Reform and Political Stability

China in the early 1980s provides the most striking example of reform phased so as to avoid disruptions brought from the world’s credit markets, and based primarily on step-by-step domestic changes. The foundation for restructuring lay in an increase in agricultural output following the introduction of market mechanisms in the countryside. The reform of the external sector alone and in isolation was recognized as an insufficient basis for the raising of productivity and the maintenance of social stability.

In December 1979, the Central Committee of the Chinese Communist Party resolved that in the past too much emphasis had been laid on steel and heavy industry and that lighter industry and agriculture had been neglected. Some of the highly capital intensive old prestige projects, including those that had involved foreign investment, such as the Baoshan steel plant financed by Japan, were scaled back. The State Planning Commission formulated a new policy of “readjustment, transformation, consolidation and improvement.”⁶ In practice, agricultural reform meant acceptance of the family rather than the commune as the basic unit of rural economic activity, which would market products grown on plots of land privatized as a result of local initiatives. Planning would be supplemented through the adoption of a decentralized and market-oriented approach. As a contemporary Chinese analysis put it: “It is inconceivable that an immense economy like ours could be managed by administrative orders issued from above by an organization of supreme authority.… Reality shows that such a system can only result in technical stagnation, chaos in production, severe bureaucratism, and lack of efficiency.”⁷ Already by the mid-1980s, the state-owned sector contributed a far lower share of output than in other socialist countries; and this process of informal privatization laid a basis for new dynamism through the creation of private property, and investment sustained through self-finance.⁸

Part of the new course involved an approach to multilateral financial institutions, which involved intrinsically political as well as economic debate. After the Chinese Revolution, Western governments had recognized the Kuomintang government in Taiwan Province of China (“Republic of China”) as the only legitimate Chinese authority. In August 1950 the revolutionary Prime Minister, Zhou Enlai, wrote to the IMF’s Managing Director that the People’s Republic of China constituted the only legal government, and at the IMF Annual Meeting in 1950, Czechoslovakia, Yugoslavia, and India unsuccessfully put forward a resolution requiring the exclusion of the representatives of the Republic of China. The diplomatic isolation of the People’s Republic of China by the West ended in 1971, and was followed by a rapid increase in trade contacts. In 1973, the President of the World Bank, Robert McNamara, invited the People’s Republic of China to apply for membership, but received no immediate reply.⁹ No decision in practice could be taken about the issue of membership in international financial institutions during the life of Mao Zedong.

Almost immediately after the reform initiatives of December 1978, a discussion began of membership of the IMF and the World Bank. In part, perhaps the attraction was negative: a Chinese membership would involve forcing out Taiwan Province of China. The Vice-Chairman of the Chinese Communist Party and the driving force behind the economic reforms, Deng Xiaoping, stated that “there would be no hitch on China’s part in joining the IMF if the Taiwan issue is settled.”¹⁰; But the positive appeal of membership in international institutions was far stronger. It would bring increased flows of information, and international openness, and above all it would lock in the reforms. The World Bank might make available resources for development projects. As McNamara pointed out to a Chinese delegation visiting the World Bank, membership of the Bank entailed first joining the IMF.¹¹ The Fund’s Executive Board agreed that, with effect from April 17, 1980, the “Government of the People’s Republic of China represents China in the Fund,” and then raised the Chinese quota substantially. It had been unaltered since the first determination of quotas at Bretton Woods, at SDR 550 million; it was now raised to SDR 1,200 million ($1,560 million) and then quickly, as a consequence of the Seventh General Review of Fund quotas, to SDR 1,800 million ($2,340 million).¹²

Initially in late 1980 and 1981, the Chinese government hesitated in using the resources of international institutions, as it believed that the Chinese economy was showing serious signs of overheating. After that, however, China became a major user of program loans, and the World Bank became (after Japan) the second most important source of external finance. By 1987, China accounted for 6.1 percent of World Bank lending and 16,0 percent of International Development Association (IDA) credits.¹³ In the initial phases, IMF credit also provided an essential source of balance of payments assistance. In negotiating the stand-by arrangement concluded in 1981 (which, together with a loan from the Trust Fund, amounted to SDR 759 million or $905 million), the IMF took the position that the government’s assessment of its balance of payments position for 1981 was too pessimistic. It argued that the constraints on reform, supply bottlenecks (particularly in energy), and the emergence of inflationary pressures required an import of capital goods. Over the period of the Seventh Five-Year Plan, the IMF encouraged China to run a substantial current account deficit in order to modernize the economy and develop China’s export potential.¹⁴ In 1986, the Fund concluded another stand-by arrangement for balance of payments assistance. In the second half of the 1980s, an outward-oriented strategy involved the abandonment of import substitution. Special Enterprise Zones (SEZ) and “open cities” with a special legal, tax, and tariff status developed with a speed equivalent to that of the other rapidly growing East Asian economies. Between 1986 and 1991 exports grew tenfold. Some observers began to call China the newest and certainly the largest Asian “tiger.”

Apart from an appropriate sequencing of reform measures, first agricultural liberalization, and then an encouragement of more general private sector development in commerce, manufacturing, and finance, China had the advantage of not having incurred a large debt to private sector creditors. In contrast with attempts at reform in the Soviet Union and in communist Eastern Europe during the 1980s, the Chinese reformers looked much more to international institutions and much less to commercial creditors.¹⁵ They started to call the representatives of those institutions “foreign monks” (recalling the technically educated and very supportive Jesuit missionaries of the seventeenth century) rather than “foreign devils.”¹⁶

Rapid growth often involves, at least for a time, large current account deficits. They may be viewed as a concomitant of the growth process. If they reflect inflows of capital invested productively, they should not he a source of concern. Ensuring that the flows are really used productively, however, requires the generation of market signals in the domestic economy. International financial institutions played a valuable role in reassuring authorities about the possibility and desirability of growth. Such reassurance was much easier in the case of countries that had not experienced, in the shape of the international debt crisis of the 1980s, shocks stemming from the consequences of bank-financed balance of payments deficits.

Yugoslavia stands at the opposite end of the reform spectrum to China. China began with domestic reforms, and appeared slow in freeing the economy to international markets. In Yugoslavia, a far-ranging international liberalization was accompanied by a severe debt crisis as well as by inadequate domestic reforms and the almost total absence of any domestic political and social consensus. Indeed, the government often secured international approval by the appearance rather than the reality of domestic change.

Of all planned economies, Yugoslavia for a long time was the most exposed to international forces and seemed to many influential figures in the West the most promising candidate for a reform and an adoption of market mechanisms. In 1961 and 1965, the government had introduced partial liberalizations of the trading system, in association with the introduction of a unified exchange rate (in 1961) and devaluations of the dinar. But import restrictions began to appear again, and new reform programs were needed but not implemented. At the end of the 1970s, Yugoslavia financed its increased current account deficits through international borrowing. In the course of 1980 alone, the Yugoslav external debt in convertible currencies rose by a third, to $17.6 billion.¹⁷ The Five-Year Plan developed for 1981–85 was to be supported by a lengthy Fund arrangement (a three-year stand-by of SDR 1,662 million, or $1,960 million), with the aim of strengthening the balance of payments, maintaining an exchange rate that would keep the economy competitive, and scaling back the rates of growth from the high levels of the late 1970s (the projected growth would begin at 3 percent and rise to 5 percent by the end of the Five-Year Plan).

