International Spectator

The International Spectator

Volume XXXIII No. 4 (October-December 1998)


The Transition from a Planned to a Market Economy: A Process Requiring Governance 1
By Claudio De Vincenti


The recent monetary crisis in Russia, only the tip of the iceberg constituted by a slump in production and by financial instability, contrasts with the more orderly state of affairs in the three main economies of Central-Eastern Europe (CEE): Poland, Hungary and the Czech Republic. This may be the most evident, but it is certainly not the only manifestation of the enormous differences among these and other economies in transition as regards both macroeconomic indicators and the degree of development of rules, operators and market institutions. CEE countries have made important steps forward in the process of transition towards a market economy and have shown a rather sustained growth trend in the last years, even if factors of uncertainty regarding its future solidity remain. Russia, on the other hand, seems to be unable to pull itself out of an unprecedented slump in economic activity, with the anarchic turn taken by the market which makes regulatory action at the microeconomic level and macroeconomic control difficult. Finally, there are countries such as Belarus, Ukraine and some other former Soviet republics in which the absence or weakness of signs of recovery combine with the continued existence of structures of administrative control over the economy to hinder market development.

The thesis put forward in this article is that this differentiation, while reflecting to some extent the different histories and legacies of the previous systems, is largely due to the initial approaches to stabilisation and systemic transition adopted in the early nineties: these policies did not take adequate account of the specific institutional characteristics and the factors of inertia present in the countries undergoing change in their political and economic regimes. The shortcomings of these approaches are also largely to blame for the high economic and social costs which still afflict the countries that are farthest behind in the transition process—costs initially paid by all countries, even those that seem to have made the most progress today.


A Brief Look at the Past

A rapid glance at the main characteristics of the centralised planning system may help to provide an understanding of the institutional legacy and the factors of inertia that transition has come up against. As is known, planned economies were institutionally characterised by: a preponderance of publicly-owned means of production; 2 rules and regulations tailored to an administrative system of inter-company transactions; a market essentially limited to the exchange between companies and families of consumer goods and labour on the basis of fixed prices; companies maximising output (or, more generally, the success indicators established by the center) and conditioned to satisfy the dictates of the planning office; and, therefore, by a very pervasive role of the state in taking decisions concerning allocation. In line with this arrangement was the state’s monopoly on foreign trade (an open economy extension of the administrative system of inter-company supply) and the “passive” role played by money, that is, the state bank’s guarantee of the money needed for the transactions set down in the plan.

The strong points of such a system are immediately evident:

Social consensus, achieved especially with the help of the last two points, was required to deal with the weak points in the system, which are equally evident:

These weak points remained latent as long as economic backwardness made it easy to predict the direction to be given to growth and the accumulation of capital; control the companies’ bargaining power; and limit and therefore maintain at a manageable level the amount of information concerning available production techniques and the changes in demand for basic goods. Furthermore, in a period of great political mobilisation such as the thirties in Russia or postwar reconstruction, the social pact underlying the Soviet system based on the central role of—and therefore the consensus of—the working class 3 made it possible to keep the bargaining power of the companies and the functioning of the system of incentives under control.

All these conditions gradually disappeared, revealing the weak points of the system in all their gravity. 4 Once the phase of backwardness had been overcome and an articulate and modern industrial system established, the amount of information regarding techniques and changes in demand grew to the point where its centralised management was no longer possible, the bargaining power of companies increased in parallel, and the errors in investment planning became more probable and more damaging in a rapidly changing international context. Furthermore, once forced industrialisation and the postwar reconstruction had been completed, political mobilisation also died down, reducing the possibility of keeping companies’ bargaining power under control and of making the system of incentives work properly—a system which, in fact, provided opportunities for collusion between management and workers to the detriment of efficiency and the coherence of the planned system.

Thus, during the seventies and eighties the weaknesses increasingly predominated over the strengths: the system’s microeconomic inefficiencies ended up creating a gap between the demands for well-being coming from society and the economy’s capacity to satisfy them in terms of growth of productivity, improvement of product quality and technological innovation. The macroeconomic manifestation of this divergence was that monetary incomes and the budget deficit grew more quickly than GDP, therefore generating the phenomenon of repressed inflation which characterised these economies from the seventies onward. 5 This phenomenon had particularly perverse economic and social effects: by strengthening companies’ bargaining power, it caused a further loss of interest in the pursuit of efficiency and quality, as well as the widespread emergence of a hidden economy, and increasingly poor social relations. All of these things naturally magnified the phenomena of microeconomic inefficiency in a vicious circle between macro disequilibria and micro distortion.


