THE TRANSITION FROM COMMUNISM TO THE MARKET: A REAPPRAISAL Joseph E. Stiglitz EBRD May 2006

Transition from Communism to Market one of great economic experiments Outcome in Russia and other FSU were a disappointment – Abandoning central planning (decentralization and move to market) –Correcting distortions –Providing incentives Should have led to unprecedented prosperity –Instead led to unprecedented increases in poverty and inequality Though some increase had been expected

INCREASES IN INEQUALITY

INCREASES IN POVERTY FROM RAVALLION AND SHEN

DECLINE IN HDI

Two big exceptions China and Vietnam –Unprecedented growth –Unprecedented poverty reduction DATA (CHART) ON GROWTH, POVERTY REDUCTION

Natural question: what explains successes and failures By 1996 World Bank thought transition was largely accomplished Issued WDR—From Plan to Markets –Abandoned research unit –Thought it understood main elements of success China omitted –Washington consensus policies Faster privatization More liberalization Lower inflation “shock therapy” would lead to faster transition

BUT HISTORY WAS NOT KIND… As elsewhere, performance in early 90s poor predictor of performance later –(Much of growth not sustainable—and not sustained) –Again, China exception

CHART SHOWING NEGATIVE CORRELATION

With more data, we have better explanations Statistical problems make it difficult to be sure –High degree of collinearity Rapid privatization did not lead to better performance Best explanations have to do with “rule of law” variables (Goody and Stiglitz) –Not Washington consensus variables

But rule of law should itself be viewed as “endogenous” The Hope….. Privatization offers an enormous political benefit for the creation of institutions supporting private property because it creates the very private owners who then begin lobbying the government...for institutions that support property rights.” »Murphy-Shleifer-Vishny 1998

The Result in Russia Broad private ownership [didn’t create] a constituency for strengthening and enforcing [the new Civil and Commercial Codes]. Instead, company managers and kleptocrats opposed efforts to strengthen or enforce the capital market laws. They didn’t want a strong Securities Commission or tighter rules on self- dealing transactions. And what they didn’t want, they didn’t get. Black et al 2000

Distribution of transition countries and all countries, by their World Bank rule of law scores, 1996 and Rule of law score Rule of law score World Transition countries kdensity rl Transition countries World

Policies affect the “demand” for the rule of law Simultaneous political and economic equilibrium Investors have a choice between “stripping assets” and creating wealth –Key issue is corporate governance –Would not have arisen if there is a single owner (can’t steal from oneself) The way privatization was done did not create “legitimate” property rights –Enhanced incentives for asset stripping Hoff and Stiglitz, AER, 2004, NBER, 2005

Economic policies made matters worse Capital market liberalization meant that new “owners” could have the advantages of property right protections abroad and weak rule of law at home High interest rates, low access to credit, weak economy further tilted balance towards asset stripping Exacerbated by regional problems –Privatization did not eliminate government interventions Exacerbated by age structure of leadership/absence of capital markets –Older leaders could not “cash in” quickly on improvements

INCENTIVES MATTER With more people gaining from asset stripping, less political demand for a rule of law INCENTIVES MATTERED—BUT THERE WERE INCENTIVES TO STRIP ASSETS AND TO KEEP POLITICAL SYSTEM (LACK OF A RULE OF LAW) TO ALLOW INDIVIDUALS TO CONTINUE DOING SO Hoff and Stiglitz, AER, 2004, NBER, 2005

Explaining China’s success Pragmatism—policies which market fundamentalism said couldn’t or wouldn’t work –Two tier price system for moving from planned prices to market prices In contrast to instant liberalization that led to hyperinflation –Individual responsibility system (not full land privatization) But kept in place input/marketing services Contrast between China and Moldova

A whole range of better economic policies contributed to success –Emphasis on enterprise creation rather than restructuring –Emphasis on competition rather than privatization –Emphasis on keeping job growth in tandem with job destruction Avoided waste of resources from unemployment –TVE’s—township and village enterprises Public enterprises But local oversight helped solve “governance problem” –Avoided instability of capital market liberalization But still was able to attract huge amounts of FDI –Avoided overvalued exchange rate And high interest rates

Alternative Explanations China had an easier task—because it was most an agricultural economy and was a less developed economy But development is hard enough Why should combining two problems make each easier? Moreover, there is no evidence (in general) that among transition economies, growth was better in poorer and more agrarian economies

Prospects Russia? Russia is not a “normal” economy –Lack of rule of law not normal –And even if it were, could have been avoided –Among most important variables affecting future growth But isn’t Russia doing better? –Growth can largely be explained by price of oil –Russia has become a natural resource economy –Perhaps this explains its problem (Natural resource curse)

Insert oil /gdp chart

Lessons for economics and for other economies in transition Economists approached problems with enormous hubris –Economic theory focuses on equilibrium –But these were problems of transition –Still there was much more understanding of key issues (“rule of law,” institutional infrastructure (corporate governance), privatization, financial markets than was brought to bear General theorem on limitations on privatization (Sappington-Stiglitz) –Problem was not fundamentally a macro-economic problem Yet macro-economists played key role in transition –What role did ideology play? –Some have suggested that West wanted a failure. I do not believe that that is the case

Political analysis did play a role –Worry about risk of backsliding –But, on other side, should have been worry that a failed transition, with large increase in poverty, would lead to disillusionment with market economy, perhaps even democracy These fears have played out Irony is that deeper political analysis would have made them aware that policies were undermining political support for the creation of the rule of law, which itself would be necessary for successful transition

The Task of Transition is not over… Nor is the task of development in the economies in transition The failures and successes of China and Russia have taught us much about how markets work and how economies grow Institutions like the EBRD can play a vital role both in distilling these lessons and in helping the development process There is a role for public private partnerships There is a role for development banks Finance is critical to successful development

Hopefully, Fifteen years from now we can look back at the past fifteen years as but a short interlude in history –Having learned these lessons –All of the economies in transition will be well on the road to succes