Divergent Paths in Post-Communist Transformation: Capitalism for All or Capitalism for the Few?

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Divergent Paths in Post-Communist Transformation Capitalism for All or Capitalism for the Few?

Oleh Havrylyshyn

Studies in Economic Transition General Editors: Jens Höischer, Reader in Economics, University of Brighton; and Horst Tomann, Professor of Economics, Free University Berlin This series has been established in response to a growing demand for a greater understanding of the transformation of economic systems. It brings together theoretical and empirical studies on economic transition and economic development. The post-communist transition from planned to market economies is one of the main areas of applied theory because in this field the most dramatic examples of change and economic dynamics can be found. The series aims to contribute to the understanding of specific major economic changes as well as to advance the theory of economic development. The implications of economic policy will be a major point of focus. Titles include: Irwin Collier, Herwig Roggemann, Oliver Scholz and Horst Tomann (editors) WELFARE STATES IN TRANSITION East and West Hella Engerer PRIVATIZATION AND ITS LIMITS IN CENTRAL AND EASTERN EUROPE Property Rights in Transition Hubert Gabrisch and Rüdigger Pohl (editors) EU ENLARGEMENT AND ITS MACROECONOMIC EFFECTS IN EASTERN EUROPE Currencies, Prices, Investment and Competitiveness Oleh Havrylyshyn DIVERGENT PATHS IN POST-COMMUNIST TRANSFORMATION Capitalism for All or Capitalism for the Few? Jens Hölscher (editor) FINANCIAL TURBULENCE AND CAPITAL MARKETS IN TRANSITION COUNTRIES Jens Hölscher and Anja Hochberg (editors) EAST GERMANY’S ECONOMIC DEVELOPMENT SINCE UNIFICATION Domestic and Global Aspects Mihaela Kelemen and Monika Koestra (editors) CRITICAL MANAGEMENT RESEARCH IN EASTERN EUROPE Managing the Transition Emil J. Kirchner (editor) DECENTRALIZATION AND TRANSITION IN THE VISEGRAD Poland, Hungary, the Czech Republic and Slovakia Julie Pellegrin THE POLITICAL ECONOMY OF COMPETITIVENESS IN AN ENLARGED EUROPE Stanislav Poloucek (editor) REFORMING THE FINANCIAL SECTOR IN CENTRAL EUROPEAN COUNTRIES Gregg S. Robins BANKING IN TRANSITION East Germany after Unification

Johannes Stephan ECONOMIC TRANSITION IN HUNGARY AND EAST GERMANY Graudualism and Shock Therapy in Catch-up Development Hans van Zon THE POLITICAL ECONOMY OF INDEPENDENT UKRAINE Adalbert Winkler (editor) FINANCIAL DEVELOPMENT IN EASTERN EUROPE The First Ten Years Also by Oleh Havrylyshyn A DECADE OF TRANSITION (co-edited with Saleh Nsouli) FUNDAMENTALS OF ECONOMIC THEORY (in Ukrainian) LIBERALIZING FOREIGN TRADE IN DEVELOPING COUNTRIES: Vol. 3, The Experience of Yugoslavia DEVELOPMENT OF TRADE POLICY IN POLAND (in Polish with Dariusz Rosati) CANADA’S TRADE RELATIONS WITH DEVELOPING COUNTRIES (with Vittorio Corbo) PLANNING FOR ECONOMIC DEVELOPMENT: The Construction and Use of a MultiSectoral Model for Tunisia (with André Martens, Robert Pindyck and Mouheb-Eddine Hamza)

Studies in Economic Transition Series Standing Order ISBN 0–333–73353–3 (Outside North America Only) You can receive future titles in this series as they are published by placing a standing order. Please contact your bookseller or, in case of difficulty, write to us at the address below with your name and address, the title of the series and the ISBN quoted above. Customer Services Department, Macmillan Distribution Ltd, Houndmills, Basingstoke, Hampshire RG21 6XS, England

Divergent Paths in Post-Communist Transformation Capitalism for All or Capitalism for the Few?

Oleh Havrylyshyn

© International Monetary Fund 2006 Foreword © International Monetary Fund 2006 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2006 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y. 10010 Companies and representatives throughout the world. PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin’s Press, LLC and of Palgrave Macmillan Ltd. Macmillan® is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN-13: 978–1–4039–9634–3 ISBN-10: 1–4039–9634–2 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Havrylyshyn, Oleh. Divergent paths in post-communist transformation : capitalism for all or capitalism for the few? / Oleh Havrylyshyn. p. cm.—(Studies in economic transition) Includes bibliographical references and index. ISBN 1–4039–9634–2 (cloth) 1. Europe, Eastern – Economic conditions – 1989– 2. Europe, Central – Economic conditions. 3. Former Soviet republics – Economic conditions. 4. Post-communism. 5. Comparative economics. I. Title. II. Series. HC244.H379 2005 330.9470009049—dc22 2005049930 10 9 8 7 6 5 4 3 2 1 15 14 13 12 11 10 09 08 07 06 Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham and Eastbourne

To my wife, Natalia Ingrid, who supported in all ways my efforts from the beginning of transition to the completion of this volume, and provided numerous insights to help see more clearly through the post-communist fog

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Contents List of Tables and Figures

x

Preface and Acknowledgements

xii

Foreword by Anne O. Krueger

xv

Introduction and Overview

1

Part I Background: Transition Debates and Statistical Facts 1

Key Debates on Transition The search for a transition model Principal debates of the 1990s Main issues looking forward The transitology paradigm in political science literature

15 15 21 38 42

2

Measuring Progress in Transition How to measure progress The EBRD transition indicator: how good a measure of progress? Patterns of reform progress over time Main determinants of growth in transition Appendix: unrecorded economic activity and measures of GDP

47 47 48 58 62 70

3 Economic and Social Costs of Transition: A Hard Look at Soft Facts Introduction Were negative effects inevitable? Aggregate economic costs: lost output and unemployment output losses Impact on individuals as measured by social indicators Summing up the evidence on social costs Appendix: estimates of output loss under different assumptions

78 78 79 81 91 115 118

Part II An Ex Post Transition Paradigm: Uncharted Waters, Pirate Raids and Safe Havens 4

The SS Transition Navigation Model Introduction The value of comprehensive explanations vii

123 123 125

viii Contents

A parsimonious approach: the navigation model Testable hypotheses What is new in the navigation model Appendix: an illustrative formalization of the navigation model 5 The Search for a Navigation Chart: Legitimate Debates, Vested Interests and Reformist Commitments The release from communist captivity: carpe diem or follow the money? Availability of navigation charts A timeline of economic transformation events Commitment to a liberal market economy 6

From Rent-Seeking to Oligarchy to State Capture Overview Partial reforms and the evolution of rent-seeking Other forces affecting vulnerability to rent-seeking From rent-seeking to state capture Appendix: rent-seeking, vested interests and entrenchment in non-transition economies

7 Safe Havens for Market Reforms: Membership in the EU and Other International Organizations Courtship games of the EU and post-communist countries EU membership incentives: sometimes a carrot, sometimes a stick Unrequited desires for membership Other international beacons EU membership prospects and reform delays Appendix: EU membership as a factor in political and economic reform in the Baltic republics

Part III 8

133 143 146 149 151 151 152 158 167 177 177 178 185 191 199 203 203 208 212 216 220 225

A Summing Up

Future Prospects for Captured States A fork in the transition road Is further transition inevitable or is it frozen? Consequences of a frozen transition Can anything be done to free the captured states?

9 Diverse Outcomes: Liberal Societies, Captured States and Undetermined Polities Introduction Variation in transition progress

233 233 234 242 248 255 255 255

Contents ix

Why such divergent outcomes? Future prospects and policy implications

264 272

Notes

277

Bibliography

295

Index

309

List of Tables and Figures Tables 1.1 2.1 2.2 2.3 2.4 2.5 2.6 A2.1 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 3.10 3.11 A3.1 5.1 5.2 5.3 5.4 5.5 6.1 7.1 A7.1 9.1 9.2

Quality of institutions in transition economies 1997–8 Recovery: estimated index of GDP, 2003 Inflation performance Cumulative FDI per captia, 1989–2003 Transition indicator values by year and type Growth of GDP since 1998 Year that the TPI growth threshold (2.55) was reached for CISM countries Transitional indicator averages Official and adjusted index of output Summary estimates of cumulative output loss Unemployment rates in the transition Average human development indicator values Range of Gini estimates in the literature Probable changes in Gini values Range of Gini values by country groups Poverty ratio estimates: various sources Range of poverty ratios by country group and period Male life-expectancy trends in transition Gross educational enrolment ratios Estimates of cumulative loss of output Chronology of events: post-communist countries Milestones of transition progress Type of first government and reform strategy Liberal commitment at start and reform strategy Countries with reversals in government State-capture index, 1999 Strength of EU ‘offer’ and reform delay Contractual relations between the EU and the Baltic republics up to 1995 Key indicators of transformation outcomes Final transformation outcomes and principal determinants

x

37 53 54 54 59 69 69 73 81 85 88 93 97 100 102 105 106 112 114 120 160 162 169 170 171 192 221 230 258 265

List of Tables and Figures xi

Figures 1.1 2.1 2.2 A2.1 A2.2 A2.3 A2.4 A2.5 A2.6 A2.7 A2.8 A2.9 A2.10 A3.1 A3.2 4.1 4.2 4.3 4.4 4.5 5.1 5.2 6.1 6.2 6.3 6.4 6.5 6.6 8.1

An illustration of the Washington Consensus EBRD transition progress indicator (TPI), 2004 Constitutional liberalism and progress in transition CE transition progress indicators CE average liberalization index per year Baltics transition progress indicators Baltics average liberalization index per year SEE transition progress indicators SEE average liberalization index per year CISM transition progress indicators CISM average liberalization index per year CISL transition progress indicators CISL average liberalization index per year Actual GDP and socialist counterfactuals Schema for calculating GDP loss under various counterfactuals An encyclopedic approach to explaining diverse transition results Transition progress and continuity of communist-era judges Vicious circle of delayed reform and oligarchic development Virtuous circle of timely reform and development of competitive market and rule of law Testable hypotheses of the navigation model Uncharted waters or too many charts? Transition countries and type of reform strategy Rent-seeking type A: gradual or aborted big-bang reformers, high vulnerability Rent-seeking, types A and B Delay facilitates state capture State capture and delay in stabilization State capture and delay in reform progress State capture freezes transition State capture leads to frozen transition

18 50 56 74 74 74 75 75 75 76 76 76 77 119 119 126 130 138 139 147 154 159 183 184 193 194 194 198 240

Preface and Acknowledgements Many years have now passed since Europe’s annus mirabilis, 1989, certainly enough time to allow more than a preliminary assessment of the transition from communist central-planning to a market democracy in the 27 countries of the former Socialist bloc. While the voyage is by no means complete in all of the countries, it is nearly so in many, and reasonably clear why not in the others. This book summarizes my efforts to describe the various paths followed by different countries, and to explain these differences in a systematic political-economy framework. The book also reflects for me a culmination of professional involvement in this issue since 1989, an involvement with a strong dose of personal connections, devotion and passion. This the reader should know, and judge my attempt to balance the personal advantage of ‘insider’ insights, and its risks of intellectual biases. As a Ukrainian-born refugee of the Second World War, I was blessed with the opportunity to live in many free societies and to be educated in a ‘Western’ professional paradigm. Nevertheless, my origins, parents and diaspora community ensured the indigenous weltanschaung was not completely lost. This did not fully equate with the experience of living in the pre-1989 communist societies, but it helped a great deal to understand them better when my professional interest, like that of many Western economists, carried me into the field of transition economies. This combined background considerably facilitated my work in the area as an academic, Ukrainian government official, and official of the World Bank and International Monetary Fund. Before I express due acknowledgements two prefatory comments on the book itself may be useful here. First, the methodological approach I have taken to seek the simplest systematic explanation of how events turned out, may to some appear counter to the historical complexity and uniqueness of this transformation. I believe a parsimonious but comprehensive explanation is indeed compatible with the unquestionably complex reality of all the changes to be made in a post-communist economy, polity and society. I do not argue that the simplified paradigm of the book is a substitute for the detailed analysis of individual countries or component issues such as privatization or development of market institutions. In fact, such detailed studies were in my own research for this volume the most useful way to condense the varied experience of many countries into a more focused understanding of the key driving forces. Second, the navigation paradigm of the book tells a fable of the S.S. Transition voyage, whose course, schedule and final port of call were determined by the ability to sail expeditiously through the ‘uncharted waters’ of market reforms avoiding extensive delays, the capacity to mitigate xii

Preface and Acknowledgements xiii

effects of ‘pirate raids’ (rent-seeking activities), and commitment to follow the beacon of EU standards to the safe haven of eventual membership. The most successful voyages have ended for those countries which acceded to the EU in May 2004. The most troublesome voyages were, and remain, those of the so-called captured states where all three of the above forces had strong negative tendencies. But there is an even simpler way of telling the story focusing on the states where an oligarch clique developed and captured not only the levers of the economy but those of the polity as well. This alternative story centres on the partiality of economic reforms, and is the story often told by frustrated reformers of the early 1990s in Russia (Gaidar, Fyodorov, Yavlinsky) and Ukraine (Yuschenko, Pynzenyk). In the socialist period, private ownership was largely illegal, and the disciplinary role of a market was largely substituted by central-plan directives backed by party and judicial discipline. In the early transition period, private ownership become legal, and the discipline of the Central Plan, the Party and the courts became so loose or ineffective that it was virtually non-existent. In theory, transition to market operation was meant to provide a substitute, the discipline of competition. But reforms that were partial not only created huge price distortions attracting rent-seeking pirate–raids, they also failed to ensure an open competition environment. Hence, oligarchs became increasingly powerful, and for now at least find it in their interest to retain the status quo of partial transformation, blocking further moves to complete liberalization. A vast number of individuals have influenced my thinking on transition and thus contributed importantly to this book. Only a few can be named here and I will note first a special subgroup: those independent thinkers and free souls – and inevitably patriots – who suffered the ignominy of Soviet suppression of ideas. I wish to thank specifically the many government officials in the region who struggled with early reform efforts and with whom I had the honour to work and thus learn: Leszek Balcerowicz, Yegor Gaidar, Vadym Hetman, Andrei Ilarianov, Pero Jurkovic, Grzegorz Kolodko, Volodymyr Lanovey, Andrzej Olechowsky, Bozo Prka, Hryhoriy Pyatachenko, Viktor Pynzenyk, Dariusz Rosati, Marko Skreb, Serhiy Teriokhin and Viktor Yuschenko, now President of Ukraine. There are also many who contributed directly to the preparation of this volume. I thank first the International Monetary Fund and its senior management not only for the opportunity to work with so many different transition countries, but also for the sabbatical year granted to me in 2004 to bring together all these experiences in a compact written form. I am most grateful for the academic home provided to me for one year by the Centre for Russian and East European Studies a the University of Toronto, and its Director Peter Solomon. I extend my appreciation to the many colleagues and students there who comprised its vibrant intellectual environment. I am also most grateful to Karlo Basta who prepared the first versions of the Chapter 1 section

xiv Preface and Acknowledgements

on transitology and the Appendix on the Baltics’ efforts to move towards EU membership; he deserves full credit for the value added by these items, but the responsibility for any errors or misinterpretations is mine. The research underlying Section 5.3 on the timeline of transformation and preparation of the index were done by Natalia Ingrid Havrylyshyn. A number of friends and colleagues read parts of the manuscript at various stages and their comments were highly beneficial: Robert Austin, Julian Berengaut, Albert Berry, Laszlo Czaba, Randal Filer, Natalia Ingrid Havrylyshyn, Gerald Helleiner, Simon Johnson, Jeffrey Kopstein, John Odling-Smee, Jacques Polak, Tapio Saavalainen, Peter Solomon, Lucio Vinhas de Souza, Paul Wachtel and Bernard Yeung. The analysis, interpretations and views presented here remain the sole responsibility of the author, and do not necessarily reflect the views of the above, nor do they represent the position of the International Monetary Fund or its Board of Directors. Last but not least, the preparation of the typescript and publication, always a large and complicated task, would have been impossible without the patient assistance of many people, including Joy Zhou, Doris Ugaz, Susana Otero, Rachel Stazi, Faiza Mohamed, Oksana Polyuga, Olive Stone, Leah Taylor and Sean Willett. At Palgrave Macmillan I am very grateful to Keith Povey for a thorough editing which much improved the text, to Amanda Hamilton for general guidance, and Katie Button for efficient administrative support. Jeanette Morrison, Sean Culhane and James McEuen of the IMF’s External Relations Department were most patient and helpful with final editorial and publications logistics. OLEH HAVRYLYSHYN

Foreword to Havrylyshyn Book It is less than 20 years since the collapse of communism in Europe. Yet, from the perspective of the early twenty-first-century, the events triggered by the fall of the Berlin Wall in 1989 seem much more distant. Even for those directly involved it can be hard to recall what life was like in the centrally planned economies – and correspondingly easy to overlook the scale of the challenge that faced those charged with transforming those countries into market economies. This is at least in part because so much has been achieved so fast. Many of the countries crippled by economic policies that wasted resources on a huge scale, stifled growth and held down living standards are now in the European Union. The transformation of many parts of the former Soviet empire has been remarkable. Turning centrally run economies into well-functioning market economies that foster competition and growth had never before attempted. The early years of the process were punctuated by intense debates among economists and policy-makers about the best way to achieve the desired objective: in particular, there were arguments about whether speed or caution would be the more effective route. The process is not complete, of course, and has further to go in some parts of the former communist world than others. But, given what has already been achieved, it is appropriate to take stock, and that is what this new book by Oleh Havrylyshyn seeks to do. In part, this is a historical exercise, to understand more clearly what happened and why. This volume presents a detailed survey of more than 20 countries, providing statistical information and analysis of policies pursued and their results. But this is also very much a forward-looking exercise. Increasing our understanding of the past couple of decades, and finding out more about which policy choices worked best, can also have a prescriptive value. There is now a sufficiently large database for us to attempt judgements about the relative merits of competing approaches. Havrylyshyn concludes, for example, that those countries where reforms were introduced most rapidly and comprehensively have experienced the most rapid progress – on all fronts. They have grown most rapidly; they have been most successful at integrating with the global economy and attracting foreign investment; they have been more successful at mitigating the social costs of transition; and they have the most mature democratic institutions. The issue of transition costs was at the heart of the reform debate. Those favouring a slower and more gradual transition consistently argued that this was essential to avoid imposing high social costs, especially on the poorest members xv

xvi Foreword to Havrylyshyn Book

of society. But Havrylyshyn’s findings suggest that delaying reforms did not reduce social costs: rapid reforms led to more rapid and sustained growth and so made possible more rapid and more significant reductions is poverty. It is tempting to note at this point that it was ever thus and this, indeed, is one of the most interesting conclusions Havrylyshyn’s detailed analysis throws up. The initial challenge for the transition policy-makers was different from anything that had gone before both in nature and degree. But as the process of turning these countries into properly functioning market economies, integrated with the global economy, got under way, the similarities with other reform efforts in other parts of the world became more striking. Many of the lessons learned from the experience of the transition economies could be usefully applied to many countries where reforms have been hesitant or stumbling. It is essential to create a virtuous circle, emphasizing macroeconomic stability, liberalization and market-friendly institutions: and equally essential to avoid a vicious circle in which vested interests undermine the commitment to reform, stifle competition and undermine growth. In that sense this book has a relevance well beyond the former Soviet bloc. Its conclusions are a further reminder that cultural and national differences need not detract from more widely applicable lessons about economic behaviour. Economic growth – rapid and sustained – is a prerequisite for raising living standards and reducing poverty. Reforms need to be consistently applied with the aim of making accelerated growth possible. Speed, comprehensiveness and consistency play an important part in determining successful outcomes. That is true in the transition economies. But it also holds true more generally, as the experience of countries as different as Chile and Korea shows. The International Monetary Fund’s relationship with the transition economies is perhaps relevant in this context. The Fund was intimately involved in supporting the reform efforts in these countries: Fund staff, like all those involved in the transition process, faced a very steep learning curve. A special department, known as European II, was established to handle the transition economies. It is a measure of the achievement of so many of these countries that by the end of 2003 it had been decided to close down European II and to integrate the work on the transition economies into the rest of the Fund’s work. They are now treated like any other Fund member country. This also ensures that the lessons learned by Fund staff in supporting economic reforms efforts can also be disseminated more widely. This volume is also an exercise in dissemination. It is underpinned by detailed statistical analysis. But it is aimed at the more general reader interested in knowing what happened, when and why; and a such it is a timely reminder of how far we have come. ANNE O. KRUEGER First Deputy Managing Director, International Monetary Fund


On 9 November 1989 the Berlin Wall fell, marking the end of the communist experiment and the beginning of the end of the Soviet Empire. This was widely considered as a momentous historical event, not only because it was so unexpected, but because it symbolized an end to the Cold War, the freeing of several hundred million individuals from an authoritarian state which had kept them closed off from the rest of the world, and a liberation of private economic initiatives from the constraints of the socialist centralplanning regime. People around the world joined in welcoming citizens of the Socialist bloc, and euphoria would not be an exaggerated characterization of the latter’s emotional state. However, the immediate impact was not yet clear, as liberation from socialism would be implemented at varying speed for different countries over the next few years. In particular, for the individual Republics of the Soviet Union, the political independence they sought was by no means assured in November 1989. But the direction of change was assumed by all to be greater openness and freedom – personal, political and economic. The subject of this book is to review how far such changes have gone in 15 years, and to explain why some countries have progressed more, others less. Citizens elsewhere in the world echoed a sympathetic euphoria. For eighty million Germans, now reunified, it was most immediate and arguably strongest; other Europeans felt a kinship for their German neighbours, and a human sympathy sharing the joy of their eastern neighbours who could now rejoin European society. Americans whose country was the major protagonist in the Cold War rejoiced in the victory and in their contribution to freeing the captured states. Many attributed this to the open and tough stance of President Reagan, symbolized in his remark ‘Mr. Gorbachev, tear down this wall!’ With time, it was understood that other forces were also at play undermining the Soviet bloc, and the possibility that had the addressee not been Gorbachev, the choice might have been to call Reagan’s bluff and not tear down the wall. At the least, Gorbachev, too, has earned historical recognition for his decision. It is also virtually axiomatic that Pope John Paul II takes 1

2


place of honour as the first, if not the major, figure leading the effort to end the communist captivity.

The outcome It has now been a decade and a half since the bloodless breaching of the Berlin Wall, and of course the euphoria has passed. But has it passed because that is the nature of euphoria, or because the euphoric expectations of that moment have evolved into disillusionment? No doubt some of both, though this book takes a positive view that, despite important shortfalls, overall there has been a lot of economic progress and social improvement. It is significant and starkly evident in most of Central Europe and the Baltics, but for others, especially the former republics of the USSR, so far it has been limited and even minimal, and has come at considerable cost to parts of the population. This relatively positive view is not shared by all observers. Numerous critics including politicians, citizens of the region and outside analysts argue that the outcome of the transition is at best mixed and in some cases disastrous; that the economic decline following transition has barely been recovered in a few countries and is far from this elsewhere; that huge increases in poverty and inequality are not an acceptable cost for any of the gains of the new capitalist endeavour; that the availability of goods at unaffordable prices is perhaps worse than the queuing for scarce but cheap goods; that the virtual theft of state assets by a new class of ‘oligarchs’ and their capture of the polity cannot be considered an improvement over the socialist period of domination by a communist nomenklatura. I do not propose to give a response to all of the above criticisms, but will present updated facts and analysis which, while confirming there were significant economic costs especially in the first half-decade, demonstrate that the outcome falls well short of the very negative picture depicted by some critics. After nearly 15 years, the initial costs have been more than overcome for the most successful countries in Central Europe, and at a minimum are on the way to being overcome in most of the others. Putting the above in the jargon of economists, 15 years of transition have yielded many benefits, and produced significant costs, but with a great divergence of the benefit–cost ratio across the region. The judgment of this book is that for about a dozen countries in Central Europe and the Baltics, the benefits have been large, the costs relatively small, though not all citizens were winners, and the losers even in these societies have not always been properly compensated. For countries in South-East Europe the balance seems to be moving in the same direction but it is still early to judge, perhaps because the costly conflicts in this region are so recent. In the rest, that is the non-Baltic part of the former USSR, the story is indeed more mixed. A handful of winners within the society have won hugely – the so-called ‘oligarchs’ – a large number of losers remain poorly compensated if at all, while the

Introduction and Overview 3

majority of the population in the middle is by now somewhat better-off, and certainly no worse-off, but even they suffered in the early years of the transformation. Another important divergence in the outcomes is the nature of the political economic system that has emerged. Eight countries in Central Europe and the Baltics have become EU members as of 1 May 2004, at least three more in South-East Europe are formally on track for membership in the near future, and the rest in this group have some hope for future EU membership. All of these countries have become, or are likely soon to become, reasonably well-functioning middle-income market economies and increasingly liberal democracies. In contrast, the countries of the CIS are highly unlikely to move in that direction in the foreseeable future, with the possible exceptions of Georgia, Ukraine and even Kyrgyz Republic, though their revolutions of colour are too recent to assess. For this group, state capture by economic oligarchs is the order of the day, bringing in parallel increasingly autocratic political regimes. EU membership prospects are virtually nil, again with the possible exception of Ukraine and less so Georgia. The history of this oligarch phenomenon varied greatly. It was most important in the CIS group, more moderate and now waning in the middlegroup of South-East Europe, and very short-lived and never fully evolved in the Central Europe–Baltic group. Many now say that for all practical purposes transition is over and there’s not much more of interest to analyse in postcommunist transformation. For the new and prospective EU members anchored to the EU and its economic-democratic liberal standards, there is indeed very little more transformation to do. Most of the Commonwealth of Independent States (CIS) are locked out of the EU path and are approaching a stable equilibrium of distorted capitalist economies dominated by a small oligarch clique, without competitive liberal markets, and polities that are at best only superficially democratic. Hence their transition is also ‘over’ in the sense of being frozen for now But the real story is neither so simple, nor so uninteresting. Certainly, the future direction for the captured states remains unclear, and this poses an important, intellectually challenging question. Even if one believes the transition issues of the 1990s are all in the past, either resolved or rendered irrelevant, a new transition debate has arisen which merits very close attention: in the oligarch regimes is further transformation indeed frozen, or is it just temporarily stalled and bound to move forward as the new capitalists (yesterday’s thieves as many label them fairly or unfairly) seek legitimation, demand secure property rights under transparent rule-of-law, and push inevitably forward the final stages of economic and political liberalization? Another way forward for them is the possibility of radical regime change and a renewed democratic opportunity, as may be happening with the Rose, Orange and Tulip revolutions. This debate is surely of enough practical and academic interest to justify continued analysis of the transition, at least for

4


the oligarch regimes. To inform this debate, it is surely important to understand exactly why some countries went ‘to the West’ – to borrow a phrase from Egor Gaidar – with its dual liberal vision of democracy and free markets, and some went ‘to the East’ with oligarchic regimes in autocratic states with formal but largely meaningless elections.1 There are many fascinating questions related to this divergence in the transition explored in detail by this volume; I flag here only three. Was the coincidence of movement towards the EU and away from state capture only a coincidence, or were there systemic behavioural forces behind the different outcomes? If this was systemic and not coincidental, was it simply historically predetermined by geographic location or were there other factors at work as well? And finally, what was the direction of causation: was it that a prior ‘invitation’ to Central European countries for EU membership prevented the excesses of oligarch dominance and state capture, or the reverse, that oligarch development and the accompanying non-liberal institutional development precluded oligarch-regimes from wanting to be serious candidates for EU membership? It seems reasonable to conclude the transition is not fully over for all countries, and from those where it is we can learn much of how it came to succeed so quickly in those countries. This understanding will not only satisfy historical curiosity, but will be critical to analysing the future of countries where the transition has not been completed.

Objectives of the book The book has three broad objectives: to describe for different groups of countries the differences in what happened, to explain why the differences in outcome, and to assess the probable future directions, that is what next? The 27 non-Asian transition countries analysed here cover a wide range of geographical, historical and cultural phenomena, hence it is tempting to look to the numerous country-specific characteristics like years under communism, distance from Western European influences, or the degree of internal social harmony as the explanations for each country’s path. While these and other initial conditions cannot be ignored, such a case-study approach leads to an overwhelmingly complex picture with a different explanation and story-line for each country. The book proposes instead a cross-country comparative framework simplified enough to avoid losing sight of the forest for the trees, but still powerful enough to explain the main forces which have driven the different outcomes of post-communist transformation in the region.

The central analytical paradigm There are two common ways for social scientists to analyse and explain different developments across countries: case study or comparative analysis.


Each has its well-known advantages and disadvantages, and I choose comparative analysis because I believe in this case its advantage – not losing sight of the forest by coming too close to the trees – is overwhelming. I show later in the book that the existing literature of post-communist transformation contains such a vast number of plausible explanations that its sum gives too many explanations (in jargon: a hugely over-determined system), hence one is quickly lost in the thicket of alternative and often contradictory explanations. Admittedly, the risk of simplification is oversimplification and reduced applicability; my approach to minimize this risk is two-fold. First, I will make country-specific references throughout. Second, I propose three explanatory factors common to all countries, but do so not in a formal mathematical model (though I do suggest how this might be done), rather as a framework or paradigm in which each of these three key determinants may themselves be explained by other factors taken from the long list of countryspecific factors. As a precursor of this framework, let me outline it in a few sentences. Consider as a mnemonic for the countries in this region after the termination of the socialist central-plan regime, the figurative paradigm of a ship setting out on a voyage; the SS Transition sailing towards a new destination, a democratic market economy. Though the nature of the final destination is well-known and there are many illustrations of it, there is no precise navigation chart based on previous sailings from socialism to capitalism, no consensus of how to get there avoiding the perils any sailing voyage or large social change encounters. Numerous country-specific and comparative analyses have been written by observers of how well this voyage has proceeded, how far along the ship has come, how much damage it has suffered in the storms of change. While accepting that for individual countries a large number of country-specific factors have played a role, I propose a parsimonious framework which, like any useful paradigm, is not a full explanation but goes a long way to explain the experience for most of this fleet of 27. The three factors are expressed in the form of hypotheses as follows: ●

●

●

the greater the intensity and time spent on debating about the right navigation chart the worse the final outcome; high proclivity of a country to fall prey to economic vested-interests results in a pirate raid by rent-seekers, and capture of the state, again a worse outcome; the accessibility of a safe-haven to escape the pirate raids or any other threats on the voyage, such as EU membership, leads to better outcomes.

The framework can be made into a formal model in the sense that the three factors individually contribute to the explanation of greater success: less debate means getting started sooner and achieving results sooner; greater rent-seeking results in less liberalization; and external commitment to a safe

6


haven like the EU pushes liberalization faster and further. The three factors are interrelated: for example chances of a pirate raid are increased by longer debates, even as they are influenced by exogenous or historical factors such as whether the first government largely excludes the former communist elite and is more committed to the dual liberal vision of democracy and open markets. Even without mathematical formalization, the framework provides at a minimum a simplifying paradigm which helps focus discussion but still allows many other factors to be included. Thus, as an example of the latter, just how early EU membership became an explicit factor in the policies of Baltic governments is not entirely clear because they certainly did not enjoy the ‘invitations’ offered early on to Central Europe until the mid-1990s. But their prior history of very reluctant adherence to socialism and the empire, as well as the fact that their incorporation into the USSR was never formally recognized by many Western powers, doubtless led to a strong desire to anchor their independence in some institutional form to Europe from the outset. That is there was a demand for membership before there was an offer. This then pointed the way to undertake early and resolute policy decisions on market liberalization; the EU ‘safe haven’ may not have been an institutional certainty, but it existed as a mental construct or vision guiding the way.

Some remarks on methodology and data A few words about the methodological approach taken in this study. My own expertise as an economist involved in the process of economic reforms in transition countries means I will naturally give most weight to economic policies, statistics, results and debates among economists. But it will be necessary to adduce analysis from the political scientists and historians who specialize in this region; it may be obvious why this is so, nevertheless let me illustrate with one point. A key strand of the heated discussions on the outcome has been whether the so-called ‘shock-therapy’ approach, or as I prefer the ‘big-bang’ approach, worked better than a gradual, piecemeal approach. In retrospect, it is clear the majority of analysts on either side of the debate do not dispute the theoretical logic of the opposing view, but rather adduce political-historical factors to argue that their approach is more realistic. Thus the critics of big-bang said that it will cause pain and a political counterreaction inimical to both democratization and economic liberalization, hence proceeding gradually would be better. The proponents of big-bang point to the role of vested interests opposed to reform who exercise their political influence while hiding behind scientific arguments of gradualism, to undermine the economic and political liberalization and diverting state assets and subsidies to their own benefit. Any analysis that ignores the political-economy of this process will surely miss the most powerful forces and explanations of the outcomes.


A few clarifications are also in order concerning the coverage and approach of the book. The first broad objective, to describe the outcome in detail and assess the benefits and costs, is not as easy as it sounds, given the many sharp differences in view about the economic performance and social impacts so far. Resolving hard debates will require a lot of detailed and seemingly arcane quantitative analysis, with conclusions which will in the end remain unconvincing to some because the data is very soft and leaves room for different interpretation. Somewhat the same problem applies to the second objective. The thesis of this book employs three key factors and their interplay as the explanatory framework for different outcomes: the choice of reform strategy at the first opportunity or ‘historical moment’; the pull of EU membership; and the influence of rent-seeking interests. These are not concepts that are easily quantifiable and therefore only soft evidence of their role can be provided. Furthermore, this analytical framework faces several diametrically opposed but deeply-rooted convictions. On one hand are those – including the majority of the population in the less successful states – who believe the whole story is simple: the red nomenklatura used their historical position of power to steal from the state and become the new capitalist oligarchs – no more, no less. On the other hand are those that argue providing the safe haven of democracy and free markets of EU membership only to geographically proximate states in Central Europe is the whole story. The book will show that while there is a lot to both these views, many exceptions exist and the causation is not linear or unidimensional. Rather both these effects plus others worked in some combination to give the final result observed for each country. The analysis relies largely on cross-country comparison rather than lengthy case studies, but many episodes from specific countries will be used both to illustrate the central tendency, and to note deviations from it. The country coverage in this analysis is limited to the non-Asian transition economies, more precisely the 27 countries covered by the mandate of the European Bank for Reconstruction and Development (EBRD). This excludes the former GDR, or East Germany, because when it became part of the Federal Republic of Germany it no longer conducted independent economic policy. The reason for excluding Asian countries is not primarily because EBRD statistical data is unavailable for easy comparison, but because I believe the circumstances are vastly different and common analysis or transfer of lessons is of limited value, for two reasons. First, China and Vietnam have remained polities under control of a communist party authority; the EBRD group all experienced a political revolution, albeit a bloodless one in most cases, with the controlling communist party initially ceding to democratic elections of varying purity. Second, the Asian economies were largely agricultural economies with huge reserves of surplus labour in that sector; almost all of the EBRD group were highly industrialized in comparison.

8


These differences allowed China to proceed on its gradual and piecemeal path to market reforms, a path – or luxury some have said – that would have been impossible for the European socialist bloc to follow and ineffective if it had been. Nevertheless, the high-profile attained by China’s strong economic performance in contrast to the output decline seen in the other non-Asian countries, plus the central role China played as an example of successful gradualism in the arguments of many analysts, makes it impossible to completely avoid a discussion of China. Therefore, in many places throughout the book, comparisons with China’s experience are made.

Judging success and failure How does one judge whether a country has been successful or has failed in the transformation process; that is, whether the benefits have exceeded the costs or vice versa? First, this cannot be a simple two-fold categorization, but rather a continuum of more and less success. Second, there is no clear-cut time horizon or end-point in which to make this judgment; transition started 15 years ago for perhaps only the four Visegrad countries in Central Europe, but began much later elsewhere either because civil unrest, political uncertainty or policy choice led to delays. The Soviet Republics were not independent until late 1991 and most of them did not make a significant beginning until about 1994–95. Yugoslav Federation Republics ended any military–civil conflicts at various times in the 1990s, and some countries like Belarus, Turkmenistan and arguably Uzbekistan to the present day have barely begun a serious transformation to the market. These different starting points must be considered in any assessment. A third consideration is how to weigh up the benefits and the costs. The serious data shortcomings are discussed in the main body of the book; I focus here on the conceptual approach to such a judgment. Measuring the benefits of renewed growth and greater efficiency raises many questions, but even more problematic is the fact that no simple metric exists to value the social costs such as unemployment, increased poverty, possible impacts on health and education delivery. Furthermore, there is no agreed-upon method for dealing with distributional questions, such as the hypothesis that the transition violated the old social contract, because some members of society were made significantly worse-off, certainly in relative terms, but also in absolute levels of material well-being. One possible approach for the last issue is to use the so-called Pareto Optimality Criterion of economists: a change results in improved well-being for society if those who gain from it gain enough to compensate those who lose. In theoretical academic analysis of economists, knowledge is generally advanced by some degree of compartmentalization of disciplines and abstractions from reality, so in the literature it often matters little if actual compensation took place as long as potential compensation to losers is possible. This


potential compensation is almost certainly feasible by now for many transition countries and approaching that state for others. But that is small comfort to losers who were not in fact compensated. In practice, to be compelling, a favourable judgment on the transition must argue compensation actually did occur or is taking place. This is again not so simple; quantitative cost–benefit analysis for the society as a whole is impossible, thus one must resort to sensible judgment. Such a judgment must also allow for delayed rather than immediate compensation, and must further be flexible (and ad hoc) in judging whether the economic losers who are not yet compensated even after a long time, may nevertheless value future economic opportunities for themselves and their children. One should also recognize that people also value the personal freedoms gained with the end of an autocratic, police state. The fact that many still vote for communist parties, which propose to revert to a socialist society with renationalization of property, suggests some citizens may not place a high value on these freedoms. In contrast, the evidence of the Rose Revolution in Georgia, the Orange one in Ukraine, and the Kyrgyz Tulip events, suggests many people do value democratic freedoms highly. In the end, I know of no other way to proceed on this assessment than sensible and well-informed personal judgment, and leave it to the reader to make a judgment as well. The main conclusions on benefit–cost results are three. First by now for countries in Central Europe and the Baltics most losers have probably been sufficiently compensated in an absolute sense by a combination of transfers and new economic opportunities. Second, and notwithstanding the first point, in some of that region, the continuing high unemployment suggests that some portion of the population has not yet received adequate compensation. Third, for countries of the CIS, the number of losers were many and they have only recently begun to enjoy meaningful compensation, though the substantially increased poverty incidence probably remains somewhat or even substantially higher than it was at the outset. Fourth, relative country performance on the Compensated Pareto Optimal Criterion tends to vary along a spectrum from very good in Central Europe and the Baltics, mixed in South-East Europe, and generally poor in the CIS group of countries.

Structure of the book Let me finally outline the contents of the book and how it addresses the three main objectives I have set. Part I, Background, addresses the first objective: describing what happened with available statistical evidence. Chapter 1 sets the stage for what is most important to seek from the statistics, with a review of the key debates in the literature about the transition process. This covers largely the economics literature, but incorporates the most relevant elements of the related literature in political science, the socalled transitology debate. Chapter 2 goes on to measure the extent of

10 Introduction and Overview

progress towards a market economy using the annual index of progress on market reforms compiled by the EBRD, which is best thought of as a policy ‘input’ intended to improve economic performance. It is shown that despite the shortcomings and many possible subjectivities of this index, it correlates very well with other ‘policy input’ measures such as the degree of democracy, media freedom, and development of institutions. It is also strongly correlated with most indicators of ‘output’ success, not only economic performance, but also and surprisingly most social progress indicators. The high degree of correlation justifies using the index in the rest of the book as a proxy indicator of progress in post-communist transformation broadly understood. The index allows a categorization of the 27 countries into five distinct groups with limited overlap and considerable within-group homogeneity. In order of transformation progress and success achieved these are: Central Europe, Baltics, South-East Europe, CIS moderate reformers, and CIS limited reformers. This greatly simplifies the further analysis without distorting it, as the broad trends can be observed and analysed for five groups rather than 27 individual countries. Chapter 3 measures the costs of transition, including output and employment losses, broad measures of social well-being, increased inequality and poverty, deterioration in health and education standards. These costs have been and remain substantial, but a hard look at these soft facts also shows that many early assessments showing dramatic deterioration were somewhat exaggerated, partly because they were premature, being done at the bottom of the transition cycle in the mid-1990s. There was virtually no disagreement in the early 1990s that the transition from a distorted and inflationary economy would create disruption, dislocation and unemployment, that is things would get worse before they got better. The many studies of economic and social conditions done in the mid-1990s showed substantial deterioration in the five to seven years of the transitional recession, but this should not have been surprising as they covered the downturn phase of the transition cycle. The present work benefits from having data for the five to seven years of the upturn, and it shows an improvement in economic and social conditions, in several cases very substantial and far exceeding the losses in the first half of the cycle. Part II of the book, An Ex Post Transition Paradigm, addresses the second objective, asking: why the different outcomes for different countries and regions, using the navigation paradigm described above. Chapter 4 elaborates on this paradigm and presents several empirically testable hypotheses that can be derived from it. Chapters 5, 6 and 7 contain the comparative empirical analysis of the relevant hypotheses for each of the three elements of the model: the debate on how to proceed, the dynamic of rent-seeking vested interests first lobbying for privileges and then in some cases succeeding in capturing the state; and the influence of potential safe-havens such as EU membership, but also others such as NATO, WTO, the IMF, the World Bank and the EBRD.


The analysis in Parts I and II forms the basis for addressing the third objective of the book in Part III, A Summing-Up, which asks what will happen next? The critical dividing line here is between those states that have been strongly captured by large economic vested interests, known popularly as oligarchies, and those that have not. This dividing line coincides closely with the one separating those countries with assured or prospective membership in the EU from those that have low or near-zero likelihood. A key question investigated is whether this is indeed just a coincidence or not. Chapter 8 focuses mostly on the captured states, considering their prospects. Most importantly Chapter 8 addresses perhaps the last but certainly not least important transition debate: for the captured states is further transformation inevitable, or has it been frozen in an equilibrium part-way to the market and democracy? Finally, Chapter 9 sums up the findings in the book, first noting the important new divide between the most successful countries where transition is virtually complete or on track, and the less successful ones where it has become stalled due to capture of the state by the new oligarchic restored interests. Two other conclusions merit emphasis: one is the overwhelming role of three factors in explaining this bifurcation: reform delays, a stronger tendency to rent-seeking under partial reforms, and the disciplining role of the quest for EU membership. Another is that any social costs were, contrary to early concerns, much lower in countries that moved on reforms early and rapidly, than in countries taking a more deliberate gradual approach. In the simplest of words, the bottom line is that the first group is already experiencing the dual vision of liberal markets and liberal democracy where capitalism is open to all, whereas the second group is characterized by restricted markets and superficial managed democracy, with capitalism being accessible only to the few.


Part I Background: Transition Debates and Statistical Facts


1 Key Debates on Transition

The search for a transition model When the World Bank undertook what was perhaps the first retrospective review of the transition process in 1996, the economics literature on transition alone was enough to result in a ‘Selective Bibliography’ exceeding 700 items. Given the lead time for academic research it is not surprising that the subsequent years led to an explosion of writings; a June 2004 internet search under ‘post-communist transition’ produced an impossible 50,000 items, and even a narrower academic works search at the University of Toronto library yielded over a hundred books, and thousands of journal articles. Anything approaching a comprehensive review has become nearly impossible, thus the aim of this chapter is much more modest but hopefully more usefully focused. On the basis of about 10 recent economic studies by recognized experts and institutions reviewing or assessing transition progress and performance, I will summarize briefly a few of the most important debates in the 1990s, and then draw attention to a handful of the most important issues looking forward. It turns out that how privatization was accomplished (regardless of how it was planned) provides an excellent link between past debates and future issues. The rest of this section discusses whether a ‘model’ or ‘paradigm’ for transition exists, as opposed to models for the beginning point – socialism – and the end-point – capitalism.1 The next section assesses the state of the main debates of the past, before moving on to focus on the handful that remain most relevant for the future. It is notable that looking-forward, an issue that was not part of previous debates, has become perhaps more important than any of the previously unresolved ones: that is whether those countries that are lagging in progress to the market will inevitably continue progressing, or remain in a sustainable equilibrium part-way to a wellfunctioning market economy. Interestingly, an analogous question has come to front-stage in the debates of political scientists about the inevitability of further progress towards democracy; the final section provides a short account of that literature. 15

16 Background

Going back to early discussions about the ‘road map’ or ‘chart’ showing the way from socialist central-planning to a liberal (and simultaneously democratic) market economy, there was a great deal of debating on the details of how to proceed with transition. Three illustrative examples are Kemme and Gordon (1990) (a Western think-tank), Zecchini (1991) (the OECD), and Clague and Reuser (1992), (an academic conference). It was very commonly said that there is no theory to guide the practical process of transition, only theories of capitalism and socialism.2 This may still be true in the sense that a new consensus paradigm has not emerged from the vast literature on transition, but I propose here that a formal unified theory is not needed to understand the main developments. To the extent it is useful to have a compact rather than complex analytical framework, it is not that difficult to cobble together from selected key writings a workable ‘model’ of transition. There are two seminal writings which when combined, suffice to provide the nucleus of a transition model: Kornai (1994), and Blanchard (1997). Kornai did not set out to posit a model, but only to describe the special circumstances of the inevitable ‘transformational’ recession compared with a market economy recession. In so doing he highlights two key actions that are needed: ● ●

forcing a move from a sellers’ to a buyers’ market (via price liberalization); enforcing a hard budget constraint (via privatization and elimination of various government support mechanisms such as budget subsidies, directed low-cost credits, and tax exemptions).

Whether intended or not, this provides the two principal changes in regime, and new behavioural incentives for profit-maximizing as needed for a market economy. Blanchard (1997) also addresses the problem of the transition recession and tries to explain it by focusing on the precise mechanisms of resource reallocation from old inefficient activities to new efficient ones. He defines the core process of actual change as comprising two elements: ●

●

reallocation of resources from old to new activities (via closures and bankruptcies combined with establishment of new enterprises); restructuring of surviving firms (via labour rationalization, product line change, and new investment).

These two changes, which are very reminiscent of the Schumpeterian concept of ‘creative destruction’, should be stimulated by the new incentives of Kornai. In the end, this process of first establishing new incentives for economic behaviour, then having economic decision-makers react to them by efficient reallocation of resources, brings the economy to a new market equilibrium with an optimum allocation in line with comparative advantage.

Key Debates on Transition 17

The combination of these four components of transition do not of course provide step-by-step guidelines for the details policy-makers have to implement, but a useful paradigm must be simple and only need provide a central framework of thinking around which the details can be logically constructed. The Kornai–Blanchard paradigm (KB) serves this purpose very well. The two most important follow-up questions are : ●

●

Is the process of resource–allocation and creative destruction necessarily ‘a thorny road’ to borrow from the title of Kolodko’s (2000b) assessment, or can it be made smoothly? How do we delineate a road-map or chart of the detailed policy steps needed; that is, how to implement the changes of KB?

The first issue led very naturally to the intense debate which rages to the present day about speed and sequencing, the choice between big-bang reforms and gradualism. An elaboration comes later in the chapter, but given the importance of this issue for social welfare (that is, how to reduce any potential pain and costs of transition) it will resurface in several places throughout this volume. Here, I will just note one point made cleverly, but I believe usefully, by EBRD Transition Report (2003) rephrasing Schumpeter to speak of ‘destructive creation’ in post-communist economies, thereby emphasizing that destruction did in practice precede creation. Could it have been otherwise, is a question addressed later.3 The KB paradigm I would consider more than sufficient on what needs to be done to achieve the goals of economic transition though not a navigational chart of how to get there. The details of a navigation chart for the ‘S.S. Transition’ specifying the key policy actions needed to put in place Kornai’s new incentives and ensure the smoothest possible process of Blanchard’s resource reallocations, are described in many works including some recommendations by Kornai (1994) and Blanchard (1997). Again the number of plans of action are too numerous to even mention, but I venture to say that the summary plan of action of the World Bank presented by Fischer and Gelb (1991) and reproduced here as Figure 1.1 serves well as a comprehensive illustration of the main elements found in most plans. Since it also provides a good illustration of the Washington Consensus (WC) ideas, it will at a minimum serve as the ‘straw-man’ for both criticism by proponents of gradualism and defence by the proponents of big-bang. The main elements of policy change include: macroeconomic stabilization; price and market liberalization; liberalization of the exchange and trade system; privatization of state-owned firms; establishing a competitive environment with easy market entry and exit; and redefining the role of the state as the provider of macro stability, a stable legal framework and enforceable property rights, and occasionally as a corrector of market imperfections.

18 Background More intense reform

Less intense reform

Macrostabilization Price and market reform Goods and services price reform Trade reform Labour market Finance and banking Restructuring and privatization Small scale privatization and private sector development Large scale privatization

Redefining the role of the state Legal reform Unemployment 0

2

4

6

8

10

12

Years

Figure 1.1 An illustration of the Washington Consensus. Reproduced from Stanley Fischer and Alan Gelb, ‘The Process of Socialist Economic Transformation’, Journal of Economic Perspectives, vol. 5, no. 4, Fall 1991, with the permission of the authors and the editors of the journal.

The early debates on the appropriateness of the WC, on gradualism v. bigbang (or as the critics but not the proponents prefer to label it today ‘shock therapy’), on the institutionalist v. market liberalization approach, and in retrospect I believe most important, the modalities of privatization – all had to do with the how. This and some other debates are discussed more fully in the next section. However, it may be useful to take off the table early the specific charges about the WC being an erroneous approach with critics saying it promotes a too-rapid approach which entails huge costs and risks of failure, and in particular fails to take account of the institutional basis needed before privatization can be successful (see for example Stiglitz, 1999, and Reddaway and Glinski, 2001. Proponents argue there was little choice in the context of the economic and political crisis facing these countries, that


the WC provides for needed flexibility on both speed and sequencing, and in the event the outcome is generally favourable (IMF, 2000). This has been in my view a debate that is so broad and so vague that it became sterile in the end. There are two main faults in the criticisms. First, the WC as a theoretical concept was very broadly cast, incorporating clearly institutional developments and long implementation times for some elements like privatization, as in Figure 1.1. Therefore, any criticism that equates the WC with shock therapy or big-bang and promotes undue speed, or that it ignores legal-institutional development is easily defended and the debate goes nowhere. A part of the problem is overzealous rhetoric starting with the insistent use of ‘shock therapy’ rather than rapid reform or at most ‘big bang’. Balcerowicz (1993) and again in (2002) clearly argues for a less-rhetorical use of words, and his main critic in Poland, Kolodko (2000a), is able to keep to the substance of their differences. An example of the sterility is the criticism by Stiglitz (1999, p. 22) that the Washington Consensus proposed ‘the use of a “shock therapy” to install institutions … [an approach historically associated with] Jacobinism … and Bolshevism’. Reddaway and Glinski (2001) in the same spirit use the term ‘Market Bolshevism’ in their title.4 Nothing in Figure 1.1 nor the detailed writings supporting it suggests an immediate or shock approach to institutions, and indeed it was always clear the rapid, big-bang approach was primarily applicable to macro-stabilization – on which Stiglitz fully agrees – and to a lesser extent on legal freeing of private ownership, and liberalization of most prices excepting some key consumer goods. This is clear in the Fischer–Gelb (1991) article, and in writings by three early implementers of rapid reforms: Balcerowicz, Klaus, and Gaidar. Balcerowicz (1993) writes: ‘market-type mechanisms were not introduced during the first stages in those fields where the necessary institutional conditions were clearly absent’. Klaus (1995) contends that gradualism v. shock therapy is a false dilemma, since ‘various measures have different time requirements e.g. price and foreign trade liberalization can be done overnight, privatization takes years to be completed. Things have to be done whenever they can be done or at least to be prepared without any delay.’ Similarly Gaidar in Havrylyshyn and Nsouli (2001) emphasizes the immediate importance of moving to a hard-budget constraint both for the government budget and for enterprises but does not insist on all other elements of reform, and indeed even for the hard-budget policies speaks of the ‘forces that could nudge [my italics] in the direction of tighter restraints on enterprises’. As the other rapid reform practitioners he clearly points not to overnight, instantaneous changes, but has a varying time-dimension for each element, much as in Figure 1.1. Apart from misstating the ‘straw-man’ position, both these major critics share another logical problem: their analysis is largely based on Russia and ignores the much more successful outcomes in Central Europe and the

20 Background

Baltics; the statement by Stiglitz (1999, p. 18) that ‘successful restructuring is rare in post-socialist economies’ is so egregious an error factually that it only serves to point out the important omission in his assessment of the successes. I will argue later that the critics are right to worry about the outcome in Russia and similar outcomes in Ukraine and the Commonwealth of Independent States (CIS) generally – the unfair, undemocratic and noncompetitive oligarchic regime with concentration of assets and power in a very few hands.5 However, their conclusion that this came from an application of ‘shock-therapy’ is a misreading: the major reason this happened in CIS countries and not in Central Europe was the insider-dominated process of privatization. The second reason the WC debate was sterile is a very simple but powerful one: virtually none of the critics argued the reforms proposed should not be done, but rather that they should have been done more slowly (as in China) or in a different sequence. The debate was largely about implementation. Furthermore the issue is now of decreasing relevance since in many countries the distance travelled means few remain at an early stage of deciding to move fast or slowly.6 If there is any historical value to continuing this debate it concerns the possible criticism that in practice the IFIs (International Financial Institutions) and other rapid reform proponents may have only paid lipservice to institution-building but pushed harder the privatization and liberalization elements, increasing the likelihood of failures or capture of the process by rent-seeking interests. This point is made by both critics noted above, and it should not be dismissed out of hand; even if one agrees that reversal of privatization is not an option, there remain possibilities for correcting the errors of privatization. In this volume, I also argue that some errors in the process of privatization contributed to the strength of oligarchic developments in many CIS countries, but while the critics’ logic goes from too-rapid reforms to ‘theft of the state’ in Russia and elsewhere, my logic is converse: too-slow reforms especially in liberalizing markets for open entry and competition is what led to oligarchic developments. On the sequencing of institution-building and privatization, the IMF World Economic Outlook (WEO) report (2000, p. 41) does put forth quietly a mea culpa, noting that while ‘the need for institutional infrastructure was recognized from the beginning … in practice it was not always given the attention it required, particularly if the macroeconomic situation appeared stable’. This does not admit the causal effect upon oligarchic developments; but the World Bank’s latest Country Economic Memorandum on Russia will doubtless be interpreted as implicitly going in that direction. It analyses quantitatively how much concentration of ownership has occurred and, rather surprisingly for an international organization report in which the country analysed is a member, it uses the journalistic label ‘oligarchs’ and names the heads of the top 23 business groups.


Principal debates of the 1990s The EBRD produces an annual transition report assessing general progress and focusing on different specific issues. In addition, many reviews with a longer backward perspective can be found in the literature. At about the mid-point of transition a number of reviews of progress were undertaken. The World Bank devoted its annual World Development Report of 1996 to the issue, an academic publication appeared in the same year, Murrell (1996), while the EBRD’s chief economist, in a personal statement, Stern (1997), also drew some lessons from the first half-decade. More recently, with 10 years of experience several other reviews have been produced. An influential piece by the Nobel Prize-winner, Stiglitz (1999), was a personal statement, though he was then Chief Economist of the World Bank. Buiter (2000) is also a personal statement from the Chief Economist of the EBRD, while the IMF’s annual World Economic Outlook (2000) focused on transition in an official statement, as does the World Bank (2000). Two recent reviews by academics are Svejnar (2002) and Campos and Coricelli (2002) which look more narrowly at the issue of recovery and growth of output in transition economies. This list can easily be made much longer,7 but the above are sufficiently representative of varying points of view (extremely critical: Stiglitz; mixed: Stern and Svejnar; and modestly positive: IMF), and certainly comprehensive enough in coverage to allow a distillation of what were the key issues of debate about transition in the 1990s. While a literal cumulative reading of these selected reviews produces a list of more than a dozen issues, it is easy enough to group these. In some cases the difference is only preferred terminology (speed and sequencing in World Bank (1996) is really the same as big-bang v. gradualism in Stiglitz (1999)). In others it is a difference in focus in the same general area (rule of law, property rights, role of government all fall under the concept of institutional development.) I propose the following eight groups of issues that capture well the most important debates, either by their intensity at the time or their stillrecognized relevance: ●

●

● ●

● ●

the debate on speed, or more evocatively big-bang/shock therapy/rapid reform on the one hand, v. gradualism/incrementalism on the other; the related debate on best approaches to privatization comparing vouchers, direct sales, insider sales; I argue below why it is critically important to include facilitation of new enterprise formation; reasons for the unexpectedly large output fall; the large difference in reform and growth performance between Central Europe and the Baltics on the one hand, and CIS countries on the other; the large social costs, rise of inequality and increased poverty incidence; the sequencing and adequacy of development of market institutions and the rule of law;

22 Background ● ●

the relationship between market liberalization and democratization; and comparison with China’s less disruptive transition.

In this section, I summarize the past discussions on the big-bang–gradualism debate, the large output fall, approaches to privatization and institutional development, while later in the chapter we look separately at the link of democracy and market reforms. The remaining debates are addressed in other chapters of this volume: differential progress in transition and growth performance across the countries and in different regions is the subject of Chapter 2; Chapter 3 provides a comprehensive and updated analysis of statistical indicators showing social costs, inequality and poverty; the relevance of the Chinese experience is considered elsewhere. Before elaborating on the above list of issues, let me mention briefly a few others that are discussed in the literature but do not merit elaboration, either because the consensus on them is widely shared, or because they have in the end not been central to the transition. The need to achieve macroeconomic stability and reduce inflation quickly is virtually universally agreed; the sharpest critic of the Washington Consensus, Stiglitz (1999), clearly says he has ‘no great quarrel with shock therapy to quickly reset expectations in an anti-inflationary program’ (1999, p. 22). At the margin, some issues of degree remain, but are not central to the overall agreement. Thus, political scientists as in Reddaway and Glinski (2001) will occasionally express ambivalence, supporting inflation control, but arguing that a better policy than closure of inefficient enterprises was to continue providing credit for old industries until they could be restructured. In the economics literature one sees an early debate stimulated by the Polish big-bang, about whether monetary tightness was not too heavy-handed or lasted too long, causing a credit crunch (see for example Calvo and Coricelli, 1993, and later Kolodko, 2000a). The need for substantial integration into the global economy and diversification outside the socialist camp through liberalization of trade and financial flows was commonly expressed, but again there was little debate on its general desirability. Furthermore, the reality was a liberalization far faster than previous developing country experience,8 and a geographic reorientation of trade that far exceeded early expectations.9 The importance of reforming the financial sector into a market-oriented intermediation mechanism linking savings and investment is a similar issue drawing much attention but limited debate on the broad substance. As with the previous two, there was a broad consensus on the importance of financial-sector reform, including a vast operational literature on dealing with non-performing loans, achieving international norms for bank-supervision standards and developing the capacity of banks to assess business lending (for example Bokros, in Havrylyshyn and Nsouli 2001). I do not wish to suggest there were no differences on the details of how to privatize banks, the role of


foreign investment, the balance between restructuring and bankruptcy; but these discussions never took on the intensity and importance of the other debates discussed here. Another reason beyond the high degree of consensus may be that the relatively shallow nature of the banking sector in most economies meant that for now, ‘lack of bank-finance does not seem to prevent private-sector growth’.10 Big-bang v. gradualism I have argued above that wide-sweeping condemnations of the Washington Consensus have not contributed usefully to the debate on transition policies; it is better to break down the issues into narrower and manageable ones. The first of these concerns speed, or the choice between gradualism and bigbang, although even this is made difficult by differences in definition and interpretation. While no-one to my knowledge proposed doing everything at once, there is certainly a useful distinction between advocates of seizing the moment of political opportunity and implementing the major feasible changes as quickly as possible, in a big-bang – Balcerowicz, 1993; Klaus, 1995; and Sachs, 1994 – and those who caution a more gradual approach to minimize disruptions, output and job losses and consequent reversal of political will – Aghion and Blanchard, 1994; Dewatripont and Roland, 1992. The institutionalist view argued in Murrell, Clague and Reuser (1992) lies in-between, admitting the need and usefulness of moving rapidly on stabilization and liberalization but cautioning that institutional developments have to begin in parallel and be sufficient to ensure the intended benefits of market reform. It is notable that the final aims of the different approaches are the same, as is the concern for minimizing disruption and avoiding political opposition to reforms. Much of the argument for a more gradual approach has been conducted using theoretical models, and as remarked by Aslund, Boone and Johnson (1996) there is somewhat of a dichotomy in the literature: theoretical analysis tends to conclude gradualism is better, while empirical analysts find that early and quick reforms result in an earlier and stronger recovery. This latter is confirmed in a review of econometric studies of growth (Havrylyshyn, 2001; Campos and Coricelli, 2002).11 In addition, as noted earlier, there were theoretical doubters of gradualism models, showing in effect that they are not very robust. Katz and Owen (1993) develop a model of optimal privatization speed which maximizes output under constraints on unemployment and re-employment, and conclude that it is never optimal to privatize instantaneously, but it may be optimal to begin rapidly then taper off, or even the reverse, begin slowly and accelerate. The outcome of the model depends on various assumptions about elasticities of response to new incentives both by state firms and newly privatized ones. In a later work, Katz and Owen (2000) show explicitly that the type of gradualist model exemplified by the seminal work of Dewatripont and

24 Background

Roland (1992) ‘may be viewed as lending strong support to the big-bang strategy’, depending on the values assigned to certain parameters of the model. The most balanced view comes in Blanchard (1997) who models the process of reallocation taking care to consider the unemployment effects of shifting labour from the state to the private sector: I have not come up with a simple list of good or bad policies or a simple judgment as to whether big-bang policies are better than gradualism … Our models rarely generate such simple messages [because] analysis of transition is very much an analysis of second-best and comes with typical attendant ambiguities. One such ambiguity Blanchard’s analysis comes to is very striking in retrospect: ‘the analysis strongly suggests that carefully designed [my italics] insider privatization is the best way to achieve restructuring of state firms in the long run’. This is diametrically opposed to the most recent consensus on effects of privatization which suggests that insider privatization increased the likelihood of concentrated ownership and the strengthening of rentseeking interests; the cases of Russia and CIS oligarchs are the clearest examples, but even the Czech privatization while appearing to be voucher-based was in fact highly dominated by insider procedures and is judged by many observers to be an explanation of the poorer performance of the Czech republic within Central Europe (Svejnar, 2002). The reason the model can produce this result is twofold: its simplifications assume agency problems are avoided by insider privatization compared to the mass-voucher based process; and the potential for generating concentration and rent-seeking is not part of the model. Attempts at empirical analysis asking specifically if big-bang cases tend to come out better than gradualism cases are limited and with ambiguous results, probably because it is not a simple matter to define these concepts in practice. There are three possible definitions of big-bang: early start after the dissolution of communism; rapid reforms once started; or a cumulative level of reforms reached after ‘x’ years. With GDP growth as the ‘outcome’ measure, Heybey and Murrell (1999) use the last definition and find speed does not help, while Berg et al. (1999) use the first and find it does. The bulk of econometric evidence on growth in transition until the late 1990s concludes that the cumulative level of reforms reached is a key determinant (see the reviews by Havrylyshyn, 2001, and Campos and Coricelli, 2002), with Central Europe and the Baltics showing much earlier recovery and faster growth than the CIS. This is consistent with an early start and if ‘x’ is defined as about five years also consistent with a cumulative reform definition. But if growth rates since 2000 are considered, the relationship seems to reverse, since the CIS with reform attainment as measured by the EBRD still far


behind Central Europe, has had much higher growth rates. One possible explanation is that what really matters for growth, as such, is the eventual attainment of a certain threshold level of market reforms, which implies that gradualism in the sense of a late start is not an impediment for eventual growth recovery, though of course the output lost before the start is higher. The threshold hypothesis and other explanations are explored further in Chapter 2, but here it should be noted that even if long–run output growth is not worse under gradualism, a late start can result in the undesirable outcome of state capture; indeed a central thesis of this book is that this is precisely what happened in the 1990s. A different argument on the gradualism side is that a too early or too rapid start causes a lot of decline in output, job losses and other social costs. The theory on this is easy enough to imagine and again with the right assumptions about the process of reallocation and unemployment–reemployment dynamics can easily go both ways. The realities, as Chapter 3 will show, suggest early starters in fact suffer less of these costs than late starters. A succinct assessment of this debate’s relevance using the case of Bulgaria is found in Bristow (1996) and is worth quoting at length: what has happened in the past five years adds up to serious macroeconomic trauma … was it all necessary? … Some of the real depression could have been avoided if trade liberalization had not been instituted so suddenly and if monetary policy had given a lower priority to the control of inflation. Inflation would have been less explosive … if a more gradual approach … to the liberalization of prices. However, if macroeconomic reform had been more gradual and if monetary policy had been concerned more with the fall in output … restructuring would have been delayed even more … There is thus no real trade-off between macroeconomic and microeconomic objectives. Those who claim that ‘shock therapy’ is all shock and no therapy fail to recognize that the therapeutic results do not inevitably follow the shock. The unpleasant macroeconomic medicine is designed to assist economic reform: the latter is not something which happens automatically if … Bulgaria’s problem is not so much that there has been a dramatic decline in living standards, but that the suffering will have been in vain if reforms at the more microeconomic level do not take place. On balance, the case for gradualism has been weakened in recent years by several counter-arguments. First, the mathematical models of gradualists have been used to derive the opposite conclusion: under certain conditions big-bang is theoretically the best strategy. Second, the evidence on growth at least until 2000 is more consistent with the rapid-reform view. Third, the evidence on social costs shows they are smallest for the early and rapid reformers. Fourth, the evidence on rent-seeking phenomena suggest a late start and

26 Background

gradual reforms increases the probability of state capture. This may not affect medium-term growth prospects but does affect long-term economic and political stability as well as democracy. Two important arguments remain in support of gradualism. The surge of growth in the CIS may with time result in an overall recovery that is greater than in Central Europe with its much reduced growth rates, and this may also lead to a reversal of the dominant oligarchic power in the CIS. Time will tell, but it is ironic how the tables have turned: in the mid-1990s proponents of gradualism criticized the high costs of rapid reform, while those on the other side of the debate asked for time to pass to see the recovery effects; now gradualists may be needing time to pass before the lagging reformers return to the right path and achieve equivalent results. The second major argument in support of gradualism remains the same as it has been from the start, the much greater and smoother success of China. As noted, this will be dealt with later in the book. The large output fall That output would fall in the initial years of transition was widely predicted. Kornai (1994) explicitly titled his article ‘The Transformational Recession’ and argued the key reason was the need to squeeze out inefficient production in the soft-budget state sector. Bruno (1993) discussed why the process of macro-stabilization after a growth crisis seen in previous emerging-market crises – especially in Latin America – would repeat itself in the early years of transition. But that output would fall so much was not predicted. Thus, Bruno admitted that even if the fall was exaggerated by soviet accounting’s overstatement of earlier GDP, ‘the extent of the post-1989 collapse has no precedent elsewhere’. The unexpectedly large decline continued to be an important element of gradualist criticism despite the clear evidence by the late nineties that those economies which reformed earliest and fastest declined least.12 Consider some of the reasons for this large output fall, which are most usefully summarized in Campos and Coricelli (2002). Chapter 2 will consider the possible overstatement noted by Bruno, but the analysis there will still show that, at a minimum, output fell at least 20 per cent in the case of Poland, about comparable to the magnitude of US decline in GDP after the Second World War: in all other countries it was higher. The major explanations put forth in the literature are: ●

●

●

a Keynesian decline in consumer demand associated with stabilization measures; trade disruption with the end of the Council for Mutual Economic Assistance (CMEA); hard-budget effects remove incentives for production of negative valueadded goods and allow the reallocation of resources through creative destruction;

Key Debates on Transition 27 ● ●

excessive monetary tightness leading to a credit crunch; and disruption of soviet period supply links (sometimes labelled as ‘disorganization’).

Campos and Coricelli (2002) are no doubt right to say pure Keynesian effects were far less important than supply-side phenomena, though their claim that in emerging markets stabilization programmes were not associated with significant output decline is wrong. Bruno (1993) was cited earlier to suggest that a more than minor decline did indeed typically follow stabilization; the output reductions in the 1990s crises of East Asia and Latin America were also substantial (ranging from 10–15%) even if quickly reversed. The second and third points above are not unrelated to the first: hard budgets coming from proper pricing of unwanted goods (including the hidden distortions of CMEA barter trade), plus cuts in subsidies from the budget, in effect reduce demand for the output of inefficient firms (not just consumer demand) and achieve the desired reductions of inefficient output as needed for resource reallocation. The supply-side phenomena that were most important are the new hard-budget policies and the disorganization effects as soviet supply links are only slowly changed to market-based links. The disorganization model of Blanchard and Kremer (1997) has tested well in empirical studies, such as Commander and Coricelli (1995), and in the review of labour market flows in the transition by Haltiwanger et al. (2003). Notwithstanding the view that earlier reformers recovered earlier, and that the laggards experienced a much longer period of reorganization, a reasonable conclusion is still that the process of reorganizing new supply chains and markets took longer than may have been expected. In this regard Bruno (1993) was understatedly prescient: ‘while there is a lot to learn from the reforms of distorted subsystems in other economies, it makes a world of difference if almost the whole economy is centrally controlled, non-market and publicly owned … and where a market economy has to be created ab initio’. The credit-crunch hypothesis first gained prominence in Central Europe, including an intense debate on this for Poland, where critics of the Balcerowicz programme argued the degree and duration of monetary tightness was excessive and resulted in a bigger recession than needed for the hard-budget effects (see Kolodko, 2000a, Calvo and Coricelli, 1993). With Poland experiencing the least amount of decline and having the earliest recovery this seems in retrospect like a marginal debate, valid as the argument may be. Indeed, to argue that Poland was ready for a loosening of monetary policy within 18–24 months of the 1989 big-bang implies the conviction that hard-budget constraints were solidly in place. The issue of when stimulative policy, monetary or fiscal, can be put in place in a transition economy is in fact an understudied question. The dilemma is simple: on the one hand stimulation if it works can go a long way to minimize output decline and lead to recovery; on the other hand, if stimulation occurs too early – or the

28 Background

worst case if it occurs by subsidies broadly-writ (directed credits to enterprises, tax breaks, tax arrears) – it will undermine the effort to impose a hard-budget mentality on producers, and inefficient negative value-added production will continue. There is no consensus on the reasons for the excessive output decline, nor indeed for how excessive it was. This last point is examined again in Chapter 2 where it is shown that the official estimates may exaggerate the magnitude, but that there is no doubt it was historically very high. On the reasons for this it is at a minimum clear – and again Chapter 2 gives the details – that the magnitude of decline was greatest for countries with slower progress in transforming their economic systems. How to privatize With the possible exception of Belarus under Lukashenka, and Turkmenistan under Niyazov, there was a universal consensus that transition needed a substantial increase in the share of the private sector, hence a large transfer of ownership of state assets into private hands. The very first conclusion to draw about this debate is that the emphasis was too much on the process of state asset disposition, or ‘denationalizing’ ownership, and too little on establishing conditions to stimulate de novo enterprise-formation. Indeed, the term privatization has become nearly synonymous with the process of state-asset disposition, though it would be better to think of the needed change more broadly, as private-sector development. It is too late to use the term privatization in the broader sense, and too awkward to employ the phrase ‘state-asset disposition’ to refer to the transfer of assets to private ownership, but readers will be able to infer which use of ‘privatization’ is intended. The voluminous new empirical literature on the consequences of privatization has come to recognize the distinction, and also to provide tentative conclusions on three key questions: What is the optimal method for state-asset disposition? Has privatization led to the expected efficiency improvements? Where high concentration of ownership occurred has this been good or bad? The choice of technical method for disposition of state assets dominated the discussions on privatization for most of the decade, with various positions being taken on the advantages and disadvantages of mass privatization by distribution of vouchers, direct sales to outsiders, and preferential sales to insiders, that is management and workers.13 The dilemmas addressed included fairness, speed of the transfer, usefulness of prior restructuring, prospects of early efficiency improvements, and, related to the last, ‘agency’ problems – that is, avoiding the situation where new managers act not in the interest of profit-maximizing owners, but in their own interest. These issues were correctly considered to be of limited importance for small state enterprises (retail outlets); hence the discussion was focused on large scale entities. Each of these methods had some advantage over the others: mass voucher privatization was thought to be the fairest, and could be implemented


relatively quickly. But in practice, as described in Havrylyshyn and McGettigan (2000) and Svejnar (2002), very imperfect secondary markets for vouchers developed leading to low-cost vacuuming up by poorly regulated institutions, or by a few embryonic capitalists with insider knowledge. In the former case, fraud pyramid schemes undermined public support as in the Czech Republic (Harvard Fund), and in even greater degree Albania and Romania. In the latter cases, especially relevant to Russia, Ukraine, and other CIS states, this allowed insiders to obtain assets at far below potential value, and has been seen by the populace and outside observers as legalized theft (Freeland, 2000b). In addition, as Svejnar (2002) notes for the Czech Republic, Slovakia and Lithuania, where in some cases large amounts of shares were retained by individuals, this meant a wide dispersion of ownership and a consequent poor-governance situation allowing ‘managers or majority shareholders to “tunnel out” assets at the expense of minority shareholders’. Insider privatization was thought to allow very speedy transfer, and immediately provide a group of owners and managers with a strong stake in improved efficiency. In practice, this method too was often abused, as managers in effect controlled the workers’ shares given the inertia of the relationship in the soviet period, and thus two problems arose. First, a potential for excessive concentration of control if not actual ownership (as described in Barnes, 2003a, in a comparison of Hungary, the Czech Republic and Russia; and World Bank, 2004, for Russia). Second, agency problems as controlling insider managers were able to tunnel-out assets at the expense of worker-owners and any outside shareholders. Sales to outsiders was considered to be very slow, and of course unfair to the population, but it had the advantage of avoiding the corporate governance and agency problems that both of the other methods suffered from. While in practice almost every country used some combination of the three methods, there are discernible tendencies to concentrate on one type; Svejnar (2002) even sees ‘remarkable differences across transition countries in the strategy of privatizing’. Havrylyshyn and McGettigan (2000, table 3) does suggest that outsider sales were the major tendency in Estonia and Hungary, and these cases are generally judged to have had far better outcomes than others. As Svejnar concludes, this ‘provided much-needed managerial skills, external investment funds, generated government revenue, and effective corporate governance, and turned out to be relatively fast when carried out by determined governments’. This seems to point to outside sales being more effective in practice than either voucher or insider buy-outs, both of which can lose their advantages if the process is captured and abused by insiders or fraudulent financial operators. But if one considers the result of outsider sales in Russia (Barnes, 2003a, 2003b; Frye, 2003; Stiglitz, 1999), starting with the loans-for-shares arrangements of the mid-1990s (and the later outsider sales in Ukraine: Aslund, 2002; World Bank, 2000), the conclusion is much weakened. The governments

30 Background

may have been insufficiently ‘determined’ in those cases, or more likely determined but already captured by the wealthy new potential purchasers. One cannot characterize Ukraine and Russia as cases of rapid mass privatization via vouchers; yes, there was a lot of that but it was subverted by the vacuuming process, and in any event as World Bank (1996) recognized, ‘Russia’s mass privatization program of 1992–94, although it used vouchers, was basically a case of management-employee buy-out because of its preferential treatment of managers and workers’. Furthermore, as Barnes and others describe, there were later a lot of direct sales, in particular to banks in the loans-for-shares exercise (some readers will doubtless replace the word ‘exercise’ with ‘scandal’). In the end, the choice of method has turned out to be far less important than two other, related, characteristics of the process: the transparency of information and process; and the role of political insiders who formally or informally influenced the mechanism of implementation, and at the same time were in a position to be the new owners. If one uses insider in the broader political sense, the larger their role, the more likely transparency did not prevail, and as a consequence any one of the technical methods could be subverted to the interests of these insiders. Conversely, the less insider influence, the more successful privatization regardless of method. Thus we see now all of the Central European and Baltic countries with a fundamentally good outcome, despite the fact that Poland and Slovenia delayed the process for a long time then used some combination of sales and vouchers, or that Latvia and Lithuania relied relatively more on vouchers than did Estonia. The efficiency effects of privatization can today be assessed on the basis of a large number of studies both at the country and firm level; the conclusions here are based on three review articles which summarize well over a hundred empirical studies covering a large proportion of the transition countries and thousands of individual firms: Havrylyshyn and McGettigan (2000); Nellis in Havrylyshyn and Nsouli (2001); Djankov and Murrell (2002); and Haltiwanger, Lehmann and Terrell (2003) who focus on job-creation effects. The vast majority of studies find that private firms have greater productivity, faster growth and generally create more jobs. The effects appear to be much stronger in transition economies than in the earlier experience of other countries, which is reviewed by Megginson and Netter (2001). Some doubts remain, as there are important studies which do not support this conclusion, but these, like Earle and Estrin (1997) for Russia, tend to be earlier ones when the period of time was perhaps too short for a good assessment, especially outside Central Europe. Also, it is not always clear as Svejnar (2002) notes that major sampling and data problems, for example ‘cherry-picking’, have been adequately addressed. Some individual studies do account for cherrypicking and some but not all find positive effects. Thus, despite the uncertainties, it seems difficult to ignore the sheer magnitude of the tendency in the econometric studies, which as the extensive review by Djankov and


Murrell (2002) puts it: ‘privatization is strongly associated with more enterprise restructuring’. The studies also show a strong consensus on the rank-ordering of efficiency effects according to the type of firm. The highest are de novo firms, small and medium-scale firms are next, large privatized ones follow, and the least efficiency improvement is found among state-owned firms. This carries an important implication: new and small firms are the most likely source of growth in the transition process, much as they have been in development experience earlier. Such a finding vindicates those who advocated at the outset putting more emphasis on new development of the private sector and not so much on disposing state assets; see for example Krueger and Winiecki’s comments in Clague and Reuser (1992). The reasons for the key role of de novo firms are elaborated in Havrylyshyn and McGettigan (2000). With no vested interests to protect, these firms are more likely to be highly energetic and innovative supporters of more liberal open markets as well as even-handed rule of law. Initially, they will operate in low capital-intensity areas thus creating more jobs, and they will not count on government support or privileges simply because they cannot get them. Given that the new, small sector is still very small in many of the transition economies outside Central Europe and the Baltics, the lesson here still has tremendous relevance for the future. One other important finding deserves attention, even though it is based on a relatively small number of studies: the interplay of ownership per se, and the market environment facing firms. A key article by Zinnes, Eilat and Sachs (2001) uses cross-country analysis and index measures of institutions such as degree of competition, openness to entry, the quality of rule-of-law, to show that it is the combination of markets and competition which leads to efficiency improvements, while private ownership alone has virtually no effect.14 Recall Stiglitz’s phrase ‘There must be both competition and private property.’ The issue of general institutional improvements has in fact come to the fore since the mid-1990s as an under-emphasized dimension in transition policy, and it is furthermore linked to the problem of excessive concentration of ownership discussed next. While it makes sense to focus on efficiency improvements as an empirical measure of how well or badly privatization has gone, there is another outcome that for the long run may be equally important: the degree of concentration of ownership, or the ability of a small number of new capitalists to influence state policy. Those who criticize strongly the results of privatization no longer generally deny the measured efficiency gains, rather they focus on the nature of the economic and political organization that is generated. The positions of major critics of transition so far was outlined in the first section of this chapter, where I argued that their full-frontal attacks on the Washington Consensus are mistaken or misplaced. But there is considerable merit to the part of their arguments which contend insider-dominated privatization has been neither good for the economy nor the polity, it has been unfair and

32 Background

undesirable, and does not augur well for future prospects. A large number of empirical studies, some qualitative, some quantitative, provide evidence on how insider-oriented processes of state-asset disposition tended to result in ownership concentration, creation of oligarch groups, and eventually state capture by these vested interests. Thus Barnes (2003a) compares Hungary, the Czech Republic and Russia, explaining in great detail how in the latter the insider mechanisms worked, how they were explicitly advocated by many reformers inside and outside the country to ensure co-optation of the Soviet-period directors to achieve a speedy transfer, how the new banks played a role in this and in fact often became the majority owners, and how in the end this led to the concentration of ownership in the hands of about two-dozen clearly identifiable individuals heading enormous business groups. Barnes includes a useful discussion of the ways in which these ‘oligarchs’ currently influence policy ensuring it is favourable to them and protects them from potential competition, internal or external. Acquisition of upstream or downstream companies – steel companies acquiring coal – mines or export ports – not only defends against competition, but often allows regional power concentration which in turn provides political leverage through bribes, campaign financing, threats of closure, job cuts. A revolving door of personnel from top positions of industry to government and back permits economic interests to influence or even draft laws and decrees pertinent to their business. More recently a World Bank (2004) study on Russia not only gives a list of ‘oligarchs’ remarkably similar to that in Barnes (2003b), but argues in great detail and with considerable supporting empirical evidence ‘that concentration of ownership in the hands of a few major players can result in collusion, create barriers to entry, and eliminate healthy competition’. The forcefulness of the conclusions and the explicit naming of names by an international institution like the World Bank is unusual enough to also speak volumes. The possibility of rent-seeking interests acting against the greater good of the society is not a new concept in economics. As a general proposition, it was thoroughly explored in theory and practice by Krueger (1974). It found its most elegant expression for transition economies in Hellmann (1998), who wrote about how the ‘winners’ – the new capitalist class which in fact arose most often from some part of the former communist elite – dominated the process of taking over ownership of state assets and used this economic power as a lever to capture the mechanisms of the state and polity. The potential for this was recognized earlier with more or less clarity in the warnings about asset-stripping in the late 1980s (Clague and Reuser, 1992), or concerns that newly established rent-seekers opposed to full liberalization would control policy and ‘freeze’ the transition (Havrylyshyn, 1995). This, more than any other aspect of privatization should in my view become the most important issue for discussion looking forward. The oligarchic outcome of insider-privatization in Russia, Ukraine and many other countries has resulted in a high degree of state capture; this


process is described in more detail in Chapter 6. Such an outcome has also been used by critics of rapid reform to buttress their argument, I believe incorrectly. Reddaway and Glinski’s (2001) central thesis may be summarized as saying that the effort to impose ‘shock-therapy’ (their term) was bound to fail as preexisting nomenklatura interests would subvert it in their favour. In the same vein, Murrell (1996, p. 42) argues that having failed in 1992 with a precipitate stabilization and liberalization, Russian reformers ‘… gambled that privatization is a sufficient condition for all other reforms’. The implication of a causality running from big-bang to vested interests pursuing rents and eventual ownership concentration through insider-privatization is also clear in the argument of Stiglitz: ‘corruption and rent-seeking itself may have been increased by the manner in which reforms were conducted’. The problem with such logic is two-fold. Conceptually, it must deal with the established rent-seeking literature’s consensus that it is precisely too-slow rather than too-fast reforms that increase opportunities for vested interests to act, both because distortions remain allowing high rents, and because more time is given to them to lobby against reducing those distortions. Empirically it must deal with the fact that, even if Russia is considered a case of rapid-reforms, only one other CIS state where state capture took place can be so labelled – Kyrgyz Republic – while all the others pursued a gradual strategy. The vast majority of the rapid reformers in Central Europe and the Baltics, which did pursue rapid reforms, avoided the worst of the insider privatization, oligarch-economy situation. Indeed for Russia it can easily be argued that the big-bang of 1992 was at best very short-lived and soon aborted, and it was its reversion to gradual and incomplete reforms that led causally to insider privatization. To summarize briefly on privatization, consider the three questions put at the outset. First, there is no one technical method of privatization that has worked better than any other, because the dominant determinant of outcomes has been the degree of non-transparent political insider influence in the process. Second, all forms of privatizing appear to have some beneficial effect in efficiency, but in a clear rank-order starting at highest: new enterprises, small and medium enterprises, large enterprises, and still state-owned ones. An important related conclusion is that private ownership alone has a limited effect, but adding a favourable institutional and competitive environment gives much greater results. Third, a high degree of ownership concentration may not in the short run preclude improved efficiency, but in the long run it is problematic if it leads to state capture by a handful of powerful business groups, or oligarchs. Development of market-enhancing institutions There is so much agreement that institutions matter in developing an effective market economy15 that the debate on this, if not properly focused, can degenerate into sterile straw-man accusations. Reference to good market institutions, government regulations and a strong legal system is to be found

34 Background

in virtually all early writings on how to undertake transition, hence debating whether the Washington Consensus road-map did or did not exclude institutions is not very useful: conceptually it did so very clearly. Arguments that institutional development should have preceded liberalization and private-sector development are only useful if very narrowly focused on precise sequencing of specific elements of reform and specific types of institutions. The institutionalist approach, as North (1993 and 1995) and Murrell (1996) note, is based on the historical lesson that it took decades if not centuries for property rights and related institutions to develop. If this argument is put too broadly it is unrealistic in practice as it implies waiting until institutions are in place. Thus, the broad criticism of Stiglitz (1999) is not helpful, while narrower analyses that demonstrate which specific institutions creating a competitive environment to ensure transfer of ownership has beneficial effects (Zinnes, Eilat and Sachs, 2001) can provide specific and implementable recommendations. Also useful are the criticisms, whether right or wrong, that suggest too little weight was given to institutional development in the early period, as in Moers (1999) and IMF (2000). The lessons of recent history on the role of government and the development of institutions are explored very thoroughly in the World Bank’s 2002 World Development Report, not only for transition economies but other developing countries. The somewhat surreal agreement by all observers that institutions matter in the transition hides the important differences, which can be summarized in two categories: ●

●

What are the most important market-enhancing institutions needed; that is, is there a minimum critical mass? Should they be developed before, during or after the main steps of stabilization and liberalization?