The outbreak of the international debt crisis forced a change of course in Yugoslavia, despite an impressive balance of payments improvement in 1981. At first Yugoslavia tried to obtain a three- to four-year loan from the Bank for International Settlements (BIS), which could clearly not be regarded as simply a bridging loan, and was thus refused.¹⁸ The package eventually negotiated¹⁹ included the elements familiar from other debt agreements: $600 million new medium-term bank money; a rollover of short-term credit; a $500 million BIS credit; a $275 million World Bank structural adjustment loan; an intergovernmental support package of $1,300 million; as well as the already agreed $1,960 million IMF stand-by arrangement. After the debt crisis, Yugoslavia’s economic development took place nominally under Fund “supervision”: first through the device of the stand-by arrangement; from 1986 to 1988 through the enhanced surveillance mechanism; and in 1988 through a new stand-by arrangement in conjunction with a rescue package coordinated with commercial banks and bilateral official creditors. It remained a largely nominal external control, however, since Fund missions were not informed of crucial policy decisions (for instance, they knew nothing in advance about the 1988 debt default) and since the statistics supplied by the Yugoslav authorities on critical components of the reform efforts, notably on fiscal and monetary performance, were illusory. The figures were perhaps not deliberately deceptive in the sense that the authorities did not possess anywhere a true second set of accounts; but they were manufactured by a weak, divided, and incompetent bureaucracy that had almost no access to any measure of how the economy actually functioned. Yugoslav statistics remained in consequence fundamentally meaningless. The experience constitutes one of the most striking examples of how international institutions were subject to a political pressure, exercised in the belief that Yugoslavia constituted a positive and non-Soviet economic as well as political experiment within the socialist bloc.

The major weakness undermining the effectiveness of Yugoslav reforms in the first half of the 1980s was the acceleration of inflation. There had been a slight fall in the rate of price increases in 1982, but from then on inflation levels rose. Without a notion of property and ownership, such as had been created for instance in the Chinese countryside after the reforms of the late 1970s, there were few limits on the growth of credit. Enterprises that were not controlled or “owned” felt no hesitation in supplying or taking goods to or from other enterprises on credit, without much concern about how the supplies would be repaid. Eventually, they believed, rightly, these debts would be monetized by the central bank. One of the dilemmas of reform appeared to be that a price liberalization, such as that implemented by Yugoslavia in 1983, invariably led to price increases. Monetary authorities accommodated these increases; and at the same time, states in an incompletely controlled federal system used the monetary system to finance their fiscal deficits.²⁰ The monetary expansion provided the fundamental dynamic of the Yugoslav inflation, which became ever more apparent in price behavior as price controls were reduced or eliminated, and the monetary overhang could be fully expressed on the market. The consumer and enterprise sectors could no longer be treated as separate. In these circumstances, the external exchange rate came to play a major role as the only reliable guide as to what stability might mean. The behavior of this rate, however, was affected by the developing inflation. As they detected signs of price increases, Yugoslavs working abroad reduced the scale of their remittances, and corporations tried to avoid repatriating their export earnings. There was in consequence continual pressure on the exchange rate, and a massive depletion of reserves.

A further liberalization of prices and import regulations in May 1988 provoked an even more dramatic rise in consumer prices. The Yugoslav authorities argued constantly, and utterly erroneously, that the fact that the real (that is, price-deflated) money supply was falling indicated that they were in reality pursuing a contractionary monetary policy. (In fact, real money supply always falls in an accelerating inflation, as the velocity of circulation increases.) Prices, which had increased by 120 percent in the course of 1987, rose by 195 percent in 1988, and by a hyperinflationary 1,240 percent in 1989. Hyperinflation in turn strained beyond endurance the federal system, already weakened by nationality conflicts, and in this way precipitated the breakup of the Yugoslav state from 1991. An attempt at “shock therapy” at the end of 1989, involving the lifting of price and trade controls and the introduction of a convertible currency pegged to the deutsche mark, achieved only a brief success. By now, another problem had emerged: the fiscal policy of the federal states was no longer set at the center. In the course of 1990 increased fiscal deficits accumulated as a result of uncontrolled spending by states. Individuals took advantage of convertibility to escape from the dinar, with the consequence of a rapid loss of reserves. A shock in short could only be sustained by a well-functioning and consensual political system, which clearly did not exist in Yugoslavia in 1990 or 1991—but had not existed at an earlier stage either.

The Long Path to Reform in Central Europe

Central European political and economic reform did not start with the dramatic political events of 1989, but had much deeper roots. The same hope that internationalism would sustain the process of domestic economic adaptation that motivated the Chinese discussion of the late 1970s inspired East and Central European reformers; but, because of the geopolitical situation, the implementation of reform took much longer. The structural distortions caused by the emphasis on heavy industrial output in the Soviet model, and the politically powerful interest groups clustered around heavy industrial management, made reform additionally harder. A discussion of a greater role for prices in making economic decisions had occurred already in the 1960s, with simultaneous debates in the U.S.S.R. (where the principal advocate was Yevsai Libermann), Poland, and Czechoslovakia. Reformers tried to approach international institutions for support. In December 1966, for instance, János Fekete, then a relatively junior official at the National Bank of Hungary, visited the IMF to explain details of the reform measures that would be launched in January 1968, and which were, he said, “based on an approach broadly that of the Fund.”²¹ In 1967, as a result, extensive discussions began with Hungary, and a general movement of centrally planned economies into the Bretton Woods framework appeared likely: the first candidates would be Hungary, Czechoslovakia, and Poland, while Romania was expected to follow later. Poland indeed had already begun to discuss a renewed IMF membership after de-Stalinization and the other political changes of 1956.²²

As these discussions proceeded, however, the political element in economic reform became more obvious and more disturbing. In the course of 1968, some of the Fund’s informal contacts in the planned economies began to present arguments that indicated that no cleat boundary existed between economic reform proposals and ideas critical of the whole political orientation of the U.S.S.R.’s European empire. A Polish representative to the General Agreement on Tariffs and Trade (which Poland had joined in 1967) for instance explained to an official of the IMF that “there were some in authority in Poland who were aware that they were paying a high price in continuing to trade with Soviet Russia. However, it was difficult to convey to certain officials in charge of enterprises that it did not make economic sense to sell at high cost to Russia and to import at a high cost in exchange for the goods exported.… He thought that the Fund would do a good service if it produced a kind of critique of the economic policies of the socialist countries. Such an appraisal would be seriously studied and would serve to point out to those in power that their policies were out of date and not in the long-term interest of their countries.” The Fund official replied that “it would be undiplomatic for the Fund to issue a critique of socialist economic policies, especially at a time when some efforts were being made to review and change these policies.”²³ The pace of reform appeared to he increasing. In May 1968, as the political reform movement in Czechoslovakia blossomed, the liberal economist and Deputy Prime Minister Ota Šik announced that Czechoslovakia would wish to join the IMF.²⁴

After a Soviet military invasion in August 1968 ended the “Prague Spring,” the U.S.S.R. vetoed the membership of Warsaw Pact countries in international financial institutions. Romania alone, as the state least dependent on the Soviet Union, continued to press for an association, and joined the IMF in December 1972. It was a step that had not, however, been taken completely independently. In 1973 the Romanian government discussed this experience, and the Fund’s practices and policies, with other members of the Council for Mutual Economic Assistance (CMEA), including the U.S.S.R..²⁵ In 1971 and again in 1975 and 1976, Hungarian negotiators claimed that there was “a body of opinion in Moscow interested in and even inclined to such a move”; and that the Soviet position had become “sofrer.”²⁶ Even the U.S.S.R. occasionally gave reminders that the decision of 1945 had been to postpone, and not to refuse, membership of the Fund and the Bank. In 1973, for instance, Deputy Trade Minister Vladimir S. Alkhimov told an American news magazine that the decision on joining the IMF was “up to our Treasury. I know that they don’t like some of the IMF’s procedures, such as its system of voting.… But I wouldn’t rule it [membership] our forever.”²⁷ In the 1970s Polish officials and ministers wanted to join the Fund, but found the Soviets inflexible on this issue. The Polish government was in consequence only prepared to apply for membership after Hungary had shown the way.

