficult to see where the investment in new machinery that is desperately required will come from. The future looks very grim.

So was the transition process a success? Some of the countries have proved that it can be if the right structural steps are taken right at the beginning. Probably the two most important fundamentals that must be in place are:

  1. A robust legal system, and in particular, clear rules governing the issue of property rights. One cannot allow the criminal elements to get their hands on vital industries.
  2. A reformed and free capital market, to attract foreign investment. Without this help the transition will struggle to be a success.

I must thank Alain Anderton, the author of the excellent textbook 'Economics', for the use of some important factual information used in this Learn-It.

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