As there are many relevant institutions, it is not surprising there would be disagreement on relative importance and sequencing. The list of institutions or institution groups given in the World Bank (2002) study, and the analysis there, does suggest there are some that should be very early, some that can be developing simultaneously with introduction of specific reforms, and others which can be allowed to evolve and respond to the market’s needs over a much longer period. The first category would surely include preexisting elements such as the state’s ability to enforce basic law and order, but also new elements such as a market-oriented laws and government agencies: a Central Bank, a Finance Ministry that enforces budget discipline, regulatory agencies for enforcing codes of commercial behaviour, an anti-monopoly regulator. The second category is exemplified by the link between, on the one hand, privatization and freedom of private-sector activity, and on the other the


legal basis for secure property rights plus ensured competitive behaviour. Without a legal basis of property rights, new owners will be very cautious about engaging in new ventures, expanding output and employment, and so on. In some countries this was established very early, with, in cases like Poland and neighbours, a smooth reintroduction of pre-communist commercial codes by 1991–92, while in Russia, Ukraine and most other CIS countries new laws allowing free enterprise coexisted for some years with Sovietperiod laws deeming it illegal until about the mid-1990s. Ensured competition and open entry are needed to avoid monopolistic behaviour which can limit the benefits of the transition from socialist to private ownership, as many have by now shown. This was much more of a problem, partly because of delays in introduction of laws, and partly because of ineffective application of laws. This last merits a separate discussion below. Other links in the second category include introduction of a commercial adjudication infrastructure for disputes, bankruptcy and so on. That this need not be fully in place before private activity begins, is illustrated by the case of Lithuanian judges in new bankruptcy courts who had no experience and no fully developed regulations on how to apportion creditor rights. They proceeded by a combination of trial and error, learning about procedures used in Western Europe, participating in training opportunities offered by external technical assistance, and recommending to their government adjustment to the laws on the basis of early experience. An analogous process occurred in all countries with tax reforms, with gradual introduction of new forms of tax (value-added tax, property tax, lump-sum taxes at first for small entities like bazaar-merchants), and new regulations concerning timing of payments, declarations of income, refund procedures for exported goods, penalties for late payments, and so on. Very few countries even in Central Europe were able to put in place a complete set of tax laws and regulations before at least the mid-1990s, and most continue with refinements. That all have seen significant economic recovery leads to the conclusion that the process of developing market institutions can be symbiotic with expansion of private market activity and does not need to precede it. There may not be clear examples of institutions that are fully postponable until after the basic reform steps are done; a more useful distinction is between having a basic and simplified legal-regulatory framework in place as the new market regime begins operation, and refinements of these regulations over time. It is therefore an ad hoc judgment to be made in each situation what the basic minimum may be, and how soon the refinements take place. In retrospect, it is clear that most of these economies proceeded along such a path, albeit at different speeds. The Central Europe group moved fastest using two vehicles: in the early 1990s reintroduction of pre-communist laws, in particular Commercial Codes or copying from Western European examples. This was the case in Poland and less so in the Czech Republic, Slovakia, Latvia and Lithuania, from the mid-1990s implementing the chapters of the

36 Background

Acquis Communautaire in their efforts to accede to EU membership. The countries of the CIS – with some exceptions such as Armenia’s land laws – moved much more slowly, intermittently introducing new autochthonous laws and abolishing Soviet ones. But this speaks only about the laws on paper, not about the effectiveness of their implementation. It is a widely held view of Kremlinologists that the USSR in particular, but also the satellites, were states in which informal legalities were far more important than the paper laws. Thus, republics of the USSR were constitutionally free to secede from the Union, but that none did so before 1991 and all did after that cannot be interpreted as a sudden mass conversion to secessionist desires. Similarly, private economic activity was largely banned, but as Handelmann (1994) elucidates, the existence of underground economic activity and a ‘soviet-mafia’ well-known to the authorities yet largely untouched speaks volumes about what the real law was. Until recently, economists have paid limited attention to the informal institutions which political scientists have long studied; but in the transition debates it has come to be recognized the issue revolves around the effectiveness of implementation, not the paper laws. Recognizing this analytical work on the level of institutional development in transition rarely measures this by the existence of legal text, but rather tends to rely on subjective perceptions of the effectiveness of different categories of institutions. Early compilations of such synthetic indicators of market institutions come from Freedom House and the Heritage Foundation, and Transparency International with its narrower corruption index. More recently, a comprehensive compilation of various sources and some new indicators have been put together by the World Bank (Kaufmann, Kraay and Zoido-Lobaton, 1999) and continue to be updated in annual surveys of the business or institutional climate. Weder (2001) uses such data to assess the degree of institutional development in the region, and Table 1.1 summarizes the results. Clearly, only Central Europe and the Baltics are beginning to approach the levels of advanced market economies, but many of the countries in South-East Europe and the CIS were by the late 1990s already comparable to developing market economies in the middle and lower range of institutional development. What does this tell us about the debate on the role of institutional development: were there damaging delays in putting in place effective institutions? And were there some particular institutional elements that were critical? The values of Table 1.1 are good evidence that outside of Central Europe and the Baltics, institutions still lag far behind desirable levels, confirming the concerns of critics like Murrell, Stiglitz and many political scientists as discussed above. But in a cross-country comparison to be elaborated in Chapter 3, it becomes clear that the pace of institutional development is broadly related to the pace of economic reform which is not consistent with the conclusion that rapid reform went too far ahead of institutional changes.

Key Debates on Transition 37 Table 1.1 Quality of institutions in transition economies 1997–8 Average value of index(a) (Range ⫺20 to ⫹20) Central Europe(b) Baltics South-East Europe CIS Moderate Reforms CIS Limited Reforms Average Industrial Countries

6.0 4.0 2.8 6.1 10.3

Developing countries in same range Chile, Korea, South Africa Uruguay, UAE India, Lebanon, Pakistan Peru, Burkina Faso, Guatemala Kenya, Haiti, Laos

12.6

Notes: (a) The Weder index is a composite of five governance indicators from the World Bank data base noted in text. (b) The country groupings are elaborated in Chapter 2 and reflect approximately the degree of progress to market economy status. Central Europe includes: Hungary, Poland, Czech Republic, Slovakia, Slovenia, Croatia, Baltics, Estonia, Latvia, Lithuania. South East Europe: Bulgaria, Romania, Macedonia, Albania – no values are available for Bosnia–Herzegovina or Serbia–Montenegro here, but these countries are included for other data tables. CIS Moderate Reforms: all CIS except Belarus, Uzbekistan, and Turkmenistan which fall in the group CIS Limited Reforms. Source:

Author’s calculations based on data in Weder (2001).

An alternative stylized fact is that where there was an ability to move fast on economic reforms, there was a parallel capacity to move quickly on supporting institutions. When one turns to the issue of isolating critical institutions that may have done the greatest damage if missing, or the biggest contribution if in place, the answer seems to be: a minimal degree of property-rights security, and a liberal free-entry environment equal for large and small enterprises. This can be seen referring back to the discussion on private-sector development. The evidence points to several stylized facts. In most of the Central Europe and Baltic (CEB) countries, early establishment of property-rights regulations and, more importantly, the perception that this was applicable to small new units, led to a boom in entrepreneurship and contributed importantly to the early recovery. In contrast, the uncertain environment in other countries drove any embryonic new capitalists underground,16 and discouraged them from becoming so large as to show their heads above the surface. Furthermore, the weak property rights plus great administrative barriers to new entrants, at a minimum facilitated the process of development of small groups of oligarchs who became owners of a large proportion of privatized state assets through insider-privatization privileges. This last fact is one of the most important and valid points made by critics of the reform process so far, though as argued above they often undermine their own argument by linking ‘bad’ privatization with rapid reform, while in fact the broad picture is that rapid-reform countries most often avoided

38 Background

‘bad’ privatization. Nevertheless the issue deserves attention as one of the most important problems looking forward.

Main issues looking forward At the beginning of this chapter I listed eight debates or contentious issues of the past decade; two of them should definitely remain in the past as they have become sufficiently resolved or at least made less relevant. The speed debate has become far less relevant, and the evidence strongly suggests that unless Chinese initial conditions of large surplus labour prevail, early and rapid reform has in practice generally given better results with the possible exception of excess speed of privatization in some cases. The arguments that large output falls were due to excessively tight stabilization and too-rapid liberalization are also shown to be questionable, in particular if some correction for Soviet-era ‘GDP’ values is done. The other six issues remain of some importance. Three of them are more historically important but not critical or contentious for future considerations: the large differences across countries in transition progress and performance; the costs of transition, both economic and social; and China’s approach as a model. The first two are considered respectively in Chapter 3, Chapter 4; the case of China is beyond the scope of this book, though many relevant comparisons are made throughout. The remaining three, plus two new issues, constitute the most interesting focus for forward-looking discussion. The three carry-over issues are: best approaches to privatization; development of market institutions; and the relationship between markets and democracy. But for the future somewhat different aspects of these problems are most relevant. The first new issue concerns the influence of ‘oligarchic’ owners on further liberalization; that is, will they support it for the sake of securing property rights, or will they oppose it for the benefits of rent-seeking gains. Looking back, this is connected closely both to the way privatization was done allowing in some countries the development of such strong vested interests, and to the underdevelopment of institutions which facilitated a non-transparent transfer of assets. Looking forward it is critically related to further progress on institutional development, completion of economic liberalization, and continued democratization. It is also related to the second new issue: the prospects for continuation of the surge in growth in the relevant CIS economies. To sum up, the huge transition problems for the future are: ● ● ● ● ●

correcting inadequacies or negative effects of privatization; institutional development; the relationship between markets and democracy; does state capture lead to a freezing of transition? and can the surge of growth in the CIS continue and lead to further progress in reform?


These new issues are of limited relevance to countries that have already become members of the EU as of May 2004 – the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia and Slovenia – and probably also for some of those in South-East Europe that have not, but are likely to do so in a few years – Bulgaria, Croatia and Romania. The other South-East Europe countries are in a marginal zone, while the 12 CIS countries are clearly the ones for which these issues are most relevant. But a historical understanding of why many countries no longer face such problems will be necessary for a good analysis of the future prospects for those that do. Therefore, all the countries will be considered in the backward-looking analysis. For the future, the challenges for the first group of countries are related to EU membership, macro and exchange-rate policies upon accession to the EU, adoption of the euro and its timing, and the like. For the others, the five new issues are the important ones. For them, I propose the most useful and critical aspects of discussions or debates (as they have already started) can be grouped under two schools of thought. The first argues that once a minimum of stabilization, market liberalization and privatization is achieved, further progress in transition is inevitable, (indeed it will also help eventually in furthering democratic processes). The second takes a conditional view of this inevitability, arguing that where the reform process allows vested interests to build up quickly and benefit from rent-seeking opportunities of partial liberalization, they acquire a concentration of state assets in opaque privatizations to become what is popularly known as the oligarchy, and finally capture of the state. Their interests are not to liberalize or democratize further, rather exactly the opposite. The transition is frozen (TF) into a capitalist but not competitive economy and an autocratic polity perhaps in superficial disguise of a voting-democracy. The transition inevitable (TI) paradigm does not simply argue that a critical mass of private ownership and market-based decision-making makes reversal impossible and progress inevitable; it has a more sophisticated logic centring on the value of property rights. Once a major part of assets is in private not state hands, the old bureaucracy and nomenklatura no longer has a power base to oppose reforms, but, more important, the new capitalists will want to have security of property rights and create a demand for rule of law, transparency, law and order and so an. Thus, Shleifer (1997) summarizes: ‘Russia’s experience shows how privatization, combined with equity incentives for enterprise insiders, transfers control rights from the bureaucrats and stimulates political and economic pressures to protect private property rights.’ Similarly, Aslund (1997) argued that ‘Russian capitalists want to be independent of bureaucrats and safeguarded by a system of law.’ A very recent exposition of this optimism is in Aron (2003) in the New York Times editorial opinion addressing the jailing of Khodorkovsky, head of Yukos: ‘oligarchs can help advance the cause of Russian democracy’. This view is more broadly applied beyond Russia by others, starting perhaps with the

40 Background

first mid-stream review of transition by the World Bank (1996 World Development Report),17 and includes important writings on how privatization should be done such as Boycko, Shleifer and Vishny (1995), as well as current recommendations for countries suffering from oligarchic concentration of ownership: Boone and Rodionov (2001), Cottrell and Ostrovsky (Financial Times, 16 April 2001). Buiter (2000) (whom I would put in the TF school) points out that the theoretical basis for this is in Coase’s proposition that efficiency only requires that property rights are assigned unambiguously, which he restates in more popular terms as ‘yesterday’s thief is the staunchest defender of the sanctity and inviolability of property rights’ (p. 606). The counter-argument of the TF school is simple: capitalists will favour rule of law not out of benevolence or ideology but only if it is in their interest. The essential difference with TI is the empirical proposition that in some cases – Russia and other CIS countries among them – it is not in the interest of the new capitalist class holding concentrated ownership of assets. Thus, for example, Polischuk and Savvateev (2004) argue ‘inequality of ownership … could make wealthier agents favor less than full protection of property rights … [and] property rights will not emerge from the grassroots’. An important corollary is that while large oligarchic owners do not necessarily generate an endogenous demand for property rights and good rule of law, small owners, and especially new entrepreneurs, do. The idea of a frozen transition has many antecedents before this formal model of PS, and corollary elaborations. An interesting aspect of these writings is that many if not most of these sceptics of coopting existing vested interests by allowing them privileges on privatization, were in fact otherwise ardent proponents of the Washington Consensus. I will make only a few references. Interestingly, the earliest hints of these different approaches are seen in the views of two well-known proponents of the Washington Consensus. In a 1991 conference gathering of eminent Western economists (proceedings published in Clague and Reuser, 1992), Fischer while recognizing the role of new enterprises emphatically stated ‘privatization of state assets is an essential step in the creation of the private sector’. In contrast, Krueger emphasized that, experience from developing countries is, by and large, that growth has taken place primarily through the emergence of new activities, not the adaptation of older ones … [and] focus upon privatization of existing assets … searching for the least unfair process … diverts attention from the more important problem of creating new earnings streams. Fischer was certainly not saying that competitive rules of the game could wait, nor was Krueger arguing not to bother with privatization, but the relative emphasis is critical.


Havrylyshyn (1995) formulated an early version of the TF argument noting that already ‘markets have been created in CIS countries with private ownership and profit opportunities … opportunities restricted … to the more privileged few and not opportunities for competitive capitalism … various interests will do everything to avoid further reforms and keep the transition process frozen’. A pioneering contribution in the TF school is in Hellman (1998), who confirms the fears that privatization of the type advocated by Shleifer et al. (which coopts existing politically and financially powerful individuals by giving them a quick and low-cost insider access to privatizing assets), did indeed result in a concentration of assets that would be inimical to further liberalization. He underlined a paradox in the matter: from the mid-1990s the strongest and most effective opposition to further reform in many CIS countries came not from the losers, the large mass of the population which felt the pain of unemployment and lower living standards, but from the ‘winners’, the new capitalists benefiting from a non-transparent and generally inequitable transfer of state assets.18 A key conclusion of Helman’s article is that these ‘oligarchs’, as they are now commonly called, have the ability to capture the state and ensure its policies are favourable to them, rather than to open competitive markets. Buiter (2000) expresses concern that this predation inhibits secure property rights and thus depresses capital formation and growth. Yavlinsky (2003), a closer observer than any of the others, makes a poignant plea for battling the oligarchy, a plea firmly planted in simple economic theory of competition: ‘the larger and more influential the group, the greater are its opportunities to deviate from the universality principle of the business climate and fair competition’. For those who are not convinced until a model is formulated mathematically, Polischuk and Savvatev (2004) provide such a formulation. It hinges on the simple trade-off calculation made by an oligarch: is the benefit of non-transparent rent-seeking greater than the cost of some uncertainty about the oligarch’s own property rights security? Since the former is large (as earlier developing-country literature showed from the time of Krueger’s, 1972, seminal piece on rent-seeking) and the latter is easily bought informally, it is not surprising that Polischuck and Savvater can conclude ‘some wealthier agents would prefer a hybrid equilibrium (with informal procedures and rent-seeking opportunities) to the market one, and thus would resist secured property rights’. In simple words, that’s because secured property rights allow capitalism for all, while oligarchs currently in control much prefer capitalism for the few. A large number of empirical studies provide evidence on how these processes of privatization resulted in concentration in some countries but not others. Barnes (2003a) and the World Bank (2004) have been cited earlier on this. A related large literature on the effects of privatization reaches conclusions that are consistent with the TF’s logic: concentrated ownership is not

42 Background

favourable to competitive efficiency or further liberalization. The consensus findings generally show that any privatization is better than none, but that by far the best privatization is one which allows small- and medium-sized enterprises (SMEs) to thrive, and new entrants to enter. Several studies show that privatization alone without a competitive environment has little or no effect, but with such an environment it is very much more effective. Another relevant strand of recent literature is on voting patterns. The general finding in studies that cover both CEB and CIS is that small entrepreneurs, and new entrepreneurs, are particularly strong supporters for rule of law, competitive markets and democracy (see on this Fidrmuc, 2000; Raiser, di Tommasso and Weeks, 2001; Frye, 2003; and Jackson, Klich and Poznanska, 2003). The future importance of this debate should not be underestimated, or overshadowed by the current reality of a surge in economic growth in these economies to levels of 5–8 per cent annually or more, approaching rates seen in the period of the East-Asian boom in the 1970s. The direction in which such polities go, freezing oligarch power, or yielding it for the sake of securing property rights for assets accumulated so far, has implications for growth prospects, further liberalization of the economy and further evolution of the fragile democracy status achieved. Since the TI and TF issues are very much political economy ones, it is of no small interest to refer to the political science literature and debates on post-communist democratization, which is summarized in the next section.

The transitology paradigm in political science literature19 There is an analogy between the TI v. TF debate in economics and the transitology debate amongst political scientists. This section will first summarize the main elements of the debate in the political science literature, and then draw on this to clarify different views on the link between market reforms and democratic developments in transition economies. The transitology paradigm predates the post-communist ‘transition’, and the similarity of terminology is coincidental. Transitology is one of the theories or views about how change from autocratic to democratic regimes takes place, and is distinguished from other models by its linearity: that is the view that once the regime begins to move away from authoritarianism it moves ineluctably towards democracy, albeit with bumps on the road. In this it bears a similarity to the TI argument in economics. The broader literature on change from authoritarian to democratic regimes became prominent in the 1970s and 1980s with writings on Latin American democratization, a centrepiece of which is a four-volume study by O’Donnell and Schmitter (1986). But this transitology paradigm is subject to considerable attack in the literature, Carothers (2002) arguing the linearity is an illusion as one goes around


the globe, and McFaul (2002) and Motyl (2004) making a similar point for the post-communist states and perhaps going even further to say that, if anything, one sees by 2000 a trend to polarization rather than a convergence to democracy. Consider first some of the general debate on the transitology paradigm. The transitology paradigm in the study of democratization, both in the post-communist world and more broadly, has been difficult to verify empirically, and is subject to much criticism, but remains an important tenet of political science studies of democratization. A seminal exposition in political science is provided by O’Donnell and Schmitter.20 One of the most recent critiques of transitology is by Carothers,21 who lists five key assumptions underlying this paradigm: 1 Any country moving away from authoritarianism is moving towards democracy. 2 Democratization takes place in a set sequence of stages (this will be further elaborated below). 3 Elections are the key to democratization and further democratic consolidation. 4 The structural conditions of democratizing countries, such as the levels of economic development or ethnic composition, as well as historical experiences, are not crucial influences on the course and outcome of democratization. 5 The ‘third wave’ of democratization takes place in functioning states. Perhaps the most contentious issue is the assumption of linearity in the process of democratization, democracy proceeding in three stages. The first is democratic opening, liberalization under the authoritarian regime, usually manifested in rifts between reformers and hardliners within the regime. This is followed by the collapse of the authoritarian regime and its rapid replacement by a new, democratic system. Democratic institutions are introduced and codified in a democratic constitution. A prolonged stage of consolidation follows, during which ‘democratic forms are transformed into democratic substance’, so that democracy becomes the only game in town, accepted by all major political actors (Carothers, p. 7). One of the key objections to the transitology paradigm is that it is too deterministic in assuming that in each case democratization proceeds through a similar set of stages. Fish (1999), for example, argues that transitologists focus too much on studying the impediments to the ‘completion’ of democracy and not enough on the exploration and theorization of the differences in democratization among countries undergoing that process.22 Alternative theories of democratization have not always arisen in response to the transitology paradigm, but sometimes in parallel to it. The most notable is the structuralist theoretical approach, focusing on economic, social and

44 Background

cultural preconditions of democracy.23 The common assumption is that countries at a higher level of economic development, characterized by ethnic homogeneity, or certain cultural prerequisites, have a greater chance of experiencing democratic breakthrough and sustaining a democratic political system. Yet, Fish’s reexamination of these postulates yields a less than convincing result, finding weak correlation between levels of economic development and ethnic homogeneity on one side, and democratization on the other. Beyond structuralist explanations, other scholars emphasize the importance of factors such as the extent of institutional pluralism within mature authoritarian systems.24 Still others emphasize the importance of functioning party systems as the key institution leading to democratic consolidation.25 Yet another approach is the argument that uncertain balance of power which requires all to compromise is more likely to lead to democratic institutions, but in post-communist experience McFaul (2002) shows that, to the contrary, uncertain balance has tended to undermine democratic formations and allow authoritarianism to renew itself, while successful democratization has been based more frequently on a historical moment of unequal power as in Poland and Czechoslovakia. Thus, one sees that the transitology paradigm is strongly challenged, although no one single alternative has replaced it since the challenges do not form a compelling unified paradigm with forceful empirical support. In that regard, the economic literature may be less complex with at most three paradigms. For countries that are clearly in the sphere of the EU (membership or near-certain prospects), the paradigm is simple: any remaining distance on the road to market economies will be automatically closed by the legal dictates and moral suasion of the EU. The others are on the Occam’s razor of oligarch’s preferences between secure property rights and continued high ‘rents’ from an unequal and non-transparent political process: the TI–TF debate has to do with the probabilities of falling on one or the other side of the razor edge. There is in fact a very analogous proposition about democratization prospects for post-communist countries in Motyl (2004), who puts Central European states in the advanced democracy group, Belarus and much of Central Asia in the least advanced, and all the others in a middle category with a razor-edge possibility of going either way. He suggest that recently the dynamic of this middle group already shows several about to join the advance category (Bulgaria, Croatia, Romania), with others falling in the other direction (Kyrgystan, Russia, Ukraine). He does not, however, attribute this to EU prospects, but vaguer historical conditions. What can one draw from this analysis to understand the linkage between market liberalization and political liberalization? A good starting point is the important prediction of Przeworski (1991) that market reforms could only be effectively implemented in a less than fully democratic regime. The most recent political science writings argue that this does not seem to be upheld.


As McFaul (2002, p. 221), puts it: ‘Many had predicted … that reorganization of economic institutions would undermine democratic transition … to the contrary those countries that have moved the fastest on economic transformation also showed the greatest success in consolidating democratic institutions.’ One broad-brush indicator of this understandable to economists and others is the striking conclusion in EBRD (2003) of a strong positive relation between the degree of democracy and progress in market reforms, rather than a negative one (see Figure 2.2 in Chapter 2). There is room for discussion on the direction of causality of the relation, that is whether market reforms led to democratization, or whether the preexistence of democracy and a more civil society enabled rapid reforms, or even a circular causation. Chapter 2 devotes several pages to this relationship using updated information on democracy indicators. It may be that third factors play a role, and that in some cases the causality is in one direction and in others the opposite. Balcerowicz (1993) argued forcefully that contrary to Przeworski’s fears early democratization facilitated economic reforms, providing a historical opportunity to give the population its first desire: a move away from communism. But the Balcerowicz approach did not ignore the concerns of Przeworski, and precisely because there was a risk that the adjustment costs of economic reforms could turn popular opinion in a democracy against reforms, he argued for a big-bang approach to put in place as much of the market as possible before the honeymoon ended. He contends that in Central Europe one witnessed a reversal of the classical sequence ‘capitalism first, democracy later’. But recent Freedom House indicators of democracy showing deterioration for many CIS countries with moderate transition progress (CISM) countries,27 after initial improvement suggests causation is not in all cases from democracy to comprehensive reforms. There, slow movements to democracy and slow reforms were the norm, and rather than reinforce each other towards further progress the partial nature of each has resulted in fragile achievements in both and recently already a reversal on the democracy dimension. Perhaps the lesson to draw from this is that while doubtless there is a tension between democracy and market liberalization in a transition from non-liberal polities, to characterize it as a conflictual either–or situation is wrong. It is more of a delicate balance and set of trade-offs. Any categorical interpretations are mistaken, because they do not distinguish enough the ends and the means. On the side of democracy, it is a common and faulty perception that ensuring a reasonably open voting process is a sufficient means to the end of a liberal democracy. As far back as John Stuart Mill it was recognized that democratic voting and liberality were not identical, and recently Zakaria (2003) has raised the same concerns arguing that even in mature democracies of Europe and North America, the mechanisms of vote-maximizing are

46 Background

degenerating to allow ‘capture’ of governments by political professionals with no ideological commitments and no automatic concern for liberalism. He argues that the degree of capture is of course far greater in less-developed democracies, and makes the same point as Carothers (2002) that one can easily be deluded into thinking that ‘minor’ voter manipulation by entrenched political elites in post-communist or emerging market polities is simply a reflection of these countries not having completed their march to liberal democracy. Carothers, McFaul and Motyl give compelling arguments that these are sustainable political equilibria. In much the same way the recent debate in transition economies has an optimistic side which argues that imperfections in a competitive market will be corrected endogenously. This argument in effect says that the means, private ownership, will lead to the desired end point: a competitive and open economy. Critics of this position argue that while the powerful new economic interests may want to see secure property rights for themselves, this is not automatic (just as vote-maximizers do not automatically uphold liberality), and indeed in current circumstances on the ground they are more likely to conclude that maximizing profits for the foreseeable future means retaining, and not giving up, their influence. In a word, analogously to the political science views about sustainable regimes with democratic voting but authoritarian results, the ‘transition-frozen’ arguments say that state capture by powerful economic interests is not a way-station to a liberal market but a sustainable economic equilibrium based on well-known profit-maximizing principles.

2 Measuring Progress in Transition

How to measure progress There is a broad consensus amongst experts that Central Europe and the Baltics have progressed much further towards a market economy than have countries of the Commonwealth of Independent States (CIS); and that of the latter, Belarus, Turkmenistan and, arguably, Uzbekistan have not changed much. Such a view is also widely held by the citizens of these countries. While such broad judgments are probably correct, for analytical purposes it is surely better to have a more rigorous, objective measure of transition progress. Unfortunately, there can be no single measure of a country’s progress along this path since transformation from a centrally-planned economy with state ownership to a market economy with private ownership involves more than changes in economic arrangements, and encompasses political, social and – as is increasingly recognized – institutional changes. Many different metrics have been used in the literature covering economic, political and social indicators. Economists tend to focus on measures of positive economic results or performance such as growth, inflation, resource-reallocation measures, job-creation, productivity improvements, as well as possible negatives or social costs such as unemployment income inequality, poverty ratios, mortality rates and so on. All the above indicators are results of the policy process and, while subject to measurement and definitional errors, are relatively objective metrics. There also exist indicators one may call ‘policy inputs’ which attempt to measure the distance a country has travelled along the transformation path using some estimate of policy reform undertaken. These tend to be somewhat more synthetic data compared to the results variables and need to be interpreted with even greater caution, though I will show below that one such indicator serves extremely well as a summary of progress in transition. This is the well-known set of ‘Transition Progress Indicators’ (TPI) produced annually by the European Bank for Reconstruction and Development (EBRD) since 1994. Similar indicators were compiled by the World Bank (1996) for an earlier period. 47

48 Background

In addition, there now exist a wide array of institutional or business climate indices covering corruption, regulatory complexity, tax burden, security of property rights and the like, put together by many institutions including the World Bank–IFC, the BEEPS data bank, Freedom House, Heritage Foundation, and Transparency International. In the political science and history literature, the focus is of course on assessment of progress towards establishment of democratic institutions, often including a variety of quantitative and relatively ‘objective’ data such as voter participation, turnover of governments, number of parties, and slightly more synthetic ones such as degree of democracy, civil liberties, media freedom and reliability of rule of law. This type of measure comes from the same approaches and sources as the institutional indicators mentioned above and is again somewhat more subjective. This is because the principles or concepts these indicators attempt to measure cannot be easily observed directly and are therefore constructed by combining perceptions of the public and businesses, with the assessment of experts. This book is primarily an economic analysis, therefore the central focus will be on economic variables with two important exceptions. First, several indicators of institutional development that affect economic agents will be noted and discussed frequently throughout the volume – for example corruption, state capture by vested interests, rule of law. Secondly, this chapter will analyse in some detail the relationship between economic indicators of progress and political indicators of democratization.

The EBRD transition indicator: how good a measure of progress? The evolution of the EBRD transition indicator by country and region It has long been a widespread practice in the economic development literature to use growth of per capita income as a summary indicator of progress, subject only to qualifying arguments that income distribution and poverty are not made permanently worse by growth. This tradition dates back to the view of a pioneer in the development field, Arthur Lewis, who argued that while widespread reduction of poverty could be better defined as the final goal of development, it was unimaginable in the long run that this could be achieved without substantial growth. Recently, the debate has been renewed (see for example World Bank, 2000) by critics who do not deny Lewis’ point but suggest policy efforts should go beyond promoting growth to ensure growth results in poverty reduction within a reasonable time period. A different strand of thought came even earlier, with the United Nations Development Programme (UNDP) effort to construct a broader measure of success, the Human Development Index (HDI) which combines growth, distribution and several other measures of well-being.

Measuring Progress in Transition 49

In the transition literature, starting about 1995, growth was used as a proxy for success or progress by many writers including this one.1 In this book, I propose to focus on the policy inputs approach of the EBRD as a better measure of progress on the transition path. The reasoning is as follows. Transforming these economies into market-based ones has the purpose of leading to better performance and improved material standards for the populace, and this is surely what people expect. But despite the econometric evidence showing a broad correlation between degree of reforms and growth (discussed later in this chapter), the result is not always immediate, it entails some social costs at least in the short run, and affects popular perceptions in ways that may make the relation an endogenous one, as predicted by Przeworski (1991) and recently confirmed in Kim and Pirtilla (2004) – that is, if reforms cause too much pain, electors will vote in a new government that promises slow reform. For the most part, in transition countries we are not yet observing the long-term equilibrium path of growth as in developing countries, but only an adjustment to a new equilibrium path. This last point is nicely illustrated by the near-universal finding in econometric studies of transition growth that investment ratios are not significant, in sharp contrast to traditional growth study results. It will be useful, therefore, to distinguish the effects of transition on growth and distribution of income from some measure of the change in the economic system on its presumed path to a market economy. This is in principle precisely the purpose of the EBRD Transition Indicators. The remainder of this chapter will discuss the degree of such progress achieved by different countries over the period 1989–2003, and show that even if one prefers economic performance indicators, human development social indicators, or democratization indicators, it turns out that the transition progress indicator (TPI) is highly correlated with these. It is incidentally negatively correlated with social costs, a finding elaborated in Chapter 3. This last point means that further progress towards the market did not result in larger social costs as gradualists argued, in fact the contrary. As to country coverage, the sample consists of those EBRD members for whom the index is constructed, a maximum of 27. None of the Asian countries is covered, but the reason goes beyond non-availability of a comparable index; it is argued here that the Asian experience had such an incomparably different starting point that it deserves a separate analysis. This is a very contentious point in the literature, with many arguing that the more gradual and less disruptive transition of China should have been followed in the European region as well.2 Turning now to the EBRD indicator, we see in Figure 2.1 a distribution of countries on a scale of 1.0 (no market reform) to 4.3 (full market reform) in 2003. The value for each country is a simple average of eight separate indicators: large-scale privatization, small-scale privatization, enterprise governance, price liberalization, trade liberalization, banking liberalization and other financial sector reform.3 The EBRD often cautions against such

TPI value

50 Background 4.5 4 3.5 3 2.5 2 1.5 1 0.5

UZB BEL TURK

KYR ARM GEO RUS KAZ UKR MOL AZE TAJ

BUL ROM MAC ALB BiH S&M

EST LVA LITH

HUN CZECH POL SVK CRO SVN

0

Countries by group Figure 2.1 EBRD transition progress indicator (TPI), 2004

averaging, but then frequently does exactly that for comparative analysis; as there is no case for weighted averaging, simple averages are not unreasonable. The picture suggests four or five groups of countries: Central Europe (CE), the Baltics (I will on occasion refer to the two as a group, CEB); SouthEast Europe (SEE); CIS countries with moderate transition progress (CISM); and CIS countries with limited progress (CISL).4 The nine CEB countries are the most advanced in transition to market economies, with values in the range 3.4–3.9. Though the Baltics are well within the group, Estonia (3.8) being second only to Hungary (3.9), and Latvia (3.6) higher than two Central European countries, it will for many purposes be useful to keep the Baltics separate given their unique experience of having been part of the USSR. Note that in the CEB group, all but Croatia have acceded to EU membership as of 1 May 2004. The next group, SEE, comprises six countries ranging in value from 2.5 to 3.4, clearly below the CEB group. The CISM group of nine countries ranges from 2.4 to 3.1, somewhat overlapping the preceding group, raising the question why some CIS are not associated with the higher group. Geographical convenience is a minor reason; a second is that the SEE laggards, Bosnia & Herzegovina, Serbia-Montenegro, have had a very short period since civil conflicts quieted and seem headed upwards. But the main reason is that most of the SEE countries are clearly on track for a second or third wave of EU accession, while as


of the end of 2004 none of those in the CIS were.5 Finally, three countries comprise the group least advanced in transition, CISL, with values 1.3 for Turkmenistan, 1.9 for Belarus and 2.2 for Uzbekistan. It is useful to compare these results with some other potential measures of policy progress. Consider first the ‘Competitiveness Index’ constructed annually for a large number of economies around the world by the World Economic Forum in Switzerland. Zinnes, Eilat and Sachs (2001) applied such a methodology comprising business and expert perceptions and assessments in a synthetic index to a similar group of 25 transition countries for 1998. The CE group, in order of country as in Figure 2.1, had rankings of: 1, 2, 3, 5, 8, 9; the Baltics, 4, 6, 7; virtually a precise correspondence. For the SEE countries, their rankings were 10, 12, 20 (Macedonia) and 22 (Albania); and for CISM 11, 13, 14, 15, 16, 17, 18, 19 (Azerbaijan), 24 (Tajikistan). The country names in brackets show placement slightly out of the Figure 2.1 order; for example Macedonia and Albania are lower-ranked than Azerbaijan, but overall the groupings and the overlap between SEE and CISM are broadly maintained. Finally, their rankings put the CISL countries at the end (21, 23, 24) save for Tajikistan which since 1998 has moved forward while the others have even slipped. In summary, this very different approach to ranking economic competitiveness of countries gives virtually the same results. The role of institutional development as discussed in Chapter 1, is considered by all analysts to be as important in the long run as liberalization policies, indeed some would assign it an even greater weight. It is therefore essential to verify that the pattern of TPI discussed above is consistent with the pattern for institutional indicators. This is in fact the case as a simple comparison of Table 1.1 and Figure 2.1 shows: the ranking of our country groupings is identical. This holds for individual country rankings as well; the correlation coefficient between the TPI and the Quality of Institutions is 0.896. In a later discussion of time trends for TPI, it is also seen clearly that EBRD’s own measure of institutions (they label this as ‘second phase’ reforms) results in the same country-group ordering as Figure 2.1. The Appendix to this chapter gives a more detailed picture with TPI values for each country in a rank order, as well as time paths for individual countries, but the five groups noted here will be the basis for comparative analysis throughout most of this volume. On the one hand this has the disadvantage of missing out on some of the variations within the group, but where important this will be noted selectively, using as reference the Appendix country values for the same variables. On the other hand, an obvious advantage of such a grouping is the ability to analyse the main tendencies in a simpler framework; given the inevitable margin of argument about a quasi-subjective indicator, it is all the more sensible to group broadly similar countries together. The first such comparative analysis by group is to consider the correlation between the EBRD indicator of policy change and some common measures of economic performance results.

52 Background

Economic performance indicators As noted, it is useful to think of the TPI index as a policy input, with results being measured by standard economic performance variables. Three measures of performance are considered: recovery of GDP by 2003; inflation control; and foreign direct investment (FDI) per capita. There are many other variables one could use in addition (or instead), but this choice is probably most reflective of the countries’ key goals in the first decade of transition. There is a wide consensus that the high inflation of the early 1990s in virtually all countries had to be controlled quickly and financial stability achieved before other reforms could have a favourable impact on growth. Economic growth is not only a measure widely used to assess performance, there is also little doubt that the expectations of the populace were primarily focused on a better living standard even more than on democratic freedoms alone.6 As to FDI, it is not only an important contributor to new growth potential, especially in economies that had been quite closed, but more importantly it is likely to reflect the assessment of foreigners about the climate for investment in general and future growth prospects. It is a better indicator than total capital inflows, because the latter includes sovereign borrowing, which is more short-term and can be due to instability rather than stability. Arguably, total investment including domestic investment might be an even better indicator, but the problems of informal activity and the embryonic nature of financial intermediation make this variable problematic for now.7 A few qualifiers are in order concerning the growth or recovery variable in particular. First, it uses official GDP estimates (EBRD reports are the source for all three), and excludes informal economic activities. The Appendix addresses this problem in some detail reaching the conclusion that the latest and most comprehensive estimates seem to imply either that the biases are minor, or their direction does not affect the overall comparison.8 The reasoning is as follows: for many countries the share of informal activity is either small or constant over time, hence bias is very small; for most others it is a clear trend with a rising share early, and then a decline later, as there are no cases of significant volatility in this share the growth rate estimates are not biased. It is also noteworthy that the share of informal activity for transition countries may be slightly lower than for developing countries (38% v. 41% as given in Schneider and Klinglmair, 2004). Interestingly, the sharp criticisms of transition growth econometrics being biased due to exclusion of activity do not seem to be echoed in the area of developing-country growth empirics. A second problem with official growth data is the non-comparability of Soviet accounting with the UN standards used in all transition economies. Starting with Lipton and Sachs (1994), and more thoroughly in Aslund (2001), many have argued that the output fall was exaggerated. Aslund makes three key points: the transition started in 1989 for Central Europe, but only about 1991–92 farther east; central planning motivated managers to overstate output; and overpricing for unsaleable unwanted goods meant

Measuring Progress in Transition 53 Table 2.1 Recovery: estimated index of GDP, 2003 (1989 100 with partial adjustment for Soviet accounting) Unadjusted 2003 value Central Europe Baltics South-East Europe CISM CISL

115 90 82 (96)** 67 104

Adjustment 139 112 86 84 n.a.

Adjustment: adjusted by 50% of Aslund (2001) estimates as shown in his table 3.1, except CISL, explained in the text. ** The first number is for all six countries; the brackets value excludes Bosnia-Herzegovina and Serbia, whose crises and hence transition start came much later. Source:

Unadjusted value: EBRD Transition Report, 2004.

real output value was much lower, with this effect being strongest in the sectors that saw the greatest output cut-backs in the 1990s. Note that this does not include any valuation for time in queues and lack of choice of goods, but even so the adjustments proposed by Aslund are enormous, for example the official output decline in the Baltics virtually disappears. In the data for recovery of Table 2.1, the arbitrary adjustments account for only 50 per cent of Aslund’s adjustments. A fuller analysis of such adjustments is undertaken in Chapter 3 which presents various estimates of lost output during the transitional recession. With these caveats in mind, consider first the evidence of official GDP recovery in Table 2.1. CE is clearly above the others, with the Baltics distinctly lower, about equal to the SEE group. The CISM group is lower still, however the CISL value is second only to CE. The correlation between transition progress and recovery appears weak. With adjustment for Soviet accounting problems, the Baltics fall into place, though CISL remain distinctly better performers than CISM or SEE countries. One possible explanation is that where there is no pain there will be no gain; that is, with so little reform even the minimal output fall that is necessary for efficient restructuring has not yet occurred. These countries have continued to support output of loose monetary policy. The unsustainability of this is comparable to what happened in the mid-1990s in Bulgaria and Romania (Havrylyshyn et al., 1998); by 1994 both saw some stabilization, and modest growth, but this was followed by a crash of output and a resurgence of inflation in 1996. It is notable that inflation levels in CISL (Table 2.2) are much higher. Another explanation is that in all three cases the official numbers exaggerate growth significantly. For Belarus, growth has been driven by exports to

54 Background Table 2.2 Inflation performance (CPI increase in 2003, per cent) Range mid-point Central Europe Baltics South-East Europe CISM CISL Source:

2.5 0.9 8.8 9.7 13.3

Low case

High case

Czech Rep. (0.2) Lithuania (12) Macedonia (1.1) Kyrgyz (3.1) Turkmenistan (6.5)

Hungary (4.7) Latvia (3.0) Romania (15.4) Tajikistan (16.3) Belarus (28.5)

EBRD Transition Report, 2004, table A2.3.

Table 2.3 Cumulative FDI per capita, 1989–2003 ($US; by subregion) Group average Central Europe Baltics Southeastern Europe CISM CISL

2,305 1,641 465 339(136)* 168

Low countries

High countries

Poland (1,355) Lithuania (1,070) BiH(282) Russia (31) Uzbekistan (35)

Czech Rep. (3,710) Estonia (2,400) Bulgaria (795) Kazakhstan (1.094) Turkmenistan (269)

* Value in brackets excludes the energy exporters: Azerbaijan, Kazakhstan, Russia. Source:

EBRD Transition Report, 2004, table A2.8.

Russia in barter exchange for energy at terms favourable to Belarus (see IMF, 1999); the decline of growth in recent years as barter was reduced is consistent with this hypothesis. In Uzbekistan growth has also fallen sharply, while in Turkmenistan exports of natural gas drive growth, but the export figures are on an accrual basis, while actual payments for gas deliveries are far below commitments, so the real value of output is much lower. Taking into account these arguments recovery in CISL may be much lower and more in line with their TPI ranking. The inflation and FDI values show a much closer and cleaner correlation with transition progress. In Table 2.2, one sees median inflation at very low levels for CEB with the Baltics even lower, then SEE, CISM and CISL follow in order. Finally, Table 2.3 shows that FDI per capita is by far the highest in CE, only slightly lower in the Baltics, followed far behind by SEE, CISM and CISL. If one excludes three energy exporters: Azerbaijan, Kazakhstan and Russia, the CIS value is far lower at 136. It is not in the end surprising that the index of transition or reform progress is positively correlated with output recovery, as many early econometric studies have found that the degree of reform progress is one of the most important explanatory factors for growth in transition. But it is important to verify that whether one measures progress as the policy input on economic reforms, or as resulting economic performance, the ordering of countries is broadly the same and comprises the above five very distinct groups.


Progress in market reforms and democratization In as much as democratization is also an important goal of the transition, and for the EBRD in particular – unlike the other International Financial Organizations – promoting democracy is explicitly part of its mandate, some attention to the relationship of economic progress and political progress is required. The EBRD itself has addressed this, first in the Transition Report 2000, and then more thoroughly in the 2003 volume. This section discusses the findings of the EBRD as well as those of some independent analyses by academics and other institutions. The central hypothesis here is whether the relation between economic liberalization and democratization is a positive one. For transition countries, Przeworski (1991) argued strongly that market liberalization could only be successfully applied by suspending democracy temporarily. The EBRD analysis purports to show this has not been the case. Before turning to the evidence, consider some problems with defining ‘democratization’. This is a big and difficult question and a permanent intellectual debate; here, I will draw on the summary of the political scientists’ debate on transitology provided in the previous chapter. Zakaria (2003) which some consider a popular treatise but is often cited in the academic literature, points to the key issues of relevance for this volume. Holding elections is not a sufficient indicator of democracy because electoral democracy can exist without secure or complete civil liberty; over time electoral rights can increase without civil liberties improving (a concern for the assessment of ‘democratizing’ societies); or electoral rights are not reduced even as civil liberties deteriorate (Zakaria suggests this may be happening even in democratic societies such as the United States). To its credit, the EBRD analysis addresses these definitional difficulties very directly, and begins by showing there is no statistical correlation between the transition indicator and frequency of elections. The point is that ‘elections alone are not enough’ (EBRD, 2003, p. 23) because without civil liberties comprising freedom of expression, openness and credible rule of law, the elections can be biased and influenced even without explicit illegal actions such as ballot-stuffing. The recent drop in Freedom House ratings for democratic freedoms in many CIS countries9 exemplifies the problem. EBRD (2003) then compiles a broader, albeit more subjective, measure of constitutional liberalism for 1996 and finds a strong correlation with the average TPI for the period 1997–2003. An update of their compilation and the consequent relationship with TPI is shown in Figure 2.2 for 2004. The correlation may be even stronger because since 1996 several lagging reformers fell in the constitutional liberalism rankings (Belarus, Moldova, Ukraine), while some advanced reformers have risen (Croatia, Slovakia). For 2004 the value of the regression coefficient R2 0.723. This overall measure of democracy might be questioned as it includes at least one component that is not in principle inconsistent with the enlightened autocracy Przeworski thought necessary for economic reforms: rule of

Constitutional liberalism, 2004

56

0.8 ESTHUN SVN

0.7

LTV, LTU

0.6

CZE POL, SVK

YUG

BGR, HRV

0.5 0.4 BLR

0.3

TKM

TJK

ROM MDAUKR MKD BIH RUS KGZ GEO KAZ ARM AZE ALB

UZB

0.2

y = 0.1988x − 0.1302 R2 = 0.7231

0.1 0.0 1.0

1.5

2.0

Country name Albania Armenia Azerbaijan Belarus Bosnia & Herzegovina

2.5

3.0 3.5 4.0 Transition progress indicator, 2004

Country code ALB ARM AZE BLR BIH

Bulgaria Croatia Czech R Estonia

BGR HRV CZE EST

Georgia Hungary Kazakhstan Kyrgyzstan Latvia Lithuania

GEO HUN KAZ KGZ LAV LTU

Macedonia Moldova Poland Romania Russia Serbia/M

MKD MDA POL ROM RUS YUG

Slovakia Slovenia Tajikistan Ukraine Uzbekistan

SVK SVN TJK UKR UZB

Figure 2.2 Constitutional liberalism and progress in transition


law. If one takes just ‘the media freedom’ component as perhaps a better direct measure of civil liberty, the average for each of the five groups designated above clearly follows the rank order of TPI. The results are on a scale of 0–100: CE 68; Baltics 71; SEE 49; CISM 39; CISL 20,10 confirming the proposition of this chapter that the TPI is not only a good proxy for progress on the economic dimension, but also for the political-democratic dimension. This is also consistent with the recent conclusions of several political scientists noted in Chapter 1 that contrary to Przeworski’s concerns that economic liberalization would undermine democracy, democracy has in fact progressed farthest in countries that have advanced fastest on market liberalization. Let us consider why his prediction may not have materialized. There is a vast literature by political scientists and historians interested in the transformation, and I give here only a selective illustration of the differing views expressed. At one end of the spectrum, Reddaway and Glinski (2001) writing on Russia argue forcefully that because economic reforms were introduced in a ‘shock-therapy’ fashion, the embryonic democratization in the early years was shunted aside to allow rapid reform; this is very much in line with the Przeworski prediction. However, this says nothing of other countries, in particular Poland, the Czech Republic, the Baltics and other transition leaders, which also undertook rapid big-bang11 reforms and did very well on economic performance as well as democratization. Nor does it adequately address the common criticism that it was the incompleteness of reforms rather than their introduction that led to the failures. But Reddaway and Glinski do make a compelling case about the consequences of insider privatization for both economic liberalization and democratic liberalism; this touches on a central hypothesis of this volume elaborated in Part II. Other political analysts, however, come to a very different view with McFaul (2002, p. 221) perhaps at the opposite end of the spectrum contending that, contrary to predictions of inevitable discordance between market reforms and democracy, ‘those countries that moved the fastest on economic transformation have also achieved the greatest success in consolidating democratic institutions’. One of the earliest precursors of this view may have been Brzezinski (1993) who spoke of ‘the primacy of political reform as the basis for effective economic reform’, and the expectation that the two would in fact go hand in hand. He also foresaw precisely the wide dispersion of outcomes that one sees in both market and democratic reforms. A similar sentiment is found in Carothers (2002) and Motyl (2004), who criticize strongly the general ‘transitology’ paradigm that countries will keep moving forward towards full democracy once a ‘breakthrough’ from autocracy occurs. They show instead that despite early democratization, some countries have clearly fallen back into a solid autocratic path, some are in an uncertain middle range or ‘gray zone’, and only about a dozen are clearly well on the way to meaningful liberal democracies. Combining the lists of

58 Background

these authors, we find in the first group the CISM countries plus some in CISL, in the second most CISM and SEE countries, and in the third mostly CEB countries plus tentatively some from SEE like Bulgaria or Romania. That a strong correlation between economic and political liberalization exists after such a short period of transition seems clear, but, as Bunce (1999) emphasizes, the deeper relationship and the direction of causation is for political analysts the most interesting issue. On the one hand, one may argue that early and successful reforms bring early results, and make it easier to advance on the democratic front (that is, economic reform causes democracy). This is broadly in the spirit of an older view amongst political scientists that higher income makes democracy more likely (Lipset, 1959). On the other hand, there is evidence of causation running in the other direction. Kitschelt (1995), in a multivariate analysis, shows that prior history of democratization (the interwar period for our CEB group) is an important determinant of democracy, and Shleifer (1997) argues that civil liberties of a democracy translate into both a demand for and a supply of economic liberalism, especially in the dimensions of property rights security and rule of law. But both of these views are broadly consistent with the reality of Central Europe at one end of the spectrum, and most of the CIS at the other end. In addition, as EBRD (2003) notes, ‘there can be little doubt that the prospect of EU membership has been a major spur for structural reform in the accession countries’. Does this mean that without the prospect of EU membership the advanced reformers may not have advanced as far, or have advanced on the economic but not democratic dimension? This issue plays a critical role in the main thesis of the present volume and will be addressed more thoroughly in Part II, especially Chapter 7. To conclude this section, it suffices to say that the EBRD Transition Indicator, despite its shortcomings as a somewhat synthetic index and not subject to a rational weighting scheme for its different components, turns out to be a very good proxy measure of progress on the path to a liberal market economy, as well as progress towards a liberal democracy and effective civil institutions. The next chapter will analyse the empirical evidence on the economic and social costs generated by the transition, in effect testing a key hypothesis of the gradualist school that social costs are greater under bigbang reforms. The antecedent of such a hypothesis is the Kuznets U-curve hypothesis in the development literature, that economic growth at first leads to worsening inequality (see for example the WIDER study by Wan, 2002). But first it may be of interest to look at the evolution of TPI overtime for the five country groups.

Patterns of reform progress over time It is not surprising to find that the pace of market reforms was not a steady one over time nor across regions; indeed, it also differed by type of reform.

Measuring Progress in Transition 59 Table 2.4 Transition indicator values by year and type

Central Europe Baltics S.E. Europe CISM CISL

Liberalization (LIB) Institutions (INST) LIB INST LIB INST LIB INST LIB INST

1994

1999

2003

3.7 2.7 3.7 2.3 3.0 1.7 2.2 1.4 1.9 1.4

4.2 3.1 4.1 2.9 3.9 2.2 3.7 2.1 2.0 1.6

4.27 3.3 4.27 3.3 4.1 3.0 3.9 2.3 2.2 1.5

Source: Averages calculated from EBRD Transition Report, 2000 and 2003, country tables. Liberalization is the average of the following indicators: price liberalization, foreign exchange and trade liberalization and small scale privatization. Institutional reforms comprise: largescale priviatization, governance, competition policy, infrastructural policy reforms, financial sector reforms.

A broad overview is seen in Table 2.4 showing for all the 27 transition countries the level of progress for what the EBRD defines as ‘initial phase’ reforms, and ‘second-phase’ reforms sometimes described in the literature as second-generation reforms. The scaling is the same as for TPI in Figure 2.1. The first phase includes price liberalization, foreign trade liberalization and small-scale privatization, and might be more usefully labelled as ‘liberalization’, while the second phase comprises the EBRD’s remaining indicators: this last can be thought of as ‘institutional’ reforms, and indeed in its analysis the EBRD discusses them in that way. EBRD notes for the average of all countries an early surge of liberalizing policy changes from 1989 to about 1994, a somewhat slower but still steady pace to 1996, then a virtual flattening at a level of about 3.2 to 3.3. This is still well-below the top value of 4.3 representing a fully functioning market economy, but importantly the reason for this flattening turns out to be the difference between the advanced countries and the slower reformers as seen in Table 2.4. Table 2.4 breaks this down by the five country groups. It is evident that in all regions institutional reforms lagged behind liberalization and in general with less of a surge as seen for liberalization in the early 1990s. This pattern is consistent with the common view that institutional reforms cannot be implemented so quickly, but it may also be consistent with the criticism aimed at the Washington Consensus that they were not given enough importance early on. This debate cannot be easily resolved, as there is no benchmark to define the phrase of Vaclav Klaus ‘as fast as possible’. The evidence is therefore easily used by both schools of thought in support of their

60 Background

arguments. However, much more can be inferred by comparing the time patterns across the five country groups. First consider what that comparison shows in Table 2.4, with the first phase ‘liberalization indicators’ averaged under the label LIB, and the secondphase ‘institutional indicators’ averaged under INST. By 1994 the Central European and Baltic countries had reached the very high LIB level of 3.7, broadly comparable to many mixed market economies with some stateownership, and price regulation of a few basic goods (housing, some staples). The value of TPI 4.0, for comparison, is described for the three liberalization dimensions by the EBRD as follows: ●

●

●

Comprehensive price liberalization except for a small number of administered prices. Removal of all quantitative and administrative restrictions on imports and exports. Complete privatization of small companies with tradable ownership rights.

By 1999 this had increased substantially, and by 2003 had effectively reached the maximum rating of the EBRD index. Six of the CEB countries were in fact rated at 4.3, and three (Croatia, Estonia, Slovenia) at 4.2, hence the mechanical result of a 4.27 average in these groups. For most observers that should be a distinction without a difference: on basic liberalization of economic activity, all nine countries must now be considered as fully functioning market economies.12 It is particularly notable that the Baltics, starting later than the others, already caught up to them by 1994 and kept pace in the final liberalization drive. South-East Europe lagged somewhat behind, though not nearly as much as the CIS group which in 1994 was far below the level of SEE (no 1994 data available for conflicted Bosnia-Herzegovina and Serbia-Montenegro). Indeed, at the mid-1990s point, the gap between the moderate CIS reformers and those with limited reforms is not visible. That quickly changes, however, and by 1999 the CISM group’s progress relative to the CISL is evident, as it surges ahead in liberalizing measures to achieve about the same position that the CEB countries had five years earlier. I argue below that it is not just a coincidence that the CISM output recovery began after reaching about the same level of TPI as had been reached by the Central European and Baltic countries when their recovery began. What is striking is that by 2003, though the CISM countries had not yet caught up to the liberalization levels of Central Europe, they, and even more so SEE, were very close to the 4.0 mark for the liberalization indicators, reflecting reasonable well-functioning market mechanisms if not institutions. The nearly stagnant process of liberalization for CISL countries is particularly evident in the Table 2.4, and reinforces the distinction drawn in Figure 2.1. Had the latter been compiled using


only the LIB indicators, the gap between these two groups would be far greater. The values for CISM range from 3.6 (Tajikistan) to 4.2 (Georgia, Kyrgyz), while for CIS they are 1.7 (Turkmenistan), 2.4 (Belarus) and 2.5 (Uzbekistan) (see Appendix figure for LIB). Indeed, even the case of Tajikistan is no longer marginal: its LIB value in 2003 was 3.6, which is well-above the 2.5 of Uzbekistan; while in 1994 Tajikistan was second last with only Turkmenistan lower (1.6 and 1.2 respectively); it has progressed steadily while the three lagging cases of CISL did not. Consider another aspect of institutional change. Table 2.4 reinforces the EBRD (2003) story that in all countries institutional reforms lagged considerably behind liberalizing measures and still do so even in the more advanced cases. While in Central Europe the index is a respectable 3.4 – with the highest value in Hungary at 3.7 – this is much less than the average of 3.7 for liberalization in Central Europe nearly 10 years earlier. The descriptors used by the EBRD for the value of 4.0 in the institutional indicators are: ●

●

●

Competition policy: significant enforcement actions to reduce abuse of power and to promote a competitive environment. Banking reform: significant movement of banking laws towards BIS standards. Securities markets: laws and regulations approaching IOSCO standards.

Clearly, the attainment of institutional development is still far from the above descriptions; hence, unlike with market liberalization; one cannot even consider these countries as being fully comparable to other market economies. It is notable that the Baltics are at the same level and South-East Europe is not however that far behind, certainly much less so than the CISM where the best that can be said is that they have been moving forward measurably since 1994, unlike the CISL. Finally, what do the values of Table 2.4 imply for the debates about the relative importance and sequencing of liberalization and institutions? First, note that the degree of institutional reform reached before growth started was not that high in Central Europe, the Baltics, or for that matter in the CISM countries. Indeed, even by 2003 the level of development of institutions still had a long way to go in the advanced countries, yet no major damage to the performance of the economies appears to have occurred. True, growth slowed a lot in Central Europe, but not in the Baltics – the reasons are discussed below. Johnson and Subramanian (2005) propose that, generally, good economic policy alone can give growth a start, but sustained growth requires improved institutions. The case of Central Europe appears to fit this well. In the first recovery phase 1993–98, GDP grew after the surge of liberalization but then slowed as institutional reform lagged. As these picked up slowly, stronger growth returned after 2000.

62 Background

Second, there is not a single instance of slow liberalizers moving ahead more rapidly (or even at the same pace) with institutional reforms as a true gradualist strategy implies. To the contrary, those that liberalized fastest also moved fastest on institutional reforms, albeit with a lag.13 The EBRD makes the point that partial liberalization creates ‘winners … who block further progress in reforms’ (EBRD, Transition Report, 2000, p. 30). Perhaps, the most important inference is that the slow reformers were not slow reformers for the reasons often given by internal proponents of gradual liberalization – ‘the economy is not ready for market operations’ – else they would have speeded up institutional reform to prepare the economy for subsequent market liberalization; significantly, nowhere is this pattern visible. This may help one understand the main problem with gradualist arguments. Recall they were motivated by the notion that liberalizing too fast ahead of institutional developments would be less effective and create more dislocation and pain. Many countries did move slowly but none did what theoretical gradualists recommend, moving faster on the institutional side. Why? Self-interest of the political leadership. Part II goes into this more deeply.

Main determinants of growth in transition14 Many studies of growth and recovery in the transition had already been done by the late 1990s, less than a full decade after the process began. There were already over a dozen econometric cross-country studies covering most of these countries, surveyed by Havrylyshyn (2001) and Campos and Coricelli (2002). While these studies fell short of definitive answers on all of the key debates of the 1990s, they showed a surprising degree of consensus: the standard factor input variables are not important; prior financial stabilization is virtually a sine qua non; liberalization and structural reforms are key explanatory variables; unfavourable initial conditions can reduce growth prospects but this effect declines as time passes; and good institutions do matter but complement rather than substitute for liberalizing policies in the sense that they need not precede liberalization, but must soon begin to catch up. Consider each of these conclusions. In the 1990s there was a renewed interest by economists in explaining growth by going beyond the role of factor inputs – land, natural resources, labour, physical and human capital – which were central to earlier Solowtype models. Factor inputs continue to play a large role, but other explanatory variables have been added as exemplified by the work of Barro and Sal-i-Martin (1995). But transition economies’ growth in the 1990s is not analogous to the long-term equilibrium growth path that is usually modelled in growth studies. As Havrylyshyn et al. (1998) noted, the dynamics in this period are not a matter of moving the economy to a higher productionpossibility frontier (PPF) through expansion of factor inputs or even technological change. Rather, it is a matter of correcting the inefficiencies of the


communist period including moving from inside the PPF to the PPF, and shifting allocation along the PPF to an international comparative advantage position. It is in a word the application to the production function of the Kornai–Blanchard (KB) paradigm changes noted in Chapter 1. Therefore it is not surprising that all efforts to include capital, usually proxied by the investment/GDP ratio, show insignificant and often negative results. A slight clarification may be needed. The above results do not imply that investment is not needed in the transition process of reallocating resources. To the contrary, at the micro-level of enterprises a lot of new (but often small) investment is taking place. But, in the aggregate, the amount of new investments in early phases of the transition may not – and need not – exceed replacement levels for the preexisting capital stock. Indeed, Campos and Coricelli (2002) list as one of seven stylized facts of growth in the transition that in the aggregate ‘capital shrank’, if old industries are inefficient, a shift from them to more efficient ones or – as was also often the case – a shift within firms to more profitable product lines, can take place in an environment of negative or low net investment, as long as small gross new investments are going into more efficient production. The primacy of financial stabilization as a prerequisite for growth recovery is not a surprising result, nor indeed was it a controversial issue; as noted in Chapter 1, most critics of rapid reform or the Washington Consensus agreed on the need for stabilization. A couple of aspects of this do deserve attention, however. Some observers argued for the use of exchange rate anchors as the centre piece of any stabilization strategy. The econometric evidence does not give a clear-cut answer on their effectiveness, because in fact several categories of cases emerged historically. Some did indeed achieve successful stabilization while using an anchor (currency-board countries like Estonia, Lithuania and, effectively too, Latvia, then later Bulgaria), but a large number of Central European and later most CIS and SEE countries achieved stabilization without this anchor, though some of these had an approximation in the form of crawling/adjustable pegs (Poland), and some maintained a de facto proximity to a peg (Croatia). Russia is still debated (as on everything else!!), but it arguably had a peg of sorts until 1998, with demonstrably limited success in stabilization. Another unresolved detail in the econometric literature is whether budget tightness or inflation control are the determinant variables, or both. The attempts to sort this out are mixed: there is a consensus that lower inflation stimulates growth, but separate effects of inflation v. budget deficits are not easily established. This may be due to two factors. First, almost all these models are ad hoc and not derived from structural equations, including for example simultaneous determination of inflation and growth. In cases where inflation is separately determined, deficits do show positive and significant correlation with both inflation and growth. Second, fiscal deficits may have been too narrowly measured, excluding off-budget transfers, central-bank

64 Background

directed lending and so on. Since stabilization cannot be narrowly defined, a typically good proxy for the entire strategy may indeed be inflation reduction; hence the results one observes: inflation control is highly significant in growth regressions. Liberalization of markets and related structural reforms also show up as one of the main determinants of growth during the transition, though this is true for the aggregated synthetic measures, such as the EBRD transition index, less so for individual components. Thus, price liberalization alone is significant in only a few studies; privatization also comes out insignificant in most but occasionally significant in a few specifications. This suggests it is the combined effect of several policies that matters in creating new opportunities for private-sector activity, not a surprising or controversial result. It may be more controversial and important if one brings into the picture market institutions. Thus, as noted already in Chapter 1, quantitative analysis of the effects of privatization have come to a clear consensus, that transfer of ownership alone may at best have some small positive effects, but significant benefits come only with the complementary development of competitive market institutions. What this means precisely is not easy to define, because invariably all of the studies use some broad synthetic index of institutions: competitive environment, security of property rights, rule of law, government corruption. But it does strongly confirm the view that some minimum degree of institutional development is needed alongside private-sector development.15 It is important to note that neither market liberalization, privatization nor institutions alone have an overwhelming explanatory power, but rather all of them matter as they act in a complementary fashion. This last econometric result may teach a humble lesson both to big-bang reformers and gradualists. Rapid-reform advocates have by now understood it was not enough to recognize conceptually the role of institutions – the fact that they developed much more slowly in some countries than others may reflect insufficient weight given to them in policy recommendations. For both gradualists and institutionalists, this result says it was indeed necessary to move on several fronts at once, and there surely would have been little mileage in pushing first for institutional development while delaying the liberalization and privatization elements. Only a handful of econometric studies of growth have grappled with the debate on gradualism v. big-bang, but have not been as conclusive as simpler qualitative analysis, because each has defined speed in a different way. Heybey and Murrell (1999) find speed does not matter, rather the cumulated level of reforms does; Berg et al. (1999) define it as early attainment of a cumulative level and find it matters, in the same way the simpler analysis in the early part of this chapter shows that early reformers have performed much better. That a cumulated level of reforms eventually also brings growth may be right, and the evidence of the CISM growth surge discussed below is


consistent with such an interpretation. But that does not gainsay the interim period loss of output that slower reformers suffer. Concerning the importance of initial conditions relative to reform policies such as stabilization, liberalization and institutional development, there is no clear-cut result in the econometric studies or in qualitative analyses. In the econometrics, these have been measured variously as degree of overindustrialization, share of defence industry, years under communism (a proxy for market memory or ‘mental’ distance from capitalism), distance from European markets, war or civil conflict, and so on. Because the possible number of measures of initial conditions is so large, the results vary according to choice of variable, choice of period, econometric specification. One of the strongest findings showing a strong role of initial conditions is de Melo et al. (1997). Later, Havrylyshyn et al. (1998), using the same measures with additional years of data, point out that even if this was true in early years, the statistical significance of initial conditions declines over time. In the same spirit, Zinnes et al. (2001) distinguish immutable conditions (geography, history) from changeable ones (degree of industrialization, share of defence), and also find the latter matter little after a short period of time. Perhaps the strongest argument against the relevance of initial conditions has not been tested in the literature, namely that some of them may have either negative or positive effects on growth. Thus, for example, the high share of defence industry in some countries (high in Ukraine and Russia, very low in the Baltic Republics; high in Slovakia, lower in Czech Republic) can be both a drag on the reallocation to new industries, but also, given that it contained the highest level of human capital and technology, an opportunity for generating a lot of new growth under the proper incentives. This is analogous to the common arguments about natural resources, which in principle under good policies should be a benefit to the country, but in practice because it may lead to complacency and bad policies often turns out historically to be a negative influence on growth. That defence industries were often strong lobbies for slow adjustment is hardly debatable. It has become a nearly unanimous view that institutions are important for sustained growth, though as an excellent review by Johnson and Subramanian (2005) warns, this sometimes verges on faddism, with a large unanswered question: is there any way one can effectively promote good institutions? The works covered by their review as well as many earlier ones address the role of institutions in non-transition economies, starting with the pioneering contributions of North (1993; 1995) and ending with the most recent revival of his ideas for developing countries. Here I note only a few points about institutions and growth most pertinent to transition. Only a handful of the writings analysing growth in transition include institutional quality as a variable. Moers (1999), Havrylyshyn and van Roeden (2003) conclude that institutions do contribute significantly to growth in transition, but especially in the later phase of sustained growth, while with

66 Background

liberalization, stabilization and initial conditions are more important in the early recovery. Beck and Thorsten (2005) show econometric results that attribute almost all the explanatory power to institutional quality alone, a suspicious result for the short term, though consistent with the ‘deep explanation’ school of thought, as Johnson and Subramanian (2005) labelled it, that is that, in the long run, since good institutions lead to good policies, they alone fully explain growth. Becks and Thorsten (2005) also attempt to model factors behind institutional development, and find that greater inertia of socialist ideology plus reliance on natural resource exports are statistically significant. Simply put, they argue these two factors lead to strong rent-seeking behaviour and evolution of vested interests which oppose institutional development. Chapter 5 elaborates on the role of ideology or commitment, and is generally supportive of their view. But the importance of natural resource exports is less convincing; a striking counter-example is Ukraine, an energy-dependent country where oligarch evolution was second to none. Chapter 6 tells the more complete story on rent-seeking in post-communist transition. Such endogeneity amongst initial conditions, policies, institutions and growth is the strongest argument for the importance of initial conditions, albeit a fragile one. It cannot be disputed that policy choices are not made in an abstract text-book vacuum, but must be influenced by the economic and political circumstances facing governments. It is entirely legitimate to describe the process as one in which actual policy choices made (say the TPI values of Latvia v. Ukraine in 1994) were influenced by the different initial conditions. But this logic in its extreme leads to nothing more than historical determinism, emasculating the role of any policy choice, and must therefore be argued with great caution. That this extreme version does show up often is manifested by the immense popularity of the view that Central Europe, being close to Western Europe and having a shorter period under communism, was bound to do better. If one buys into these simple explanations, one must also conclude there are millions of wasted pages of print discussing transition policies and recommendations in the past decade; such an argument basically says what happened would have happened regardless of policy advice. I take the view here that there was a relevant policy choice despite the importance of these historical influences. This is exemplified in the early 1990s by the very slow reforms in Romania, the aborted efforts to move quickly in Albania, Bulgaria, Kyrgyz Republic, Moldova and especially Russia, and the very early efforts of Armenia and Georgia which were stalled by civil conflicts. Some of these were reversed by policy (Bulgaria, Moldova, Russia), some frustrated by the land-bound geographic isolation (Kyrgyz Republic) and some by inattention to financial time-bombs (Albania and less dramatically the Czech Republic). These examples show that choices could be and were made contrary to what the historical forces dictated. This view is also


informed by the reality of how choices are made; that is, not objectively according to the most compelling intellectual argument, but influenced by vested interests. Anyone closely involved with policy-making in the early euphoric period of post-communism will find the following examples familiar. In the former USSR republics, many politicians and policy-makers had been members of the political or technical nomenklatura, and it was not difficult even for outsiders to understand quickly who was in favour of a shift to the market and who was, for various reasons, opposed. The opponents never stated publicly, or even in large closed meetings, that they were against the market; instead they played for time to find good arguments against, or at least for not going all the way to a private-market economy. Intellectual debates on how best to do it, the many methods of privatization, the burden of initial conditions, the pain of too-rapid reforms provided the opponents to reform with the ‘scientific’ rationale they needed. Thus, one soon heard from them that one must go slow lest the people starve as prices become unaffordable, that one can privatize bakeries but require new owners to produce only bread lest there be shortages, that one must put in place all the legislation and agencies that regulate competition before privatizing. A personal favourite of mine is the use of market-memory arguments, especially by Kolkhoz directors arguing against too rapid privatization of the land: ‘It’s a good idea of course, but it must wait until the people are ready for the market.’ Invariably when such words were uttered, it was in fact the speaker who was not ready for the market. Let me be clear that the above discussion is not part of the logical criticism of gradualist arguments: one must not hold intellectuals responsible for the misuse of their arguments by politicians and policy-makers in government. Thus, intellectuals who recommended gradual reforms cannot be at fault that their arguments were used to buy time by politicians who were against any reforms. But at the same time, one should also not fault proponents of big-bang reforms whose arguments were misused by politicians who had no intention of doing the full package but were playing off various interests and the public for popularity, as in Russia early on. It is, however, the intellectual responsibility of both sides when doing an ex post analysis to recognize the potential abuse of ideas by practitioners, and to factor this reality of implementation of ideas into the historical assessment. Understanding the surge in CIS growth rates after 1998 The econometric studies of growth generally cover only the 1990s given the time lag between data availability and publication of research papers. Unfortunately they miss a key turning point in the recovery, that is the surge in growth rates after 1999 for CISM countries, at which time interestingly the CISL experienced a slowdown. The broad outlines of this trend are seen in Table 2.5. The simplest and most popular explanation has been the sharp

68 Background

increase in oil and gas prices which directly benefited Azerbaijan, Kazakhstan, Russia and Turkmenistan and was thought to benefit indirectly others in the region through the spillover effect of increased imports. The problem with the spillover argument is that it was not enough to explain the equally high growth rates for major energy importers such as Ukraine – surely the termsof-trade loss should have kept their rates lower. Furthermore, the import effect was declining over time, as the diversification of trade away from intra-CIS trade continued and for many in the region the share of exports to Russia had fallen from well over 50 per cent in the 1990s to a third or less by 2002 (see Elborgh-Woytek, 2003). Owen and Robinson (2003) demonstrate that even for Russia oil was not the whole story – at least as important was the beneficial side-effect of the 1998 financial crisis of a real exchange rate adjustment, initially nearly 50 per cent devaluation, followed by a gradual appreciation to 75–80 per cent of pre-crisis value until 2003. The rouble then rose sharply to regain its real 1998 value by mid-2005. Most of the other CISM currencies eventually followed the rouble devaluation, and hence also benefited from this effect on growth of export and import-substituting domestic production. Berengaut et al. (2002) provides a good analysis of the various possible factors behind this growth surge, and include, besides the above two, the simple possibility that Ukraine (and by extension others) had hit such a low point in the decline, that the rebound was bound to be strong. It is useful to recollect the very high growth rates (5–10%) in the mid1990s when war and internal conflicts subsided in countries such as Albania, Armenia and Georgia. Tajikistan, since 2000, may be a similar case. But Berengaut et al. (2002) also include a policy variable in their explanation for Ukraine: a distinct hardening of the budget constraint especially as it relates to implicit energy rents and subsidies under the more reform-minded Prime Minister Yuschenko and his Energy Minister Tymoshenko. Owen (2004) and Aslund (2004, Moscow Times) and others describe a similar hardening in Russia under Putin, with regional budgets subordinated to the federal budget, tax collections greatly increased, and oil revenues wisely used to pay off substantial portions of the external debt, which fell from over 60 per cent of GDP in 1999 to about 25 per cent in 2003. Does this surge in growth conform with the econometric consensus described above? In one way it is contrary to expectations: the Central European countries, with much higher values of the TPI, have now seen growth decline to an average far below that of the CISM, as seen in Table 2.4, though the average for the Baltics remains high and comparable after a sharp dip in 1999 reflecting the Russian crisis. However, this is too static an interpretation of the relation between level of market progress attained and growth. For the Central European and Baltic countries which by this time had TPI values in the range 3.4 to 3.8, or very close to a well-functioning market economy, and indices of output that even


in official terms were beyond full recovery, the short-term factors which explain recovery begin to be replaced by conventional explanations. This is not the place for a detailed analysis of that sort, but note that the much faster growing Baltics have kept their public deficits well under 3 per cent, while those of Central Europe have exploded way beyond 5 per cent. For the CIS countries, the most relevant question to ask with the background of earlier econometric studies may be whether they had by 1999 reached the same cumulative level of TPI values that one saw for Central Europe and the Baltics at the time of their first recovery; that is, an average in the year preceding first positive growth of TPI 2.55 (2.50 for Central Europe and 2.65 for Baltics). Table 2.5 shows for each CISM country the approximate year in which this value was reached, in brackets the TPI value, and then the year of first positive growth. With a few exceptions,16 the picture one sees is that when the first positive growth was seen in CISM countries, they had reached something close to the same magnitude of TPI values as had been the case in the Central European recoveries. In most Table 2.5 Growth of GDP since 1998

Central Europe Baltics CISM

1999

2000

2001

2002

2003

2.4

3.7

3.5

3.3

3.2

0.1 4.2

6.0 8.8

7.0 6.4

6.3 5.5

5.7 6.7

Source: EBRD Transition Report, 2003, table A3.1. For 2002 the average excludes Kyrgyz where a goldmine incident caused growth to fall from about 5–6% trend to 0.5%.

Table 2.6 Year that the TPI growth threshold (2.55) was reached for CISM countries

Armenia Georgia Kazakhstan Russia Kyrgyz Moldova Ukraine Azerbaijan Tajikistan Source:

Year reached

TI value

Year of first growth

1997 1996 1996 1995 1995 1995 2000 2001 2003

(2.45) (2.5) (2.6) (2.5) (2.5) (2.5) (2.54) (2.45) (2.39)

1994 1995 1996 1996 1996 1997 2000 1996 1997

EBRD Transition Report, various years.

70 Background

CISM cases this was before 1998, but the beginning of the recovery trend was hit by the financial crisis in Russia, though the delay was not long with the recovery even picking up additional momentum from the post-1998 factors mentioned above. Therefore, one can conclude that the recent surge in growth, while attributable to several factors, is at least in some part a reflection of having finally reached a sufficient degree of progress towards a market economy to stimulate local economic activity. The prospects for this being sustained are better left to a later discussion in Chapter 8, in particular for the countries where the role of vested interests or ‘oligarchs’ has become so important that their influence on policy must be considered when asking whether reforms will continue as they did in Central Europe, or perhaps be stalled if not actually reversed.

Appendix: unrecorded economic activity and measures of GDP Economic activities not captured by official GDP figures have many labels such as shadow, underground, unofficial or unrecorded. I use the last and Feige and Urban’s helpful shorthand YU. Feige and Urban (2004) is perhaps the most up to date and comprehensive review for transition countries, containing an excellent assessment of both the measurement issues and the analysis of factors driving activity underground. Their analysis by no means originates with transition country concerns but dates back at least to the early 1980s and previous work of Feige and Tanzi, and for transition starting with the comprehensive estimates by Kaufmann and Kaliberda (1996). This Appendix addresses only the measurement, focusing on the question of possible bias imparted to official GDP data. The magnitude of unrecorded activities in the post-communist period is generally considered to be a problem because it has increased sharply as a proportion of total economic activity (TEA in Feige-Urban), raising issues of GDP measurement, lost taxation and policy needs. How big is YU compared to other economies and how much has it increased? A recent comparison for 110 countries by Schneider and Klinglmair (2004) shows the average ratios in 1999–2000 by groups are: OECD countries 18 per cent; developing countries 41 per cent; and transition countries 38 per cent. I draw from these two operative conclusions. If there is a problem using official GDP for analysis in transition countries, the problem is probably as large for all developing countries – yet, little has been written about the need to redo the vast numbers of econometric studies of growth for this group. Nevertheless, in what follows I take seriously the criticisms about official GDP studies and try to ask how in the transition process there may be special biases. A second conclusion is that, with OECD country values around 18 per cent (low of 8.6% for Switzerland and high of 28.7% for Greece), a working cut-off point for ‘low’ values will be set here at 20 per cent. How much of an increase there was in the post-communist period is shown by Alexeev and Pyll (2003), who estimate a value back to 1979 for the FSU by republic. They show a (weighted) average for the USSR then of 34 per cent, dropping to 25 per cent in 1989. For comparison with post-independence years and other studies, an unweighted average is more useful. Using 1989, as this is the earliest available in Central Europe, the averages are: five Central European countries 19 per cent (22% if

Measuring Progress in Transition 71 the outlier Czechoslovakia is excluded); Baltics 22 per cent; four western CIS countries 25 per cent; four Caucasus-Central Asia countries 33 per cent. The comparable values in 1999–2000 given by Schneider and Klinglmair (2004) are: CE 29 per cent; Baltics 35 per cent; western CIS 47 per cent and Caucasus Central Asia 48 per cent. As some estimates even for the recent period after decline are in CIS higher than this, it is evident that the post-communist period did indeed see a considerable rise in the averages – which means it is important to analyse how the changes may bias GDP. Another important conclusion is that in the Soviet period, Central Europe, the Baltics and the western republics of the USSR were not very different with regards to unrecorded activities. This has great significance in the discussion of Part II of how the new oligarchs may have had roots in the soviet ‘mafia’, suggesting this force was not much less in Central Europe than in the USSR. A large unrecorded economy has the immediate bias that official GDP underestimates the total, and underestimates income and consumption. If this share is growing, as it was, the measures of increased poverty and inequality need to be considered cautiously. I return to this in Chapter 3. In this chapter, the concern is with growth rates and indices of recovery after the transition recession of the early 1990s. There are four categories to address the increasing bias problem. First, for countries where the shares are low, say about 20 per cent or less, as in OECD countries, there is little reason to undergo substantial effort to adjust or correct the calculations; second, for countries where the share is high, but fairly constant over the period, again too little bias exists in official figures to justify corrections; third, countries may show a clear trend up, or down, or a rise followed by a decline – this last is in fact the most common situation, and it implies a strong bias but one whose timing and direction is evident and correctable at least qualitatively; fourth is the worst case, where the share is volatile. Feige and Urban (2004) provide a thorough summary for 25 countries for 1990–2001, using several different measures. The authors conclude on a note of concern that the overall magnitudes, the sometimes large differences among methods, and the occasional ‘nonsense’ result of a negative share make estimates of YU very unreliable. On a constructive note with which the present author very much agrees, the vast amount of new information this study provides should be used to better understand the dynamics of unrecorded activities and thereby the transition process itself. What they do not discuss is the bias effect on official GDP growth estimates and hence the reliability of growth analyses. I will, with some caution, attempt to do by inference from their data, at the risk of coming to conclusions with which they might not agree. It is striking that for most countries different methods of estimation may show large absolute difference in some countries – over 20 percentage points in Azerbaijan – but very rarely do they show a different trend. This leads one to conclude that method variation is not a serious problem for growth-rate bias. Considering the four categories of outcome above, the most important and comforting inference is that only Turkmenistan shows considerable volatility over the decade, with about 2 1/2 cycles of ups and downs over a range of 0–40 per cent. The data problem for Turkmenistan is broader than this and, as noted in the body of the chapter, growth rates are probably overestimated. In the first category of low ratios we find five of the six Central Europe countries of Figure 2.1. The levels are in the range 10–25 and all trend slowly downwards over the decade, making the problem very limited by 2000. If there is a slight bias, it is to underestimate GDP growth in early years. The exception is not a major one: Croatia has values between 20–30 per cent, but quite constant in the trend, putting it into the second category and implying that growth rates are not much

72 Background biased. Only one other country shows a similar constancy in the trend line, Uzbekistan in the range around 10 or around 30 depending on method; again, the differences in method do not have significance for robustness of growth-rate estimates. Recall that in the main text discussion it was suggested that rates are overestimated, but for reasons unrelated to unrecorded activity share. Most of the countries are in the third category: medium to high ratios and a rising trend to about the mid-1990s and then a decline. There are some systematic differences among the groups of Figure 2.1, but these have little implication for growth-rate bias; the rise and decline trend for all these groups is the fact of greatest relevance to bias. The Baltics differ slightly from the other CEB cases with somewhat higher ratios in the early 1990s, between 35–45 per cent; clearly too high to consider as in the OECD range, and insignificant. But they experience a very sharp decline, especially after 1995, reaching CEB averages of 10–15 per cent by the end of the decade. SEE countries have ratios in early years as low as about 25 per cent (Romania), up to 60 per cent (Albania). The CISM group have all much higher ratios, typically 50 per cent or more, but declining to 20–40 per cent. That the CISL cases are lower is a reflection not of more advances, but the contrary: the freedom of private activity is still more circumscribed in these least-reformed economies so that the risk of penalties is great enough to discourage such activity. On this see inter alia Feige (1997), Feige and Urban (2004) and Kaufmann and Kaliberda (1996). In summary, only one country suffers from volatility of these ratios, but it has other serious data problems which make all interpretation for it uncertain. Another five countries in Central Europe have ratios too low, especially after 1995, to make much difference. The rest have medium to high ratios but a clear pattern of rise then decline. This means that official growth rates in the early years are underestimated compared to total economic activity (TEA) – in practice less negative than official data – and in later years somewhat overestimated, but as the share declines this bias narrows. Qualitatively, this applies to CE countries as well, since they too saw a rise and decline trend, but the effect is much smaller given the low ratios. Is this bias enough to reverse the common view that all economies suffered a decline? Feige and Urban (2004) compare period growth rates using official data and their TEA estimates, and the answer is clearly no, the transition recession remains a fact. Is the bias differentiated by countries enough to reverse the common view that the decline is greater as one goes East? The CE group in their estimate of TEA had less of a recovery than official data suggest, but still an overall positive growth over the period, hence an index by 2001 over 100 per cent compared to 1989. The CISL all show more of a decline, which is in keeping with the arguments made earlier that their decline was underestimated and recovery overestimated. For the Baltics period growth is a greater negative, because the recovery saw an apparent absorption of unrecorded activity. There is a mixed message in this: given the total activity in 1989 including unrecorded, the total 12 years later was still lower, but most unrecorded activity had been enticed into the open by the reforms including, presumably, perception of fairplay and a secure rule of law for small firms. The reader is also reminded of the fact that other reasons for underestimates of the absolute achievements exist unrelated to unrecorded activity – these are reviewed in Chapter 3 and while rough adjustments are shown in the second column of Table 2.1, the CISM countries show much variation by country, but for the group as a whole the net decline since 1989 is not nearly as large for TEA as for official data; however, it is still larger than in the other groups. Overall, then, the broad-brush picture of Table 2.1 is only moderately modified by taking into account the ‘best-practice’ information currently available about unrecorded economic activities.