In the mid-1970s, a wider rapprochement between Central Europe and the international financial system was held up, not so much by Soviet pressure, but rather by the consequences of the first oil price crisis for the non-oil producers. A major goal of the domestic reform exercise in Central Europe lay in bringing domestic and international prices together, but the increase in Western prices made such a move practically impossible for Hungary and Poland, which were unwilling to face the domestic unpopularity that would follow from sharp price increases. For some time, moreover, the Soviet Union used the new disorder as a way of binding the members of the CMEA more closely by supplying them with oil at prices below the new world market levels. It is not surprising that it was precisely the reformers in Poland and Hungary who were most articulate in calling for a stabilization of the world economic and monetary system in the middle of the turbulences of the early 1970s. Some even called for the restoration of gold as a “disciplinary gimmick” that would ensure world price stability.²⁸ Inflation and rapid changes in parities defeated their objective of moving their economies closer to a single world market and increased the artificiality of the price structure in most Central European countries. The oil crisis forced a retreat into the erroneous and harmful belief that “there were two world markets and negative events on the capitalist market did not affect our economic relations with our socialist partners.”²⁹

Romania, despite its advantages in the 1970s as a major energy producer, did not seem an altogether alluring model for the integration of a socialist economy into the world order. Along with a very dynamic economy, and very high growth rates in the 1970s (there was general agreement that the projected 10–11 percent growth of the plan period 1971–75 had actually been realized), there were major problems. Romanians were reluctant to supply economic information, with the result that until 1980, the Fund could not compile a country page for its International Financial Statistics publication. External advice that did not amount to praise for the Ceauşescu regime was unwelcome. In a system that did not permit public discussions of ideas or policy, government officials found criticism unfamiliar, and feared it.

As a consequence, Romanian programs were rather smaller than the government had initially hoped. The IMF agreed a first credit tranche drawing in November 1973, but in the absence of more detailed information refused higher tranche drawings. There were new stand-by arrangements after Romania was hit by natural catastrophes—floods in July 1975 and an earthquake in March 1977—but they were accompanied by a continuing suspicion that incorrect data had been supplied. Once the Fund program ended in September 1978, the agreed performance criteria were immediately broken. By the end of the 1970s, a more skeptical attitude toward the Romanian experiment had developed in the Fund; although the World Bank continued to supply rather upbeat verdicts on Romanian performance.³⁰

A reward of membership in international institutions appeared to be a ready access to international capital markets. A growing Romanian deficit on the current account (which rose from 1.5 percent of GNP in 1978 to 4 percent of GNP in 1980) was financed quite smoothly at first, through international borrowing.³¹ By 1981, however, conditions on the market had become more difficult, and Romania wanted to use a Fund arrangement as a way of reassuring its foreign lenders. Romania pressed for a longer (three-year) commitment under the extended Fund facility, on the basis of a precedent in the case of Yugoslavia, but never obtained it. As part of the conditionality of a SDR 1,102.5 million ($1,300 million) three-year standby arrangement, Romania in 1981 agreed to reduce the current account deficit to 2 percent of GNP in the next financial year and to prepare a schedule for the elimination of the majority of consumer price subsidies. Despite the stand-by arrangement, difficulties in paying debt service mounted, and by September 1981 there were delays in payments. Although the conditions of the stand-by arrangement were violated, the Romanian authorities attempted to “insist” on the release of the drawing due on November 15 and refused to request a formal rescheduling of bank debts. They preferred instead to let smaller banks quietly withdraw credits and to negotiate on a bilateral basis with the larger creditor banks.³² The result of this unwillingness openly to acknowledge the payments problems was a sharp deflationary crisis as Romania repaid almost all its foreign currency debt. It might be viewed, at least from the standpoint of the creditor banks, as a heroic performance by a government with sufficient authority to force its population to pay the higher cost of quick adjustment. It was thus fundamentally the gesture of a dictatorship. The result was a dramatic fall in imports from market economies and a shift to greater dependence on CMEA trade.³³ The repayment was also necessitated by the Romanian obsession with not disclosing economic data.

As a consequence of the Romanian decision to repay external debt at any and all domestic costs, a general Central European debt crisis did not break out until six months later, and involved Poland and Hungary, and not Romania. It has been described, briefly, above. Hungary had attempted to link domestic reform with institutional internationalization from 1979, when the more liberal “New Economic Mechanism” had been reintroduced. At the beginning of 1982, new regulations allowed greater scope for private enterprise, particularly in services. But the deflationary early 1980s were at least as unpropitious as the highly inflationary mid-1970s for exposure to an international economic and financial order. Hungary actually joined the IMF and the World Bank on May 6, 1982, in the midst of its debt crisis.

The liberalization carried out in 1982–83 went at a faster pace than had been spelled out in the letter of intent prepared for the first Hungarian IMF program. Gasoline prices were increased and the forint devalued farther than had originally been suggested. But the risk of a major foreign currency crisis remained. The withdrawal of foreign bank deposits constituted a monthly drain of at least $30 million in the first half of 1983, and the government expected the gross capital outflow for the year to amount to $1.75 billion. Hungary negotiated with the major creditor banks. At the same time, the BIS committed additional funds in support.³⁴ Hungary also—without telling Western creditors or the IMF—tried to replace the lost credits with increased inter-CMEA credits from the U.S.S.R., a strategy that lasted until the U.S.S.R. insisted on a reduction of credit lines in 1984.³⁵ (In 1989, it emerged that there had been a consistent misreporting of Hungary’s external and internal debts over the course of the 1980s.)

In 1983, Hungary prepared a much more extensive economic reform program. A paper prepared by Vice-Prime Minister J. Marjai envisaged the reduction of most consumer subsidies in stages beginning in 1984. The reduction in subsidies would be compensated through wage increases; in order not to penalize enterprises, the existing very high profit taxes should be cut as wages rose. A general freeing of wage setting would facilitate the movement of Labor out of low-efficiency and loss-making enterprises. The combination of a mildly inflationary impetus, with the imposition of enterprise budget restraints, could accelerate a transition to market economics. Credit offered through the State Development Bank would be limited.³⁶ This reform would be accompanied by a long-term IMF package. Throughout the negotiations, the Hungarian negotiators insisted that the length of the program was more important than the quantity of funding. It was essential to secure an external support for a sustained process of adjustment.³⁷ In January 1984, a new stand-by arrangement was approved to accompany the Hungarian stabilization plan.

During the 1980s, Hungary implemented a gradual incremental liberalization, accompanied by external support. In 1986, commercial banking was separated from the activities of the Bank of Hungary, and the new banking system was allowed flexibility in setting interest rates for enterprises. In May 1988, Hungary negotiated an SDR 265.35 million ($357 million) stand-by arrangement. In 1989, banks were permitted to take deposits from and lend to the household sector. In order to strengthen and consolidate the reform impetus, a new stand-by arrangement was agreed on March 14, 1990, ten days before Hungary’s first free elections since the 1940s. In February 1991, the process of structural adaptation was supported through a three-year extended Fund facility.

The end result of increased liberalization in gradual doses in the 1980s did not look encouraging. As in other planned economies, growth rates had fallen sharply in the course of the decade. The average annual growth rate of real GNP for the first half of the decade had been 1.4 percent; it fell to 0.5 percent in the second half.³⁸ The crisis of the end of the 1980s proved to be not just a crisis of the planned economy, but also a demonstration of the inadequacy of Hungarian-style gradualism.

A Model Reformer

Economic reform initiatives in Poland often appeared to follow a similar course to the Hungarian experience, but the dynamic instability of Poland’s political evolution generated a very different outcome. In the 1970s under First Secretary Edward Gierek, the Communist Party attempted to promote modernization. As in Hungary, the oil shocks in the Western economies constituted a caesura. Growth rates fell off after the mid-1970s. Social resistance to the reduction of consumption levels constrained the Polish regime even more than in Hungary. Government attempts to raise (or “liberalize”) prices not only formed a leitmotif running through Poland’s economic and social experience between 1970 and 1990, but also a fundamental cause of political change.