Stabilisation and Transition after the Change in Regime

Given the situation described, the post-communist governments that came to power between 1989 and 1992 in the various CEE and CIS countries adopted different approaches to the problems of macroeconomic stabilisation and systemic transition. However, the various approaches all made reference to the model adopted in Poland known as the Balcerowicz programme; it became, so to speak, the benchmark, the prototype against which to compare. In any case, it provided the cultural context and the frame of reference for the measures adopted in the most important countries of the socialist area.

The strategy theorised in the programme of the Polish Minister of Finance envisaged rapid stabilisation along with the immediate launching of transition which was to proceed at a rather rapid pace. 6 At the time, it was spoken of in the same terms as the big bang theory.

The main stabilising measures were immediate price liberalisation (with very few exceptions, basically limited to energy products, which were to be liberalised more gradually, and public utilities), a drastic cut in subsidies to industries taking a loss and, more generally, a sharp reduction in public spending, a tight credit squeeze anchored to targets of nominal growth of the money supply and credit; more severe controls on the dynamics of nominal wages in state industry (through punitive taxation of wages exceeding a set ceiling); strong devaluation of the exchange rate, pegging it to a set target; suspending payment of foreign debt and subsequently restructuring it.

The main measures used to trigger transition were the total elimination of any kind of administrative control over the firms, leaving them free to respond to market signals; a hyper-liberalist opening of foreign trade; the immediate privatisation of small-scale enterprises and the rapid privatisation of large enterprises as a precondition for the subsequent restructuring of their production capacity; fiscal reform based on the introduction of VAT instead of a turn-over tax and of a personal income tax, as well as a tax on the capital of state-owned firms; the creation of an articulated system of private commercial banks subject to the authority of the central bank; the construction of other institutions typical of a market economy, from trade legislation to anti-trust regulations, etc.

It is beyond the scope of this brief article to describe in detail the concrete way in which this programme was applied in the various national variants; a brief comparison will, however, be made later between the progress made in transition in Poland and in Russia. Here, it is enough to observe that the stabilisation measures were applied immediately—in Poland with a maximum and in Russia with a minimum of consistency— while the measures meant to trigger transition came up against the difficulties and inertia encountered by any plan for structural readjustment: it is easy to remove the administrative constraints on enterprise, but more difficult to establish real market relations between operators, because of both the immediate emergence of transaction costs that must be managed and minimised and behavioural inertia. 7 Similarly, it is easy to privatise small-scale enterprises rapidly, especially in the services sector, but more difficult and complex to privatise large state-owned industries, 8 with the result that in those countries where privatisation proceeded slowly (Poland), restructuring was also delayed, whereas in those countries where it was carried out rapidly (Russia), it caused a serious lack of transparency in ownership and a loss of control over the distribution of wealth. Not to speak of the difficulties in getting a fiscal administration with completely different traditions to manage totally new forms of taxation to be collected from a private sector that is obviously harder to control fiscally than the former state enterprises. Equally complex was governance of a liberalised banking system by a central bank used to completely different tasks. 9

These things must not overshadow the merits of the policies pursued after the changes in regime: in the most important countries in the area the transition has become an irreversible process, in which market regulations and institutions are taking shape and stabilisation (at least in CEE countries) has been completed. Yet it is time to realise that the underestimation—implicit in those policies—of the complexity and the time needed for systemic transition hindered a more cognisant governance of the processes that were being set into motion. This aggravated the costs of stabilisation for those countries that achieved it and moved on to recovery, resulted in a lack of consistency in the overall strategic design in Russia, with disintegrating effects on the economic fabric which are an obstacle to recovery today, and strengthened reservations and opposition to transition in other countries of the Commonwealth of Independent States (CIS).