Table A2.1 Transitional indicator averages (by group) 1989.0 1990.0

1991.0

1992.0

1993.0

1994.0

1995.0 1996.0 1997.0 1998.0 1999.0 2000.0 2001.0 2002.0 2003.0

CE Hungary Poland Czech R. Slovakia Slovenia Croatia

1.5 1.3 1.0 1.0 1.6 1.6

2.0 2.0 1.0 1.0 1.7 1.7

2.3 2.4 2.1 2.1 1.9 1.8

2.5 2.5 2.6 2.6 2.0 1.9

2.9 3.0 3.1 3.0 2.8 2.1

3.1 3.1 3.3 3.2 2.9 2.6

3.5 3.4 3.4 3.3 3.1 2.8

3.6 3.5 3.5 3.4 3.2 3.1

3.8 3.5 3.6 3.4 3.2 3.2

3.8 3.6 3.6 3.4 3.3 3.2

3.8 3.6 3.7 3.5 3.3 3.2

3.9 3.7 3.7 3.5 3.4 3.3

3.9 3.7 3.7 3.5 3.4 3.3

3.9 3.7 3.7 3.6 3.4 3.4

3.9 3.7 3.7 3.6 3.4 3.4

Baltics Estonia Latvia Lithuania

1.0 1.0 1.0

1.0 1.0 1.0

1.3 1.1 1.1

1.8 2.0 1.6

2.6 2.1 2.5

3.0 2.5 2.8

3.2 2.9 3.0

3.3 3.2 3.1

3.5 3.2 3.2

3.5 3.2 3.2

3.6 3.2 3.3

3.6 3.3 3.3

3.7 3.3 3.5

3.7 3.5 3.6

3.7 3.6 3.6

SEE Bulgaria Romania FYR Macedonia Albania Bosnia-Herzegovina Serbia & Montenegro

1.0 1.0 1.6 1.0 1.0 1.0

1.0 1.0 1.7 1.0 1.0 1.0

1.6 1.2 1.8 1.1 n.a. n.a.

1.8 1.6 1.8 1.6 n.a. n.a.

2.0 1.9 1.9 1.9 n.a. n.a.

2.3 2.3 2.4 2.1 n.a. n.a.

2.5 2.6 2.6 2.5 1.1 1.5

2.5 2.6 2.8 2.6 1.4 1.5

2.9 2.9 2.8 2.6 1.6 1.5

2.9 2.9 2.8 2.6 2.1 1.4

3.0 3.0 2.8 2.6 2.1 1.4

3.2 3.0 3.0 2.7 2.2 1.4

3.2 3.0 3.0 2.8 2.3 1.9

3.3 3.0 3.0 2.8 2.3 2.4

3.3 3.0 3.0 2.8 2.4 2.5

CISM Armenia Georgia Kazakhstan Russia Kyrgyzstan Moldova Ukraine Azerbaijan Tajikistan

1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0

1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0

1.0 1.0 1.0 1.1 1.0 1.0 1.0 1.0 1.0

1.5 1.2 1.3 1.9 1.5 1.4 1.2 1.1 1.3

1.5 1.4 1.5 2.2 1.8 1.7 1.3 1.3 1.3

1.5 1.4 1.8 2.4 2.5 2.1 1.5 1.3 1.3

2.2 2.1 2.3 2.7 2.9 2.7 2.3 1.8 1.8

2.5 2.6 2.8 3.0 2.9 2.7 2.5 1.9 1.8

2.6 2.8 2.9 3.0 3.0 2.7 2.6 2.3 1.9

2.7 2.9 2.9 2.6 3.0 2.8 2.6 2.5 2.1

2.7 2.9 2.8 2.5 3.0 2.8 2.6 2.5 2.2

2.7 3.0 2.9 2.6 3.0 2.8 2.7 2.5 2.3

2.9 3.0 2.9 2.8 3.0 2.8 2.7 2.2 2.3

3.0 3.0 2.9 2.9 3.0 2.8 2.8 2.7 2.4

3.0 3.0 3.0 2.9 3.0 2.8 2.8 2.7 2.4

CISL Uzbekistan Belarus Turkmenistan

1.0 1.0 1.0

1.0 1.0 1.0

1.0 1.0 1.0

1.1 1.1 1.0

1.4 1.6 1.0

2.0 1.6 1.1

2.4 2.1 1.3

2.4 1.9 1.3

2.3 1.8 1.6

2.2 1.6 1.5

2.1 1.5 1.5

2.1 1.6 1.4

2.0 1.8 1.3

2.2 1.8 1.3

2.2 1.9 1.3

73

Source: Author calculations based on EBRD Transition Report, various years.

74 5.0 4.5

TPI average

4.0 Hungary Poland Czech R. Slovakia Slovenia Croatia

3.5 3.0 2.5 2.0 1.5 1.0 0.5

19 97 .0 19 99 .0 20 01 .0 20 03 .0

19 89 .0 19 91 .0 19 93 .0 19 95 .0

0.0

5 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0

Hungary Poland Czech R. Slovakia Slovenia Croatia

19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03

Average LIB index

Figure A2.1 CE transition progress indicators (avg. per year)

5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 2003.0

2002.0

2001.0

2000.0

1999.0

1998.0

1997.0

1996.0

1995.0

1994.0

1993.0

1992.0

1991.0

1990.0

Estonia Latvia Lithuania

1989.0

TPI average

Figure A2.2 CE average liberalization index per year

Figure A2.3 Baltics transition progress indicators (avg per year)

75

Average LIB index

5 4.5 4 3.5 3 2.5

Estonia Latvia Lithuania

19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03

2 1.5 1 0.5 0

5 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0

Bulgaria Romania FYR Macedonia Albania Bosnia-Herzegovina Serbia & Montenegro

19 89 19 91 19 93 19 95 19 97 19 99 20 01 20 03

TPI average

Figure A2.4 Baltics average liberalization index per year

Figure A2.5 SEE transition progress indicators (avg. per year)

4 3.5 3 2.5

Bulgaria Romania FYR Macedonia Albania Bosnia-Herzegovina Serbia and Montenegro

2 1.5 1

03 20

01 20

99 19

97 19

95 19

93 19

91

0.5 0

19

Average LIB index

5 4.5

Figure A2.6 SEE average liberalization index per year

5 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0

03 20

01 20

99 19

97 19

95 19

93 19

19

19

91

Armenia Georgia Kazakhstan Russia Kyrgyzstan Moldova Ukraine Azerbaijan Tajikistan

89

TPI average

76

Figure A2.7 CISM transition progress indicators (avg. per year)

Average LIB index

5 4.5

Armenia Georgia Kazakhstan Russia Kyrgyzstan Moldova Ukraine Azerbaijan Tajikistan

4 3.5 3 2.5 2 1.5 1

03

20

02

01

20

20

00

99

20

98

19

19

97

96

19

19

95

94

19

19

93

19

92

19

19

91

0.5 0

03 20

01 20

99 19

97 19

95 19

93 19

91

Uzbekistan Belarus Turkmenistan

19

89

5 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0

19

TIP average

Figure A2.8 CISM average liberalization index per year

Figure A2.9 CISL transition progress indicators (avg. per year)

5 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0

20 03

20 01

19 99

19 97

19 95

Uzbekistan Belarus Turkmenistan

19 93

19 91

Average LIB index

77

Figure A2.10 CISL average liberalization index per year

3 Economic and Social Costs of Transition: A Hard Look at Soft Facts

Introduction Experience in developing countries of adjustment to macroeconomic imbalances and price distortions showed that some short-run costs were inevitable before improvements came. This accords with the economic theory of market equilibrium, that before investors, producers and consumers can react optimally, they need to have equilibrium price signals, but these come only after some period of trial and error. During this period there may be severe welfare costs as restructuring and reduced government support result in job losses, cuts in social services and a widening of income distribution differences. This was expected, but what was not predictable in advance was the magnitude of these costs, their burden on different groups, and their duration. This chapter will present the best available information on such costs over the period 1989 to about 2003–04. The main findings are three. First, these costs occurred in all countries and their magnitude ranged from significant to enormous. Second, the evidence also shows that many early assessments overstated the costs, partially because they were done too soon, at the mid-1990s bottom of the transition recession, and partly because of data biases. Third, the evidence shows these costs varied considerably across countries, with the faster reformers experiencing much lower negative effects, and over time even with lagging reformers having generally bottomed out about 1995 and reversed direction. The chapter is structured as follows. The next section will discuss conceptually the nature of transition costs, how to assess them relative to the benefits, how to measure them, and the caveats of statistical comparisons. We then give some numerical estimates of the aggregate magnitude of lost output and employment, followed by a focus on alternative social indicators including the UNDP’s Human Development Index (HDI), poverty, income inequality, health and education. A final section will draw some key conclusions about the patterns of the transition costs over time and across countries. 78

Economic and Social Costs of Transition 79

Were negative effects inevitable? An assessment of transition costs is best made in a Pareto-optimality context. There are three possible outcomes: first, only positive effects occur and a pure Pareto optimal state obtains with no-one made worse off; second, some individuals suffer costs but are adequately compensated; third some individuals suffer costs but are not fully compensated.1 The simplified framework of Chapter 2 describing what transition from plan to market entails leads to a corollary about negative transition effects of at least three types: direct effects, as jobs are lost in the process of reallocating resources from old inefficient firms and absorption by new efficient firms is delayed or partial; indirect effects on social programmes as government budgets are unable to maintain an adequate level of compensation; and distributional effects as a market-economy regime results in a widening of income distribution.2 With the possible exception of China where surplus labour in agriculture allowed new job-creation to precede destruction of inefficient firms, it is likely that all transition countries experienced these three effects to some degree and therefore experienced either a compensated Pareto-optimal result or an uncompensated one. The assessment I make in this book is still far from definitive as it may even now be too soon to make a judgment; but with that caveat it is possible to indicate where in this spectrum each of the country groups fell, and to note deviations of individual countries where relevant. In making such an assessment, some judgment on a time-horizon for compensation is necessary: a displaced worker who in a few years attains a standard of living superior to or with better prospects than in the socialist period might consider the temporary unemployment as compensated. The most practical question is: for any social indicators showing a deterioration, has this recovered to original levels, or at least turned around? Given that in all 27 countries in our groups, even the lagging ones, economic recovery is well on the way and indeed in many CIS countries is very strong since 2000, negative answers to these two questions would lead one to conclude that if after 10–15 years recovery to or beyond original levels is not attained, this is surely not a compensated Pareto optimal state. If the answer is ‘yes’ the judgment might be that a compensated Pareto optimal state, while not attained yet, is close. How to measure the economic and social costs? It is already possible to undertake an exhaustive inventory of economic and social indicators and the changes over time. Indeed the existing literature on this is already very large, and the availability of data continues to grow with many recent and continuing micro surveys on incomes, jobs, unemployment, health and education, even perceptions and attitudes. That literature reflects a vigorous debate between those who view the costs as excessive due to reforms that were too rapid, and those who argue that the costs were in fact lower where reforms were more rapid. I will provide here a selective rather than exhaustive

80 Background

set of information which captures the most important indicators of wellbeing, and attempt do so with balanced consideration of the two sides in this debate. As I associate myself with the rapid-reform school, it is appropriate to avoid methodology and data sources that bias results in that direction. In particular let me note that most of the data on social indicators is taken from detailed studies by proponents of the ‘too-rapid’ school and UN sources such as the UNDP Human Development Report and UNICEF Transmonee database; these sources are not generally suspected of Washington Consensus bias. The variables used here are: a measure of the output loss using official and adjusted GDP; some measures of unemployment; the percentage of population below the poverty line; Gini coefficients measuring equality or inequality of income distribution; the Human Development Index of the UNDP which has stood for more than a decade as the key alternative to GDP per capita for measuring well-being; life expectancy, considered by most analysts as perhaps the best single proxy for health status; and finally some measures of educational attainment. There are many data problems for three main reasons: comparison between Soviet-period definitions and market-period ones (the GDP loss calculation is most affected); a limited data availability for most recent years (income distribution); and accuracy of measurement (actual consumption; actual unemployment). Where these are particularly severe, I present a range of estimates. Specific data problems are described in more detail in the discussion for each of the variables. One last prefatory comment needs to be made on the problem of benchmarking. Part of this is a data problem as for example with the Gini-coefficient measure of income inequality. Values for the Socialist period abound, but using them as a reliable benchmark is not entirely objective,3 because it ignores the importance of an institutional reality of that period nicely captured in Feige (1997): ‘although incomes were distributed equally, differential access to [goods and services] and selective opportunities for illegal wealth accumulation created a highly unequal distribution’. This reality must at least be recognized in any assessment of changes after the transition to market. But the benchmark problem here is more than data definitions: a shift to private ownership and market determination was expected to lead to some widening of income distribution and that this would be arguably a good thing, creating incentive to greater effort both by labourers and entrepreneurs. The proper benchmark comparison is then not with the Gini levels of 1989, but perhaps those of market economies considered having ‘reasonable’ patterns of distribution. Another possible benchmark is China given its huge success in achieving high growth; the results may be surprising to some. To avoid misunderstanding, it should be clear from the outset that the above remarks on a benchmark for Gini do not apply to poverty measures. These are subject to data problems in both periods, but there is no analogous rational argument of a ‘good’ rise in poverty for motivation purposes. If


poverty ratios increase, this is prima facie evidence of a deterioration that requires compensation.

Aggregate economic costs: lost output and unemployment output losses A striking feature of the transition in the non-Asian region has been a substantial and extended decline in output. The extent of this output loss using official data is shown in Table 3.1, showing in the first row for each country group the index of aggregate GDP with 1989 as the base year. It is often characterized as ‘higher and more persistent than during the Great Depression’ (Grun and Klasen, 2001, p. 360). Many works have analysed the extent of this decline and consequences for welfare, and it is worth citing two important studies. UNDP (1998) analysed in great depth the evolution of various social indicators through 1995 and labelled them ‘the most acute poverty and welfare reversals in the world’. Milanovic’s (1998) analysis of income distribution, while noting ‘the economic landscape is changing for Table 3.1 Official and adjusted index of output (1989 100) Output index Low point

2002

Central Europe Official (Adjusted) Average

80 (94) 87

120 (148) 134

Baltics Official (Adjusted) Average

52 (80) 66

82 (128) 105

SEE Official (Adjusted) Average

61 (80) 71

81 (85) 83

CISM Official (Adjusted) Average

40 (70) 55

55 (96) 76

CISL Official (Adjusted) Average

60 (70) 65

96 (112) 104

Source: Official figures from the EBRD Annual Transition Reports; adjusted based on Aslund (2001), as explained in the text.

82 Background

the better’ nevertheless concludes that ‘massive dislocations … have had huge social costs’. For the worst-hit region, CISM, the index reached a low of 45 in the mid-1990s, and as late as 2003 had recovered only to 67. For Georgia these figures are correspondingly 27 in 1994 and 41 in 2003. The long duration of the decline is further exemplified by the fact that it continued as late as 1999 in Moldova and Ukraine, that is a full decade of negative growth. With numbers like this, it is small wonder that many observers concluded that transition has created a human disaster. While the fact of a large output decline is virtually undisputed, these orders of magnitude are overstated by varying degrees in different countries. Furthermore, the temptation to focus on the worst cases is misleading inasmuch as the best cases – especially in Central Europe – can easily be characterized as having suffered relatively minor losses over the period. As an illustration, consider that Poland’s decline lasted only two years, and even without any adjustment of official GDP the low point was 80; by 1996 the index had surpassed 100, and in 2003 was 135. For the Central Europe group in this study, if one excludes Croatia, the bottom was reached in 1992–93 at about 75–80, 100 was reached variously between 1997–99, and the average index in 2003 was 115. The correlation between limited decline and greater recovery on the one hand, and the early start on reforms on the other, has already been discussed in the previous chapter. The corollary point to be made here is that characterizing output decline in transition as a disaster without reference to the far superior performance in Central Europe, and eventually also in the Baltics, is somewhat misleading. An additional source of overstatement comes from using official GDP and the same benchmark date of 1989 for all countries. This point has been made by many analysts as noted in Chapter 2, but is most comprehensively dealt with in Aslund (2001). There are several corrections made, and his work provides estimates of how each of these adjustments change the index of output for 20 countries in 1995. His adjustments may go too far, and to minimize bias in my argument they will only be used for a broad-brush estimate of what might be the absolute minimum output losses for our five country groups. First consider a brief outline of the corrections. The simplest and easiest is the start date: Aslund argues that 1989 can be considered the last year of socialism in the four Visegrad countries, but that for almost all the rest – former Yugoslavia, former Soviet Union, Bulgaria, Romania – transition could not have begun earlier than 1992, making 1991 a more reasonable benchmark.4 This seems eminently sensible and indeed a bit conservative: one could argue that attributing output loss to transition reforms should start with the year in which significant reforms began, not the year in which they could have begun. This would mean the start year in much of the CIS other than Russia and Kyrgyz Republic would be about 1994–95, and in the CISL group arguably still in the future. But I have not done this, rather I take Aslund’s suggestions of 1991 for some countries. The main point is that any


loss before the start year should be attributed to socialism and not to transition. Aslund’s change in start year alone accounts for 15–25 points of the CIS 55 per cent decline. A second correction, perhaps the most important, is to discount the soviet period GDP for ‘value-subtracting activities’, that is the enormous inefficiency of producing unusable or very poor quality products all valued as if they were saleable on open markets.5 Informal activities and international trade mispricing make for further corrections, but of less significance generally than the previous ones. It is notable that Aslund’s corrections do not attempt to discount the soviet period GDP for the cost to individuals of queuing and attendant frustration of not always obtaining the desired goods. This is another reason his corrections are not greatly excessive. Value-subtraction adjustments, according to Aslund, account for 20 per cent or so of the loss under official GDP estimates. Aslund’s total adjustment paints a very different picture of output trends. His index values for 1995 show Central Europe (excluding Croatia) already more than recovered to 112, and the CIS is put at 86 (compared with official index values about 90 and 45 respectively). The adjustment for CIS is far greater because of the shift in the benchmark year to 1992 and the higher degree of ‘value-subtraction’ in the Soviet period compared to Central European satellites. To allow for a comparison with official data and a tracking of output at the trough, and in the latest year, I have projected Aslund’s 1995 estimate to the trough year where necessary and to 2002 using official growth rates. Aslund does not cover all the 27 countries, hence group averages using his sample are applied to the five groups here. The resulting calculations provide the comparative estimate of Table 3.1 (in brackets in the second row for each country group), and show a substantially greater recovery for all regions. Central Europe and the Baltics are well-beyond initial levels, SEE is close to recovery, and the CISM group had virtually recovered by 2002; the high growth rates in 2003 and 2004 might easily bring them over initial levels. While Aslund’s estimates are a reasonable but still conservative adjustment for this historical comparison, I propose to take an even more conservative approach and use an average of official and Aslund values for a calculation of cumulative output losses, in effect allowing for only one-half of the Aslund adjustment. This average is in the third row of Table 3.1 within each group. An alternative calculation not shown here, to adjust the GDP index only by shifting forward the start year for countries outside Central Europe, in fact gives values quite close to this average. Thus, even ignoring the effects of differences between Soviet and market accounting, and correcting only for the timing problem – that is attributing declines before regime change to socialism and not to the transition – changes the story considerably. What then is the picture that Table 3.1 paints? A painting may inadvertently be a nice analogy, because the vision will be in the eye of the beholder, ranging over three variants. The official data show a dramatic decline of

84 Background

60 per cent in CISM, 50 per cent in the Baltics, 40 per cent in SEE, but much less in Central Europe. The Aslund-adjusted decline is much less dramatic, about 30 per cent in CIS, even less in Baltics, and only 5–6 per cent decline in Central Europe. The average of the two moderates the worst-case scenario under official data but still implies a significant decline to the mid-1990s outside Central Europe of about one-third or less in the Baltics, SEE and CISL, and 45 per cent in CISM. This is an important and indisputable conclusion: with the exception of Central European countries, even the estimates after adjustments for accounting definitions (Aslund) reveal an output decline of at least 20–30 per cent in the first half of the 1990s. This may fall a bit short of the decline in the 1930s Depression, but is large enough to qualify historically as a serious deterioration and cannot but have had painful consequences for a large proportion of the population. The alternative picture of the economic cost of transition, providing an estimate of cumulative loss of output over the decade, again shows a range based on official data and the partial adjustment (third row) of Table 3.1. The exercise is necessarily very approximate for two reasons: the loss must be relative to a hypothetical counterfactual of output levels had transition not occurred, a counterfactual which can be disputed; and official annual data even where available for the whole period suffer from severe inconsistencies between recent and earlier publications. The technical details of these assumptions and the calculation mechanics are found in the Appendix to this chapter. Two counterfactuals are proposed here, both relatively favourable to the ability of continued socialism to maintain its output level. The first counterfactual, extremely favourable to socialism, is that for another decade or so under socialism, output might have continued to grow modestly for a few years, then to decline slowly. This is approximated roughly by an output level that stays steady at the 1989 (or 1991) level for a decade, and is implicitly assumed in most discussions of output loss.6 That this can actually be done with continued subsidization, inflation – creating credits, and barter trade arrangements – is arguably suggested by the cases of Belarus and Uzbekistan. A less favourable assumption is that the sustainability policies are less successful, and that after a year or two of mild positive growth, output crashes (as in fact it did before transition started in virtually all countries) reaching the same level as did actual output at about the same time in the mid-1990s. This is roughly approximated by a steady output level to the mid-1990s and a full crash to the actual low point reached.7 Even the last counterfactual is still relatively favourable to socialism. In fact it is undisputed that output started to decline in almost all countries well-before any serious transition reforms began, and it would not be implausible to posit as the least favourable counterfactual that continued socialism would have resulted in an output decline to the mid-1990s not much different from the actual one observed.8 The implication? Cumulative


output loss would be close to zero or at least very low until the actual low point was reached. To retain a conservative bias in calculations, I do not employ this least favourable counterfactual but it is discussed more fully in the Appendix. In assessing the values of Table 3.2, I wish to emphasize once again that even the lowest values rely on making the most conservative assumptions about the advantages of rapid market reforms and disadvantages of continued socialism. None of its values assumes continuation of socialism would have resulted in a decline after 1989–91 similar to the actual one observed before, though the case for this could easily be made. The smallest cumulative value, 25 per cent of annual GDP minimum loss in Central Europe under the average adjustment, is in fact more conservative than the full adjustment of Aslund (about 10 per cent loss), and further takes no account of eliminating the costs of queuing in the shortage economy. On the other side, the highest values of maximum loss using official data, 650 per cent of annual GDP, lean strongly in the direction most favourable to socialist continuation in two ways: there’s no need to make adjustments for overvalued socialist output, and socialist continuation would have allowed sustaining a viable and only declining economy for a decade beyond 1989. For those who accept both these assumptions, the loss in one of the regions could be said to reach nearly seven years of output. As noted several times, however, both the assumptions are highly implausible. The range of values in Table 3.2 is still very wide with a low of 25 per cent of initial output lost in 14 years in Central Europe under the partial Aslund adjustment, to a high of 650 per cent or nearly seven years of output in the CISM group under official accounting and assumptions most favourable to the viability of the socialist economy. But even the minimum values clearly show that for all but the Central European countries the losses were unusually high by historical standards, and proponents of rapid reform cannot deny the fact of a large aggregate cost. On the other side it seems equally clear that terms like ‘dramatic disaster’ are misplaced. Furthermore, if the

Table 3.2 Summary estimates of cumulative ouput loss (as per cent of 1989 GDP) Maximum (official data and most-favourable counterfactual)

Minimum I (partial adj. and less-favourable counterfactual)

Minimum II (full Asland adj. and less-favourable counterfactual

100 190 360 650 400

25 45 90 160 120

10 25 60 110 100

Central Europe Baltics SEE CISM CISL Source:

Appendix Table A3.1.

86 Background

time horizon for Pareto-optimality judgments goes beyond one decade, there are already substantial gains in Central Europe, somewhat less but still positive in the Baltics and the SEE group. The CISM countries with recent growth rates 5–10 per cent per annum are probably approaching the gains phase as well. The last column in Table 3.2 shows the cumulative losses using the full Aslund adjustment, which might be indicative of applying the least favourable counterfactual on socialism. This would amount to saying that socialism was already unable to sustain output by 1989, and without transition the decline would have been inevitable and perhaps not much less than the actual pace observed. Under this assumption much less output loss could be attributed to market reforms. Readers will choose what they judge most reasonable in this picture: the author’s (conservative) choice is that Central Europe experienced cumulative losses up to one-quarter of initial output, the Baltics one-third or so, SEE probably less than one year, and CISL somewhat over one year. The strongest impact came in the moderately reformist CISM with losses significantly more than one year, but probably less than two years of initial output. I admit to being tempted by the assumption that continued socialism would have resulted in nearly the same decline as actually occurred, in which case the cumulative losses would be lower still. The focus of this chapter is on the costs of transition rather than on its benefits. It may nevertheless be useful to give some indication of how much of the aggregate lost output has been recouped or surpassed. The simplest approach is to estimate how much cumulative GDP gain there has been from the time the index reached 100 per cent of the benchmark year value. Taking the average values of Table 3.1 (partially adjusted index), full recovery came sometime after 1995 but certainly well-before 2000. Hence, on average there has been about five years of pure ‘gain’, with index values by 2003 reaching 135–150 per cent (partial adjustment), which implies a cumulative gain of 50–60 per cent annual GDP. This gain exceeds the median estimates of loss for Central Europe and is about equal to the loss in the Baltics. Ignoring the CISL group with questionable data, the other groups, SEE and CISM, are only recently achieving full recovery, and net gains are minimal or still to come. However, the above characterization is the one least favourable to the case for market transition. If the hypothetical counterfactual were that under continued socialism output would have continued to deteriorate to reach nearly the same bottom as did actual output, then pure gain would have started from the first year of positive output growth. It would thus be far greater for CEB countries than the above rough estimates, and already significant for the others. Trends in employment and unemployment As with GDP, labour force data are subject to several problems of measurement and comparability. With appropriate caveats, it is nevertheless possible


to give a reasonable picture of the trends and note some stylized facts, the principal one – on which there is broad consensus – being that all countries experienced a substantial increase in unemployment. This section describes the main conclusions of earlier analysis on three issues: trends for unemployment rates by country group over time; labour-force participation and mobility; and some of the explanations for the fact of a very high and persistent unemployment. First, however, comes a brief discussion on the nature of the data problems. There are two main sources of unemployment data which provide coverage of all these countries for most of the period since the early 1990s: the UNICEF Transmonee database, and the EBRD Transition Reports.9 In principle, they both use the same national data sources, but some anomalies arise. EBRD provides more recent data, and for a number of countries, especially SEE, gives a longer time series. But while Transmonee indicates that for all countries the concept of unemployment is ‘Labor-Force-Survey’, which generally avoids the underestimation of ‘official registration’ data, the EBRD notes that in many CIS countries surveys are unavailable and the data shown is therefore registration-based. The anomaly is that despite the different definitions given, the actual values are very similar in Transmonee and EBRD, as seen in the group averages of Table 3.3; I infer from this that in fact both these sources give data from labour-force surveys where available and registration where not. This of course makes comparability across countries difficult, though the bias is clear. Many CIS countries show values less than 5 per cent, quite unlikely on the face of it; hence, their lower average is partly explained by this data problem. Thus, one sees in these two sources very low 2002 values for individual countries Tajikistan (2.4), Ukraine (3.8), Uzbekistan (0.4), Belarus (3.0), and the extreme case of Turkmenistan where employment is ‘guaranteed’, hence the official rate of unemployment is precisely (0.0). EBRD wisely treats the last case as ‘unavailable’ for the period. Transmonee shows a blank for all years, except 1999 where it is given at 4.9%, with unfortunately no explanation. These individual underestimates obviously imply the group averages for CISM and CISL are much too low. In a handful of cases informal estimates of actual unemployment exist, and EBRD (2003) notes the much higher figures: Tajikistan about 30 per cent and Turkmenistan about 19 per cent in 1998. Beyond this, comparability over time is also in question, as suggested by the cases of Georgia and Kyrgyzstan: for both EBRD shows very low rates until about 1997 and after that the values jump to the teens, 12.3 per cent and 17.4 per cent by 2002. As a last example of the difficulties such soft data create for a researcher, consider that in the EBRD (2000) summary of unemployment, Azerbaijan, along with Armenia, Kazakhstan and Russia, is one of four CIS countries with plausible values in the teens, suggestive of the possibility the data is based on surveys; but unhelpfully, there is no country-specific information on the

88 Background Table 3.3 Unemployment rates in the transition (percentage of labour force) 1996 Central Europe T_M EBRD

1999

2001–2

9.3 9.5

11.6 11.6

12.3 12.2

Baltics T_M EBRD

15.3 15.3

13.5 13.6

14.2 12.0

SEE T_M EBRD

17.6 10.5(28.8)*

18.4 15.1(32.9)

18.6 13.6(33.8)

CISM T_M EBRD

8.7 5.5

12.7 9.3

10.3 8.0

CISL T_M EBRD

n.a. 0.7

n.a. 1.4

n.a. 1.9

* The values in brackets are the average for 3 outliers: Bosnia-Herzegovina, Macedonia and Serbia-Montenegro. The unbracketed values are for Albania, Bulgaria and Romania. Source: The first row for each group is based on UNICEF Transmonee database (2004); the second row is from EBRD Transition Report (2000), table 5.1, and the 2003 report for latest values. Explanations: Transmonee data is in principle labour-force survey-based, EBRD official registration. For SEE, EBRD data is shown for two subgroups: the first number includes Albania, Bulgaria and Romania; the second in brackets Bosnia-Herzegovina (missing in 1996), Macedonia and SerbiaMontenegro. For CISL the average excludes Turkmenistan.

concept, only the general statement that in many CIS countries only registration is available. Also an internal anomaly appears within EBRD reports since 2002, showing in country tables values for Azerbaijan throughout the 1990s about 1–2 per cent. Transmonee shows only one year 2001, 12.8 per cent. Nevertheless, for most countries the two sources are broadly consistent, the values are plausible or the bias is known, and therefore general patterns can be deduced from the averages in Table 3.3. Ignoring the implausible values of the CISL group, it is clear all countries experienced a substantial level of unemployment during the transition. The higher values in the advanced reformers reflect a combination of the data underestimate in CIS, plus the well-recognized fact observed by many that, until the late 1990s, slow reformers’ workers were indeed kept on in the payroll, but they did little and were paid little, that is ‘in these countries labor market adjustment


took the form of … wage arrears’ (Campos and Coricelli, 2002, p. 807).10 The increase over time for the CIS is also a reflection of data problems and the gradual ending of informal employment, though in much of Central Europe where recovery occurred early, unemployment generally fell only slightly then rose again in the late 1990s. There are only a few exceptions to the persistence of high unemployment; in Hungary and Slovenia one observes a peak of 9–11 per cent about 1994, then a steady decline to less than 6 per cent by 2002. In the Baltics, Estonia had lower values, but also a continued rise until 2000, while the other two peaked at higher levels by 1995–96 with a steady decline thereafter. In SEE Bulgaria has somewhat the same pattern, but much higher values peaking at 20 per cent, declining to 15 per cent. Incidentally, there are two distinct subgroups, with Albania, Bulgaria and Romania in the range of just below 10 per cent to about 20 per cent, while Bosnia-Herzegovina, Macedonia and SerbiaMontenegro, no doubt reflecting the civil conflicts and greater political instability, range between 20–40 per cent. In the CIS, Kazakhstan and Russia show faint signs of a peaking in the late 1990s and a small reduction to 2002 consistent with the surge in growth since 1999, though the weak data of the region may hide other such cases or mislead on these two. Available observations are too few and too uncertain to allow any meaningful conclusion for the CISL group; recall however the informal estimate for Turkmenistan unemployment of 19.8 per cent. Patterns of labour-force mobility in the transition varied a great deal across countries in line with the variation in the nature of the adjustment, a point elaborated in Haltiwanger, Lehmann and Terrell (2003), who note that in the early period job-destruction dominates, and later job-creation rates catch up. Since CIS countries were slower to reform and force adjustment, the net misemployment came later than in Central Europe and the Baltics. But two other aspects were similar: there was a lot of mobility out of the labour force (Boeri, 2000), reflecting the traditional discouraged worker theory, and very little geographic mobility (Campos and Coricelli, 2002). The latter also note, however, that the mobility or turnover was very high in the sense of considerable flows from state to private activities and, as EBRD (2000) also illustrates, from declining sectors to growing ones. I turn now to some explanations of trends and an assessment of the unemployment cost of the transition. Why has there been such a high and persistent level of unemployment after more than a decade of transition? It is not enough to say this simply reflects the sharp decline in output, for two reasons: first, the actual output decline has probably been far less than official GDP figures show, especially in the Central European region; and second, the trend for unemployment after the mid-1990s did not follow the output recovery trend, but continued to stay high, or even rise despite positive output growth. There are two main (and complementary) explanations found in the literature: the excess employment of the communist period was very high and is still being worked out;

90 Background

and institutional labour-market rigidities have prevented a greater reabsorption of the unemployed. That excess employment of labour characterized the central-plan period is a widely accepted consensus, but there were no systematic estimates of the order of magnitude of this excess. The nature of inefficiencies, as explored ex post in Easterly and Fischer (1995), resulted in overemployment relative to the output produced. The excess is not simply attributable to the socialist principle enshrined in law that all are guaranteed employment. In fact, the tautplanning nature of the regime resulted in a ‘constant excess demand for labor’, as managers trying to meet monthly targets and obtain wage subsidies hoarded labour (Campos and Coricelli, 2002, p. 797). Rather, the inefficiencies came from misallocation of resources to labour-intensive technologies, poor incentives for employees, and a rigid system of centralized factor allocation that meant a low elasticity of substitution between labour and capital. Together these elements led to a level of employment that by international standards was highly inefficient, hence a labour to output ratio that was excessive. But the order of magnitude of this excess has not been estimated for this period. One possible ex post clue may come from those countries where the adjustment has been fastest, and unemployment performance best. Poland is not such a case even though recovery came earliest and the index of output has achieved the highest level, for there the problem of unemployment seems far greater than in other Central European and even Baltic countries. Poland’s unemployment rose sharply to about 15 per cent by 1993 before declining gradually, but the decline was reversed by a sharp rise since 2000, reaching a new high of about 18 per cent in 2002. In contrast, unemployment stayed at much lower levels in the Czech Republic, Estonia, Hungary and Slovenia, with peaks reaching 9–11 per cent, albeit at different points of the output cycle. While this might be considered a minimum indicator of Soviet-period overemployment, that value may be higher because these four countries were in Soviet times generally considered to have the highest efficiency (and not coincidentally highest per capita income). Furthermore, the process of cleaning out inefficient labour was certainly not complete by the mid-1990s when the peak was reached, but as Haltiwanger and Vodopivec (2002) show for fast-restructuring Estonia, job reallocation was very high even later, at a rate of 20 per cent, similar to that of the USA. Nevertheless, these better performers do set a rough benchmark for the others, making it difficult to deny the conclusion that the level of unemployment has been probably higher or of longer duration than the excesses of the Soviet period alone would imply. Unlike many other indicators, one cannot here adduce the explanation that slow reforms are to blame, since the very high rates are seen in many if not all of the rapid reformers of Central Europe and the Baltics and not just the CIS.11 It is useful to look for additional explanations, at least in cases of unemployment rates persistently above 10–15 per cent. Some of these are


country-specific, as the very high rates noted for three of the conflict-torn countries of SEE where political and social instability suppresses entrepreneurial initiative and output activity remains very low, while of course informal activity no doubt thrives. Feige and Urban (2004) show that Macedonia has not only a much higher share of informal sector than many others, but also a rising rather than declining trend. The EBRD (2000) analysis of employment trends argues that weak labour markets still obtain even in the more advanced reformers, reducing labour mobility and reallocation. One aspect of this is geographic mobility, which is very low, and which Campos and Coricelli (2002) attribute to distortions in the housing market such as urban registration formalities and a low stock of housing, both rigidities a carryover inherited from the Soviet period, though more of a problem in CIS than Central Europe. These explanations have some merit, but it is hard to complete the circle of logic and say ‘Eureka’, we now understand, for none of the analysis is able to assess how much of the actual unemployment is due to each of the determinants. For example, one might argue that institutions or housing constraints impeding geographic mobility are not yet truly binding factors, for the restructuring is far from complete in most of the countries, even in many of the more advanced reformers, and the output recovery is not strong enough to absorb unemployed at the new ratios of capital to labour. We are left in the end with a picture of substantial labour market shifts, considerable reallocation, but nevertheless rates of unemployment and discouraged employees which are very high and a good indication of the individual cost to the population brought about by the transition. Better performance on market reforms, growth and stabilization has eased this somewhat in a handful of countries, but the problem persists for most others.

Impact on individuals as measured by social indicators This section will review in some detail a number of concrete social indicators commonly used in the analysis of economic development and well-being. A key source for such data is the United Nations Development Programme’s annual Human Development Report (UNDP-HDR); in addition a large number of analytical studies of the UNDP, UNICEF and other agencies have produced studies of the social costs which provide considerable data. The following specific indicators are analysed over the period 1990–2001: the UNDP overall index of well-being (the Human Development Index, HDI); two income distribution indicators: the Gini coefficient and the per cent of population in poverty; life-expectancy proxying for health in general; and education enrolment ratios representing education and human-capital developments. Numerous studies exist assessing the worsening inequality, increased poverty and declining life-expectancy in the region, with many concluding

92 Background

like Grun and Klasen (2001) that: ‘Due to low inequality and moderate income levels, socialist countries enjoyed relatively high levels of economic well-being. In the transition, rising inequality and falling incomes have led to a dramatic absolute decline in well-being.’ An important work on this issue, UNDP, Poverty in Transition (1998) succinctly summarizes these events as ‘the most acute poverty and welfare reversals in the world’. Such strongly negative assessments may be exaggerated for three reasons: the data from the socialist period overstate well-being and understate inequality of distribution (primarily by ignoring the fact that distribution of income was more equal than distribution of goods); second, not all countries suffered to the same degree; and third, the time-lag of academic research resulted in coverage largely for the period of decline and did not adequately reflect possible recovery of well-being measures since the mid-1990s. Simply put, it may have been premature to assess costs of a process at its expected mid-point. Thus, the UNDP (1998) study compared 1990 and 1995 values; this is easiest to correct, as data up to 2001 are now available in UNDP sources to update the findings. The variation by country or country group is also easily observed and will figure prominently in this section. The most difficult correction to make is for the problem of data comparability between the Soviet and post-Soviet periods. I will not attempt to adjust for the (real) possibility that the communist regimes exaggerated data in a favourable direction, and use data as available, but I will refer to some evidence of such exaggeration. Students of economic methodology will find a lot of evidence of McCloskey’s (1987) ‘economic rhetoric’ in this literature, which includes not only the very negative assessments cited, but also rather more positive ones, as for example the EBRD Transition Report analysis on social costs in 1997, 1999 and 2000. The latter note inter alia a general tendency to recovery in these indicators, and further demonstrate that the degree of deterioration that did occur was highest where economic reform was less advanced. Indeed, the EBRD goes as far as concluding that, in Central Europe, indicators such as life-expectancy and education saw virtually no decline even in the first half of the decade. In the same conservative and balanced spirit as in the preceding data analysis, I rely as noted largely on data of the UNDPHDR, presumably not subject to the ‘Washington Consensus’ bias. Indeed, the very purpose of the Human Development Report when it was first initiated more than a decade ago was to provide an alternative to the GDP per capita and growth criteria most commonly used to evaluate development progress. This alternative is now exemplified by the HDI statistic the UNDP publishes annually. Though it may be useful to note that, just as economic performance statistics, social indicators are not problem-free and some caveats need to be laid out, the evolution of the HDI for the transition countries will be the basis for the first important quantitative assessment of social costs in transition.


Overall well-being: the human development index The HDI is, like the TPI of the EBRD used in preceding chapter, a synthetic construct with some implicit subjectivity on two counts: the choice of components, and the weighting scheme. Both of the above indices use equal weighting of components for lack of a good rationale justifying any other weighting. I do not propose any modification of either the TPI values or the HDI ones, and take them as they are reported by the respective institutions. Among the components of HDI, those most subject to difficulties are inequality indicators. Even in advanced economies there are many problems related to survey coverage, definition of the poverty line, and comparability across countries. For transition countries these are exacerbated by the nature of the communist regime with distorted prices, considerable in-kind support by enterprises, the fact that distribution of income and distribution of goods were different and separable concepts. Data on life-expectancy, mortality and school enrolment may be most free of problems, but even they suffer from incompleteness of data and deteriorating statistical services in the early transition period.12 With these caveats in mind, consider the evidence on general well-being or human development, as measured in UNDP’s HDI. It contains several elements, one of which is GDP per capita, while the others are more direct measures of well-being related to health, education, roles in society, gender and minority empowerment, and so on. Thus, it reflects not just social conditions but a combination of social and economic ones, and is meant to be a broader measure of well-being. Table 3.4 summarizes the tendencies for the five country groupings.

Table 3.4 Average human development indicator values 1990

1995

2001

Trend

Central Europe

.815

.821

.845

Baltics SEE (3 of 6)

.812 .752

.779 .749

.822 .772

CISM

.772

.721

.737

CISL

.767

.743

.760

5 rising, 1 decline full recovery 3 full recovery 1 rising, 2 decl., full recovery 1 rising, 7 part recovery, 1 cont’d decline 3 decline, full recovery

(Maximum 2001, Norway .944) Note: ‘Full recovery’ means that the 2001 HDI value regains its 1990 level; a ‘’ denotes it exceeds the 1990 level. Source:

UNDP, Human Development Report, various years.

94 Background

The EBRD conclusion that Central Europe suffered very little deterioration is strongly confirmed, as the average HDI shows no decline even in the first half of the decade. Within the group only Croatia shows a slight deterioration 1990–95 (from 0.801 to 0.794) which may not be surprising given the post-Yugoslav conflict. The EBRD conclusion on the negative correlation with reforms is also confirmed, as country groups with less reform progress experienced stronger deterioration in overall well-being. A strong deterioration is undeniable in the Baltics; however, by 2001 all three had surpassed the initial HDI level – a finding incidentally more in line with the adjusted output than the official output indicator of Table 3.1. The same appears to be true for South-East Europe, though the data here cover only three of six countries. Even in the CISM group we observe a clear recovery since 1995, albeit only partial. The exceptions to this trend are Moldova which has suffered a continued decline, while Kyrgyz Republic is shown to have been rising continuously, a result inconsistent with the data of UNDP on poverty ratios, but one that can be ignored without affecting the broad conclusion. The view of many critics that some countries like Belarus and Uzbekistan have avoided the worst of the deterioration (Grun and Klasen, 2001, p. 380) seems at first sight to be confirmed. The decline of HDI to 1995 was clearly much less for the CISL slow-reformers than for the CISM group. One should, however, leave to future analysts to determine whether the correct inference is that the very gradual reformers of CISL have successfully minimized the social costs, or whether their lack of adjustment and now-slower growth have merely postponed those costs. Some evidence like life-expectancy declines in Belarus and recent analysis of extensive poverty in Turkmensistan (World Bank, 2000) – discussed below – belie this rosy conclusion. The evolution of HDI clearly supports the view that countries which moved fastest and farthest on economic reforms experienced far lower social costs than slower reformers. This is contrary to the expectations of gradualists that rapid reforms would lead to substantial deterioration in social well-being. The evidence is consistent with a compromise view that partial and too slow reforms are worse than rapid, or no reforms: ‘slow transition might mean the process has been captured and delayed by old elites who are able to slow the move to a market economy and enrich themselves at the expense of the population’ (Grun and Klasen, 2001, p. 379). The lesser impact in CISL than CISM countries is consistent with the latter view. But the results for SEE countries which were also partial-reformers raise a question: why did they not suffer the same sharp deterioration as the CISM group? One possible answer is related to the effect of a strong desire for integration with Europe or, more explicitly, EU membership, which mitigates somewhat state capture and keeps reforms moving forward even if slowly. As discussed in Chapter 7, measures of state capture show lower values in SEE states. Finally, it is notable that the HDI values show a recovery trend from 1995 for all the groups, and individual country values (where available) show only one exception to this, Moldova.


But the overall patterns do not tell us how significant, costly or painful were the declines that did occur.13 As the HDI measure is a synthetic one, a per centage decline is not very meaningful; I suggest a useful benchmark is comparison to other countries in the HDI tables for the same year. Thus, the Baltics fell from a level in 1990 comparable to Malta and Argentina, to one in 1995 comparable to Mexico and Trinidad-Tobago. All these values are still in the range of the UNDP Report’s category of ‘High Human Development’. For the SEE the small decline was the equivalent of falling from the level of Panama to that of Saudi Arabia and Thailand, with the initial and subsequent values all in the top half of the Medium Development range. For the CISM group the more substantial decline can be envisioned as a decline from the bottom of the High Development range (about the same as Mexico, Trinidad-Tobago) far down the Medium Development range (about the same as Turkey and Ecuador). The recovery to 2001 has not lifted them much in the relative ranking, as most other developing countries have experienced continual improvements in HDI. Individual countries do not deviate much from this picture; only Tajikistan’s HDI falls below 0.700 in 1995 to a value of 0.665, which still put it solidly in the middle of the Medium Development range, at about the same level as Algeria and Syria, and incidentally only slightly below China’s 0.679 value. The above comparisons suggest that even the worst declines in well-being to 1995 were probably short of disastrous, and kept these countries’ life-standards in a broad sense well-above the levels of the least developed, that is the UNDP’s category: Low Human Development with HDI values below 0.500. On the other side of the ledger, it must be emphasized that HDI declining this much while in most other countries it was continually rising, is, if not disastrous, highly disappointing; China’s HDI of in 1990 began well-below that of the CIS (0.624 v. 0.772) and had by 2001 nearly caught up (0.721 v. 0.737). The averages alone, which of course do not capture any internal dispersion in these countries, again show, as with output loss data, that there was unquestionably a significant cost to transition. Some of the evidence on the dispersion and specific dimensions of social costs is discussed next. Change in income distribution: the Gini coefficient While the overall average HDI values show significant deterioration only for the CIS countries, the distributional impact was doubtless more severe, and the compensated Pareto-optimal criterion set as a benchmark for this assessment dictates a closer look at statistics for income distribution and poverty. These measures are fraught with measurement difficulties even in market economies where institutional arrangements are relatively stable over time, and these difficulties are compounded by the uncertain comparability of data in the socialist regime before 1989 and the market transformation period in the 1990s. The most recent review of inequality trends, Grun and Klasen (2001), addresses this issue and, relying on earlier detailed work of

96 Background

Atkinson and Micklewright (1992), Milanovic (1998) and Flemming and Micklewright (2000) conclude ‘no strong case can be made that … data from socialist countries systematically understate true inequality’. This may be too sanguine, because the reason a strong case cannot be made of how much privileged access to goods and in-kind services14 downward biases a Gini coefficient is that no hard data is available. An inability to make the case is not proof that there is no case to be made. The same can be said for the costs of queuing – even a simple arithmetic of hours spent in queues is not possible, and least of all is it possible to put a value on the costs of frustration at not getting the goods despite queuing. The last is not a minor nuance or splitting of hairs – in this chapter we are in the realm of welfare broadly defined à la HDI, where political empowerment is – as it should be – an element of the well-being index; the frustration of queuing is surely in the same dimension of human satisfaction. None of the authors cited is able to assess these critical characteristics of income–consumption links of the communist regime. Their efforts are limited to comparisons of survey design and coverage, the importance of in-kind earnings, the role of rationing of goods, but do not attempt to value queuing time. In fact, even on these matters, the cited works – while not able to make a strong case of bias – do admit there are biases, and generally in the direction of understating inequality in the socialist period. But without hard evidence they conclude effects are small. Atkinson and Micklewright (1992), Flemming and Micklewright (2000) note that Soviet data were ‘somewhat less reliable’; in-kind earnings were ‘not significantly’ more important in socialist countries; and were ‘not generally’ more unequally distributed. If one focuses on the italicized words, their sanguine conclusion can be drawn about comparability; if one focuses on the non-italicized ones, much more caution is warranted. Indeed, the best interpretation of these technical assessments is that there remains a suspicion of biases in the direction of understating inequality in socialist countries. Milanovic (1998) puts it nicely (p. 324) ‘We cannot do much [or anything] to remedy them.’ Indeed, he goes slightly further and expresses the belief that for Eastern Europe (our Central Europe and SEE) any effects are of a small magnitude and make comparisons over time meaningful, while for the Soviet Union comparisons are ‘much less reliable … [and] were biased … to show higher average incomes and lower inequality’. The reason he cites for this conclusion is the selective oversampling of two-employee parent households, which does not even account for further possible biases of the goods-access sort. What to make of all this? I would argue that while a strong quantitative case for systematic downward bias in socialist measures of inequality cannot be made, a strong case can be made that any biases were generally in that direction, and particularly so for the Soviet Union. Milanovic is right to say they cannot be corrected in the data, but adds that ‘these caveats … should … provide some caution when it comes to interpretation of the


results’. Here I will in fact use these data as they are, with the caveat that for Central and South-East Europe the bias is likely small enough to ignore, but for the countries formerly within the Soviet Union it is much larger, hence the deterioration in any inequality measure is ‘almost certain to appear larger than the actual change’ (Milanovic 1998, p. 324). Most important, some spotty evidence on very high poverty ratios in the Soviet period suggests the data on Gini values is distinctly biased. Consider first the most general measure of income distribution, the Gini coefficient, whose values theoretically range from ‘0.0’ with all incomes exactly equal, to nearly ‘1.0’ with a very few individuals enjoying most of the society’s income. Historically, typical Gini values were about 0.20–0.25 in socialist economies, 0.30–0.40 in advanced, industrial economies, and 0.35–0.45 or more in developing countries.15 Turning to the available data for transition economies, it is not surprising that a good single data source cannot be readily identified. The UNICEF Transmonee database is the only source that gives Gini values for most of the countries from 1989 to 2001, and these are shown in Table 3.5: the Transmonee group average is the first row in each cell, the second is the Table 3.5 Range of Gini estimates in the literature Pre-transition 1988–92

Mid-transition 1993–96

Most recent 1998–2001

Central 22 Europe 20–29 Transmonee average 19–28 (36) Transmonee range Others range

29 25–36 22–35

29 26–39 24–31

Baltics

25 24–25 23–25

35 28–39 31–35

36 32–40 32–37

SEE (3 countries only)

n.a. 16–26 16–23

27 23–29 25–33

33 28–40 28–41

CISM

27 25–32 23–30 (45)

42 32–49 34–50

46 39–52 29–52

CISL

25 23–26 23–28

n.a. n.a. n.a.

33 27–34 27–41

Source: UNICEF, Transmonee database (online) for the first two rows in each cell; others are: UNDP, HDR various years; UNDP (1998); EBRD Transition Reports various years; Milanovic (1998), Commander, et al. (1999), Svejnar (2002), Popova (2004), Kolodko (1999), Notten (2004), Keane and Prasad (2002), Sukiassyn (2004), Berry and Karin (2003).

98 Background

range of values across countries. Apart from the fact these are based on gross earnings – and therefore may overestimate inequality by excluding social transfers which we know took place16 – it turns out they are not always similar to the values found in the very large number of other studies and official data sources. Therefore, Table 3.5 shows, as the third row in each cell, the range of values found in a dozen such sources. These differences are too large to make one comfortable relying on one source only simply because it is the only one to have a time series. But all sources clearly coincide on the important conclusion, that the direction of change was towards an increase of the Gini coefficient, that is a greater inequality of income distribution. It must be emphasized that Table 3.5 is no more than a compilation from about a dozen studies culled from the literature, showing the range of Gini values for individual countries in the relevant groups, without adjustment for methodological differences: different years, different definitions, different survey methods. The compilation is meant only to show that the variation is very large, and conclusions about changes in the Gini coefficient must be treated with extreme caution. Grun and Klasen (2001) already noted the wide range of estimates for individual countries from just three different sources. With a lot of new data, Table 3.5 shows an even wider range than they observed. This is partly due to cases of just one country in a group having a much higher Gini coefficient, thus the significant outliers are identified separately. Thus, in the pre-transition period Russia ranges from 0.22 in one estimate for 1989 to 0.45 in another for 1992; in Central Europe an estimate for Croatia shows a value of 0.36 much beyond the range for the others in the group, 0.19 to 0.28. In the intermediate years, Russia with 0.52 is again at the high-end of the group, but for all the transition countries; however, it is not that much an outlier since within the CISM several others are in the upper forties range: Georgia 0.49, Ukraine 0.47, and Azerbaijan 0.45. At the end of the period, Russia is in one study as high as 0.49, again an outlier, with the rest of the group in the range 0.29–0.41. Similarly in the CISL group one sees a wide range with Turkmenistan at 0.45 and Belarus 0.27. There are several reasons for this wide range of estimates: even for individual countries, different surveys for approximately the same time period show different results; adjustments for comparability by researchers may lead to different estimates for the same country; the definitions vary, with Gini being calculated on earned income, net income, inclusive of inkind transfers, adjusted for public transfers, or even in a few cases the basis is expenditures rather than income. I have decided not to attempt any reconciliation, partly to demonstrate an important point: the level of the Gini in any year and hence the magnitude of change over the decade is extremely sensitive to assumptions made in survey designs, choice of income (or expenditure) basis, adjustments by researchers using the primary data, and so on.


Can any conclusions be drawn from such a wide range of estimates? I propose five, in approximate order of robustness: ●

● ●

●

●

The wide variation strongly signals the need for caution in drawing any conclusions. Despite the dispersion, it is evident that the Gini values rise in all countries. The rise in available estimated values is distinctly greater in CIS countries with Russia an evident outlier on the high side. There appears to be a stabilization and perhaps even a decline in the values from the mid-1990s to the latest period except in the Transmonee data. There is a strong hint for at least some CIS countries that the first big jump occurred in the first two or three years of the 1990s, that is before transition in any meaningful sense could have had much impact.

The first conclusion needs no further elaboration, and appears to be widely accepted in the literature. The other conclusions are more tentative and perhaps contentious, and merit some discussion. On the basis of the available data used for Table 3.5, there is not a single country case where the Gini does not rise from pre-transition values; this appears to be a very robust conclusion.17 This should not be surprising and was of course expected by all observers as an obvious effect of regime change. Socialist income precluded profit or rental income, and even wage structures were intentionally and transparently compressed; the switch to private ownership and market-determination of labour income necessarily widened the dispersion. I leave till later any normative consideration of whether the rise in Gini was excessive or about as large as might have been expected. The precise amount of increase is difficult to specify given the wide range of estimates but taking as a rough measure the difference between mid-points in the ranges of the three periods in Table 3.5, one can construct a rough approximation as in Table 3.6. This shows a clear pattern across the region, with Central European countries experiencing the least increase, about 3–4 points to the mid-1990s, compared to a rise in the same period of at least 10 and as much as 15 points in the CISM group. For all the other groups the rise is around 10 or less, though three cases of higher increase are seen: Estonia, Turkmenistan 12–13; and Romania 15, though the latter is only 10–12 if one excludes the (arguably) implausible value of 0.16 in the pre-transition period. The much greater increases in CIS countries may be systemically related to the state capture phenomenon, but this is less applicable to SEE, and is certainly not an adequate explanation for the Baltics. An additional factor is the greater likelihood in the Soviet countries of underestimating inequality in the socialist period as observed by Milanovic (1999). While it is not (yet?) possible to attempt any quantitative estimates of these two effects, it is surely

100 Background Table 3.6 Probable changes in Gini values

Central Europe Baltics SEE CISM CISL

To the mid-90s

Overall to about 2000

3–4 points 8–9 points 8–9 points 12–15 points n.a.

3–4 points 9–10 points 12 points 12–15 points 9–10 points

Source: Calculated from Table 3.5 as follows: approximate difference between mid-point of ranges shown for each time period.

plausible to conclude that some part of the difference in CE’s rise of 3–4 points and the 10–15 point rise elsewhere is attributable to an underestimate of the Gini coefficient in the early period. The greater entrenchment of communist elites and consequently greater abuse of privilege in the Soviet Union compared to Central Europe is, if not universally accepted, a common view held by Kremlinologists and political analysts of the transition.18 Did the rise in Gini peak at values reached in the mid-1990s? The available data seems to suggest it did for most countries, but is too weak to ascertain if an actual decline occurred. Thus for example for Poland, Svejnar (2002) gives values for 1993 and 1998 at 0.30 and 0.33, while Kolodko (2004) shows a peak in 1996 at 0.34 declining in 1998 to 0.31. Two groups are clear exceptions, Baltics and SEE with an apparent continual rise to latest years. The last group is easier to understand as cases of stop and go transition. Two of the countries, Bulgaria and Romania, experienced a renewed financial crisis in the mid-1990s after a reform process that was at best hesitant, then undertook a fresh start in 1997–98. Macedonia continued (and continues?) to be buffeted by civil conflicts at its borders and internally. The explanation must be different for the Baltics where reforms were rapid and steadily progressing; the most that can be said is that the increases after the mid-1990s were much lower than the fist big jump in the early 1990s. The evidence of peaking is stronger for CISM countries, and some Gini values in fact appear to fall somewhat from their peaks of the mid-1990s in most countries. Even the outlier case of Russia shows a range of Gini values that is about the same for both the intermediate and latest period. The same tendency is observed for Ukraine in Berry and Karin (2003), who cites consistent estimates for the years 1999–2002 as follows: 0.29, 0.29, 0.30, 0.31. There is also suggestive evidence from poverty data discussed below, showing that in Russia and Ukraine the peak of deterioration was about the time of the 1998 financial crisis, and that subsequently, as the strong recovery began in 2000, conditions improved measurably. Some of the evidence suggests that in CIS countries most of the widening of inequality occurred still in the socialist period or in the years before


significant market reforms. For maximum possible consistency I will refer here only to sources which have data for more than one year, presumably on a similar basis. Thus Popova (2004) gives a value for Russia in 1988 of 0.27 and in 1992 a value of 0.45; Svejnar (2002) shows for 1991 a value of 0.26 and in 1992 of 0.54. Commander et al. (1999) show a more gradual rise from 1987 (0.26) to 1992 (0.29) with the first big jump occurring in 1993 to 0.40. Some will conclude the jump was due to Russia’s 1992 ‘big-bang’, others will argue it was aborted soon and could not have had such a guide effect. Ukraine delayed any real start of stabilization and reforms until 1994–95 – as did many other CIS countries – hence any change in Gini before 1995 is clearly attributable to the socialist period or the inaction of governments and not to market reforms. For Ukraine, Svejnar (2002) shows Gini values in 1988 and 1995 of 0.23 and 0.47 respectively, suggesting much of the widening occurred before reforms. Any conclusion about deterioration of inequality prior to significant reforms cannot be definitive given the limited and weak database. Nevertheless, it is not implausible that income distribution would widen in CIS countries before the transition started for two reasons: the sharp deterioration of the fiscal and inflationary situation began before 1992–93; CIS countries continued to operate a regime that was at least quasi-socialist, and certainly did not approach market-like operations until the late 1990s,19 with an attendant sharp decline in output and hyperinflation. In addition, since the 1988 Law on Co-operatives legal opportunities for private ownership and profit income increased quickly. Both of these phenomena would result in some early widening of income distribution. At this point it may be useful to step back and ask the normative question: was the increase in Gini coefficients higher than appropriate for a regime switch from a planned socialist economy to a market economy with private ownership? There is no theoretically ‘correct’ benchmark for this, but to obtain some purchase on the issue consider three possible benchmarks: ●

●

●

the Gini values of Central European countries which, according to the HDI measure of well-being, went through the transition with virtually no worsening and certainly a net improvement after a decade of the process; the Gini values in other market economies, including in particular middleincome emerging markets, but also the high-income OECD countries; the Gini values in China, which like Central Europe saw a continued improvement in the HDI, and is frequently cited as a model of how transition should have been done.

Comparative data for this purpose are shown in Table 3.7, which shows the well-known fact that high-income countries of the OECD have much lower Gini coefficients than do middle-income developing countries, with ranges approximately 0.25–0.40 and 0.30–0.60 respectively. Transition countries,

102 Background Table 3.7 Range of Gini values by country groups

Transition countries Central Europe Baltics SEE CISM CISL Market economies High-income Middle-income

Lowest 2 countries

Highest 2 countries

Hungary, 0.24 Poland, 0.25 Latvia, 0.32 Macedonia, 0.28 Kyrgyz, 0.29 Kazakhstan, 0.31 Uzbekistan, 0.29

Slovenia, 0.31 Croatia, 0.36 Estonia, 0.37 Romania, 0.41 Armenia, 0.38 Russia, 0.49 Turkmenistan, 0.41

Denmark, 0.245 Sweden, 0.25 Indonesia, 0.30 South Korea, 0.32

Portugal, 0.39 USA, 0.41 Colombia, 0.57 Brazil, 0.60

Notes: Data ranges from 1996 to 2002. Ukraine (within CISM) estimates range from 0.29 to 0.41 which could make it one of the lowest or one of the highest – an excellent example illustrating non-robustness of Gini estimates. Memo item: China 0.40. Source: UNDP (1998) first column of table 4.5; all others UNDP, HDR, 2003. Highincome countries: top 21 by HDR rank. Middle-income emerging markets: Korea, Uruguay, Chile, Mexico, Malaysia, Panama, Colombia, Brazil, Venezuela, Thailand, Peru, Philippines, Tunisia, Turkey, Jordan, Indonesia.

which as socialist economies earlier were even lower than this, now seem to fall in the middle between these two groups. Central European economies have values in the mid-twenties comparable to the lowest of the OECD countries (like Denmark, Sweden and other Scandinavian countries sometimes called ‘welfare states’). The Baltics and probably SEE, with few exceptions,20 are in the range 0.30–0.35, hence comparable to the mid-range of OECD countries and the low-range of middle-income emerging markets. The CIS countries show the widest range, with a few below 0.30, but several over 0.40 and approaching 0.50.21 These last are then comparable to the middleincome and developing countries with much more unequal income distribution. However, most except Russia still fall short of the very high cases with values of 0.50 and more, like Brazil, Colombia shown in the table, and Chile, Mexico, Venezuela and Paraguay. Similar high values are found in a number of low-income African and Latin American countries as well. From this one may conclude that increased income inequality as measured by the Gini coefficient has certainly taken place after the transition, but comparatively modestly for those countries in Central Europe, the Baltics and SEE with more progress on market reforms. In the CIS cases of slower reforms, it approaches levels at the lower end of the range for developing countries of


comparable income levels. One is tempted to say that with few exceptions the advanced transition countries are about where they should be on income distribution for a high-income market economy, and the lagging ones are also about where they should be relative to middle-income market economies, although generally better than the most unequal distribution cases. As to China, the UNDP’s most recent estimate for 1998 is 0.40, well in the upper range of the CIS countries. If one takes the high values of Table 3.5, China is exceeded only by Georgia, Armenia and Russia. Other studies show somewhat lower values for China, about 0.32–0.35. Comparing with the ranges in Table 3.5, it is clear that China’s income distribution by the end of the 1990s is certainly far less equal than that of Central Europe, slightly less equal than in the Baltics, and comparable with the range observed for SouthEast Europe and most CIS countries excluding outliers. It is useful to look at the changes in Gini values for China. Two recent studies, Gustafsson and Shi (2001) and Benjamin, Brandt and Giles (2004), provide a thorough analysis over time, differentiating rural and urban Gini values. As they use different methodologies, the results do not coincide precisely, but both conclude that a substantial rise in the Gini coefficient took place. The first of these shows urban Gini values (income) rising nine points from 0.23 in 1998 to 0.32 in 1995; the second for rural China shows a six-point rise from 0.29 in 1987 to 0.35 in 1999. They attribute the change to falling agricultural incomes as food prices declined, and to the rise of income opportunities in non-agricultural activities in rural areas. This reflects the well-known Chinese success of liberalizing reforms in rural areas. What is most important in this comparison is that despite avoiding a net output decline, China experienced increased inequality of a magnitude not much different than the average for non-Asian transition economies. The explicit policy aims in China were to introduce market mechanisms for their motivational and efficiency benefits, while receding only very gradually from various socialist instruments.22 Since China is generally considered a success in its own right even by those who do not believe its approach could have been used elsewhere – including the present author – it seems reasonable to infer that an acceptable and natural change in the Gini coefficient might be at least five and perhaps as much as 10 points. The China benchmark leads to the conclusion that none of the Central European countries exceeded this ‘reasonable’ increase (indeed they were generally at the lower end), and very few of the others did so. Depending on which Gini measures are correct, perhaps only Armenia, Russia, Turkmenistan and Ukraine did exceed the China benchmark by a few points, at least to the mid-1990s. Changes in income distribution: poverty ratios We turn next to direct measures of poverty, using in particular the povertyline concept and the measure ‘per cent of population below poverty line’, or poverty ratio. General caveats on data have been made earlier,23 but some

104 Background

difficulties and inconsistencies particular to poverty measures should be noted. First, however, a point on normative interpretation is warranted in advance. The reader will have understood from the preceding discussion on the Gini coefficient that I argue some increase in its value from the socialist period is not only ‘normal’ (unfortunately an indefinable magnitude), to be expected, and in fact a desirable part of the regime change to the extent higher income opportunities not available under socialism are a motivating factor for both labour and capital to exert greater efforts and enhance productivity. The empirical evidence hints at the view that the extent of increase seen in Central Europe and perhaps in other countries (to about 0.25–0.30 at least) is probably within this ‘desirable’ range. The same argument is categorically not applicable in the case of indicators showing people below the poverty line; any long-term increase of this indicator immediately fails the compensated Pareto-optimality test set out at the beginning of this monograph, and the word ‘deterioration’ is most appropriate. Simply put, governments of transition economies should at a minimum have ensured the necessary support and transfer mechanisms to avoid any worsening of poverty beyond a short term of, say, five years. Unfortunately, enormous data and poverty-line definition problems may exaggerate the extent of this deterioration, and furthermore underestimation of poverty in the socialist period analogous to that for Gini measures adds to the bias of exaggeration. The most comprehensive coverage of estimates for the poverty ratio is found in EBRD annual Transition Reports from 1998 which give values of the ‘international poverty line ratio’. But again, as with the Transmonee source for Gini values, there are internal inconsistencies and there exist several other sources which give sometimes very different values either because they use the national poverty line (most common in the transition literature – UNDP, 1998; Milanovic, 1998). Therefore, it will again be best to show both the EBRD values and those in other sources in our compilation. Table 3.8 gives individual country values from four sources to help track evolution over time, while Table 3.9 shows ranges for country groupings to allow an easier visualization of the tendencies. The first shortcoming of the EBRD compilation is that the year to which the data applies is not indicated except in the case of the 2003 Report, where it ranges from about 1998–2000, with a few cases of 1996 and 2001. It is thus difficult to assess the change in poverty over the transition, and for the CIS countries in particular where significant recovery only started in 1999–2000, difficult to see if there was a consequent decline in poverty. Also, the compilation switches sources and apparently definitions: from 1998–2000 the source is UNDP and the poverty line is 4$/day at PPP; in 2001–02 it is World Bank survey data at 4.3$/day; in 2003 it is the World Bank’s World Development Indicators at 2$/day. Does this explain the dramatic declines seen from the 2002 Report to that in 2003: Hungary 15.4 to 7.3; Poland 18.2 to 2; Georgia 30.9 to 15.3; Kyrgyz 84.1 to 34.1? Maybe, but in that case the

105 Table 3.8 Poverty ratio estimates: various sources Pre-transition

Mid-transition

Most recent

Central Europe Hungary Poland Czech R. Slovak R. Slovenia Croatia

1/2/2/1 6/13/-2 0/1/-/0 0/1/-/0 0/1/-/0 n.a.

3/15/25/4 19/18/24/20 1/1/-/1 1/1/-/1 1/1/-/1 n.a.

-/7/-/-/2/-/-/2/-/-/2/-/-/2/-/n.a.


1/-/-/1 1/-/-/1 1/-/-/1

40/40/9/37 25/35/-/22 46/23/-/30

-/5-/-/-/8/-/-/14/-/-

South-East Eur. Bulgaria Romania Macedonia Albania Bosnia-H. Serbia-M.

2/-/-/5 6/-/-/6 n.a. -/-/-/n.a. n.a.

33/33/36/15 39/45/22/59 n.a. -/-/29/n.a. n.a.

-/24/13/-/21/-/n.a. -/-/25/n.a. n.a.

14/-/-/13/-/-/5/-/-/5 2/-/-/12(10)(11) 12/-/-/12 4/-/-/4 2/-/-/2 (12–30) 34/-/-/51/-/-/-

-/86/55/-/60/12/50/50/35/65 45/50/31/50(-)(32) 84/84/51/88 65/85/23/66 41/41/32/63 (55) -/64/68/-/96/-/-

-/49/54/-/12/-/-/15/-/-/24/-/-(-)(15) -/34/64/-/64/-/-/46/-/-/ (45) -/9/50/-/51/-/-

24/-/-/24 1/-/-/1 12/-/-/12

47/31/-63 23/47/23/22 57/58/-/61

-/44/28/-/12/42/-/44/-/-

CISM Armenia Georgia Kazakhstan Russia Kyrgyz R. Moldova Ukraine Azerbaijan Tajikistan CISL Uzbekistan Belarus Turkmenistan

Notes: Pre-transition is before 1992 for Central Europe, before 1993 for others; mid-transition is respectively 1993–96 and 1994–97; most recent period 1997 and later, 1999 and later. EBRD Reports show the year of survey only in the 2003 reports, hence I have inferred years from earlier reports as follows. Central Europe, Reports of 1998–2000: assumed to be pre-transition and only highest value shown here; reports of 2000–02, assumed to be for mid-transition. For all other countries values in Reports 1998–2002 are assumed to be for mid-transition. This is partly based on a judgment of how the order-of-magnitude of values in EBRD correspond to other sources. Sources: The four values of poverty ratio estimate, separated by the forward slashes, are from the sources: UNDP (1998); EBRD TR; World Bank WDI; and Milanovic (1998) in that order. For Russia bracketed values is from Commander et al. (1999), Notten (2004). For Ukraine Berry and Karin (2003).

106 Background Table 3.9 Range of poverty ratios by country group and period

Central Europe Baltics S.E. Europe CISM CISL

Pre-transition

Mid-transition

Most recent

0–13 1 2–6 2–30 (51 Taj.) 1–24

1–25 22–46 15–45 12–96 22–63

2–7 5–14 13–24 12–64 12–44

Source: Table 3.8, lowest and highest values in each group for each period. In CISM, Tajikistan is an outlier at 51%, and is thus shown in brackets here.

time-series data in this source can hardly be used to make an analysis over time. The questions do not stop at this, because only the values shown in the 2003 Report can be reconciled with the World Bank publication of World Development Indicators (WDI); values in earlier reports cannot be reconciled with published World Bank data. The World Bank publication is also problematic, because it shows very few values for the earlier part of the 1990s precluding an assessment of what happened in the first part of the transition,24 when of course the expectation would be a deterioration of poverty. Fortunately, this deterioration trend is evident in the EBRD data as well as the key 1998 study on poverty by the UNDP. These data conundrums suggest a better approach is, as with Gini, to make a compilation with a range of estimates from different sources ignoring the methodological differences, and only refer to a single source when it gives useful comparative insights over time or across countries. As with Gini coefficient estimates, the first striking fact about poverty ratios in various sources is the very wide range. The main reason for the large differences is definition of the poverty line, whether it is national or international, the threshold (for example for international it is sometimes 4$/day PPP, sometimes 2$/day), the use of income or expenditure basis, and different survey coverage. Just as an example of the large sensitivity, the mid-1990s national poverty rates shown in Milanovic (1998) for Kyrgyzstan and Ukraine on an income basis are an astonishing 88 per cent and 63 per cent – higher than least developed African countries according to WDI data – while EBRD in its first detailed analysis of social impacts (Transition Report, 1999, Annex 1.1), calculates that with expenditure base the rates fall to about half, 46 per cent and 37 per cent respectively. Any effort to find consistent data, to reconcile different sources and definitions, or compile a time series for individual countries for a consistent definition ineluctably leads to two conclusions. First, it’s not possible to get enough consistent data for enough countries over the full period to allow a definitive assessment – or at least it would be a huge undertaking. Second, it is clear that the high-end estimates of the poverty ratio in the literature may be 2–3 times too high, because they


reflect simultaneously several upward biases: use of income rather than expenditure, a national rather than international poverty line, and an unrealistically high poverty threshold (for example 4$ a day rather than the $2 or 1$ commonly used in WDI for international comparisons). The wide range is especially evident in the Former Soviet Union (FSU). Thus, in the middle period Estonia ranges from 9–40 per cent, Lithuania 30–46 per cent, Russia 12–50 per cent, Ukraine 41–63 per cent and Georgia 11–60 per cent. Outside the FSU, only for Bulgaria (15–36%) and Romania (22–59%) does one see similar wide dispersion, while in contrast the maximum variation in Central Europe is for Hungary at 7–25 per cent. Can one infer anything about changes in poverty ratios since the start of transition despite the wide range of estimates? The answer as with Gini values is clearly yes, and equally clearly that in the first five to seven years of transition poverty increased substantially – though the high-end estimates may be exaggerated. The biggest changes, as with the findings on Gini, are in the CISM group. Many of the middle-period values in the CISM countries are so high that they are on the face of it doubtful: is 88 per cent for Kyrgyz Republic and 66 per cent for Moldova truly plausible? These values would seem to bespeak a disaster of starvation or nearly so, and are neither consistent with the anecdotal knowledge of the situation in CIS countries in the mid-1990s nor with the observation made earlier related to the HDI values falling no farther than to about the middle of the Medium Human Development range. Both the HDI and the Poverty in Transition report from which such values are taken are products of the UNDP, and to put it charitably they cannot both be right. It is likely the estimates of the cited report are exaggerated by the use of a poverty line which is unrealistically high. The effect can be substantial, using the EBRD (2002) report with a poverty line of $4.3/day the CISM average poverty ratio is calculated as 62 per cent. Using the (2003) report with a poverty line of $2.15/day, the CISM average falls by nearly half to 35 per cent, a value generally below that found in the very low-income African and Asian countries. But even 34 per cent is a large increase from the values thought to prevail in the socialist period, that is well-below 10 per cent for the western republics and moderately above 10 per cent for the others – with some exceptions as seen in Table 3.8. However, here too great caution is needed: as with the Gini coefficient, there may have been Soviet-period biases in the data showing less inequality and less poverty than in fact existed. This is clearly suggested in two detailed country studies. A very detailed study of poverty in Ukraine, Berry and Karin (2003), provides some further caution about interpreting these values noting the fact of unofficial economy activity being about equal to official at this time. The study also provides a hint of the unrealistic levels of poverty-line definition: for 1990 this is set at 100 karbovantsy (100 Soviet roubles), which was a very typical wage for a large majority of the population then. If projecting this

108 Background

poverty line forward with inflation results in the 41 per cent poverty ratio in the mid-1990s given by the UNDP (1998) Poverty Report or 63 per cent in Milanovic (1998), then either the poverty line is being set unreasonably high or the number of people in poverty in the socialist period was also very high. This last is a real possibility: for Ukraine Berry and Karin (2003) give poverty ratio values for 1980, 1990 and 1992 respectively of 38 per cent, 12 per cent and 30 per cent. These are for the 100 karbovantsy poverty line; for a lower poverty line defining the ‘ultra poor’ (83 k. which is not much lower and in my mind still doubtful), the percentages for the above years are: 23 per cent, 6 per cent and 17 per cent. For Russia, Commander et al. (1999) also show initial values higher than UNDP (1998), though much less so than Berry’s Ukraine numbers: 1990 5 per cent, 1991 10 per cent. As a further indication of how the Sovietperiod official values may have been downward-biased, they refer to a study of McAuley (1979) which suggests a poverty ratio in the late 1960s as high as 35–40 per cent. These estimates strongly suggest that the initial pretransition levels of poverty were rather higher than UNDP values show, analogous to the evidence of higher Gini coefficients already noted. Note also the anomalously high values in the pre-transition period for Azerbaijan (34%) and Tajikistan (51%), compared to about 12–14 per cent for Armenia, Georgia and Kyrgyzstan, also very low-income republics. Given the nature of the regime, it is difficult to believe that the transfers to low-income republics which kept poverty lines there not much above 10%, were not applicable to these two republics. A comprehensive study of poverty in the Soviet Union by Matthews (1986) points to several sources of downward biases in official poverty ratios, even as individual regional studies in the 1970s showed far higher ratios ranging from 15–18 per cent in richer places like Moscow and Estonia, 20–35 per cent in middle-income regions (Odessa, Novosibirsk) to 50–60 per cent in low-income locations (Tuva). At a minimum, this casts great doubt on the low-end estimates of single digits in the pre-transition period for USSR successor states, including even the Baltics. If we take the Soviet-period Matthews value of 18 per cent in Estonia as indicative for the Baltics and compare the values in Table 3.8, we can conclude that poverty increased to the mid-1990s by 10–20 percentage points, but by 2000 or so it fell sharply to levels well-below the Soviet period. Berry and Karin (2003) makes an excellent point that may explain the large differences: ‘many families were [never] too far above the poverty line’ and therefore it did not take much of a decline in output and consumption to push a lot of people over the edge into ‘official’ poverty. Similarly, Commander et al. (1999) show that ‘Russia entered the transition with a significant degree of inequality … significantly greater than in … Central Europe.’ Nevertheless, this does not negate the conclusion that outside of Central Europe there was a more than marginal increase in poverty, but rather a


significant one.25 Even taking roughly the top values for the early period (10–12%) and the middle of the range in the intermediate period, the poverty ratio jumps in FSU countries by about 20–30 points to values in many countries of at least 40 per cent or more.26 This is by no means a small number; poverty did increase dramatically, and it must have meant a great deal of suffering and pain for many individuals in the FSU countries, even in the Baltics, for at least half a decade, probably more. Consider briefly the other country groups. For much of Central Europe the increases can indeed be considered negligible, and the levels not much above 1–4 per cent, similar or even lower than some rich countries’ poverty ratios. Hungary and Poland were exceptions, with some estimates up to 15–20 per cent respectively in the mid-1990s using the national poverty line, though these have fallen a lot if one uses the WDI international line definition: from 11 per cent and 15 per cent in 1993, to 7 per cent and 2 per cent in 1998–99. In the Baltics, initial trends were similar to that of other former republics, though the peak levels reached were rather lower, in the range 25–40 per cent, but by the end of the period they all had values of 5–15 per cent, closer to Central Europe. Using an international line basis, the WDI shows for 1993 values of 20–30 per cent, and for 1998 already 2–14 per cent.27 The extent of poverty decline in the SEE group is also very large, and indeed close to the CISM experience. In some cases it was probably exacerbated by civil conflicts, but this was not a factor in Bulgaria and Romania where the ratio reached 35–45 per cent, or even higher in some estimates. Thus a deterioration of 20–30 points as in CISM is a reasonable assessment. Finally, the changes for the least-reformed economies are, as often for this group, open to interpretation. Those who want to argue these slower, gradual, reformers minimized social costs, will point out that national poverty line ratios rose less than in the CISM. Thus, UNDP (1998) notes in Belarus among the western CIS, it rises only to 23 per cent, compared to 40–60 per cent in the others; similarly, Uzbekistan had a value of ‘only’ 47 per cent, low for Central Asia. Those who argue the slow reforms did not help much to mitigate social costs (including this author) would counter with three points. First, other estimates (Milanovic, 1998) give values for Uzbekistan and Turkmenistan that are much higher and similar to the other CIS cases: 63 per cent and 61 per cent. Similarly for Belarus, Demidkina in Heenan and Lamontaigne (1999b) contends it may have been as high as 80 per cent, and actual unemployment not the 4 per cent official estimate but over 30 per cent. Second, using an international line comparison as in the WDI 2004, for most recent years (2000–01) the average for CISM is 33 per cent, while Turkmenistan (44%) and Uzbekistan (77%) are much higher, only Belarus remaining at very low levels (2%). Third, both Turkmenistan and Uzbekistan saw a continuing deterioration, from 1993 values of 26 per cent and 32 per cent, while many of the CISM countries experienced a decline in poverty ratio once the recovery began. I turn now to the recovery period trends.

110 Background

Was there a general stabilization or even reversal of poverty ratios since the mid-1990s? For Central Europe and the Baltics, some reversal is already apparent by the late 1990s, as the last column of Table 3.8 shows, but this conclusion is very tentative given the definitional change problem in the only data compilation which gives very recent years, the EBRD. If one ignores the warning of the World Bank’s WDI that international poverty ratios ‘cannot be compared with values reported in previous editions for individual countries’,28 the apparent trend is a decline in the ratio from its peaks for all but one country in Central Europe and Baltic group, also a decline for Bulgaria and Romania (no early years data for others). For the CISM, six of nine saw a decline (though marginal in case of Armenia: 55 per cent to 49 per cent), while two saw an increase (Moldova and Ukraine); no data given for Tajikistan. Some country-specific studies of poverty also show evidence of a decline after 2000. Notten (2004) gives values for Russia for 1994, 1998 and 2001 as 12 per cent, 32 per cent and 15 per cent, respectively. The pattern here is a sharp rise to the 1998 crisis and then a substantial improvement as the economy recovered from 2000. Berry and Karin (2003) find a similar pattern for Ukraine, but a less dramatic improvement from 2000, with an inferred decline in the ratio from 55 per cent in the mid-1990s to 50 per cent or a bit less. On balance, a tentative conclusion can be made that the deterioration in the poverty ratio has either flattened out, or even begun to reverse as output recovery translated into higher incomes, and the improved fiscal situation perhaps also resulted in better social safety nets. The worsening of poverty in the aggregate may have been mitigated by the short duration and the large turnover seen in labour-force dynamics: do the poverty percentages reflect a fixed group of people, or are there movements in and out of poverty over short periods? If so, as EBRD Transition Report 1997 argues, an additional relevant statistic is the share of population that is chronically or persistently poor, this being defined as falling under the poverty line throughout a 2–3-year period of a longitudinal survey. A striking result comes out: the share of chronically poor in the mid-1990s in Hungary was 12 per cent, but in Russia it was no higher, and indeed in the early 1990s Russia was lower at 8 per cent. One interpretation is that the stable part of poverty in Russia (and perhaps in other CIS countries) is about the same as in Central Europe, but the volatility of economic conditions (output, inflation, exchange rate movements) result in any one year in sharp ups and downs giving the higher poverty ratios typically observed. This result does not reverse the basic conclusion that, in particular in CIS countries, a large rise in poverty occurred with its attendant social costs: any reversal seen so far in that region is too little to be considered as compensation for about a decade of suffering for a large percentage of the population. On balance, the CIS countries did not meet well the Pareto-compensated criterion.