The government had been shaken by working class protest in 1970, when Gierek’s predecessor Władysław Gomułka had been forced to resign. While in the first half of the 1970s, the average annual rate of real consumption increase was 9 percent, in the second half of the decade it fell to 4 percent. The regime knew its weakness, and saw its unpopularity as limiting the possibility for effective action. In 1976, confronted with popular demonstrations, it backed down on an attempt to increase prices. Instead it encouraged a buildup of Western debt, a substantial proportion of which was used to finance increased consumption. From 1977 to 1980, a third of credits are estimated to have been used in this way, the largest part of them to pay for purchases of agricultural goods.³⁹ Poland became the world’s third largest wheat importer. Some Poles suspected that after 1978 an increasingly political motive underlay the enthusiasm of Western governments for loans. The German Chancellor, Helmut Schmidt, who publicly urged German banks to extend credits to Central Europe, hoped that credit would contribute to political stabilization and the implementation of gradual reform. Western engagement also had a purely commercial motive. A combination of prompt service payments, skillful debt management by a limited number of state-owned banks, and the widespread assumption by creditors that there existed a Soviet “guarantee” or “umbrella,” made Poland appear as a model debtor. Gierek’s attempt to buy popularity with foreign money succeeded only in raising consumption levels. It brought none of the hoped-for macroeconomic gains, and almost no increases in productivity levels. Prices remained distorted, and an attempt to correct them provided the trigger to the crisis of legitimacy of the Polish regime that developed in the course of 1979 and 1980.

Poland became one of the first states shaken by the international debt crisis. As in other debtor countries, maturities shortened in the early 1980s, and the surge of interest rates increased the cost of service.⁴⁰ In order to deal with the unanticipated decline in foreign lending, the Prime Minister, Edward Babiuch, attempted a drastic Romanian-style adjustment program aimed at eliminating the Polish trade deficit in the course of a year, and repaying foreign debt. In 1980, the government repaid about a fifth of its long- and medium-term debts (about $5.2 billion), in addition to paying $2 billion in interest. France agreed to a rescheduling of official credits. The domestic side of adjustment was to be accomplished through price increases, which the government hoped to camouflage through undertaking quality reductions for goods that would stay at the same price, and by introducing the “reforms” at the start of the summer holiday season.⁴¹ This attempt to raise prices on the sly failed miserably. Initial strikes against the price hike were successful in obtaining wage increases, and these victories of the workers’ opposition groups helped to create a national movement (Solidarity), which demanded the creation of free trade unions, the right to strike, and freedom of speech and publication.⁴²

For some time in 1981, it appeared that it might be possible, given skillful negotiating by both the government and the opposition, to produce a consensus around economic reform, coupled with some measure of political opening. Both sides agreed on the desirability of some measure of liberalization. But the opposition found it hard to accept the responsibility for a harsh stabilization that the government was attempting to impose on it, while the regime was stalling on demands for further political liberalization. Solidarity leaders insisted, rightly, on some measure of power: they did not simply want to take the hard task of selling an initially unpleasant liberalization package and thus making the government’s part easier. They worked out their own plans. There was even a detailed blueprint prepared by Professor Leszek Balcerowicz of the Warsaw School of Planning and Statistics, drawn up on the basis of discussions that had been taking place since 1978. Its main suggestion was an operation of independent firms, run on a self-managed basis, within a market and cut off from central planning. This plan had been drawn up in the knowledge that it represented a second-best solution to a full transition to the market—but the basic premise of the would-be reformers was that they needed to stay within the boundaries of “our understanding of political realism.” At this time this included both remaining within the CMEA, and not introducing private property.⁴³

Some elements of economic reform were realized in Poland between September 1981 and February 1982. Large economic supra-enterprise organizations and the so-called branch ministries were abolished, and responsibility decentralized to the enterprise level. Firms were given greater autonomy in setting wages. A unified external exchange rate was introduced. But in its essentials, the program brought by the government to the Polish parliament on December 1, 1981 (termed the “provizorium”) ignored Solidarity’s suggestions, To emphasize the fact that the decrees were not the result of negotiation with the domestic opposition, the government announced them during a meeting of Warsaw Pact defense ministers in Moscow. In fact, it was the world political scene that shaped the outcome of the upheavals of 1980–81. A different international context might have made possible an agreement on a more far-ranging reform, including both political and economic elements. Some Solidarity activists, as well as sympathizers outside Poland, advocated a Marshall Plan style aid package that would make bearable the costs of reform. The government too hoped for a broad-based international support. On August 14, 1981, the first secretary of the Polish Communist Party, Stanislaw Kania, and the Prime Minister, Wojciech Jaruzelski, traveled to a meeting with the Soviet leader Leonid Brezhnev in the Crimea, and inquired whether Poland might join the IMF. The Soviet Foreign Minister Andrei Gromyko firmly opposed the suggestion, as did a Soviet delegation under the head of Gosplan which was sent to Poland to investigate Polish conditions. In the meantime, the Polish government had made other soundings (the Foreign Minister asked the Pope about IMF membership); and in November 1981, despite continued Soviet hostility, Poland applied for readmission to the IMF.⁴⁴

In fact, however, the political part of the reform endeavor came to an abrupt halt on December 13, 1981, with the imposition of martial law and the banning of Solidarity. This visibly and brutally destroyed both the domestic and the international basis for consensus over reform. The United States imposed economic sanctions, including a veto of Polish membership of the IMF. Martial law also threatened the process of debt negotiation.

Debt had played a crucial part in the shifting balance between Eastern and Western orientation in Polish politics. Until April 1981, Poland was regularly servicing its debt, despite the disruptions to output caused by the political turmoil. For some time, the U.S.S.R. tried to prevent a loosening of Polish political control by the provision of financial assistance. Since the U.S.S.R. reduced its deposits in Western banks between December 1980 and March 1981 by $3.1 billion, it was assumed by Poland’s creditors that their loans were being repaid with Soviet help. In fact, the U.S.S.R. indeed advised against some Polish suggestions that they should declare a unilateral default, and provided the means to continue payments.⁴⁵ On August 31, 1981, Poland’s medium- and long-term foreign liabilities had stood at $23.4 billion. They included $8.5 billion nonguaranteed debt to private creditors (501 banks), with the largest claims being held by German banks (around $2 billion). The German banks had adequate reserves against potential losses in Central Europe, and the exposure of bankers in other countries was insufficient to create a systemic threat of the kind posed one year later by Mexican developments (the largest exposure of a U.S. bank in Poland amounted to 8 percent of its capital).⁴⁶ In the Paris Club rescheduling of debt in April 1981, in the face of the political uncertainty surrounding the rise of Solidarity, a clause had been added (Article IV, Paragraph 3) providing for the suspension of the agreement without notice in the case of “exceptional circumstances.” These were understood to include both “the entry of foreign troops into Poland, whether they were invited by the Polish government or not” and “the emergence of violence among Poles.” Most creditors believed that General Wojciech Jaruzelski’s imposition of martial law unambiguously constituted the latter. After December 1981, the imposition of Western economic sanctions by the major creditor countries meant that new foreign funds were unavailable (apart from some officially guaranteed credits from Austria).