The Gap between Objectives and Results

The gap between the predictions of economic policy authorities when the stabilisation and transition plans were launched and the results obtained underlines the underestimation just referred to.

Table 1: Transition economies, output dynamics and inflation
  1990 1991 1992 1993 1994 1995 1996 1997 1997
Growth in real GDP Percentage change 1989=100
Poland -11.6 -7.0 2.6 3.8 5.2 7.0 6.0 5.5 110
Hungary -3.5 -11.9 -3.1 -0.6 2.9 1.5 1.0 3.0 89
Czech Republic -1.2 -11.5 -3.3 0.6 2.7 5.9 4.1 1.0 90
Russia -4.0 -5.0 -14.5 -8.7 -12.6 -4.0 -5.0 1.0 57
Ukraine -3.4 -11.6 -13.7 -14.2 -23.0 -11.8 -10.1 -3.0 37
Belarus -3.0 -1.2 -9.6 -7.6 -12.6 -10.4 2.6 3.0 66
Kazakhstan -0.4 -13.0 -2.9 -10.4 -17.8 -8.9 1.1 2.0 58
Inflation Percentage change in the year-end retail/consumer price level
Poland 60 44 38 29 22 19 15    
Hungary 32 22 21 21 28 20 17    
Czech Republic 52 13 18 10 8 9 9    
Russia 144 2,501 837 217 132 22 14    
Ukraine 161 2,730 10,155 401 182 40 15    
Belarus 93 1,558 1,994 1,900 243 40 99    
Kazakhstan 137 2,984 2,169 1,160 60 29 12    
Source: EBRD, Transition Report 1997.


Table 2: EBRD transition indicators 1997
  Enterprises Market and trade Financial institutions
  a b c d e f g h
Poland 3+ 4+ 3 3 4+ 3 3 3+
Hungary 4 4+ 3 3+ 4+ 3 4 3+
Czech R. 4 4+ 3 3 4+ 3 3 3
Russia 3+ 4 2 3 4 2+ 2+ 3
Ukraine 2+ 3+ 2 3 3 2 2 2
Belarus 1 2 1 3 1 2 1 2
Kazakhstan 3 3+ 2 3 4 2 2+ 2
a: large-scale privatisation
b: small-scale privatisation
c: governance and restructuring
d: price liberalisation
e: trade and foreign exchange system
f: competition policy
g: banking reform and interest rate liberalisation
h: securities markets and non-bank institutions
Source: EBRD, Transition Report 1997. The EBRD numerical indicators are intended to represent on a 1-4 scale the cumulative progress in the movement from a centrally planned economy to a market economy in each dimension (a detailed description of this classification is given in the volume).

Behind the unprecedented fall in GDP and the slow and incomplete curb on inflation, with the related social and economic consequences (a drop in investments with negative effects on future growth, the reappearance of budget problems due to problems of yield from taxation and balance of payments due to internal inflation, the emergence of long-term unemployment and therefore marginalisation and impoverishment of the population, 10 etc.) there were not only the inevitable difficulties deriving from the economic and social crisis inherited from the preceding regime, but also real errors in strategy and management of economic policy. 11

To some extent these were external shocks, however largely self-inflicted by economic policy authorities, such as those deriving from the break in trade flows caused by the dissolution of the Council for Mutual Economic Assistance (CMEA) or the effects on the balance of payments and the survival of some enterprises caused by the risky policy of opening up foreign trade, even though not reciprocated by Western partners. But they were also internal shocks caused by the lack of governance of the transition process. To give only a few examples:

No less important are the consequences of the failure to re-establish a social pact, different from the previous one, but adequate for sustaining systemic transition: wherever enterprise faced the fall in production with more or less implicit agreements aimed at limiting the fallout on employment, there was a drop in profitability and, with it, in the prospects for a recovery of the investments which was essential for carrying out the necessary readjustment and restructuring; wherever unemployment openly manifested itself, long-term phenomena of marginalisation occurred eroding the skills of the unemployed and jeopardising their prospects for reabsorption. 13 If one adds a polarisation in income distribution which was formerly unknown in those economies and hardly transparent processes of concentration of ownership, 14 the outcome is a troubling social picture.