Life-expectancy: best proxy for health status Among the most often cited, dramatic and undeniable statistics reflecting the individual costs of transition is the figure of male life-expectancy in Russia ‘which declined by six years from 1989 to 1994’ (EBRD TR, 1999), specifically from 64 to 58 years, a level to be found only in the lower-middleincome countries. While this figure is an extreme, it serves well to focus attention on the fact that some of the transition countries did experience significant declines in health conditions. It is widely recognized that lifeexpectancy is an excellent proxy for other health indicators, and is for that reason the indicator the HDI formula uses it to represent health status. In this section I will use the male life-expectancy, as did the UNDP (1998) transition poverty study, in order to focus even more narrowly on the specific problem area.29 The quality of this statistic may be the highest for all the data so far used, as it is a simple enough definition subject to little alternative interpretation and generally thought to be reliably estimated in the socialist period, though some doubts are raised by analysts. For example, Handelman (1994) suggests official data overstated life-expectancy in the USSR, with informal sources giving a value of 63 years rather than 68 as in official data. While possible, this is less likely for these simpler data than for GDP or poverty indicator estimates. If the six-year decline is the upper bound, what were the trends for the rest of the region over the decade? As in our preceding analyses, the main questions asked of the statistics will be: how much of a change was there? how did this vary across the region, and in particular how was it related to the pace of reforms? has there been a recovery from the mid-1990s? It will not surprise the reader that the answers to the last two questions are very similar to the answers for all the other economic and social indicators. Table 3.10, based on the 2003 UNDP Human Development Report, summarizes the changes in this indicator. The Central European countries as a group and individually experienced no decline between 1990 and 1995, indeed there was a substantial increase to 70 years by 2001. In the early years of their transition, some of them did, however, experience minimal declines of 1/2 to 1 year to about 1993, so the phenomenon was marginally observable there as well. The early recovery of output discussed in Chapter 2 and the early correction of budget difficulties allowed the health expenditure to GDP ratio to recover and indeed rise from an average of 6 per cent in 1990–91 to 7.2 per cent in 1993–94 (UNDP, 1998). For the Baltics, the first half of the period brought a visible decline in male life-expectancy of 2 years, but this was fully recovered by 2001. South-East Europe for the most part avoided any decline; for Bosnia-Herzegovina and Serbia-Montenegro no data are available in the UNDP source, but any declines there would be likely be more attributable to war conditions. It is only when we look at CIS countries that significant deterioration is evident, though the sharp decline seen in Russia was not common. Despite

112 Background Table 3.10 Male life-expectancy trends in transition Type of trend (no. of countries) Life-expectancy (years)

CE Baltics SEE CISM CISL

1990

1995

2001

Rising

67.4 66.0 68.5 66.2 65.3

68.2 63.8 68.5 64.1 63.3

70.0 66.2 69.1 65.1 64.7

6 – 3 1 1

Decline Decline – No change surpass part recovery Decline (1) – 3 – 2 1

– – – 4 1

– – – 1 –

– – – 1 –

Notes: 1: The trend of life-expectancy rates is characterized as follows: rising continual increase from 1990 value; decline surpass decline after 1990, but recovery to reach value in 2001 higher than 1990; decline – part recovery decline with recovery to 2001 still below 1990; decline continual decrease 1990 to 2001; no change stable level in all 3 years. Source:

UNDP, Human Development Report, 2003.

the 3–6-year declines in some countries, the overall average fell much less, 2 years to be precise, and half of this was recovered by 2001. The comparison of CISM and CISL is interesting; while the output decline for CISL countries was apparently much less severe using official statistics, the decline in lifeexpectancy on average was the same as for the CISM, about 2 years. Indeed, for Belarus where the authorities and many outside observers proclaim that their very gradual approach to the market avoided the pains seen elsewhere, the decline in male mortality was 3 years, second only to Russia’s and higher than most other CISM countries which ventured farther on economic reforms. Furthermore, the recovery to 2001 is very modest in Belarus (64.0 to 64.3) compared to a recovery of 1 year in Russia and Ukraine, 1.5 in Moldova, 1.7 in Tajikistan and 3.1 in Kyrgyz Republic. What kept the CISM average so far below the extreme Russian values? The declines were very minor in Armenia, Georgia and Kazakhstan, while Azerbaijan actually experienced a modest increase throughout, rather surprising for the Caucasus given the conflicts that took place and the huge reported decline in output. Tremendous resilience of consumption and selfcare in such regions is one explanation (see Stillman and Thomas, 2004, for such an analysis of permanent income effects in Russia as well).30 The reasons for the decline in life-expectancy warrant a few observations. It has been noted that Central Europe’s early recovery and ability to maintain public expenditures was a factor. Also, the inefficiency of health delivery reforms in western CIS countries (see for example the analysis of closure of health facilities in Jack, 2002) explains the poor results there despite a very early recovery of health expenditure by the mid-1990s. Other studies have provided a thorough review of the linkages between the process of transition and health indicators such as life-expectancy: EBRD Transition


Report (1997), UNDP Poverty in Transition (1998) and Micklewright (1999) are excellent sources pointing to the following combination of key factors: the large drop in income, reduced budgetary resources for healthcare, poor policy coordination of the change in healthcare ‘from excessive security to the uncertainties of the market’ (UNDP, 1998, p. 39, the stresses associated with job-losses) or non-payment of wages even for the employed, high levels of alcohol and drug abuse especially for males, and increasing incidence of HIV/AIDS. To summarize in brief, life-expectancy trends again demonstrate that Central Europe, and to a lesser extent South-East Europe and the Baltics, either avoided altogether any deterioration of health standards as experienced a relatively minor decline, fully recovering or even surpassing initial standards. It is the CIS countries that experienced the greatest deterioration, again confirming the hypothesis that partial reforms may cause greater adjustment costs than more rapid and more complete reforms. Unlike economic indicators, however, life-expectancy trends in those countries which have undertaken least reform, the CISL, deteriorated about as much as in the more advanced CISM reformers. One interpretation of the latter is that the official output was upwardbiased in the CISL, either through data manipulation, or the simpler possibility that valuation with unreformed Soviet prices and accounting overstated the value of production. In any event, the evidence on life-expectancy adds to that from Gini and poverty-ratio data, to suggest the CISL group’s model of very gradual market reforms either shows much overstated output performance, or is unable to translate this better output performance into significantly better results for the well-being of the population compared to the CISM group. Education indicators: enrolment ratios A well-known criticism of Russia’s approach to economic reform by Reddaway and Glinski (2001) describes the result of applying the ‘shock therapy’ supported by many Western institutions and advisors as follows: ‘Russia from at least 1990 has been sinking into turmoil or decay’. In other parts of this book, I take issue with their assessment of the extent of decay and in particular the reasons for it. But on one dimension, the deterioration of the existing human capital base and the educational infrastructure that provided it, their concern is entirely valid: Russia which is their focus, as well as the other non-Baltic countries successor to the USSR, have been ‘precipitously losing … status as intellectual powers … and losing huge numbers of scientists’. In Russia they note the number has fallen from 3.4 million in the late 1980s to 1.3 million at the start of the current decade. Indeed, educational standards appears to be the one area, even more than with the case of life-expectancy, where data is not easily exaggerated in favour of one’s argument, and hence critics and proponents of rapid reform are largely in

114 Background Table 3.11 Gross educational enrolment ratios (%)

CE Baltics SEE CISM CISL CIS (EBRD)

1990

1995

2001

71 70 66 80 [84] 66

72 71 64 73 [78] 60

78 86 67 72 [81] 62

Source: 1995 and 2000 figures are from UNDP, HDR, 2003; the value for Turkmenistan is about 90%, far higher than any other: it was adjusted to 80%, similar to data in other sources. The values for 1990 were not given in either UNDP reports on a comparable gross basis, and hence these were inferred from the EBRD Transition Report 2002. For CISL this implied 86–89% for this group, far higher than values shown for other USSR republics before dissolution. The 1995 and 2001 values also seem higher, hence all are square bracketed for caution.

agreement.31 But yet again deterioration in education is barely visible, if at all, in the countries that have moved fastest on economic reform, Central Europe and the Baltics. The CIS countries are the ones where the problem is most acute, as seen in Table 3.11. There are some problems with the CIS data in particular, as the UNDP source gives values in 1995 and 2001 of 73 per cent and 72 per cent in the CISM, and 78 per cent and 81 per cent in CISL. Averaging the two gives about 76 per cent and 78 per cent respectively. These are not only implausibly higher than in the Central European and Baltic countries, but are inconsistent with the EBRD (2002) values for the CIS as a whole of 60 per cent and 62 per cent (whose source is UNICEF). There is no inconsistency between the two sources for the other country groups. Given this anomaly, I consider only the EBRD data for all CIS, which clearly show a sharp decline in gross enrolment rates for the CIS from a high of 80 per cent in 1990 to 73 per cent in 1995. No recovery is seen using UNDP data, indeed a small drop occurs, while the EBRD data show a partial recovery. It is significant that the average masks some of the more dramatic declines in the war-torn and lessdeveloped economies of the Caucasus, Central Asia as well as Moldova. Even worse, the deterioration is greater at the basic education level as noted in EBRD (1999). In 1989, all the republics of the USSR enjoyed broadly similar basic education enrolment percentages for the population between 7–15 years, at about 94–95 per cent even before transition. These ratios declined, in particular for the more agricultural economies such as Moldova, Caucasian countries and Central Asia, reaching levels of 84–85 per cent by 1995. While they have begun to rise since, much ground has been lost. Enrolment at the secondary and tertiary level has not fallen as much, hence if the numbers used to calculate the gross ratios shown in Table 3.10 are


correct, enrolment overall appears to have recovered to pre-transition levels. For some countries, the downward trend continues: Armenia, Georgia, Moldova and Azerbaijan. But the recent numbers are cast in doubt by the anomalies and inconsistencies among sources noted above. What about quality of education, and its reorientation to the different skills a market economy might demand? This is of course much more difficult to assess and indeed it may be too early to do so. There are three important dimensions to the quality of education: the quality of basic education, the role of private education opportunities and the reorientation of skills (see Spagat, 2002, for a good conceptual analysis of human-capital issues in transition, as well as the comprehensive review of skills and labour-market changes in EBRD TR, 2000). Several recent studies are beginning to throw some light on this, with some positive conclusions and some less rosy ones. On the positive side, Munich, Svejnar and Terrell (2002) show for the Czech Republic that reorientation to newly needed types of skills has increased the return to human-capital investment. UNICEF (1999) and Micklewright (1999) indicate there is a recovery of enrolment at least in tertiary education. But on the gloomier side, EBRD (1999) worries about the continued slump in enrolments at basic education levels, especially in the less-industrialized countries, and Micklewright (1999) notes the inequality of opportunity created by the development of private education. In as much as a broad and high-quality education was, by wide consensus, a positive legacy of the communist period – as was universal healthcare – it is surely a welfare-reducing effect that the process of transition to openmarket economies, which was intended to bring improvements, should result in a deterioration of this legacy. Reversing this decline must be very high on the priority list of remaining challenges for transition country governments.

Summing up the evidence on social costs No-one writing about or involved in the transition issue at the beginning expected immediate benefits; everyone agreed there would be a period of disturbance, decline in output, unemployment, and costs imposed upon some segment of the population. After about five years, many analysts (and politicians) began to make early assessments, which generally tended to emphasize the much higher than expected output and job losses, the sharp deterioration in various social indicators of health, the growing inequality and poverty. There was somewhat of a rhetorical tilt to these conclusions, and they seemed apparently to confirm the worst fears of the gradualism proponents that too-rapid reforms would generate huge cost which a more gradual pace was intended to minimize. The evidence in this chapter suggest two difficulties with such a conclusion. First, a closer look at what happened in the first half of the decade and how this varied across country groups strongly suggests that the costs were far less in the early and rapid reformers

116 Background

than they were in the delayed and partial reformers. Second, given the consensus that the process was going to be a U-curve, any assessments done after such a short period would necessarily emphasize the cost phase, and be unable to capture much of the benefit phase. This is not to say it was wrong to do interim assessments – it was absolutely legitimate and indeed useful. But it should have been clear that there would be a bias towards the cost side of the balance. Some remarks on each of these points. There is a large amount of evidence now available for social, political and economic results to about the mid-point of transition, mid-nineties when many countries had recovered and the laggards were bottoming out. The majority of performance measures is much more consistent with the view that more rapid reforms give earlier results and minimize costs, than it is with the opposing view that gradual reforms can minimize the costs. The advanced reformers of Central Europe and the Baltics had by 1995 done much better than the slower reforming CIS – with South-East Europe somewhere in between – on such indicators as output recovery, inflation, FDI per capita, democracy indicators, the broad measure of well-being captured by the UNDP’s HDI, as well as the more specific social indicators such as inequality measured by the Gini coefficient, increases in poverty ratios, lifeexpectancy and educational enrolment. For some indicators, the CISL group does better than the CISM, but in no case do any of the indicators show CISL countries doing better than the advanced reformers. Furthermore, not all the indicators are consistent on the CISL’s ‘superior’ performance: on output recovery, the HDI index, they come out slightly ahead, but on all the other indicators covered they do not, or indeed on some like inflation and FDI per capita are behind the CISM. Even apart from the possibility that the official GDP data for them is particularly uncertain, there is the deeper question of whether their lesser costs are because of successful implementation of a gradualist adjustment strategy or simply reflect a postponement of any advance towards a market economy and necessary restructuring. Certainly, their scores on the TPI measure show minimal progress in that direction, and indeed some reversal since the mid–late nineties. Even more indicative is the measure of TPI values for institutional elements, or as the EBRD labels them, second-phase reforms. A true gradualist policy would imply delaying liberalization and privatization while putting in place good institutions; the evidence in Chapter 2 is clear: they are farther behind on institutional development than they are on liberalization reforms. The quantitative evidence leaves no doubt that considerable costs were incurred even in the most advanced reformers – the high unemployment still persisting in most of Central Europe and the Baltics is undeniable. At the same time, critics of the transition who attribute such social costs to rapid economic reforms must think again: it is too obviously the case that deterioration in education, health and other social measures has been largely


avoided or quickly reversed precisely in the countries of Central Europe and the Baltics where reforms were the most rapid and consistent. To say, as for example Reddaway and Glinski do, that even proposing rapid reforms in Russia was a mistake as they would inevitably degenerate into abuse by elites, and neglect of the mass of the population, is not enough: the case needs to be made how gradual reforms would have avoided such abuse. There are possible answers, and I will return to this debate in the central part of this volume which argues that it was not too-rapid reforms but precisely the opposite, too-gradual, which allowed new capitalist elites – oligarchs in popular parlance – to capture the process, abuse it for their own interests and neglect the negative impacts on the larger populace. It is no coincidence that the countries which were the slowest in achieving economic recovery, and experienced the largest non-economic costs, were the countries with slowest reforms and greatest degree of non-democratic capture by a relatively small newly-minted or regenerated economic elite. On the timing issue, that the interim assessments were necessarily incomplete, it is now much easier to update most of the indicators to about 2000 or later, and to show that the worst of the deterioration is over and for all indicators the bottom has been reached with many but not all of them turning up. For the advanced reformers this means that the initial levels have not only been recovered, but have been surpassed. For the SEE and CIS countries, this is not yet the case, but the gains are now clearly visible. This conclusion is not as positive as it sounds at first sight: where the recovery of losses is not yet complete, there is clearly a situation one can compare to Latin America’s ‘lost decade of the eighties’ reflecting their debt-crisis. Beyond this is the result that losers are in such cases probably not yet being compensated even if there are many gainers and sufficient gains to have a compensated Pareto optimum. As a last word on costs, consider the Pareto-optimum criteria set out at the beginning, and how different countries have fared. Central European countries and perhaps the Baltics seem to fall on the margin between a compensated and an uncompensated Pareto optimum, while the SEE are surely still uncompensated for the most part, and the CIS even more so. The difficulties of interpreting the minimalist reforms of CISL countries preclude even a reasonable guess on this issue. For comparison, how about China? Its rapid growth, high growth of income across all income categories and declines in poverty ratios, suggest that despite a widening of income distribution it is surely in the zone of a Pareto optimum, perhaps even a more felicitous than a compensated one since, in absolute terms, there is no evidence that anyone was made literally worseoff, in an economic sense, though the loss of democratization and the continued rule of the communist party may be the trade-off. Does this mean European transition countries should have followed the Chinese model? I argue later that it does not.

118 Background

Appendix: estimates of output loss under different assumptions To measure the overall output decline from the start of transition is difficult enough given the data comparability problem noted in the main text. To measure the cumulative loss over the transition period is even more difficult because there are two additional problems: GDP values given in the standard sources are inconsistent over time; and one must assume a counterfactual of what GDP would have been under continued socialism after 1989 or 1991 respectively. The data problem becomes evident if one attempts a comprehensive but simple approach: measure the loss as an output index in year ‘t’ minus the initial year index (say 1989). EBRD Annual Transition Reports provide the best comprehensive time series of GDP indices and growth rates from 1989 to 2003. Taking the index value shown for each year from individual Annual Reports, unfortunately often gives rather different values than using the latest Report index value. This (not unusual) discrepancy reflects the substantial and frequent revisions of these estimates by country authorities and outside observers as statistical agencies struggled with the conversion to UN accounting standards, informal economy incorporation, and other problems. Arguably the latest revised data are generally considered the best; but given that the objective was to give only an approximate range of these losses, the decision I made was that using a year-by-year estimation with such uncertain data had no advantage over a cruder ‘triangle area’ approach described below. I will exclude the third counterfactual that is least favourable to socialism, but will include the one most favourable, SCFI, even though it flies in the face of the historical reality that brought these regimes to an end. Assuming the area Z1 and Z2 in Fig. A3.1. are roughly equal, one can approximate SCF2 using a simplification: output is flat from 1989 and then in the year that actual bottom was reached (low-point), it crashes to the level of actual output. This gives the SCF2 path shown in Fig. A3.2. Analogously, if in Fig. A3.1 the two areas between actual and SCF1 are about equal, one can simplify SCF1 as a straight line at the initial level of GDP. Note that this is exactly what is implicitly assumed in most discussions of GDP loss due to transition, which typically take the difference between actual GDP and the initial level. Thus for example, the EBRD Transition Report updates GDP annually as an index value, with 1989 100. The EBRD may not wish to suggest that the actual loss is the simple difference, but it leaves the door very wide open to precisely such an interpretation. First, however consider the range of possible counterfactuals for the path of GDP had the socialist regime continued. Given the nearly universal consensus that socialist efficiency was deteriorating well before 1990, the most favourable assumption (SCF1 in Fig. A3.1) might allow for some modest GDP increase under stimulus of subsidies for a few years followed by a gradual decline over several years, perhaps falling to the actual levels observed. The least favourable assumption (SCF3 in Fig. A3.1) starts from the reality that GDP in most countries began to fall before the regime change. Arguably, continuation of socialism would not have been able to halt this trend, hence GDP would have suffered about the same decline actually observed in the transition period, hence in effect no GDP loss attributable to transition. I also propose an intermediate assumption of delayed deterioration in which socialist output would have continued to grow very modestly with artificial support for at most 1 to 2 years, but would eventually crash dramatically as it in fact did in the early 1990s with negative growth rates in the double digits (SCF2 in Figure A3.1).

119 GDP index Actual 100

Z1

100 SCF3

SCF1

Z2 SCF2

Years of transition Lower point Full recovery Initial level of GDP Actual path of GDP Socialist counterfactual 1: Sustained but declining performance Socialist counterfactual 2: Briefly sustained growth, eventual crash Socialist counterfactual 3: Decline approximately as in ‘actual’ Figure A3.1 Actual GDP and socialist counterfactuals

GDP index

Actual SCF1 100

100 SCF2 A

Lower point SCF1 as in Fig A3.1 SCF2 as in Fig A3.1

B

Full recovery

Figure A3.2 Schema for calculating GDP loss under various counterfactuals

120 Background Table A3.1 Estimates of cumulative loss of output

Per cent loss using official data

Central Europe Baltics SEE CISM CISL

Years decline

Peak loss %

3.7

18

2.7 6.2 7.2 6.7

48 39 60 40

Min. loss %

Per cent loss using 1/2 Aslund adjustment

Full Aslund adjustment

Max. loss %

Peak loss

Min. loss

Max. loss

Min.

33

100

13

24

72

11

65 121 216 134

194 363 648 402

34 29 45 35

46 90 162 117

138 270 486 351

27 62 108 101

Note: For Central SE Europe this is the number of years 1989, though the cases of countries in the former Yugoslav Federation might, arguably, take 1991 as a start. For the Baltics and all CIS, the start is taken as 1991. Source: Author’s calculations as explained in the text using official GDP data from EBRD Transition Report 2003, and adjusted index values from Aslund (2001).

Here, I propose to calculate a range of loss values based on the triangles A and B in Fig. A3.2 as follows: A Loss in decline period [1/2 loss in through x years of decline]; B Loss in recovery period [1/2 loss in through x years of recover]. The value of Minimum Loss shown in Table A3.1 simply represents the intermediate counterfactual, SCF2, and is equal to the triangle A; under this counterfactual period of recovery does not imply any further transition losses, since by then the socialist regime would have crashed to about the same lows actually observed. I calculate a Maximum Loss based on the assumption most favourable to socialism; SCF1 in Figure A3.1, approximated by the flat line all the way across in Figure A3.2. Hence an additional output loss occurs in the recovery period equal to the area of the triangle B. This, added to the minimum, gives the maximum loss of output. Since the period of recovery appears to be longer than that of decline (see Table A3.1), the maximum is more than twice the minimum. Under the assumptions made here, even the resulting minimum is arguably on the high side because it ignores the decline actually experienced in the last years of the socialist period, and ignores the SCF3 counterfactual least favourable to socialism. Certainly, the maximum gives an extremely favourable tilt towards the ability of socialism to continue a decent ecnomic perfomance beyond 1989–91. To balance this tilt, Table A3.1 shows the maximum and minimum under different actual values, that is official data, one-half of the Aslund adjustment, and the full Aslund adjustment. It does not show values for SCF3, but the reader can easily imagine such a column added to Table A3.1, which would in fact show values of about zero as explained earlier.

Part II An Ex Post Transition Paradigm: Uncharted Waters, Pirate Raids and Safe Havens


4 The SS Transition Navigation Model

‘The fox knows many things, but the hedgehog knows one big one.’ Archilocus 7th c. BC1

Introduction Preceding chapters have described progress in transition towards a market economy for 27 countries, concluding that the degree of progress has varied a great deal. Most Central European countries – Croatia, the Czech Republic, Estonia, Hungary, Poland, Latvia, Lithuania, Slovakia and Slovenia – have essentially become fully operational market economies with little vestige of the communist period to distinguish them from other middle-income market economies. Though all of them retain some degree of government involvement in prices of critical consumer goods and varying degrees of state-ownership especially in utilities, a few may in fact have surpassed typical market economies in the extent of liberalization of the market and privatization of utilities. Estonia, and to a lesser degree Latvia and Lithuania have had to reduce liberalism recently to accord with the norms of the EU as they entered this club, especially on external trade. But most others are still far short of the typical market economy with considerable state-ownership even outside of utilities, and substantial state intervention in the economy both formal and informal. This is more true for CIS countries than for those of South-East Europe, and in the former group there is furthermore a significant gap between a small group who have moved only marginally from the regime of socialist central planning – Belarus, Uzbekistan, Turkmenistan – and the other nine where economic reforms, while far short of the transformation achieved in Central Europe, have gone far enough to dramatically alter the nature of these economies. Their transition is far from complete, the role of the market is not always dominant, free-entry and competition are often trumped by oligopolisic and lobbying powers, but they are nonetheless economies with reasonably functioning markets. 123

124 An Ex Post Transition Paradigm

Having explained what happened in Part I, we now turn, in Part II, to the second objective, to give an explanation of why it happened as it did, in particular why the considerable differences in progress described in Part I. Our preceding discussion already contains hints, suggesting broadly that countries which undertook relatively earlier and more rapid policy changes not only achieved a higher degree of market functionality, but generally did better on performance indicators in the areas of economic, social and democratic transformation. Part II puts this into a more complete logical framework, providing a parsimonious synthesis of the most important determinants of a country’s progress in transition. The present chapter begins by laying out a theoretical model or paradigm explaining the path of progress towards a market economy in a post-communist society.2 The model comprises three interacting elements or variables that determine progress in transition: the delay in starting reforms; the risk of rent-seeking vested interests capturing state policy; and the potential of EU membership acting as a guide to transformation. Chapters 5 through 7 provide an empirical application of the model, discussing how each of these elements played a role in the transition countries and how it leads to a better understanding of the actual outcome. Let me briefly motivate the model. The vast literature on transition of post-communist economies summarized in Chapter 1 contains a wide variety of explanations for the differences in progress among countries. Some of these differences arise between economists and political scientists or historians (many of the latter often arguing that a template approach such as the Washington Consensus ignores the political, historical initial conditions), but the spectrum of views is very large even within each discipline, and a parsimonious model to explain differences in progress does not readily offer itself from this literature.3 I will argue in the next section that the literature provides, if anything, too many explanations. One might try to reduce this vast diversity of views by focusing on the most important debated issues noted in Chapter 1: gradual v. big-bang reforms; the sequences among privatization, market liberalization and macro-stabilization; the relevance or irrelevance of how privatization is done; the timing of policies to promote competitive market institutions relative to other economic reforms; the potential conflict between market liberalization and democratization; the role of initial historical conditions v. new policy initiatives; the importance of EU membership prospects; the pros and cons of external involvement by international organizations and individual country assistance; and what may be the current most important question, whether the new oligarchic capitalists are a voice for rule of law and democracy, or the opposite. But even this approach risks losing perspective, because a comprehensive analysis for each of the outstanding issues leads to many explanatory factors and results in losing sight of the forest for the trees. The alternative followed here is to identify a parsimonious paradigm with sufficient explanatory power across countries to identify the most important common elements.

The SS Transition Navigation Model 125

The rest of the chapter is structured as follows. The next section discusses the pros and cons of what one may call an ‘encyclopedic approach’ to explaining progress, concluding that the approach is much too broad and indeed either confusing or inconsistent. I then set forth the parsimonious paradigm of the transition process (the navigation model), to provide a framework for the large number of factors delineated in the previous section. The model is built around three elements: the nature of the early debate on how to sail out into the ‘uncharted waters’ of market transformation; the extent of capture of the 27 ‘transition ships of state’ by rent-seeking ‘pirate raids’; and the impact on the process of having or not having a potential ‘safe haven’ such as EU membership or other external commitments like the WTO, the IMF, the World Bank, and so on (the sea-voyage allusions provide a useful mnemonic, and lead to the shorthand reference of a Navigation Model). I then go on to derive a number of testable empirical hypotheses from this model, and indicate the possible ways of measuring the relevant variables. In subsequent chapters existing quantitative studies are brought to bear on these hypotheses, and some new statistical analysis is presented. This provides results consistent with the Navigation Model. The final section concludes by noting how the model relates to the existing literature on transition, and what it offers that is new and unique; and an Appendix illustrates in broad terms how the paradigm might be formalized in a mathematical model.

The value of comprehensive explanations The process of transformation involves so many dimensions of the economy, polity and societal relations that one is easily tempted to conclude no simple systematic explanation of the process is possible because each country has a set of unique features which influenced the decisions and choices made. One way to deal with this is the case-study approach; that is, a detailed analysis of a single country or perhaps a small number of countries in a comparative analysis.4 Another is to include in cross-country quantitative studies a large number of characteristics of each country and allow the statistical analysis to tell the story of which ones matter most. In literature explaining growth in transition using econometric analysis one frequently finds initial-condition variables alongside policy-choice variables (Chapters 1 and 2). Were one to simply make an inventory of factors adduced in the transition literature, the list would be very long: in Figure 4.1 I illustrate this point with a listing of only some of the factors that such an ‘Encyclopedic Approach’ would produce. This already long list is easily extended in two ways. Additional factors have been considered, such as prior national status in history (Romania yes, Moldova no), intensity of national sentiment (Baltics high, Belarus modest), quality of transport infrastructure (Central Europe good, Western FSU


Initial conditions ● Natural resources* ● Landlocked status* ● Distance from Brussels* ● Years under communism ● Level of per cap. income ● Share of industry ● Concentration of heavy/military ind. ● Type of first gov. (communist/other) ● Ethnic homogeneity ● Major religion ● Educational attainment ● War/civil conflict ● Int’l organization membership ● Continuity of old elites

Transition policies Gradual or big-bang ● Year stabilization starts ● TPI value reached by year t ● Share of private sector by year t ● Effectiveness of rule-of-law ● Type of gov.: right, left ● Frequency of gov. change ● Freedom of press ● Degree of democracy ● Amount of foreign aid ● Involvement of IMF/WB ● Performance on IMF/Bank programmes ●

Figure 4.1 An encyclopedic approach to explaining diverse transition results (some illustrative factors) * Zinnes et al. (2001) usefully label these as immutable conditions, that is they cannot be changed by policy or time.

moderate, Central Asia poor). The reader will easily be able to add still others. For each of the factors listed, it is possible to elaborate or measure them in different ways: natural resource base can distinguish energy, mineral and agricultural wealth; overindustrialization can be measured as share of GDP, or the excess of this share relative to some benchmark; rule-of-law can be measured using one of the broad institutional indices mentioned earlier, or proxies, such as the length of time for commercial cases to be settled, the continuity of judges from communist period, and so on. The possibilities are endless and mind-boggling, pointing simultaneously to the major pro and con of this approach. On the one hand, a detailed recounting of how these myriad factors play out in a given country can give a rich and full understanding of a specific country, and in particular how its initial conditions have influenced policy choices. On the other hand, there may be so much country specificity that one loses all comparative perspective and fails to observe important common elements across countries. The Reddaway and Glinski (2001) study on Russia is best viewed as a superb historical account of why the initial conditions made it so difficult to successfully implement a rapid reform and stabilization policy agenda, but its limited comparative analysis precludes an understanding of why rapid reforms worked poorly there but far better elsewhere. Similarly, Van Zon (1998) attempts to explain the slow reforms in Ukraine by the need to build a nation state and the difficult inheritance of the Soviet period, but fails to address the question why other countries with the same national need and burdens – Moldova, Kyrgyz Republic, Georgia, not to speak of the Baltics – moved much faster.5 Kolodko (2000a) is right to note that the diverse


circumstances of countries makes the analysis of transition difficult, and is particularly prescient in saying ‘it becomes even more difficult if one looks not only at common denominators, but also searches for more detailed descriptions’. The advantages of the encyclopedic or comprehensive approach are clear and must be recognized: to understand well an individual country, the more comprehensive the story the better. A further advantage is that country specifics can be very helpful in understanding outliers in systematic crosscountry models. Thus, very early economic recovery in Poland compared to all others was not only due to its rapid stabilization and structural reforms, but was helped by the easing of its external debt burden and the fact of a populace that had been allowed to travel in the Socialist period much more than most others.6 The landlocked status of Kyrgyzstan may be the reason its growth has not been as strong as expected despite an early advance on reforms and it being the first in the CIS to attain WTO membership. Analogously, Moldova with a strong comparative advantage in food products was held back by the lack of access to the EU’s protected markets. But when it comes to comparative analysis across countries, the disadvantages of the encyclopedic approach outweigh its advantages. First, there may be too many factors which allow an enormous number of permutations, and in the end it becomes difficult to follow a line of logic applicable across countries, and difficult if not impossible to discern common factors. Second, it often happens that the same factor has opposite effects in different countries or over time,7 or an advantage works well for some and not at all for others. Third, there is a common tendency to fall into the ‘special case’ or ‘uniqueness’ trap for each country. The first point was illustrated above in reference to some well-known studies on Russia and Ukraine. The other two points are expanded upon below. There are numerous instances of inconsistency of explanatory effect for a certain factor. Overindustrialization and a strong emphasis on military production is most commonly considered as a negative initial condition, for example in the pioneering study on growth by De Melo et al. (1997). But why should this be so? The need to reduce overemployment in inefficient industries is indeed a burden, but their technical and human-capital capacities are a positive inheritance. Estonian industry very quickly developed a sub-contracting relation for electronic goods with Scandinavia, while Ukrainian firms in Kharkiv specializing in space electronics did not; Hungarian producers of Soviet military optics now produce Zeiss-Ikon binoculars for the world market, while Russian firms still struggle to convert. Geographic location was for centuries a bane for Poland, lying between Russia and Germany, but as Kolodko (2000b) points out, suddenly became an economic asset. Slovenia has benefited greatly from historical and geographic proximity to Austria and Italy, but Albania has not exactly thrived on its connections with Italy and Greece. The dominance of protestant religion as a factor explaining


prosperity was argued by Weber more than a century ago, and has found some echo in the transition literature: for example Wolf (1997) uses this variable in equations explaining the degree of reform progress (TPI ) chosen, and finds some significance. But the explanations are not easy to interpret consistently; while most protestant countries did move quickly (Hungary, Czech Republic, Baltics), so too did many Catholic countries (Poland, Croatia, Slovakia). While a lot of the slower reformers are Orthodox or Moslem, the exceptions are too many to buy into the religion explanation: Russia, Kyrgyz Republic, Moldova, Armenia and Albania at least undertook early efforts at rapid reform even if these were not fully successful or sustained. On the political-institutional side, consider three further examples: the preexistence of a strong nationalist commitment; the ideological orientation of the first government, that is, was it communist or not (a related hypothesis applies to subsequent governments as well); and the effectiveness of rule-of-law. A strong national commitment in the Baltics is often adduced as perhaps the key factor behind rapid and sustained economic liberalization; in the present volume, this factor and its relation to EU membership are given due recognition when discussing the Baltics, but as a systematic explanation in other transition countries it works poorly because it does not have the same direction of causation. Thus,8 the nationalist commitment in Ukraine is more an explanation for slow reforms, based on the argument that one needed first to build the institutions of a nation-state.9 In Belarus and Central Asia a weak sense of nation is part of the problem of slow liberalization, while in the Caucasian states the conflicts and turmoil, coming from very strong nationalism, also shows reforms – Serbia is doubtless another such example, although in Croatia the effect was the opposite. Continuation of the previous communist regime after transition begins is thought to be a barrier to market reforms; but why then did Slovenia steadily move towards a market economy and adoption of the EU’s Acquis communautaire conditions despite the fact that the government in power saw very little change in personalities after independence in 1991? The answer lies in the fact that its communist (or better socialist) government in the Yugoslav period was already highly committed to a market economy, had indeed already promoted a much more market-oriented regime well before 1991, and simply continued on the same path.10 Somewhat analogously, in Poland and Hungary the communists who had lost power in 1989–90 returned in a few years as a social democrat party of the Western European variety but made no significant directional change in economic reforms. In Poland, the Solidarity government which began the transition lost the October 1993 election to the Democratic Left Alliance, and Leszek Balcerowicz who led the big-bang programme of January 1990 was replaced by a sharp critic of his, Grzegorz Kolodko. But Kolodko’s (2000a) criticism of the big-bang nevertheless recognized that ‘a radical approach is practicable in the case of


liberalization and macroeconomic stabilization’, and was concerned most about what he and others considered an ‘overkill’ of monetary tightness and consequent social costs.11 Thus, the fundamental transformations, liberalization and stabilization were not reversed and indeed continued, with the TPI value rising steadily from 3.0 in 1993 to 3.4 in 1997, at about the same pace as in the other transition leaders (Czech Republic and Hungary). Of course this was less of a jump than the first four years, but it is a mathematical necessity for an index that is capped at some maximum value that its pace eventually slows after an initial sharp rise.12 In Hungary, the Communist Party which had reconstituted itself as the Hungarian Socialist Party (HSP) already in October 1989, lost the first free elections in April 1990, to the new Hungarian Democratic Forum (HDF) and some allies. The latter’s platform of ‘anti-Communist rhetoric and a gradualist [my emphasis] program of economic reform’ (Pittaway, Chapter 2 in Heenan and Lamontagne, 1999a), nevertheless led to a substantial increase of the TPI from 1.5 in 1989 to 3.1 in 1994, hardly gradual. In June 1994, elections brought what appeared to be a sharp political reversal with the HSP winning a majority of seats. And what did they do about economic policy? They appointed as Finance Minister Lajos Bokros, an outspoken reformer, and pursued a vigorous continuation of market reforms even sharpening the fiscal stabilization with ‘a dramatic package of tax rises combined with savage cuts in welfare spending. Although Bokros resigned in February 1996 his policies were continued and augmented with … widespread and rapid privatization’ (Pittaway, ibid.). This story of former-communist parties continuing market reforms or even speeding them up, is found repeatedly in Central Europe and SouthEast Europe, making it difficult to correlate market reform with the label or colour of the political party in power.13 One could of course still argue that the labels and former associations of the new parties do not reflect the changes in the nature of the party and the real platform is what matters. But this is circular logic, as the measure of a party’s platform has to be what it actually does in government, rendering useless the argument about continuity. The inability to correlate economic policies with the nature of the first government, or the type of party (or for that matter the stability v. turnover of governments as witness the frequent changes in the Baltics), has stymied not only economic analysts but also political scientists who might be expected to better understand how polities function historically and globally. The difficulties for that discipline are encapsulated by the following citation from a scholar of transitology, Valerie Bunce (1999, p. 779) trying to explain the diverse patterns of development of democracy in the region: There are a variety of factors that while logical and suggestive, do not seem to provide a robust explanation. For example, while all the stable and fully democratic cases are by regional comparative standards, both


rich and homogeneous [au; ethnically] some relatively rich states score low on both democratization and political stability (Slovakia, Croatia, Ukraine) [au: paradoxically these last serve to emphasize Bunce’s non-robustness point, as all have since seen changes in government and substantial improvements in their democracy ratings] and some homogeneous states do the same (Albania, Armenia) Moreover, state age is not all that helpful a factor, given, for instance, the inclusion of Slovenia and the Czech Republic in the group of stable and fully democratic orders. Finally, such factors as religion, imperial lineage (or inclusion in the Habsburg versus the Russian or Ottoman empires), and institutional designs (parliamentary government versus forms of presidentialism) do not seem to account all that well for these differences. Let me turn to the example of effective rule of law which is now universally agreed to be an important factor in transition. Broad measures based on subjective perception do correlate well with the TPI as shown in Chapter 2, but most analysts consider these measures are too broad and not helpful for policy. Consider a more specific measure sometimes discussed in the literature on law and the transition: how many judges are carried over from the communist period? Figure 4.2 shows a three-way grouping for progress in transition based on Chapter 2, and a three-way grouping of continuity of judges based on the Freedom House Nations in Transit publication, Karatnycky et al. (1997). Clearly no good correlation exists, perhaps because this is simply not the right way to measure this phenomenon. But that only

PROGRESS

CONTINUITY High

Medium

Low

Low

Uzbekistan

Belarus

Turkmenistan

Medium

Georgia Kazakhstan Macedonia Romania Ukraine

Azerbaijan Russia

Albania Armenia

High

Latvia Slovakia Poland Slovenia

Estonia Hungary

Czech Republic Lithuania

Figure 4.2 Transition progress and continuity of communist-era judges Source: A transition progress based on Chapter 2; continuity of judges based on Karatnycki et al., Nations in Transit (1997), response to query: ‘How many judges remain from communist era?’ The responses did not use the same wording and the three categories are the author’s interpretation.


leads to the conclusion that for many of these factors it is very difficult to find a good quantitative measure, and hence it is risky to do any analysis based on such factors as there are simply too many measurement and interpretation problems. Finally, the worst outcome of the encyclopedic approach is to fall into the trap of seeing each country so narrowly that it appears to be unique in being well-positioned or poorly positioned for this difficult historical transformation, and therefore unable to follow the standardized path of transformation. This may be the logical outcome of observing so many different factors and the conclusion that they do not necessarily have a systematic effect in different countries, but it is a mistaken point of view. Kolodko (2000b) is clear and firm that the constraint of initial conditions ‘should not be seen as an excuse for a lack of comprehensive reform and institutional change … [but in fact ] has to be offset by still more determined attempts’. It is not surprising to find the ‘uniqueness’ story most commonly told in countries which have lagged in reforms or performance, because it is of course a position likely to be promoted by the leadership in less successful cases. This is not to deny that each country does have some special attributes that differentiate it from others and that these must be taken into account in deciding how quick is ‘as quick as possible’, as Klaus, 1995, defined rapid; but an overemphasis on uniqueness tends to hide the important commonalities which this work tries to argue were in the end more important than the differences. The fact that uniqueness is abused comes out very clearly when one observes that it is not two or three cases of uniqueness that are claimed in the literature, but almost all countries, especially in the less successful groups, are thought by many analysts to be unique. It is possible logically for all countries to be unique, but a closer look at the literature reveals that in most cases these countries are said to be unique in the same way! One wonders, were Tolstoy writing about this today, might he perhaps say that all unfortunate transition countries are unlucky in the same way, while all the fortunate ones are lucky in different ways? This sameness is exemplified by the following citation from the CIS Handbook (1999), chapter 9, for country ‘XXX’ left unnamed: XXX was a state that had never existed in history, with borders not of its choosing and one of these (an important piece of territory) in dispute, and with a population and a political elite that had no experience of functioning in a democratic fashion and very little experience of performing the functions of modern government. There was a pool of talent and scholarship on which to draw for advice, but the administrative elite had no training for running an independent state, managing a currency or dealing with the rest of the world – or for doing all of this in conditions of severe economic dislocation, exacerbated by internal conflict. In addition given the complex ethnic composition of the population and the


patently confused question of relations with [neighbour states ] A,B,C, the task of creating a distinct XXX identity and allegiance naturally featured near the top of the political agenda … Further, the political culture of the communist system had not trained politicians to seek compromise which may be regarded as the essence of democracy. If the performance of the political and administrative elite has been less than was hoped for or expected, that is hardly to be wondered at. Any member of the unfortunate elite of this country facing so many ‘unique’ hurdles would be proud of the above apologia. But what is truly interesting about the citation is that the initial conditions described fit in large part so many transition countries that even an expert on the region would be hard put to guess what country name to replace for XXX. The reference to a nonexistent historical state narrows it, though the remaining list of problems is commonly cited even for countries with pre-existing states. The present author, whose early work on transition focused a lot on Ukraine, found this citation extremely familiar. Those working on Caucasian, Central Asian or any Balkan states would probably recognize most of the hurdles cited as arguments of the special or unique problems faced by these other countries as well. In fact the country analysed in this citation is Moldova; but the literature on individual countries is replete with very similar lists of the special difficulties the country faces, particularly for countries that have so far not been as successful in the transformation as the Baltics and Central Europe.14 A truly unique twist on the ‘unique’ label comes in a description of Bulgaria (The CEE Handbook Chapter 5 (Heenan and Lamontagne (1999a)): ‘Bulgaria faced no problems that were not experienced elsewhere in central and eastern Europe: it was simply that the country had all of them at once, and to a degree not shared in other countries.’ The present author disagrees categorically that Bulgaria was somehow more unlucky than all the others, and the evidence of the literature also suggests so too would many analysts of other countries. But it is surely not a useful exercise to claim one’s country was the most ill-favoured by history, or buffeted by historical storms from all sides,15 because in many cases most of the same ills are shared by many other countries, or as I illustrated above, the same condition has opposite effects in different countries. The unconvincing nature of the ‘unique and unfavourable conditions’ approach gives greater credence to the approach chosen here of a parsimonious paradigm applicable to all, complemented by a subsequent use of country-specific factors where needed. To show the difficulties of the encyclopedic approach is an easy game to play, and one could go on with examples of inconsistencies in an explanatory direction for the factors in Figure 4.1. But the main lesson to draw from the discussion here is that the explanations of the inconsistencies and exceptions comes from some other not always easily identifiable combination of


factors, which of course means that one quickly becomes lost in the thicket of explanations as easily as a city-slicker in the boreal forests of Northern Ontario.16 I have gone on in great detail here to demonstrate that this approach provides rich and very useful historical detail on transition progress but, in the end, becomes so complicated, or so country-specific, that it fails to satisfy. That is why I propose the simplified framework of the next section. The upshot of our discussion will be that for present purposes, explaining the difference in progress on the TPI measure across 27 countries using the encyclopedic or comprehensive approach will create more difficulties for understanding what happened than will reliance on a simpler paradigm consisting of a small number of factors. But this parsimonious approach still allows one to adduce the more detailed list of factors as underlying explanations. For example, the lengthy period before undertaking reforms in Ukraine may be explained by the fact that the independence movement Rukh agreed to have the communists conduct economic policy in exchange for a commitment to independence. Similarly, one can turn to the list in Figure 4.1 for explanations of outlier cases like Slovakia’s temporary slowdown on institutional and especially democratic reforms in the mid-1990s: the greater concentration of heavy-military industries contributed to the election results bringing in temporarily the slow-reforming vested-interest party of Meciar.

A parsimonious approach: the navigation model The reality of the historical process of transition in each country is far too interesting to be adequately captured by a simplified theory, and hence there cannot be perfect applicability of the model to each of the 27 countries. But the aim is to capture the most important common elements, and to provide a model based on a consistent theory of economic behaviour which allows prediction of how transition may develop further. The core theoretical idea is found by investigating the fact that countries with least progress towards the market, are generally those where the power of economic vested-interests or oligarchs is greatest and the reason for this is that profitmaximizing behaviour leads capitalists to oppose open competition if they can. This is most clear in the transition literature’s recent debate between the ‘transition inevitable’ (TI) and the ‘transition frozen’ (TF) views described in Chapter 1. The TI writings reach the optimistic conclusion that a large enough private sector will ensure demand for institutions of liberal competitive markets and democracy. In contrast, those in the TF school argue this will not happen if ownership is too greatly concentrated. But different authors give different reasons for this cause and effect relation, and may differ in their explanations of how this concentration came about. Buiter (2000) notes that popular


opinion considers the privatization to have been illegitimate or at a minimum very unfair, hence even if oligarchs were ready for legitimization and expressed a demand for secure, transparent property rights in keeping with the Coasean axiom that underlies the TI arguments, political sentiment may prefer renationalizing the assets. But renationalization would only create more uncertainty, thus a dilemma faces governments. Barnes (2003b) argues that the oligarchs are not yet ready for secure property rights because there continues to be a struggle for redistribution for privatized assets and opportunities for still unprivatized ones; for example in agriculture and energy distribution. The well-publicized case of Yukos in Russia is a focus for many of these debates, and I will return to it later in discussing prospects in captured states (Chapter 8) and policy implications of the model proposed here (Chapter 9). While both of the above arguments in favour of the TF view are valid for the present historical moment, they only give reasons why the transition is temporarily delayed. A more fundamental theoretical reason for permanent freezing of economic liberalization (that is a sustainable equilibrium) lies in the possibility that oligarchs find the non-transparent, non-competitive environment to be optimal because of the large rents to be had from retaining and even enhancing monopoly power. Such a view has deep roots in the history of economic thought, going back at least to Adam Smith in his many warnings that capitalists may need markets to maximize their profits, but they seek at the same time to limit competition in those markets since the size of profits is of course larger the smaller the extent of competition. This is the principle that underlies the rent-seeking theories of Krueger (1974) and others described earlier, wherein existing vested interests oppose trade liberalization to limit competition and maximize profits. The same principle underlies the work of Rajan and Zingales (2003a), which describes theoretically and historically the efforts of existing vested interests in the financial sector to oppose development of transparent and competitive financial market institutions. Their simple and succinct explanation is worth citing: ‘The economically powerful are concerned about the institutions underpinning free markets because they treat people equally and make power redundant, [and] the markets are a source of competition forcing the powerful to prove their competence again and again.’ Morck, Wolfenzon and Yeung (2005) have, in a recent survey, elaborated the concept of ‘economic entrenchment’ by powerful vested interests, arguing that while opposition of the powerful to free-market institutions may not always be the equilibrium result, there are many reasons to believe that in the majority of historical circumstances, the gains to be had from rentseeking in an environment of weak rule of law favour the powerful incumbents and outweigh the risks to them of insecure property rights as these can be purchased non-transparently from governments. Both of the above works are oriented as much to developed as developing countries, and the reality of


lobbying power in the most highly developed and democratic market economies is illustrated in the work of Faccio (2003). The applicability of this idea in countries with varying degrees of market development makes it even more appealing as an explanatory factor. In the transition literature, a theory of optimal behaviour of ‘oligarchs’ is most fully developed and explicit in Polischuk and Savvateev (2004) who posit a formal model in which oligarchs seek to maximize their profits by tradingoff the benefits of fully secure property rights against those of rent-seeking profits. It is not difficult to imagine real circumstances in which they will favour what the authors call a ‘hybrid equilibrium’ – that is, the noncompetitive, non-transparent environment currently prevailing. When potential rents are still very large because some assets remain unprivatized, or government policy is inclined to continue distorting prices, and in addition institutions are so weak that the wealthy can buy security of property from government agents, it is highly likely the optimal behaviour of the oligarch is to support the status quo. Hellman (1998) had discussed this possibility earlier noting that the new capitalists soon turned to lobbying efforts protecting their acquired assets against the threats of free, competitive markets, and hypothesized they would oppose further liberalization. Hellman and Schankermann (2000) provided empirical evidence for this hypothesis, using an index of ‘state capture’ developed at the World Bank by Kaufmann and others. The role of economically powerful vested interests in opposing further competition once they have attained their position is an important part of the explanation for transition progress in the second half of the 1990s, but can it also help one understand the first half? Certainly the preexisting vested interests, the political and technocratic ‘nomenklatura’ of the communist period would surely attempt to behave in the way described above and simply transfer their power to a new capitalist regime.17 Some of this did happen, but if it were as simple as old communists repainting themselves capitalist blue, we would not see the huge differences in the extent of power they wield in Russia and Ukraine at one extreme, and much of Central Europe and the Baltics at the other extreme. Indeed, even within the CIS the vested-interest principle may help explain why Russia’s 1992 radical reforms failed, but not why they were attempted in the first place, or why Armenia and the Kyrgyz Republic undertook early big-bang measures and Ukraine did not. The framework I propose here incorporates the vested-interest principle and adds another link to the logic: historical or external factors that facilitate the rise of the oligarch economy, in particular explaining why it occurred in some transition countries but not in others. I do not develop a formal model here, though formalization is not difficult as an Appendix to this chapter will illustrate. Even without formalization, it is possible to derive several testable hypotheses later in the chapter. The ‘Navigation Model’ takes as the independent variable progress in transition (TPI), and not the resulting success in terms of economic growth,


democratization or other performance measures. However, as Chapters 2 and 3 have amply demonstrated, there are very strong statistical correlations between the TPI and these various measures of success, so in that sense the navigation model can be a building block for any explanation of performance differences as well. The explanatory factors are perhaps best thought of as three proximate causes of progress in transition: ●

●

●

The length and intensity of debate on the ‘navigation charts’ that is the strategy of reform programmes. The vulnerability of a country to ‘pirate raids’ on state assets by rent-seeking interests. The availability of ‘a safe haven’ such as EU membership prospects disciplining the process to achieve a non-oligarchic transition.

These three factors are not independent of each other, and indeed any formal specification would comprise a set of simultaneous equations (see Appendix) including some exogenous variables taken from the list of initial conditions in Figure 4.1. Some have argued that the prospect of EU membership is an exogenous variable,18 but I argue below why it was not so simple; the exogenous offer of membership (independently of the model’s other variables) was limited to at most two or three countries, far fewer than the eight that have already become members and the additional three or more with now-high prospects of membership before 2010. The model’s line of reasoning can be stated briefly as follows. The longer and more intense the debates on how far and how to transform the economy into a market-oriented one, the greater the opportunities for old and new vested interests to obtain large rents via continued distortions and also to concentrate the transfer of state assets in a few hands; the more concentrated the new ownership the slower will be subsequent stages of liberalization and the less likely the development of new entrepreneurial activity. This is because of the vested-interest principle described above, that capitalists prefer less competition, not more. They also prefer less transparency, as this best ensures continued high profits from rent-seeking and state capture. Similarly with property rights, new oligarchs may be willing to trade-off rule-of-law (ROL) security for the benefits of rent-seeking, using their financial influence to ensure property rights informally. In a word oligarch capitalists behave optimally when they oppose full liberalization, democratization and rule-oflaw. The TPI rises, but stops short of its full value. The degree to which rent-seeking interests can be successful in their efforts to influence government policies varies, however, hence not all the postcommunist states experience the extreme degrees of lobbying that result in dominant state capture including the ability to determine results of nominally-free elections. An important factor working against vested interests


is the strength of desire and prospects for EU membership, since this requires automatic implementation of many liberalization measures that limit the opportunities for rent-seeking. But other historical factors may also play a role here; a radical change in government towards one that has a strong market commitment, or a powerful and charismatic leader who leads such a visionary change in the society.19 A commitment to some outside organization or institution such as the EU or others can discipline the process of economic as well as political liberalization, helping to curtail debate and get started quickly, and helping to reduce the power of vested interests. I argue below why EU membership was the only such commitment to have any significant impact, though in principle membership in NATO, the WTO, the IMF, the World Bank or the EBRD, all provide vehicles for disciplining reform paths and all were influential in practice. An important finding of this book is that the force of this discipline depended not only on the warmth of the EU’s ‘invitation’ to join, but on the country’s own intensity of desire to do so. A strong ‘return to Europe’ commitment may have been the way this effect worked in the Baltics, leading to a rapid rise in the TPI which helped overcome an initial reluctance by the EU itself to extend an offer. Chapters 5–7 elaborate on the dynamics of each of these three factors in the actual transformation and reform process observed in different countries. Here, it will be useful to give a brief description of four categories of countries according to the outcome, measured by the degree of state capture and oligarchic development. ●

●

●

Captured states. Countries with a high degree of concentrated ownership in a few hands, that is a very powerful ‘economic oligarchy’ able to capture state policy and virtually determine election outcomes: Russia, Ukraine, Kazakhstan, Azerbaijan, Moldova and Armenia, and probably Georgia and the Kyrgyz Republic are in this category, though the last two may be on the margin of the second category. Serbia was very likely in this category during the Milosevic years (but not Montenegro as it was able to conduct an independent economic policy even within the ‘union’) but appears to have moved into the second group.20 Partial oligarchies. Countries with an intermediate situation, a considerable degree of oligarchic development, but declining in recent years or always lower than the first group hence state capture less complete: Albania, Croatia, Bulgaria and Romania are or were in this category until recently, as was Slovakia for an interim period in the mid-1990s. Competitive market economies. Countries that have largely avoided the development of an oligarchic concentration of power strong enough to virtually determine state policy and election outcomes: all three Baltics, the Czech Republic and Hungary are in this category, with Bulgaria, Croatia and Romania moving into it recently.21

138 An Ex Post Transition Paradigm ●

Lagging reformers. Countries where market transformation has not gone far enough to result in any significant change in elite-power structure: Belarus, Turkmenistan and Uzbekistan are in this group, with the original nomenklatura and its role little changed, except for taking advantage of also becoming a capital-owning class in the margin where privatization has occurred. But that is limited and in any event the role of state guidance in the economy remains dominant. Tajikistan, despite greater advances in economic reform recently, has not yet undergone enough development of elites to be easily classified and may still be in this group or the second, intermediate group.

The navigation model may have very little relevance to this last group because it has seen too little change in economic and political structures. The second, intermediate group comprises countries which are not yet clearly in the state-capture or competitive-market category, though much can and will be said later about the tendencies over time in these cases. It will be most useful to illustrate the interactions of the variables in the model by describing the first, state-capture group in a vicious circle of oligarchic development (Figure 4.3), and the third competitive market group in a virtuous circle that avoids the extreme effects of oligarchic development (Figure 4.4).

Captures state policy for self-interest

Against competition, prefer status quo, prefer non-transparent procedures

Oligarchy develops Fear EU membership discipline

Creates rent-seeking opportunities / old elite revived START

Delayed reform

EU membership offer (weak)

New entrants’ SMEs face difficulties Weak rule of law Weak support for EU membership

EU membership desire (weak)

Figure 4.3 Vicious circle of delayed reform and oligarchic development


Limits development of powerful vested interests Facilitates SME development & new entry

Limits rent-seeking

Transparency, evenhanded rule of law High level of market competition

Small entrepreneurs support liberal democracy, open markets

Early & steady reforms START

Support for global integration, EU

EU membership offer (strong)

EU membership desire (strong)

Figure 4.4 Virtuous circle of timely reform and development of competitive market and rule of law

It is useful to begin the story of Figure 4.3 by assuming that reforms are delayed or extremely slow, in any event very partial; the reasons may be historical continuity of anti-reform governments, the lack of any external pressure such as a mutual understanding with the EU on a high probability of EU membership, a consensus in new nations that state-building takes priority over economic transformation, or even a sincere intellectual conviction that market reforms are not the optimal strategy in the long term. As long as some new private ownership is made possible legally, this situation creates capitalism with distorted markets and government regulation, creates an ideal breeding ground for rent-seeking lobbies to operate, influencing governments to obtain privileges which generate huge profits. Buying still very cheap energy and reselling it at the world price either in a domestic liberalized market or abroad was one of the most common and dramatic vehicles, but as Chapter 6 describes, there were many other ways to accumulate the first large fortunes. It is important to note this was very different from the Soviet period when underground ‘mafia’ operations as described in Handelman (1994) were widespread, but these were illegal. The new oligarchs became capitalists legally, and indeed most of the wealth accumulation that


was so morally abhorrent to the populace – and with good reason – were formally legal. This is what makes partial reforms so risky: it effectively legalizes what should be theft, but of course limits access to this process to a privileged few. If the reforms do not advance and cut off the distorted price and regulations vehicle for rent-seekers, a few of them may become wealthy enough to merit the title of oligarch, and at that point become powerful enough to capture or at least hugely influence state policy, certainly on economic aspects that affect them, but perhaps also on broader political direction as well. If there is a quick-enough advance even after an early delay, the process may limit the ability of powerful economic interests to capture the state and one moves into the virtuous circle of Figure 4.4. Where state capture prevails, the interests of the oligarch are clearly to limit competition, and even rule-oflaw transparency. This last goal of powerful vested interests can in the extreme mean they are more likely to support an autocratic or quasi-democratic regime than a truly democratic one. In a word, they support the status quo which gives them maximum benefit, and the transition to market (and democracy) is frozen part-way to its end goal. It goes without saying they also oppose a return to a communist regime and are more likely to favour what text-books on comparative economic systems used to label a capitalistcommand economy.22 Is there a link from this to the EU prospects? On the one hand, any capitalist wants to have access to a wider market, and hence becoming part of the EU may seem like a good direction for them. On the other hand, membership only marginally improves access which is already there in a globally open economy (especially for any product other than agricultural goods), while the exigencies of membership include substantially increased competition which sharply reduces the margin of profits. Oligarch opposition to EU membership leads them to support of politicians who may express pro-EU rhetoric but will not work hard in that direction; additionally the limited economic and democratic reforms cools the desire of the EU side to offer membership. All this leads back in a circular causation to limited economic reforms and an enhancement of the power of oligarchs. The views held by oligarchs on the policy orientation of a country will not of course be openly expressed.23 But this is not news in the history of the interactions between powerful capitalists and the society nor is it by any means a monopoly of Soviet-formed personalities, rather it is the inherent nature of capitalists. It has been argued that even in the country where the degree of openness and competition in financial markets was highest, the United States, the 1934 Glass–Steagall Act which did so much to cut back competition in this sector, was played up publicly as having precisely the opposite purpose, to curb ‘abuses in the financial system’ (Rajan and Zingales 2003b, p. 222). On the virtuous circle side, Figure 4.4, the storyline follows an analogous path with the major difference being that sufficiently early and sufficiently


advanced liberalization of the market closes off the many opportunities for rent-seeking that exist under a mixed economy of partial reforms. This limits but does not preclude concentration of ownership, because the latter under any privatization process may be a natural tendency driven by efficiency considerations. But the limited influence of such a group in the middle years means that a committed government can establish better rules for transparency of privatization, for institutional rule-of-law development that is even-handed, for easier entry of de novo enterprises, external competition and so on. Indeed, allowing for small-scale private ownership to flourish early creates a political middle class that is likely to support more liberal policies and act as a counterweight to large vested interests. It is not, in retrospect, entirely a coincidence that large-scale privatization in the more successful transitions of Central Europe did not come that much earlier – indeed sometimes even later – than in the CISM group of intermediate reformers where the problem of state capture was so much more prevalent.24 In this scenario, EU membership prospects could again have been both cause and effect in the model. Certainly, for three countries, Czechoslovakia, Poland and Hungary, the offer of membership while not explicit or guaranteed at the beginning, was signalled in much warmer tones than for anyone else. But as Chapter 7 will show, that was not the whole story by any means and there is good reason to believe all three countries (later four with Slovakia’s emergence) would have done much the same in the first two to three years without such a signal. I will for the sake of argument provocatively suggest that they might have moved even faster without the offer, because like the Baltics their inherent demand for membership would lead to a more vigorous effort to show Brussels they deserved the invitation. In the event, the fact that they did move forward on economic and political fronts towards a liberal and transparent polity, greatly enhanced their EU prospects and evoked a much stronger ‘offer’ from the EU side by the mid-1990s, which in turn fed into the virtuous circle by disciplining further advances on reforms under the AC guidelines. It should be clear from the above analysis using the navigation model that the three proximate factors are partly underlying causal variables (and can in principle be given quantitative value as shown later), but partly they are themselves dependent on some other initial conditions. In addition they are interdependent, as for example a strong prospect of EU membership results in a curtailing of debate and an early start on transition. Such a formulation of the explanatory model allows the incorporation of the most relevant initial conditions discussed in the previous section, but only where these work clearly to affect the intensity of debate, vulnerability to rent-seeking lobbies, and prospects of EU membership. In that sense, the three factors provide a framework, or hat-rack on which to hang other determinants when relevant. Subsequent chapters discuss in detail each of these three factors, and illustrate how this simplification can help to incorporate a large number of relevant


initial conditions without the degeneration into inconsistent explanations noted earlier, without, that is, losing sight of the forest for the trees. Finally, a few words on the methodological nature of the Navigation Model. The terms ‘framework’, ‘model’, ‘theory’ and ‘paradigm’ are powerful analytical concepts because they imply something much more than a mere description of what happens. They imply a cause–effect relation of a systematic nature, reliance on an underlying theory or paradigm of social/ societal behaviour, and the capacity for predicting future developments. While there is no rigorous definition in social sciences differentiating the four terms, there exists a generally understood rank-ordering. In economics, in particular, a good rule of thumb is that the more formal the mathematical specification the safer the use of the term ‘model’ or ‘theory’, because the internal consistency of the mathematical system of equations allows peers to see immediately if there is an overall logic. In social sciences generally this is more relaxed, but nevertheless there is some consensus that the higher the degree of analytical sophistication and comprehensiveness of the explanatory story, the higher up the rank order of the above four terms one can comfortably go. So what then is the proper label for the parable of the ‘Ship of State Transition’ that I attempt to tell here? It is not a fully developed mathematical model, nor does it capture broadly enough the evolution of different economic systems in history to be a ‘systems’ paradigm. It is at a minimum a framework for organizing a large number of disparate causal relations in the process of transition. It also provides a good mnemonic device to keep some order in the storytelling and avoid the confusing, contradictory assessments illustrated in the first section of this chapter. But it is much more than a framework, because it has at its core two extremely important theoretical points – I will venture to label them as axioms – from the received wisdom of the economics discipline: only competitive markets result in the social optimum; and incumbent capitalists may oppose competition because their private optimum comes from having an established position in the market. It is also much more than a framework because the parable explains how these theoretical axioms interact with different initial conditions to give different results for various countries. Finally, it is more than a framework since it provides a mechanism for projecting history forward and indicating under what conditions the incomplete transition may move forward or be arrested. The central role of rent-seekers, now known as oligarchs, and the strong coincidence that many from the old nomenklatura (or their children from the Komsomol) comprise the oligarchy, leads many analysts, in academe and the all-wise street, to see all this as a simple conspiracy theory. It would be naïve to exclude the thesis of the red elite in the late 1980s confabulating to seek ways of remaining powerful – though evidence for this awaits still unwritten memoirs from many of these individuals – but this does not tell the full story. In another work which also bases itself on the above two economic


axioms, Rajan and Zingales (2003b) note that ‘for this to be more than a conspiracy theory, it has to be useful in predicting when and where markets will develop’. Thus, if the conspiracy of the economically powerful at the start were the whole story, one would have seen all of the former communist states develop the oligarch class. Indeed many predicted this,25 but it clearly did not happen to anything like the same degree in all countries. The navigation model shows why; in a word, at this historic moment it was possible to make a break from the past and avoid the path-dependency result of the conspiracy, and this was possible – but not automatic – where other factors such as the attraction of the EU, a national vision of independence, or the happenstance of a committed leadership outweighed the efforts of the conspirators. In the end then I choose to use the term ‘model’ even if a mathematical formalization is not given, because the three-factor explanation I posit does meet the three criteria noted: it contains an accepted theoretical axiom, is comprised of behavioural cause–effect relations, and has predictive capacity. For the less-academic reader, it may be easier and less esoteric to think of this approach as a parable: the SS Transition undertaking its voyage on uncharted waters and seeking a safe-haven from pirate raids and other dangers of the high seas.

Testable hypotheses One of the important values of a behavioural model is its predictions or hypothesized relations to empirical facts. This section first discusses the problems and possibilities for measuring quantitatively each of the variables in the model, and then derives a number of testable hypotheses. The remaining chapters in Part II bring to bear empirical evidence from the vast transition literature to test these hypotheses. While no direct statistical estimate is undertaken for the parameters of the model itself, it will be shown that the empirical evidence on the transformation process is consistent with its logic. The dependent variable, Transition Progress is measured by the TPI values compiled by the EBRD. The end goal of transition is improved performance of the economy and polity, but Chapters 2 and 3 have demonstrated amply that these final goals, which can be measured by several different variables, are closely correlated to the degree of market transformation captured by the TPI, which can be considered as the necessary means towards the ultimate aims. Furthermore, the point of the model is not to explain performance as such, but to answer the simpler question: what explains the fact that after 15 years there is a substantial variation among countries in the movement towards a complete transformation to a liberal market economy with a high degree of open competition? TPI is not a perfect statistic and can be criticized on many counts including its subjectivity in general, and under or overestimates in particular countries. However, it is the only comprehensive measure of this


sort covering the full period of the transition, and despite its shortcomings it appears generally consistent with all other, partial indicators of market transformation or subsequent performance. The three independent variables are more difficult to quantify, partly because some of them are not directly measurable, thus must be proxied, and while there may be different ways of doing so it is certainly possible to find values. Thus, the concept of delay in beginning reforms could be measured literally as the time between the change in political regime which is easily identified, and the date of a stabilization programme, which was first specified in the work of Fischer, Sahay and Vegh (1996) (shown in third column of Table 5.1). Broadly this does separate countries as between rapid or big-bang and lagging reformers, but there are several cases where the first attempt failed to achieve stabilization and consequently led to a halt or even reversal in liberalization as well. This is true not only of the renowned instance of Russia’s January 1992 programme, but also of Croatia, Bulgaria, Albania, Armenia and others. In the logic of the navigation model, a failed early attempt at reforms might result in the same opportunities for rentseeking as a delayed reform. Alternative measures are: the amount of time from regime change to the sustained stabilization: (first column in Table 5.2) attainment of some threshold level of TPI (columns 3 to 5 in Table 5.2); and the level of TPI reached after four years (TPI 4), a measure of reform speed.26 The threshold might be taken as TPI 2.7, which on the EBRD’s scale is half-way to a market economy, or a tougher standard of ‘near-market’ operations of TPI 3.3 reflecting an economy where the role of the market is dominant and likely entrenched. There are two measures relating to rent-seeking effects that might be considered: the fact of eventual state capture, and the prior vulnerability to rent-seeking pressures. The first of these has been estimated by the extensive World Bank study cited in Chapter 2 summarized by Hellman and Schankermann (2000), and is measured as a continuum. In later chapters I will use their measure and label it SC99, the first year for which the survey data was compiled.27 This also permits testing the link between state-capture by the late 1990s and continued progress of the TPI values, in effect the ‘frozen transition’ hypothesis. To test the link between reform delay and the degree of state-capture, it is important to condition this as well on the vulnerability of the polity to pressures from preexisting lobby groups. Initial vulnerability to rent-seeking is increased by reform delays, but there may also be exogenous, underlying characteristics of a society that makes it particularly vulnerable to rent-seeking efforts. All these countries had a preexisting rent-seeking history in the Soviet period, with a powerful nomenklatura, sometimes working with an illegal ‘mafia’ of economic operatives, skimming-off substantial personal benefits. This is well-documented in Handelmann (1994) or Anderson and Boettke (1997), and it is often said in the literature that this was more deeply ingrained in the USSR than the


others, hence years under communism might be a good proxy for this. Indeed it has been used in the political science literature in particular. But the alleged difference between the USSR and others, while plausible, is unfortunately never empirically demonstrated in the literature, nor indeed thoroughly argued from first principles. Time under communism (see Table 5.1) is a particularly easy trap in this regard. It was no less than 40 years or two full generations in Central and South-East Europe, 50 years for the Baltics, and 70 for the now-CIS countries or three generations (with exception of Moldova, 50 years). That one additional generation may add somewhat to entrenchment of communist rent-seeking is plausible, but that it would make a dramatic difference is harder to accept. A variant of this is the notion that people have forgotten how to operate in the market. This too is not compelling. Even 40 years was long enough for those who remembered markets in the 1930s to be over 60 in 1990, and by all evidence in Central Europe they were not the generation that leaped to support reforms and participate in new entrepreneurial activities such as a hot-dog stand outside Warsaw airport. Another difficulty is that the degree of ideological commitment varied by country regardless of the tenure of the regime. It is well-known that Czechoslovakia, Bulgaria and, arguably, Serbia experienced more rigorous communist regimes than did others in Central Europe with the same tenure; indeed, under Gorbachev the USSR was arguably far less devoted to communist ideals than the aforementioned countries. Alternatively, the continuation of a communist government at the start of transition (changed perhaps in name), could better capture the notion of stronger vested interests from the very beginning. Broadly, virtually all the CIS countries saw a continuation of the political nomenklatura; minor exceptions such as the choice of Akayev, an academic, as president in the Kyrgyz Republic do not comprise a significant deviation since the bulk of government figures and parliamentary majorities still came from the list of former communists. Also, broadly, the degree of state capture is higher in the CIS than in other countries where a change in government was most common. But in Central Europe this was not universal, with some cases of the former political elite (‘communists’) continuing in power (Slovenia, Croatia, Romania), and many cases of transformed communists returning in the second elections (Bulgaria, Hungary, Poland, Slovakia). In general they did not pursue a transformation strategy markedly different from the noncommunist first governments, which suggest that their conversion was sincere, or indeed that their commitments to communist ideals was low already in the 1980s and Gorbacchev’s liberal stance permitted taking a new position favourable to markets. The ideal measure of proclivity to rent-seeking is not directly available: the elite’s commitment to market reforms. If one is careful in understanding the above nuances, the ideological nature of the first government, and not simply its label, can indeed be a reasonable proxy for the proclivity of the political establishment to be pressured by existing and new


vested interests. Measures for this variable can be found in two publications: Heenan and Lamontagne (1999), Central and East Europe Handbook, and CIS Handbook (CEEH and CISH henceforth). Thus ‘period under communism’ seems a poor measure of proclivity to rent-seeking, nor is ‘first-government communist’ any better. However, Chapter 5 will show that a deeper analysis of the underlying causal factor, ideological commitment for or against liberalism, can yield meaningful quantitative tests of the relevant hypothesis. The prospects of EU membership can be thought of as a probability on a continuum of zero–one, but this is not subject to quantitative measurement. At best, it is possible to infer at different times (early, mid, late-1990s) whether the prospect was high, medium or low. Chapter 7 will argue that this probability results from the interaction of a country’s own desire or ‘demand’ for membership and the EU’s inclination to invite the country or ‘offer’ membership. One point merits comment here: this interaction typically implies some circular causality: the more intensely a country wants membership the faster its transformation, and the more likely the EU will extend an offer; the stronger the signal of an offer by the EU, the stronger the motivation to proceed with transformation There is no ready-made quantitative measure, and I will infer this qualitatively from various analyses in the literature. There are four sets of hypotheses derived from the navigation model that are testable using at least bivariate correlations of the above variables, with some being testable in more than one way; this is summarized in Figure 4.5. The Appendix lists several possible ways of quantifying the variables of the model. But for many concepts (strength of EU offer, or intensity of a country’s demand for membership), quantitative measures can be at best only rank-ordered (High, Medium, Low or 1, 2, 3) based on interpretations of experts in the field. However, all the hypothesis tests can be supplemented by a more qualitative, less-rigorous assessment based on country case studies – which of course reemphasizes the value of the encyclopedic approach as a complement to the systemic explanatory approach of the Navigation Model.

What is new in the navigation model So what is the one big thing the hedgehog knows? It is that Adam Smith’s felicitous result of the Invisible Hand providing the Benthamite ‘greatest good for the greatest number’ comes not simply from having private owners (capitalists) seeking to maximize profit, but from the discipline that an open and competitive market imposes upon them, preventing excess profits and accumulation of monopoly power.28 A different way of putting it is that private ownership is a necessary means to the end of optimal social welfare, but it needs two additional (related) elements: a competitive open market; and transparent rule of law to ensure the security of property rights on a


H1: Reform delay increases probability of state capture* ●

Degree of state capture (SC99) is negatively correlated with some measure of delay, such as time from regime change to start of reforms, or to achievement of a certain threshold.

H2: The greater state capture the more likely reforms are frozen ● ● ●

TPI late-1990s is negatively correlated with degree of state capture (SC99). ‘Oligarchs’ less supportive of reform parties than small entrepreneurs. ‘Oligarchs’ prefer easy rents to efficiency-based profits.

H3: Higher EU prospects reduce delay in reforms ● ●

● ●

Favourable ‘offer’ signals in early-1990s encourage early reforms. Strong ‘own demand’ for membership drives early reforms regardless of signal from EU. Strong progress in reforms induces more favourable stance of EU. Reluctance of EU in face of strong own ‘demand’ induces speed-up of reforms.

H4: Other miscellaneous hypotheses ● ●

Stronger political commitment to liberal vision, delay is shorter. Stronger independence/nationalism sentiment, delay is shorter unless violence results in which case the liberalization is even slower.

Figure 4.5 Testable hypotheses of the navigation model * Possible ways of quantifying the variables of this list are shown in the Appendix to the chapter.

‘level-playing field’ for all capitalists, big and small, established and inchoate. The ‘level-playing field’ term is new, but Smith might well have used it too if football were an eighteenth-century game, as it captures perfectly his oft-expressed concern that the established and powerful capitalists use their influence to prevent competition from new and unestablished merchants. This simple way of putting the matter highlights the main distinction between the ‘transition frozen’ school of thought and the ‘transition inevitable’ view. TI concentrates as it were upon one of the hands in the Invisible Hand paradigm, the fact of private ownership, and errs by not paying due attention to the other equally necessary hand of competitive discipline. Smith’s emphasis on the interplay of motivated private owners with the discipline of competition is an important part of neo-classical dogma. If the market is not competitive but monopolized, profit maximization does do good things as it results in technically most efficient production processes yielding the greatest profit for the owner-capitalist, but not necessarily for society at large.29


In this connection it is useful to comment on the frequent comparisons of post-communist oligarchs with robber barons of the nineteenth century, which often draw the mistaken lesson that with time oligarchs too will have amassed enough and become good capitalists scattering cornucopias of philanthropy and accepting to live in a state with equal rule of law for all. There is one big similarity and one important difference between the two groups. They both amassed a lot of wealth and hence had similar oligopolistic or even monopoly powers. But the robber barons did not get their wealth primarily by underpriced transfer of preexisting state assets, rather they created value-added. It is also important to remember that they did not benevolently and willingly push for Anti-Trust legislation which limited their profit-making. (Acemoglu, Johnson and Robinson (2004) give thorough accounts of this.) The real lesson from the robber baron period is that drawn by Rajan and Zingales (2003b): powerful capitalists do not willingly give up their positions of wealth, influence and future monopolistic profits or rents, and not only do they fight against any legislative and implementation initiatives for a level playing field coming from the body politic broadly writ, but in fact often initiate government regulations masked as benefiting society but in fact resulting in limited competition. This is not a matter of an evil class conspiracy, but a simple matter of economic behaviour: capitalists (big and small) worship maximum profits and abhor any competition which reduces them.30 The above theoretical basis for the navigation model is therefore not new, but it is often necessary in economic writing to keep reviving forgotten principles. That capitalists seek to limit and not expand competition makes a large difference in the eventual outcome, and such behaviour during the transformation has to be part of the analysis. Furthermore, the three explanatory factors in the model are also not novel ideas and have all been discussed in the literature in many different contexts. But there are three important new points that the model does put on the table. First, these three causal factors suffice to explain a substantial part of the variations in results, hence they provide a useful framework for understanding cross-country differences, allowing relevant reference to country specifics, but avoiding the impenetrability of comprehensive explanations for each country. Second, this parsimonious model provides a simple but powerful result: an explanation of an important new divide that has been noted by many observers: an incomplete and halted transition in many CIS countries and perhaps some Balkan countries compared to the advanced and continuing progress in Central Europe. The latter ended up with a partially reformed economy subject to ‘capture’ by powerful vested interests. This state of affairs has generated a hotly debated question. Is ‘the increasing strength of Russian capitalists essentially a liberalizing force’ as Aslund (1997), Aron (2003), Arvedlund (2004 and most forcefully Shleifer (1997) argue, presumably not just for Russia. Or alternatively could ‘the power of concentrated vested


interests could seriously compromise institutional and regulatory developments that underpin good governance’ (Hellman and Schankermann, 2000), and freeze transition as the current author argued in the book. This leads to the third new element: the navigation model provides a basis for discussing the TI v. TF debate. Though it is conceptually consistent with either result, its logic strongly suggests that the TF conclusion is both theoretically and empirically more compelling. Once concentrated ownership and oligarchy comes about, these new vested interests have good reason to oppose further economic liberalization and democratization, which results in an equilibrium half-way between plan and market, half-way between autocracy and democracy, or a ‘frozen transition’ (Havrylyshyn, 1994).

Appendix: an illustrative formalization of the navigation model This Appendix illustrates how the navigation model might be formalized into a system of four equations for the variables discussed: transition progress, delays in reform, proclivity to rent-seeking, and EU membership prospects.

Definitions and possible measures of variables Endogenous TPI04 EBRD Transition Index in 2004 average of six indicators, excluding infrastructure. DELR Delay in starting reforms (i) months from regime change to start of stabilization, (ii) or months from regime change to 5% monthly inflation, (iii) or years from regime change to reach TPI 2.7; half-way to market economy, (iv) or value of TPI four years after start. TPIⴙ4 Value of TI four years after regime change (alternative to DELR) benchmark year see Table 6.1 ‘Transition Star’, 90 for POL, 91 for other CB and SEE, 92 for war cases of YUG, 92 for 15 successors of USSR. Coefficient signs opposite to those for DELR. SC 99 Index of state capture 1999 World Bank and BEEPS survey (as in Hellman, Jones and Kaufmann 2003) Belarus Uzbekistan are anomalies, BEEPS shows very low value of state capture, but this is misleading because it is the state that holds captive enterprises, not vice versa. Therefore, our rationale that high capture by the state is equivalent to high capture of the state, I would set their index at an average of the highest five. EUM Prospects of eventual EU membership about 1990–94 (i) strength of ‘offer’ by Brussels assigned values of 3, 2, 1, 0 (high, medium, low, zero) based on formal and informal signals from EU, (ii) strength of desire by society. H: Visegrad four three Baltics, and Slovenia M: Bulgaria, Romania, Croatia (?) L: SEE, Ukraine, Moldova, Armenia, Georgia 0: Russia, Belarus, all Central Asia

150 An Ex Post Transition Paradigm Exogenous variables LIBVIS Society commitment to dual liberal vision at start (H, M, L) a composite index of strength of nationalist sentiment, First Govt. Non-Com, Committed Reformers before transition. Possible values: H: Pol, H, Czech, Slovenia, Baltics M: Slovakia, CRO, MDA, Russia, KYR, ARM, GEO L: AZ, KAZ, TAJ, UKR O: BEL, UZB, TRK LEADER Happenstance of strong leader with liberal vision Measure as dummy 1, 0 (1 Poland, CZR, SVK (89), EST, LVA, Russia, KYR 0 all others) VESTED Strong vested interests inherited from Soviet period Composite variable: First Gov. not communist: VESTED yrs of com. 1.0 First Gov. coalition: VESTED yrs of com. 1.5 First Gov. communist: VESTED yrs of com. 2.0 SVKD Dummy for Slovakia 1, others 0; to reflect short period of democratic reversal in Méciar years. CROD Dummy for Croatia 1, others 0; to reflect quasi-liberal democracy in war period of Tudjman government despite liberal economy. DIST Geographic, contact or historical-cultural distance from Europe Possible measures: GEO. DIST kilometers from Brussels as in Fischer, Sahay and Vegh (1997) CONTACT distance for each country to closest European country as in Kopstein and Reilly (2000) CULT. DIST years under communism or average of yrs CONTACT index

The navigation model (in all equations, DELR could be substituted by TPI ⫹ 4) (1) TPI 04 a1 b1 DELR c1 SC99 d1 EUM () () () (2) DELR a2 b2 EUM c2 LIBVIS d2 LEADER () () () (3) SC99 a3 b3 DELR c3 VESTED d3 SVKD d4 CROD () () () () (4) EUM a4 b4 DELR c4 DIST d4 LIBVIS () () ()

5 The Search for a Navigation Chart: Legitimate Debates, Vested Interests and Reformist Commitments

The release from communist captivity: carpe diem or follow the money? When the Berlin Wall fell on 9 November 1989, the euphoria of the satellite countries was palpable, and the rejoicing at the opening of prison gates for millions of repressed people was shared by the population of the noncommunist world, particularly in Europe. In the USA, to sympathy was added a strong dose of victorious pride, since Americans saw this as an act of capitulation to President Reagan’s challenge, ‘Mr. Gorbachev, tear down this wall!’ The citizens of the Soviet Union remained uncertain of their fate for another two years until the convulsive events of mid-August 1991 first brought the putsch of anti-Gorbachevites, then within a week of almost vaudevillian dynamics, its termination, ‘not in a bang but in a whimper’. Declarations of independence followed in a flood from all republics including de facto Russia, most of them preceding the formal dissolution of the USSR in mid-December 1991. The euphoria had now spread to the whole of the Soviet bloc, and was virtually universal save perhaps for some high-ranking members of the nomenklatura who faced an uncertain future.1 While the level of expectations may have been unrealistic as is characteristic of the state of euphoria, it was not unreasonable to expect that quick and dramatic steps would now be taken to implement democratic and freemarket mechanisms in these societies. The euphoria certainly served to generate a strong consensus in the populace for such changes, an enabling environment for policy-makers that Balcerowicz (1993) has labelled a period of ‘special politics’. But, the opportunity to put in place radical and often painful changes during the honeymoon – for example closing inefficient 151


factories which put people out of work – was not seized equally rapidly by the leaders of all countries. The main objective of this chapter is to understand these differences, why some countries started the march towards a free market economy within months after the beginning of a new regime, and others delayed this for as much as three–four years. The central thesis is that the extent of delays and the subsequent pace and trajectory of market implementation were related to the strength of commitment to the dual vision of a liberal economy and a liberal polity. In one sense this is almost a truism, but it will become clear why it is so important to understand the intensity and nature of the commitment. The statement ceases to be a truism when the forces behind different degrees of commitment are understood. Four such forces are explored: the desire to break with the communist past; nationalist sentiment; the hidden agenda of those previously in power and able to retain at least some influence in the new regime; and the vision of integration with major international institutions, in particular the goal of EU membership – this last is postponed to Chapter 7, while the first three are the subject of this chapter. This chapter is structured as follows. The next section first addresses the question: was there a real problem of ‘uncharted waters’ or a lack of roadmaps forcing policy-makers to take more time to debate an optimal plan of action for setting out into uncharted territory? The answer given here is that not only were there several clear charts, but if anything there were too many options to choose from. That leads to the second question: was it not sensible to delay taking action and to analyse the options closely to decide what was the optimal path? To answer this question, we move on to attempt to lay the empirical groundwork for each country by tracing the timeline of events: the appropriate dating of the regime change in each country, the dates of the first steps in economic stabilization and transformation, and the dates of milestones reached in progress towards a market economy. This clearly points to the historical fact that many countries started almost immediately and proceeded at a steady pace, while many others delayed the beginning and/or proceeded at a very slow pace. I then turn to the core of the historical analysis, assessing the role of the above-noted forces in explaining delays in starting and the differences in strategies chosen. A final section summarizes how the historical facts of the search for a ‘navigation chart’ accord with the navigation model.