Jaruielski’s government tried to muddle through. After 1982, economic growth resumed, at an annual rate of some 4 percent, but output never reached the peak levels of the late 1970s. Military expenditure increased. The regime both recognized that reform was needed, and at the same time it knew that it was too weak to make the necessary moves on its own. Could international support, this time from the West rather than the U.S.S.R., help?The price for international assistance, however, was a domestic political as well as economic liberalization. The U.S. attitude involved a leveraging of economic change into political adaptation. In 1986, the U.S. government lifted its veto on Polish membership of the IMF; and, as a result of one of the conditions imposed by the United States for IMF membership, the Polish government freed all of its 225 political prisoners and declared a general amnesty. The movement of Poland toward the international economy continued to be carefully analyzed by the underground Solidarity organization. In September 1985 the Solidarity office in Brussels sent a message to the IMF’s Managing Director stating that the movement welcomed Polish membership, and urging that “the IMF should familiarize itself with the numerous reform projects worked out in 1981” (such as the Balcerowicz plan). It also added that “only extensive, all-embracing economic reforms can achieve positive results and that partial modifications, on the other hand, can only achieve results opposite to the expected.”⁴⁷

The results of partial reform became apparent in 1988–89. Throughout 1987, the government puzzled over the problem of how to make economic reform acceptable. One of the more innovative solutions involved a range of opinion surveys, intended to impress on the public the inevitability of some kind of price rise (“Do you prefer a 50 percent rise in the price of bread and 100 percent for gasoline, or 60 percent for gasoline and 100 percent for bread?”). There was also a referendum on economic reform. In late 1987, after a substantial delay, the second stage of the economic reform process envisaged in 1981–82 began to take effect. At the end of 1988, the government of Mieczyslaw Rakowski lifted restrictions on the establishment of private firms. Two obstacles stood in the way of further reforms at this stage: one international, the other domestic. The debt mountain had been increasing, as official debt piled up due to the suspension of the debt service in 1982–84 and subsequent restrictions on debt service. The unpaid interest was capitalized into the sum of the outstanding debt, with the result that it rose from $25,950 million at the end of 1981 to $39,170 million by 1988.⁴⁸ But there could be no further credit inflows without an IMF program, and the IMF would not support an unsustainable program. Rakowski’s realization that the government would be unable to meet its foreign debt obligations drove him to a consideration of more extensive domestic economic reform and liberalization. As elsewhere, the debt crisis proved to he a catalyst for a profound reorientation of economic policy as well as of political structures.

The second problem was domestic. The most contentious aspect of the reform was the “adjustment” (or elimination) of subsidies. The rate of price rises increased (the average of consumer prices rose by 25 percent in 1987 and 60 percent in 1988), and sparked two waves of renewed labor unrest. Faced with these conditions, the government admitted Solidarity representatives to a Round Table to discuss the political future of Poland, then legalized the movement (April 1989), and allowed its candidates to contest a restricted number of seats in parliamentary elections (all of which the government lost). The General Secretary of the Soviet Communist Party, Mikhail Gorbachev, telephoned the Polish Prime Minister to urge him to abide by the election results. After a series of unsuccessful experiments in forming a communistled government, a Solidarity-led government with Tadeusz Mazowiecki as Prime Minister was installed in September 1989. The effects of partial economic reform had in the event augmented the political crisis, and led to a complete collapse of the old order.

In its first months in power, the Mazowiecki government launched its own very radical version of a reform program. At the outset, Mazowiecki had remarked that “I am looking for my Ludwig Erhard!”⁴⁹ The man appointed as Finance Minister, Leszek Balcerowicz, had been the author of the influential 1981 program; and since 1987 had been involved in intensive private discussions of economic reform involving privatization, currency convertibility, the liberalization of international trade, and the abandonment of notions of import substitution.⁵⁰ After the revolution, in the words of one observer, “economics revealed itself with a vengeance to be the key determinant of the political realm.… What is the essential point of reference, the shorthand designation, the symbol associated today with the Polish revolution?… it is … the Balcerowicz Plan.”⁵¹

The fundamental threat to the plan was monetary. A partial financial reform at the beginning of 1989 had created a two-tier Western-style banking system, with a central bank and also a network of (fundamentally regional) commercial banks. The new banks were, however, in most areas in a practically monopolistic position, and they continued, without much central control, to give credit to enterprises. Once price controls were lifted, the consequence of an uncontrolled explosion of enterprise credit would be inflation. In consequence, in late 1989, as a result of the combination of price liberalization with the fiscal aftermath of the previous regime’s last-minute attempt to buy for itself political stability, Poland was threatened by hyperinflation. Between December 1988 and September 1989, open inflation rose to 230 percent. In October, it seemed that hyperinflation had arrived. Consumer prices increased 54 percent in a single month.⁵² Tackling this became the most urgent economic issue, as well as an opportunity for a much more broadly based reform. Pegging the zloty to an external standard could be the only guarantee of monetary control. Only ten days after the formation of the government, Balcerowicz traveled to Washington to lay out the details of the government’s very radical reform and stabilization program in his speech at the IMF Annual Meeting.

Already in September budget spending was reduced by cutting the coal subsidy. Credit to the nongovernment sector was cut. The gap between the official exchange rate and the market rate was reduced. Wages would be held in check by a tax of 100 to 200 percent on wage increases in excess of a sum set at 80 percent of the cost of living increase. The two principles underlying the reform package were that stabilization should be accomplished “quickly and decisively” and that there should be a move to marker mechanisms. In a memorandum for the IMF, the Polish government stated that: “We believe that speed is of the essence, so that the transitional stage—so hard on society—will be as short as possible. Radical change is also dictated by the bad experience with piecemeal reforms in the 1980s.”⁵³

The most radical phase of the reform, the Balcerowicz plan implemented in January 1990, was explicitly designed as a “shock treatment” and constructed in a deliberately tight time frame. Balcerowicz believed that the government should use the political capital generated by the honeymoon period of transition to democracy in order to introduce reforms that would be beneficial in the long term but inevitably carry short-term costs. The outcome of a liberalization, he thought, could not be predicted. No one could forecast how output, prices, and external trade would behave in a completely transformed situation. But the level of certainty about the outcome would not be increased if the reforms were to be applied more slowly. As a result, a rapid passage through government committees and through parliament with an imposed deadline of January 1 offered an alternative far superior to unending negotiations about individual details of the plan.

In addition, as a result of the democratic revolutions Poland stood at the focus of world attention, but it could not expect to occupy that place for long. The country should use its “five minutes of history,” Balcerowicz thought, in order to introduce a program so ambitious that it would encourage creditors to accept a generous solution of the international debt issue. It was consciously devised as a program that would appear to the rest of the world as a model of the application of economic liberalism, a new version of Ludwig Erhard’s achievement.

It included the achievement of fiscal balance in 1990, a sharp restriction of monetary growth, the continuation of a tax-based wage indexation policy, a lifting of price controls (with especially dramatic effects in energy: there was to be a fourfold increase of the coal price for industrial consumers, and sixfold for retail customers; and a 300 percent rise in electricity prices). The foreign exchange market was to be unified, in order to create greater incentives to export. Credit policy would be tightened (with the result that “some enterprises are likely to become bankrupt and close”). But the policy would also be supported by a Labor Fund, financed from a 2 percent levy on the payroll of enterprises, to create a “protective shield” for those workers made redundant in the course of the transition, and to pay for retraining and vocational training programs. Pensions benefits and family allowances would be reviewed on a quarterly basis. IMF drawings would be used primarily to build up Poland’s foreign currency reserves. This was in essence a program largely produced in Poland—and not either an “IMF program” or one laid down by any one of the numerous foreign advisers who now descended on Warsaw.