The economic and social costs described are important not only per se but also for their conditioning effect on the pace of transition processes and the determination of the authorities, especially in the less advanced countries, to proceed with them. The picture of the states of transition provided by the European Bank for Reconstruction and Development in Table 2 illustrates the enormous differences among the countries and, above all, the way in which transition has proved to be slower and more difficult for those processes that call for maximum governance capabilities: the restructuring of large enterprises and the building of a coherent framework of corporate governance, competition policies and regulations, and financial markets.


The New Course in Poland Between 1994 and 1997

Throughout the nineties, awareness of the need for readjustment of the strategy of economic policy grew, because of not only the political and electoral vicissitudes in many countries in the area, but also the cogent force of real problems. Once again it was Poland, with the programme adopted in 1994 by Finance Minister Kolodko, which first indicated that there was a need to preserve continuity with the general lines of the stabilisation and systemic transformation already underway but at the same time to introduce a number of important corrections and innovations. Since then, the debate and the economic policy strategies implemented in the various countries have been more aware of the complexity of the systemic transition process and the interaction between economic recovery and growth, on the one hand, and the pace and quality of transition on the other. 15

The strategic lines of the programme adopted in Poland in June 1994, taken up and further developed in the subsequent Poland 2000 programme worked out in 1996, can be summarised as follows: 16

In summary, the correction brought about by the Kolodko programme was aimed at strengthening the ability to govern processes set into action by systemic transition as an essential condition for making economic recovery stable and for building functioning and efficient markets.(17) In this changed cultural context, it became obvious that it was necessary to dedicate greater attention to the functioning of the public administration as a prerequisite for the success of this strategy. Furthermore, the need was increasingly felt for legislation and institutions that make it possible to pursue adequate competition policies and modern regulatory policies in the field of public utilities.

The policies implemented—not always in the time set down in the plan—have made the transition process more orderly and at the same time more rapid: restructuring, commercialisation and privatisation of state enterprises has accelerated since 1994, despite several difficulties exemplified by the presidential veto which delayed the entry into force of the act on commercialisation of state-owned firms until 1996; the legislation on safeguarding transactions has reached a good stage of implementation; the first timid forms of competition policy and regulation of public utilities are emerging; 18 the improvements in fiscal yield have made it possible to contain the budget deficit between 2.5 and 2.7 percent of GDP. As for macroeconomic performance (Table 1), there has been a strengthening of the recovery which began in 1992, a substantial reduction in inflationary dynamics, and a decline in the unemployment rate to 10.5 percent at the end of 1997, compared to the peak of 16 percent in 1994. Furthermore, the recovery has been mainly investment-led with growth rates considerably outstripping consumption (also positive).

However, there are weak points and uncertainties about the future development of both the state of transition and the prospects for stable growth. Moreover, it remains to be seen whether the new government that came to power after the September 1997 elections, with the return of Balcerowicz to the position of Finance Minister, will be able to consolidate the results and deal with the unresolved problems.

Some of the major problems related to transition still open are:

As for macroeconomic prospects, the following matters are of concern:


The Russian Crisis

The kind of recovery of governance of transition processes introduced in Poland with the Kolodko programme has, instead, been drastically lacking in Russia. First of all, though, it must be mentioned that the defects in the initial stabilisation and transition strategy described earlier were magnified in Russia by a number of factors: the size of the country and the disintegration of the Soviet Union, which diminished the possibility of political control over the processes triggered; the minor trade integration with Western countries previously achieved; the emergence of high transactional costs due to the disintegration of the intra-USSR trade system; and the disappearance of the inter-enterprise administrative system of transactions, a system that was much more pervasive in the USSR than the one in the Central and Eastern European countries which had already undertaken some important pro-market reforms. Secondly, the corrections introduced in Russia to the initial Gaidar strategy were not part of an organic alternative programme and strategy and ended up producing inconsistencies in the stabilisation policy and accentuating the lack of governance of the market transition processes. Particularly evident were the distortions that characterised the privatisation of state enterprise, including a lack of transparency and the domination of the interests of specific organised power groups in the emerging ownership structure and control over companies. 19