Availability of navigation charts At independence, facing the dual task of building a new state and a market economy … Ukraine was entering uncharted waters … The slow progress of economic reforms was understandable given the policy-maker’s lack of knowledge of a market economy. (Shen, 1996, p. 187)

The Search for a Navigation Chart 153

Although the sea was essentially uncharted, the prior experience of Eastern Europe had produced a veritable Babel of voices proffering strategies on how to get from here to there. (Schroeder, 1996, p. 12) Although parts of the transformation represent uncharted territory (mass privatization), many other aspects … are quite familiar. Many other countries once cut off from the rest of the world by immobilizing authoritarian regimes have successfully integrated in to the rest of the world … the proto-typical one in Europe is Spain. (Laar, 2002, p. 13) Experience shows clearly that the major difficulties were not because of a lack of the theoretical knowledge … but because of the inability of governments to carry out social policy based on this knowledge. (Kolodko, 2000a, p. 5) The above citations are respectively from two outside academics, and two key policy-makers in Estonia and Poland. Where does the truth lie? It depends on the meaning of the word ‘uncharted’, to paraphrase a former US President. If it means narrowly that no country had ever shown the way from plan to market, indeed this was virgin territory and even Spain’s example did not help much, at least on the economic dimension.2 If it means the country’s leaders had absolutely no idea how to proceed, it is simply untrue and ‘uncharted’ takes on the obfuscatory valence of President Clinton’s now famous syllogism. Schroeder is certainly right that the popular notion of ‘uncharted waters’ resulted in an unfortunate surfeit of ideas, strategies and programmes – debate on which seemed justified by the laudable goal of seeking ‘the optimal route which minimizes social costs’.3 Unfortunately, the Babel of voices included not only those sincerely seeking the social scientist’s Holy Grail of optimality, but also most of the nomenklatura who were opposed to reforms altogether, fearing for their privileged positions, and thus delighted to find a ‘scientific’ reason for delay.4 Some of the many alternatives available and well-known at the time are listed in Figure 5.1; its contents clearly contradict the plaint that there was no chart or roadmap. Any leaders and governments committed to begin reasonably quickly had plenty of choices with clear and concrete details. The list can easily be expanded – for example it has sometimes been argued that the substantial liberalization of distorted markets in Asia, Africa and Latin America in the 1970s and 1980s provided considerable lessons if not a precise precedent for the transition.5 But the five broad approaches shown suffice to demonstrate that plenty of choice and flexibility existed where policy-makers were committed to move forward. It is useful to discuss briefly the nature of the five main options. Consider the first option, ‘Goodbye Lenin and just do it’, which in effect means reversing one-by-one the main elements of communism. A popular aphorism at the beginning was that you can make fish-soup from an aquarium


Rapid reform charts 1 Goodbye Lenin, and just do it ● ● ●

Reverse the actions taken in 1917 Denationalize (privatize, restitute) Decollectivization Brigades on land

2 Mimic market economies ● ● ●

●

Washington Consensus (some flexibility of timing and sequence) EU’s Acquis Communautaire (limited flexibility by negotiation) Best-practice standards (banking from Basel rules; corporate governance from OECD; budget operation IMF standards) Borrow legislation/institutions (Baltics from Scandinavia) Gradual reform charts

3 Mimic China ● ● ● ●

Liberalize agriculture first Maintain state firms but ease new entry Liberalize sector-by-sector, but do so radically Was Perestroika China model?

4 Import-substitution strategy ● ●

Private ownership with infant-industry support Gradual opening-up of foreign competition

5 Institutions precede market liberalization ● ●

●

Stabilization rapid, liberalization gradual Market and legal institutions of minimal adequacy before liberalization and privatization Synchronized liberalization and institutional progress

Figure 5.1 Uncharted waters or too many charts?

but you cannot make an aquarium from fish-soup. Such glib comments may have contained a smidgen of truth but were at best a diversion and at worst nonsense. The process of turning a capitalist economy into a socialist one from 1917 involved very concrete steps, many of which could without much trouble be reversed: central plan and supply-price bureaucracies could be abolished rather than just renamed ‘Ministry of Economy’ and ‘Committee for Price Regulation’, the infamous Collectivization Brigades that helpfully came to the peasants to show them how to collectivize could be mimicked in the form of ‘Decollectivization Brigades’ to help land-owners begin serious private farming. The list is endless, and the feasibility of such an approach is seen in Poland’s rapid abolishing of many economic laws


replaced by reinstatement of the prewar commercial code; and Estonia’s nearly Xerox-like adoption of the German commercial code, in contrast to the bit-by-bit efforts in the Balkan countries, Ukraine and even Russia despite its mini big-bang in 1992. Mimicking market economies was a second possibility, not inconsistent with the first but more forward-looking and with more specific and detailed content. There were a number of specific charts for this approach. The Washington Consensus (WC)6 remains the best-known and was based on the similar but more limited liberalization experience of developing countries adapted for the comprehensiveness and size of the transition task. The many elements of such a reform path could be flexibly and experimentally applied, adapting the pace and sequence of implementation, with the exception of an urgent priority for financial stabilization. Despite some flexibility, in spirit the WC emphasizes the need for a comprehensive package and early achievement of some critical mass to ensure it is irreversible and effective; hence it is not wrong to allege it promotes a rapid and big-bang approach. There were other mechanisms for copying market economies, though they coincide or overlap with the WC in many dimensions. The vast body of legislation required of all potential members of the EU, the Acquis Communautaire, was freely available to all countries as a maquette to put in place the institutions of a market economy, though it did not contain all instructions, for example how to build or rebuild the private sector. The dominant role of this mechanism for many Central European and Baltic countries is best understood in the context of their quest for EU membership explored in Chapter 7. Still other mechanisms for emulation of markets existed, such as adoption of best-practice standards in finance, budgetary operations and the like. This could be done from the blueprints (charts) established by various international bodies including the IMF, the OECD, or the International Accounting Standards Board. Borrowing with minimal adaptation from an existing market economy was also an option followed by most countries in Central Europe. In the newly-independent countries of CIS, in contrast, the most common approach was first to re-adopt the Soviet constitution and laws, then begin to modify it. The third option was to mimic China, whose economic reforms had started more than a decade earlier and were certainly already known for the success in stimulating rapid growth, considerable inroads of private-sector activity and attractiveness to foreign investors. I argue elsewhere that almost none of the Eurasian countries could have followed the same route successfully, but here the point is merely that the example did exist and China’s experience was available as a chart. Many participants in the early debate spoke of China, including outside academics who argued for a gradual approach, but in practice little serious attention was paid to this possible route by the leadership. Central Europeans who chose a more rapid route


ignored the China example or even spoke of it dismissively, as Klaus (1995), lumping it in with all other ‘unique’ or third-way approaches as ‘the way to the third-world’. For them the lack of any political changes in the Chinese model was enough to cast doubt on its applicability. Others in the Balkans and the CIS who did not jump into early reforms did not seriously follow the examples of China in practice, but tended to use its possibilities rhetorically as a reason for continued delay in reforms. In particular note that CIS countries, with the exception of Armenia, Georgia and Moldova, did not emulate China by undertaking land privatization as a first measure. Another reason for not following the China model was that in effect Gorbachev’s perestroika tried to do so and failed miserably. Most of the leaders of the CIS countries may have wanted to see the partial and slow pace of perestroika continued, but seeing the writing on the wall, feigned support for an eventual transformation to a full-fledged market; perhaps only Nazarbayev was courageous enough to argue openly for a continuation of the perestroika strategy. The import-substitution (IS) model – sometimes called the industrialpolicy model – was the fourth possible alternative. Its philosophy is antithetical to the WC whose genesis was the search for a strategy to overcome the import-substitution regimes of many developing countries. It is nevertheless a market-oriented model, for in theory at least the markets are liberalized, private-ownership prevails, and the government only selectively and temporarily assists infant industries to get on their feet. Regardless of one’s view of its efficacy, it has a long history and was a ‘chart’ with many precedents for implementation, going back to Alexander Hamilton’s strategy of protecting Yankee industry at the start of America’s national experience, and goes forward through the cases of Meiji Japan, Witte’s industrial promotion policy for Tsarist Russia, Ataturk’s industrialization strategy for postOttoman Turkey, even France’s Indicative Planning. There is no shortage of historical precedent, yet it was not until several years into the transition that these ideas were trotted out as the ‘unique’ path for Belarus, Uzbekistan, Ukraine, Kazakhstan and, most recently, Russia. Why not earlier? Could it be because at the beginning in these countries, most of the governments were largely a continuation of the previous communist nomenklatura who found it advantageous to say they were in favour of a market economy but that the best way forward needed a lot of thought – and time. In effect they were implementing a hidden agenda as the resulting delay in reforms would lead to better opportunities to convert themselves into a capitalist elite. The one exception with some claim to sincerity, or at least consistency, may be Karimov in Uzbekistan, whose strategy of promoting domestic industry was explicitly formulated early on and has been more or less consistently maintained.7 The last group of available charts are those that emphasize the primacy of market and legal institutions. It is not entirely distinct from either the WC


or gradualist prescription. It agrees with the WC about the need for immediate financial stabilization and eventual market liberalization and private sector expansion, but distinct from the WC proposals (which, as Chapter 2 noted, also list this element) is its insistence that some minimal amount of institutional change is needed before the other liberalizing reforms are undertaken. The roots of this view are in the work of Douglass North (1995), analysing the several-centuries history of the development of effective market institutions one sees in advanced economies. Its adaptation to transition countries is best exemplified in the work of Murrell (for example in Clague and Reuser 1992). Though he did not of course propose waiting centuries or even decades for all institutions to be fully developed, but warned that one should not leap forward with a big-bang until some minimally adequate institutional framework exists to ensure competitive markets, free entry, and fair treatment of small enterprises. On the face of it this is in principle not only eminently sensible but seems clearly superior to taking the risk of a big-bang leap towards the market with a copy of the WC in hand. Indeed no-one today argues that institutions do not matter. This debate has seen enough ink in preceding chapters, but here it is worth adding one point. The institutional strategy was never applied, but was more honoured in the breach and much abused for political advantage. Many countries did delay their reforms giving precisely such reasoning, exemplified by popular phrases such as ‘we must first build the conditions for a market’, ‘our goal is a social-market economy’, ‘we must protect the poor’, or ‘the people are not ready for the market’. Had these been more than slogans, then countries that took a gradual approach, as did most of the CIS and some in the Balkans, should have been implementing institutional reforms while delaying the liberalization of markets and privatization. The stark truth is that none of them did, as already hinted earlier in Chapters 2 and 3 and explicitly demonstrated below. One is hard put to resist the conclusion that there were no sincere gradualist policy-makers committed to properly applying this particular theory of the academic scribblers. In practice, the debate on alternatives quickly ‘coalesced into two polarized strategies, big-bang v. gradualism’,8 probably for worse not better. Broadly, the first two strategy types – reverse communism, mimic the market – can be considered as big-bang approaches while the other three – mimic China, import-substitution, institutions first – are typically thought of as implying gradualism. The match is not perfect, but close. The claim that there was no theory or historical experience to guide the process of transition from central plan to market appears in retrospect to have been a red-herring, perhaps understandable and harmless were it only an academic debating point. But unfortunately it became an extremely useful tool for opponents of reform whose real reason was the fear that any change would be harmful to their privileged pre-transition positions. In the


end, two things mattered most about these debates: how long they went on and delayed the start of the transition; and whether they resulted in a radically different ‘third-way’ strategy. In retrospect, it is impossible to argue that delays in reforms were due to the lack of precedents, the non-availability of charts or roadmaps, for if anything the problem was not too few charts to follow but too many. That could still mean that delay was justified to allow an adequate debate and discussion of what was the best path, what was most suitable to the social preferences of each nation. It should be unnecessary to demonstrate in detail that in societies truly open to democratic debate, the choice at least initially was to move relatively fast. In countries where reforms were delayed, open democratic debate was not really possible. Indeed in most cases this ‘debate’ was abused by the hidden agenda of potential losers from transition, the economic and political elites of the nomenklatura. To make this case it is useful to quantitavely measure the delays in getting started, and identify the strategies actually chosen – which is the task of the next section.

A timeline of economic transformation events Logically, categorizing countries by strategy must be based on the history of the main events of economic policy and the subsequent results. For presentation purposes, it will be easier to follow the events chronology by turning the logic around and showing first the outcome, grouping countries into the five strategy types of Figure 5.2.9 The 10 countries of Central Europe and the Baltics enjoyed a wide consensus and hence experienced very limited debate, and proceeded to early reforms. But among them some were already more advanced and did not move as quickly (Type I: Advanced Start, Steady Progress), while others starting farther back undertook a more rapid pace, closest to the big-bang concept that is so often but so loosely used in the literature (Type II: Sustained Big-Bang). A third, small group of countries, some from South-East Europe, some from the CIS, also started early and moved fast but did not sustain the pace and should be considered as aborted big-bang cases (Type III: Unsustained Big-Bang). They differed significantly from the clear big-bang cases, both in the extent of change in the first years and, most importantly, in not sustaining this strategy but experiencing policy reversals and resurgence of inflation. In a fourth group of gradual reformers the start was delayed for a long time and/or put on a very slow-track as a result of the extended debate (Type IV: Gradual, Delayed Reforms). Some countries of Type III suffered renewal of the debate and later fell into Type IV: Russia, Moldova, perhaps Kyrgyz Republic. Finally a fifth group is identical to the limited reforms group in Chapter 2 though two of these countries, Belarus and Uzbekistan, did show


I Advanced Start, Steady Progress

III

Big-Bang Unsustained

Croatia Hungary (Poland?) (Macedonia?) Slovenia

Albania Bulgaria Kyrgyz R. Macedonia (Moldova?) Russia

II Sustained Big-Bang Estonia Czech R. Latvia Lithuania Poland Slovakia

IV

Gradual, Delayed reforms

Azerbaijan Armenia Georgia Kazakhstan Moldova Ukraine Tajikistan Romania V Limited or Reversed Reforms Belarus Uzbekistan Turkmenistan

Figure 5.2 Transition countries and type of reform strategy

some modest early progress similar to many in the gradual reformers, but later this was halted and indeed reversed (Type V: Limited or Reversed Reforms). In popular memory and as a historic symbol, 9 November 1989, the day that the Berlin Wall fell under the euphoria of German youth with hammers of many sizes and shapes, will doubtless mark the beginning of transition. For a more analytical comparison among the 27 countries it has to be recognized that this event did not immediately mark an opening of new opportunities, as these openings came in steps over the next year for most of Central and South Europe and only two or more years later for the 15 countries arising from the ashes of the USSR. Table 5.1 lists the most important such events reflecting the beginning points of transformation. Consider first as a measure of reform delay the time between the regime change (defined as independence or change from communist party control) and the start of financial stabilization efforts, which virtually all observers agreed should be undertaken quickly. For the majority of countries of the first three types in Figure 5.2, this was almost immediate, and certainly within a half year. The exceptions are Croatia and Macedonia where war or embargo kept the situation unsettled for at least one or two years, and Romania where political struggles and debates went on even longer. For the CIS this delay was far longer, from 20 to 40 months except in Russia with its almost immediate big-bang effort to stabilize.

160 An Ex Post Transition Paradigm Table 5.1 Chronology of events: post-communist countries Years under comm.

Regime change

Transition start

Stabilization start (months)

Europe Agreement

Central Europe Hungary Poland Czech Rep. Slovakia Slovenia Croatia

42 41 42 42 46 46

Oct 1989 June 1989 Dec 1989 Dec 1989 June 1991 June 1991

1990 1990 1991 1991 1992 1992

March 1990 (5) Jan 1990 (7) Jan 1991 (1) Jan 1991 (1) Feb 1992 (8) Dec 1992* (18)

March 1992 March 1992 March 1992 March 1992 June 1996 June 2004


51 51 51

Aug 1991 Sept 1991 Aug 1991

1992 1992 1992

June 1992 (10) June 1992 (9) June 1992 (9)

June 1995 June 1995 June 1995

SEE Bulgaria Romania Macedonia Albania

43 42 47 47

June 1990 May 1990 Dec 1991 March 1992

1991 1991 1992 1991

Feb 1991 (7) Jan 1993 (32) Jan 1994 (24) Aug 1992 (5)

Jan 95 Feb 95 – –

CISM Armenia Georgia Kazakhstan Russia Kyrgyz R. Moldova Ukraine Azerbaijan Tajikistan

71 70 71 74 71 51 72* 70 71

Sept 1991 April 1991 Dec 1991 Dec 1991 Aug 1991 Aug 1991 Aug 1991 Oct 1991 Sept 1991

1992 1992 1992 1992 1992 1992 1992 1992 1992

Dec 1994 (38) Sept 1994 (38) Jan 1994 (38) Jan 1992* (2) April 1993 (20) Sept 1993 (24) Nov 1994 (38) Jan 1995 (40) Feb 1995 (40)

– – – – – – – – –


71 72 71

Sept 1991 July 1991 Oct 1991

1992 1992 1992

Nov 1994 (38) Nov 1994 (40) 1999?? (90)

– – –

Note:* Three dates have been arbitrarily changed by author. For Croatia, the October 1993 date in IMF source is the finally successful effort; the first in August 1991 was stillborn due to war financing, while a second shown here in December 1992 was temporarily successful though reversed. Russia’s first stabilization undoubtedly started with Gaidar’s reforms in January 1992 even if they failed. April 95 dates the first large IMF standby which was more successful. Ukraine had a socialist government as early as 1917, but Republican governments contended for power until 1919. Sources: Years of communism, transition start, stabilization start from IMF (2000), Tables 3.1 and 3.6; regime change, Europe Agreement from Heenan and Lamontagne (1999a).

Table 5.1 also shows the number of years under communism, often noted as a determinant of the transition path proxying for ‘market memory’. It is a matter of interpretation whether 70 years v. 40 years is a large difference, and Chapter 4 has already argued that perhaps three generations is not


really very different from two generations. Since the Second World War period did not exactly provide a normal market experience for the populations of Central Europe, only those in early adulthood or older could remember the market from the 1930s. They would have been well over 60 years of age at the start of transition. On the other side of the argument, there is no denying the broad correlation: countries with 40–50 years under communism generally moved more rapidly on economic transformation, those with 70-plus years moved more slowly. The exceptions suggest other factors at work. Russia with the longest communist history at least attempted a stabilization and big-bang within a few months of its regime change, while Moldova with a communist period about the same as in the Baltics delayed this for two years. Kyrgyz Republic was the third Former Soviet Union (FSU) case with a relatively early stabilization effort within 20 months, though it did begin other reforms even earlier. For Russia and Kyrgyz this was mostly attributable to ‘accident’ of personalities,10 while Moldova was like Romania where political instability put off serious efforts for nearly three years. War conditions in Croatia and Macedonia caused some delays albeit much shorter ones than seen in the war-torn Caucasus and Tajikistan. Bulgaria had a shorter history of communism than USSR successors, but it was well-known as the most fervent adherent to the communist ideology among the satellite countries, demonstrated symbolically by its formal request to become a republic of the USSR.11 Furthermore, at the start of transition its first government was not radically changed, being comprised of communists albeit younger and mildly reformist. Nevertheless it undertook an early first effort at stabilization. The number of exceptions to the communist continuity thesis is large enough to conclude at a minimum that it is only a partial explanation. The next section will attempt to reconcile these inconsistencies. An equally important measure of delay concerns the deeper reform of the economy, liberalizing prices, markets and private activity. The movements and milestones of the EBRD’s TPI which capture these changes are shown in Table 5.2. While Table 5.1 focused on starting points and an indication of how soon first efforts at reform were undertaken, Table 5.2 gives some measure of how quickly results were achieved: how many months from regime change to inflation stability defined as 5 per cent month inflation (while this seems still high recall annual inflation in many countries was in the thousands of per cent); the year that the private-sector share of GDP reaches respectively about half and two-thirds; three milestones of progress to a fully-functioning market economy as measured by the TPI; and the points change of the TPI index in the first three years after regime change (del TPI). The three milestones have the following rationale. A TPI value of 2.5 represents the average reached by Central European and Baltic countries the year before their GDP started to recover, reflecting the notion that at

162 An Ex Post Transition Paradigm Table 5.2 Milestones of transition progress Months to 5%/months inflation

Year priv. sec. share 50%/65%

Year TPI 2.5

Year TPI half-market 2.7

Year TPI near-market 3.3

del TPI first 3 yrs

Central Europe Hungary Poland Czech Rep. Slovakia Slovenia Croatia

0 12 0 0 10 25

1993/96 1993/97 1993/94 1994/96 1995/00 1996/03

1992 1992 1992 1992 1993 1994

1993 1993 1993 1993 1993 1995

1995 1995 1994 1995 1998 2000

1.0 1.2 1.6 1.6 0.9 0.6


14 14 10

1994/95 1995/98 1994/95

1993 1994 1993

1994 1995 1994

1996 2000 2000

1.7 1.4 1.6

SEE Bulgaria Romania Macedonia Albania

45 48 28 15

1995/98 1996/01 1996/03? 1994/96

1995 1995 1995 1995

1997 1997 1996 2000

2002 [2003 3.0] [2003 3.0] [2003 2.8]

1.0 0.9 0 0.9

CISM Armenia Georgia Kazakhstan Russia Kyrgyz R. Moldova Ukraine Azerbaijan Tajikistan

45 45 39 44 29 32 51 40 60

1996/02 1996/02 1997/02 1994/97 1996/02 1998/03 50 1996/02 2001/03? 2002/03 55

1996 1996 1996 1995 1994 1994 1996 1998 1998

1998 1997 1996 1995 1995 1995 2002 2000 2003

[2003 3.0] [2003 3.0] [2003 3.0] [2003 2.9]* [2003 3.0]* [2003 2.8]* [2003 2.8] [2003 2.7] [2003 2.7]

0.5 0.4 0.8 1.3 1.5 1.1 0.4 0.3 0.3


43 42 70

[2002 45] [2002 25] [2002 25]

[1995 2.4] [1995 2.1] [1997 1.6]

[2003 2.2]* [2003 1.9]* [2003 1.3]*

1.0 0.6 0.1

Notes: * denotes a TPI score constant or reduced in recent years, as shown in CISL cases with maximum under col. 3–4. For Russia the maximum was 3.0 in 1997; Kyrgyz has remained at 3.0 since 1997, and Moldova at 2.8 since 1998. ? indicates data not available after 2002, but recent trend if projected would give 65% by 2003. [x] denotes latest or closest relevant value of TPI achieved. Sources: Months to reach 5% monthly inflation taken from Kraft (2000) for 10 cases, IMF reports for the rest. Other data author’s computations based on EBRD Transition Report 2003 and PI values as in Chpater 3 Appendix.

least this much progress was needed to turn around the transitional recession. The second I define as ‘half-way to market’ with a TPI value of 2.7, halfway on the EBRD scale from central plan (1.0) to full-market (4.3). The third milestone with a TPI value of 3.3 I define as ‘near-market’, reflecting a situation where market forces start to become more important than government plans or directives. This is not simply a mechanical and arbitrary


choice of a value much closer to 4.3 than 1.0, but reflects the qualitative descriptions the EBRD gives for the value 3.0 in different dimensions:12 For example, under enterprise governance ‘significant and sustained actions to harden budget constraints’; under prices ‘significant progress in price liberalization’; under trade ‘removal of almost all import and export restrictions’; under competition ‘substantial reduction of entry barriers’. One might have chosen an even higher value for ‘near-market’ as the EBRD also notes that at 3.0 ‘substantial state procurement continues’ and that small-scale privatization is complete only at 4.0. But there is no intent here to be precise or categorical in any of these definitions. Besides, as seen in Table 5.1, only 10 of the 27 countries had reached the 3.3 level by 2003, thus setting a higher value would not be very illuminating or discriminating. The delay in achieving stabilization is measured here as the sum of the delay in undertaking an effort and the time to reach 5 per cent inflation per month on a sustained basis for at least a year;13 later reversals are discussed separately. All but one CEB country achieved this within about a year; Croatia had two unsuccessful attempts in 1991 and 1992 as war activities continued, but the October 1993 programme achieved an almost immediate drop of inflation well below 5 per cent per month. The SEE and CIS groups generally suffered through extremely high inflation levels for three to four years with the exception of Albania (15 months), Macedonia (28) and the Kyrgyz Republic (29). Several countries saw reversals. Bulgaria and Romania who only reached this level about 1994 continued deficit financing due to direct and indirect subsidies of state firms (most importantly farms in Romania) so even that achievement was reversed with a resurgence of inflation in 1996–97. Albania’s reversal was due to a crisis of confidence when inadequate control on new private investment funds allowed many shady pyramid initiatives which exploded in 1997 with spillover to legitimate funds. In Russia after the 1998 default and sharp devaluation there was a relatively mild and short-lived resurgence of inflation which spilled over to some of the neighbouring countries, but since then inflation has fallen to single digits annually in most CISM countries, and not above 15 per cent. In the CISL group, Belarus and Uzbekistan continue to have annual inflation well above 20 per cent. Their initial stabilization efforts were about as effective as of the CISM countries, but have not continued towards the ultimate goal of single-digit annual inflation seen in virtually all other transition countries. The difference between the advanced and lagging countries are equally stark on the milestones for private-sector share. For Central Europe and the Baltics, 50 per cent was achieved within two–four years of the start of transition, and the two-thirds mark in another two–three years, that is in well under a decade for most of them. Even Poland, where large-scale privatization was intentionally delayed, reached the two-thirds point by 1997, much of


this attributable to the boom in de novo enterprises. In the SEE region this was only marginally slower, whereas in the CISM (the CISL needs little comment, the figures fit well the label ‘limited’) some interesting exceptions exist. Both Croatia and Slovenia were much slower privatizing but for different reasons explored later in the book. Albania and Bulgaria, despite their problems of achieving stabilization, were not much behind the leaders in Central Europe. Nor indeed was Russia, but its rapid ‘insider’ privatization strategy may have had severe negative effects leading to oligarch development; this is elaborated in Chapter 6. Indeed, it is reasonable to ask if rapid privatization is a positive sign of progress; the answer is not necessarily so, but in this chapter the aim is merely to describe the different pace and trajectory of reforms pursued by countries. The judgments on the consequences come elsewhere in the volume. The most dramatic difference between leading and lagging reformers is seen in the trajectory over time towards the goal of a functioning market economy, in the TPI. Whether it is the growth-recovery threshold, the ‘halfway to market’ point, or the ‘near-market’ one, the CEB group is clearly far ahead of all the others. While they long ago passed the ‘near-market’ point, none of the others come close except Bulgaria which changed course after the United Democratic Front victory in 1997 and the adoption of a successful currency-board regime. Three countries in the CISM group were relatively quick starters: Russia, the Kyrgyz Republic and, to a more limited extent, Moldova. They can be considered to have taken a big-bang approach initially, and indeed the last column of Table 5.2 shows that their TPI index increased in the first three years from the start of transition by 1.1 to 1.5 points, little different from the values for many of the early rapid reformers in the CEB groups. However, the process was not sustained; in all these cases stabilization took much longer, and structural reform progress stalled or even reversed somewhat so that none of them had reached the ‘near-market’ TPI even as late as 2003. Russia reached its maximum (3.0) in 1997 and may have slipped marginally since; Moldova has not moved forward from a 2.8 score in 1998, and Kyrgyz has similarly stalled at 3.0 since 1997. The choice of strategy for economic transformation This brief review of the events and milestones provide the rationale for the categorization of countries by type of transformation strategy as shown in Figure 5.2. The five groups are based on specific values in Tables 5.1 and 5.2 as follows:14 I Advanced Start, Steady Progress: those which may not have needed a big leap or big-bang given an advanced start but pursued steady progress to stay in the forefront [TPI(0) 1.5 and TPI(4) 3.0]. II Sustained Big-Bang: those which undertook and sustained an initial bigbang [TPI3 3.0 and no inflation resurgence].


III Unsustained Big-Bang: those which undertook an initial big-bang but aborted it and/or were unable to sustain it [TPI(4) 2.5; but stalled and/or followed by resurgence of inflation]. IV Gradual, Delayed Reforms: those which delayed the start of reforms and/or pursued a gradual and not always steady pace [TPI(4) 2.5; stalling, reversals, restarts]. V Limited or Reversed Reforms: those which undertook very limited reforms or reversed early progress to remain at low levels [TPI(4) 2.0; at no time reach 2.5]. The clear cases of countries with an advance start are Hungary and the former Yugoslav republics with estimated TPI values in 1989 of 1.5 or more. Macedonia may not be appropriately classified here despite its initial TPI value because it did not – or was unable given the conflicts and embargo of the Yugoslav region – pursue steady reforms for the first few years. It may be more correct to put it in the intermediate category with Bulgaria, whose trajectory it follows closely (see Appendix, Chapter 2). On the other side, Poland which by wide consensus was a sustained big-bang case, might also be classified as an advanced-start case, with TPI value of 1.3. Many analysts have in fact argued that Poland, while perhaps not as advanced as Hungary, owed its rapid progress to considerable partial reforms in the late 1980s.15 While noting this, I have chosen to keep Poland in the sustained big-bang group with the three Baltics, the Czech Republic and Slovakia. Note in Table 5.2 that the change in the TPI value over three years was well above 1.0 points for the big-bang cases, and even above 1.5 for the Baltics and former Czechoslovakia; in contrast it was 1.0 or less for the advanced starters. In Type III, about five–six countries must be considered as attempting a big-bang but unable to sustain it – though the start was early in only the cases of Russia and Albania (and Bulgaria?), and much delayed in Romania, Moldova and Kyrgyz Republic. It is a toss-up whether Moldova falls in this group or the delayed-reform one; while it started stabilization and reforms somewhat earlier than the other CIS countries and achieved a lot in the first three years, by 1997 its reforms stalled and moved haltingly so that after 2000 many of the late starters had caught up. Some major reversals in the last few years – partial renationalization of airline and power companies, reversal of agricultural marketing liberalization, would argue for grouping Moldova with the gradual, unsteady reformers. Most important here is that no country of Type III was able to sustain reforms, as inadequate hard budget constraints prevented full attainment of stabilization objectives, and continued political struggles over the pace of reforms and the redistribution of wealth led to reversals of the process. Of these, eventually only Bulgaria was able to get back on track as of about 1997–98, to a considerable extent in reaction to the external commitment of EU membership desires.


The gradual reformers comprise most of the CISM group, countries that generally delayed a serious stabilization effort for more than two years, that even then pursued a pace that was much less rapid than the preceding cases. Considering only the recent years, Russia and Kyrgyz Republic, while moving forward much earlier, appeared to have exhausted themselves by 1997, from which time as noted the first actually undertook many reversals, especially in the area of external trade restrictions, while the second appears to have stalled since 1997. Nevertheless, both remain at the top of the CISM group as seen in Figure 2.1. Finally and unsurprisingly, Belarus, Uzbekistan and Turkmenistan have clearly chosen a strategy of not simply slow, but minimalist market reforms. In fact early progress in Belarus and Uzbekistan has been gradually eroded and reversed. I end this discussion with the question: have any countries pursued gradual reforms according to the institutionalist model? Figure 5.2 does not show this as a type for the simple reason that no country appears to have pursued that sort of strategy, notwithstanding much rhetoric to the effect that the society needs first to put in place market institutions. The hard evidence for this conclusion is simple; under a pure institutionalist rationale, market liberalizing reforms are delayed while institutional reforms move ahead to reach some level considered minimally necessary, or at least the two move forward simultaneously. The EBRD Transition Report 2002 investigated the different paths for these two categories of reforms which they define as first and second-phase reforms,16 and reach two conclusions. First, in all transition countries the liberalization reforms came first, with a considerable lag for the institutional ones. Second, the lag of institutional reforms behind liberalizing ones is much greater in CIS countries where the gradual reformers are – it is particularly large in the CISL group – than in Central Europe and the Baltics where the rapid reformers are found. This was already shown in Figure 2.4, and in the Appendix data of Chapter 2, which confirm there was no single case where institutions came first, or even in parallel with liberalization reforms. This would seem to put the lie to assertions by many policy-makers and advisers in the early 1990s that they were delaying market reforms for the sake of putting in place the proper legal and institutional framework needed in a market economy. If, for the sake of argument, the three CISL countries are taken to best represent gradualism at work, it is striking that not only did the TPI average for institutional reforms lag behind the liberalizing ones, but that the group average has remained unchanged at 1.5 since 1994 (Figure 2.4). In contrast, the rapid Central European reformers had by 1994 already a much higher value (2.7) and continued to improve with a 2004 TPI value of 3.3. Even the CISM, which in 1994 was at the same level as the CISL, progressed slowly but steadily on institutional reforms. This claim to be going slowly while preparing institutions was surely one of the biggest and


most scandalous canards that were trotted out in the early debates, and the evidence 15 years later strongly confirms there was a different hidden agenda of policy-makers.

Commitment to a liberal market economy To say as did Bunce (1999) that countries with a commitment to a ‘vision that is fully anti-communist and hence fully liberal’ will move earlier and more forcefully on economic transformation is fundamentally correct but, without some understanding of the forces that lie behind the commitment, it is an incomplete explanation. Here, two such forces are discussed: a renunciation of communism including a concomitant breach with its political role in society; and pursuit of a national vision integrating or reintegrating the state into the global economy and the liberal, democratic assembly of nations.17 Renouncing communism At one extreme, Baltic countries exemplify societies with a very strong commitment to ‘renounce communism’ (Laar, 2002). There are no clear cases at the other extreme of countries fully retaining the system of communist central-planning, but several are not far from this. Belarus, since Lukashenka took over in 1994, and Turkmenistan, from the beginning under Niyazov (Turkmenbashi), exemplify autocracies in which the communist leadership has continued in power and practised a version of the old system only marginally modified. Uzbekistan began a bit differently. Despite the continuing rule of former communists under Karimov, at first it moved at least as fast on the economy as several CISM gradualists, but this began to be steadily reversed in the second half of the 1990s. Comparing only these two polar groupings, the much greater success of the Baltics compared to the CIS is unquestioned and finds few if any counter-arguments, and hence it appears to confirm the popular hypothesis that ‘the best predictor of economic reform [progress] … is the outcome of the first election’.18 But once the countries between the Baltic–CISL polarities are considered, the use of first-election results as a proxy for the commitment to a vision of a liberal society in fact does not work all that well. Nevertheless, I will show below that the fundamental idea of Bunce about anti-communist hence liberal vision is correct. The problem is measuring this concept. Consider the three groups that Bunce identifies. First, with a clear noncommunist victory in first elections are the Czech Republic, Estonia, Latvia, Poland and Lithuania; added to this are Hungary and Slovenia because ‘reform communists’ had been in power for some prior time. This group is almost identical to the two first groups in Figure 5.2 with a rapid and steady path of reforms. At the other extreme she lists countries with a clear first win for former communists: Serbia, Uzbekistan, Kazakhstan, Belarus and


Azerbaijan, again as predicted the slow-movers. However, in between Bunce lists cases where neither communists nor opposition won a clear victory and hence the path of reforms was indecisive: Russia, Ukraine, Romania, Slovakia and Croatia. There are several problems with the Bunce test. The list includes only 17 of 27 countries and misses out on the actual beginning at the time of regime changes where no elections took place; she does not consider the very important consequence of early second elections; and miscategorizes several cases where a renamed communist party wins the first election (for example Ukraine); and groups several countries incorrectly as having ‘indecisive reforms’ (Russia, Ukraine, Romania, Slovakia and Croatia surely do not belong together). All of this is easily corrected on the basis of information available in Table 5.1, and compendia on the transformation process in the region (Heenan and Lamontagne (1999a) and (1999b)). Doing so results in the groupings of Tables 5.3 and 5.4. Consider some of the changes this brings to bear on her categories. Belarus can be considered to have had at least a coalition government at first, where the new Chairman of the Supreme Council in September 1991, Stanislau Shushkevich, was a centrist politician with a reform agenda who was often supportive of the unelected popular front, and able to begin a process of gradual economic reform at least equal to the delayed slow-movers like Ukraine.19 It was only the ‘election’ of 1994 that brought in a clearly communist-oriented regime led by Lukashenka after which (as the Appendix figure in Chapter 2 make clear) there began a reversal on economic reforms. Bunce’s intermediate list also contains three countries whose experience is not properly characterized. Characterizing Ukraine as a ‘mixed result’ is questionable; the Presidential elections were easily won by Kravchuk, the former First Secretary, and the renamed but non-ideological communists.20 The Rukh opposition and its allies formed a sizeable opposition and agreed to a co-habitation, but were not greatly influential in the government’s agenda, particularly on economic matters.21 Making this correction on Ukraine brings the results more in line with the original hypothesis: Ukraine’s very slow progress on the economic front is related to the continuation of the former communists in power. Croatia might be characterized as a nationalist independence-oriented government, but there was considerable continuity from the pre-transition socialist party governments22 who must be considered as ‘committed reformers’ no less than those in Slovenia. These adjustments and additions to Bunce’s grouping result in Table 5.3, which also cross-classifies by the type of reform strategy of Figure 5.2. The ‘first-government is non-communist’ explanation would imply a diagonal going from top-left to bottom-right in the table; but this is only weakly evident with many exceptions in the opposing corners. The communist or coalition cases which followed rapid reforms are the three countries with a clear history of pre-transition commitment to a market orientation (Hungary, Croatia, Slovenia). The three cases of non-communist or coalition


governments which did not pursue rapid reforms were not clear-cut cases of an anti-communist and liberal vision, but also in each case there is a simple specific explanation. Armenia and Georgia had strongly nationalist governments that pursued the earliest effort at land privatization, but they were soon embroiled in civil wars and cross-border conflicts which drained energies and slowed reforms. The case of Belarus was explained above: an early second election solidified the dominance of the former communists and quickly reversed the mild early reform. Bunce’s attempt to use first-government as a proxy for liberal vision does not work well on a strict definition of communist or non-communist, as Table 5.3 makes clear. Thus, she tries to rescue the test by two stratagems: allowing Hungary and Slovenia to be ‘non-communist’ because their communists (or socialists in the latter case) were reform-oriented; and she lumps together in a too cavalier fashion a lot of intermediate cases. These errors of categorization make the test appear less convincing and certainly very soft. But in fact, once these categorization problems are dealt with carefully and one recognizes it is not the party name but the commitment to liberalism that Table 5.3 Type of first government and reform strategy Non-communist Advanced Start, Steady Progress Sustained Big-Bang

Limited or Reversed Reforms

Renamed-communist

Hungary Croatia

Slovenia

(Russia?) (Bulgaria 1992)

Albania Bulgaria 1991 Macedonia Russia Kyrgyz R.

Georgia

Romania Kazakhstan Moldova Ukraine Azerbaijan Tajikistan

Belarus

Uzbekistan Turkmenistan

Poland Czechoslovakia Estonia Latvia Lithuania

Unsustained Big-Bang

Gradual, Delayed Reforms

Coalition*

Armenia (Georgia?)

* Coalition here means with a communist or renamed communist party. Coalitions that were entirely non-communist fall under ‘non-communist’. Source: Type of government as described in Heenan and Lamontagne (1999 a and b), Handbooks for Central Europe and CIS. Some cases were marginal or unclear or very short-lived; these are recorded twice, without brackets in most likely interpretation, in brackets for alternative. Strategy as in Figure 5.2.

170 An Ex Post Transition Paradigm Table 5.4 Liberal commitment at start and reform strategy Commitment Strong Advanced, Start Steady Progress

Croatia* Hungary* Slovenia*

Sustained Big-Bang

Poland* Czechoslovakia Estonia Latvia Lithuania


Gradual, Delayed Reforms

Limited or Reversed Reforms

Armenia

Moderate

Weak

Bulgaria? Albania Kyrgyz Russia

Macedonia

Georgia

Romania Kazakhstan Moldova Ukraine Azerbaijan Tajikistan

Belarus Uzbekistan

Turkmenistan

* Reform oriented leadership even before transition starts. Visionary leader in a weak commitment polity.

is the real driving force, the evidence is found to be very consistent with the thesis. Table 5.4 adjusts Table 5.3 categorizing by degree of commitment: strong (countries with clearly non-communist first-government plus those with a strong reformist orientation pre-transition); moderate (coalition governments plus ‘continuity’ governments with a visionary leader, that is, Russia, Kyrgyzstan23); weak (clear-cut ‘continuity’ governments of former communists regardless of party name). Not all the categorization of commitment is clear, but the few cases where it is on the margin do little to change the strong implication of Table 5.4. When liberal commitment is defined combining as best as possible actual election results, pre-transition reformist tendencies and the happenstance of a visionary leader in a weakly-committed polity, the expected diagonal is far more clear; that is, the stronger the commitment the more likely reforms will start early and proceed steadily. Where commitment is weak or wavering, reforms will tend to move slowly, or at best initial early efforts will not be sustained, will stall and in some cases reverse. The inadequacy of the partylabel as a proxy for commitment is even more clear when one goes beyond


the first government and observes the effect of government changes on reform strategy. This is best discussed in the context of the Przeworski thesis. The prediction of Przeworski (1991) that the pain caused by too-rapid economic transformation would quickly lead to a replacement of democratic first governments is realized in several countries as Table 5.5 shows and for the reasons he raised. Kim and Pirtilla (2004) provides a nice analysis of voting patterns in second elections confirming that people were most concerned about the loss of employment and reduced social benefits caused by tightening budgets. But Przeworski’s associated prediction that these governments would reverse economic and democratic transformation did not on the whole come true. The clear exception is Belarus where both of these visions were indeed sharply reversed, and to a lesser extent Azerbaijan where the short-lived hope for democratic development was nipped in the bud and economic liberalization was slowed but not reversed.24 In Hungary (1994), Poland (1993), Slovakia (1994) and arguably Albania (1997) one sees the clearest cases of former communists returning to some degree of power in government – sometimes in a coalition as in Poland – but not changing the course of policy very much, except perhaps to ease a little the pace of economic transformation and its first negative impacts on the populace. The trajectory of the EBRD Transition Index is not perceptibly different after these changes than it had been before (Appendix, Chapter 2), except slightly in Albania where it is slowed but certainly not halted or reversed. For the first two the democratic liberalization also continued unabated. In Slovakia, this dimension is the one that suffers, but not for long as the same voters that may have reacted to early pains and voted in the Meciar government of reconstituted communists in 1994, within four years returned a more democratic government again. In Albania the return of former communists is attributed by Clunies-Ross and Sudar (1998) to very Table 5.5 Countries with reversals in government Non-communist to comm. or coalition Advanced, Start, Steady Progress Sustained Big-Bang

Hungary (1994) Poland (1993) Slovakia (1993)


Albania (1997)

Gradual Reforms

Georgia (1992) Azerbaijan (1993)

Limited Reforms

Belarus (1994)

Source:

As for Table 5.3.

Communist to non-communist

Slovakia (1998) Croatia (2000) Bulgaria (1997)


different concerns; the populace was not at all unhappy with the privatization of land and new-found freedoms after the dungeon-like years under Hoxha, but was enraged at their financial losses in the crash of pyramid schemes of 1997. The degree of conversion of former communists to a liberal vision was perhaps strongest in some Yugoslav republics and in Hungary and Poland. I discuss the last two. The Hungarian Socialists (renamed-communists) took power in coalition with the Alliance of Free Democrats in June 1994, and, despite the platform of easing the transition pains caused by the previous government, appointed as Minister of Finance a well-known reformer and banker, Lajos Bokros, who proceeded to implement an even harsher budgetary policy (see Pittaway, Chapter 2 in Heenan and Lamontagne, 1999). This echoed the Polish result in 1993 where the Democratic Left Alliance in coalition with the Peasant Party replaced Solidarity, but named as its Deputy Prime Minister for the economy Grzegorz Kolodko, who though a vocal critic of the too-harsh measures of Balcerowicz, was an unquestioned proponent of market transformation.25 Slovakia’s first steps on the economy took place before the Velvet Divorce in 1993, and cannot be ignored since they were not reversed by the new 1994 Slovak government of a more mixed nature. Furthermore, the government changed once again to a non-communist one in 1998, with expected effects on the pace of economic (and political) liberalization. Croatia, too, is surely in the category of committed reformers at least on the economic side. Its first government was indeed composed of many former members of the Yugoslav (and Croatian) Socialist Party, but so too was that of Slovenia and Hungary, both of which Bunce correctly designates as having been committed reformers in the late socialist period. All of this leads to the following conclusion: the fact of a non-communist first-government is not a good measure of the degree of renunciation of communism. There is no objective metric available to measure the strength of such renunciation and one must inevitably seek to understand the deeper but unfortunately vaguer notion of commitment to liberalism. In doing so, it is useful to consider party identification, but only in combination with the other forces mentioned at the outset: nationalist sentiment; external vision of a European anchor; the negative force of the hidden agenda behind former nomenklatura expressions of support for the market and democracy; and the happenstance of a visionary leader. Nevertheless, there is something to the simpler view that replacing the communist governments with new ones is a recipe for success; indeed Laar (2002) insists it is necessary for success because ‘the state apparatus from the old regime is unsuitable to implement the appropriate path. It can only transplant corruption and “telephone rights” [Laar means insider privileges: Au.] from the old system to the new.’ In the context of Estonia and the other Baltics it may indeed have been impossible to proceed with any significant


involvement of the nomenklatura because it shared neither the important national vision nor the liberal market one. In other Central European countries much of the old nomenklatura was much less conservative and ready to ally with others, or even on their own (Slovenia) move with determination on the vision which ‘bundled two projects: democratization and economic reform’ (Bunce, 1999). This is seen not only in the cases at the upper-righthand corner of Table 5.3, but even more so in the Central European cases where second elections replaced non-communist governments with renamed-communists, sometimes in coalition. National vision and economic liberalism I have often criticized Baltic nationalism, but in the post-communist world it is of irreplaceable importance to providing some sort of hedge against blatant corruption and in mobilizing a sense of service and sacrifice. (Lieven, 1993) Few observers would disagree with the above prescient remark on the positive role played by nationalism in the Baltic transformation. But many would and indeed do emphasize the negative consequences that nationalism may have, ranging from the vicious fighting and resulting bloodshed of the post-Yugoslav space to the same in the Caucasus, and including many cases of mistreated minorities throughout the region. The negative effects are those more often evoked when the word ‘nationalism’ is used, despite the historical evidence that it can also be a force for good. Just as the ‘nationalism’ of Allied nations in the Second World War provided the strength to combat the negatives of Hitler’s nationalism, Lieven argues nationalism contributed to the bloodless dissolution of the Soviet empire in the late 1980s. As Tsygankov (2002) shows, it was not only the Baltics who were kept on a clear path to democracy and a free market by this force, but to some degree, this also played a role in the CIS countries, with those having a greater ‘degree of national identity strength’ following a stronger ‘foreign economic policy sharply away from … the Soviet empire and toward new partners’.26 That the negatives of nationalism are more often studied than the positive ones is an issue well-beyond the present study, but two points merit attention as they help understand the link between nationalism and commitment to liberalism. First is the historical reality that ‘old’ nationalisms which have been solidly entrenched for centuries as in Western Europe or North America, have, at least since 1950, generated much fewer sharp disputes and violence,27 while unfulfilled nationalisms often do. The differences between entrenched and embryonic nation states is often reflected in the terminology used. Nationalists of long-ago revolutionary wars were called by the imperialist force rebels, traitors and the like; today they are patriots. Nationalists taking up armed struggle for independence or autonomy are


today called patriots by their supporters, rebels and terrorists by the ruling powers. ‘La plus ça change!’ That ruling powers easily abuse this value-laden term is too well-known to need examples.28 Second, it is important to distinguish the difference between cases where violence or negative effects come because nationalism is resisted by imperialism, and cases where nationalism leads to mistreatment of minorities. If a legitimate nationalist desire for independence is stymied by an imperialist force which resists autonomy or independence, the ensuing violence cannot be primarily attributed to the evils of nationalism, but should equally be explained by the evils of imperialism. The refusal of Milosevic’s rump Yugoslavia to accept the independence of Slovenia and Croatia was surely partly responsible for the initial fighting. At the same time, a comparison of these two illustrates well that a strongly nationalist environment can simultaneously contain the positive and negative forces. Since, as Croatia’s struggle with Yugoslavia (Serbia) went on much longer than that of Slovenia, it led to mutual atrocities and spillover of harm to minority Bosnians in the contested territories. This simultaneity in much less violent form was observed in the Baltics and their treatment of Slavic minorities, who had come there during Soviet times. No matter the correctness of the historical argument about this ‘colonization’, the Baltic countries eventually had to yield to pressures of the EU to soften their citizenship laws for the minorities. Herein lies a nice paradox of how positive nationalism drove the Baltics towards European values, and how the demands of EU membership led them to attenuate the negative element of minority treatment. Mature nation states or national groups that have attained secure status are not immune from this simultaneity. According to The Economist Catalan nationalists in Spain, who have for years had the right to the use of their language, are said to oppose recent proposals of the centre to accord the same privilege to other languages, in particular to Valencian which some argue is simply a dialect of Catalan.29 The possibility of negative forces in nationalism should not obscure the (possibly simultaneous) positive content. The point here is that in the postcommunist transformation, these positive nationalist elements were for many countries an integral part of the strong commitment to the dual vision of democratic and economic liberalism. The logic is simple. A national desire for self-expression could only be accepted by the global community if it emulated the established nation states with a liberal democracy and open free-market economy; hence this drove much of Central Europe and the Baltics to emulate such modern nation-states. In South-East Europe and the CIS the force was less pronounced, but not totally absent. Bulgaria and Romania had a strong desire to be taken in by the global community and, despite a much slower pace, did move eventually in that direction. In the CIS, Tsygankov notes that the very weak national basis in Belarus compared to Ukraine explains why the latter did move forward, albeit slowly, and the


former has remained virtually unchanged. Even in Central Asia one sees a variant of outward looking vision for the nation. Gleason (1997) describes how the more ‘socialist cosmopolitan’ leaders of Kazakhstan and Kyrgyz Republic (Nazarbayev, Akayev) have over a decade led their country to a far more advanced state of market operations than was the case in Uzbekistan, or in Turkmenistan.30 An interesting example of how strength of nationalism led to greater commitment on economic policy is provided by Kraft (2000), who shows that the stronger the nationalism movement, the sooner it led to achieving financial stabilization. In his sample of 14 countries, six countries with strong nationalism all had very early and successful stabilization (Slovenia, Croatia, the Baltics and Moldova), while of five countries with weak nationalism only one (Kyrgyz Republic) was moderately successful in stabilization, while the others (Kazakhstan, Uzbekistan, Turkmenistan, Belarus) took much longer to stabilize. His measure of success, months from independence (or regime change) to reach 5%/month inflation was used in Table 5.2. Clearly, strength of nationalism alone does not discriminate adequately between slower and faster reformers, but its positive incentives add another building block to the understanding of the underlying force: commitment to a liberal polity and economy. It is also an incomplete explanation because there are instances where, arguably, nationalism led to less liberal commitment and not more, in particular the diversion of energies from economic reforms to armed conflict seen in extreme form in Serbia until Milosevic was replaced, and in lesser but also damaging form in Armenia and Azerbaijan fighting over NagornoKarabagh. Finally, to show as is done here that a positive drive may have come from nationalism, is not to diminish the potential and actual instances of its becoming a negative force, if it turns inward from a struggle with an imperialist resistance to the mistreatment of minorities. There are plenty of examples of this, but the simultaneity of opposing forces from nationalism should not be considered as too complex to deal with, for it is surely not rocket science to judge when a legitimate national desire for independence is resisted by an imperialist force or when that desire is unjustifiably aimed at internal minorities and in effect becomes itself a form of imperialism.

Historical evidence and hypotheses of the navigation model There was no lack of possible navigation charts to follow, so the delay in starting reforms cannot be attributed to this. Figure 4.5 included a hypothesis (H4) that delays were more due to a lack of national commitment to a liberal vision, and another that a visionary leader could add to a weak national


commitment and push forward early reforms. This chapter has demonstrated three things. First, that a non-communist first-government is not by itself a good measure for such a commitment. But, second, if judiciously qualified by an understanding of prior reformist inclinations and supplemented by evidence of positive nationalism forces, the nature of firstgovernment can be redefined as to the degree of its commitment. Such a measure, albeit soft in its quantitative rigour, does allow one to confirm the positive correlation between commitment and short delay. Third, a review of stated commitments to market reforms contrasted with actual underlying commitment and actual steps taken, leads to the conclusion that many policymakers who argued for the theoretical advantages of gradualism did so not from a sincere desire to find the optimal strategy of transformation, but to rationalize a long delay creating opportunities for personal enhancement of the previous nomenklatura and its transformation into the new capitalist elite. How this was achieved is the subject of the next chapter.

6 From Rent-Seeking to Oligarchy to State Capture

Overview All but a handful of the post-communist countries have experienced a substantial increase in the role of private-sector activity, which means a lot of new capitalists are now active in these economies, many with small enterprises, but a few owning and controlling vast amounts of industrial, financial and even agricultural assets. The term oligarch is now almost universally used to describe these few whose holdings are estimated to have values in the billions of dollars, and unsurprisingly they attract the greatest attention of popular and academic commentary. Popular interest in the notoriety surrounding oligarchs is not simply following the lives of ‘the rich and famous’. Taras in Sumy, Ukraine, reading complex accounts in Post-Postup of how 30-plus Rinat Akhmetov became a multi billionaire, is not to be equated with Arthur of Eau Claire, USA, absorbing all the juicy details in People magazine about Brad Pitt’s latest off-screen romance. Akhmetov’s past and future dealings doubtless have far greater impact on the well-being of Taras and his family than do Pitt’s twists and turns on Arthur’s life, and they both know this. Serious analysis of such oligarchs in the post-communist region has, in fact, great importance not only in understanding this episode in history, but also in countries where they have become politically powerful it is essential for a proper perspective into the future. The goal of this chapter is to elucidate the evolution of this new capitalist class, to understand what conditions during the transition nurtured the evolution of such great concentrations of ownership, to investigate who they are and who they were in the Soviet period, and finally to make clear why the term is more typically applied to countries in the CIS group and less so, if at all, in Central Europe.1 These issues are analysed in the rest of this chapter under three headings. The next section describes the process of new capitalists evolving, and argues that the most powerful paradigm for explaining this evolution was the extent to which delayed and partial economic liberalization created rentseeking opportunities. But the rise of the oligarchy is more interesting than 177


a one-note tune. In concert with the central theme of partial reforms there were a number of other forces which made a particular country more or less vulnerable to rent-seeking and eventual state capture by oligarchs: prior historical conditions such as a stronger and more united nomenklatura; happenstance of a bolder or more cautious leader; the effect of international commitments such as EU association or membership. These complementary forces are considered in the second section, before moving to the most critical piece of the story: how did rent-seekers become powerful enough to merit the title ‘oligarch’ and how did they then go on to ‘capture the state’? The fact of a handful of powerful rent-seekers or lobbyists established in an economy does not by itself make Kazakhstan, Ukraine or Russia uniquely different from other developing or even developed economies. As Shleifer and Treisman (2004) correctly observe, in Brazil, Mexico, Italy, Sweden and others, ‘a few family-run firms often control a large share of national production’. Indeed, rent-seeking activities were, and are, common to all the transition countries to some extent, even the more advanced ones. But Shleifer and Treisman’s argument that all of this makes Russia a normal country misses an important distinction. A large-enough difference in degree of such power and influence may result in a difference in kind: the oligarchs can not only influence specific policies to favour themselves (this is how best to define rent-seeking), they may in fact be powerful enough in collusion with each other to ‘capture the state’ in the sense of virtually controlling the direction of general policy or even election outcomes. Finally, to better understand what is unique about vested interests in these captured states, an Appendix to this chapter summarizes the literature on lobbying, entrenched interests and buying political favours in non-transition societies.

Partial reforms and the evolution of rent-seeking Principal methods of capital accumulation In almost all of the transition countries, laws prohibiting private enterprise were changed relatively early, indeed in a literal sense even before the transition truly began. In much of Central Europe it was possible to set up a small business well before 1989, and in the USSR the key laws on co-operatives came in 1997 and 1998. The combination of legalizing private business with continued government regulation of prices, export, import and internal trade licensing, immediately opened up possibilities for arbitraging or rentseeking. A new private firm that could obtain a licence to export Ukrainian beer at still-low Soviet prices in 1992 to Poland where prices had long ago moved towards European levels, stood to make a lot of money very quickly. Seeking out differences in purchase and sale price of beer in different markets is what the term ‘arbitraging’ means in economics, and is a perfectly valid and justifiable way of making profits, as long as the opportunity to buy low

From Rent-Seeking to Oligarchy to State Capture 179

and sell high is available to all. When the low price is set by government, and the transaction is regulated, not all can participate. Obtaining the government privilege (not granted to everyone) of buying the beer and exporting it to Poland or anywhere that it fetched a higher price yields a special kind of profit economists call ‘rent’; while influencing the licence-giving agency is the activity of ‘rent-seeking’. I will also refer to this dual situation of government regulated prices and government-assigned transition licences as ‘insider arbitrage’. The beer to Poland example is simple enough to illustrate clearly the process of rent-seeking, but in reality it was penny-ante stuff compared to the major ways in which the first post-communist capitalists accumulated wealth. The incentive for a new capitalist to make maximum profits was universal in all countries because, no matter how rapid the reforms, some time elapsed between legalization of private activity and the elimination of government regulations which created a gap between market prices and official prices. But the extent of such opportunities and the magnitude of potential rents was greater the longer the delay and the more partial the reforms. Thus, countries in the Figure 5.2 categories of gradual reformers and unsustained big-bang cases (IV and III) became most vulnerable to rent-seeking. These delays allowed a continuation for many years of fiscal and monetary instability, consequent inflation and exchange rate crisis, a plunge in credibility and a much deeper fall in output; that is, conditions ideal for arbitrage, abuse of insider contacts, and favouritism in granting government privileges. This was typical of all CIS countries in varying degrees, but also many in SEE. The period of instability and extended debate on how best to reform in fact provided a perfect opportunity for development of a rapacious new capitalist class based on insider-privileges, regardless of the formal mode of privatization. The legal opportunity of private enterprise provided by Gorbachev’s 1988 law on co-operatives and reinforced in most of the new states by legalization of ownership in the early 1990s, formed the initial basis of capital accumulation.2 But the truly big opportunities came after 1991, in particular using four broad vehicles. Three of them were included in the first phase: direct budget subsidies for state firms and the skimming-off of assets to associated private firms; borrowing from the government at low interest in times of hyperinflation; and buying energy and other natural resources at still-controlled low prices and reselling them at far higher market prices. A second phase was particularly focused on the fourth: ‘insider’3 privatization of large-state firms. Consider each of these vehicles in turn. Direct subsidies to state firms continued for several years in most of the CIS countries and several large ones elsewhere like Bulgaria, Romania and for a short time in Slovakia. This was not simply the inertia of Soviet-period operations, but also a reaction to the heated debates on how to reform without generating large social costs like unemployment. Since in all these countries private firms could be established, many of the members of the old


nomenklatura did so, including managers of firms or Red Directors, while the debate and subsidization went on. The Director and other members of upper management of a Russian machinery firm like UralMash or a Bulgarian industrial conglomerate like Metalchim could and did establish private firms that did business with the still state-owned firm: buying and selling products, providing services such as accounting, marketing, organizing the sports-teams sponsored by the firm, running the subsidized cafeteria – the list is simply endless. Unsurprisingly, the deals were very favourable to the private firm and caused a financial loss to the state firm, often making it effectively bankrupt. This in turn, at the time of economic crisis and increasing unemployment, provided the Director with the argument that ‘for the good of his workers and local community’ there should be help from the state budget. The venality of this position did not go unnoticed to the general public which, incorrectly but understandably, blamed capitalism for the whole packet of problems.4 High inflation and low interest rates combined with privileged relations between government officials and owners of the co-operatives (often called ‘Konserny’) in the late Perestroika period, allowed them to borrow at huge negative rates – in fact often not even repay. Sometimes this was indirect borrowing, that is by the state firm whose management also happened to have some new private ventures, and used these funds to ‘buy’ goods or services from the private firms at highly inflated prices, or to sell at below market prices, in effect transferring resources to that firm. When the time came to repay after two or three years of hyperinflation, the amount was so low in real terms that it was often forgiven by the government. In Ukraine with 10,000 per cent inflation in 1992–93, such credits were supplied to industry and agriculture at interest levels of 20 per cent in a magnitude estimated at 50–60 per cent of GDP.5 Controlled prices of energy and raw materials at well below world levels, again with privileged access to trade licenses, gave the first large dividends to rent-seeking activities. The narrative of Freeland (2000b) on this ‘Sale of the Century’ is particularly good reading with great personal detail in such stories as the formation of Lukoil in Russia, United Energy Systems of Ukraine, the analogue in Moldova, and others. There was a special twist in Ukraine and Moldova, both energy importers. Unlike Russia, rents could not be made from exploitation of oil resources, but instead elaborate schemes were established starting with privileged licensing for imports of Russian gas and oil at ‘government’ prices (low of course) with a government guarantee, and rights for resale at higher prices either on the open market including exports, or to budget agencies (city heating plants, hospitals, schools) again at higher prices but with government energy subsidies going to these agencies. The government guarantee was often invoked, as some of these licencees, having siphoned off considerable financial capital, were, surprise, surprise, unable to pay the Russian supplier: the government picked up the debt.


Balmaceda (1998) and Puglisi (2003) describe how these operations evolved and changed hands over time, starting with several firms sharing this rent and moving to greater concentration. The individuals are well-known to observers of Ukraine including Scherban of Industrial Union of Donbass (later apparently murdered) and Ischenko of Ol-House, followed by virtual monopolization of the sector by United Energy Systems under Lazarenko, a Prime Minister who soon fell out of favour and lost the privilege to Neftehaz Ukrainy within the circle close to the President, including Surkis and Pinchuk,6 and in the South-East regions to a new rising star Rinat Akhmetov, then only 30 years old. Once financial stabilization and inflation control began to be achieved by tighter fiscal and monetary policies, and many of the price distortions were reduced, the process of accumulating wealth entered a second phase: obtaining favourable conditions for the privatization of the largest state firms. In the CIS countries in particular this was very much a ‘political-insider’ process in the broad sense of favouring those who were close to the political powers, even if they were not literally ‘firm-insiders’, that is Red Directors. This non-transparent process was not significantly affected by the choice of formal modality – public vouchers, auctions, direct sales, privileged sales to firm-insiders to workers or managers – as every one of these modalities could and was easily abused. As many have shown (Reddaway and Glinski, 2001, for Russia; Barnes, 2003a, for several countries), such unfair privatization favouring the old nomenklatura and new young entrepreneurs who developed connections with the nomenklatura began with the ‘spontaneous’ transfer of assets from state entities to associated ‘Konserny’ which accumulated sufficient assets to play the rent-seeking games above, and by the mid-1990s had amassed enough to be first in line for the privatization of the huge firms of 10,000-plus employees and potential value in the billions. However, the 1990s privatization was different from that of the 1980s in two respects. It was much bigger in scale than the early process, and it involved not only the old nomenklatura but also new young capitalists – though often not ‘as new’ as they might seem, since many of them were high-level Komsomol members who were closely associated with the former elite.7 Who the new capitalists were and who became part of the very small coterie of oligarchs is addressed in the next section. Even if there were some new ones not from the old nomenklatura, the delays in stabilization and liberalization in most countries outside Central Europe and the Baltics allowed the disoriented top nomenklatura echelon to regroup politically, relabel themselves using the word ‘democratic’ somewhere in the party name, recolour themselves from red to green (not as in environment but as in ‘buksy’), and by quickly accumulating large sums of capital regain influence and indeed control of the political apparatus of the state regardless of open democratic elections, that is to ‘capture the state’ as described later in the chapter.


Reform dynamics and potential rents In Chapter 5 the transition countries were categorized in five groups according to the type of economic reform strategy (Figure 5.2). For countries in group V – Belarus, Uzbekistan and Turkmenistan – with very limited liberalization progress or significant reversals, ‘the private sector is very small [and] important elements of the command system [remain], state capture can only be minimal’.8 These countries are therefore excluded from the analysis in this chapter. To understand the link between the strategy of reforms (timing, speed, sequencing) and state capture it is most useful to consider only two types: ●

●

Type A: high vulnerability to rent-seeking: countries pursuing gradual reforms, and countries experiencing an unsustained big-bang (approximately groups IV and II in Figure 5.2). Type B: low vulnerability to rent-seeking: countries with advanced start and subsequent steady progress, and countries undertaking a sustained big-bang approach (approximately groups I and II in Figure 5.2).

Many analysts of transition recognized very early the risks of rent-seeking opportunities arising with too-slow reforms, though the precise balance was of course not easy to define. The broad relationship was noted in Havrylyshyn (1994 and 1995) and Hellman (1998), the slower the elimination of distortions in the economy, the larger the potential rents. In retrospect, one can paint a much clearer picture of this causal link. In type A, high vulnerability countries (Figure 6.1), the formal right of private activity comes early, but other reform elements are delayed for a year or more. They come in the following approximate sequence: partial price liberalization excluding key raw materials, energy and some consumer items; partial liberalization of external trade; small-scale privatization; financial stabilization based on gradual tightening of fiscal, monetary and firm credit policies; limited institutional changes such as formal anti-monopoly laws; large-scale privatization. There is a considerable variation across countries, as for example much earlier liberalization and stabilization efforts in Russia and Kyrgyz Republic, though these were not sustained, and the much later large-scale privatization in Ukraine compared to Russia. For Ukraine, in the end this delay made no difference as the process was no less ‘insider’-oriented than Russia’s loans for shares.9 Also common to this group of countries is the very long delay on institutional measures which stimulate de novo small enterprise: simplification of licensing and tax regulations, and equal access to transparent commercial adjudication process. Such a combination resulted in a rapid increase of rent opportunities and an extended period for accumulating considerable wealth from these rents prior to the sales of the very large state firms.

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From Rent-Seeking to Oligarchy to State Capture 183 16 14 12 10 8 6 4 2 0 1

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Figure 6.1 Rent-seeking type A: gradual or aborted big-bang reformers, high vulnerability

In the first few years (1989–92 in the USSR successor states) rents were easy to generate, but limited because the economy was still too much stateowned, and the lack of early stabilization sharply reduced the economic base for these rents. But once small-scale privatization added to the real assets available for purchase and stabilization began to take hold, the rent potential took off (at the inflection point about year 4–5, Figure 6.1) with widespread use of the mechanisms described above, and continued to rise as large-scale privatization provided the new capitalist class an even greater base for profit-making. At some point (notionally years 12–14 in Figure 6.1), a maximum level of rents is achieved, by which time the massive privatizations led to a highly concentrated ownership structure because the number of individuals allowed insider privileges was necessarily small. If liberalizing reforms were to continue, with elimination of all price and regulatory distortions, removal of barriers to entry and establishment of a level rule-of-law playing field, the potential rents would begin to shrink and eventually approach very low levels again. It is precisely to prevent this decline in rents and maintain a status quo near the maximum that the largest rent-seekers, with enough financial power to wield great influence, put on the mantle of ‘oligarch’ and go beyond lobbying governments to controlling them and ‘freezing’ the transition at a partially-liberalized state. Type B countries – Central Europe and the Baltics and some in SEE – are shown as low-rent cases in Figure 6.2. The strategy of reforms also begins

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Years of transition Figure 6.2 Rent-seeking, types A and B

with an early legalization of private activity, indeed in several (Hungary, Poland, the successor states of Yugoslavia) this preceded the beginning of transition by many years. But in these countries some marginal liberalization of prices and external trade came earlier, already reducing distortions and therefore potential rents. The main difference vis-à-vis type A is that widespread liberalization followed very soon after and over a short period: quick stabilization, extensive price liberalization including for key raw materials, small-scale privatization, and institutional changes encoded in commercial codes. The result was that while the rent curve rose, at first perhaps even more sharply than in the type A, it very soon reached an inflection point in year 3–4 after which the opportunities were rapidly curtailed by removing the distortions underlying insider arbitrage and closing off the various state privileges of explicit and implicit subsidies, monopoly licensing and so on. Rent opportunities reached an early and low-level peak and continued to decline as the increasingly open and competitive environment limited any excess profits or rents. Finally, the much more open, transparent and disciplined privatization of large-scale enterprises virtually shut the door to the huge concentrations of wealth, and reinforced the establishment of a small group of oligarchs in type A countries. Just as later large-scale privatization in Ukraine than Russia


had little effect on the final outcome, so too earlier rather than later privatization in the Czech Republic had some but limited effect: a somewhat fuzzier governance situation ensuing in a hiccup of economic stagnation in the second half of the 1990s. In the grand scheme of things this was not enough to put the country into the same state capture league as the CIS ones. As noted several times, the anchor of EU membership also played a role to limit the damage. There were cases in type B of falling behind and only catching up much later (Croatia and Slovakia), as well as cases of gradual reformers with a more successful second start – Bulgaria and Romania, who may have shifted from the high-rent to the low-rent curve. For the most part, however, Central Europe minimized rent-seeking activities early by quickly reducing the major distortions of government policy which provide the opportunities for privilegebased profit-making. It is not surprising that while the key phrase ‘oligarchs’ yields numerous internet entries for Russia, Ukraine and other CIS countries, for Central Europe the first reference I found with Google is to the eleventhcentury magnates in Hungary and Poland! This is not to say there was no rentseeking and corruption, or that it is eliminated fully. All of these countries suffered from these ills early, and all of them continue to experience some degree of corruption, because the roots of bribery and lobbying efforts remain in all societies: there is some minimum amount of government regulation in even the most marketized economies (see the Appendix). But the difference in degree is so large that it is in fact a difference in kind. In Central Europe there are new millionaries and enough insider privatization scandals. But these involve magnitudes in the tens and rarely the hundreds of millions in value. As an illustration, the Forbes (2005) list of world billionaires show only Poland with two. In contrast, Ukraine, with a GDP about half Poland’s (due to much lower per capita income level) appears with three billionaires, and Russia, with a GDP 2–3 times that of Poland, has twenty-six billionaires. Nissinen (1999) for Latvia, one of the advanced reformers with the highest corruption indicators, explains succinctly that difference: ‘Pressure group activity is focused rather than universal. Private companies have neither the incentive [my italics] nor the means to interfere with the formulation of general direction of the [policy] … They become active on a specific question where their business interests are directly involved.’ This activity may be labelled as lobbying, which was, is, and will continue to be common in all market economies, as distinct from state capture, which is limited to a few post-communist states and perhaps post-colonial African ones as well.

Other forces affecting vulnerability to rent-seeking The evolution of oligarchs While the pace and consistency of reform strategy followed by each country goes a long way to explain why some fell prey to considerable rent-seeking


and oligarchic developments while others did not, this was not the only force at play. The effects of external commitments, such as EU membership, are left to Chapter 7. Here, a few observations are warranted on specific country cases where two other influences affected the relationship between reform delay and state capture: prior historical conditions, and the happenstance of a visionary leader. It is often said that in the Soviet period the nomenklatura was more powerful in the USSR than the satellites, and this was reflected in a higher level of informal networks, including the Soviet-era mafia.10 If true, this certainly implies a greater historical vulnerability in the CIS countries – with the Baltics eliminating this effect immediately by removing virtually all former communists from important positions. But it is not clear why this would be so, or if indeed it was. A study of informal or underground activities in the Soviet period shows that it was at about the same level in Central Europe, the Baltics and western USSR republics, 20–25 per cent of GDP, and much higher only in the Caucasian and Central Asian republics.11 This does not seem to be the difference which can explain why the nomenklatura in Czechoslovakia yielded power to the opposition so much more easily than, say, the one in Ukraine; one must rely on saying the opposition itself was not as committed to economic reform as was the one in Czechoslovakia. Nor does it tell the right story about why Russia with perhaps the strongest most centralized and disciplined nomenklatura, and Kyrgyz Republic, allowed a radical insider to take over. Happenstance and personalities are another part of the story here: Yeltsin was at least passionate about, if not in the end intellectually committed to, the market (Shevtsova, 1999); Havel and Klaus usually agreed on little, but instinctively and firmly agreed on the need to turn westward; Chornovil and his intellectual dissident colleagues were adamant about independence for Ukraine, but fundamentally indifferent to economic system issues; Akayev, a renowned Academy of Science physicist, initially ruled from an intellectual attitude and not as an apparatchik or Asian autocrat. In a word, these inertial facts of history are often the most important factor explaining a slight deviation from the central tendency of the navigation model, but do not themselves provide a consistent enough result across countries to support path-dependence interpretation. The special case of Yeltsin deserves some elaboration because he was not after all an outsider even to the extent that Akayev was, but very much past member of the top echelon of the nomenklatura, a member of the Politburo. His early ambitions for taking over from Gorbachev led to loose alliances with emerging democratic forces and young technical reformers, all culminating in the famous leap upon the tank of August 1991 which was symbolically at least a revolutionary action. Biographers do suggest Yeltsin was a much more emotionally driven personality than Gorbachev, and it is not unreasonable to believe that the way in which he came to power, not as in Soviet history through Politburo intrigue, but in fact by seizing the opportunity


of disarray in the party and the country, instilled in him a vision of a saviour who would lead society towards the radical changes it needed. His choice of Gaidar and other young Turks for economic portfolios and his blessing for the initial big-bang efforts of January 1992, and indeed his later decisions to bring back Gaidar, Chubais, Fyodorov and others, are all actions consistent with this vision. But as a child of the nomenklatura, he may not have been completely convinced intellectually, and certainly was not cured of his politburo habits of intrigue and compromise by the tank-epiphany. When the resistance to Gaidar’s programme became too strong, Yeltsin retreated at least temporarily but kept trying to push the reform agenda in fits and starts. In the Loansfor-shares episode, he compromised with the Red Directors lobby by giving them privileged access to the privatization process. This might be seen as a full retreat to the ‘nomenklatura-Yeltsin’; in fact, it fit perfectly with his split personality of nomenklatura–revolutionary. Loans-for-shares was touted by its proponents and outside advisors as the perfect compromise, because the opponents of economic transformation would be bought-off, while privatizing the bulk of state assets would move the economy far forward on its path to the market, creating a new capitalist class that in the long run would be the staunchest defender of market institutions. How could Yeltsin not go for this perfectly balanced tactic? It worked in the short run, but I will argue in Chapter 8 that these new capitalists have not become proponents of completing the creation of market institutions, but instead powerful opponents of further liberalization.

Who are the oligarchs? In the countries where rent-seeking was substantial and an oligarchy has developed there is one important and fascinating continuity from history, which is the lineage of the new capitalists, and eventual oligarchs. There appear to have been four main sources, with some overlap: the upperechelon nomenklatura including Red Directors of the Soviet period; younger members of the nomenklatura dynasties still in the Komsomol in the late 1980s; newcomer entrepreneurs seemingly unaffiliated with the nomenklatura, but known to have made connections to someone in the nomenklatura early on; and members of the Soviet period underground economy, the ‘mafia’ network of traders. Many books and articles have been written on the new capitalists and how they became so wealthy so quickly and there is no need to repeat such details, fascinating as they are, or even to systematize precisely the personal history of these individuals. Here I wish only to illustrate with a few examples from these writings.12 Naturally, the information is often incomplete and unverifiable, especially for the last group, and especially on the possibilities of criminal wrongdoing being involved at some stage of an individual’s evolution as a major capitalist.


The upper-echelon nomenklatura provenance was most significant for some of the Central Asian states, with the formal ownership of large companies in the hands of relatives and close associates of the respective presidents, be it Nazarbayev in Kazakhstan or Aliyev in Azerbaijan. The regional clan structure of the new oligarchs is not really a new fact: the communist nomenklatura there was also reflecting clear leadership powers. What is probably new is the much smaller role of ethnic Slavs in the upper ranks. The nomenklatura provenance is also seen in Ukraine with family members but also close associates of President Kuchma, like Pinchuk, Surkis and Medvedchuk now controlling large ‘holdings’ in many sectors. It includes regional politicians from Dnipropetrovsk, like the erstwhile Prime Minister and oligarch Lazarenko in the energy business, now exiled and doing time for money-laundering in the USA. In Russia this provenance of big capitalists is not as important as the next one, the Komsomoltsy, but does include some very important players, like Chernomyrdin and Viakerov of Gazprom. Some middle-level apparatchiks did become important, like Potanin, a Department Director in the Ministry of Trade (Souyzpromexport to be precise) who set up the trading company Interros later to become a bank which, ‘in a lucky break’ (Brady, 1999, p. 136), took over management of the COMECON bank’s assets and clients when it was disbanded. How ‘lucky’ or ‘insider’ this break was may never be known, but Interros is ranked today by the World Bank (2004) as the fifth largest of two dozen oligarch holdings. At about the same time, Vagit Alikperov, then Deputy Minister of Finance of the Oil Ministry also got a ‘lucky break’ according to the interview he gave to Rose Brady as written up in her book: the government rejected his suggestion to set up an independent oil company so he did it on his own, and thus was born Lukoil, today number six in the World Bank ranking. As with Potanin, we will never know how much was luck and how much was the insider connection. Arguably, the Komsomol may have been the largest source of this new entrepreneurial talent in Russia, though the definitive PhD thesis quantifying the provenance of oligarchs is yet to be written. Certainly a very large number of the new capitalists were much below the average age of the nomenklatura members, though by the late 1980s dynastic tendencies were evident as one of the privileges of the nomenklatura had been to place their kin in the top schools, in top Komsomol positions, and so on up the ladder. When the definitive thesis is written, it will be very important to identify any family links of seemingly non-nomenklatura young capitalists to the upper echelon of the party. From the existing accounts, it is clear that several of today’s major oligarchs had precisely this provenance. Khodorkovsky of Yukos, now jailed for tax evasion, began business as Deputy Secretary of the Komsomol at Moscow’s prestigious Mendelev Chemical Institute, using 7,000 roubles from the Komsomol to organize graduate students who prepared special studies for enterprises ‘at cost’.


This yielded a hefty 169,000 roubles (evidently not a not-for-profit exercise) allowing the network to expand hugely, and eventually generate enough to set up a new bank, MENATEP, in partnership with a small state bank; MENATEP still exists and the fate of Yukos is well-known. Very entrepreneurial for a 26-year-old indeed. Gusinsky had organized music festivals for Komsomol, and went into a construction co-operative instead of completing his theatrical studies. This co-operative became another of Russia’s major banks, MOST. The Komsomol source includes many others, like Aven of Alpha, Deripaska the aluminum and nickel king, Bendukidze, Dubinin. In Ukraine this was also evident at least among the ‘mini-garchs’ like Poroshenko in food products, or the deposed banker Zherdytski, now in jail in Germany for fraudulent use of German reparations funds for Ukrainian victims of war crimes. The third category, new unaffiliated entrepreneurs, is on the face of it the only one suggesting pure competitive entrepreneurship. It is not as important as the first two, and may in fact be less pure than appears at first sight. The biographies are not always clear, and often, in the otherwise excellent books such as Brady, are based only on interviews with the individuals.13 Perhaps, most important, in many cases the history of these capitalists shows that very early on they turn to the established institutions and hence to partners within the nomenklatura with offers of setting up big enterprises or banks. Nevertheless there are many capitalists who at least began outside the establishment. In Russia there were scientists whose future turned very bleak after 1991, and therefore decided to go into business. Aven and Berezovsky are two such examples who still figure among the big players a decade later. But again, very early on, they became partners with establishment enterprises or nomenklatura individuals to leverage their first big earnings into truly big opportunities when privatization started. Many others who became wealthy in early years are noted by Brady, but not all were able to make the big leap into oligarchy, failing to find an insider connection for big privatizations. Soviet-period price and supply distortions generated many underground capitalists, who in a market economy would probably have been legal traders. Under Soviet laws prohibiting ‘speculation’ defined as any private economic activity, they were not legal and indeed often engaged in other crimes besides ‘economic speculation’. They generally had much more wealth than most top nomenklatura people, and therefore should have been in an ideal position to jump into capitalism. Indeed Handelman (1994) describes in detail how they did try to do this. But it did not work out well for most of them because the insiders, who had tolerated the mafiosi in the Soviet period for the financial benefits these could provide ‘informally’ when being a capitalist was illegal, wanted to become capitalists themselves once it became legal. It is striking that in the index of Handelman’s book, not one of the big mafia players of the Soviet period is recognizable today as an important new


oligarch. This could of course reflect anonymity of ownership, but a more likely explanation is that most of them were unable to go clean quickly enough to avoid the fate of one such important mafiosnik, Smolinsky, who was arrested on criminal charges in 1991. An alleged exception noted in Puglisi (2003) may have been, indirectly, Rinat Akhmetov, now regarded as the top oligarch in Ukraine’s Donbass region. Though the early biography is unclear, many references are made (including in Forbes, 2005) to his inheriting leadership of the economic fortune built up by Akhat Bragin, allegedly a ‘Mafia’ boss of Donetsk, who was killed in 1995. The 29-year-old Akhmetov took over the major companies of Lyuks and the local football club, Shakhtar (Miner), but like many Russian ‘new comers’ he decided early on to link up with powerful insiders, including then governor of Donetsk Viktor Yanukovich, to found a bank whence business took off to reach an estimated net worth over $2 billion.14 In conclusion, it is clear that being part of the upper-echelon nomenklatura did not automatically lead to oligarchy today. Goldman (2003) emphasizes that in Russia only two came from this source and the rest he claims, somewhat unconvincingly, ‘were ne’er do wells, from the fringes of society, engaged in black-market speculation’, while Brady (1999) concludes ‘some did come from the black-market, but the majority surprisingly were professors, scientists, managers – in other words from the intellectual elite’. Neither of these characterizations is altogether correct, for they seem to suggest most new capitalists were new faces unaffiliated with the party. In fact, this was only so on the surface. A large number of these newcomers were in the Komsomol, the party’s training school,15 many were in middle management positions; these positions were traditionally the middle rungs on the nomenklatura career ladder. Thus, the second conclusion is that many of those who may have been outsiders were only eventually successful in building very large business empires after establishing some insider contact with an existing state bank as firm, or with the patronage of someone in the upper-echelon nomenklatura. It seems clear that in the CIS countries at least there was a considerable continuity from the political power-holders of the Soviet period to the new capitalists, rent-seekers and eventual oligarchs. Does this mean the new capitalists were not entrepreneurs in the Schumpeterian sense, but simply inherited their power? They were most certainly very entrepreneurial, as some of the short stories above illustrate and, more important, far from everyone with inside connections exhibited such energy, ingenuity and industriousness: that is, entrepreneurship. But equally important, insiders had a great advantage over those on the outside, as was best demonstrated by the cases of the latter seeking early on to bring on board an insider. In a word, in countries with partial market reforms to become a big capitalist it was not sufficient to be on the inside, one had to be entrepreneurial enough to seize new opportunities. But neither was it sufficient to be entrepreneurial, because the


continued regulations by the state meant one had to have an insider connection as well. The new capitalists, and certainly the powerful oligarchs, are best characterized as the most entrepreneurial insiders. An unfortunate implication of this was that entrepreneurial outsiders with no connections could not go very far in business. This is elaborated in Chapter 8 under the rubric of small–medium enterprise prospects.

From rent-seeking to state capture Rent-seeking opportunities were not only greater in the gradual reformers outside Central Europe, but lasted much longer allowing new capitalists to accumulate considerable wealth. But, until the large-scale privatization began in the mid-1990s, this did not differ greatly from the situation in many market economies where powerful enterprises lobby for favours (see Appendix to this chapter). The transfer of these vast state assets to private firms not only hugely increased the holdings of the most successful rentseekers, but led to even greater concentration of ownership, since the largely non-transparent process favoured the largest of the early rent-seeking capitalists. The World Bank’s April (2004) study of ownership concentration in Russia finds that about two dozen oligarchic groups account for at least 35 per cent of sales, and in key sectors such as energy, chemicals, metallurgy and banking this share is much higher. The high degree of concentration of ownership in Russia at the top is also suggested, approximately, by a simple count of billionaires in Forbes (2005). The 26 individuals in Russia (it may be two or three more if some former emigrants and recent exiles domiciled elsewhere are included) out of a 700 total in Forbes’ count is an extraordinary number for an economy which accounts for 1–2 per cent of world GDP.16 Russia, in fact, ranks third in the billionaire count after the USA with 340 and Germany 41, but it ranks first if measured proportionately, using the ratio: share of Forbes billionaires to share of world GDP. For Russia this is about 2 to 4, for the USA about 1.5, and Germany about 1.0. In other large, high-income economies in Western Europe (the UK, France, Italy) with world GDP shares around 5 per cent, the number of billionaires is 10 or less and the ratio noted above is far lower, about 0.25 to 0.30. The extraordinary concentration in Russia is even more clear if compared to some economies of roughly equivalent GDP size (1–2 per cent of world GDP): Australia, Brazil, Canada, Mexico, Netherlands, Spain, Sweden. For these, the numbers of billionaires range from 16 in Canada to four in the Netherlands, and, with the exception of Canada and Sweden, the ratio defined above is well below one.17 Only three other transition countries appear in the Forbes list: Ukraine with three billionaires, Poland with two, and Kazakhstan with two. In all cases, the individuals are at the very bottom of the list with at most $1–2 billion; while in Russia, 15 of the 26 have fortunes ranging from $2.0 to $13 billion.