The total effect of the program was estimated to involve in the immediate aftermath of the “shock” a drop on real wages of between 30 and 40 percent. But it appeared to be strikingly popular. In an opinion poll held on January 4, 1990, over half of those surveyed claimed to be in favor of the “shock cure.” The new government’s approval ratings stood at 90 percent.⁵⁴ When the IMF’s Managing Director traveled to Poland in December 1989, he was surprised by the broad range of support for the program from Solidarity, church leaders, parliamentarians, but also from the leaders of the former official (that is, communist) unions and from the President, General Jaruzelski.⁵⁵

The IMF program (an SDR 545 million ($740 million) stand-by arrangement) approved in February 1990.⁵⁶ was designed as a demonstration of external support and as a reassurance and a catalyst for foreign investors initially hesitant about Poland’s prospects for stability. The Fund’s preparations, and the discussion on the Executive Board, also emphasized that it was essential to protect the neediest groups in the population and to provide funds for retraining and unemployment benefits to cushion the process of transition to the market economy.⁵⁷ Some of the Polish advocates of the reform plan even felt that the IMF should have taken a tougher stance on fiscal issues, and especially about the question of pensions, which later proved to be one of the most intractable difficulties facing the reform government. Within Poland, the idea of conditionality was not used by the government to justify its program, which it explained as being necessary for “our internal considerations,” but rather in terms of making the program internationally credible and achieving a debt reduction. Balcerowicz later argued that “this was not only truthful but also probably politically more effective than trying to push through tough measures on the pretext that the IMF had imposed them.”⁵⁸

At the beginning, no one knew quite how the key economic indicators would develop over the course of the transition. Most, including the major foreign economic adviser of the Solidarity government, assumed that the greatest problems would be in the first months rather than years of the restricting program.⁵⁹ In the first half of 1990, fiscal policies turned out to be even tighter than had been anticipated, because the initial estimates of revenue had been rather low and failed to take account of the effects of inflation. At the same time, the output collapse appeared greater than anticipated, although much of the fall proved to be partly an optical illusion brought about as a consequence of the exaggeration of production figures for 1989, and partly because statistical collection involved primarily the large state-owned factories most hit by the collapse of production. Thus the earliest official Polish figures gave the decline of GDP in 1990 as 18–20 percent, but more recent calculations place it more modestly at between 5 and 10 percent.⁶⁰ The result of a strong fiscal performance combined with an apparently dramatic output decline played into the hands of officials from the old planning authorities, who now began to argue that a demand-oriented policy on allegedly “Keynesian” lines should be applied in order to promote recovery. They said that they did not want to modify the basic impetus toward liberalization and structural change of the reform; but at the same time, they claimed that the shock had been “overcooked.” As a result in the third quarter of 1990, fiscal policy was relaxed, wages began to increase at a faster rate than had been targeted, and the basis of the IMF program was endangered. Negotiating a new program in 1991 became much harder, although eventually an extended facility of SDR 1,224 million was approved by the Fund in April 1991. The central bank’s response to enterprises paying higher wages and to the new fiscal policy was monetary expansion.

In addition, social pressures mounted. During the summer of 1991, in the run-up to elections, the Ministry of Social Affairs received desperate phone messages every morning from all over Poland requesting emergency resources for the support of the unemployed, funds that the government provided. The consequences of adding new social expenditure to existing and rather inefficient social transfer mechanisms inherited from the socialist past produced a growing fiscal problem; and at the same time, because of the inaccurate targeting of the older transfers, many of the problems of the new poverty were left unaddressed.

At this time, the prospects for Poland looked bleak: the budget deficit was out of control, and the IMF support was suspended in September 1991, with the result that the initial drawing on the extended Fund facility was not followed by subsequent installments.⁶¹ But at the same time, the privatization program of share-offerings for large enterprises continued, and some 70 percent of retail stores were transferred to private management. Very quickly a vigorous private sector developed. The increase in the number of small businesses alone generated employment equivalent to 7 percent of the work force.⁶² The ending of the old “official rate” and the adoption of a realistic, perhaps even slightly undervalued, exchange rate in addition set off an export boom. Export earnings increased faster than had been anticipated, and the first estimates showed that in 1990 Poland had run a surplus on current account in convertible currencies of $700 million.⁶³

The April 1991 Fund facility paved a way for a negotiated solution to the international debt problem. At a meeting of the Paris Club on April 19–21, 1991, the official creditors agreed to an extraordinary debt reduction on the $33 billion outstanding debt that was equivalent to 50 percent of the net present value. The relief was to come in two stages, the second of which (in 1994) depended on continued compliance with Poland’s commitments to the IMF, The debt plan thus secured a longer-term framework for the continued application of successful policies. The Paris Club agreement also in turn facilitated a solution to the problem of the (smaller) volume of outstanding bank debt, some $12 billion in capital and capitalized interest arrears.⁶⁴ The negotiation of a solution to the long-standing debt problem, as in other severely indebted countries, could only be accomplished adequately in the more general context of a reorientation and adjustment of the entire approach to economic management. A major Polish mistake, which for a long time acted as an irritant and a deterrent to new foreign investment, was the failure to reach agreement on the bank-held (London Club) foreign debt (there was eventually an agreement, but only in 1994). Despite the delay in negotiating, the early adoption of liberalization was a step toward a satisfactory debt accord. The “big bang” approach had created a Polish model of how to carry out an economic transformation.

Renewed growth in Poland was delayed by the drastic fall in exports to the East as a result of the collapse of the Soviet Union (1990–91); but real GDP had already begun to grow again in 1992 (1.0 percent) and rose at a much faster rate in 1993.⁶⁵ In 1992, the government of Hanna Suchocka began to pay greater attention to issues of micro-adjustment (such as reform of the financial sector and improvement of credit allocation) that had been relatively neglected in the rush to conclude the original stabilization plan. This development reflected a more general experience of the economic transition. The IMF came to the overall conclusion that by 1992, “the focus of discussions on eastern Europe is increasingly shifting to the microeconomic aspects of reforms. These are proving more difficult to formulate and implement than expected initially.” ⁶⁶ But the Polish case also demonstrated how the first true experimenter in Central Europe was also the first country to show sustained recovery and growth. The uncertainties in Poland’s post-communist era development, and the challenges to the IMF programs in 1990 and again in 1991, underlined the degree of difficulty in the economic transformation. The experience suggests a lesson, that is similar to that derived from other cases (for instance, Turkey at the end of the 1970s): not every reforming country whose IMF program runs into unexpected problems (not necessarily from a commodity shock) is inevitably doomed to see the experiment fail. Given sufficient commitment to reform, the setbacks can be overcome; and the existence of the program may work as a helpful disciplining instrument (even, in some cases, without the disbursement of resources).

Why Hesitate?

Czechoslovakia too had been concerned with the possibility of economic reform even before the political upheaval of 1989. In May 1989, the Federal Finance Minister and the President of the Czechoslovak State Bank had visited the IMF to discuss the possibility of membership. They announced that they were preparing the political gamble of a two-year economic reform program to be launched in 1990. But unlike in Poland, the old regime never even had the chance to alienate the population by imposing price rises. The communist government was quite unpopular enough on its own account, and the example of effective Polish and east German anti-communist revolution proved inspirational. It was the new democratic Czechoslovak government that applied for membership of the Fund on January 22, 1990. A few weeks later, Bulgaria, also shaken by the political turmoil, pledged free elections and proposed to join the international financial system. By 1990, the price of a failure to undertake economic reform had become as clear as the price of undertaking it with the insufficient support and legitimacy of old-style East European regimes.