Thus, this summer’s monetary and financial crisis was the result of the great structural weakness of the Russian economy deriving from objective difficulties and the limits of the transition policies pursued. Then again, that crisis was preceded by a number of alarm signals, especially visible since autumn 1997: everything pointed to the fact that the problems that had been intertwining in the last years and that the Chernomyrdin government’s economic policy had left in legacy for young Kiriyenko would come to a head. In particular:

This situation, full of latent tensions per se, rapidly developed into an open monetary and financial crisis under the pressure of some triggering factors: the drop in oil prices, which reduced the trade surplus and brought about a current account deficit; the minor inflow of budget revenues due in particular to the reduction in the taxes paid by exporting companies as a result of the drop in oil prices and the appreciation of the exchange rate in real terms; the resulting policy of further containing expenditures and its consequences on delays in wage payments and on the accumulation of debt arrears among enterprises; the loss of budget policy credibility and the difficulty in placing the securities covering the public debt; the turbulence of financial markets triggered by the crisis in the former Asian tigers, which accentuated the endemic instability in the Russian financial market.

Independently of these catalysts, the Russian crisis has its roots, as already mentioned, in the gloomy production slump and the systemic instability that confirm once and for all the fundamental shortcomings of the strategy pursued in that country. It was a mistake not to have distinguished between the problem of stabilisation, which should have been solved rapidly and energetically, and the problem of transition which, above and beyond price liberalisation, had to be undertaken immediately but with an awareness of the complexity and the long time frame required to construct the relations and institutions required by the market.

It is in this light that the Polish experience can provide an important lesson today. The fact is that the evolution of systemic transition and macroeconomic performance have benefited from the establishment, as of 1993-94, of a new cultural environment, which is finding difficulty in taking hold in Russia; building the rules and institutions of a market economy calls for tenacious and continual political action. The process cannot but go ahead by trial and error, but it has to keep a fundamental direction: building functioning and efficient markets requires a maximum, not a minimum, of capacity for governance.

Claudio De Vincenti is Associate Professor of Economics at the Department of Public Economy, University of Rome “La Sapienza”.



Note 1: Translation is by Gabriele Tonne.  Back.

Note 2: See, for example, M. Lavigne, Les économies socialitstes soviétique et éuropéennes (Paris: Libarie Armand Colin, 1974) and A. Nove, The Soviet Economic System (London: Allen & Unwin, 1980). For a theoretical analysis of the Soviet-type economic mechanism, see C. De Vincenti, L’economia di tipo sovietico. Impresa, disequlibrio, ordini e prezzi (Rome: La Nuova Italia Scientifica,1989).  Back.

Note 3: See, for example, R. di Leo, Il modello di Stalin (Milan: Feltrinelli, 1977) and “La gestione populista delle relazioni industriali nell’URSS degli anni ‘80”, Giornale di diritto del lavoro e relazioni industriali, vol. VII, no. 26, 1985.  Back.

Note 4: De Vincenti, L’economia di tipo sovietico.  Back.

Note 5: D. M. Nuti, “Hidden and Repressed Inflation in Soviet-type Economies: Definitions, Measurements and Stabilisation”, Contributions to Political Economy, vol. 5, 1986 and C. De Vincenti, “Disavanzo pubblico, inflazione repressa e politiche di stabilizzazione in una economia di tipo sovietico”, Economia Politica, no. 1, 1991.  Back.

Note 6: L. Balcerowicz, Socialism Capitalism, Transformation (London: Central European University Press, 1995); for a critical comment, D. M. Nuti, “Stabilizzazione e transizione: il proptotipo polacco”, Europa—Europe, no. 2, 1994.  Back.

Note 7: D. M. Nuti, “Economic Inertia in the Transitional Economies of Eastern Europe” in M. Uvalic, J. Lorentzen and E. Espa (eds) Impediments to the Transition in Eastern Europe (Florence: European University Institute—EPU, 1993) and J. Eatwell et al, Transformation and Integration: Shaping the Future of Central and Eastern Europe (Brussels: The European Forum for Democracy and Solidarity, 1995.  Back.