The much smaller fortunes in other transition countries are to some extent a reflection of much smaller economies and do not reflect the state-capture phenomenon. In Moldova, fortunes of less $100 million or even less are proportionately already very large and suffice to provide influence of an oligarchic type. It is nevertheless striking how large are the disproportions in Russia and the much more limited evidence of such wealth concentration in non-CIS transition countries. That Poland with a GDP about one-half of Russia’s counts only two billionaires with assets of about $1.0 billion is illustrative of the much more restricted opportunities for quickly amassing large wealth based on rent-seeking and political influence. The related index of ‘state capture’, devised by a World Bank team led by Hellman and Kaufmann, attempts to directly measure the extent to which a small number of enterprises is powerful enough to not only lobby and occasionally influence government measures, but in fact to capture and control government policy and its general direction. A summary of these results for 20 transition countries in 1999 and average by country group is given in Table 6.1.18 Belarus and Uzbekistan can be ignored for the reason cited earlier – they are still closer to central-plan than market economies. For the rest, it is easily demonstrated that Hypothesis 1 of the navigation model in Chapter 4, that the degree of state capture is strongly correlated with delay in undertaking stabilization and reforms, is consistent with this data. Figure 6.3 Table 6.1 State-capture index, 1999 Hungary Poland Czech Republic Slovakia Croatia

0.10 0.17 0.16 0.34 0.43

Central Europe

0.20

Estonia Latvia Lithuania Baltics Bulgaria Romania Macedonia Albania Bosnia-Herzegovina Serbia-Montenegro South-East Europe

0.14 (0.22) 0.17 0.18 0.40 0.30 (0.35) (0.35) (0.40) (0.50)

Armenia Georgia Kazakhstan Russia Kyrgyz Republic Moldova Ukraine Azerbaijan Tajikistan

0.11 0.34 0.18 0.45 0.41 0.52 0.45 0.58 —

CISM

0.38

Uzbekistan Beralus Turkmenistan

0.08 0.12 —

CISL

0.10

0.35 (0.38)

Source: Author’s calculations averaging two concepts of state capture, pervasiveness and concentration, as reported in Figure 6.3 of Hellman and Schankermann (2000). For bracketed cases, no values are reported in the 1999 study; 1999 values are pro-pated using a 2003 World Bank study of ‘crony bias’ (a related but different concept; Sce Hellman and Kaufmann (2003)), Chart 2.


Degree of state capture Months to start of stabilization Years to reach half-point to market

Low

Medium

High

1–10 (Arm.: 38)

7–32

20–40 (Russia: 4)

2–3

5

3–11

Figure 6.3 Delay facilitates state capture Notes: Months to start of a stabilization programme from IMF (2000); half-point to market economy as measured by European Bank for Reconstruction and Development, Index of transition. A full-market economy 4.3, a central-plan economy is 1.0, hence I take the index value of 2.7 as the half-way point. As examples, all of Central Europe reached this level by 1993, the Baltics by 1994–95, Russia and Kyrgyz Republic by 1995, Ukraine in 2002, Tajikistan in 2003, while Belarus, Turkmenistan and Uzbekistan are still not there.

groups the countries into high (Kyrgystan and up), medium (Kazakhstan to Bulgaria) and low state capture and correlates this with two measures of delay: months from regime change to start of stabilization, and years to reach a TPI value of 2.7, designated in Chapter 5 as the mid-point from a central plan to a market economy. There is a clear progression: countries of low state capture began stabilization efforts no later than 10 months, those with medium capture ranged from seven months to 32, and those with high state capture were in the range 20–40 months. There are two outliers, Armenia and Russia. Armenia is an outlier where stabilization came very late (38 months) but the state capture index is suspiciously low. There may be a measurement problem. It is on the face of it implausible that its state capture is so much lower than even the medium level of Georgia, and indeed lower than all but Hungary and Slovenia in Central Europe. Russia with very high state capture was very fast off the mark on stabilization, four months, but this was not a successful stabilization and the big-bang effort of January 1992 was aborted in less than one year as noted earlier. A more precise correlation between delayed reforms and degree of state capture is seen in Figures 6.4 and 6.5. The first is a scatter diagram showing the number of months from the start of transition to inflation stabilization (5% per month) with a correlation of 0.4882. The implausibly low values for Armenia (0.11) and Kazakhstan (0.18) are set at a level 0.25 (similar to Bulgaria, Slovakia and Croatia but still lower than other CIS countries) the correlation is 0.719. Slovakia and Croatia are also outliers, with an immediate stabilization but a quite high state-capture index of 0.34 and 0.43. In Slovakia this reflects a short period of the Meciar government and a tendency

State capture index, 1999

194 0.7 AZE

0.6 MDA

0.5

RUS KGZ

0.4

ALB

UKR

BGR

MKD

GEO ROM

0.3

KAZ SVK

ARM

HRV

0.2

POL CZE

0.1

LTU EST

HUN

y = 0.0057x + 0.143 R2 = 0.4882

SVN

0 0

5

10

15

20

25

30

35

40

45

50

55

60

Months to 5% / month inflation

State capture index, 1999

Figure 6.4 State capture and delay in stabilization

0.7 AZE

0.6

MDA

0.5 UKR

RUS KGZ

BGR

0.4 ALB

0.3

MKD ROM

GEO ARM

y = –0.2306x + 0.9239 R2 = 0.4545

KAZ SVK

HRV

0.2

CZE POL, LTU EST

SVN

0.1

HUN

0 1.5

2

2.5

3

3.5

4

Transition progress indicator after 4 years Figure 6.5 State capture and delay in reform progress


to rent-seeking and vested interest favouritism, which were quickly reversed after 1998. The values for them are set at the top of the CIS range, 0.20. A broader measure of early reform achievement is the actual level of TPI reached four years after the start of transition (1996 in CIS and Baltics, 1994 elsewhere), which is to say it is not how fast a country moved initially but how far it had got in closing the rent-seeking opportunities within four years. The correlation with state capture is shown in Figure 6.6, with a negative coefficient of 0.593. 0.4545 again adjusting for Armenia, Kazakhstan, Slovakia and Croatia. Other cases also appear to be mismeasured, and in general the direction of bias understates the correlation between slower reforms and greater state capture. Armenia and Kazakhstan have been mentioned, and also Slovakia under the Meciar government 1994–98 which did indeed experience a lot of insider privatization resulting in the temporarily high state-capture index. But the latter’s degree of market liberalization as measured by TPI did not reverse in this period, indeed it kept increasing, albeit slightly slower than in other rapid reformers. When the Dzurinda government brought back a more democratic and market-oriented policy the backsliding under Meciar was easily overcome, as there had not been enough time to enshrine the new policy.19 Croatia like Slovakia had a high level of market liberalization progress, but the insider dealings for privatization created some bias towards state capture. This was curtailed by the new government in 2000, determined to change Croatia’s image in Europe and jump-start the process of EU membership. Something analogous occurred in Bulgaria in 1997 with the replacement of the renamed communists (Socialists) by the democratic and market-oriented Union of Democratic Forces. All of these changes since the 1999 index was compiled by the World Bank go in the direction of reinforcing the hypothesis that state capture is least where market reforms move fastest to close the opportunities for rent-seeking. Kyrgyz Republic and especially Russia both pursued an early start and did reach the ‘halfway’ point within three–four years; however, both as discussed earlier then stalled and even experienced some reversals in their liberalization. More important, Russia’s large-scale privatization was explicitly insideroriented, which perhaps unintentionally but inevitably led to development of oligarchs and state capture. Privatization in Kyrgyz Republic did not in the end differ much from the clan-based distribution of state assets in Central Asia, despite the early liberalism of Akayev. It is noteworthy that the mass popular demonstrations in March 2005 were first of all directed towards the large retail establishments owned by the President’s family. The bivariate correlations shown above illustrate the hypothesis that the greater the delay in stabilization and reform, the higher is the degree of eventual state failure. In Appendix 4.A, equation (3) suggests a formalization where delay is measured both for the stabilization elements (M 5% INF) and the broader measure of marker reform (TPI 4). A regression analysis using


both of these variables, and adjusting for the four countries with questionable SC99 values gives even stronger statistical results than the separate bivariate correlations, and the expected positive coefficient for M 5% INF, negative for TPI 4. SC99 0.55 0.004 M 5% IMF 0.129 TPI 4 (0.23) (0.002)* (0.072)** R2 0.569 n 20

F 11.24 significance 0.0008***

Values in brackets are standard errors. Significance: * 10%; ** 5%; *** 1%. A regression without adjustments gives lower R2 ( 0.324) and less statistical significance, but with such a small sample the most important test is the consistency of the signs of coefficients; these remain for all variants of the regression as above. Interestingly, if the questionable cases are simply excluded, despite the resulting very small sample of 16, the statistical fit is stronger (R2 0.676), and significance (F, statistics) remains much the same. For some observers, the statistical link between delayed reforms and state capture will remain unconvincing and a simpler and historically deeply-rooted thesis is preferred: Central Europe and the Baltics had a European history to which they always wanted to return, and this meant that even in the Soviet period they were already more liberally inclined. This set the stage for a radical change in governments from communist to democratic, and enabled them to apply rapid reform measures that the countries farther East could not afford politically. Such an interpretation implies the following hypothesis: the process of rent-seeking, insider privatization and state capture was inevitable in the CIS and perhaps in some SEE countries, but unlikely to occur in Central Europe. This is one of the most interesting hypotheses for historians to debate, but a difficult counterfactual to resolve. This book argues that in some of the large post-USSR countries it was not inevitable, even if the forces of nomenklatura inertia were more powerful than in Central Europe. For Ukraine, Havrylyshyn (1997) argued it may have been avoided if the independence movement (Rukh) had not explicitly and willingly made what Kuzio (1997) called a ‘Faustian bargain’ with the former communists led by Kravchuk. The latter guaranteed to support independence and the former agreed to let the old communist hierarchy form a government. In addition, Rukh was a movement dominated by writers and dissidents with few technocrat economists, and perhaps because of this it did not press for rapid economic reform but was satisfied in the bargain with the nomenklatura’s guaranteed support of independence – which has so far been upheld both by Kravchuk


and Kuchma, but at the cost of a strong tendency to oligarch development, state capture, and even a deterioration of democratic standards. Did Rukh have a choice? This continues to be debated by scholars of Ukraine, but there is at a minimum agreement that the communists, even while remaining formally in power, were at that time uncertain of what the future held, and feared the opposition movement’s ‘ability to unleash social unrest on a massive scale’.20 This strongly suggests they could have been pressed for much more economic reform in the first years. In Russia, the bargain was between reformers around Yeltsin and the Red Directors, part of the nomenklatura. Compared to Ukraine, it was more implicit and focused on the loans-for-shares process in 1994–95. Both the early privatization and certainly those in the mid-1990s were intentionally insider-oriented to coopt the opposition of the Red Directors. Boycko, Shleifer and Vishny (1995), as well as many others, consider this to have been a wise tactic to achieve a rapid privatization and reach the critical-mass of private ownership needed to avoid reversal. Could this insider relationship have been avoided? Reddaway and Glinski (2001) argue yes, if Yeltsin had incorporated more of the early democratic movement into his government and not relied so much on young technicians and former nomenklatura. Other critics focus on the fact that before the big-bang was aborted, a lot of progress had been made. TPI had reached the half-way mark by 1995, almost as quickly as in the Baltics, and hence no special coopting was needed. Odling-Smee and Thomsen (2003), while urging continued reforms, recognize performance since 1998 has been very good. There remains much for historians to sort out. In Armenia, ‘insider-arbitrage’ was avoided for a while with an early liberalization including the first land privatization in the CIS, but it soon fell into line with others as a result of the need for support of the war with Azerbaijan. The very early years in Belarus and especially Kyrgyz Republic with relative outsiders as new leaders, Shushkevich and Akayev, also demonstrate economic liberalization could be done early in an attempt to cut off the rent-seekers. Thus, there is plenty of evidence for the argument that choices could be made and path-dependence broken, as this was after all a historical moment of opportunity to greater or lesser degree in all transition countries. Freezing of transition To conclude, it will be useful to test the hypothesis in Figure 4.5 that once an oligarch class captures the state, the transition process is frozen (H2). One of the tests suggested is that the higher the state-capture index in 1999, the less the advance in further transition. It’s not so straightforward to measure the extent of continued progress in transition, since the TPI index has an upper limit of 4.3 and the uncaptured states had already reached very high levels by 1999. Mathematically, this means they could not by definition experience such rapid advances as in early years.21 Thus, the actual level of TPI reached in the latest year is in fact a better measure than the change in TPI.

Transition progress indicator, 2004

198 An Ex Post Transition Paradigm 4.5 HUN

4

SVN ARM

3.5 3

ESTCZE POL LTU KAZ

SVK BGR HRV

ROM

MK

GEO

2.5

KGZ RUS ALB

BIH

UKR

MDA

AZE

YUG

2 1.5 y = −1.9478x + 3.8244 R2 = 0.4878

1 0.5 0 0

0.1

0.2

0.3

0.4 0.5 0.6 State capture index, 1999

Figure 6.6 State capture freezes transition

Figure 6.6 shows the clear negative correlation; even without any adjustments for the questionable SC99 values noted earlier, there is statistically significant regression coefficient of 0.4878. Chapter 8 will explore this correlation further and address the question of reversibility of state capture and a frozen transition; here it is useful to describe a handful of cases where it was in fact reversed, but at a relatively early stage of intermediate state capture. Bulgaria is an excellent example of oligarchization being reversible: the capture of the state was not unlike that in the CIS and some other countries in SEE (Hellman and Schankermann, 2000, put it in that category in 1997–98). But it was quickly reversed after the 1997 elections which brought in a highly reformist government. In the background of this was the desire to be European and the clear signals from Brussels of what it desired to see. But the most intriguing question is why the Socialist Party consented to a sufficiently open election to risk losing – which it did. It is also interesting to note the unique process of negotiations with the IMF on a badly needed stand-by loan: both the Socialist and the UDF publicly agreed to the conditions of a programme to be implemented after the elections.22 In Romania, no sharp return to a liberalization policy occurred, though the desire for eventual EU membership probably mitigated the excesses and kept the liberalization process moving ineluctably forward albeit with fits and starts. Slovakia may be the best example of the latter force. Recall that all three countries were included in the early groups of potential candidates under Europe Agreements – Slovakia in 1992, the other two in 1995. Most recently, Croatia has seen a similar development motivated also by EU membership desires, and in 2004–05 one sees this force pushing recent development in Ukraine and Georgia and providing a potential escape


route from state capture. The EU membership effort is explored in Chapter 7, while Chapter 8 considers more explicitly the prospects for states which remain under state capture.

Appendix: rent-seeking, vested interests and entrenchment in non-transition economies Efforts to lobby and influence the government for economic favours by the vested interests of the nomenklatura or any new post-communist capitalists are by no means unique to the period of transition from socialism to capitalism. Economic theory going back to Adam Smith has always been clear that profits are greater in a noncompetitive environment, and that those with greater economic power prefer to keep that power than to face open competition. Smith’s famous warning to governments that they should never promote a gathering of merchants of the same trade was meant to emphasize that such a gathering would inevitably result in efforts among them to collude against new competition and self-serving proposals that government, in the interests of the common good, promote that trade by one or another mechanism, say protection against damaging foreign interests. Subsequent development of imperfect competition theory by numerous economic thinkers of the early twentieth century – Marshall and Robinson are examples – made clear that monopolists and oligopolists have an interest in collusion and lobbying of governments to prevent competition which may erode their excess profits. Smith’s marvel of the Invisible Hand of the market giving the greatest welfare benefit to all society requires that there be perfect competition, and not monopoly or oligopoly, and not only private ownership. Smith’s felicitous result comes in fact from the interplay of two hands: the incentive to greatest efficiency from private ownership (capitalism), and the discipline of competition (an open market economy) to prevent monopoly profits. The role of competition has often been overlooked or at least underemphasized in the transition, with the consequence of too much effort devoted to the process of disposing state assets into private hands – that is, creating capitalism – and too little effort to the development of competition – that is, creating a market. The evidence presented so far in this book strongly suggests that most post-communist societies have gone a long way to creating capitalism, but unfortunately many of them have not gone very far in creating an open market economy. The history of capitalism without competitive markets is replete with the kind of lobbying, rent-seeking and oligarch phenomena that have gripped the slow reformers of the post-communist region. Post-communist oligarchs are often compared to American robber barons of the nineteenth century. Are Russia’s Abramovich and Potanin, and Ukraine’s Pinchuk and Akhmetov the same as Rockefeller, Vanderbilt and J.P. Morgan in the USA? Through the narrow lens of economic theory of profit maximization, they all look like extremely wealthy capitalists, they act like powerful capitalists and they try to influence governments like powerful capitalists, so they are the same. But looked at in a wider and historical perspective, there is one, very big, difference. The initial wealth accumulation of the robber barons came from entrepreneurial value-added activity, not from bargain prices for preexisting state assets in privatization, or privileged purchase of energy at regulated prices and resale at world prices five–ten times higher. Goldman (2003) makes the same point and shows that most other powerful capitalists in history – European industrialists like Krupp or Agnelli, chaebols in Korea, even Latin American padrones – differed greatly from the oligarchs in this way.23 The similarity only

200 An Ex Post Transition Paradigm begins once both have become wealthy and powerful: robber barons are then best seen through the eyes of Mark Twain’s The Gilded Age, or Thorsten Veblen’s Vested Interests, as financial giants with the resources and connections to influence government decision in their favour, or in Twain’s phrase, ‘get to know a Senator, sell a project’. Another similarity of great importance to the debate on frozen v. inevitable transition: the robber barons did not easily or willingly go along with the various efforts to restrict their monopolistic power, such as anti-trust legislation, or the establishment of regulatory agencies (such as the Securities and Exchange Commission) to prevent non-transparent insider-trading – and neither have the oligarchs shown they are willing to give up power. In a recent book of great relevance to this matter, Rajan and Zingales’ (2003b) Saving Capitalism from the Capitalists, the point is made succinctly: ‘those in power, the incumbents, prefer to stay in power’ (p. 10). In this same context, one should note an important difference: before the robber barons, the American economy had developed a very large middle class of entrepreneurs and, at a minimum, some rudimentary contract-enforcement institutions, that is rule-of-law. This is far from the case in the CIS today.24 America’s powerful vested interests – or for that matter those in other parts of the world – did not ever give up their efforts to lobby for protection against competition, even after the high concentration of wealth were reduced by anti-trust and other institutional measures. Rajan and Zingales (2003b) provide many examples for the financial sector in several countries, essentially arguing that these markets were more open and competitive in 1913 than they became over the next decades thanks to such lobbying. One example for the USA will suffice. In 1932–34 the US Senate Banking Committee (the Pecora hearings after the chief counsel) investigated abuses in the financial system by commercial banks in the issuance of securities for firms that were also their banking clients: clearly a conflict-of-interest risk. The outcome was two pieces of legislation, the Securities Act and the Glass–Steagall Act which, as the authors explain in detail, prohibited commercial banks from underwriting securities and from paying interest on demand deposits. The winners? The traditional investment banks – like J.P. Morgan and Kuhn Loeb – which, it turns out, instigated the hearings as they were feeling the competitive pressure of commercial banks in the issuance of new corporate securities. For the sake of avoiding conflict-of-interest (which the authors note was not necessarily there) the legislation favoured the incumbents and restricted competition in the financial sectors. Some part of the profits of the traditional investment houses was now gratis the legislation, hence, rents. A more recent example of successful rent-seeking is described, wittingly or unwittingly, in the autobiography of Lee Iacocca, president of Chrysler Corporation in the 1970s at the time of the first big threat from Japanese imports. Iacocca – who made his reputation as a dynamic manager and eventually CEO at Ford, including introduction of the legendary and profitable Ford Mustang model – was also entrepreneurial enough to sense that considerable ‘profits’ could be made by obtaining certain government privilege. His book describes how, as new CEO at Chrysler in the early 1970s, he travelled out of Detroit to make many strategic speeches around the country on the imminent demise of the American auto industry, and meet with politicians in Washington to push for legislation that would give low-cost loans to Chrysler that would restrict ‘temporarily’ Japanese auto imports to give American producers breathing-room for restructuring. One can literally count in his autobiography the number of days spent on this versus those in Detroit fixing the internal problems of Chrysler. The former dominated by far and to good effect: in early 1972 the US Congress imposed a temporary quota on Japanese imports, and the following day the side-window

From Rent-Seeking to Oligarchy to State Capture 201 price stickers in automobile showrooms of America (and Canada for that matter) had an extra line added: producer surcharge $500 to $1,000. The following year’s financial statement showed Chrysler moving from a loss of about $1 billion to a profit of $1 billion. The reader now familiar with the difference between profits made by better management v. ‘rents’ should have no difficulty calculating that Iacocca made for Chrysler a one-year rent of $2 billion, and well-deserved the hefty (for those days) bonus of a million dollars – indeed, I would have thought it right for the shareholders of GM and Ford to award him a bonus also, because of course these rents of up to $1,000 per automobile were reaped by them as well. The power of wealthy capitalists in advanced market economies has been reviewed most thoroughly by Morck, Wolfenzon and Yeung (2005), which reviews the literature on corporate governance and what they define as ‘entrenchment’, in effect the ability of the incumbent big-players to remain in power. They note the common phenomenon in many countries of a small number of individuals or families controlling large parts of an economy, often with relatively small holdings in pyramidal structures, cross-holdings and super-voting privileges. They also observe that the entrenched elites ‘to preserve the status quo … are able to influence public policies so as to curtail private property rights development, capital market development, and economic openness’. This, too, bears upon the frozen-transition inevitable debate. In developing countries the rent-seeking phenomenon was closely studied by economists in the late 1960s trying to demonstrate that the prevailing policies of import-substitution were damaging the prospects of growth. The key point is that the protectionism of these regimes generates rent opportunities for those who are able to obtain the licence to import, export or produce regulated goods. Krueger (1974) lays out the theoretical basis for rent-seeking activities using the example of import licences, though it applies to any situation where governments regulate economic activity creating a distortion that can yield excess profits for those permitted to engage in that activity. The model describes why and how economic agents compete for these licences devoting resources up to the value of the rent itself, hence resulting in a waste of resources. This can, however, be avoided if the licences are granted by governments to whom they choose, a situation closest to what one sees in many of the big vestedinterest stories described above. As Krueger notes, doing so redistributes income towards the beneficiaries of this favouritism, which in turn affects societal perceptions; this is surely what one sees happening in post-Soviet transition. The magnitude of these potential rents was shown to be very large – for India and Turkey 7 per cent and 15 per cent of GDP respectively – and numerous detailed studies of the costs of trade and other restrictions at that time confirmed such high values. Equally important, the literature of the time generally concluded that liberalizing trade regimes was best done rapidly to reduce the time available for the rent-seeking vested interests to mount an effective opposition to the policy.25 Clientelism is the term applied to the analogous phenomenon in post-colonial Africa. That some of this favouritism and pork-barrel politics was necessary and served ‘as the glue that binds together weakly integrated societies’26 does not alter the fact that regardless of the geographical, social and historical environment, where governments regulate the economy, rent-seeking opportunities arise and the rights to these rents are distributed somehow. Africa differs from the transition countries in not having a strongly entrenched pre-colonial power elite that stood ready to benefit from the opportunities, hence in many cases the clan or tribal affiliations and happenstance of which group took power served as the analogue for the communist nomenklatura. In Central Asian countries the two were already combined in the Soviet period, hence

202 An Ex Post Transition Paradigm it is little surprise that their new big capitalists are the leaders of regional clans. The African post-colonial experience which now covers several decades bears a lesson for the future of captured transition states. Sandbrook (2000) refers to the theory of the ‘new broom’ that many writing on Africa adduce as the way in which the clientelism can be broken up and a more liberal, competitive and fair environment can be created. He notes that so far the evidence is that new brooms may begin well – the early liberalizing efforts of Lt Rawlings in Ghana – but that in most cases with the possible exception of Mauritius, ‘the new leaders soon fell into old neo-patrimonial patterns’ as in Zambia, Niger, Madagascar and Ghana. This serves to highlight the nearly axiomatic incentive for anyone with a chance to obtain economic privileges, to go for it, and to predict that any new leaders in the captured states may simply sweep away the existing oligarchs and sweep in their own favourites.27 This brief review of how the rich and powerful in non-transition economies became so, and how they are all driven by the same principle of using that power to make monopoly-like profits, might be taken as confirmation of the Shleifer and Treisman (2004) argument that Russia is just a normal country. This is not quite justified, for it only shows that Russian (and Ukrainian or Kazakh) new big-capitalists behave exactly the same way as big-capitalists have always behaved historically and around the globe: in their own interests. The difference in degree of such power and influence, as argued in the main text, is big enough to become a difference in kind: the oligarchs are able to influence not only economic measures affecting them directly, but are powerful enough to influence the general direction of economic policy and even the outcome of elections. That is what one means by state capture. Historically, in the Middle Ages in Europe or post-colonial Latin America, or in East Asia, state capture may have existed. Today, and certainly in the advanced countries, the power of the entrenched is less extensive, as an analysis of lobbying for 42 countries by Faccio (2003) shows. She demonstrates that for low corruption countries the benefits of a political connection are often small and statistically insignificant, with the exception of making for a higher market share, where the effect is high and significant. But the more corrupt a country, a proxy for good rule-of-law, the greater the benefits for firms of making political connections. It has been demonstrated in Chapter 6 that the captured states of the CIS rank near the bottom of the Transparency International corruption index. The implication is that to keep benefits high, oligarchs will want to maintain the nontransparent high-corruption environment. It also follows, as Morck, Wolfenzon and Yeung (2005) suggest, that in low-corruption countries entrenched elites may wish to see less openness, but it may for these cases be too late to reverse the institutional achievements of even-handed rule-of-law, as political influence that is purchased is often found out and punished, and the role of middle-class civil society is as entrenched as the big-players. While the highly corrupt societies of the world, including some post-communist ones, may be in a low-level equilibrium of illiberal polities and economies, the advanced countries may be in a high-level equilibrium of liberal polities and largely but not fully liberal, competitive market economies.

7 Safe Havens for Market Reforms: Membership in the EU and Other International Organizations

Courtship games of the EU and post-communist countries The Community has taken the necessary decisions to strengthen its co-operation … with States which intend their founding principles to be democracy pluralism and the rule-of-law. It … will continue its examination of the appropriate forms of Association with the countries which are pursuing the path of economic and political reform. (Statement of the EU Strasbourg Summit, 12 December 1989)1 Was the above an invitation to EU membership for the countries to the east of the Berlin Wall? Of course it was, albeit its terms were already a bit more guarded and constrained than earlier political statements welcoming these countries and calling for new initiatives to respond to their needs. Thus, for example, Chancellor Kohl insisted at the G-7 Summit in June 1990 on including a reference to East European integration and more concretely: ‘to ask the European Commission to take the necessary initiatives … and to associate … all interested countries’. The Commission’s first response was to establish the PHARE programme of economic assistance to Central Europe, but it then went further, preparing the Strasbourg Statement cited above. As a good bureaucracy with the duty of reining in the flourishes of politicians, the Commission enshrined in the Strasbourg Statement an initial cautionary principle: ‘the legal basis of forthcoming negotiations was to be Article 238 (Association); not Article 237 (Accesssion) as many East European governments had hoped’.2 The intention was to dampen expectations of a rapid process leading to eventual membership, and to establish three important principles of the Association process: integration into Europe was to be stepwise and flexible; it was conditional on a country’s progress along democratic 203


and economic dimensions; and Accession did not automatically follow. Thus began the courtship games between the EU and the aspirants. The very fact that such carefully crafted statements were necessary to dampen membership expectations is virtually prima facie evidence that for the post-communist societies themselves membership was in fact the final goal.3 The lack of explicit formal statements of this desire was not because of ambivalence about the final goal, but because the leaders understood the nature of the game: do not expect explicit public reference to membership from the EU side too early. The actions of governments on legal and other changes attest even more strongly to the Accession intention. Thus, Czaba (2004) points to Hungary’s 1990 Law on Legislation requiring any proposed legislation be pre-screened to ensure it did not contradict European legislation. Similarly, Laar (2002) emphasizes for Estonia that borrowing German legislation was done to avoid future changes required by harmonization with EU requirements (the early approach of all the Baltic countries is elaborated further in the Appendix to this chapter). Kolodko (2000b) also makes similar points: there was no question about the unilateral wish of all these countries to join the community, but neither was there doubt about the inherent value of the reforms that followed. If the reforms were also consistent with EU accession, so much the better. Myant in Heenan and Lamontaigne (1999a) notes that as early as the 1992–93 Slovak debates concerning independence, one important argument was how this would affect EU membership, with some Slovaks proposing a postponement of independence until after accession. To the candidate countries, the hurdles established by the three principles of the Strasbourg Statement, which did not explicitly mention Membership but only Association, were not an overwhelming deterrent as they well understood the game. After all, the Statement did not explicitly exclude Membership as had been done in the case of some earlier Association Agreements for the Lomé countries or the Barcelona Agreements for the Mediterranean countries. While ceding this first round of the game, the aspirants gained some purchase in a statement of the External Relations Commissioner, Frans Andriessen, who as early as January 1990 elaborated: ‘As democracy and economic liberalization take root the agreements can be applied flexibly, and further developed to provide for a form of Association corresponding with aspirations [my italics] in East Europe, and the Community’s own interest.’ The word ‘aspirations’ was understood to be code for ‘accession to membership’. This was made official at the April 1990 Dublin Summit of the EC Council which incidentally also reaffirmed the wide scope of the potential offer ‘to all the countries of Central and Eastern Europe’.4 Thus long before the first formal Association Agreements (known as Europe Agreements) were signed with Czechoslovakia, Hungary and Poland in December 1991, the aspirants had won an important victory: recognition by both sides that while the attainment of membership was conditional on

Safe Havens for Market Reforms 205

progress, and this was to be assessed by the European Commission (EC) experts, it was indeed membership that was the end-goal and not anything short of that. True, the EU won the right to make the judgments virtually unilaterally, but that is hardly surprising since the incumbents would surely have to be the final arbiters on admitting new members. This meant that the negotiations were hardly that, but rather as a Bulgarian negotiator put it ‘a set of instructions for us to follow’. For countries which had achieved an internal consensus and strong commitment to the dual liberal vision anyway, this was not giving up much and progress towards accession was the carrot of reward for good behaviour they broadly intended to pursue anyway. For countries with a weaker commitment this was much more of a burden, and the EC’s power was in several instances applied as a stick to punish them with postponement. The critical references to eventual accession were made even more explicit in the Europe Agreement preamble which recognized accession as the candidates’ ‘ultimate objective’, though at the same time it reaffirmed that the EU made no commitment to ‘automatic’ passage from Association to Accession. The Agreements themselves did not fully spell out the precise conditions for allowing progress towards membership; this was done in the June 1993 decisions of the Copenhagen Council, which in the first instance removed the veil from the meaning of ‘aspirations’, but also set the very tough agenda to follow including the vehicle for the Commission’s power of judgment, annual Progress Reports for each country. Czaba (2004) describes how these reports led to ‘a beauty contest’ among aspirants as to which country would be put on the fast-track for accession, and emphasizes how this provided a strong incentive for reformist momentum. The destiny of different countries as dictated by these reports is explored later in this chapter. The 1991 Europe Agreements were followed by a series of others. After the velvet divorce of the Czech Republic and Slovakia they had to be redone as two separate Europe Agreements in late 1994, sometimes leading to the misperception that these two countries came later than Hungary and Poland. In early 1995 Agreements were finally signed with Bulgaria and Romania, and in mid-1995 with the three Baltic states and Slovenia. It is notable that by this time the Copenhagen criteria were in place, hence the ultimate goal of accession was no longer implicit. The last Europe Agreement came for Croatia in June 2004. For each of the countries, a formal application to membership was filed at various times, usually sometime after the Europe Agreement rather than before, reflecting the reality noted by Schimmelfennig (2003) that: ‘states may want to become members long before they formally apply but they wait for favorable circumstances’.5 Only after the approval by the EU was a schedule set for beginning negotiations on the 34 chapters of the Acquis. The first group of countries completed their negotiations by 2002–03, and in the Athens Summit the EU officially declared Accession for them in May 2004.


In the interim, a lot of negotiation, postponement and restarting took place, and game playing continued until the very end. Indeed, in this game Bulgaria and Romania were held back for a very long time, despite a start in 1995. At the 2002 Athens Summit they were excluded from the May 2004 accession, but were still rewarded for recent improvements with a new negotiating schedule and indications of accession about 2007–08. The gameplaying for a new set of countries in South-East Europe was started in the Athens Summit with varying ‘offers’. Croatia, was given the warmest new ‘offer’ with a very fast-track – an early signing of a Europe Agreement in June 2004, application immediately after. But Acquis negotiations, to start in May 2005, were delayed as a political condition concerning war-crimes was not met. Nevertheless, Croatia may still catch up with the slow-moving Bulgarian and Romanian cases. Albania, Bosnia-Hercegovina, Macedonia and Serbia-Montenegro (with Kosovo unmentioned) were more vaguely promised good ‘prospects’ and ongoing discussion, but no indications of a timetable. Nevertheless, their formal inclusion in the South-East Europe Co-ordination Commission vehicle is implicitly understood as a pre-Europe agreement process. Reviewing this entire process, it is evident that the candidates had a great deal to gain from this game, economically, politically and for future security. But many analysts have argued that the gains for the EU were marginal at best, except possibly on the security element. Security gains are to be interpreted very broadly and mean far more than the uncertainty about the future direction of Russia and its possible renewed dominance over the countries of the region. The dissolution of the Soviet empire provided some assurance of a much less confrontational relationship for some time to come. Overtime, global integration would lead to economic prosperity and political stability in the periphery countries, and for some EU membership would contribute considerably to stability. Papadimitriou (2002) and Schimmelfennig (2003) both give considerable weight to the security arguments, but insist that was not the whole story behind the EU’s eventual willingness to accept so many new members. Papadimitriou emphasizes a sort of Grand Game involving a large number of elements with attendant costs and benefits – economic, political, moral obligations, security – in which any economic costs for EU (subsidies, low-cost labour threats) were too marginal to matter in the end. Schimmelfennig gives especial emphasis to the moral obligations of Western Europe to offer a democratic home for the released captives of communism. In a game-theory negotiation, he notes how this gave the candidates a great bargaining tool of ‘rhetorical actions’, which they used to great advantage. After the early political calls for ‘maximum help’ (Papadimitriou, 2002, p. 73), ‘the CEE governments and their [EU] supporters based their claims for enlargement on the collective identity and … the liberal values of the community … The opponents of eastern


enlargement found themselves rhetorically entrapped’ (Schimmelfennig, (2003), p. 5). How is this ‘courtship game’ to be interpreted in the navigation model of Chapter 4? In the jargon of economists, the ‘variable’ EU membership prospect or probability might be considered exogenous – that is not determined by the other variables of the model but simply given from the outside – or it might be considered endogenous – that is caused by one of the other variables, as for example progress on the TPI measure. In fact it is some of both. The very early rhetorical signals from European leaders can certainly be considered as exogenous ‘invitations’ or offers to join the club, albeit with conditions. These conditions motivated countries that desired or demanded membership to move more expeditiously on political and economic liberalization. The membership probability variable becomes endogenous at this point, as the continued willingness of the EU to proceed towards accession is increased with greater reform progress, or reduced with lagging reforms, in the circular causation shown in Figures 4.2 and 4.3. But endogeneity may have come even earlier if the desires of a country to turn away from communism and the dominance of Moscow had led to a vision of EU membership (also NATO and other groupings in parallel) which in turn had led to a consensus on needed reforms well before early signals from the EU or the statement of Copenhagen criteria. One way to think about this is that candidates demand membership and the EU ‘supplies’ it simultaneously: the interaction determines the equilibrium result, which here would be not so much a financial price, but the waiting time before accession.6 The remainder of this chapter shows that the degree of exogeneity v. endogeneity of EU prospects varied for different countries and over time. Thus, the next section will discuss EU membership being used sometimes exogenously as a carrot providing ex ante enticement towards liberal reforms and ex post reward for progress on reforms, and sometimes as an endogenous stick to punish poor performance with the hope of herding-in these strays and laggards. We then turn to a handful of countries where an EU offer was withheld or denied despite desires of the country, and analyse the counterfactual of what might have happened to reform progress in some CIS countries like Ukraine (or even Moldova and Belarus) if the EU had made a more explicit early offer of the membership carrot. Moving then beyond the EU to other international organizations we ask the question: did they have similar effects to that of EU membership, did any of them provide the same ‘safe haven’ for liberalization? The final section returns to the explanatory model of Chapter 4 to test the hypothesis that the stronger the prospects for EU membership in the early years, the less the delays and the quicker the pace of transformation policies. An Appendix provides a more detailed illustration of the dynamics between EU membership desires and offers in the Baltic countries.


EU membership incentives: sometimes a carrot, sometimes a stick Ex ante enticement: Visegrad countries It will be useful to start with a brief discussion of the ways in which EU prospects influenced reform strategy. The effect of potential EU membership can be separated into two parts: the beacon effect attracting the country – or more precisely its citizens – to a safe haven of calmer, richer and more democratic waters; and the navigation chart effect provided in the details of the Acquis Communautaire (Acquis) the concrete instructions needed to transform the economic and political institutions. The beacon effect has both a demand and offer side as defined above, but the influence on internal policy is in principle similar whether it is the demand or the offer that is stronger. The beacon of a liberal democracy and market that the EU’s early warm signals ‘offered’ to the Visegrad countries was the same beacon that the Baltic countries envisioned for themselves despite the lack of any such early warmth from Europe. The Baltics in fact provide the best example of countries that chose to follow the beacon on their own with very little being offered by the EU initially. This is not to suggest that the Visegrad countries only moved quickly on the liberal vision because the EU enticed them with an early membership offer. The evidence of Chapter 5 is clear that their commitment and consensus on the direction of change was second to none and doubtless strong enough to keep up the momentum of liberalization. Even if there had not been an EU offer they would surely have proceeded, as did the Baltics, trying hard to show the EU they were worthy candidates.7 But the EU offer did no harm in this respect, and in the words of one of the negotiators for Hungary, Bela Kadar, ‘it certainly added to the resolve and arguments of the rapid-reform proponents within society, especially to keep up the momentum’.8 In all cases, these countries organized their reform efforts with the goal of EU membership in mind, with Hungary doing so in the most rigorous way with its aforementioned Law on Legislation requiring consistency with EU legislation. The early candidates with an ‘offer’, albeit a non-automatic one, were enticed ex ante to move forward by the formal and informal nature of such an offer, and were rewarded along the way with many carrots: the political and symbolic value of an early signing of the Europe Agreements; its immediate economic benefits; an early start on accession negotiations; generally positive annual reports by the EC;9 and an assured accession in the first wave. The value of the interim rewards before accession is not to be underestimated. The free-trade part of the agreements helped spark an export boom to the EU and a shift in trade patterns much earlier than for FSU countries, which in turn contributed to an earlier economic recovery. The strong signal of the agreements and generally positive messages of steady progress in the


annual EC reports greatly ‘improved the region’s reputation both in international forums and among foreign capital investors’.10 The high level of FDI per capita in the early candidates is evident in Table 2.1. This was also related to the more advanced status of economic liberalization, but Havrylyshyn (2004) shows in a regression analysis that the prospect of EU membership was as important to foreign investors, and in particular it is this factor rather than TPI differences that explains the wide gulf of FDI per capita between prospective members and those with no such prospects in the foreseeable future. It is notable that these large FDI flows were anticipational and came well before the actual accession in 2004. Ex post reward: the Baltics The Baltics were not given the same ex ante incentive signals as the Visegrad countries (or for that matter Bulgaria and Romania discussed later), other than the faint hope signalled by including the Baltics under the PHARE programme of assistance for Central Europe and not the TACIS programme devised for the successor states of the USSR. They only benefited from an ex post reward for doing what the EU was asking of the earlier candidates. Why did they do it without the EU membership enticement? Because they had a strong desire for membership which served as well as a strong offer to motivate policy in the liberalizing direction. Like the old marketing story of Avis who as No. 2 in the car-rental business behind Hertz made a lot of its slogan ‘we try harder’, so too the Baltics in the period 1992–95 tried harder and, as seen in Chapter 2, essentially caught up to the leaders by 1995 on the TPI measure of economic transformation. They were indeed rewarded with a Europe Agreement in 1995, subsequent negotiations and, with some ups and downs, accession in the first wave. The Appendix to this chapter elaborates on the hypothesis of how the early reform policies in the Baltic states were influenced or at the least informed by the desire for eventual membership. The lack of an early offer, equivalent to that received by Visegrad countries, meant this linkage was not as precise; in the beginning, it was explicit only in Estonia but became much more explicit over time in the other two as well, even before the signing of the 1995 Europe Agreements. As early as 1991–92, there is evidence of these countries orienting the process of legislation and policy formulation towards the EU membership goal, again especially in Estonia. Prime Minister Laar’s monograph cited earlier avers to this, and it is more fully analysed by Pisuke (2001) who concludes that, as preparation for potential membership, the new legislation was modelled on EU member states. Levits (2001) suggests that in Latvia the orientation of conforming to EU standards came slightly later, but was in evidence in 1993–94 well before the signing of Europe Agreements. At the beginning Lithuania may have been somewhat less intensely focused on EU membership than the others, perhaps because, as Lane (2002) argues, it promoted and had the best relations with Russia.


Nevertheless, this did not preclude following the same model of borrowing from European law as in the 1992 Law on Principles of Accounting, at least suggesting the same motivation: ensuring future concordance with EU accession requirements (O’Rourke, 1995). The differences began to be minimized and the common objectives highlighted in the June 1993 joint declaration of the three Baltic presidents calling on ‘EU countries to initiate negotiations on the granting of associate member status to the three Baltic states’.11 In fact this was not the first step in the courtship game; the broad invitation of the April 1990 Dublin Summit to ‘all countries of Central and Eastern Europe’ may or may not have been intended by the EU to include the Baltics who were still de facto part of the USSR then, but for the Baltic states who insisted successfully that they were never de jure part of the USSR, Eastern Europe by definition included them. And so they acted, so they spoke publicly during 1990–91, including their declarations of sovereignty and independence of mid-1990. Their first success was the signing of Trade and Cooperation Agreements with the EU in May 1992, very soon after the dissolution of the USSR, and well before analogous agreements for the CIS states (1994–98). This was followed by a Free Trade Agreement in July 1994, and finally the Europe Agreements in June 1995 which put them on the explicit track of potential membership, albeit again non-automatic as per the principles established in 1990 by the Strasbourg Statement. The arbitrary power of the EC to decide on timetables led to the inclusion of Estonia in the first wave, but a postponement for the other two. In the event they too caught up and acceded in May 2004. The Acquis as a navigation chart The ‘navigational effect’ provided by the Acquis is extremely detailed and comprehensive, comprising 34 chapters and over 80,000 pages of requirements a country needs to fulfil in legislation, institutions and procedures to aspire to accession. The overwhelming negotiating position of the EC was partly due to the volume and detail of the Acquis – any country truly serious about membership had little room for manoeuvre here apart from some marginal ability to negotiate interpretation and timing of implementation. Three points are worthy of attention. First, there is an important similarity or at least consistency between the Acquis as a chart towards the market, and the elements of the Washington Consensus (WC), though the Acquis harmonization process has virtually no prioritization of elements, no specific sequencing or recommended timetable. But the annual reports from the EC about how countries were progressing to meet the Acquis and the requirements listed under the Copenhagen criteria, implicitly supposed the WC approach, with frequent references to having and implementing a programme with the IMF and World Bank – or failure to do so. Second, the process of negotiating the Acquis chapter by chapter permitted the EC to differentiate among countries and in effect rank their progress, with the possible consequence of


delaying the accession timetable or even suspending temporarily negotiations; this ‘stick’ was applied in several cases. Third, it should not be forgotten that while the Acquis is a formal requirement only for those on the path to EU membership, it is a public document available to any government that in the early 1990s was debating alternative paths to a democratic market economy. For those desiring EU membership but not immediately receiving welcoming signals, there was nothing to preclude demonstrating their seriousness of purpose by proceeding on their own to implement Acquis components, at least in spirit if not precisely to the letter. Some like the Baltics did, even to the point of setting up government units for eventual implementation of the Acquis before the EU clarified its ‘offer’; others – like Ukraine before Yuschenko – professed a desire for membership but did not try at all hard to follow such a strategy. EU membership as a stick to herd-in strays There were several cases of an offer being given to countries that had a weak internal commitment to the dual liberal vision and therefore did not respond to the enticement. The earliest examples may be Bulgaria and Romania. They were already in the list of countries mentioned in various documents as early as 1990, for example Commissioner Andriessen’s clarification of 4 January 1990, President Delors 17 January speech to the European Parliament, and others. By August of 1990, however, concerned about the continuation of governments with a heavy communist presence, the Commission proposed putting Bulgaria and Romania in a second wave behind the Visegrad countries.12 This was the first application of the stick as a punishment for poor results on the democratic dimension. Interestingly, this was soon reversed by an EU Council decision in September 1991 to reopen negotiations for an Association Agreement, that is the offer of a carrot. But the game of carrot–stick–carrot has continued for these two countries to the present day. The slow progress on economic reforms delayed the signing of the Europe Agreement until 1995, four years later than the Visegrad countries. But even then delay continued and negotiations also started only in 2000, much later than for the first wave applicants. This second postponement ‘stick’ came as a result of the resurgence of inflationary pressures and financial instability in 1996. This was followed by a new and more successful stabilization – particularly in Bulgaria with the election of a democratic government in February 1997 and the successful establishment of a currency-board regime three months later. Nevertheless, both countries had fallen so far behind that they could not catch up to the first wave. In contrast, several others that were in a second wave – Latvia, Lithuania, Slovakia and Malta – did catch up and were included in the May 2004 accession. Another episode of the stick being applied came later and was much briefer: Slovakia. During the Méciar period (1994–98), considerable doubts were raised about regression in democratic practices and to a lesser extent on


economic reforms, especially favouritism in privatization. The EC dropped Slovakia from the first wave and suspended negotiations, with the intent not only of punishing but hoping to bring policies back on track. Slovak analysts give a lot of weight to voters’ concerns of not joining the EU with their neighbours as a factor leading to Méciar’s defeat in 1998, and the restart of reforms under Dzurinda.13 Less dramatic were the cases of Latvia and Lithuania. The 1997 Reports of the EC warned both of lagging behind. Unlike Slovakia, neither of these had been on the list of first-wave countries, with Estonia always ahead of them. But the impact of this warning was considerable, and sufficient to spark an acceleration of efforts which in the end succeeded putting these countries in the May 2004 accession group. Slovenia also started much later on the EU path, but that was perhaps less a case of the EU wielding a stick and more of a case of the Slovenians being confident that they were doing the right things all along, even before 1990,14 and did not need to bend over backwards to satisfy the EC. In the event they acceded to the EU with the first group and the highest per capita income of all the transition countries – about $9,000–10,000 at the time. The stick effort in Croatia differed in many ways from all the others. It was excluded from the beginning – despite an advanced level of economic reforms, market operations (like Slovenia) and steady progress – because of European concerns about war practices and democratic violations. Until at least 1995, the nation was reasonably united as the independence war was being conducted. Economic liberalization was proceeding perhaps more slowly than in the rest of Central Europe, but was proceeding from a higher base and without reversals; on this there was an internal consensus and strong commitment, as indeed there was on the desire for EU membership. But as long as the war President, Tudjman, was alive, any efforts by opposition forces to win elections failed, and the stick of withholding the EU membership beacon had little effect. With his passing and the 2000 election win of Mesic, discussions began immediately with the EU, resulting in a Stabilization and Association Agreement (a sort of precursor to a full Europe Agreement) in May 2001, and a Europe Agreement in June 2004 with immediate application for membership. Echoes of the past sensitivity to warcrime issues continued, however, and have slowed the pace of negotiations despite the sense on all sides of the very high prospects for successful progress towards Accession.

Unrequited desires for membership A number of countries on what has become the new eastern periphery of the EU, on the other side of the new ‘Schengen Curtain’, have at different times and with varying intensity stated a desire for EU membership: Ukraine, Moldova, Belarus before Lukashenka, even some Caucasian countries. The response of the EU has been lukewarm at best and categorically negative at


worst; economic and democratic transformation of these countries have in general lagged considerably behind the new members, which on the face of it vindicates the lack of reciprocation by the EU. However, an important historical counterfactual question may be raised: could these countries have been motivated to greater advances if the EU had responded more favourably, that is used more boldly the carrot of enticement and as needed the stick of punishment which we saw had such a powerful effect in the central swathe of Europe? As a counterfactual this can only be analysed in a speculative fashion, but it is possible to derive examples from the successful cases which lend support to such a hypothesis. I will not consider the Caucasian cases here, and concentrate on Ukraine, partly because of its much larger role in the region, and partly because it suffices to make points applicable to the other two periphery countries: Belarus and Moldova. Most important, of course, the issue is once again on the table for Ukraine: can a warmer EU offer help buttress internal commitment to reforms? There has also been something of a membership dance between the EU and Ukraine over the past decade, but it has been less like courtship and more like shadow-boxing with no real blows struck and no real achievements to note. Kuzio (2003) characterizes the result as a stalemate attributable to ‘virtual policies adopted by the EU and Ukraine towards each other. The EU has never adopted a clear strategy towards Ukraine [and] Ukraine has espoused “European choice” rhetoric [while] adopting domestic policies that undermine these goals.’ He goes on to argue that had the EU been bolder and made a warmer offer with some hope of eventual membership despite the unquestionably inadequate reforms in Ukraine, this might have tipped the scales in the direction of greater progress on the dual liberal vision. The EU position is not without weighty counterarguments, two of which are explicit. Countries need to demonstrate greater action as had been done in much of the region to the west of Ukraine, and not just express good intentions. Ukraine has been engaged in the Partnership and Cooperation Agreement since 1994, and can participate in the new initiative of the European Neighbourhood Policy (ENP). Two others are implicit such as enlargement fatigue and the view that Ukraine and the other eastern aspirants are really outside of ‘Europe’ in some geographic and/or societal sense. I elaborate on these four below. The EU rationale that Ukraine has not done enough to merit more of an offer is very powerful, but at the same time there are clear precedents among the successful aspirants that the EU can, by extending the hope of membership, have an extremely powerful influence reorienting a country’s policies in a more liberal direction. The recognized democrat in the candidacy for the Ukrainian presidential election of November 2004, Viktor Yuschenko, made a passionate appeal (Herald Tribune, 9 September 2004) for the EU to take a clear position for integrating Ukraine, including eventual membership. He referred to the 1998 precedent of the ‘clear European position that helped the democratic forces in Slovakia defeat an authoritarian regime’. Slovakia


under Méciar was indeed straying from the path, and the stick of postponing the membership process did have the desired impact. Perhaps an even better example – which would have been absolutely impolitic for Yuschenko to use but an academic tome can – is Romania. It was, as noted, on the very early membership lists despite the political instability and slow economic reforms, and while punished by postponements it remained on a tentative membership track. In the second half of the 1990s, as the Economist 6 November 2004 notes, The EU has treated Romania quite generously … Setting out to reunite post-communist Europe it tried hard not to omit Romania, even when it seemed to be going backwards. [Now] democracy seems to be working and the direction of the country in the next election is not fundamentally in question. [My italics] The italicized part contains the key lesson: EU membership has made a big difference in at least three critical cases already – Slovakia, Bulgaria and Romania – and Croatia looks set to become a fourth example, which suggests it could also have done so in some of the cases of unrequited desires. These precedents give some credence to the counterfactual: had the EU in its own interest for stability on the periphery offered a warmer welcome to Ukraine despite its reform shortcomings, the direction Ukraine took might have been more felicitous. This might have been done at two moments of important advances in reforms: in 1994–95 when President Kuchma first came in and began to demonstrate reform zeal, and more recently when Mr Yuschenko became Prime Minister in 2000 and reinvigorated the reform process that had stalled after 1997, moving reforms forward smartly in a period when democratic standards though beginning to falter were far from reaching the ugly depths of the 2004 campaign.15 The second opportunity with a reformist democratic PM, oriented to and popular in the West, could easily have been taken by the EU without fear of losing credibility on the principles of Europe Agreements. Of course these are counterfactuals, the EU judgment that a membership offer in 1994–95 was too early, and one in 2000 while Yuschenko was PM too risky because the real power had by now been consolidated in the new oligarch clique with Kuchma as the political if not financial leader. But even a third opportunity was not taken: a response to Yuschenko’s plea for some sort of signal, a little flash of the EU beacon somewhat analogous to what had been done prior to the 1998 Slovak elections. The EU could not and was not being asked to suggest a Yuschenko victory would reopen the issue of membership, just as it could not in 1998 openly point to Dzurinda as a preference. But just as then it indicated a return to a more democratic and liberal path after the elections might allow a retracking of Slovakia, it could have signalled that pursuit of an open democratic process and continued economic


reform progress might lift Ukraine out of the ENP group with no expectation of future membership. In the event, democracy prevailed without such a carrot from the EU, on the basis of the home-grown urges of the people manifested in the well-known events of the Orange Revolution. A fourth opportunity, after the 26 December 2004 presidential election of Yuschenko, offers the EU an even more auspicious moment. The oligarch power has been defeated, a democratic and civil society has demonstrated its capacity (even if it is not yet fully entrenched), and a new government with an evidently much stronger commitment to the dual liberal vision is in place. What about the arguments that Ukraine had nevertheless been given something in the Partnership Agreement and the new ENP arrangements? The evidence of this chapter is clear that nothing short of a possible future accession, no matter how unclear the timing, has much effect. Some of the financial and trade-investment facilitation assistance can generate positive benefits for the partners, but as Wolczuk (2004) notes, these sort of nonmembership agreements ‘are too weak to make any difference on the general direction of policy’. The EBRD Transition Report 2000 is somewhat more guarded in the use of words but the meaning is clear in the following: ‘In the absence of prospects for closer integration, EU association agreements have not exercised significant influence on the reform process in the CIS.’ Indeed the ENP goal of ‘creating a ring of friends’ may be counterproductive since the message it sends is not a faint hope of future membership but its opposite, an implicit but clear ‘NO’. The choice of the word ‘neighbourhood’ was effective in making the message clear, but may have been unfortunate if it launches a self-fulfilling prophecy that ‘bad fences make bad neighbours’. The European Neighbourhood Policy risks reinforcing the feeling of these countries being spurned, already fed by the existence of a new curtain replacing the old Iron one, the Schengen Curtain; it is a paper curtain, but surprisingly strong paper. What about the implicit geographic argument that Europe cannot be extended indefinitely eastward. For the western CIS countries, the relevance of this argument was completely undermined by the correct, laudable and bold decision of the EU to finally clarify the possibility of membership for Turkey. It extends further east than several aspirants in the CIS, it has a lessEuropean historical, cultural and religious nature. The implication that all these differences did not in the end matter surely strengthen the case for potential inclusion of Ukraine, Moldova, Belarus and even the Caucasus. The only argument that has some objective weight is expansion fatigue, but it is unimaginable that any opponents to further enlargement would use this argument explicitly. It is so contrary to the high-minded principles of common democratic, liberal values that opposition is forced to use false or weak arguments, which of course strengthens the hand of the aspirants. The counterfactual question of whether things may have gone better in Ukraine, Belarus or Moldova (and possibly farther east as well) had the EU


been bold enough to offer the enticement of membership will remain speculation, but the evidence of the carrot–stick approach for many other countries clearly shows the line of causation: EU membership strongly contributes to more liberal policy directions. At a minimum, such evidence should lead to Europe keeping an open mind about new, additional suitors. In Ukraine, there may be a new opportunity since Ukraine’s large size and strategic role are both advantages and disadvantages for its EU desires: it is too big to ignore, but so big it is not easy to absorb. Similarly in Belarus, the only past opportunity in 1992–93 with a reformist Prime Minister, Shushkevich, is long past and it is inconceivable that the Lukashenka administration would respond properly to an EU offer; a future change may or may not generate a new opportunity. Moldova may be more susceptible to such an influence even under the latest communist-dominated government, because its small size means that its benefits from membership would be huge, but the costs to Europe tiny. But given the very political nature of the courtship game within Europe, it is unlikely that either of these would be brought on board before Ukraine; and for all three enlargement fatigue may result in continuing the status quo even if the aspirants radically change their policy. It is not inconceivable that countries last in the SEE queue – Albania, Bosnia-Herzegovina, Serbia, as Judah (2005) pointedly describes the driving force pushing both a strong demand and an eventual reluctant offer is the ‘need for security of EU membership in the EU to keep them from slipping back into violence and hatred’ (p. 76), and a new Kosovo – would become members before Ukraine, Belarus and Moldova.

Other international beacons In principle there are other safe havens for a transition country apart from the EU: NATO; the WTO; international financial institutions (IFIs), in particular the IMF; the World Bank; the EBRD; as well as regional trade or commonmarket arrangements, such as the Single Economic Space (SES) under discussion for some CIS countries. The primary concern in this discussion is the beacon and navigation chart effects discussed above – not the economic benefits of free trade or free economic zones, but some indication of how large these last might be will be useful. NATO needs little comment. First, it is unlikely to be relevant for countries outside the CEB and SEE with two possible exceptions: Ukraine, where it is still conceivable to see NATO membership without EU membership (like Turkey had been for decades), and Georgia. And, second, while NATO membership has effects beyond security issues by drawing countries closer to the club of liberal market economy and functioning democracy, it has virtually no requirements or levers to motivate market reforms, or even ensure democratic ones. Arguably, it can help inculcate such a spirit by osmotic example and informal peer pressure, but there is nothing in NATO even approximating


the Acquis requirements for membership that would make it as powerful. The long-standing fact of military governments, de jure or de facto in Turkey until the early 1980s is indicative of the lack of a democratizing influence. This holds even more true for liberal economic institutions. WTO membership16 almost certainly will have more influence on economic policy than NATO, although it falls far short of the impact EU membership has had on liberalizing market institutions, and has virtually zero effect on democratic standards. Its attraction to potential members has to do with the trade-creating opportunities it provides by lowering barriers to its exports in all the incumbent members; along with this, the new member receives yet another ‘certification’ of approval by an international organization which raises somewhat its status in the eyes of international investors, financiers and traders. But some doubt has been raised in the literature whether the WTO has much of a trade-creating effect. Rose (2002a) shows econometric results that it does not, but Subramanian and Wei (2003) counter this with more positive results for advanced countries, and accept trade creation is limited for developing countries. The unhappiness in Kyrgyz Republic and Moldova that WTO membership has not generated a trade boom would find a resonance with these results. Nevertheless, it is clear that the WTO could potentially provide the magnitude of economic benefits that EU’s very large economy can,17 and that the continued efforts of countries not yet members are justified. One may disregard the sceptical view of Rose (2002a) about the trade-creating effects of the WTO, but it is far more difficult to disregard the arguments by Rose (2002b) and Irwin (1995) that for developing countries with high-trade barriers WTO membership is not that powerful an influence on liberalizing trade comprehensively. Partly this is due to the historical inertia of the GATT then WTO of giving developing countries more leeway to protect domestic industries, and partly it is due to the bilateral process of negotiating protocols between the candidate and interested incumbents on just how much liberalization and on which goods it applies. There is no standard requirement of all new members, hence, the result is likely to be uneven and certainly incomplete liberalization. In addition, there is very limited possibility in the WTO either before membership or after to exert liberalizing influence on domestic markets, unless a member puts forth a dispute claiming that certain internal regulations – say energy subsidies or provincial government support – indirectly create an unfair trading advantage. The dispute then goes through a lengthy process of adjudication with no certainty about the direction of the results. On balance, therefore, the WTO impact on liberalization is necessarily far more limited than that of EU membership. Other regional trade arrangements are even less likely than the WTO alternative to provide an EU-like effect for two reasons. First, any trade-creation benefits will be much smaller and may indeed be outweighed by trade-diversion effects in a very small regional grouping where each country does a lot of


trading outside the group. Second, the motivation and discipline for the broader political and economic transformation under the EU is virtually non-existent. As to the IFIs, the major shortfall compared to the EU is that mere membership provides neither the beacon nor the navigation-chart effect. The minimum requirements for continued membership are a minor financial contribution, and agreement to undergo regular reviews of policy – such as the Article IV Consultation at the IMF. It is only if the country wishes to borrow that any serious policy conditionality is applied, with a firmness that is broadly proportional to the size of the borrowing but which may also be softened by the relative political importance of countries.18 Since Slovenia has never wished to have an IMF programme, its slow pace of privatization was not subject to any formal conditionality. Turkmenistan’s total disinterest in IMF financing left it free to undertake whatever level of reforms it wished, with the only consequence being a critical Annual Report during the Article IV consultation. As these reports cannot carry significant sanctions by the institution itself, even if they have some impact on perceptions of outside business interests, their recommendations are applied entirely voluntarily. In this case the authorities maintained the formal dialogue and consultation, but with significant delays on data provision and timing of missions. In principle, the IMF and the World Bank could in extreme cases impose a sanction for non-cooperation on data provision, for example precluding the country from borrowing. The irrelevance of this for Turkmenistan is obvious. The story can go in the opposite direction – the unwillingness of Belarus to undertake significant liberalization and monetary stabilization meant it could not receive the large financing it did desire and continually requested. But wanting financing while not wanting to do what is necessary to obtain it ends up at the same point as not wanting financing at all; that is, no conditions are imposed, hence no leverage can be applied by the IMF. Much the same logic applies to the operations of the World bank and the EBRD, and, not surprisingly, the same cases of ineffectual leverage on slow reformers are echoed in those institutions. The only relationship powerful enough to approximate the effect of the EU is the programme conditionality of the IMF, the World Bank and regional banks, the EBRD in this case. But conditionality only applies if a country already wishes to carry out such reforms (most CEB countries did follow very successfully such programmes with and without lending), or has a deep financial crisis and must accept the conditions to receive the financing. Many analyses of IFI programmes over decades, including econometric estimates, have shown that IMF programmes generally do have a positive impact on both inflation and growth, but the effect is not overwhelming and not always statistically significant.19 The problem for statistical analysis is twofold: failure of a programme is sometimes due to poor implementation of the conditions; and it often takes a long time for the effect to work through, by


which time many other influences are at work and the programme’s contribution is not easily separated out. Many reluctant borrowers negotiate hard for the least difficult conditions, do not implement them well, and negotiate after the fact for waivers of the initial conditionality; thus many programmes give poor results because they are not well-implemented. When this can be controlled in the analysis the programme’s effect is seen to be stronger. In any country trying to overcome a crisis, IFI programmes and their financing are only a part, and sometimes a small part, of the environment determining success or failure; econometric analysis cannot always separate out all these influences. It is notable that the leverage of IMF/World Bank conditionality was in fact enhanced by EU membership dynamics; in most cases, the EC’s annual progress reports encouraged candidate countries to do better on IMF standby programmes, or praised them for good performance. Outside programme conditionality, all the IFIs have probably made a very large contribution that is virtually unmeasurable through the technical assistance and general policy advice provided to government officials. OdlingSmee (2004) describes the nature of this contribution for Russia by the IMF. The initially limited knowledge of market-economy institutions and concepts in the post-communist countries was fertile ground for such knowledgebuilding, exemplified by the establishment of the Joint Vienna Institute sponsored by the Austrian government, the three main IFIs and other bilateral donors. It has in 10 years provided practical economic training for thousands of officials from the region. It has of course been said numerous times that the advice of the IFIs was incorrect and misguided, but such criticisms are only worth debating in reference to actual programme conditions as in Chapter 1; for technical and policy advice the contribution is more likely to be positive as it is but one of many channels through which varying advice was provided to authorities, who then chose to follow it or ignore it. The knowledge transfer came from many other sources as well, including independent academic or business community advisors financed by foreign assistance programmes of major public and private donors, short-term training programmes in donor countries, a large inflow of students from the region into western universities for undergraduate and graduate programmes and so on. With such a wide variety of vehicles for knowledge transfer, it is unlikely that any bias in the IFI contribution could have overwhelmed the process. It is perhaps paradoxical that the benefits of IFI general policy advice and technical assistance, outside programme conditionality, was generally greatest in countries with a strong inherent commitment. This was so not only for the obvious reason that committed reformers were far more receptive to market-oriented advice, but also because in the early years of transition there was limited local knowledge of market operations. Over time, the broad concepts became well-known, but – even to the present day – detailed technical


assistance on day-to-day operations of governments’ rules, regulations and procedures has in general been welcomed. Even in countries where the commitment of the leadership was low or limited, operational assistance was often very well met by the middle-level bureaucracy.20 In summarizing the evidence of beacon and navigation effects provided by different international organizations, one must conclude that no alternatives come close to having the effect of EU membership. NATO simply has no mechanisms for leveraging policy on economic or democratic dimensions. The IFIs when applying programme conditionality may approximate for a time the effects of the EU, but their influence is far more limited if a member does not need or want financing and therefore does not enter into a programme-conditionality relation. The WTO has a very focused influence on trade liberalization, that is often limited, but not on any other dimension of reform. Regional trade arrangements are even less important. It bears repeating that various EU cooperation arrangements which explicitly exclude membership as a possible end-point are also of limited impact.

EU membership prospects and reform delays While academic analysts have engaged themselves in endless debates about the proper choice of ‘East European capitalism’, and its alternative models, for both Left and Right policy-makers most decisions have been either determined by or suggested by the exigency of adjusting to the formal and informal requirements of the European Union. (Czaba, 2004, p. 338) In Chapter 5 it was argued that internal commitments of a country, such as a stronger renunciation of communism and more intense nationalist sentiment, generally led to an earlier start on economic stabilization and liberalization. These forces can be summarized as the degree of internal commitment to the dual vision of a liberal market and democracy. We can now blend into this the influence of the external commitment to eventual EU membership. In the illustrative formalized version of the navigation model (Chapter 4, Appendix) each of these, and possibly other historical conditions such as the number of years under communism, would be the independent variables of the equation determining the delay between regime change and the start of an economic transformation programme. While it is particularly difficult to find measurable proxies for the initial prospects or probability of EU membership, a number of testable hypotheses relating EU membership to delays in reform start – as set out in Figure 4.5 – can nevertheless be tested. The analysis in Chapter 5 and Chapter 7 provides qualitative evidence using category groupings or so-called Latin-square tests. Consider first the hypothesis that a more favourable ‘offer’ of membership in the early 1990s encouraged earlier reforms, as illustrated in the relationship of

Safe Havens for Market Reforms 221 Table 7.1 Strength of EU ‘offer’ and reform delay Scale of the no. of months to 5%/month inflation

Strength of EU offer Strong

Moderate

60

Weak Turkm(70) Taj

50

Ukr Rom Bulg

40

Arm/Geo Rus/Uzb Bel Aze Kaz Mol Kyr Mac

30 Cro 20

[Alb] Pol

Est/Lva Slv/Lith

10 Hun Czech/Svk Source: Based on the no. of months to 5%/month inflation, Tables 6.1 and 6.2. For details of the EU offer see text.

Table 7.1. On the basis of the preceding discussion, countries are put into three broad categories according to the strength of the initial ‘offer’ of membership from the EU; that is about 1990–91 for non-USSR cases, about 1991–92 for the others: ● ● ●

Strong: Czech Republic and Slovakia, Hungary, Poland. Moderate: Bulgaria, Croatia,21 Romania and Slovenia; the three Baltic states. Weak or zero: all others.

Over time the strength of the initial offer changed, and the impact of such changes has already been reviewed. But the early decision to begin reforms – typically not more than two–three years even in most of the laggards – was affected only by the strength of the initial offer. The delay measure used is the number of months from regime change to achievement of the 5% per month inflation, as defined in Chapter 5. If it is the start of stabilization that is thought to matter, one could use that as an alternative measure of delay;


in fact, this does not materially change the correlation that emerges. As a third alternative, delay might also be measured as the time to attain a certain TPI level of liberalizing reforms, but again this does not affect the correlation materially. That the time to achieve stabilization proxies well for other reform measures is not surprising. In virtually all cases, programmes of reform once started were quite comprehensive and included stabilization, liberalization, privatization and some institutional change; where stabilizations failed it was also generally the case that other reforms stalled or even reversed. The pattern of the Latin square in Table 7.1 conforms well to the hypothesis, with three exceptions which are easy to explain: Bulgaria, Romania and Albania. The countries with a strong prospect, Poland, Hungary and thenCzechoslovakia, had a delay of no more than 10 months.22 Slovenia, Croatia and the Baltic states in the moderate group had only slightly longer delays of 10–15 months. All the countries with weak or effectively non-existent offers had delays typically in the range 30–50 months and even higher, with the exception of Albania at 25 months. This last outlier is easiest to deal with: it is square bracketed to reflect the eventual breakdown of the stabilization by 1997 due to the unregulated financial-pyramid schemes, which suggests its placement ought to be higher up on the vertical axis. As to Bulgaria and Romania, their weak commitment to a liberal agenda overwhelmed their desire for membership, and the failure to sustain stabilization stemming from inadequate progress on structural reforms (especially a continued soft-budget attitude towards state enterprises) resulted in the EC wielding the stick of postponement of negotiations well beyond the mid-1990s. Thus even a very simple picture relating only two variables, reform delay and EU membership offer, needs only minor adjustments for three outliers to yield a strong correlation consistent with the first hypothesis. But this chapter has emphasized that the membership influence was not simply as an exogenous offer from the EU side, but had also a demand side, that is the desire of the aspirant countries themselves. The relevant hypothesis was stated in Figure 4.5 as follows: strong demand for membership drives early reforms regardless of the signal from the EU. In Table 7.1, nine countries judged to have strong internal commitment and related desire for EU membership (as described in Chapter 5), are noted in bold. Only four of them had a strong offer early on. Thus, statistically, it would be very difficult, if not impossible, to separate out the respective influences of commitment and EU offer and thus assumes the counterfactual that they would have done exactly the same even without a strong offer. However, this hypotheses appears to be confirmed by the experience of the group with strong commitment and strong EU desire, but at best a modest initial offer: this certainly comprises the three Baltic states, Slovenia, and arguably Croatia. For the first four the preceding discussion concluded that strong commitment and desire for membership drove their early and steady reform progress. The end-goal was to demonstrate to the EU that they merited


inclusion in the first wave of accession – and they succeeded. There is also no doubt about Croatia’s strong desire for membership or its demonstrated commitment to economic liberalization. While throughout the decade it was last on the TPI indicator among the Central Europe group and was surpassed by the Baltics in 1995–96, it continued to keep pace with progress in Central Europe and remained clearly above all the rest of the post-communist countries, including in the effectiveness of stabilization and economic reforms. The issue in Croatia has been almost entirely one of democratic standards and judging them in the sensitive context of a war with mutual abuses of varying degree. The evolution in the two other countries with a modest offer, Bulgaria and Romania, is also supportive of this hypothesis. Their weak commitment meant in effect that the demand for membership was weaker than in the others, hence, they did not proceed to early and steady reforms in the early years despite having a modestly positive signal even earlier and stronger at the outset than the other four modest cases. The relatively early upgrade of the EU offer for the Baltics and Slovenia, as well as the much delayed upgrade for Croatia, supports the third hypothesis on membership: strong progress in reforms induces a more favourable stance by the EU. The first four were able to sign a Europe Agreement by mid-1995 with Estonia and Slovenia, the stronger reformers, leaping ahead of Bulgaria and Romania to join the first wave. The 2003 decision to designate Bulgaria and Romania as the next wave of accession with a 2006–07 time horizon is another example of the hypothesis, though I have noted above that the evidence of actual progress is far stronger for Bulgaria than Romania, suggesting that for the latter it is perhaps more enticement than reward. The EU has not been as generous with Macedonia and Albania despite the fact their progress on the economic dimension is not much below that of Romania; the continued instability in the region and the shadow it casts over democratic practices is no doubt the explanation – in all of these hypotheses reform progress must not be interpreted as economic liberalization alone, but must account for democracy status as well, because the EU places such great weight on this. Consider finally the fourth hypothesis: negative stance of the EU (use of a ‘stick’) in a country with strong demand for membership, induces acceleration of progress. Several cases of this sort have been described earlier, and need only be recapped here. Latvia and Lithuania were not put into the first wave with Estonia, and this ‘stick’ clearly was taken seriously by the leadership and led to accelerated efforts to comply with EC concerns expressed in annual Progress Reports in the years 1996–99. It worked, as the EC began to soften its stance in 2000 and eventually consented to include them in the first wave. Analogously, Slovakia was dropped from the first wave after the Méciar government undertook some regressive steps especially on democratic rights. In the 1998 election, the opposition stressed EU membership as an important campaign issue, and interpreted the veiled signals in EU Reports as


saying a democratic win could bring Slovakia back on track. This greatly contributed to the opposition’s eventual victory and consequent policy retracking. Analogously, the long period of withholding a membership offer from Croatia also contributed to the election victory of the opposition forces in 2000 and the almost immediate warming of relations under Prime Minister Mesic. To some analysts all of this is too sophisticated by half, and many suggest one can cut through the dynamics of this courtship game and the arguments about greater or lesser commitment to a liberal vision with one word: geography. Though this has been addressed earlier, it again merits attention to understand what geography can and cannot tell us. The attractiveness of geography as a simple and powerful explanation is understandable. All of the countries that have been or will be included in the EU, and have been pulled to it by some interplay of their own desires, philosophical commitments and European on–off offers, are undeniably geographically close to Western Europe. All of the countries given the cold shoulder and/or showing little credible commitment are much farther away. Though this last point is now made more debatable after the decision on Turkey, one cannot deny the broad validity of proximity as an explanation. The simple distance measure also turns out to work very nicely in econometric analysis of post-communist evolution, as for example in an early work of Fischer, Sahay and Vegh (1996) explaining growth performance, where the distance from Brussels was a very powerful and statistically significant variable. But this does not satisfy analytical curiosity for two reasons. First it implies a very rigid historical-geographic determinism with little room for policy choice; why bother with all of the analysis, discussions and resources devoted to designing policies in the countries close to Europe? No policy recommendation automatically follows from proximity, and it is easy to point out exceptions where equal proximity leads in very different directions. Is Albania and Moldova that much farther away from its European neighbours than the Baltic states? No, but they went very different ways, including the first two not getting the warm European welcome that the Baltics did. It is essential to understand the much stronger Baltic commitments and implementation of policies in order to know why they went different ways despite equidistance. The second reason distance does not satisfy as an explanation is that kilometres tell one nothing about the behavioural mechanisms through which proximity influences attitudes, commitment and policy choice. The geography approach only begins to take on weight, help understand events, and – not least important in social science – result in sensible recommendations for policy, when such mechanisms are explored in detail. Fortunately, this has been done in the study of transformation by many analysts – typically political scientists rather than economists. One recent study provides a succinct example of the way in which the analysis can be made satisfying and useful. Kopstein and Reilly (2000) go well-beyond showing that distance from the nearest large European city (Berlin and Vienna are


the two chosen) has strong and significant explanatory power in regression for economic and democratic freedom. They peel back the first layers of the onion to investigate how proximity enhanced diffusion of knowledge and attitudes, creating a composite variable of ‘openness’ comprised of measurable elements including television-ownership, newspaper-circulation, international telecommunications, inbound tourism, FDI, and trade. Greater proximity gives greater trade, FDI and so on, but its diffusion is also multiplied by greater availability of communication modes. This already allows one to understand that the much earlier opening-up of Poland and Hungary mattered a lot, as did the Estonian’s ability to watch Finnish television well before 1989. Further layers are peeled to reveal that not only does proximity to Europe (or contiguity more usefully) give positive liberalizing impetus, but, symmetrically, the contiguity of Kyrgyz Republic to others in Central Asia may give the opposite impetus – which is a possible way of understanding the eventual deterioration of the liberal start undertaken there by a visionary leader, President Akayev. Even deeper layers are explored, for example with the explanation that in Hungary EU proximity and strong membership prospects did not automatically determine all policy. Internal politics provided a strong consensus against foreign ownership of land, but the inevitability of this under EU requirements was understood by all sides and was in the end reluctantly accepted. In summary, EU membership clearly played a very large role in determining the rapidity of initial reform actions, in the pace and steadfastness of political and economic liberalization, and on the final outcome after about 15 years. But it is imperative to emphasize that the dynamics of this were not a straightforward relation of the EU inviting a country to membership and thus motivating the progress. The EU invitation came in varying strengths, it came sometimes earlier, sometimes later, it came as reward for self-generated liberalization in some countries, and it was very effectively withdrawn and used as a stick to herd-in strays. But, also, it was not a force unto itself, but was intertwined with the internal push to liberalization which was higher the greater the degree of a non-aggressive national vision, and the greater the commitment of society and its leaders to the dual liberal vision.

Appendix: EU membership as a factor in political and economic reform in the Baltic republics The prospect of EU membership has provided the Baltic republics with a strong incentive to economic, political and administrative reform in the post-communist period. However, this incentive has not been equally strong throughout, nor has it been equally strong in all three countries. Table A7.1 shows the timing of formal events in the process. Prospective membership became much more important in the reforms of Estonia, Latvia and Lithuania only after the signing of the Europe Agreements (Association and Accession agreements) in mid-1995. Prior to that, the republics had made only preliminary attempts to approximate their socio-economic structures to

226 An Ex Post Transition Paradigm that of the EU member states. After the signing of Europe Agreements, a more systematic approach was undertaken in each instance. Furthermore, even prior to 1995 Estonia dedicated more resources and was more advanced in its efforts to obtain membership in the EU than were the other two republics. Thus, while all three have declared their desire to work for EU membership even prior to gaining firm signals from the Union on the viability of such expectations, real internal efforts commenced only in the second half of the 1990s, intensifying with each new achievement. This Appendix documents these efforts and illustrates the differences between countries and between time periods. It draws heavily on Basta (2004b).

Estonia On the ideological level, Estonia was as dedicated to integration with the Western economic, political and security organizations even before gaining independence in 1991 as were its Baltic counterparts. Membership in the EU was part of this strategic (re)orientation. Presidents of Estonia, Latvia and Lithuania met in June of 1993 to sign a joint declaration calling on ‘EU countries to initiate negotiations concerning the granting of associate member status to the three Baltic states’ (Bleiere (1999), p. 50). In the case of Estonia, this initiative was accompanied by the public statements reiterating the importance of integration with the EU as part of a guarantee of the country’s security23 (Park (1995), p. 33). Although the request was not granted, the EU indicated the conditions for the signing of Association agreements, including the harmonization of legislation in line with that of the EU (Bleiere, op. cit). On a number of accounts, Estonia took EU countries as role models for reform. One needs to be careful, however, not to overinterpret the Estonian government’s actions as being motivated exclusively by the prospect of membership. Rather, many reform packages may have been informed by EU legislation because Estonia had little in terms of its own legislative heritage and experience to draw upon. For instance, Estonia’s legal reform starting in 1991 drew on the laws of Germany, Austria, the Netherlands and Denmark (Pisuke (2001), p. 192). Pisuke concludes that new Estonian legislation was modelled on national laws ‘of the EU Member States or the states (Austria, Finland, and Sweden) who were in the stage of approximating their laws with EC law at the time that Estonian laws were being drafted’ (ibid., p. 194). The latter might be taken to mean that Estonia wanted to prepare for membership even without any assurances that membership was likely and that this is why it took laws of current and prospective EU members as a template for reform. On the other hand, these same countries would seem to be logical models for emulation as it is, since Estonia wished to attain their level of prosperity and efficiency. Furthermore, it is possible that both reasons played a part simultaneously. However, it is unclear which consideration or combination of considerations had primacy in decision-making. What is clear is that Estonia implemented institutional provisions aimed at preparation for EU membership, and approximation of legislative and administrative frameworks of the republic to those of the Union, as early as 1993. In December of that year, the government established a working group ‘to review issues concerning Estonia’s possible accession to the European Union and to prepare the corresponding documents’ (ibid., p. 196). The working group included government bureaucrats, members of parliament and academics. It outlined a theoretical foundation for Estonia’s reforms in line with EU legislation (ibid.). The establishment of such a forum by the government with EU membership in mind is something that was, as far as this author has been able to ascertain, present only in Estonia, not in Latvia and Lithuania. Beyond this, the government adopted a resolution for the establishment of a system aimed at

Safe Havens for Market Reforms 227 coordinating the inter-ministerial activities related to potential accession to the EU. This took place in December of 1994 (ibid., p. 197). Although the resolution failed to be implemented, it signals the early dedication of Estonia to the adoption of EU laws even prior to the signing of the Accession and Association Agreement. Estonia signed the Europe Agreement with the EU on 12 June 1995, together with Latvia and Estonia.24 This Agreement, although not ratified until 1 February 1998,25 was a clear signal by the European Union of its intent to seriously consider Estonia as a potential member. The systematic efforts to approximate Estonian laws to the Acquis Communautaire (AC) took place after this date. Beginning in January 1996, Estonia established the institutional system devised to facilitate approximation of national laws to those of the Union (Maniokas (1999), p. 125). The following is a point-form representation of that system: ●

●

●

The Ministers’ Committee (or European Integration Committee) comprised of key ministers and in charge of setting the general policy principles (Pisuke, p. 198). The Council of Higher Civil Servants, comprised of members of most ministries and the Bank of Estonia, coordinating inter-ministerial work related to issues of European integration (Pisuke, p. 198). It furthermore elaborates and implements policies related to the EU and it prepares meetings and drafts decisions for the Minister’s Committee (SIGMA 1, p. 22). Office of European Integration coordinates the activities of the above two organizations, arranges for information exchanges with the European Commission, coordinates technical assistance and trains public officials in EU matters, and monitors progress on approximation of national laws with the AC (Pisuke, p. 198).

However, individual ministries have the responsibility of complying with EU legislation in their area of activity (ibid., p. 199). According to Maniokas (1999), this is the distinctive feature of Estonian EU-related organizations (p. 125). Having established the institutional infrastructure, the Estonian government adopted the first Activity Plan for Joining the European Union on 6 June 1996 (Pisuke, (2001), p. 201). The February 1997 Activity Plan was devised for the purpose of the implementation of the European Commission White Paper which outlined the steps that applicant countries needed to implement in order to be considered for membership (ibid.). Like the other two Baltic republics, Estonia was subsequently subject to careful scrutiny of the European Commission, which requested regular reports on, and then produced regular reactions to, the progress of each of the countries. As a result of this process, the Commission decided in 1997 to open accession negotiations with Estonia.26 The EU’s influence from that point on was increasingly more direct and explicit. Like other applicants, Estonia had to meet the demands of the Commission, or face the postponement of the accession date (Beselaere (1999), p. 79).

Latvia and Lithuania As already mentioned, Latvia and Lithuania did not initiate the institutional reforms as early as Estonia. Indeed, Latvia devised a systematic foreign policy as late as early 1995 (Pabriks and Purs (2002), p. 124). In his study of reform of Latvia’s legal system, Levits (2001) mentions vaguely that the reform ‘in the direction’ of conforming to EU quality standards of public administration and court system was begun in 1993 and 1994, but that it was ‘flagging’ from 1995 to 1999 (p. 184). Again, as in the case of Estonia, it is difficult to ascertain whether such reform was driven by the need for what were perceived as proper legislative arrangements solely on their own merits, or whether the intent was to impress upon the EU the desire for membership. Certainly,

228 An Ex Post Transition Paradigm this author has found no evidence of a government-initiated institutional framework for the approximation of Latvian laws with those of the European Union prior to the 1995 signing of Europe Agreements between Latvia and the EU. Latvia established the institutional framework for approximation of legislation to the Acquis Communautaire in 1995, and the following is a point-form schematic representation of that framework: ●

●

●

The European Integration Council is an inter-ministerial body comprised of the relevant ministers and headed by the Prime Minister (SIGMA 2, p. 23). Council of Senior Officials, acting as a preparatory body for the European Integration Council, first met in February of 1998. It provides the ‘interministerial framework for dealing with EU co-ordination’ (ibid.). European Integration Bureau is an administrative unit providing policy and administrative support to organizations involved in the integration process. Furthermore, it is in charge of the preparation of the National Programme for European Integration (SIGMA 2, p. 23). This body has been part of the organizational infrastructure since 1995 (Maniokas, p. 124).