The most successful efforts at reform involved, as already in the Polish case, a quick and far-reaching implementation. The Czechoslovak federal government in May 1990 accepted a “Strategy of Radical Economic Reform” and implemented it at the end of the year. As in Poland, it involved price liberalization, privatization, the liberalization of the external trade regime, and the introduction of currency convertibility (on January 1, 1991, supported by an IMF program). Monetary stabilization was easier, because there had been a much less pronounced development of a monetary overhang in the immediate pre-reform period. The mass privatization program, involving vouchers generally distributed to the population, was implemented more quickly than in Poland (where privatization had been delayed by the adoption initially of a mechanism rather more suited to the privatization of a few public sector enterprises in advanced industrial countries). The major architect of the reforms, Václav Klaus, the Finance Minister of the Czech and Slovak Federal Republic (and later the Prime Minister of the Czech Republic), like Balcerowicz in Poland concluded that the hotly debated issue of sequencing was essentially a diversion from the real problem. “I am deeply convinced that the idea of sequencing is just a technocratic or rationalistic notion based on unrealistic beliefs in social engineering, in scientific control of the reform process, and in the fine tuning of reforms.… The only prescription that must be followed for successful institutional and systemic change is macroeconomic stabilization based on prudent macroeconomic policies.”⁶⁷

Partial reform, gradualism, or even carefully sequenced reform produced few useful or attractive results in Central Europe. In Poland, gradual attempts at economic reform during the 1980s had failed, and the failure precipitated a general crisis of the system and the implementation of a far-ranging economic reform that was only acceptable because it was accompanied by democratization and the creation of a legitimate political system. In Hungary, despite a great deal of discussion, the economy remained fundamentally a nonmarket system until the end of the 1980s. Some elements of gradualism remained in the Hungarian approach to reform after 1989: for instance, a reluctance to use a commitment to a fixed exchange rate as an anti-inflationary instrument; and a willingness to tolerate inflation and fiscal deficits. The results of this reform program surprised many commentators, who on the basis of a relatively strong performance in the 1980s believed that Hungary would be the first Central European economy to show a recovery in output; in fact, in this regard, the turnaround followed rather than preceded the reappearance of economic growth in Poland. In other countries, debates began as to whether output falls could be avoided. In Romania, the contraction of credit was more than compensated by a sharp growth of interenterprise credit; but this attempt to soften the impact of reform only made the microeconomic aspects of the transition much harder.

The most extreme example of an economy that shrank from reforming action may have been educative. In the former German Democratic Republic (GDR, or east Germany), under the old political regime, the international economy and its institutions loomed as a specter foretelling the end of a certain kind of controlled society. Throughout the 1980s, economic growth slowed down. Even according to the overoptimistic official data, use of the net material product (NMP) for either consumption or investment grew only at 2 percent a year in the 1980s.⁶⁸ The state attempted to stabilize itself through massive loans from west Germany, but by the end of the 1980s it faced an imminent debt crisis. A calculation presented to the Central Committee of the ruling SED (Socialist Unity Party) in late October 1989 detailed the gravity of the situation. Just maintaining debt service would require an almost impossible twofold increase in exports to the hard currency area. But without such an economic transformation, the GDR would have no alternative but to declare a moratorium. “The consequences of the immediately imminent incapacity to pay would he a moratorium in which the Intetnational Monetary Fund would determine what would happen in the GDR. Such a process requires examination by the IMF of the affected country on matters of cost development, currency stability, etc. This examination is linked with the demand that the state should not intervene in the economy, should reprivatize enterprise, limit subsidies with the goal of a complete elimination, and end import restrictions. It is necessary to do everything to avoid taking this course.”⁶⁹

In the end the GDR of course did join the international system, through the monetary and economic union with west Germany (July 1990), and then in October 1990 political integration. The reform led to a larger drop in output than in other Central European states, less because of the intrinsic character of a transformation process than because of the shock produced by the sudden creation of a fully integrated labor market and currency union with an economy in the west with far higher levels of productivity. The peculiar nature of the east German collapse was thus not typical of the movement from the plan to market.

The Technical Support of Reform

A market economy cannot simply be conjured up, either by wishing it or decreeing it. Its development depends on the existence and interplay of a network of institutions and legal provisions. Implementing a privatization plan, or re-equipping central banks to deal with emerging domestic financial markets, or designing tax systems and administrations, or instituting social security networks are all extremely complex procedures and cannot be realized simply through a working out of first principles. The IMF, with other international institutions, played a vital role in providing technical assistance on such issues to formerly centrally planned economies in transition, not only in Central and Eastern Europe, but also in Algeria, Angola, Benin, Cape Verde, the Lao People’s Democratic Republic, Mongolia, Mozambique, and Viet Nam. The IMF Institute expanded in order to provide courses for officials concerned with the transition to the market. The IMF’s Monetary and Exchange Affairs Department gave advice and assistance on banking supervision, payments and settlements mechanisms, and economic and monetary analysis. (For instance, at a very early stage of the Polish reform process, in the spring of 1989, a staff team from that department helped to design a procedure for monetary control and banking supervision. When the so-called shock program started on January 1990, an IMF ream worked on the implementation of monetary policy.)⁷⁰ The Legal Department drafted and reviewed draft legislation; and the Fiscal Affairs Department provided advice on tax policy, tax and customs administration, treasury systems, budgetary accounting, public expenditure management, and social security. The Statistics Department advised on guidelines for the calculation of information essential to economic policymaking: the national accounts and the balance of payments.

The Soviet Crisis

In the case of the U.S.S.R. in the late 1980s, the pace of political change far exceeded an economic transformation. There had been experiments with an introduction of effective prices in the Khrushchev era, but the main reforming energies of Mikhail Gorbachev, who became General Secretary of the Communist Party of the Soviet Union in March 1985, were directed initially at political restructuring. There could, however, he no doubt about the existence of an economic crisis, or of the need for a radical solution rather than piecemeal tinkering. In 1987, in the Soviet politburo, Gorbachev asked rhetorically why the reforms of Nikita Khrushchev in 1965 had produced no real growth, and then gave as a reply the advice of Count Sergei Witte, the reforming tsarist Finance Minister and Prime Minister: “if reforms are made, they need to be undertaken quickly and in depth.”⁷¹

According to Soviet official statistics, the average annual growth of net material product had been 7.8 percent in the second half of the 1960s, hut 4.3 percent in 1976–80, and 3.2 percent in 1981–85.⁷² This was not due simply to a slowing of the labor supply; productivity growth had also fallen. Gorbachev tried to promote an acceleration (uskorenie) as part of the Twelfth Five-Year Plan (for 1986–90), which involved increased investment in retooling, greater quality control, and an alteration of the “human factor.” The most spectacular part of the program, an anti-alcohol campaign, failed to halt drunkenness at the workplace, and instead quickly became the object of ridicule. The investment plans ran into bottlenecks.

The Twenty-Seventh Party Congress in February 1986 approved a scheme that was described as “radical reform” and was intended to create a “market socialism.” There was, as Gorbachev put it one year later, no price system, only an absurd pattern of random figures termed “prices” that had been created as the chance relic of decades of planning.⁷³ As part of the reform process, enterprises were to be allowed to deal directly with suppliers and consumers and to be run on the principle of “self-financing” (1987 Law on Enterprises). Also in 1987, cooperatives were re-established, as a training ground for future entrepreneurial talent. By 1990, 215,000 such cooperatives existed, employing 5.2 million workers (though for many, this was not the full-time occupation).⁷⁴ In 1988 new banking institutions were created to perform commercial banking operations. In June 1990, joint-stock companies could be established.