Note 8: See A. Chilosi, “Processi alternativi di privatizzazione: caratteristiche rilevanti e conseguenze economiche”, Europa—Europe, no. 3, 1993; P. Aghion, O. J. Blanchard, R. Burgess, “The Behaviour of State Firms in Eastern Europe Pre-privatization”, European Economic Review, vol. 38, no. 6, 1994; P. Aghion, O. J. Blanchard, W. Carlin, The Economics of Enterprise Restructuring in Central and Eastern Europe, CEPR Discussion Paper, no. 1058, 1994; and M. Uvalic, D. Vaughan—Whitehead (eds) Privatization Surprises in Transition Economies (Cheltenham, UK: Edward Elgar, 1997).  Back.

Note 9: With regard to the last two points, see above all Eatwell et al., Transformation and Integration.  Back.

Note 10: On this subject, see G. A. Cornia, R. Paniccia, “The Demographic Impact of Sudden Impoverishment: Eastern Europe during the 1989-94 Transition” Economic Policy Series, no. 49, UNICEF ICDC, 1995 and G. A. Cornia, “Public Policy and Welfare Conditions during the Transition: an Overview”, MOCT, vol. 6, no. 1, 1996.  Back.

Note 11: For an analysis of the causes of the fall in output, see, for example, A. Calvo, F. Coricelli, “Output Collapse in Eastern Europe. The Role of Credit”, IMF Staff Papers, vol. 40, no. 1, 1993; M. Ellman, “Transformation, Depression, and Economics: Some Lessons”, Journal of Comparative Economics, vol. 19, 1994; D. K. Rosati, “Output Decline During Transition from Plan to Market: a Reconsideration”, Economics of Transition, vol. 2, 1994; L. Taylor, “The Market Met is Match: Lessons for the Future from the Transition’s Initial Years”, Journal of Comparative Economics, vol. 19, 1994; C. De Vincenti, M. Mulino “Stabilisation and Output Decline in Previously Planned Economies: a Model of Imperfect Competition and Credit Rationing”, JOICE—Economic Systems, vol. 20, no. 1, 1996.  Back.

Note 12: A. Schnytzer, A. Weiss, “The Failure of Supply Response in Transition: a Market Based Explanation” Economic Systems, vol. 16, no. 2, 1992, and A. Chilosi, Economic Transition and the Unemployment Issue, Economic Systems, vol. 17, no. 1, 1993.  Back.

Note 13: T. Boeri, “Labour Market Flows and Persistence of Unemployment in Central and Eastern Europe”, Unemployment in Transition Countries: Transient or Persistent? (Paris: OECD, 1994).  Back.

Note 14: Uvalic, Vaughan—Whitehead, Privatization Surprises in Transition Economies.  Back.

Note 15: This has been accompanied, in parallel, by a theoretical debate on economic recovery, growth and transition. See, for example, P. Aghion, O. J. Blanchard, On the Speed of Transition in Central Europe, NBER Macroeconomic Annual (Cambridge, Mass.: MIT Press, 1994); F. Coricelli, Fiscal Constraints, Reform Strategies, and the Speed of Transition: the Case of Central-Eastern Europe, CEPR Discussion Paper, no. 1339, 1996; B. Lissovollik, “Costs and Causes of Inflation during the Transition: the Case of Russia (1992-1995)”, paper presented to the conference “Russia and the Wrold Economy”, University of Rome “La Sapienza”, 20-21 March 1996; C. De Vincenti, M. Mulino, “Understanding Unemployment Dynamics in the Transition: the Role of Aggregate Demand and Investment”, Rivista Italiana degli Economisti, vol. 2, no. 1, 1997.  Back.

Note 16: See Nuti, Stabilizzazione e transizione and G. Kolodko, Poland 2000. The New Economic Strategy (Warsaw: Poltext Publishers, 1996).  Back.

Note 17: G. Kolodko, D. M. Nuti, “The Polish Alternative—Old Myths, Hard Facts and New Strategies in the Successful Transformation of the Polish Economy”, Research for Action, no. 33, UNU/WIDER, 1997; as well as, for a more overall view of economies in transition, Eatwell et al., Transformation and Integration.  Back.

Note 18: Transition Report (London: EBRD, 1996).  Back.

Note 19: B. Lissovolik, “Rapid Spread of Employee Ownership in the Privatised Russia” in Uvalic, Vaughan—Whitehead, Privatization Surprises in Transition Economies.  Back.