The Latvian Cabinet adopted the Latvian National Programme for Integration into the European Union in December of 1996 (Levits, p. 185). However, despite the more focused efforts on behalf of the Latvian government to satisfy the so-called Copenhagen Criteria of the EU,27 the Commission’s opinion on Latvia’s application for membership left it, together with Lithuania, out of the next round of accession negotiations. The stated reasons for the postponement of negotiations were the perceived incapacity of both countries’ economic sectors to cope with the competitive pressures of the single market (Bleiere, p. 51). Lithuania differed somewhat from its Baltic neighbours in its approach to integration into Western institutions. Namely, while it was in principle as dedicated to membership in the European Union and integration into Western institutions as the other Baltic republics, its relationship to Russia was initially more amicable than in the case of Latvia and Estonia. In his treatment of the subject, Thomas Lane (2002) cites numerous examples of this. Before the actual dissolution of the Soviet Union, Russia formally recognized Lithuania’s independence on 29th July 1991, referring ‘uniquely’ to the ‘annexation’ of 1940 as the legal basis of this recognition (Lane, 2002, p. 200). Furthermore, although politicians of all hues agreed on the necessity of extracting the country from Russia’s sphere of influence, ‘there was general agreement on the need to maintain good neighborly relations with Russia’ (ibid.). Efforts in this direction yielded the most favoured-nation status with Russia in November 1993 (ibid., p. 201).28 Lane furthermore emphasizes that although Lithuania continued reorienting its trade towards the West, especially the countries of the European Union, ‘it was widely accepted that [economic relations with the West] would not completely displace Russian markets and supplies’ (p. 202). Thus, early on, Lithuania’s foreign policy efforts were divided between cooperation with the West and the East.29 This could explain in part the reasons behind the apparent lack of urgency in conforming to the EU Copenhagen criteria in the early 1990s. Like the other Baltic states, Lithuania, too, modelled its legislative reform on the legislative systems of the EU member states. For instance, Lithuania’s law on Principles of Accounting, passed in 1992, was in line with EU company law (O’Rourke (1995), p. 121). However, as in the above cases, it is difficult to establish whether this was merely a case of legislative and policy learning or a matter of trying to increase the chances of EU membership in the future. The institutional framework for the approximation of

Safe Havens for Market Reforms 229 national legislative and policy structures to those of the Union did not exist long before the signing of the Europe Agreement. Lithuania’s system of EU-related institutions was established a month before the signing in 1995 (Maniokas, p. 125), and the following is a point-form outline of the system: ●

●

●

●

The Governmental Commission of European Integration, established in 1995, is the institution in charge of the strategic direction of Lithuania’s EU integration. It develops the ‘basic principles of the integration policy pursued by the government, and … [coordinates] and [supervises] the activities of the ministries and government agencies in this field’ (SIGMA 3, p. 25). Chaired by the Prime Minister, it is comprised of key ministers in charge of the integration process (ibid.). The Delegation for the European Union Pre-accession Negotiations is an interim interdepartmental entity in charge of coordinating the work of the departments in preparing Lithuania for membership. It is comprised of senior public sector officials and related persons. It was established in 1997 (ibid.). The Ministry of Foreign Affairs establishes policy guidelines in the integration process, coordinates economic policy development in line with EU criteria and is the liaison between Lithuania and the EU (ibid.). The European Committee under the Government, established in 1998, ensures the implementation of the National Programme of the Adoption of the Acquis Communautaire, and the Institution-Building Programme (ibid.).

Just like with Latvia, Lithuania’s negotiations for accession were postponed by the Commission in its 1997 opinion. In addition to having been considered poorly prepared for the competition of the single market, both Latvia and Lithuania were found to have had an inadequate administrative capacity to implement the Acquis.30 However, the postponement provided a strong impetus for further reform to both countries. As Bungs (1998) states, ‘within weeks, however, the Latvians and Lithuanians were back at work, striving with even greater intensity than before to raise their countries’ standing vis-à-vis the membership criteria’31 (Bungs, (1998) p. 13). The eventual full compliance with the EU criteria has led to the membership for all three Baltic republics in May of 2004.

Conclusion The prospect of EU membership has had significant impact on the course of political and economic reform in the three Baltic republics. However, this influence was much more explicit and easily discerned in the aftermath of the 1995 signing of Europe Agreements, and especially in the aftermath of the 1997 Commission opinions on the membership applications, and the decision to open negotiations with Estonia. In the pre-1995 period, the influence is less clear. Although there is evidence that all three states used EU member states’ legislation as a template for reform in various sectors, it is not clear whether this was because they wished to put pressure on the EU for membership, or whether it was due to the lack of indigenous knowledge on how to organize democratic polities and market economies. Certainly, it is possible that both considerations played a part. However, no definitive evidence is available in the existing literature to make a proper assessment in this matter. What is clear is that Estonia was the only state systematically preparing for EU membership negotiations even before having signed the Europe Agreement, having initiated the development of institutions to coordinate the approximation of domestic legislation to that of the EU. That all three countries have eventually completely reformed their administrative,

230 An Ex Post Transition Paradigm legislative and economic systems in as little as a decade is a testament to the power of the EU membership prospects in the post-communist era.

Table A7.1 Contractual relations between the EU and the Baltic republics up to 1995 Estonia

Latvia

Lithuania

Establishment of diplomatic relations with the European Communities

27 August 1991

Signing of Trade and Cooperation Agreement with the EC

11 May 1992

Free Trade Agreement signed with the European Union

18 July 1994 (entered into force 1 January 1995)

Signed Europe Agreements

12 June 1995

Applied for EU membership

24 November 1995

27 October 1995

8 December 1995

Source: Commission Opinion on Estonia/Latvia/Lithuania’s Applications for Membership of the European Union. Accessed at europa.eu.int/comm./enlargement/candidate.htm

Part III A Summing Up


8 Future Prospects for Captured States

A fork in the transition road ‘Forecasting is very difficult – especially for the future.’ Mark Twain The 27 post-communist countries have diverged considerably in their progress towards open markets and democracy, but the two dimensions which have perhaps the greatest implication for future prospects are the degree of oligarchic development and the potential for EU membership. These dimensions in fact overlap closely. One group in Central Europe, the Baltics and some of South-East Europe have either already achieved membership as of May 2004, or are in the process of negotiating accession in the near future. Most of them overcame strong rent-seeking and state-capture risks early on, while others like Bulgaria, Croatia and Romania are well on the way to reversing such effects. The transformation in these countries is for all practical purposes complete, any final refinements of market and democratic institutions being more or less assured as EU standards kick in. Their future economic problems are those of middle-income emerging-market economies, plus all that is associated with working in a new enlarged EU. The remaining countries in South-East Europe have been provided a conditional offer from the EU without a clear time-horizon, and while they face the challenge of continuing to move forward in their transformation reducing any remaining state-capture elements, they do this with a strong beacon to motivate the political consensus and the clear guidelines of the Acquis. For them the transformation is not over by any means, but the light at the end of the tunnel is strong and almost certain to grow stronger year by year. The future for these two groups is fairly clear even if not assured, as it rests within the sphere of EU integration and accession. It will not be explored in any greater detail here. It is in the third group one finds the most important and interesting issues, and of course uncertainties. With the possible exception of Ukraine, the 12 countries of the CIS face a zero or low prospect of EU accession in the 233

234 A Summing Up

foreseeable future, and have become burdened with an oligarch class that dominate the economy and to varying degrees have captured the polity. For them, the central issue is whether the transformation is for now slowed down or temporarily stalled, or whether it had been frozen in a politicaleconomy equilibrium somewhere between plan and market, between socialism and capitalism, no longer a communist dictatorship but far from a liberal democracy. Three of these countries, Belarus, Turkmenistan and Uzbekistan, are clearly much closer to the original starting point of a communist regime, and their future is much too uncertain to permit useful discussion of prospects until a radical change in leadership occurs. It is therefore the nine CIS countries with moderate but significant progress in transformation that form the focus of this chapter. For them I propose the most useful and critical aspects of discussions or debates (as they have already started) can be grouped under two schools of thought. The first argues that once a minimum of stabilization, market liberalization and privatization is achieved, further progress in transition is inevitable (TI); indeed, it will also help eventually in furthering democratic processes. The second takes a conditional view of this inevitability, arguing that where the reform process allows vested interests to build up quickly and benefit from rent-seeking opportunities of partial liberalization, they acquire a concentration of state assets in an opaque privatization and become what is popularly known as the ‘oligarchy’ which captures governance of the state. Their interests are not to liberalize or democratize further, rather exactly the opposite; the transition is frozen (TF) into a capitalist but not competitive economy and an autocratic polity perhaps in superficial disguise of a voting democracy. The arguments pro and con for these two views are explored in the next section. This is followed by a discussion of the consequences for a country where transition is in fact frozen by vested interests, and a final section will consider what policies might be undertaken to overcome the equilibrium of frozen transition and to free the captured state. One of the theoretical possibilities, a new revolution to overthrow the oligarchy, has become quite realistic, as already three instances of Gandhian non-violent people-power have materialized: Georgia, Ukraine, Kyrgyz Republic. While in all three cases it is much too early to understand well these episodes – not to speak of declaring success – the ‘Revolutions of Colour’ can be usefully analysed in the context of the Navigation Model.

Is further transition inevitable or is it frozen? The theoretical arguments The TI view is more than a simple optimistic assessment on the future behaviour of oligarchs, or a mechanical ‘critical-mass’ argument that private ownership and market rules have passed a threshold and are irreversible. It has a much deeper economic logic. First, it argues that the critical mass of private

Future Prospects for Captured States 235

interests and market mechanisms has reduced the power of the bureaucracy so much it no longer threatens continued liberalization. Second, the new private interests, in particular the big capitalists or oligarchs, now want to secure the rights to their property and will begin to demand good ruleof-law, transparency and so on. Thus, for example, Shleifer (1997) argues ‘Russia’s experience shows how privatization, combined with equity incentives for insiders, transfers control rights from the bureaucrats and stimulates political and economic pressures to protect property rights.’ Aslund makes the same case that ‘the strength of capitalists is essentially a liberalizing force’ (1995) because ‘capitalists want to be independent of bureaucrats and safeguarded by a system of law’ (1997). Many have extended this logic to a demand for democracy; thus, Aron (2003) sharply criticizes the jailing of the head of Yukos, Mikhail Khodorkovsky, stating that ‘oligarchs can help advance the cause of democracy’.1 These views often lay behind the arguments for privatizing rapidly and early, even at the cost of using ‘insider co-opting’ approaches, as for example in Boycko, Shleifer and Vishny (1995): ‘the main contribution of large scale privatization is to jump-start the demand for institutional development’. Gaidar was a very forceful proponent (and of course implementer) of the need to break the overweening power of the state and bureaucracy by rapid and substantial privatization, and to overcome what he called the deeprooted historical ‘eastern’ vision of private property (always) being subordinate to the state and its bureaucracy. However, Gaidar was not necessarily in agreement with the prediction that new capitalists could soon demand better institutions. Indeed, he worried as early as 1994 whether Russia was ‘moving into a free and open Western-type market, or into nomenklatura capitalism’ (Gaidar, 2003, p. 82), and worse that a renewed desire for a ‘firm hand’ was leading in the direction of the traditional strong state in the ‘eastern’ mode (p. 109). In that caution he seems to lean towards the TF arguments. A similar ambivalence is reflected in Buiter’s (2000) article. On the one hand it provides one of the clearest expositions of the argument based on the Coase proposition that efficiency only requires unambiguous assignment of property rights, and the derived implication that all capitalists want such transparent property rights law. On the other hand it expresses great concern about the ‘predation’ seen so far and is sceptical that there is a goodwill by oligarchs now that privatization is done to press for a future of ruleof-law in Russia and other CIS states.2 The efforts for oligarchs to become legitimate and gentrified are clearly increasing, as exemplified by the recent comment of Vladimir Potanin of Russia: ‘We want to be normal and socially acceptable. Let us pay our personal taxes and show how much money we spend on sponsoring culture.’3 This is consistent with the TI prediction that once they have ‘stolen’ enough (or all there is), oligarchs wish to normalize their status enshrining property

236 A Summing Up

rights. But such gentrification is also consistent with maintaining enough political influence to prevent full liberalization with open entry for new, small capitalists who receive equal treatment from governments and the legal system. Most of the TI arguments are made in reference to Russia, but they clearly apply to all countries where a concentrated ownership and formation of a few powerful capitalist groups has occurred. The World Bank (1996), in its first review of transformation progress, on the one hand expresses the same caution as did Gaidar about the process of such accumulation, but on the other hand elaborates in a more positive tone the ideas of further development of good institutions in response to the demands for secure property rights. The hopeful tone of the 1996 Report is not repeated in the 2004 study of Russia’s privatization and the concentrated ownership structure that has resulted.4 The counter-argument of the TF view can be put most simply as follows: capitalist-oligarchs will demand general improvements in rule-of-law not out of benevolence but only if that is what gives the optimum outcome for their profits. In the current circumstances of oligarchs in captured CIS states, there are many reasons to believe that the optimum for them means a continuation of the status quo. Some, such as Barnes (2003b), argue that privatization opportunities still exist, hence oligarchs still prefer a nontransparent environment for the near future. But the substance of the TF argument extends beyond this, for even when all is privatized there are substantial rents to be obtained by the large and influential oligarchs; for example, Puglisi (2003) in an interview with the head of Neftehaz Ukraine, learned that the additional profits to be made from their unique privilege of buying gas below world prices were as much as a third higher. The historical evidence of the Chapter 6 Appendix makes clear that around the world, over time, there is considerable value to the rent-seeking efforts of ‘entrenched vested-interests’ in economies at different stages of development. As long as there are rents or excess profits to be had, it makes most sense to analyse the behaviour of the entrenched post-communist oligarchs as a choice to be made trading-off the benefits of secure property rights in a transparent rule-of-law environment, against the benefits of continued rents from lobbying and influence in a non-transparent environment. In that context, the TF views agree with those of the TI school that there are benefits for oligarchs from improved rule-of-law, and if these benefits are large enough they will indeed demand such improvements. The TF views, however, deny that this is automatic. A number of recent theoretical analyses of this trade-off have been undertaken and, though the mathematical models developed show that the choice can go in either direction, their authors first point out that the automaticity of the TI school’s predictions is not theoretically justified, and second tend to lean in the direction of the TF school that for the near-future it is more


likely that oligarchs would choose to continue the status quo. Thus, Polischuk and Savvateer (2004) show that the more unequal ownership, the more likely that the choice goes in the direction of the status quo; the evidence suggests ownership is in fact highly unequal. They conclude that ‘some wealthier agents would prefer a hybrid equilibrium with informal procedures and rent-seeking opportunities [my italics] to the market one and thus would resist secure property rights’. Their model also shows a very important result that the status quo – where oligarchs retain their privileges, competition is restricted and property-rights security does not prevail – can be an equilibrium state and can continue for some time contrary to the predictions of the TI school. Sonin (2003) goes even further by including in his model the possibility that security of property rights can be bought individually rather than provided as a public good. The very rich can buy a lot of such security, hiring guards for their physical property (which is no small deterrent in such an environment even against unfriendly government inspectors), hiring the best lawyers, buying out high-level bureaucrats and politicians. Doing this, rather than pressing for rule-of-law as a public good, means not having to give up the privileged position of protection from competition. Sonin thus comes to a result that, for a long time to come, the trade-off will not lead to oligarchs demanding rule-of-law, but rather to support for a non-competitive and non-transparent status quo. The strength of Sonin’s variable – purchase of property rights – is surely even greater when one thinks of the combined effect of oligarchs in collusion going beyond specific narrow acts of lobbying for individual privileges, to the broader notion of state capture and control of electoral outcomes and powerful influence on general policy direction. An important and pioneering contribution to the TF school is Hellman (1998), who confirms the fears that privatization which coopts, politically and financially, powerful individuals by giving them a quick and low-cost insider access to privatizing assets, did indeed result in a concentration of assets that would be inimical to further liberalization. He underlined a paradox in the matter: from the mid-1990s, the strongest and most effective opposition to further reform in many CIS countries came not from the losers, the population which felt the pain of unemployment and lower living standards, but from the ‘winners’, the new capitalists benefiting from a non-transparent and generally inequitable transfer of state assets.5 A key conclusion of Hellman’s article is that these oligarchs have the ability to capture the state and ensure its policies are favourable to them and not to open, competitive markets. A small qualification is in order concerning support for reforms. The new capitalists, unlike the soviet bureaucracy, were far from categorically opposed to all economic reforms. Havrylyshyn (1995a and b) recounts the history of what they favoured and what they opposed. They enthusiastically supported Gorbachev’s perestroika efforts which legalized private activities,

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such as the 1988 Law on Co-operatives, and continued to favour freeing markets and privatization of state assets, even the general liberalization of most goods other than energy and raw materials. They were happy to see only a quasi-liberalization for the latter, as the wedge between still-controlled and world prices on such key goods became a major source of the first large accumulation of wealth. They were also not opposed to the continued fiscal support for state firms as most of the new private entities were implicitly connected to them and could easily practice transfer pricing which siphoned off funds to the private firm. Nor did they oppose the monetary looseness of cheap credits to help enterprises keep paying their workers but often joined in the chorus of demands for such ‘socially-oriented’ policies. To them, the high inflation this generated provided yet another form of capital accumulation allowing borrowing at negative rates of interest.6 By the time they had accumulated very large amounts of wealth however – about the mid-1990s – they reversed position on inflation which would in the long-term undermine growth prospects and kill the goose that lays the golden egg. But they continued, perhaps even more forcefully, to oppose further economic liberalization which could lead to growing competition from newcomers, domestically and externally. The historical evidence of non-transition economies Powerful economic interests influencing governments in their own favour is not a ‘monopoly’ of the post-communist states, but is historically widespread, as summarized in the Appendix of Chapter 6. This historical experience is, unsurprisingly, adduced by proponents of both the TI and TF schools. The former, for example, will sometimes describe the Russian oligarchy as a passing phase analogous to that of the Robber Barons in the USA. In Chapter 6, I have already noted how the oligarchs differ from these and from East Asian crony capitalists, who accumulated their first wealth by value-added activities, as Krueger (1999) notes, rather than privileged access to privatization of state assets. Where there is a similarity, the historical lesson favours the TF conclusions: powerful entrenched interests resist liberalization rather than support it. Both the theoretical rationale for this last proposition and considerable historical evidence is to be found in overview studies of entrenched interests or powerful incumbents such as in Rajan and Zingales (2003b) and Morck, Wolfenzon and Yeung (2005) summarized earlier. An application of the historical lessons for transition economies by Durnev, Li, Morck and Yeung (2004) is worth citing at some length: There is thus a potential danger that some transition economies are in transit from communist dictatorship to economic dictatorship by a small clique of politically well-connected, entrenched insiders. Once installed the elite undertake further rent-seeking to lock in the status-quo. This rent-seeking aims to limit outsider’s property rights, public investor’s


rights transparency, and openness to the global economy. It induces capital misallocation and therefore slows growth. It seems likely that a lack of upward economic mobility for latecomers should also result though there is no evidence for or against this at present. The present author finds arguments such as the last much more realistic and more compelling than those of the TI school. Certainly, the historical evidence of how powerful capitalists have behaved in market economies does not lend support to the proposition that their post-Soviet reincarnations will want to gentrify and therefore begin to demand a generalized improvement of property-rights institutions. The Robber Barons, or Latin American tycoons, did not yield up their power willingly, but had it reduced by external pressures of populist government policy, or financial crises catalysing deep structural reforms. Today, the difference between the captured post-communist states and others is not of course that the latter are free of corruption, powerful entrenched capitalists and government lobbying; the phenomenon has and will continue to exist everywhere. The real difference is that the degree of the oligarch power is so much more than elsewhere that it becomes a difference in kind. More precisely, restating the points made in Chapter 6, government lobbying by large firms typically involves selected actions when an issue is on the government agenda affecting that particular firm. However, as Nissinen (1999) notes for Latvia, ‘they have neither the interest, the time nor the resources to try to influence the general directions of policy’. Captured states are different in that the oligarchs there do have the interest, the time and the resources to influence the general directions of policy up to and including colluding on efforts to determine election results. The election of Putin in 2004 is clouded by the fact of his disfavouring some of the oligarchs while having the support of others, and of the populace seeking the stability of a strong hand. The election of Ukraine, with its egregious and in the event much more transparent manipulation and fraud, provides a clear example where the candidate of the incumbent party-in-power was supportive of and supported by virtually all the major oligarchs.7 Empirical evidence of frozen transition Both the TI and TF schools make predictions of what will happen next in the captured states, and only time will tell which is more correct. However, there are already indications of the choices being made by the oligarchs at least to the present TF position. In Chapter 4 three testable hypotheses related to the debate were posited: ● ●

●

A high level of state capture freezes or slows transition. Large firms tend to be much less supportive of liberalization rule-of-law than are small and new firms. Large firms generate less efficiency improvements and innovation than do small and new firms.

240 A Summing Up

Transition progress indicator, 2004

The first two are explored below, while the third is discussed in the next section under the rubric of growth prospects in captured states. The first hypothesis can be found very early in the literature. Both Havrylyshyn (1995a) and Hellman (1998) argue that new powerful capitalists at first support reform progress, but at some point further reforms will, by reducing distortions (recall Figure 6.1), begin to reduce their rents. At this point they will attempt to ‘freeze’ the reforms as this maximizes their profits. The statecapture index (SC) compiled by the World Bank for 1999 (SC 99) and the annual TPI measures of reform progress of the EBRD permit a simple test of the hypothesis broadly illustrated already in Fig. 6.7. Some further statistical refinements are given here. As noted in Ch. 6, some of the SC99 values might be questioned. The later estimates of ‘corny bias’ (Kaufman, Kraay, and Mastruzzi, 2003) do in fact put Armenia much higher up the scale and Croatia much lower (though Kazakhstan remains low and Slovakia high). As before, one can test for the consistency of statistical results by making adjustments for outliers or excluding them. In Fig. 6.7 all available data is used; Fig. 8.1 sets the values for Armenia and Kazakhstan at 0.25, and those for Croatia and Slovakia at 0.20 for reasons given earlier. The statistical fit is subtantially stronger with R2 rising to 0.720; if instead the four countries are simply excluded, the R2 rises even higher to 0.793 and despite the smaller sample the statistical significance remains high. Indirect supportive evidence for this hypothesis is also to be found in numerous studies describing the process of privatization in the region,8 the ways in which insider-favouritism was likely to lead to much greater 4.5 HUN ESTCZE POL

4 3.5

SVN

SVK

BGR

LTU HRV

3

ARM KAZ

ROM GEO

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MKD ALB

KGZ RUS MDA UKR BIH YUG

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2 1.5 y = 2.4736x + 3.9725 R2 = 0.7201

1 0.5 0 0

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0.2

0.3

Figure 8.1 State capture leads to frozen transition

0.4 0.5 0.6 State capture index, 1999


concentration of ownership in a few hands,9 and the subsequent ways in which these powerful owners could use their influence to reinforce their position. The most thorough such analysis is the World Bank 2004 study of ownership accumulation, concentration and consequences in Russia. It identifies the 23 largest Financial–Industrial groups (FIGs) and lists the names of 36 individuals as the major shareholders, a list quite similar to that found in Barnes (2003b). The study estimates that at a minimum they control 35 per cent of sales in the entire economy, and perhaps as much as 60–80 per cent in the key sectors of autos, metallurgy and energy. The degree of such control is unparalleled elsewhere, except perhaps in the other captured states of the region where such a thorough estimation remains to be undertaken. The second hypothesis posits that small, medium and new entrepreneurs are more likely to support liberalization and even-handed rule-of-law than large oligarchs. This is not new to transition, and as Aslund and Johnson (2004) outline is based on Olson’s 1971 theory of Collective Action (represented with application to post-communist countries in Olson (1993)). If there are very few small firms, there is no incentive for anyone to lobby the government for a public good shared by all, and each is too small to get the sort of insider privileges an oligarch can. Once the group becomes large enough it can form coalitions to lobby governments for their interest. For each small entrepreneur the goal of profit maximization is the same as for oligarchs, as is the wish to have less competition. But while the oligarch can reasonably expect success in efforts to restrict competition, a large number of small entrepreneurs cannot and can only work to establish the public good of fair and transparent laws to ensure no-one is given more privilege. As of now, the extent and political power of small and medium-sized enterprises (SMEs) in captured states remains very small; Aslund and Johnson (2004) estimate that while in Central Europe this has now reached levels where 50–60 per cent of GDP is produced by SMEs as in the industrialized countries, it is only about 20 per cent in CIS countries. Thus, it is far too small to have much impact even if their efforts are devoted to support improved institutions. Are they? A number of quantitative studies of voting behaviour in transition economies provide the closest approximate test for the hypothesis. While to my knowledge no evidence exists correlating support for better rule of law by small enterprises or efforts against competition by oligarchs, the voting pattern analyses do show that the strongest supporters of reform-oriented parties and liberalizing policies are indeed SMEs.10 The third hypothesis is discussed below under the rubric ‘Growth Prospects’. On balance, the theoretical, historical and direct empirical evidence in transition countries tends to be much more consistent with the TF view. Where does the TI proposition err? Certainly not in the theoretical concept of Coase-theorem market efficiency and the values of secure property rights for all capitalists small and large. As described in Buiter (2000), if there arises a demand for good institutions there will indeed be a supply response from

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the government and the society. But the reality on the ground in captured states is that so far, and for the near future, there is no evidence of such a demand coming from the oligarchs, and there is evidence that small entrepreneurs, who may demand this, are too powerless as a group, for now, to achieve results.

Consequences of a frozen transition If transition is indeed frozen for this group of about 10 states, what are the consequences for their further evolution? I consider here four dimensions: enlargement of the SME sector; institutional development; growth prospects both in the short and long term; and the prospects of future EU membership. Enlargement of the SME sector In a captured-state equilibrium where powerful oligarchs can influence even the general direction of policy, their interests would likely result in a much less favourable environment for small and new enterprises. Competition restrictions would continue, the legal environment would not be very transparent, consistent or even-handed, and SMEs would face greater burdens of taxation, bureaucratic harassment and the need to engage in bribery. In fact such effects prevail already in the relevant countries. As noted, the sector remains very small in the CIS countries, accounting for only about 20 per cent of GDP compared to the 50–60 per cent norm of advanced market economies; the latter norms have incidentally been reached by now for many Central European and Baltic countries (see Aslund and Johnson, 2004; World Bank, 2002). How far behind the CIS group of countries finds itself is dramatically pointed out in Frye (2003) and Frye and Shleifer (1997): Poland, with a much smaller population and economy, already by the mid-1990s had six times the number of registered SMEs than did Russia. The importance of this for development of civil society and a political force for improved rule-of-law cannot be overestimated; the World Bank (2002) not only discusses this linkage, but suggests that historically a critical mass of about 40 per cent of GDP is needed before the political weight of this sector begins to be felt. If the transition is frozen, the continued growth of SMEs may not be halted, but it will certainly be slowed, and reaching the critical mass may require not years but decades. Actual tax payments by SMEs appear to be higher than for large enterprises as indicated in many survey results for these countries (EBRD Transition Reports 2000, 2003; the 2002 World Bank study; an IFC 1999 study for Ukraine). In Ukraine, for example, the average tax load was 30 per cent of gross sales. In addition, the ‘bribe-tax’ businesses are forced to pay in order to be in business is also much higher. The rate for small firms in all transition countries is on average 5.4 per cent of sales, twice the 2.8 per cent rate for large firms. In the CIS states, subject to greater state capture, figures are even


higher, as much as 8 per cent of revenues and in effect ‘a third or more of their profits’.11 Parallel to the higher tax and bribe payments, SMEs face much greater bureaucratic harassment, time-costs of dealing with inspections, amorphous and changing regulations. It is reported in Kaufmann and Kaliberda (1996) that for small enterprises senior management spent an extraordinary 18 per cent of their time dealing with government officials. On lack of consistency, Puglisi (2003) cites a business consultant in Ukraine: ‘nobody plans long into the future … you may start by playing chess, then in the middle of the game you find you are playing basketball or football’. The bureaucratic burdens, bribe costs and changeable rules, rather than the formal tax levels, are widely agreed to be the main reason behind the large increase of underground economic activity in many CIS states, even beyond the high levels in the Soviet period. Kaufmann and Kaliberda (1996) and Feige and Urban (2004), as discussed in Chapter 2 Appendix, amply demonstrated the very high levels (50–70%) and the predominance of harassment as the reason for going underground. Most analysts attribute the poor environment facing SMEs to the fact of oligarch interests and influence on policy. Hellman and Schankermann (2000), in the key article reporting on state capture, make this link explicit and explain the higher burdens for SMEs noting ‘the interaction between firms and the state is rooted in a bargain that is tailored to the … bargaining power of the individual firms’. Ronnas (1996) describes how SMEs ‘are likely to be most affected by poor law enforcement [while]; large enterprises are usually able to fend for themselves’. That this discrimination is not simply an expression of the will of the government is argued forcefully in Puglisi (2003): ‘Political power allowed … big business to shape the rules of the market to fit their own preferences.’ But not all analysts agree. In a paper arguing compellingly that SME development is critical and recommending a simple lump-sum tax to stimulate it, Aslund and Johnson (2004) attribute the discrimination against SMEs to government policy and outside advisors like the IMF, the World Bank and OECD, which insist the same rules should apply to enterprises of all size. They also note there is no direct evidence big businesses who have captured the state want to block the development of small enterprise, and make two contentions: small and large businesses operate in different sectors, hence do not compete with each other; and Ukraine managed to liberalize small business operation at the height of oligarchic rule in 1998. On the first point, can one really expect to find direct evidence of the oligarchs’ actions to reduce competition? That they currently operate in different sectors is not necessarily evidence of good intentions by oligarchs, it may in fact be evidence of the contrary, that oligarchs are restricting competition. The last point about Ukraine’s SME liberalization deserves more elaboration. It may be questioned just how great this liberalization was compared to the desired end goal. The EBRD’s value for the index of competition policy,

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which covers this area, shows for Ukraine a steady 2.0 from 1995 to 1999, a modest rise to 2.3 ( 2 in the EBRD Reports) and no further change since then. But, more important, some SME activity is not only unpreventable by oligarchs and their government captives, but it is desirable for them to have a small SME sector to demonstrate good will, and indeed to divert attention from the oligarch dominance.12 Corruption has become a four-letter word in the international community, and even the most corrupted and captured government has reacted by establishing anti-corruption laws, agencies and campaigns. To make the practice of anti-corruption appear credible, there must be enough small and medium-sized business to inspect, raid and prosecute on occasion, otherwise government would have to attack the large firms.13 For a captured state this serves as an excellent diversion from the high level of corruption which is formally legal, but nevertheless results in a huge legal diversion of state revenues by rent-seeking oligarchs. Institutional development There appears to be universal consensus in the literature on the proposition that promoting SMEs is also good for institutional development. Aslund and Johnson (2004) may or may not agree that oligarchs try to block small business, but are unequivocal in the view that the most important effect of a stronger SME sector ‘is to change the political equilibrium, creating a powerful force for further institutional improvement’. The wider literature on institutions has for a long time expressed this consensus, but also frequently pointed to the very different interests of large and small business. In the classical work of North on institutions and economic development in a long historical perspective, he states clearly: institutions are not usually created to be socially efficient, [but] are created to serve the interests of those with bargaining power to create new rules. (North, 1990, p. 16) The role of institutions in the development of a liberal and market economy, as well as democracy, has been much analysed by North and others and, as Chapter 1 discussed, was a big part of the debate on how to undertake the transition. It has come back into fashion as the ‘missing link’ not only in understanding the transition, but also the stubborn inability of many poor countries to take off on a sustainable growth path. In one such recent analysis, Acemoglu, Johnson and Robinson (2004) provided up to date evidence of how important institutions are, describe the history of their development in different parts of the world, but admit they are unable to provide an easy recommendation of how to put them in place where they remain weak. Laar (2002), the first Prime Minister of Estonia, in a book describing a successful transition including quick institutional improvements, comments on


a failing case, Russia, and its strategy of quick privatization to insiders: reformist politicians … were convinced that by giving the market economy a chance, businessmen involved in making improper deals would suddenly become proper businessmen involved only in honest business. It was also assumed these businessmen would soon support the government which had given them the chance to get richer. This was a grave mistake. The newly wealthy were the first to stand up against the policies [of the reformers] and opposition from industry to the further liberalization of the economy … was now blocking reforms. This was actually still a minor problem. The attitude had even more serious consequences because it slowed the construction of civil society.14 A more powerful statement of the frozen transition argument cannot be imagined, and more authoritative practitioners than Laar are few in number. The critical role of small business elites in ‘forming the backbone of civil society’15 goes back to Weber if not earlier, and so too does the counterposing of interests of the large and small entrepreneur in this regard. That oligarch development is inimical to good institutional development has become nearly an axiom in the historical literature. Nothing appears to suggest that the cases of post-communist captured states will become an exception. Growth prospects Growth in the short and medium term may not be much impeded by the illiberal environment of a captured state, (the same point is made in Johnson and Subramanian (2005)) but the analytics of such a situation as well as the considerable historical evidence of analogous situations of dominance by entrenched big business generally point to unfavourable prospects for economic growth in the long term. Consider the long-term effects first. Other things being equal, the oligarchs doubtless prefer higher growth which extends the base from which their rents are taken. This was already seen in the mid-1990s when they switched from favouring high inflation policies to support stabilization, recognizing this would be better for growth. But things are not always equal, and as Engerman and Sokoloff (2003), two well-known economic historians reviewing the role of institutions in the long-run history of economic growth around the globe conclude: ‘elites may prefer policies that raise their share of national income even if they reduce long-run rates of growth’. The circumstances under which such a trade-off may arise for economic elites are precisely the ones elaborated in great detail in the preceding discussion: a more competitive, open, transparent environment leads to more efficiency, innovativeness, productivity improvements and hence higher long-run growth; but more distortions raises the share of the elite’s rents. The lack of open competition and the uncertainty of property rights, under the non-transparent institutions that prevail in a frozen transition, impede a healthy SME sector from emerging and operating. This

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is already noted by many in the relevant transition economies: ‘Insecure property rights are the most important barrier to sustained growth, entrepreneurship, and private sector development’.16 That large entrenched business entities are less likely to be innovative and highly productive was long ago recognized in the non-transition literature. This is summarized in the recent review work of Morck, Wolfenzon and Yeung (2005): ‘growth is lower where inherited billionaire wealth is larger as a percent of GDP’. In transition countries there is already considerable evidence from econometric studies of firm behaviour after privatization pointing to a strong consensus consistent with the above, and indirectly consistent with the third hypothesis derived in Chapter 4, that is the link between state capture and the freezing of transition: oligarchs, like all monopolists, prefer easy rent-seeking to the more difficult work of seeking efficiency improvements. The general conclusion of numerous firm-level studies is that all privatized firms are better than state firms in productivity, higher growth and job-creation, but that these effects are strongest in the following order: new firms, small firms, large firms, still unprivatized firms. In parallel, crosscountry studies show that the gains from privatization are greatest where the degree of competitiveness and quality of institutions is highest.17 Buiter (2000) also expresses concern that the predation which led to state capture inhibits secure property rights and thus depresses capital formation and growth in the long run. In the same vein, Yavlinsky (2003) makes a poignant plea for battling the oligarchy, a plea firmly planted in simple economic theory of competition: ‘the larger and more influential the group, the greater are its opportunities to deviate from the universality principle of the business climate and fair competition’. In the short run, however, it is quite possible for oligarchic captured states to experience surges of growth. Since about 2000, the fastest growing economies in the post-communist world are in fact those with highest state capture indices, providing the basis for an important counter-argument on the impact of oligarchy on growth. Shleifer and Treisman (2004) correctly note that the crony capitalism of East Asia coincided with ‘some of the most rapid growth ever seen’. For Russia, they point to the timing of the sharp output decline before the oligarchs emerged and the rapid growth after. The timing of facts is correct in all cases, but the simple ‘post hoc’ causation implied is arguable. For East Asia’s unquestioned miracle many empirical studies have found that the major driving force was not productivity improvement, but very high investment ratios.18 This does not gainsay the real growth and its real benefits, but it speaks to the long-term sustainability of high growth under crony or oligarch capitalism. In the case of the recent recovery with East Asian-like growth rates, it is a bit of a stretch to attribute this only to the dynamism of the big new companies and their new investments. Chapter 2 discussed the various factors that jointly explain this surge of growth and the new confidence of domestic business of all sizes to invest,


risk and expand is undoubtedly part of this. But so too are other elements of luck and good policy: a natural bounce-back from the bottom, oil prices, devaluation, macro-stability, and minimal threshold attainment of structural reforms. The fact that oligarch companies have contributed to this growth does not tell us if this is proportionately more or less than SMEs, not until more studies are done to determine whether the productivity improvement effects vary by size of firm, and how. The recent performance does make clear that in the short and medium term it is altogether possible for captured states, like other economies which suffered from entrenched incumbents (for example Latin America), to have periods of high, even very high, growth. This may depend more on the underutilized potential of the economy than on the degree of capture or entrenchment. But the recent strong performance in no way assures a continued strong performance in the long run, indeed the historical evidence points in the opposite direction. Future EU membership For Russia the issue of future EU membership is arguably irrelevant; as the nominal inheritor of the USSR superpower status, its nuclear arsenal, and an uncertain but continuing regional power position,19 means it does not wish such membership and the EU will not initiate such an idea. The most likely aspirants in the foreseeable future have been noted earlier and will not be discussed specifically here. Rather, the issue is for those that may have a nonzero probability, what will the frozen transition do to that probability. The answer is surely to reduce the chances, because both the demand for membership by the country and the offer by the EU will be lower. On the demand side, the reasoning has been outlined in preceding chapters (see the discussion of Figure 4.3) and is succinctly captured in Wolczuk (2004): ‘entrenched business interests would oppose the greater openness and transparency that would come with [EU-mandated] changes’.20 An indication of such attitudes is seen in Ukraine, under Kuchma, both in the vagueness and ambivalence it displayed on membership (recall the analysis of Kuzio, 2003) and the more direct statement of disinterest and preference for the Single Economic Space concept a few months before the 2004 presidential election. The reaction of the EU itself is a mirror image: the less competition, the more oligarch dominance leads to halting or even reversing liberality in markets and polity, the less welcoming will the EU be to any entreaties for membership. This behaviour by the EU is already observable since the mid-1990s, when it used the stick of delaying membership for Slovakia, Bulgaria and Romania, then re-tracking them a few years later as these countries returned to the path of liberal righteousness. The EU’s continued reluctance to give positive signals to Ukraine as the political environment became less and less liberal, and its parallel criticisms of these developments, are also evidence of a negative response to a frozen transition.

248 A Summing Up

Can anything be done to free the captured states? If a country is ‘captured’ by powerful economic elites or oligarchs and a frozen transition prevails, what policies could one recommend to the government? It may be an oxymoron to speak of recommendations to the government of a captured state on how to unfreeze the transition; after all, the government that is captured by powerful economic interests may be unable and/or unwilling to change the status quo. But the grip of oligarchs – even in today’s post-communist captured states – is not that complete or irreversible, nor the institutions so solidly frozen as to render the situation hopeless. The Rose Revolution in Georgia in 2003 and the Orange Revolution of Ukraine in 2004 clearly demonstrate the opportunities for quick change – and slow underlying change is surely even more possible. Whether the changes made are quiet and slow or more rapid under a political ‘revolution’ of some appropriate colour,21 it may be useful to group the recommendations into three: ●

● ●

to reverse the most offending privatizations and take away the power of the oligarchs; to restrict the power of the oligarchs by anti-monopoly regulation; and to promote the SME sector by policies of open competition, easy entry, fair and even-handed institutional development.

In addition, time may bring internally generated changes that could reduce the power of oligarchs, and these too need to be considered. Finally, a revolution of people power, as may have happened in a handful of cases, could also unfreeze the transition. These five points are considered in turn. Reverse privatization It is certainly possible to reverse the cases of privatization that were most egregious and led to the overwhelming power of a few dozen individuals, but it is a risky approach despite the popular support it may evoke from the mass of the population. First, it risks being not what it appears, but simply the transfer of assets from disfavoured oligarchs to newly or more favoured ones. The vastly popular Russian action to jail Khodorkovsky and punish Yukos with ‘back-tax’ penalties large enough to threaten bankruptcy seems so far to be an isolated action not affecting the operations of the remaining two dozen dominant Financial–Industrial Groups (FIGs) except to impart the lesson that FIGs cannot ignore the authority of government. The nontransparency of a captured state hides well the possibility that the relations between the government and the majority of the oligarchy remain as before, with the interests of the two being nearly indistinguishable or at least highly overlapping. In one interpretation the Yukos affair is a small correction of


the general tendency, intended to reduce the excesses of consumerist and financial greed of the oligarchy, and rebalance towards ensuring the state has enough resources to carry out its tasks of stability. Mid-2005 is too early to tell either way, and the action may indeed be the start of deeper changes which truly will reduce the ability of oligarchs to virtually control government policy. In the more recent Ukrainian Post Orange Revolution case of reviewing the privatization of Krivorizhstal, great care will need to be taken to avoid the analogous appearance of punishing the oligarch, Rinat Akhmetov, who supported President Yuschenko’s opponent. In particular, any action must avoid a result in which some of President Yuschenko’s supporters (‘lesser’ oligarchs like Mr Poroshenko, Ms Tymoshenko or others) in any way benefit from the resale. The second risk is that any renationalization sends a confusing signal of the freedom of private activity and security of property rights: is this a sincere attempt to counter the power of oligarchs, or is it a manifestation of what Gaidar feared in his 1994 book, another historical reversal to the ‘eastern’ dominant state which is the final, and arbitrary, arbiter of property rights. The uncertainty this creates for producers and investors, including foreign ones, is not good for the economy. A limited number of reversals, for the most egregious insider transactions, can be done and give good results, as long as the process is very strictly legal, transparent and seen to be just, in the sense of rendering justice to the nation and not just revenge by those newly in power. Restrict power of oligarchs It is certainly necessary to have in place and forcefully apply anti-monopoly, insider-trading and minority shareholder rights regulations to limit as much as possible the excess profits and insider deals that reinforce the power of the oligarchs. But the problem is not one of legislation or formal institutions, but of enforcing these regulations without the political influence that very large interests can apply. The US anti-trust climate did not bring results overnight as has been discussed, and that was in an economy where an influential small business class already existed; in the CIS captured states it does not, hence its additional political pressures to ensure regulators do their job as per the regulations is missing. Quis custodiet custodies (who regulates the regulators) continues to be a problem in the most institutionally advanced polities; in the captured states of the post-Soviet region the phrase has to be capitalized in bold. There, the risk obtains of continued arbitrary favouritism as with privatization reversals, enhancing the signal of confusion about property rights for all property owners, large and small. Small business may, as individuals, feel some satisfaction with actions to punish some oligarchs, but the general lesson they draw from this reinforces their mistrust of the state apparatus: if they are willing to do this to some of the big guys, imagine what they can to do to me!

250 A Summing Up

Promote the SME sector by easing its bureaucratic burden The critical role of the SME sector, as a forceful part of civil society and a political counterweight tipping the balance towards liberalizing policies, is virtually universally cited in the literature on transition, the history of institutional development, and growth prospects. I return below to the possibility that it will increase on its own even under the difficult conditions it faces in lagging reformers or captured states. Here consider the specific policies that might be implemented. The preceding analysis of what these impediments are directly leads to the recommendations: lower tax-burden; simplified regulations (the lump-sum tax proposal kills both these birds with one stone); ease of entry of new firms; reduced bribe-seeking harassment by tax, health and safety regulations; and, most important, fair and even-handed security of property rights under the law. The more of these impediments are removed, the faster one might expect to see small enterprise evolve and increase its share of GDP. At the same time, it may be the case that improvement on one of these dimensions is minimal and offset by worsening in another – that is, less frequent inspections but higher bribes each time – and the overall impact is negligible. If the lump-sum tax does not lead to worsening of other burdens, it may make a difference. Also, the phenomenon has been studied sufficiently to indicate what aspects have the most effect, with the consensus saying that complexity and unpredictability of government regulations is more important than the actual financial burden. Thus, the simplicity of the lump-sum tax rather than a lower level may be what matters most. The question remains whether a captured government can or is willing to follow these recommendations. There is some hope that the oligarchs find it hard to publicly oppose measures of improved operations for private activity, hence any remaining autonomy of politicians and policy-makers might be used to weasel in a few gradual changes to ease the operations of SMEs. Certainly, any leverage that foreign actors have to insist on continual improvements of this sort should be used to move as far as possible in that direction. But international organizations must be extremely careful here to avoid being captured as well and agreeing in a financial programme framework to partial changes that seem to be cumulative but are in fact devices containing the sort of offsets noted above. Such episodes provide no benefit and only cast doubt on the intentions of these organizations. Arguably, the strongest such case is the loans-for-shares episode in Russia, or the privatizations of local energy companies in Ukraine after 2000. Time will heal some wounds The contentions of the TI argument that time will correct the inequities and institutional shortcomings of insider-privatizations may not on balance be convincing, but it is not entirely without merit. Some individual oligarchs will be the exception to the rule and seek to change their personal goals from further accumulation of wealth to nation-building and favourable future


recognition in history. It is of course far too early to see clear evidence of this. But could Russia’s Mikhail Khodorkovsky be sincere in his support for the very liberal parties of Russia, and is it for this he is being punished? Could Yulia Tymoshenko, a key supporter of the liberal reformer Yuschenko in Ukraine, be sincere in her claims that she is not interested in regaining her earlier economic power as the ‘Gas Princess’, but wants to work to democratize Ukraine and counter the dominant power of its oligarchs?22 Can the ‘gentrification’ of Potanin and other Russian oligarchs lead to a gradual reduction of their enormous power? Time will tell, but if it is not these, there will surely be some who enjoy a Pauline conversion on the road to Zurich and the Cayman Islands. Other oligarchs, in fact probably many, will want to move from notoriety to perhaps a philanthropic reputation. But this is less likely to be a fully sincere conversion, as tax laws will probably provide incentive, as well as simple personal ego requiring some good deeds that may return a notional profit in opening other opportunities. More effective will be the cases of going global to increase the operation and/or to improve access to low-cost international financing. Just one example is described by Gerth (2004): the efforts of Vagit Alekperov, CEO of Lukoil, to establish a beachhead in the United States. At a minimum, this will begin to force such companies to attain international standards of accounting, reporting, and minority shareholder treatment (I hope not Enron standards!). The reference to Enron is partly serious – there is much such companies can do to create the appearance of new legitimacy without seriously undermining the power of the incumbent controlling interests. Furthermore, it is not clear that the attaining of such global standards will do much to reduce the ‘state capture’ behaviour domestically in the near future. The greatest effect of time passing is likely to come eventually with a steady and even, if slow, build-up of the SME sector. Despite the impediments they face, small business operators continue to expand and grow in numbers, and only the near-Soviet conditions that prevail in Belarus, Turkmenistan and Uzbekistan might halt or freeze their development. High growth rates in the CIS countries are the driving force, as is the hope that conditions will change and their opportunities open up even more. Just as every MBA graduate wants to be a CEO, so too every small entrepreneur in the region wants to become at least a lesser oligarch with tens of millions if not hundreds of millions of worth. The more of this competition there is, the less likely there will simply be a replacement of present oligarchs by other individuals, and the more likely the power of the oligarchy breaks down, for the various reasons adduced earlier. But such a natural evolution of small business, in a captured state environment without any major policy efforts to help them, may be inevitable but very slow, taking not years but decades to reach the critical mass when they become an effective political counterweight to the influence of oligarchs.

252 A Summing Up

Revolutions of colour Until December 2004, the only reasonable possibilities for loosening state capture by oligarchs comprised marginal and gradual effects. With the dramatic events of the Orange Revolution in Ukraine, the unthinkable became almost conventional as occasionally happens to turn the direction of history. While the colour revolution in Ukraine was not the first on the palette, being preceded by that of Serbia in October 2000 (no colour was affixed) and Georgia’s Rose Revolution in November 2003, Ukraine’s size, strategic importance and massive popular participation fixed the world’s attention on the the power of the ‘demos’ as a systematic prospect. Though reference to Gandhi has not often been made, the historical similarity of non-violence and massive participation is striking. As this is being written in spring 2005, popular analogies are also being drawn with Lebanon, Palestine and elsewhere outside the post-communist region. These are well-beyond the scope of this book, but the March 2005 events in Kyrgyz Republic (Tulip Revolution) are surely within the same category. So, too, are the quieter rumblings in Moldova, Belarus and elsewhere in the group of captured states. It is early days to discuss the success of these revolutions in breaking the state capture by oligarchs, except possibly in Serbia where one could say ‘so far so good’.23 It is even more premature to speculate on the prospects of such revolutions spreading to the other states of the region. Here I propose to focus briefly only on the connection between the navigation model and these people-revolutions. Does the logic of the model lead naturally to such people-power actions, or are the latter in fact contrary to the model’s predictions? Tentatively, I suggest a case can be made both ways: there is a systematic causal relation from the model to these few cases of a people revolution; at the same time such revolutions seem contrary to the ‘freezing’ predictions of the model, and one should seek other forces (or simply happenstance) as explanations. Consider the latter argument: non-violent revolt by the masses seems contrary to the prediction of a frozen transition. Where state capture is most severe, the ruling coalition of oligarchs and their political satraps is far too strong to be overthrown politically. The policies of frozen transition prevent significant development of a middle class of entrepreneurs, of truly open and equal competition in the economic, or political market. The increasing value of oligarch assets and potential rents motivates them to increasingly stronger resistance to a change in regime. Given the inertial effect of Sovietperiod complacency and fear in the populace, they are able to prevent any democratic-liberal opposition from developing sufficient power. The tools are well-studied by political scientists,24 and include legitimate financial support of favoured political parties, as well as various degrees of illegitimacy through corruption of individuals, restricted access to media, voter tests and vote-rigging, purchase and falsification of votes – all the way to physical violence including assassinations.


If the captured state logic in its most rigid interpretation precludes popular revolt, what are the other factors early analysis lists as explanations? Two preliminary assessments of Ukraine’s Orange Revolution in the Journal of Democracy (2005), Kuzio (2005) and Way (2005), list the following indicative factors, also common to the other cases: ●

●

●

●

●

A catalytic political event, typically a presidential or parliamentary election with a patently distorted result in favour of the ‘non-democratic’ ruling clique. The presence of a charismatic opposition leader to rally anti-regime forces. A high degree of resentment and frustration with the economic power of oligarchs, sufficient to overcome popular complacency and lead to a universal cry ‘ENOUGH’. A minimal level of civil-society institutions, sufficient to provide vehicles for mass demonstration. A sufficiently soft authoritarianism to permit some real political opposition to exist.

The first of these, a catalytic election, has so far been a necessary condition for all such episodes and needs only one additional comment: it must be considered as a ‘necessary but not sufficient’ condition – many cases of egregious elections, such as two recent ones in Zimbabwe, attest to its nonsufficiency. The second factor, presence of a charismatic leader, one sees in only two cases – Saakashvili in Georgia and Yuschenko in Ukraine. Thus, it may not be necessary as Serbia and Kyrgyz Republic suggest, though in the former the attraction of EU membership were extremely powerful ( Judah, 2005) and probably provided a good substitute. A soft authoritarianism and some threshold level of civil society are essentially two sides of the same coin, and together with the resentment against the oligarch clique probably reflect major forces which led to the revolutions of colour. But the resentment factor is not exogenous to the navigation model, indeed, it is very closely connected. Consider how these three factors are related to the logic of the navigation model and the creation of a captured state. The first thing to note is that the egregious misconduct of the catalysing elections, that is the various distortions and manipulations, is as a manifestation of the profit-maximizing behaviour of oligarchs: they will go to great lengths to ensure the status quo.25 The oft-cited financial support to the tune of $600 million for Yanukovich by Ukraine’s number-one oligarch, Rinat Akhmetov,26 exemplifies this. The yet unproven attempt at assassination by poisoning of Yuschenko is certainly part of the public’s perception of the extreme behaviour possible to defend the power of the ruling clique.

254 A Summing Up

Furthermore, the resentment of the oligarch’s ‘ill-gotten’ gains, and even the soft authoritarianism, are also consistent with the profit-maximizing axiom of the model, when it is interpreted with some nuance. Levitsky and Way (2003) developed the concept of ‘competitive authoritarianism’ not only for transition countries but also for other developing countries. In the transition group, Way (2005) elaborates on this phenomena in Ukraine and notes two pillars for it: the use of informal authoritarian levers in a context of formal ‘competitive’ democracy; and a coalition of oligarchic forces in a symbiotic relationship with politicians. But Way may not go quite far enough, for he gives no answer to the question: why did Ukraine’s oligarchs concur with a ‘soft’ authoritarianism and not press for a harsh and secure authoritarian regime? One answer lies in the trade-off much discussed in Chapter 6. As long as their capture of the state is not threatened, a soft authoritarianism – including ‘pretend’ elections which can be manipulated – is more likely to ensure a good image domestically and in the world, provide the political and economic stability that stimulates higher economic growth, and hence maximize their long-term profits. Jumping forward to the time of actual mass protest, stability-seeking and profit-maximizing, oligarchs may have been hesitant to favour the substantial force needed to overcome mass demonstrations, though they were surely altogether prepared for minor control actions and violence in the shadows. When the levels of extreme economic and political abuse reached the tipping point between political apathy and the passions of people empowerment, the conditions for these revolutions were met and a change in regime resulted, though a full reversal of state capture and unfreezing of transition is far from being instantly achieved. Resentment was, unlike some of the other factors listed earlier, common to every recent episode of people’s democracy and was emphasized by many observers, for example by McFaul when he succinctly characterized the common element with one word ‘enough!’27 That is, a critical mass of the populace was prepared to go on the streets, risk the force of the authorities to express their view, to say enough of this abuse of power, unfairness, corruption and so on. In post-communist states that had attained a high degree of truly competitive democracy, this and other resentments were able to find vehicles of a less radical, more conventional sort. Even where oligarch tendencies had gone some way – Bulgaria, Croatia, Romania, Slovakia – sufficiently fair elections precluded the need for a colour revolution. In these cases, the role of EU membership prospects, one of the pillars of the navigation model, must not be understated. Elsewhere, where this was not on the cards, and where state capture had reached extreme levels, the opposition and the populace had only two choices: continued political apathy (fed by fear of forceful suppression), or mass demonstrations. The weight of the ‘enough’ had in these cases become sufficiently large to overcome the fear-based apathy of the past.

9 Diverse Outcomes: Liberal Societies, Captured States and Undetermined Polities

Introduction In assessing the outcomes of post-communist transformation to the present date, one should begin with the question: has the country completed the change-over from communist central planning to a liberal market economy, in a word, is transition over? The first conclusion of this book points to the wide divergence of outcomes among the 27 countries, with one group having essentially completed this journey, a middle group still short of the end-point but progressing steadily, and a third group not only farther behind but stalled at a stage of partial, frozen transformation. In the light of their new EU membership, the transition in Central Europe and the Baltics is surely over for all intents and purposes; while in South-East Europe it is clearly not over yet, though steady progress is evident. For the rest, the CIS countries’ transformation is definitely not complete in the conceptual sense of establishing a liberal economy and polity regime. But in a practical and unfortunate sense, it could be said it is ‘over’ for now because they have become trapped in an oligarchic-autocratic regime of partial capitalism and a far from matured democracy. While the people-revolutions in a handful of these countries may break open this trap, it is far too early to judge their prospects, or the possibilities of a similar development in other countries. The rest of this chapter summarizes this variation in outcome by recapping, in the next section, what happened in the course of 15 years, followed by our explanations of why transition evolved differently across the region. A final section summarizes the differing implications for future prospects and policy.

Variation in transition progress A first look at individual measures of progress such as indices of market operation, democracy, economic recovery, poverty ratios and life-expectancy 255

256 A Summing Up

trends shows a tremendous diversity of outcomes across the 27 countries. One might conclude from this that there are almost as many different outcome stories as there are countries and measures; however, it turns out that a grouping of countries into four to five categories provides a simplified yet systematic picture of the dynamics of transformation in this period. Chapters 2 and 3 have shown that five internally homogeneous groups can be identified in rank order of progress or performance in transition as follows: Central Europe, the Baltics, South-East Europe, the Former Soviet Union (FSU) countries with moderate economic reform (CISM) and those with limited reforms (CISL). This rank ordering holds for nearly all reasonable measures of progress. Using the synthetic transition progress indicator (TPI) of the European Bank for Reconstruction and Development to rank order and group countries, one finds the overlap among the groups is almost non-existent, except marginally between South-East Europe and the CIS moderate group. Most important and somewhat surprising, this measure, which was always intended to be a summary or proxy only for the economic dimension of the transformation, is highly correlated with a large number of other measures that transition scholars consider to indicate progress in transformation. The detailed analysis in preceding chapters is summarized in Table 9.1, which shows selected proxy indicators for each of six dimensions. The first two should be considered as measures of the dual economic and political transformation: progress towards a market economy as measured by the TPI, and the degree of democratization as proxied by the corruption index (CI) of Transparency International, and the media freedom index prepared by Reporters Without Borders. These three might be interpreted as policy inputs aimed at generating desirable outcomes or results in the society. The next two indicators in fact do measure results: first, economic recovery from the transitional recession using an index of 2003 output partially adjusted for changes in GDP definition;1 and social well-being as measured by the overall human development index (HDI) of the UNDP. Finally, the chart shows two important institutional outcomes: the extent to which the polity has been subject to ‘state capture’ by powerful economic vested interests (oligarchs in the vernacular); and the status of EU membership. The definitions and measurement problems for these and other data used have been discussed in great detail in the relevant parts of the book, and here it will suffice only to remind the reader of some of the key conclusions, and qualifications where relevant. The information in Table 9.1 reflects the earlier extensive analysis which concluded that the various measures of policy change (inputs) and of performance results were highly correlated, and that the rankings of the country groups were essentially the same regardless of the measure used. The only exceptions to this were the ranking of the CISL group for the index of output recovery and the HDI. If one uses official GDP with a benchmark year of

Diverse Outcomes 257

1989 for all countries, this index ranked the groups as follows: Central Europe CISL, Baltics, South-East Europe and CISM. But the use of 1989 as a benchmark for countries other than the Visegrad four cannot possibly be right, as this attributes the output declines of the late years under communism to transformation policies that did not begin until much later. Adjusting for this alone makes a big difference, bringing the ordering almost to that of other indicators, with CISL still appearing to do slightly better than CISM. Some partial adjustment for differences in GDP measurement in the communist and market period brings the ranking even closer to that of other measures, with the values shown in Table 9.1. The CISL group still does better than CISM, although even that can be questioned: it may reflect overvalued GDP due to barter trading at favourable terms; it may reflect a mere postponement of the necessary rationalization of inefficient producers; it may be simple output overstatement in official data. Most important, all other economic performance indicators reviewed such as inflation and FDI per capita distinctly rank the CISL countries last, far behind the CISM group. On the human development index (HDI), the CISL group also does somewhat better than CISM, although again the detailed analysis of specific indicators in Chapter 3 suggests the deterioration may have been more than official data show. In particular, more recent poverty ratio estimates and hence also Gini values for at least two of the CIS countries – Turkmenistan and Uzbekistan – suggest levels quite comparable to CISM countries. But even if the values of HDI in Table 9.1 are about right, the most reasonable interpretation is not that CISL countries managed the transition successfully by a gradual approach that minimized social costs. Rather, they have simply postponed the transformation and at best postponed some of the inevitable adjustment pains that all others, including the CISM, have by now largely absorbed. In the early debates, a number of important hypotheses correlating policy inputs with results were mooted. Two in particular merit attention here: too rapid market reforms threatened evolution of democracy, and rapid market reforms would result in greater social costs. Consider the first. The wellknown proposition of Przeworski, that rapid progress to market institutions and democracy may be incompatible, is directly contradicted by the data as Table 9.1 recaps: countries that have moved fastest and advanced farthest on economic reforms have seen far greater progress in liberal democracy than those that have lagged behind. This is proxied in the media-freedom indicator of Table 9.1, and was shown in Chapter 2 by the strong correlation between the TPI measure and different measures of democracy, especially Figure 2.2 using an index of constitutional liberalism. The prediction of Przeworski that rapid implementation of economic stabilization and liberalization policies would be unpopular, and lead to early governments losing elections to more populist governments favouring gradual transformation, was only partly borne out. In many Central European

258

Table 9.1 Key indicators of transformation outcomes

CE

TPI 2004

Democracy ● Corruption index 䊊 Media-freedom rank

3.7

● 䊊

Baltics

3.7

● 䊊

SEE

3.1

● 䊊

CISM

2.9

● 䊊

CISL

1.8

● 䊊

Economic recovery ● 2002 GDP 䊊 FDI per capita

5.9–3.6 11–33

●

5.5–3.8 11–17

●

3.9–2.3 34–59

●

3.0–1.8 73–148

●

Uzbekistan 2.4; others n.a. 151–158

●

䊊

䊊

䊊

䊊

䊊

HDI ● 2001 䊊 Change

134 $2,300

●

105 $1,640

●

83 $470

●

76 $340

●

104 $170

●

䊊

䊊

䊊

䊊

䊊

State capture index

EU membership

845 .030

15

5 acceded in May 2000; Croatia high prospects

822 .010

11

All 3 acceded in May 2004

772 .020

24

Bulgaria and Romania high prospects; others distant but feasible prospects

737 .035

30

Most virtually no prospects; Ukraine a possibility since Orange Revolution

760 .010

n.a.

Zero prospects

Notes: TPI EBRD transition indicator 2004; the corruption index is taken from the latest values from the 2004 listing on the Transparency International website; the media-freedom rating is from Reporters Without Borders (2003); Economic Recovery lists the index of GDP where 1989 100; and Table 3.1; FDI is from Table 2.3, HDI human development index, as described in Chapter 3, with the second value being the change in HDI from 1990 to 2001; the state capture index is as in Chapter 6.


(but not Baltic) countries, former socialist-communist parties returned but, surprisingly, most of these second governments modified the policy only marginally if at all. The reasons could be many but include most importantly the following: more populist parties were as convinced of the need for change as the first governments and were only electioneering to get into power; all parties had the same vision of the EU membership goal, which meant necessarily steady progress towards the market. These two motivations are impossible to disentangle and both are part of a strong commitment to market reforms and liberal democracy, the ‘dual liberal vision’. Another aspect of this is that the countries which delayed their economic reforms and moved slowly – countries south and east of those Przeworski analysed – did not do so in concordance with his implied sequencing, that is for the sake of first establishing democracies and then proceeding to economic liberalization, but to a large extent as a delaying tactic to allow the former nomenklatura time to reorient itself to the new game of capitalism. The end-result was slow progress on both fronts or, worse, development of oligarch regimes in which a short period of democratic progress was followed from the mid-1990s by reversal toward autocracy. This phenomenon is considered further below under the rubric of state capture. Consider the second major hypothesis on the effect of rapid reforms upon social well-being. Recall the intense debate discussed in Chapter 2 on the speed and intensity of reforms. Those proposing a gradual and one-step-at-atime approach were primarily motivated by concern for the social costs to the population that would result from a sharp adjustment in the highly inefficient socialist enterprises. The prediction was that greater suffering would come from more rapid reforms. In fact, the evidence does not support the prediction and is strongly suggestive of the very opposite proposition: the earlier and faster the reforms were imposed, the smaller the costs and the faster the recovery of well-being. It is certainly the case that Central European and Baltic countries which moved most rapidly not only experienced minimal social costs, but even these were more than recouped by the end of the decade. There are two alternative interpretations of the data that may still support the original gradualist argument. First, some argue it is not the level of TPI achievement today that defines rapid v. gradual reformers, but the intensity of the initial ‘shock’ of stabilization. Thus, countries like Hungary and Slovenia might be categorized by some as gradual reformers, while Russia and Kyrgyz Republic as big-bang cases. This is somewhat of a red-herring; true, as Chapter 5 has demonstrated the first two did not leap forward in the first years, while the second two indeed did see an initial leap. But this leap was soon aborted and they moved to a stalled and even reversed trajectory of the TPI index, while Hungary and Slovenia never wavered. Why did they not jump quite as fast as did Poland, Czechoslovakia and the Baltics? Because they started so much farther ahead in 1989 there was less need for an immediate big-bang effort.

260 A Summing Up

The second interpretation of data favourable to the gradualist position has been that within the CIS, the three countries that moved much more slowly – Belarus, Uzbekistan and Turkmenistan – have maintained their social wellbeing better than the CISM with faster reforms. As already noted, updated information of such social indicators casts doubt on such an interpretation; these countries may have fared a little better on such measures as lifeexpectancy and income distribution than did the extreme cases in the CISM group like Russia, but they did so at the expense of no progress on transformation, simply a postponement. Furthermore, they did no better than the above average CISM performers. One last conclusion on outcomes merits emphasis in this summing-up concerning EU membership status and state capture. EU status is shown here on three levels: attained membership, on-track for membership, and very low prospects for future membership. State capture is measured by the World Bank survey described in earlier chapters. It is evident that the ranking of progress in transition is much higher the higher had been the early prospects in the quest for membership. Similarly, the greater the progress on transition the lower the degree of state capture. What does this imply about cause and effect? For the previous measures, the broad implication was that the faster the progress and the higher the achievement on transformation of the economy and the polity, the better the performance on economic and social indicators. In the case of EU and state-capture status, the causation is not so simple; indeed it is the central analytical proposition of this book that the policy choice on reform strategy, EU membership goals and prospects, and the risk of state capture by rent-seekers, are interrelated in a circular causation which can lead either to a virtuous circle or a vicious one. This issue is addressed in the next section. But first consider again the question ‘is transition over?’ in somewhat greater detail. For Central Europe and the Baltics transition is essentially over, save for a few minor refinements in legal and institutional regulations that were not fully completed at the time of EU accession, but were allowed short delays. Of this group, only Croatia is not yet an EU member, but by mid-2004 a Europe Agreement was signed, and accession negotiations are likely to start soon and proceed quickly. By all indications, it must now be thought of as a middle-income market economy rather than a transition regime in most regards. A small exception is on privatization where it is slightly behind the others in this group: Croatia has about 65 per cent private-sector share in GDP, the others are typically at 75–80 per cent or even more. A notable exception on the opposite end is Estonia, where even infrastructure like public transportation and utilities tends to be more privatized than in Western Europe. South-East Europe has two sub-groups. Bulgaria and Romania are far ahead of the others, and the only ones in this region to have essentially completed negotiations of Acquis chapters. Of the two, Bulgaria has been distinctly


more dynamic in its reforms since the financial crises of 1996–97. All indicators of progress show that by 2003–04 it compared well with the countries at the lower end of the Central Europe–Baltic group, while Romania has been moving forward at a more deliberate pace. Nevertheless, the pull of EU-accession negotiations, which by early 2005 were virtually complete for both, provides optimism for a rapid catching-up in both countries. The others in SEE have fallen behind for various reasons, including continued civil instability, and with less certain vaguer prospects for EU membership their progress is less assured. Macedonia may be particularly unfortunate in this regard, as the spillover effects of the Yugoslav Federation breakup and the Kosovo conflict have greatly impeded economic reforms. On the EBRD index, it was well-ahead of both Bulgaria and Romania until the mid-1990s (reflecting its advanced start as part of the Yugoslav Federation), but by 2003 despite some modest progress fell far behind both of the leaders in this region. But even these countries have at least a positive albeit vague indication that membership may be possible. Nine of the CIS countries are well-advanced on market reforms, but nevertheless they are far from the degree of market, and even more so democratic status, one might consider as a completed transition. While a form of capitalism thrives in these countries with private-sector GDP shares at least 55 per cent and in many cases 65–70 per cent, the market economy is not an open competitive one, but one dominated by very large often monopolistic entities and a very low share of small and medium-sized enterprise activity. Market and legal institutions are far from conducive to new small entrepreneurs challenging the giants. Evenhandedness and transparency of regulations and legal actions are overshadowed by insider influence-peddling and rent-seeking behaviour of large politically connected entities. This state of affairs has come to be labelled as a regime of economic oligarchs who have captured the state, not only profiting from insider privileges, but largely controlling its economic policies and political nature. Paradoxically, one can at the same time say transition is far from complete in these countries, but also that it is for all practical purposes ‘over’ because it has reached a politicaleconomy equilibrium that is unlikely to allow further liberalization in the near future. Finally, there is the small group of three CISL countries – Belarus, Turkmenistan and Uzbekistan – where transition has barely started, and where the economic regime has not changed much from the Soviet period. In all cases the degree of privatization remains very low with a share of GDP at 25 per cent in the first two and 45 per cent in the third. As of 2003–04 all scored extremely low on the EBRD index of market development, though there were differences in the time-path of market reforms. Turkmenistan has taken very few steps towards a market economy since independence. Belarus made a modest leap forward until Lukashenka became President in 1996, and reversed these achievements over the next four years. Some modest

262 A Summing Up

liberalization, partial privatization and macroeconomic stabilization took place since 2000, but even that fell short of the progress marked in the preLukashenka years. Uzbekistan’s initial reforms were even bolder and within the context of its ‘Industrial Policy’ strategy were until 1996 comparable to those of some modest but gradual reformers like Ukraine and Kazakhstan. But while the latter subsequently accelerated their transformation efforts, Uzbekistan’s leadership began to worry about losing control in a more privatized and free market economy and slowly reversed many of the liberalizing measures. In these three countries transition is best described as barely begun. A useful way to sum up the outcome of transformation across the region is to describe four regime types now prevailing in the post-communist countries. These four coincide closely but not precisely with the five groups used throughout this book. While there is a clear geographic bunching, the underlying criteria for these groupings are far more important than geography: the extent of liberality in both economic and political dimensions. Liberal societies At the more successful end of the transformation spectrum, one finds at least eight or more countries that have steadily developed a functioning market economy with open entry and considerable competition, and in parallel an increasingly liberal and transparent democracy. They have largely avoided the development of an oligarchic concentration of power strong enough to influence state policy and election outcomes, although they were like all market economies subject to lobbying by economic interests seeking protection or privilege. They comprise at a minimum all three Baltic states, the Czech Republic, Hungary, Poland and Slovenia, and by now Slovakia and Croatia. The last two for some period in the 1990s had been subject to some captured-state tendencies, but these are now being overcome. Bulgaria and Romania also experienced this intermediate phase, but have begun, albeit more slowly, to move in the direction of liberal economies and polities. For all of these countries, the degree of advancement to a liberal society is also reflected in better performance of most economic and social indicators. Also significant is the parallel fact of eight countries having achieved EU membership in the May 2004 first wave, with two to three others (Bulgaria, Romania and perhaps Croatia) on-track for the next wave. Captured states At the less successful end of the spectrum are several countries with a high degree of concentrated ownership in a few hands; that is, a very powerful ‘economic oligarchy’ which has captured state policy and has overwhelming influence on election campaigns and their outcome. Russia, Kazakhstan, Azerbaijan, Moldova and Armenia are in varying degrees in this category, as


are for now Georgia, Ukraine and Kyrgyz Republic, though they may be moving away from this status since their revolutions of colour. Serbia was certainly in this category during the Milosevic years (but not Montenegro as it was able to conduct an independent and generally very liberal economic policy, even within the ‘union’), but now appears to have moved at least into an intermediate group (described below). Tajikistan has not yet undergone enough evolution to be easily classified and may be in this group or the intermediate group. Economic and social indicators in this group, while not necessarily the worst among transition countries, have until recently been on the lower end of the scale. The recent surge in economic growth has been impressive, but given the low points reached during a decade long recession, these countries are still far from catching up to the leaders in transition. On democratic institutions, most of these countries reached a peak in the mid-1990s and have seen some reversal to non-democratic norms. Intermediate regimes Countries with an intermediate situation still have a considerable degree of rent-seeking and oligarchic tendencies, but generally lower than in the captured states, and in several cases this has receded in recent years. Albania, Bosnia-Herzegovina, Macedonia and perhaps Serbia are in this category, and until recently so were marginally Croatia, Bulgaria, Romania and even Slovakia for a short period of three–four years under the Meciar government. Their performance on economic and social indicators has also been in the middle range of the scale. Also very important is the apparent growing seriousness of interest in eventual EU membership, which would appear to be the main force pushing them away from the captured state type and towards the liberal society type. Lagging reformers A small group of three countries have barely moved forward from the preceding communist regime; market transformation has not gone far enough to result in any significant change in the role of open markets or even in elite power structure. Belarus, Turkmenistan and Uzbekistan are in this group, with the original communist nomenklatura and its role little changed, except for the name and its taking advantage of the spirit of the day by becoming a capital-owning class in the small margin where privatization has occurred. But all these changes are limited and the role of state guidance in the economy remains dominant. Official data on economic and social indicators suggests somewhat better performance than that of the captured-states group, but there remains a lot of controversy on these data. Some suggest these are overstated, others argue they confirm the gradualist hypothesis that one can avoid the worst of the social costs by going more slowly, still others say they simply reflect the postponement of eventually inevitable transition costs.

264 A Summing Up

Why such divergent outcomes? The central analytical thesis of this book is that the diverse transformation outcomes described above do not need elaborate explanations, but can be largely understood in the ‘navigation paradigm’ framework comprising three key factors or determinants of transition progress. The three factors which can be considered as proximate causes of the transformation outcome are: ●

●

●

The length and intensity of debate on the ‘navigation charts’; that is the reform programmes. The debate has most often been between proponents of a rapid, comprehensive approach and those advocating a gradual and piecemeal approach. The vulnerability of the government to ‘pirate raids’ on state assets and privileges by rent-seeking interests, and the subsequent development of oligarchs who capture the state. The availability and prospect of a ‘safe haven’ such as the EU, or other organizational membership which disciplines the process to ensure a non-oligarchic outcome.

The three factors are interdependent and a formal specification would comprise a set of simultaneous equations, including some exogenous variables reflecting different historical experiences and starting conditions. One obvious candidate for an exogenous variable is the prospect of EU membership, but I have argued it is not so simple; the exogenous offer of membership was limited to at most two or three countries, far fewer than the eight that have already become members and the additional three or more with very high prospects of membership before 2010. The navigation paradigm developed in this book aims to explain the differential progress in transition of different countries, and not necessarily the resulting success in terms of economic growth, democratization or other performance measures. However, as Chapters 2 and 3 have amply demonstrated, there are in fact very strong statistical correlations between the TPI and various other measures of success, so in that sense the navigation paradigm can be a building block for an explanation of performance differences as well. Table 9.2 summarizes in qualitative terms the ways in which these three explanatory factors played out to give the outcome-types observed for different countries: the ‘lagging reformers’ type is excluded since it reflects essentially no significant change. The model’s line of reasoning can be restated briefly as follows. The longer and more intense the debates on how to transform the economy into a marketoriented one, the greater the opportunities for old and new vested interests to lobby the government for the rents available in a partially reformed

Table 9.2 Final transformation outcomes and principal determinants Outcome types*

Reform debates

Proclivity to rent-seeking

Eu beacon

Liberal societies

●

●

Most had first government non-comm. or coalition, or reformed communist Privatization generally open, transparent Bulgaria and Romania renamed-communist Slovakia short period of ‘crony’ privatization Croatia somewhat greater degree of insiderprivatization

●

Almost all renamed-communist gov. Privatization generally oriented and non-transparent

●

●

Almost all rapid reformers, either advanced start and early progress or sustained big-bang Marginal: Bulgaria early efforts but unsustained; Romania always gradual

●

●

●

●

Captured states

Intermediate regimes

● ●

●

●

All but 2–3 gradual Russia, Kyrgyz, Moldova (perhaps Armenia) cases of aborted big-bang

●

Albania and Macedonia aborted big-bang Others very late and gradual

●

●

●

●

●

●

First governments generally renamedcommunist. Albania exception, very mixed but lots of political instability Privatization very mixed, but with exception of Albania late and not always transparent

●

None enjoyed a warm signal from EU, but own desire ranged from very low to lukewarm No willingness by EU to try ‘stick and carrot’ in serious way All had long-term vision of EU membership, but no expectations of early Accession EU disinterest less categorical than for CIS countries, and by 2003 slightly positive 265

* The categorization of outcome types is as given in Chapter 9.

●

Visegrad four, Bulgaria and Romania had early ‘invitations’ Baltics and Croatia had clear and strong vision, demand for membership and eventually convinced EU through reform progress In several cases, EU played ‘stick and carrot’ game effectively: Slovakia, Bulgaria, Romania best examples

266 A Summing Up

economy, and also to concentrate the transfer of state assets in a few hands; the more concentrated the new ownership the slower will be subsequent stages of liberalization and the less likely the development of new entrepreneurial activity. This is because of the vested-interest principle that capitalists prefer less competition, not more. They also prefer less transparency as this best ensures continued high profits from rent-seeking and state capture. Similarly, oligarchs may be willing to trade-off the security of property rights that good rule-of-law (ROL) provides against the benefits of rent-seeking. In a word, oligarch capitalists behave optimally when they oppose liberalization and democratization. The degree to which rent-seeking interests can be successful in their efforts to influence government policies varies, however, hence not all the postcommunist states experience the extreme degrees of lobbying that result in dominant state capture including the ability to determine results of nominallyfree elections. One of the factors working against vested interests is the strength of desire and prospects for EU membership, since this requires automatic implementation of many liberalization measures that limit the opportunities for rent-seeking. But other historical factors may play a role here, such as a radical change in government towards one that has a strong market-commitment, or a powerful and charismatic leader who leads such a directional change in the society. This is the most plausible explanation for the early big-bang efforts in Russia and Kyrgyzstan, but the reason for their being aborted and unsustained are more difficult to pin down; in Russia it was partly because Yeltsin’s commitment was a ‘heat of the moment’ phenomenon, partly because the powers of non-reformers were overwhelming. The latter factor may be the best simple way to explain the eventual stall and reversal in Kyrgyzstan, and its slippage into a captured-state mode. A commitment to some outside organization or institution, such as the EU or others, can discipline the process of economic as well as political liberalization, helping to curtail debate and get started quickly, and helping to reduce the power of vested interests. In practice, EU membership was the major such commitment to have had significant impact, though in principle membership in NATO, the WTO, the IMF, the World Bank or the EBRD all provide vehicles for disciplining reform paths and all had some influence. It is important to note that the discipline came not only when there was an EU ‘invitation’ to join, but equally importantly from the intense desire of a country for membership, driving it to demonstrate an ability to do so even without an invitation. A strong ‘return to Europe’ commitment may have been the way this effect worked in the Baltics, leading to a rapid rise in the TPI which helped overcome the initial reluctance by the EU to include them in early discussions. The interplay of these three factors involves a circular causation starting with the delay of reforms that may begin a vicious circle, or a rapid reform which leads to a virtuous circle. In the case of delays they may be partly due


to low EU membership prospects or desire, but, regardless of the reason, delay creates greater opportunity for rent-seeking, allowing rapid accumulation of wealth especially by insiders, and a solidification of such vested interests into an oligarch clique. Their desire to maintain a status quo in turn leads back to limited economic reforms and an enhancement of the power of oligarchs. The views held by oligarchs on the policy orientation of a country will not of course be openly expressed, with one possible exception, revealing their humanity if not humanness: they have often recognized publicly the extent of their political power.2 But this is not news in the history of the interactions between powerful capitalists and society, nor is it by any means a monopoly of Soviet-formed personalities, rather it is the inherent nature of capitalists. As Rajan and Zingales (2003b) show, even in the country where the degree of openness and competition in financial markets was relatively highest, the United States, the 1934 Glass–Steagall Act which did so much to cut back competition in this sector was played up publicly as having precisely the opposite purpose to curb ‘abuses in the financial system’ (p. 222). How did these three proximate causes lead to the four regime types noted above? It is easiest to deal with the last type separately and then focus on the other three. In the three lagging reformers, reform efforts from the beginning were at best very limited and even these were reversed later in the decade. With the exception of a very short period in Belarus, there was virtually no change in the ruling power structure, other than the renaming of the communist party; the commitment to deep market and democratic reforms was extremely weak, instead their leaders were more inclined to very modest reforms and some self-serving actions to preserve and enhance their positions. There was, furthermore, neither the prospect of EU membership offers nor a strong desire for such ties. All other international memberships were either unavailable or had very limited influence to push in the direction of more liberalization. None of these countries faced such a dramatic economic crisis that they were forced to seek external support from IFIs, hence even that form of leverage on policies was mostly absent. For the other three types, the interplay of the three main factors – plus others in certain cases – was not quite so simple, but nevertheless the forces are evident; Table 9.2 summarizes the cause and effect dynamics until the onset of the colour revolutions in 2004, which are treated separately later. Consider first the Liberal Societies. All but two of the countries of this type undertook early, rapid and comprehensive reforms, either with a big-bang effort, like Czechoslovakia, Poland and the Baltics, or a more moderate pace but from a higher initial level as in Hungary, Slovenia and Croatia (though in the last the progress on democratic institutions was much slower until 2000). The quick start on liberalization precluded a lengthy period of distorted subsidies, pricing and administrative regulations and thus prevented any rent-seeking activities from attaining the magnitudes of the captured states. Privatization was not neat and transparent in all cases, with insider

268 A Summing Up

preferences evident to some degree in Croatia, the Czech Republic and particularly Slovakia for a few years in the middle of the decade. Nevertheless, in all cases the degree of liberality and competitiveness in the markets was high enough to limit the damages of insider problems, and eventually corrections were made in the privatization process itself. The other two factors played an important role in curtailing the period of debate on strategy. In most cases, the proclivity to insider privileges was low as first governments tended to be very reform-minded non-communists or former communists who had probably become converted to the dual liberal vision even before 1989. This reflected a strong commitment in society for a radical turn away from communism and to markets and democracy, and a ‘return to Europe’. This alone was enough to ensure a rapid and transparent process of transformation. For several of these countries a clear signal from the EU was provided early on that they were welcome to apply for membership, and this helped cement the commitment. The Baltics did not enjoy this warm embrace immediately, but their own commitment and intense desire for membership drove their transformation so effectively that by 1995 they, too, were on the formal path to membership. These different paths show that the discipline of EU membership could come either from an offer by the EU, or a strong demand by the country even without an offer. But sometimes even a clear offer of eventual membership was insufficient to ensure reform discipline, as exemplified by Bulgaria and Romania. They can only be included in the liberal society category in recent years and this is still a marginal judgment. In the early years they were at best in the intermediate regime group, with tendencies to state capture. An aborted mini-bang for Bulgaria and a clearly gradualist reform strategy in Romania throughout kept them on a volatile path of transformation. Both were in formal discussions for the first steps towards membership, about as early as the Visegrad four, but the continuation of governments, which are best categorized as renamed communists with some democratic influences, meant their commitment to the dual liberal vision was far weaker. Consequently the EU put them on hold for many years. Until a second financial crisis in 1996–97, they were moving more in the direction of developing rent-seeking, oligarch regimes. But, since then, a turn to more democratic governments means both have become much more strongly committed to the EU vision, and more willing to accept the discipline of the Acquis. This has been especially so in Bulgaria with the victory of the Union of Democratic Forces in the 1997 election. None of the three factors by itself suffices to explain the path of these countries, and in all cases the prior history cannot be ignored as it is often part of the underlying explanation for the initial choice of reform strategy. The variety of country experiences even within this group also demonstrates that the pull of EU membership is not a simple deus ex machina force. The lack of an early offer to the Baltic states did not reduce their zeal for a liberal


strategy, indeed it may even have strengthened their resolve to show that they were as good as the Visegrad four. On the other extreme, the offer to Bulgaria and Romania was not enough to overcome the lack of internal commitment and consensus until much later. Even for some of the others with much greater internal commitment, the EU had to play a game of carrot and stick to maintain the disciplining effect. This was the case for Slovakia in the period 1994–98, Latvia and Lithuania who had been left behind Estonia until the late 1990s, and later Croatia. In the case of the Captured States, the storyline is close to a mirror image of the liberal societies. If one begins with the second factor, proclivity to rentseeking, it is clear that even in CIS countries which have eventually achieved a moderate degree of reform progress, the leadership and perhaps even society did not have the same degree of commitment to the dual liberal vision. Almost all the new governments comprised in the majority renamed communist parties, whose members could not be compared to the reformed communists in Hungary and Slovenia, but instead sought to maintain their privileged position either by preventing radical reforms or by taking advantage of opportunities to become the new capitalist class. The latter force generally prevailed and led to the choice of a strategy of long-delayed stabilization, gradual structural reforms, and non-transparent privatization favouring political insiders. This created a perfect environment for huge rents, low-cost privatization by the few, and the evolution of what is now widely recognized as an oligarchic regime and a captured state. There were some temporary exceptions to this where an early big-bang effort was attempted, but in all these cases it was either soon aborted (Russia), or insufficiently sustained to prevent reversal (Armenia, Kyrgyz Republic, Moldova). In Russia, the tendency to the oligarchy direction was not only due to insufficient stabilization and liberalization in the 1992 big-bang to close the major opportunities for rent-seeking, it was further exacerbated by an explicit privatization strategy of coopting the powerful opponents of reform by giving them privileged access to state assets. The Loans-for-Share arrangement in the mid-1990s was perhaps not intended by its reformist architects to create a group of oligarchs, but its aim to create a capitalist class that would favour further liberalization and rule-of-law to protect their new property backfired somewhat; an oligarch class that is inimical to liberality and transparency appears to be the result. EU membership as a factor in these countries was essentially Sherlock Holmes’ dog that didn’t bark. There was certainly no signal from the EU itself of an invitation or potential membership even in the long term, and very few countries made expressions of membership desire at the beginning. Those that did were clearly ambivalent and not sincere enough to accept that membership could only come on the EU’s terms. Thus, for example, Ukraine’s authorities began after the mid-1990s to express such interest, but this was not backed up by consistent political or economic demarches.

270 A Summing Up

By this time, the grip of oligarchs whose interests are not best-served by the liberalization demands of the Acquis process steered policy, and while it was easy enough to express the desire, it was much harder to follow through with the sort of demonstration effort that the Baltics had undertaken in the early 1990s. It will remain a question for academics whether a bolder initiative by the EU to use not only the stick of refusal to Ukraine, but also the carrot of an explicit (always conditional) offer – as was used in Slovakia and Romania – would have enticed Ukraine to much more substantial liberalization on both economic and political dimensions. In the case of the Intermediate Regimes (where until the late 1990s one would include Bulgaria, Romania and perhaps Croatia) the three principal determinants of the navigation paradigm not surprisingly entail a mixed picture. Some countries undertook early and rapid reform efforts, but these were not sustained; Bulgaria soon slowed its structural reforms and, more important, allowed the stabilization to fail by continuing large subsidies to state firms; Albania suffered a financial confidence crisis because of the inability to properly regulate pyramid-scheme activities. All the other countries (within SouthEast Europe) proceeded at a very gradual pace, partly due to civil conflict and political instability in the territory of the former Yugoslav Federation. The nature of internal commitment and its relation to the nature of the first postcommunist governments was also mixed. Albania was racked by continued struggles among political groupings from all parts of the spectrum. Bulgaria and Romania saw a dominance of the old power structures, but not without significant roles for new, more democratic coalitions. The former Yugoslav Republic also had considerable mixtures, starting with a continuation of the former socialist political elites, but moving to more mixed governments. Finally, the role of EU membership was also mixed. As noted, Bulgaria and Romania were in the very early group for informal discussion, while the others may have had some distant hope that their geographic proximity would put them in line for eventual membership but realism led to official silence on the matter. The EU itself was never encouraging until the most recent declarations of 2002–03 hinting at the possibility; nevertheless, it was also not as explicit in discouraging the idea as it was in the case of CIS countries farther east. In sum, none of these three determinants alone explains the final outcome one sees for each country in 2004, but together they tell a story that is relatively uncomplicated but still compelling. In the body of the text, several testable hypotheses are derived from this navigation paradigm, and where possible simple statistical tests are undertaken. Some of them give very strong results, others are weaker as measuring a variable such as prospect of EU membership is difficult, but in all cases the results are consistent with these hypotheses. Thus, the extent of state capture by 1999 as measured by the World Bank is significantly correlated with the extent of delay in starting the stabilization and reform process. When EU membership prospects


are measured either as the strength of the offer from the EU side or the strength of the desire by the country itself, the higher this value the shorter the period of delay in reforms. Most important for future implications is the following statistical result: the higher the degree of state capture in 1999, the lower is the level of progress to the market as measured by the EBRD transition index; this is consistent with the hypothesis that in captured states transition is frozen at an equilibrium part-way to a true market economy. Two additional observations should be made about this paradigm. An even simpler paradigm has been put forth by some with the claim that is overwhelmingly powerful as an explanation: geographic proximity to Western Europe. In a superficial statistical sense any good measure of geographic proximity is indeed a very powerful explanation of transition progress. But apart from the many exceptions to this that have been elaborated in the book, geography fails to leave any room for policy choice effectively implying that the closer to Europe the more a country will choose the right, progressive reform policy. It also fails to elaborate the behavioural mechanisms that lead to such results, surely a necessary element in any social science analysis purporting to explain different outcomes in different countries. Geography as an explanation is too deterministic and rigid in its path-dependency storyline. Path-determinacy is a powerful and generally compelling analytical paradigm, but surely there are moments in the history of a country when a new environment presents itself allowing for a sharp departure from the forces of the past, and surely the downfall of the communist empire and its ideological vision in 1989 was just such a moment.3 In many countries, elites seized the moment to undertake radical changes: Poland, Czechoslovakia, the Baltics, even for a short time Russia and Kyrgyzstan, as well as others. That fact alone strongly suggests that in countries where elites did not opt for radical change did so by choice and not due to the rigidity of geographic pre-determinacy. This is not to say that geography and history cannot be used to explain why they chose non-radical strategies, but the fact remains they had the choice to do differently. Consider just one illustration: a comparison of Czechoslovakia and Ukraine, both with a nomenklatura that was ideologically untainted by reformist ideas like those in Hungary or Poland. Prior to the regime change, the powerful democracy movements of the late-1980s that brought masses of people on the streets were in both countries composed of non-communist dissidents, intellectuals with a limited number of technical-professional types. In Czechoslovakia, this loose movement did not hesitate to take power from the communists when the latter, in disarray, were losing control. In Ukraine, the Rukh forces were uncertain of their ability to run a government, and were willing to compromise with the nomenklatura led by Kravchuk in what has been called the Faustian Bargain, with the latter promising to support independence and the former agreeing that economic reforms were secondary and could be postponed.

272 A Summing Up

As a final observation on the relationship between strategy chosen and final outcome, it is notable that in practice none of the countries that chose a gradual strategy followed closely the theoretical recommendations of first establishing good market institutions and then liberalizing the economy. In fact, it is easily seen in the time-path of the transition index components that those countries which moved most slowly on liberalization elements moved even more slowly on the institution-building elements. This implies that the proclamations of the political elites in these countries, that the society was not ready for the market and a gradual evolution was necessary, were not sincere proclamations but masked a hidden agenda. It is not hard to conclude what that was: retain and enhance personal positions of power. It is in that sense that the big-bang strategy, while inferior theoretically as demonstrated by many mathematical models, was in practice superior – it did not as easily allow for the duplicity of incumbents pursuing a hidden agenda in the name of the social good. There was no theoretical error in the models of gradualism, there was an error in the assumption that selfinterested politicians would implement its recommendations faithfully and not abuse the science. Was this erroneous assumption due to the tendency of gradualist arguments to be formalized mathematically? Not at all. A more recent generation of mathematical transition models applied to captured states include self-interest of ‘oligarchs’ as part of the mathematics, and sensibly conclude that these oligarchs may very well choose the high-rent status quo to a more liberalized economy which will ensure the security of their property rights. That is to say, the abstraction of mathematics does not preclude reaching the same conclusion as a practical interpretation.

Future prospects and policy implications The 27 post-communist countries analysed in this volume were first grouped into five categories using the TPI measure as a proxy of transition progress, this was then collapsed into four political-economy regime types observable in 2004. For a look forward, three groups will suffice to discuss general tendencies: the first group comprises Central Europe and the Baltics, where transition is effectively over, plus most of South-East Europe where it is not but the future path for the next 5–10 years is almost certain to be determined by integration into the EU; a second group comprises the three lagging reformers where transition has barely begun; and the third comprises the captured states of the CIS. Policy implications for the future are simplest and easiest to derive in the first two groups, but much more complex and incidentally more interesting in the third group. For the countries now tied by membership or advanced accession negotiations to the EU, future policy is less related to transition from socialism to the market and more related to the problems typical of middle-income emerging markets, with perhaps some institutional inadequacies still to


be resolved. These are more the subject of development economics, public finances, monetary and exchange rate policies. There are some additional specificities related to EU membership, such as the optimal timing of euroadoption, but these too are not transition issues any longer. For countries less advanced in the transformation but highly likely to be put on a track to EU membership, the relevant transition issues (liberalization, privatization, institutional development) will be guided by the requisites of the negotiations of Acquis chapters, with limited room for deviation except perhaps on timing. The analysis of this book bears two simple lessons for them: structural liberalization was done most successfully by those that moved early and fast; and privatization gave the best results when it was open and transparent. Direct sales under close supervision of committed reform governments has been more successful than other methods, but only because it is easier to ensure transparency under this method. Once the laggards which are much closer to a socialist planned regime than to a market economy are in a position to begin significant transformations, the experiences of the other 24 countries can provide many useful implications. First, while it is important to develop good institutions, waiting for these to be in place is costly, and risks yet again creating the rent-seeking environment that has been so harmful in the region. It is important to move fast enough on liberalization to close up the various loopholes of price distortions and government regulations to minimize the rent opportunities. Big-bang, when sustained, has worked far better than gradual liberalization. Even the fears that it would cause greater social costs for the population have proven unfounded, though of course separate mechanisms to compensate those displaced by the inevitable job losses should be provided as well. Second, the process of large-scale privatization can come early or late, but most important is that it be an open and transparent process that precludes those on the inside and/or well-connected individuals to access large state assets at bargain-basement prices. Such insider phenomena hurt the prospects of transition in two ways: they cause huge resentment in the population and erode popular consensus for market reforms, and they may lead to the creation of powerful financial interests who can capture the policies of the state. Third, an underestimated aspect of a good transformation is the creation of a market and institutional environment that encourages new small business. This requires dramatic simplification of new business licensing, taxation and regulation; it is not enough to put in place the simplified legislation as some room for bureaucratic discretion will always remain – tax inspectors do have a legitimate purpose in the most open of economies – there will need to be sincere efforts to deal with bribery as well. Demonstration from the top has been the most powerful tool in this regard. The captured states pose the greatest dilemma for future policy. To begin with recommending policy to members of a government that is captured by the financial benefits that ‘oligarchs’ bestow upon them may be about as

274 A Summing Up

effective as showing the fox alternative routes out of the chicken-coop. At the extreme, captured governments and their oligarch captors are indistinguishable. It is conceivable that some of these individuals will begin to desire legitimation and historical glory, and will be inclined to accept advice on how to overcome the power of oligarchs. In principle, it is reasonable to argue that once opportunities for acquiring state assets are exhausted, oligarchs will want to seek ways of protecting their property rights. There is a powerful argument made by some analysts that this point will inevitably be reached and the political demands of the oligarchs themselves will lead to liberalization and reduction of their power. But this ‘transition inevitable’ view is not consistent with the historical evidence of the behaviour of powerful vested interests, nor with the evolution reached in captured states where opportunities for huge rents from existing assets will remain even after all privatization is done. The theory that oligarchs want protection of property rights is correct, but it has been amply demonstrated that these property rights can be purchased individually and that their value may be far less than the rents to be gained from non-transparent lobbying. While there may indeed come a time that the oligarchs become proponents of more open markets, in practice this may be very far for the CIS countries finding themselves so entrapped; their transition is likely to be stalled or frozen for the near future, though a radical change in government as in Georgia, Ukraine and perhaps Kyrgyz Republic may provide a new liberalization opportunity. But few, if any, of the countries are in this extreme form of state capture, so there is room for seeking out policy-makers and well-meaning oligarchs who may be able to implement policies that slowly undermine the power of vested interests. Where a revolution of colour has occurred, and a more democratically-elected leadership has come into power, it is reasonable to assume that a new commitment to liberalism exists and policy-makers confront the issue of reversing state capture directly. There are three types of possible policy actions to reverse the capture of the state: ● ●

●

Reverse privatization and reduce the power of oligarchs. Restrict the power of oligarchs by anti-monopoly regulations and elimination of any subsidies, and licences. Facilitate development of new and small–medium-sized enterprises as a political counterweight to the large economic entities.

The first of these is the most risky and the least advisable of the measures. It is likely to be extremely popular politically in many of these countries where, with some justice, the oligarchs are seen as nothing more nor less than thieves. But unless there is an extremely clear case of illegal privatization, this approach is likely in the long run to do more harm than good. But such cases are few, given the general murkiness that pervaded this process,


hence the overall impact of clean reversals may be very limited. Taking away from one oligarch risks being a simply political rather than an objective action, and sends the signal that the government is always more powerful than the private sector, exactly the spirit that transformation meant to overcome in this region. Even small entrepreneurs will read this less as rendering of justice and more as confirmation of the omnipotence of the state. The greatest danger is to have the reversal flawed by a re-privatization to another favoured insider. In sum, to undo some of the worst cases of insider privatization effectively, several conditions must be met. First, the number of cases must be very limited. Second, they have to be selected very judiciously, focusing on those that are most egregious, and that have the greatest chance of being a reversal by an open judicial process. And, third, one must avoid an outcome where powerful people close to the new government are seen to benefit from the action. Restricting the power of oligarchs by anti-monopoly regulations is not a simple matter of having the legislation and institutions; in fact, these are now commonplace in the relevant countries. The problem is the classical one that powerful monopolists influence or even ‘buy-out’ the regulators and the dilemma becomes ‘quis custodiet custodies’, who regulates the regulators. This, as well as elimination of programmes that provide subsidies, government procurement favours and licences, means the ability to resist the influence of the oligarchs. If there is some will by politicians to do so, even marginally, that is all to the good, though it may not amount to much for a very long time and any sincere efforts of this sort may not be easily distinguishable from political demonstrations of anti-corruption efforts. In short, governments with some degree of independence and desire to work for the general good should go as far as they can in effective and sincere restrictions of oligarch power, even if it is slow-going. The third policy, facilitating the small business sector, will also be slow to give effects, but it is the most powerful of all the approaches. The word ‘facilitating’ rather than ‘promoting’ is used to emphasize that it is not a matter of throwing government resources at small business, but easing the great bureaucratic and taxation burdens that this sector faces in most of these countries. These burdens are the reason the sector is so little developed compared even to the newly transformed Central European countries, and its limited development goes a long way to explain the weakness of civil society. The importance of having a strong small-enterprise sector lies in the fact that it not only tends to be the most innovative and dynamic part of any economy, but its members are the strongest proponents of transparency, even-handed treatment by the state and democracy – in a word, proper ruleof-law. There is good reason to believe that this sector is slowly growing on its own even with the impediments it faces; but any effort to reduce these impediments will speed up the process and create perhaps the most effective

276 A Summing Up

counterweight to the political influence of oligarchs. This approach is central to the future of the captured states where transition is stalled, where capitalism thrives only for the select few who function in a noncompetitive and restricted market economy. Opening up the markets to new entrants and creating a level playing field of competition between big and small will be the most powerful lever to transform these states into real market economies with capitalism for all. As of this writing, three special cases of captured states appear to have moved sharply to reverse state capture: Georgia with its Rose Revolution, Ukraine with an Orange one, and Kgyrgyz Republic with Tulips. It is far too early to assess the prospects for a successful return to the dual liberal vision, beyond the obvious uniqueness of Ukraine: its much larger size and far greater strategic position result in a much higher probability of being put on the EU membership track. The evidence of 15 years of post-communism clearly shows how strong a discipline this can be towards felicitous policy change. As a final word, two points will be briefly noted here. First, each of these revolutions of colour had some unique aspect, but the overwhelming common factor which drove the tremendous force of people power was the resentment of the populace at the egregious abuse of political and economic power by the ‘oligarch’ clique. Second, the probabilities of analogous peoplepower revolutions in neighbouring countries are hard to judge; it is notable that despite some precedents, like Slovakia 1998 and Serbia 2000, no-one appears to have imagined – never mind predicted – any of the three recent cases. However, the common element of mass resentment against abuse of economic and political power is surely there aplenty in other countries. Predictions should not be attempted, but pleasant surprises should be awaited.

Notes

Introduction and Overview 1 I borrow here the East–West distinction of society’s attitudes emphasized by Gaidar (2003).

1

Key Debates on Transition

1 Stiglitz (1999) and Campos and Coricelli (2002) both aver to this problem. A counterargument to the lack of historical precedents is, for example, Dornbusch in Zecchini (1991) which draws lessons from the dissolution of the Austro-Hungarian empire, though largely on macro-policy. 2 Kornai (1994) explores the possibility of what he prefers to call a ‘system paradigm’; one key argument he makes is that transition by definition does not need a paradigm or theory – only the beginning and end-point systems do. 3 The issue of minimizing dislocation was addressed theoretically in an early article of Aghion and Blanchard (1994); this seminal piece spawned a large number of mathematical models of the dynamics of reallocation, providing at least a theoretical basis for determining optimum speed of transition. A typical example is Dewatripont and Roland (1992), which, as many of these articles tended to do, concluded gradual change is better, to allow time for new job-creation to absorb the disemployed. The second section explains some of the debate on this, including counter-illustrations showing the model can just as easily conclude in favour of big-bang: Katz and Owen (2000). 4 A very successful practitioner of ‘shock therapy’, former Prime Minister Maat Laar (2002) of Estonia, chides Western critics for the misguided phrase ‘too much shock too little therapy’, and addresses directly their illustration of Russia by describing in detail the very limited reforms and the consequently limited restructuring which explains the failure there. 5 I agree fully with Stiglitz (1999) ‘that for a market economy to work well (to be Pareto optimal) there must be both competition and private property’. Such a perspective strongly informs a principal thesis of this volume. 6 The major exceptions which do propose a very different agenda are not by analysts, but country governments like those in the CISL group who are lagging and do proffer an alternative model: essentially socialism with a minor role for the market in Belarus and Turkmenistan, or an industrial policy approach as in Uzbekistan. 7 The present author has written two review works, Havrylyshyn and Nsouli (eds) (2001) a conference volume covering transition issues widely, and Havrylyshyn (2001) focusing on econometric studies of growth. These obviously inform my judgment on what are the key issues, but I have attempted to derive the list objectively from the reviews by others as cited. 8 IMF (2000) shows that most transition countries have a far lower index of trade restrictiveness, using an IMF-constructed measure, than most other developing countries. 9 EBRD (2003) chs 4 and 5 provide an up-to-date review. 277

278 Notes 10 Johnson, McMillan and Woodruff (2000). 11 A question has arisen since 2000: why are the less reformed economies of the CIS growing much faster than the advanced transition countries in Central Europe? This is considered in Chapter 2. 12 Roland and Verdier (1999), p. 40, while recognizing Central European countries which reformed earliest are now growing again, nevertheless goes on to say the policies of the WC ‘led … to unexpected outcomes [such as] the important output fall [which] was not predicted’. 13 Several chapters in Clague and Reuser (1992) address this; Frydman et al. (1999) give an extensive overview of the arguments, and World Bank (1996) provides an early retrospective. Later reviews of privatization include Havrylyshyn and McGettigan (2000), Nellis in Havrylyshyn and Nsouli (2001) and Megginson and Netter (2001). 14 The authors may be overly rhetorical in their claim that this result implies a ‘failing grade’ for the Washington Consensus; even apart from the fact that one of the authors, Sachs, had earlier been a strong proponent of rapid privatization in some cases – not Russia to his credit – the WC as explained nowhere pretends that it is merely the transfer of ownership that is needed. 15 I will not cite the numerous recent statements from all corners about the importance of institutions, the need for better ‘second-stage’ reforms (one example is Svejnar, 2002). A useful flavour of the agreement is in the narrower literature of growth determinants and the increasing use of institutional development indices as explanatory variables, reviewed in Havrylyshyn (2001) and Campos and Coricelli (2002). As two examples, consider Brunetti, Kisunko and Weder (1997) who find reform variables do not matter if institutions are included, v. Havrylyshyn and van Rooden (2003) who argue that if properly specified such econometrics yield the result that both reform policies and institution matter. Two recent papers provide broad-ranging reviews of the role of institutions and attempt to move towards a manageable framework: Djankov and Murrell (2002) and Acemoglu, Johnson and Robinson (2004). 16 Johnson and Kaufmann (2001) analyse how the rise of underground activity is related to institutions (ref. is ch. 10 in Havrylyshyn and Nsouli, 2001). 17 This early optimism of the World Bank analysts may be understandable as the realities of oligarch power were not yet evident. The Bank’s latest Country Economic Memorandum on Russia, World Bank (2004), reflects a much less optimistic view of the demand for good law by capitalists. 18 Titling his article ‘Winners Take All’ nicely poignantly evokes this paradox. The sub-title ‘Politics of Partial Reform’ clearly signals his view that it was not rapid but gradual reform that is to blame. Another paradox is the contrast with the expectations of strong opposition to reforms from ‘almost everyone in the production hierarchy’: Holzmann (1992). 19 This section has been prepared jointly by the author and Karlo Basta, on the basis of Basta (2004a). 20 Guillermo O’Donnell and Philippe Schmitter, Transitions from Authoritarian Rule: Tentative Conclusions about Uncertain Democracies (Baltimore: Johns Hopkins University Press, 1999). 21 Thomas Carothers, ‘The End of the Transition Paradigm’, in Journal of Democracy vol. 13, no. 1 (January 2002), pp. 5–21. 22 Fish (1999), p. 799.

Notes 279 23 For a review, see Fish (1999), p. 797. See also a review in Pridham (2000), pp. 5–8. However, Pridham calls this approach ‘functionalist’. Furthermore, the fact that he lumps all theoretical approaches dealing with democratization under the rubric of ‘transitology’ reveals the extent of the conceptual confusion in the study of this phenomenon. 24 Philip Roeder’s chapter in Anderson, Fish, Hanson and Roeder (2001). 25 For a brief summary of this view, especially as expounded by Herbert Kitschelt, and an interesting critique, see Hanson and Kopstein (1997). 26 Motyl (2004) also emphasizes this, noting that Croatia, Bulgaria, Romania and Slovakia, which had indices of democracy much worse than Poland, Hungary and others, saw a sharp move in the democratization direction, while many CISM countries moved in the opposite direction approaching the magnitude of the most authoritarian states.

2

Measuring Progress in Transition

1 Sachs and Warner (1996) is an early study using relatively simple cross-country regressions; Fischer, Sahay and Vegh (1996) a more sophisticated one pooling time-series and cross-country data. Two recent survey articles assess a large number of econometric and other studies of growth in transition: Havrylyshyn (2001) and Campos and Coricelli (2002). 2 Roland and Verdier (1999) is an example of a large theoretical literature on the speed of reforms, which often concludes that gradualism as in China would have been better for the European economies as well. Stiglitz (1999) is a key reading making the same case with ex post evidence of actual developments. 3 For a fuller explanation see EBRD Transition Report (2003). I have excluded infrastructure indicators in my calculations as it is not available in all earlier years for comparison; arguably it may be as much a ‘results’ as an ‘input’ indicator. 4 I use the term CIS, Commonwealth of Independent States, for convenience as it is widely, albeit improperly, used; formally not all the countries have fully accepted membership. There is equally a sensitivity to including the Baltics as a former republic of the USSR, as their inclusion in 1945 was not internationally recognized by all. When I make such references, it will be obvious they refer to the objective functioning of these economies within the USSR and not the willingness of the peoples to be there. This last could be said about the populations of the other republics as well. 5 Ukraine’s prospects since the ‘Orange Revolution’ may make it an exception; this is discussed in later chapters. 6 Kolodko (2000b) discusses opinion polls. 7 See Buiter (2000) on some of these issues. 8 The conclusion is mine, and though based on Feige and Urban (2004), they do not necessarily agree nor state it explicitly. 9 In the early 1990s, all CIS countries reached ratings as ‘Partly Free’ democracies. By 2004 seven had fallen back to ‘NotFree’, and the other five all saw a slight drop in the Freedom House points system. 10 EBRD 2003 Transition Report also shows a strong positive correlation between media freedom and the TPI. 11 Those familiar with the writings on transition will have noted that critics of rapid reforms use the term shock-therapy, while proponents use big-bang or, even more neutrally, rapid reforms.

280 Notes 12 There is little doubt that some of them, especially the Baltics, have greater market liberality than many of the West European neighbours who have now joined, with more infrastructure privatized and trade barriers that will now have to go up to harmonize with EU levels. 13 The reader can quickly observe an illustration of this point by calculating the ratios of INST to LIB in each group. For CEB where most rapid reformers are, this ratio is higher in 2003 than in 1994, reflecting a catching up. For CISM and CISL, dominated by slower reformers, the ratio in 2003 is lower, reflecting an even greater lag of institutional reforms. 14 With the exception of the analysis of the growth surge in CIS countries since 2000, this section is drawn in large part from Havrylyshyn (2001), and incorporates several points from the survey of Campos and Coricelli (2002). 15 The use of synthetic indices for institutions may not be such a big shortcoming, because objective measures generally cannot capture the implementation quality which is after all what matters. Most objective measures show the quantity of legislation, judicial resources devoted to commercial issues, etc. It is possible that some measures such as length of time taken for bankruptcy cases begin to capture quality, but so far the best measure of quality may indeed be ex post perceptions of market actors. 16 The main exceptions can be mostly explained: Azerbaijan is due to oil bonuses coming in before exploitation; Armenia, Georgia and Tajikistan were hit hard by war and conflicts, hence the usual sharp recovery.

3

Economic and Social Costs of Transition

1 As a preview of conclusions, one could arguably say that China falls on the margin of the first and second, some Central European countries fall on the margin of two and three, while most of the rest fall clearly into the third category. But China’s outcome was due largely to felicitous circumstances and not necessarily superior policy, while the worst-case outcome for the last group was indeed due to inferior policy. On this debate see Brezis and Schnytzer (2003), Garner (2001) and Jones and Owen (2003). 2 This last remains relevant even if it is purely a perception of ‘unfairness’ and does not entail any absolute loss of welfare. Such perceptions may have political economy consequences, that is people who feel worse off may vote against a reformist government, as in the Przeworski thesis. I am grateful to Gerald Helleiner for this point. 3 Micklewright (1992) contends it is because no formal mismeasurement problem could be identified. For poverty and the Gini coefficient, several counter points are given later. 4 Dabrowski and Antzak in Kaminski (1996) point out the negative growth began at least as early as 1990 in the USSR, and the cumulative decline through 1992 was 29 per cent, that is an index of 71 before any reforms. 5 Though a counter-argument made by Milanovic is that the value of many products like energy and machinery was underestimated. 6 The output loss is then calculated as the two triangles under the 1989 flat line of Appendix Figure A3.2, including a loss in the period of decline, and a continued loss in the period of recovery until actual output returns to its start level. This is labelled as the MAX loss. 7 The output loss in this case is only the ‘A’ triangle for the decline period shown in Appendix Figure A3.2.

Notes 281 8 Kolodko (2000b) is one of many insiders who argue the status quo could not possibly have prevented a decline; indeed as a previous footnote points out, the negative rates began well before transition. 9 Transmonee data is found at www.unicef-icdc.org The EBRD Report of 2000, ch. 5, provides an excellent overview of the statistics and analytical discussions on the issue. More recent data is found in the later reports. 10 Lehmann, Wadsworth and Acquiti (1999) has a detailed analysis of such underemployment in the case of Russia, but the process was very similar in other CIS countries. 11 It is not inconceivable, however, that properly measured underemployment in the CIS countries could be well above 15 per cent, in which case the positive relationship between performance and pace of reforms is maintained. 12 Critics of too-rapid reforms would be entirely justified to note that deterioration of the state’s ability to continue good data collection is itself a sign of social worsening. 13 Nor do they show any distributional effects. Even if HDI in Central Europe on average did not decline at any time, the very high unemployment rates must have caused pain to a significant segment of the population. 14 Low-cost lunches, food and clothing for Gosplan employees is an illustration. 15 Atkinson and Micklewright (1992) give useful comparisons, and for socialist economies other earlier literature generally shows values in the same range. Replacing ‘inequality with dispersion’ raises a legitimate normative question: how bad was this increase of the Gini? 16 The importance of the difference between income and expenditure Gini is exemplified by Keane and Prasad’s (2002) findings for Poland. Using wage earnings, there is a sharp increase in Gini; using household expenditure data, there is a very little or no increase. The explanation in this case is very generous transfers to the ‘losers’. 17 An exception is the extremely thorough and careful analysis of household expenditure data by Keane and Prasad (2002) for Poland, which comes to the conclusion that inequality did not rise between the late 1980s and the late 1990s, or at most the rise was de minimis. 18 See Eyal, Szelenyi and Townsley (1998) and the special issue of the Slavic Review, Winter 1999, articles by Roeder, Bunce and Fish. 19 This is shown more concretely in Chapter 6, especially in Table 6.2 of milestones in transition. 20 Croatia is an outlier at 36. 21 Russia is an outlier at 45. 22 It is notable in the Benjamin et al. (2004) study that the Gini coefficient for consumption is lower in both years (0.22 and 0.28) than that for income. 23 An excellent review of the data and conceptual problems in measuring poverty in any country are in Deaton (2004). He concludes current statistical procedures tend to overstate the magnitude of poverty. 24 Not to mention internal inconsistencies: the poverty ratio for Hungary in 1993 is shown in various issues of WDI as follows: 8.6, 14.5, 23.8 and 25.3. These are not minor discrepancies. 25 Both of the cited studies come to this conclusion as well; their findings affect it only in pointing to a lesser degree of deterioration than indicated by the extreme high-end estimates in other sources. 26 For perspective, this range includes countries like Bangladesh, Burkina Faso, Kenya and Philippines (WDI, 2003). In comparison, China has a national poverty line ratio of 6 per cent, but in an international comparison with 2$/day, this jumps to 47 per cent, higher than most CIS countries.

282 Notes 27 Latvia shows an opposite trend: the values are in 1993, 2 per cent, and in 1998, 8 per cent. There may be a country-specific explanation, but given the very similar paths followed by all the Baltic countries one is more tempted to conclude this is yet another reflection of the problems with which this variable is afflicted. 28 The meaning of this warning is illustrated by the nonsensical result of poverty ratios in early 1990s for the Czech Republic and Slovenia of 55 and 85 per cent respectively; I noted earlier the anomaly of Latvia in the early 1990s having less than 2 per cent while other Baltics were 20–30 per cent. But apart from these outliers most of the values of WDI are more plausible. I take the risk. 29 Even in the cases of the worst declines in male life-expectancy in Russia and other CIS countries, the trend for females was much less dramatic: in Russia this fell by three years, in Ukraine and Kyrgyz republic less than two years, but in many other CIS countries including Caucasus and Central Asia the female life-expectancy remained virtually constant at about 74–75 years, or even rose modestly (see EBRD, 1997). 30 Public expenditures on healthcare do not seem to correlate well with the variation in the life-expectancy death rates. According to UNDP (1998), the Caucasian and Central Asian economies with the exception of Kyrgyz saw sharp drops in this ratio, while the western states saw increases. One possible explanation is that budget data are a poor reflection of actual service delivery, or in some cases are not believable: for example Belarus is reported to have increased this share from 3.5 to 7.0 per cent. 31 This is exemplified by writings on the subject by all the major IFIs which bear the brunt of Reddaway and Glinski’s general criticism. The EBRD Transition Report for several years has made this point, and it is most recently thoroughly analysed in the (2003) issue which concludes succinctly that ‘educational services have declined dramatically in quality in some countries’ (p. 6). Its chief economist, Willem Buiter, in a (2000) article assessing the state of affairs in Russia and its neighbours, also points to the threat of the hollowing-out of human capital.

4

The SS Transition Navigation Model

1 Modern reference is to Isaiah Berlin (1953), The Hedgehog and the Fox, who differentiates those works which ‘pursue many ends [and] those who relate everything to a single central vision’. 2 The focus on the post-communist era immediately distinguishes my analysis from efforts to explain market reforms in Asian economies, such as China and Vietnam, where communism has remained the ruling political if not economic paradigm. 3 The KB paradigm I describe in Chapter 1 is a model of what changes are needed to achieve a transformation; here, I seek a paradigm that can, ex post, explain why these changes occurred faster in some countries and have not yet occurred in a few laggards. 4 Selected examples of the former are the study of Russia by Reddaway and Glinski (2001), Ukraine by Banaian (1999), and Shen (1996), Romania by Shen (1997), Poland by Kolodko (2000a) and numerous others shown in Bibliography. The comparative approach is often found in conference volumes such as Kaminski (1996) or Havrylyshyn and Nsouli (2001) with chapters covering many countries or different cross-country issues. 5 In Havrylyshyn (1997) the author has argued that overemphasis on building state institutions in Ukraine, whether well-meaning or a tactic of old vested interests,

Notes 283

6

7

8 9 10

11

12

13

14

resulted in reform delays which allowed rent-seeking to flourish and create a new class of oligarchs. A similar interpretation is given in Kuzio and Wilson (1994) and Harasymiw (2002) Motyl and Kravchenbo in Bremmer and Taras (1997) argue exactly the opposite: too rapid reforms caused oligarch development. This was also true for Hungary and even more so in former Yugoslav Republics. A softer version of this advantage is noted by Laar (2002) for Estonia which saw more Nordic visitors in the Soviet period than other republics, and – given the similarities of Estonian and Finnish languages – had meaningful access to Finnish television. Which for econometricians implies the coefficient on the independent variable is of different value for each country, or in the worst case of a different sign for each country, making any consistent quantitative analysis meaningless. Recall the case of nationalism discussed earlier. The cases illustrated are drawn from CISH for convenience, though the points are made in many other writings on these countries. The effect of strong nationalism may have changed after the ‘Orange Revolution’ to that experienced in the Baltics at the start. Basta (2004a) and Gray, ch. 9 in Heenan and Lamontagne (1999a), discuss the easy-going but steady pace of transformation in Slovenia, attributing it to the strong consensus in society on two points: Slovenia had done very well during the Socialist period and did not need to make any quantum leap; there was no risk of going too slow because there was a strong commitment to the final goal of a fullfledged market economy, democracy, and eventual EU membership. One might add that the need to move fast was less urgent because the extent of marketorientation in 1989 (TPI 1.7) was, together with Croatia, far more advanced than in Poland (1.3) or even Hungary (1.5). Chapter 6 describes the starting points for each of the transition countries. I do simplify Kolodko’s views for purposes of exposition here: he also argued there was insufficient systematic planning for a social safety net and institutional developments, and disagrees with Balcerowicz (2002) that the period of ‘special politics’ had to be used for a big-bang, which gave additional benefits of ensuring irreversibility. In the event, what is clear is that Poland was successful in the transition, despite some costs, which may or may not have been avoided, and this is because fundamentally both of these major players representing different groups on the political spectrum had their sights firmly fixed on the same long-term target. This point is made in Rzonca and Cizkowicz (2003) in trying to explain why the TPI as an explanatory variable for growth, becomes gradually less significant as it reaches values closer to the limit. As I write this in Toronto, Ontario, I am starkly reminded that expecting ideological consistency or correspondence between election platforms and policy actions is folly even in the most advanced democracies. The new Liberal Party Government of Ontario, which came into power in 2003 on a strong platform against any tax increases, has gone ahead and done precisely that in 2004, reimposing a healthcare premium that was abolished many years ago. Polls suggest the move is highly unpopular, but the same polls suggest the public buys into the explanation that ‘the finances were much worse than we realized and something had to be done’. I would nevertheless not care to predict the outcome of the next elections. One does in fact come across similar lists of difficulties faced by the eventually more successful countries. Laar (2002) states: ‘The first years of independence were difficult for Estonia. The markets in Russia were gone and it was necessary to

284 Notes

15

16

17 18 19

20

21

22

23

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restructure the economy totally. The young country had to confront the urgent issue of land reform, reorganization of industrial production and markets, and the mobilization of ethnic minorities.’ However, this was recognized as ‘nothing unique’ and taken as a reason for moving fast rather than a complaint of how difficult it was. Similarly, Kolodko (2000b) notes many difficult initial conditions of all countries but concludes that this was a reason to work even harder and not blame history. Being at the historical crossroads of trade routes, or caught between competing empires, was not only Bulgaria’s or Ukraine’s inheritance, (as described in the relevant Handbook chapters) but can be legitimately claimed by Serbia, Slovenia, the Baltics, Kyrgyz Republic and many others – or in theory by any country surrounded by a number of other countries, which is to say most countries. Having an apathetic population unprepared to throw the rascals out, when relatively free elections allowed, could apply not only to Belarus (again in CIS Handbook), but to Ukraine, Moldova and others or not: the Slovak, Serbian, Georgian and Ukrainian apathy very suddenly turned to Ghandian resolve when abuses by those in power became overly egregious. The reader is welcome to substitute Wyoming, southern Siberia, or, where it may still exist, a Western European equivalent. I assume that at least the literary allusion of not seeing the forest for the trees is clear. Anderson and Boettke (1997) argue that is precisely what they did; more on this in Chapter 6. Bergloff and Roland (1997). This is a possible explanation for the early efforts of very radical reforms in Russia and Kyrgyz Republic; but if so one require a good explanation of why this was reversed, subsequent chapters elaborate on these and analogous cases. This characterization applies before the Rose and Orange Revolutions in Georgia and Ukraine. It is too early to judge whether they are moving out of their captured status, but later chapters will discuss how it was that the oligarchies there lost elections to democratic forces, and what are the prospects for reversing the oligarch power. I am not saying by this that the process of liberalization and democratization is complete in these countries, nor that former nomenklatura members had no ability to use influence and become important new capitalists. I am saying that the extent of concentration of ownership is far lower than in the first group, and far from what it would need to be to control elections and policies. Many text books on Comparative Economic Systems give Nazi Germany as the prime example of this form, and also note the softer versions thereof in many war-period economies. With one possible exception reflecting both their hubris and their human frailties: they have recently recognized publicly the extent of their political power. One of the first to do this, Berezovsky in Russia, may have paid the price of exile. Hungary and Estonia did move much faster than Poland and were not later than Russia, but the process was much more transparent, based mostly on direct sales, and the governments much more committed to a clean privatization. This is explored in Chapter 6 as an example of lesser vulnerability to oligarchic development. The reader who wishes to see in this the continued role of old communist elite, is reminded that while in Estonia it did not continue, in Hungary it did much more. Eyal, Szelenyi and Townsley (1999) review these predictions of ‘political capitalism’, that is how the communist elite would conspire to become the capitalist

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elite in the new regime. The main part of their study is to show that in Central Europe this did not happen, and then explain why. See Kraft (2000) for an application to transition economies measuring the time from independence to the achievement of this threshold, and showing the lag was longer the weaker was national sentiment or commitment. Updates in Kaufman, Kraay and Mastruzzi (2003) compute an analogous variable called ‘crony bias’, but the earliest data are most relevant here. Later data will be used to test the TF hypothesis in Chapter 8. And it certainly does not come from the goodwill of capitalists as Smith’s succinct comment on the baker emphasizes: ‘it is not because of the benevolence of the baker that we eat fresh bread every morning but because of his desire to make money’. I wish to emphasize that the TF criticism of TI is not a critique of the WC except in the limited ex post sense of recognizing that privatizations which resulted in overly concentrated ownership created strong vested interest in monopolistic and rent-seeking behaviour, which in turn means strong opposition to full liberalization. This is not the place to discuss critiques which argue it should have been foreseen and the negative outcome is therefore the fault of WC and its proponents; (Reddaway and Glinski (2001) is only one of many. Note that in the model of the present work, delayed and incomplete reforms are the cause of the oligarchic formation, rather than the substance of the proposed reforms themselves. One of my modest objectives here is to bring back into focus the forgotten adjective modifying ‘market’ in the neo-classical welfare maximizing arguments: Competitive.

The Search for a Navigation Chart

1 The author was fortunate enough to be close to both events, first at an academic conference in Budapest in mid-November, watching on television with Central European colleagues the Velvet Revolution events in Prague, then in late August on an interrupted vacation with his spouse in Yalta not far distant from Gorbachev’s temporary incarceration in Foros. The rollercoaster of emotions in that short week included the fearful frenzy of crowds seeking safe return to their homes at the Simferopol airport, and the joyful celebration of Ukrainian independence on the streets of Kyiv on 24 August 1991. 2 China of course had began such a transformation but focused first on the economic dimension. 3 Chapter 1 has discussed how this quest triggered considerable efforts of economists to model alternative paths often coming to the mathematical conclusion that gradual was better. 4 The concept of ‘uniqueness’ of each country also had considerable appeal and contributed to the rationale for a longer debate. That this was a misguided view coopted by reform opponents has been argued in Chapter 4. 5 Thomas (1991) summarizes the reform experiences of developing market economies. 6 The term was coined by John Williamson (1993), in a volume reviewing the experiences of stabilization and liberalization in developing countries, but including already some early discussions on the lessons for transition. 7 Yalcin (2002). Its implementation may have been partial and its success not yet evident, as Chapter 9 will outline, but the degree of consistency of strategy is

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relatively unique in the region. Turkmenistan cannot be considered as analogous, for its strategy starts from the primacy of the wisdom of the leader, goes on to political social issues and only last gives an economic recipe. Schroeder (1996). Some cases shown in brackets in the figure are on the margin between two categories; this is discussed more fully in the next section. This is elaborated in Chapter 9. Akayev was not a politician but an academic who at first was inclined to be more experimental, and Yeltsin though a high ranking member of the nomenklatura certainly supported a more radical approach for at least a short period. A brief history of this is in Bristow (1996) and Bristow’s chapter in Heenan and Lamontagne (1999a). No descriptions are given for 3 or 3.3. It is to be emphasized that the EBRD does not to my knowledge define any analogous milestones or benchmarks and all the interpretations here are the author’s alone. Hungary and then Czechoslovakia started with much less macro instability and did not attain such a high level of inflation at any time. TPI values in years 0 and 4 are not shown in Tables 5.1 and 5.2. Source is the same as in the tables. This is explored in Kolodko (2000b). These are not exact equivalents as in the second phase are also included largescale privatization; however all the other elements in the second phase are institutional in nature. A third, commitment to EU membership, is part of this or parallel to it; it is elaborated in Chapter 7. In the formalized Navigation Model of Chapter 4 Appendix, the first two forces combine to define the variable LIBVIS, while the third is captured by the variable EUM. Bunce (1999), p. 280. See Demidkina, Chapter 4 in Heenan and Lamontaigne (1999b). The fact that a party with the name Communist won a minority and was not in government should not mislead one; the mainstream pragmatist nomenklatura renamed itself as the Democratic Party, while ideological communists and proUSSR members stayed in a Communist party. This arrangement also exists to the present day in Russia, Moldova and the Caucasus. Kubicek, ch. 5 in Heenan and Lamontagne (1999a). In Yugoslavia, the dominant party had been named ‘Socialist’ rather than communist since Tito’s break from Moscow. This is the variable LEADER noted in Appendix of Chapter 5 describing the Navigation Model. It is narrowly defined as cases where a leader was far more visionary than the rest of the polity, but this is not to suggest that Havel or Waleson, or Baltic personalities, were not as visionary as Yeltsin and Akagev. They surely were and even more but in a context of a society showing and supporting this vision. The return of a communist government in Moldova in 2000 does not conform to Przeworski’s thesis either. It came much later when the economy was in fact turning around. It is also very different from the other cases as these were not the renamed and perhaps somewhat reformed-pragmatic former communists who had been in power since 1991, but the much more ideological traditionalist communists who had been consistently against liberalization and privatization and

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were victorious as much for the public revulsion against oligarchic power, as the pain of transformation. Not surprisingly they did indeed reverse both dimensions of the transformation. Kolodko (2000a) argues forcefully that the changes needed to overcome ‘the disastrous experience with central planning … were not simply adjustments to the existing system but the establishment of systemic new foundations’. Shulman (2003) explores the opposite causation for Ukraine: does economic performance affect the strength of national identity? He finds it does not. But numerous minor ones do continue. As the author writes this in Toronto, several unresolved cases of border conflicts for Canada are written about on back pages. Tiny Hans Island in the strait between Greenland and Ellesmere Island was recently visited by the Navy of Denmark which reportedly laid claim to it in June 2004. A much larger issue is the dispute with the USA on a vast part of the Beaufort Sea, revolving around the angle of the line drawn from the mainland border between Alaska and the Yukon Territory; oil resources there may be considerable. Toronto Star, 25 March 2004, p. A7, ‘Canada–Danish spat erupts over island’. Economist, 28 August 2004, p. 38. Economist, 9 October 2004, p. 48. Gleason in Chapter 16 in Bremmert and Taras (1997) also notes that while in Central Asia nationalism did not exist – this is perhaps too strong given the references that follow in the same work to the national myths of the Kahantes in Khiva, Samarkand, Tashkent – the settled peoples of the river plains in Uzbekistan were far more authoritarian than the nomadic ones with traditions of tribal democracy.

6 From Rent-Seeking to Oligarchy to State Capture 1 Interested observers will not take long to come up with 5–10 names or more of oligarchs, but almost all of them will be from Russia, perhaps one or two from Ukraine, maybe another from Central Asia where the family name of a president suffices to make the association. Any from Poland, Hungary, Latvia? Highly unlikely to be named; but is this because their oligarchs are less well-known? The answer given later is that it’s because their big-capitalists are not of the variety which can be labelled oligarch, both in size and political influence. 2 An exception was the capital accumulated by the Soviet era mafia based historically on black-market trading in a shortage economy, but later including drugs and other criminal activity. Handelman (1994) describes this group of new capitalists, but it may not have been the major source underpinning the future oligarchs. It is notable that in the Index of his book, one cannot find a single one of the names that now comprise Russia’s oligarchs listed methodically in Barnes (2003b) and World Bank (2004). 3 The vast literature on post-communist privatization has unfortunately enshrined the nuance of ‘insider’ to mean the managers and owners of the enterprise; here I will emphasize its much broader meaning as in ‘insider-trading’ regulations: operations undertaken by those who have special knowledge not available to the rest of the market. 4 The literature on these activities is too vast to be cited; I mention here only a few good writings which give numerous examples, most of them focusing unfortunately on Russia. Handelman (1994), Aslund (1995), Brady (1999), Barnes

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(2003b), Goldman (2003), Freeland (2000a,b); for Ukraine see Havrylyshyn (1997), Aslund (2003), Balmaceda (1998), Puglisi (2003) and Zimmer (2004). Aslund (1999). As late as 1998, after considerable closing of these price gaps and loopholes, the young reformist Prime Minister of Moldova, Jan Sturc, remarked in a personal conversation: ‘give me 15 minutes sometime and I can tell you about sixteen different ways in which it is still possible to make a lot of money on energy operations’. Handelman (1994) provides good evidence of their importance, citing on p. 63 a statement of a businessman: ‘Many of us [in the Komsomol] have been involved in some kind of business since the late eighties’. Hellman, Jones and Kaufmann (2003). It is notable that these authors who are responsible for the measurement of a state-capture index (SC99) used by many to distinguish oligarchic from non-oligarchic cases, emphasize in this passage that the very low levels of SC99 for the lagging reformers are not meaningful. This was in contrast to the delay in Poland which many eventually praised, as it allowed development of stronger market and competitive institutions. But delay alone was not the determinant of success, as Ukraine’s example attests; the difference was far greater commitment in Poland which assured progress on institutions (see the figure in Chapter 2 Appendix which show the much slower institutional developments in Ukraine), and transparency in the privatization process. Feige (1997) is an example; Eyal’s Szelenyi and Townsley (1999) explore the process of former communists leveraging political power into economic power in the transition, and show this was far more effective in the USSR. Alexeev and Pyll (2003). I rely in particular on Brady (1999), Freeland (2000b) and Goldman (2003) for Russia; Aslund (1999), Puglisi (2003) and Zimmer (2004) on Ukraine. Forbes (2005) also provides useful input. On Central Asia, no focused writings are available and the information must be gleaned from a large number of general studies of these countries. The details on the background of some new additions to the Billionaires’ Club is given in Forbes (2005) and illustrates the paths followed. Kuzio (2005) argues that Akhmetov’s support of Yanukovich in Ukraine’s presidential election illustrates how oligarchs effectively block liberalism while advocating publicly democratic forms. The head of a large Latvian bank with many rich Russian clients quite proudly related to the author how his connections in the Komsomol were critical to business success, and how the organizational training the Komsomol provided ‘was the best MBA School in the USSR’. A precise measure of GDP in transition countries remains elusive. The fact that Canada and Sweden have a ratio slightly above one may seem surprising as both have a reputation as ‘welfare-states’ with a large public sector, virtually free education and health services, and – apart from the few billionaires – an income distribution measured by the Gini coefficient that is more equitable than in many other industrial countries. But for students of ‘capitalist entrenchment’, as reviewed in Morck, Wolfenson and Yeung (2005) and summarized in the Appendix to this chapter, the existence of a small but extremely wealthy group in these two countries has been known for some time. More recent values are available and will be used in later chapters. The earliest available value, 1999, is shown here because it is the best indicator of how the

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dynamics of slow, partial reforms, plus non-transparent privatization led to very different results in different countries. Lecture of Prof. J. Mazesnikov, Slovak Institute of Policy Analysis, University of Toronto, 15 September 2004. Motyl and Kravchenko in Bremmer and Taras (1997), p. 253. In fairness, the authors argue in the event that Rukh probably did not have much choice and that they made the right decision to not press for rapid economic reforms which would have threatened the stability of Ukraine. This is not a view shared by the present author. Recall the argument of Rzonca and Cizkowicz (2003) in the discussion of growth determinants, Chapter 2. Something similar was done in the 2002–03 programme with Brazil, with an analogous result of the opposition winning the election. True, land grants for latifundia in South America or railway-building are closer to the privileged privatization of Soviet assets, but in fact without the activity of building railways or cultivating the land, the assets granted had little if any value. In the case of railways, the grants were at least conditional on a completed railway. Another similarity is the source of an oligarch joke (anekdot) in Russia and Ukraine: ‘Our oligarchs are just like the American Robber Barons – they both invested their money in America.’ In the 1970s and 1980s several multi-country projects investigated this problem under the general editorship of top trade and development economists such as Anne Krueger, Jagdish Bhagwati and Bela Balassa. The last of these mega-projects covered 18 countries: Papageorgiou, Choksi and Michaely (1991). Sandbrook (2000). Viktor Pynzenyk, Deputy Prime Minister of Ukraine in the early 1990s, was put the question at an international conference: ‘couldn’t one just get rid of all the old nomenklatura people and start over again as in Poland?’ His answer: ‘You can take the pigs away from the trough, but then you just get another group of pigs jump in; the only solution is to take away the pig-trough.’

Safe Havens for Market Reforms

1 As cited in Papadimitriou (2002). This book, plus the ones by Schimmelfennig (2003) and Palankai (2003), provide excellent and comprehensive accounts of the Eastern Enlargement of the EU; the following section draws much of its information from these three sources. 2 Papadimitriou, p. 35. 3 Laar (2002) asserts unequivocally that for Estonia, at the very beginning the people and political elites overwhelmingly saw EU membership as the central part of the transformation. He judges this was also the case in the other Baltic countries, and Central Europe. 4 Palankai (2003) p. 429. 5 Although the pattern over time is for a shorter delay between the stages for latecomers. Thus, the first four applied in 1994, three years after the Europe agreements and had negotiations until 1999, while the Baltics and Bulgaria and Romania moved quickly from the Agreement to application to start of negotiations. This record gives some hope to Turkey (and Ukraine?) that the actual accession date

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could be earlier than first noted. But late comers did not necessarily catch-up as will be shown below. An alternative model is posited by Plumper, Schneider and Troeger (2004); they separate the decision by candidates to apply as being determined by the level of democracy and market reforms, from the EU decision to accept which is determined by compliance with AC criteria. The historical process seems closer to a simultaneity. Cooley’s chapter in Karatnycky et al. (2003) discusses the EU anchor and is right to argue that the internal commitment in Central Europe was very strong without EU carrots. I argue later that sticks may have been even more important than carrots to keep the laggards on track. Lecture given by Bela Kadar on the EU enlargement, University of Toronto, 16 September 2004. An exception was Slovakia in the period 1994–98 with Méciar as Prime Minister; the EC gave negative reports and threatened delays in accession. This is explored below as one example of the EU using membership as a stick. Palankai (2003), p. 433; he goes on to note that despite having the highest wage costs of all the post-communist countries, the Czech Republic, Hungary and Poland received the lion’s share of FDI, to a large extent because of the favourable signals about EU accession. Bleiere (1999). The same proposal also put Yugoslavia and the Soviet Union (not yet dissolved) on the shelf for later examination. It is best to think of this not as a stick but a withholding of an offer for lack of clear prospects on reform progress. A recent article on the series of second-wave democratic revolutions (Slovakia, Serbia, Georgia, Ukraine) reemphasizes this in a somewhat popular but fundamentally sound conclusion: ‘Slovakia’s opposition … had two things working in their favor: one was the immense lure of joining the EU and NATO. The other was the Internet.’ In ‘Belarus and Moldova, Hopes for Democracy’, New York Times, 24 February 2005. Indeed, as the Financial Times Survey of 22 June 2004 described it, the Slovenian leaders – and populace – always felt they were good managers of the economy under socialist Yugoslavia, never suffered a financial crisis, were not far from having a functioning market economy, and were confident they would get to EU membership in due time. Note in the Appendix table of Chapter 2 that the 2002 TPI measure for Ukraine, 2.8, had nearly caught up to Romania’s value of 3.0; furthermore, this was for Ukraine forward momentum while for Romania it had been stalled at 2.9–3.0 since 1997. This lies behind a judgment such as the Economist made of generosity by the EU; such a long stall might instead have been cause for applying the stick and delaying Romania instead of putting on the same pace as Bulgaria. Many countries are still not WTO members: Bosnia, Macedonia, Serbia and Montenegro in the Balkan region, and Azerbaijan, Belarus, Kazakhstan, Russia, Tajikistan, Turkmenistan, Ukraine and Uzbekistan in the CIS. On the large EU effects and the potential superiority of this approach to WTO, see Tolchitskaya and Vinhas de Souza (2004). The reason EU free trade may have a larger impact though it includes only EU countries is that the extent of tradebarrier reduction is almost certainly larger than that initially obtained upon WTO membership.

Notes 291 18 Argentina is not the only case of political influence by a powerful patron, but has become one of the most thoroughly analysed, see for example Mussa (2002). 19 Ul-Hague and Khan (1998) show in a broad sample how difficult it is to observe in econometric analysis any positive impact of IMF programme because it is not generally the most important determinant of success; but when the analysis is done carefully, the effects are found to be positive if not always large. MercerBlackman and Unigovskaya (2002) find stronger results for transition countries’ growth in the 1990s by measuring very carefully the effectiveness of actual implementation; that raises the question whether countries that implement IMF programmes well would have done all the right things without the programme. 20 For example, central bank operations, and its regulation of the banking system, continued to be steadily improved in Belarus. Personal communication from financial sector specialists at the IMF. 21 There may be some dispute as to whether any ‘offer’ to Croatia existed at all; it was certainly weaker and less explicit than to the other countries in the modest group, but informally it was at all times understood that given the advanced economic transformation, once the impediment of an awkward conflict situation and related questions of democracy was removed, Croatia was a good candidate. In the event the uncertainties on democracy remained for a long time after any conflict was ended, but as noted earlier, with election of a government deemed more democratic, the EU moved fast to upgrade the offer. 22 A minor adjustment is made: Hungary and Czechoslovakia at no time had inflation as high as 5% monthly, but instead of showing zero months delay, the chart takes the values from regime change to the start of stabilization. Using zero clearly would strengthen the pattern observed. 23 Estonia’s President Meri, for instance, stated in November of 1993 that ‘the Baltic states would “integrate into Europe economically, politically and militarily” ’ (quoted in Park (1995), p. 33). In February 1994, he stated that ‘Estonian security policy should be based on economic integration, first with the Baltic states, then with the Baltic sea states and the European Union’ (ibid.). 24 See the Commission Opinion on Estonia’s Application for Membership of the European Union, p. 112. Accessed at http://europa.eu.int/comm/enlargement/ dwn/opinions/estonia/es-op-en.pdf. 25 See the ‘Chronology of Estonia’s Accession to the EU’ at http://www. riigikogu.ee/?id12974. 26 See Commission Opinion on Estonia’s Application for Membership of the European Union, p. 116. Accessed at http://europa.eu.int/comm/enlargement/ dwn/opinions/estonia/es-op-en.pdf. 27 The European Council outlined a set of broad membership criteria to Central European countries at its June 1993 meeting in Copenhagen. The criteria were ‘the stability of institutions guaranteeing democracy, the rule of law, human rights and respect for and protection of minorities; the existence of a functioning market economy; the capacity to cope with competitive pressures and market forces within the Union; the ability to take on the obligations of membership, including adherence to the aims of political, economic and monetary union’ (Mayhew, 1998, p. 162). 28 The social-democratic government of the reformed ex-communist Brazauskas was continuously attacked by the right wing politicians for being too friendly with Russia and betraying national interests (Lane, 2002, p. 201). 29 Lane is explicit in emphasizing that both the left and the right in Lithuania’s politics wanted membership in the Western political, economic and security

292 Notes organizations. However, ‘the question at issue was how to treat Russia; nationalists were basically Russophobic and doctrinaire, the Left was pragmatic and flexible’ (Lane, p. 202). 30 See Commission Opinion on Latvia’s Application for Membership of the European Union, pp. 111–12, accessed at http://europa.eu.int/comm/enlargement/dwn/ opinions/latvia/la-op-en.pdf. For Lithuania, see Commission Opinion on Lithuania’s Application for Membership of the European Union, pp. 104–5, accessed at http://europa.eu.int/comm/enlargement/dwn/opinions/lithuania/li-op-en.pdf. 31 The progress in compliance with the EU criteria is illustrated in the regular annual reports of the EU from 1998 onward. For Latvia, reports can be found at http:// europa.eu.int/comm/enlargement/latvia/index.htm#Overview%20of%20key% 20documents%20related%20to%20enlargement. Lithuania’s reports can be found at http://europa.eu.int/comm/enlargement/lithuania/index.htm#Overview%20 of%20key%20documents%20related%20to%20enlargement.

8

Future Prospects for Captured States

1 Somewhat less forthright arguments that oligarchs will eventually promote liberalization because it is in their own interest are found in Boone and Rodionov (2001), Cottrell (2002) and Shleifer and Treisman (2004) inter alia. 2 References to individual analysts are not meant to imply categorical adherence to either the TI or TF views. Such pigeon-holing is neither necessary nor in fact would it be objective, because many analysts explore seriously both sides of the debate in the same or different writings. Thus Gaidar and Buiter, as noted, recognize the validity of some arguments in both views and, as cited later, Aslund and Johnson (2004) also recognizes the primary role of small rather than large business in pushing institutional development. 3 As cited in Financial Times, 7 June 2004. 4 World Bank (2004) Country Economic Memorandum, Russian Federation. 5 Titling his article ‘Winners Take All’ nicely and poignantly evokes this paradox. The sub-title ‘Politics of Partial Reform’ clearly signals his view that it was not rapid but gradual reform that is to blame. Another paradox is the contrast with the expectations of strong opposition to reforms from ‘almost everyone in the production hierarchy’: Holzmann (1992). 6 Rajan and Zingales (2003a and b) also emphasize how powerful capitalists cleverly spin their entreaties to governments for protection against competition as being for the good of the workers, the nation. 7 Mr Poroshenko, who supported the opposition candidate, Mr Yuschenko, and Ms Tymoshenko, remain for now far short of the billion-plus class of major oligarchs, and should be regarded as ‘lesser-oligarchs’, or ‘mini-garchs’, with mere tens or hundreds of millions of dollar assets. The lessons of the 2004 election and ‘Orange Revolution’ in Ukraine are explored further late in the chapter. 8 I note only a few: Nellis in Havrylyshyn and Nsouli (2001), Megginson and Netter (2002), Barnes (2003a) and Frye (2003). 9 Many recent analyses show concentration has increased in all countries and that the share of major owners in Russia is not much higher than in Central Europe at 35 per cent plus most recently. This is a measure of firm-level and not economywide concentration which is the relevant measure of oligarchic concentration. Hashi, Kozarzewski and Radygin (2004).

Notes 293 10 I cite only a few examples: Fidrmuc (2000), Frye (2003) and Jackson, Klich and Poznanska (2003). 11 Hellman and Schankermann (2000). 12 One can imagine an inverted U-curve with an optimum SME share of 20–24 per cent. 13 An almost surreal example of this was the action of the Uzbekistan government in mid-2003. To meet the IMF conditions of a maximum gap between official and curb rates for the som, they undertook a sweep of informal markets and imposed new licensing requirements for minor traders. This temporarily reduced such activities to near-zero levels; foreign currency demand dried up and the formal target was met; to the chagrin of IMF critics, the latter did not buy the trick. 14 That the architects of the loans-for-shares privatization believed in such a Damascene conversion of the new capitalists is confirmed in Freeland’s (2000b) fascinating account quoting Chubais: ‘Let them steal and take their property. They will then become owners and decent administrators of their property.’ 15 Isajiw (2004). 16 Johnson, MacMillan and Woodruff (2000). 17 The large number of such writings is reviewed in the following three articles: Havrylyshyn and McGettigan (2000), Djankov and Murrell (2002) and Haltiwanger et al. (2003). 18 Krugman (1994). 19 Bugajski (2004) is an excellent source on the question of Russia’s future ambitions on these dimensions. 20 Plumper, Schneider and Troeger (2004) conclude with virtually the same words: ‘The EU requires severe reductions in market distortions.’ Thus, special interests that profit from these [distortions] oppose EU membership. 21 Many good colours remain. Imagine such a popular revolution in Moldova occurring in early summer of 200X – it might be called the Cherry Revolution for Moldova’s bountiful orchards, Mr Lukashenko’s own words may suggest a colour in Belarus: ‘There will be no revolution of any kind here, not even a banana revolution.’ 22 Her very successful actions as Minister of Energy in 1999–2001 cut rents in this sector by one-third or more (Aslund, 2002), suggesting she was not using her position to improve personal future opportunities. Coincidentally, and without prejudice, her actions are said to reinforce the old adage ‘it takes a thief to catch a thief’. Her own oligarch days were as an energy rent-seeker in partnership with the later disfavoured Prime Minister Pavlo Lazarenko. 23 Judah (2005). 24 The earlier references, Carothers (2002) and McFaul (2002), cover these ‘managed democracies’ of some post-Soviet states. 25 As Kuzio (2005) suggests: ‘The attempted poisoning of Yuschenko during the campaign shows how far his opponents were willing to go to stop his election.’ 26 Forbes, 28 March 2005 annual ‘Billionaires’ issue estimates his worth at $2.3 billion. 27 Michael McFaul, in an interview on American National Public Radio (28 March 2005), noted that in Kyrgyz Republic – which had neither the charismatic leader of Georgia and Ukraine, nor the allure of EU membership in Serbia – the anger of the crowds was first and foremost directed at the large commercial outlets known to be owned by members of the President’s family: a more focused expression of ‘enough of the abuse’ cannot be imagined. It is notable that an Egyptian opposition movement has been named ‘Enough’.

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Diverse Outcomes

1 The reader is reminded of the analysis in Chapter 3 on the potential bias in official GDP data and alternative estimates correcting for these problems; the measure here is the average between official and Aslund-adjusted estimates as described in Chapter 3. 2 One of the first to do these, Berezovsky in Russia, may have paid the price in exile. Potanin’s plea for social acceptance cited earlier is in the same category. 3 The second wave of ‘colour’ revolutions against oligarchies may also be such a moment.

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Index Accession to EU, 203–4 Acquis Communautaire, see European Union Agricultural sector, 7, 79 Akaev, Askar, 186–7, 195, 197, 225 Albania, 29, 51, 66, 68, 72, 89, 128, 130, 137, 144, 163–5, 171, 206, 216, 222–4, 263, 270 Anti-trust legislation, 148, 199–201, 249 Armenia, 36, 66, 68, 87, 103, 108, 110, 112, 115, 128, 130, 135, 137, 144, 156, 169, 175, 193, 195, 197, 240, 262, 269 Aslund, Anders, 23, 29, 39, 52–3, 68, 82–6, 120, 148, 235, 241–4, 287 n.4, 288 nn.4, 5, 12, 292 n.2, 293 n.22 Association Agreements, 203–5 see also Europe Agreements Azerbaijan, 51, 54, 68, 71, 87–8, 98, 108, 112, 115, 137, 168, 171, 175, 188, 197, 262 Balcerowicz, Leszek, 19, 27, 45, 128, 151–2, 172, 283 n.11 Baltics, 2, 10 economic performance, 53–4, 69, 71, 81–2, 88 EU membership, 3, 6, 29, 173–4, 209–10, 221–2, 225–30, 268 institutions, 36–7, 57, 60, 65, 128, 186, 284 n.15 nationalist sentiment, 125–6, 128, 173–5 social costs, 93, 97, 100, 102, 105–6, 108, 112, 114, 116–17 transition progress, 2, 9–10, 20, 24, 50–1, 73–4, 90, 128, 137, 145, 158, 162, 165, 195, 258, 260, 272, 280 n.12 see also Estonia; Latvia; Lithuania Barnes, Andrew, 29, 32, 41, 134, 181, 236, 241, 287 n.2, 288 n.4, 292 n.8 Belarus, 8, 28, 44, 47, 51, 53–5, 61, 84, 87, 94, 98, 109, 112, 123, 125, 128, 138, 156, 158, l63, 166, 167–9, 171,

175, 182, 192, 197, 207, 212–13, 215–16, 218, 234, 251–2, 260–1, 263, 267 Berlin, Isaiah, 123, 282 n.1 Berlin Wall, 1, 2, 5, 151, 203 as date of transition start, 8 Big-Bang, see reform strategy Bosnia and Hercegovina, 50, 60, 89, 111, 174, 206, 216, 263 see also Yugoslav Federation Blanchard, Olivier, 16–17, 23–4, 27, 63, 277 n.3 Buiter, Willem, 21, 40–1, 133, 235, 241, 246, 279 n.6, 292 n.1 Bulgaria, 25, 39, 44, 53, 58, 63, 66, 82, 89, 100, 107, 109, 110, 132, 137, 144–5, 163–5, 174, 179–80, 185, 193, 195, 198, 205–6, 209, 211, 214, 222–3, 233, 247, 254, 260–3, 268–70 Campos, Nauro, 21, 23–4, 26–7, 62–3, 89–91, 278 n.15, 279 n.1, 280 n.14 Captured states, see State capture Carothers, Thomas, 42–3, 57 Central Europe, 2, 10, 27, 33, 97, 100, 102, 105–6, 109, 112, 117, 135, 145, 173, 177, 183, 279 n.4 economic performance, 52–4, 63, 69, 81–6, 186, 281 n.11 EU membership, 3, 6, 7, 155, 203–4, 208–9, 220–3, 233, 272–3, 289 n.3 institutions, 36–7, 42, 47, 55–9, 178, 192, 196, 241, 280 n.13 transition progress, 2, 8, 9, 30, 35, 50, 72–3, 158–64, 255–62, 272, 282 n.29 China, 7–8, 20, 22, 26, 38, 49, 79–80, 95, 101, 103, 117, 154–6, 174, 279 n.2, 280 n.1, 281 n.26, 282 n.2, 285 n.2 Chubais, Anatolyi, 187, 293 n.14 CISL, see Lagging reformers Clientelism in Africa, 201–2 Coase theorem, 40, 235, 241 see also Transition inevitable thesis 309

310 Index Collective action theory, 241 Commonwealth of Independent States (CIS), 3, 10, 33, 131, 135, 145, 156, 177, 190, 196, 198, 210, 216, 233–4, 273–4 economic performance, 52–4, 63, 81–6, 186 growth surge after 1998, 67–9, 245–6 institutions, 36–7, 40, 42, 55–9, 192, 235, 241, 274–5, 280 n.13 social costs, 88, 93–4, 97–102, 104–8, 112, 114, 117 transition progress, 36, 47, 50, 72–3, 158–64, 179, 255–62, 272 Comparisons with non-transition economies, 95, 102, 153, 156, 173–4, 178, 191, 199–202, 226, 239, 247, 249, 251–3, 267, 281, 291 Competitive or open, markets, 146–7, 183–4, 191–3, 262 Copenhagen Criteria, 205, 291 n.27, see also European Union Coricelli, Fabrizio, 21, 22, 23, 26–7, 62–3, 89–91, 277 n.1, 278 n.15, 279 n.1, 280 n.14 Corruption, 36, 48, 64, 172, 185, 202, 239, 244, 254 index, 202, 258; see also Transparency International tax bribes, 250, 273 Croatia, 39, 44, 50, 55, 60, 63, 71, 82–3, 94, 98, 123, 128, 130, 137, 144–5, 159–60, 161, 164, 168, 172, 174–5, 185, 193, 195, 198, 205–6, 212, 214, 222–4, 233, 240, 254, 260, 262–3, 267–8, 270, 291 n.21 see also Yugoslav Federation Crony capitalists, 238 see also Robber barons Czech Republic, 24, 29, 32, 35, 39, 44, 57, 65–6, 90, 115, 123, 128–30, 137, 165, 167, 185, 205, 222, 259, 262, 268 Czechoslovakia, 44, 71, 141, 145, 186, 204, 267, 271 see also Czech Republic; Slovakia Delayed reforms and EU membership, 220–3 and national first government, 168–72 and nationalism, 173–5 and social costs, 115

Democracy, 38, 45 measures, 54–7 relationship to markets, 11, 38, 42–6, 57–8 see also Transitology paradigm Distance from Brussels, see Geography Economic elites in history, 148, 178, 199–202, 236, 238–9 see also Oligarchs; Robber barons Economic performance, see Transition progress Economic rhetoric, 92 Education, 113–15 see also Reform strategy; Social costs Elite entrenchment, 199–201, 238–9 see also Economic elites; Transition frozen thesis End of transition, see Transition is over Energy sector, 179–80, 238 Estonia, 29, 30, 39, 50, 60, 63, 89–90, 99, 107–8, 123, 137, 153, 155, 167, 172, 204–5, 208–10, 212, 222–3, 225–7, 229, 244, 259, 260, 262, 267, 269 Europe Agreements, 160, 203–5, 225, 227, 229–30 see also Association Agreements European Bank for Reconstruction and Development, 7, 10, 17, 21, 24, 45, 48–9, 51, 55, 58, 62, 87, 91, 104, 110, 114–15, 118, 137, 144, 162, 171, 174, 218, 242, 261, 266, 270 see also Transition progress European Neighbourhood Policy (ENP), 213, 215 European Union (EU) Acquis Communautaire, 35–6, 154–8, 195, 205, 210–11, 228, 230 membership as reform discipline, 4, 5–6, 10, 137, 141, 198, chapter 7, (203–25), 211–12, 225–30, 233, 266–7 Faustian bargain, see Kravchuk, Ukraine Financial–Industrial Groups (FIGs), 241–2, 248 First transition government, see Initial conditions, continuity of communists

Index 311 Fischer, Stanley, 17, 19, 40, 90, 224 Forbes billionaires list, 185, 191 Foreign direct investment, 54, 209 Freedom House, see Democracy, measures see also Transition progress, democracy and freedom indicator Gaidar, Egor, 4, 19, 160, 187, 235–6, 249, 292 n.1 Geography, and EU membership, 7, 213, 215, 224–5, 271 see also Initial conditions, location Georgia, 3, 9, 61, 66, 68, 82, 87, 98, 103–4, 107–8, 112, 115, 126, 137, 156, 169, 193, 198, 216, 234, 248, 252–3, 263, 274, 276 Rose Revolution, 3, 9, 252–4 Gini coefficient, see Income distribution Glinsky, Dimitry, see Reddaway Gorbachev, Mikhail, 1, 151, 156, 179, 186, 237 Government guarantees, supports, see Subsidies Gradualism, see Reform strategy Growth recovery, 2, 3, 54, 62–70, 86 prospects, 245–7 see also Output decline Handelman, Steven, 36, 139, 144, 189, 287 nn.2, 4, 288 n.7 Hard budget, 16, 68 Havrylyshyn, Oleh, 23, 29, 41, 62, 65, 182, 196, 209, 237 Health indicators, see Life expectancy Heenan, Patrick, 109, 129, 132, 146, 160, 169, 172, 204, 283 n.10, 286 nn.19, 21 Hellman, Joel, 32, 41, 135, 144, 149, 182, 192, 198, 237, 240, 243, 288 n.8, 293 n.14 Historical cross roads, 132, 284 n.15, see also Initial conditions, uniqueness Historical inertia, see Initial conditions Human Development Index, 48, 92–5 Hungary, 29, 32, 39, 50, 61, 89, 90, 104, 107–8, 123, 127–9, 137, 141, 145, 165, 167–9, 171–2, 184–5, 193, 204–5, 208, 222, 225, 259, 262, 267, 269, 271

Import-substitution model, 156 Income distribution, 95–103 see also Poverty ratios Inflation, 54, 63–4, 162–3, 180, 238 see also Macrostabilization Informal sector, 70–2, 243 see also Kaufmann Initial conditions, 65–7, 126 continuity of communists, 128–30, 167–9, 190, 286 n.20 location, 127; see also Geography nationalist commitment, 128, 173–5 overindustrialization, 127 religion, 127–8 uniqueness, 131–2 years under communism, 144, 160, 167–8 and policy choice, 196–7 Insiders, 179, 181, 197 political insider v. firm insider, 181, 287 n.3 Institutions, 18, 33–8, 59–62, 154, 156–7, 166, 280 n.15 International Monetary Fund (IMF), 10, 19, 20, 21, 137, 198, 210, 216, 218–19, 243, 266 International organizations and reform, 216–20 technical assistance, 219–20 see also EU, membership as reform discipline Invisible Hand, 146–7 Johnson, Simon, 23, 61, 65–6, 148, 241–5, 278 nn.10, 15, 16, 292 n.2, 293 n.16 Kaufmann, Daniel, 72, 135, 192, 243, 278 n.16, 285 n.27, 288 n.8 Kazakhstan, 54, 68, 87, 89, 112, 137, 156, 167, 175, 178, 188, 191, 193, 195, 202, 240, 262 Khodorkovsky, Mikhail, 39, 188–9, 235, 248 Klaus, Vaclav, 19, 59, 156, 186 Kolodko, Grzegorcz, 17, 19, 22, 27, 100, 126–8, 131, 153, 172, 204, 279 n.6, 281 n.8, 282 n.4, 283 n.11, 284 n.14, 286 n.15, 286 n.25 Komsomol, 181 and new capitalists, 181, 187–8 see also Oligarchs, origin

312 Index Kornai, Janos, 16–17, 24, 26, 63, 277 n.2 see also Transition model; Output decline Kravchuk, Leonid, 168, 196 Krueger, Anne, 31–2, 40, 134, 201, 238, 289 n.25 Kuchma, Leonid, 188, 197 Kuzio, Taras, 196, 213, 247, 253, 283 n.5, 293 n.25 Kyrgyz Republic, 3, 9, 33, 44, 61, 66, 82, 87, 94, 104, 106–8, 112, 126–8, 135, 137, 145, 158, 161, 163–6, 170, 175, 182, 186, 193, 195, 197, 217, 225, 234, 252–3, 259, 263, 266, 269, 271, 274, 276 Tulip Revolution, 3, 9, 252–4 Laar, Mart (former PM of Estonia), 153, 167, 172, 204, 205, 272 n.4, 283 n. 14, 289 n.3 Labour markets, 89–90 Lagging reformers, 10, 37, 50–1, 59–60, 69, 115–16, 138, 261, 263–4, 267, 273 see also Belarus; Gradualism; Transition progress; Turkmenistan; Uzbekistan Lamontagne, Monique, see Heenan Latvia, 30, 35, 39, 50, 63, 66, 89, 123, 137, 167, 172, 185, 205, 208–12, 222–3, 225–9, 259, 262, 267, 269, 292 Law on cooperatives, 238 see also Perestroika Liberal societies, 137, 262, 267–8 see also Liberalism Liberalism, 55, 167–71 dual vision: markets and democracy, 11, 152, 162, 204, 208 Life expectancy, 111–13, 282 n.29 Limited reforms, see Lagging reformers Lipset, Seymour, 58 Lithuania, 29, 30, 35, 39, 63, 89, 107, 123, 137, 167, 205, 208–12, 222–3, 225–9, 259, 262, 267, 269 Loans-for-shares exercise, 30, 187, 197 see also Privatization Lobbying, 178, 185, 199–201, 239 difference from state capture, see State capture see also Rent-seeking Lukoil, 180, 251 Macedonia, 51, 89, 91, 100, 159–61, 163, 165, 206, 223, 261

Macrostabilization, 18, 22, 59–62, 159, 162 Mafia, 36, 144, 186–7, 189–90, 287 n.2 Market memory, see Initial conditions, years under communism McFaul, Michael, 43–6, 57, 254, 293 nn.24, 27 Moldova, 55, 66, 82, 94, 107, 110, 112, 114–15, 125–8, 132, 137, 145, 156, 158, 161, 164–5, 175, 180, 192, 207, 212–13, 215–17, 224, 252, 262, 269 Montenegro, 263 see also Serbia and Montenegro; Yugoslav Federation Murrell, Peter, 21, 23–4, 30–1, 33–4, 36, 64, 157, 278 n.15, 293 n.17 Navigation charts, 152–8 see also Reform strategy; Transition model Negative interest rates, 180 New firms, or denovo firms, 28, 31, 42, 182 North Atlantic Treaty Organization (NATO), 10, 137, 207, 216–17, 220, 266 Oil prices, 68 Oligarchs, 2, 3, 7, 33, 40, 42, 70–1, 134–40, 142, 147–8, 177–91, 197–9, 215, 234–9, 241–6, 248–51, 255–9, 261–4, 266–76 origin, 7, 142, 177–85 and robber barons, 148, 238 and state capture, 3, 5–6, 10, 32–3, 135–6, 183 and transformation frozen, 3, 11, 183, 233 Orange revolution, see Ukraine Organisation for Economic Co-operation and Development (OECD), 16, 70–1, 101–2, 243 Output decline, 8, 26–8, 81–6, 118–20 Pareto optimality, 8, 79 see also Reform strategy Partial reforms, see Delayed reforms Partnership and Cooperation Agreement, 213, 215 People revolutions, 234, 255 see also Revolutions of colour

Index 313 Perestroika, 11, 154, 156, 180, 237 Poland, 19, 22, 26–7, 30, 39, 44, 57, 63, 82, 90, 100, 104, 109, 123, 127–8, 141, 145, 153, 163, 165, 167, 171–2, 179, 184–5, 191, 204–5, 222, 225, 242, 259, 262, 267, 271, 281 n.16 Pope John Paul II, 1 Poverty ratios, 103–10, 281 n.23, see also Social indicators; Reform strategy and social costs Price controls or regulation, 178–80 see also Price liberalization Price liberalization, 17–19, 59–60, 178–9 Privatization, 18, 24, 28–31, 59–60, 67, 162, 177, 178–9, 195, 197, 261, 278 n.13 see also New firms, or denovo firms; Privatization Property rights, 35–6, 39–40, 136, 199–201, 235–7 Przeworski, Adam, 44–5, 49, 55–7, 252, 257–8, 286 n.24 Rapid reforms and EU membership, 220–3 and nationalism, 173–5 and social costs, 115, 259 see also Reform strategy, big-bang Reagan, Ronald, 1, 151 Red Directors, 180–1, 186, 197 Reddaway, Peter, 19, 22, 33, 113, 117, 126, 181, 197 Reform strategy, 159, 164–7 big-bang, or rapid, 6, 19, 23–6, 153–5 debate and delay, 5, 10, 11, 17–20, 136, 138–40, 152, 154, 158, 176, 192–4, 220–22 gradualism, 6, 19, 23–6, 59–60, 156–7 measuring success or failure, 8–9, 94 shock-therapy, 6, 19 and social costs, 94, 115–17, 259–60 Rent-seeking, 3, 10, 32, 134–5, 178–85, 191–2, 233, 266–7 see also Krueger, Anne Re-privatization, see Reversing state capture Reversing state capture, 248–54, 274–6 see also Revolutions of colour Revolutions of colour, 234, 252–4, 263, 293 n.21, see also Georgia, Rose Revolution; Kyrgyz Republic, Tulip Revolution; Ukraine, Orange Revolution

Roadmaps for transition, see Navigation charts; Reform strategy Robber barons, 199–202 see also Oligarchs Roland, Gerard, 23–4, 277 n.3, 278 n.12, 279 n.2, 284 n.18 Romania, 29, 39, 44, 53, 58, 66, 72, 82, 89, 99–100, 107, 109–10, 125, 137, 145, 159–61, 163, 165, 168, 174, 179, 185, 198, 205–6, 209, 211, 214, 222–3, 233, 247, 254, 260–3, 268–70 Rose Revolution, see Georgia Rukh, 168, 196–7, 271 Rule-of-law, 35, 40, 130–1, 136, 139, 199–201 Russia, 20, 24, 29, 30, 32–3, 35, 39–40, 44, 54, 57, 63, 65, 66–8, 70, 82, 87, 89, 98–103, 107–8, 110–13, 126–8, 135, 137, 144, 148, 151, 155–6, 158, 159–61, 164–6, 168, 170, 178, 180–2, 184–93, 195, 197, 199, 202, 206, 209, 219, 228, 235–6, 238, 241–2, 245, 246–8, 250–1, 259–60, 262, 266, 269, 271–8 Sachs, Jeffrey, 23, 31, 34, 51–2, 54, 278 n.14, 279 n.1 Schengen curtain, 212–13 Security issues, 216–17 Serbia and Montenegro, 50, 60, 89, 90, 123, 127–8, 130, 145, 164, 167, 174–5, 206, 216, 252–3, 263, 276 see also Yugoslav Federation Shadow economy, see Informal sector Shleifer, Andrei, 39–40, 178, 197, 202, 235, 242, 246 Shock therapy, see Reform strategy Slovakia, 29, 35, 39, 44, 55, 65, 123, 128, 130, 133, 137, 165, 168–9, 172–5, 193, 205, 212, 218, 222, 225, 259, 262, 267, 269, 283 n.10, 290 n.13 Slovenia, 30, 39, 60, 89–90, 123, 127–8, 130, 145, 164, 167 see also Yugoslav Federation SMEs (small and medium enterprises), 138–9, 241, 242–4, 275–6 and oligarch influence, 243 see also New firms, or denovo enterprises Smith, Adam, 146 see also Invisible Hand Social indicators, 10, 91–2 see also Reform strategy, and social costs

314 Index South-East Europe, 3, 9, 10, 79–81 Soviet Mafia, see Mafia State capture, 3, 10, 135–6, 178, 191–3, 262, 269–70 and reform delay, 192–6 v. lobbying, 33, 178, 188, 202, 239, 262–3, 273–4 see also Oligarchs; Rent-seeking; Transition inevitable; Transition frozen Stiglitz, Joseph, 17–22, 29, 31, 33, 34, 36, 277 nn.1, 5, 279 n.2 Subsidies, 179–80 Svejnar, Jan, 21, 29–30, 100–1, 115, 278 n.15 Tajikistan, 51, 61, 68, 87, 95, 108, 110, 112, 138, 161, 263 Trade and exchange liberalization, 17–19, 59–60 Transformational recession, 26 see also Kornai; Output decline Transition costs, 3, 78–81 Transition frozen (TF) thesis, 40–1, 46, 134, 147, 183–5, 197–8, 236–8 empirical evidence, 238–40 Transition inevitable thesis (TI), 39–40, 46, 133–4, 181, 233–6 Transition is over, 3–4, 255, 260–1 Transition model, 15–20, 124, 133–43, 149–50, 264–6 debates on transition, 21–3, 138–40, 152 see also Reform strategy Transition progress, 47–8, 146, 255–6 correlation among indicators, 10, 49, 51, 54, 58, 256 democracy and freedom indicator, 54–7 EBRD Transition Progress Indicator (TPI), 10, 48–52, 73–7, 162–4, 256–8 economic performance measures, 52–9 historical explanations, 125–33 see also Human Development Index; Social indicators Transition start, 152, 158–64 Transitology paradigm, 42–6 Transparency International, 36, 48 Tulip Revolution, see Kyrgyz Republic

Turkmenistan, 8, 28, 47, 51, 54, 61, 68, 71, 87, 89, 94, 98–9, 109, 123, 138, 166–7, 175, 182, 218, 234, 251, 257, 260–1, 263 Twain, Mark, 200, 233 Ukraine, 3, 9, 20, 29–30, 32, 35, 44, 55, 65–6, 82, 87, 98, 100–1, 106–8, 110, 112, 126–8, 130, 133, 135, 137, 152, 155–6, 168, 174, 177–8, 180–2, 184–6, 188–91, 196–9, 202, 207, 211–16, 233–4, 236, 239, 242–4, 247–54, 262–3, 269–71, 274, 276 and EU membership efforts, 213–14, 247 Orange Revolution, 3, 9, 215, 252–4 timeline, 158–64 see also Kravchuk; Kuchma; Rukh; Yuschenko Underground economy, see Informal sector Unemployment, 87–91 United Nations Development Programme (UNDP), 48, 78, 80, 91–3, 95, 104, 106, 111, 114, 286 Uzbekistan, 8, 47, 51, 54, 61, 72, 84, 87, 94, 109, 123, 138, 156, 158, 163, 166, 167, 175, 182, 192, 234, 251, 257, 260–3 Veblen, Thorsten, 200 Visegrad countries, 8, 23–6, 34, 40, 63, 80, 92, 265 Washington Consensus, 17–20, 154–5, 210 World Bank, 10, 15, 20–1, 29–30, 32, 34, 36, 40–1, 48, 94, 104, 106, 110, 135, 137, 144, 149, 188, 191–2, 195, 210, 216, 218–19, 236, 240–3, 266, 270 World Trade Organization (WTO), 10, 127, 137, 216–17, 220, 266 Yeltsin, Boris, 186–7, 197 Yugoslav Federation, 8, 172, 184, 261, 270 Yukos, see Khodorkovsky Yuschenko, Viktor, President of Ukraine (2005–), 68, 213–15, 249, 292 n.7

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