Attempts at creating a market socialism in practice, however, failed to tackle two fundamental issues: they did not provide for effective competition, and they did not secure the principle of private ownership. The process established a decentralization, but without the coordination that would have been the outcome of an efficiently operating market based on the incentives created by private ownership. Gorbachev’s advisers prepared a large number of more far-ranging plans for a more thorough and effective transition to the market, and for an abandonment of hybrid attempts at “market socialism.” Abel Aganbegyan, Leonid Abalkin, Nikolai Petrakov, Stanislav Shatalin, Grigory Yavlinsky all developed schemes for the marketization of the Soviet economy, and all were not taken seriously by the political leadership. Yavlinsky later complained, after his advice had been refused, that “you cannot know what Gorbachev is thinking.”⁷⁵

As it was, political reforms began to destroy the central planning apparatus, and authority shifted away from the center. Already by May 1987, Gorbachev was speaking about the complete discrediting of the administrative system.⁷⁶ Output stagnated, and then declined sharply at the end of the decade. In 1990, real GDP fell by 2.4 percent, and in 1991 by 17.0 percent.⁷⁷

The effect of the revolutions in Eastern and Central Europe also shook the U.S.S.R. By 1990, the central authority of the state had become less acceptable to the Soviet population. The political and economic stability of the U.S.S.R. emerged as a central issue on the international political agenda. It provided the major theme of the Houston G-7 summit of July 1990, which commissioned a study of the Soviet economy, and of reform scenarios, to be undertaken by the World Bank, the newly created European Bank for Reconstruction and Development, the Organization for Economic Cooperation and Development, and orchestrated by the IMF. These multilateral institutions produced a report and recommendations which were published in 1991.⁷⁸

Was this exceptionally thorough and well-prepared but rather academic document, which read as a indictment of previous Soviet policy, too hesitant and bureaucratic a response to the current problems of the peoples of the U.S.S.R. in 1990–91? Before a reform process could begin, those who would implement it needed to realize the extent of the problems they had inherited, and to appreciate that no quick or easy fix existed. The study provided an eloquent statement of the difficulties that would face the reformers. It also demonstrated the theoretical and practical superiority of far-reaching reform in the Witte style over small-scale palliatives of the Khrushchev type. At the same time, it said little about the likely costs of a more dramatic reform, or on the effect on output or employment levels. In this way the report contributed to a debate that had already begun within the Soviet leadership. The study also acted as a disincentive to any Western government that might feel tempted, whether for general political reasons or from personal sympathy with the brave reformer Gorbachev, to support financially an incomplete or partial reform. At the Houston summit, the West German Chancellor and Foreign Minister had demanded very extensive assistance for Moscow.⁷⁹ Such assistance could only lead to a dissipation of resources and would be incapable of tackling the fundamental problems of the Soviet economy. Gotbachev later acknowledged that no amount of G-7 money in 1990 or 1991 would have made a difference to the development of Soviet economics, or politics.⁸⁰

At first, membership of the IMF had been seen fundamentally by Gorbachev in terms of the desirability of greater Soviet access to Western private credit markets. In 1986, the U.S.S.R. offered to honor in part the pre-Soviet (tsarist) debt of Russia, a move widely interpreted as a conciliatory gesture to the international financial world. During the long period of debate about the possibility of economic reform but inaction about its implementation, the U.S.S.R. came to depend increasingly on credit given or guaranteed by Western governments concerned with Soviet stability, or (in the German case) eager to ensure that there were no obstacles to the process of building German unity, and that there would be an orderly withdrawal of foreign troops from Germany. The foreign debt of the U.S.S.R., which had risen from $30.7 billion in 1986 to $53.8 billion in 1989 as a consequence of perestroika loans, increased yet further by 1991 to $67.2 billion. By October 1991, it was estimated that Germany alone had provided $30 billion for the U.S.S.R.⁸¹ The consequence was that in Russia serious economic reform began with the impediment of a very large external debt burden on the state, owed largely to commercial banks but with a very evident political component.

The London G-7 summit in 1991 referred to an Association Agreement with the IMF and the World Bank as the best channel for external assistance, but this pace seemed frustratingly slow to an increasingly desperare Soviet leadership. Gorbachev had already begun internal discussions about an application for membership of the IMF in 1988, in part as a response to the increasingly serious external debt problem of the U.S.S.R.⁸² Within two weeks of the London summit, the U.S.S.R. announced, unilaterally and unexpectedly, that associate membership would be “humiliating,” and that it intended to apply for full membership of the Bretton Woods organizations. The United States promptly described the application as “counterproductive.”⁸³ The discussion of reform had set off a painful discussion about how economic restructuring could be combined with Soviet political standing in the world.

In October 1991, a few weeks after an attempted coup against Gorbachev’s fading authority had been undertaken by communist hard-liners, the U.S.S.R. eventually concluded the association agreement with the IMF. By that time, however, the issue of economic reform had proved, appropriately enough, to be the final element that drove the old Soviet empire apart. The Baltic republics—Estonia, Latvia, and Lithuania—had already declared their independence in the course of 1991. On December 24, 1991, the Russian leadership under President Boris Yeltsin stated that it would introduce price and other economic reforms on January 2, 1992. The next day, Gorbachev announced his resignation and the Russian flag was raised over the Kremlin. On January 7, Russia applied for full membership of the International Monetary Fund; and by May 1992 membership for the 15 states that had formerly been Soviet republics was approved in principle. One effect—an important one—was at last to turn the Bretton Woods system into the truly universal framework envisaged at the conference of 1944. Even before Russia formally became a member of the IMF, it launched a radical price liberalization (January 2, 1992, one day before the membership application was sent) in which the Finance Ministry began negotiations with the IMF “as if we were members.” Membership in the international institutions was an essential part of the effort of reforming and restructuring the Russian economy.⁸⁴ By 1994, looking back on the experience of reform, one former Russian Finance Minister commented, half jokingly, that “they are citing the IMF the way they used to cite Karl Marx.”⁸⁵ Few would disagree that this represents an improvement.

In Russia, reform began with an abolition of central planning, and a decontrol of many but not all prices. This was followed by a privatization both more extensive and rapid than that carried out in Central Europe.

The reform program in the former Soviet republics was supported by a low conditionality systemic transformation facility (STF) created in April 1993 that allowed members to draw up to 50 percent of their IMF quota. Financing from this facility would be available to member countries “experiencing severe disruptions in their trade and payments arrangements due to a shift from significant reliance on trading at non market prices to multilateral, market-based trade,” The conditions affected only the external trade regime, and included no fiscal criteria. The countries would simply agree “not to intensify exchange or trade restrictions.”⁸⁶

The economics of the transformation were difficult enough, even without the attendant political complications. It was hard to see a future for a vast heavy industrial sector. A peculiarity of the Soviet economy had been the relatively minor role played by consumer industries (in the mid-1980s, the estimated world share of consumption in GDP was 78 percent; in the U.S.S.R. it was believed to be 55 percent).⁸⁷ in addition, it was acknowledged that all industries used labor with extreme inefficiency. In 1990, overmanning in the Soviet economy had been estimated at over 20 percent. The Labor Ministry, Goskomtrud, estimated that 3 million workers were employed in loss-making enterprises, although in the absence of an effective price structure there was inevitably an arbitrary quality to such estimates.⁸⁸ Even the “conservative” plans of the late Gorbachev years for a gradualistic transition to a more market-orient ed approach acknowledged that many millions of jobs would be lost in the state sector. But the cost of these job losses in terms of social stability looked very high for a weak government: too high to be acceptable either to Gorbachev or to his Russian successors. Toward the end of 1992, the Russian government changed the emphasis of its reform approach, ignoring advice from the IMF, and began to support industry more, to move away from the principle of fiscal and monetary stabilization, and to see inflation less as an economic threat than as a way of assuaging a multitude of political demands.⁸⁹ For the early years, the fate of the reform initiatives seemed constantly precarious, as if perched on a knife’s edge.

In addition, for the initial period, Russia (and the 14 other former Soviet republics) faced enormous constitutional uncertainty. As struggles between the Russian President and the Congress of People’s Deputies unfolded, it appeared uncertain whether anyone had the political authority to launch a reform strategy, whose initial consequences were bound to be hard to bear. For much of the early period, the Central Bank seemed independent of the government, and committed to a course that produced ever higher rates of inflation. As elsewhere under central planning, monetary policy had been passive. Monetary growth was held in check by price controls, not monetary control. Price deregulation produced big increases, and raised demands for interenterprise credit, which functioned as an uncontrollable source of claims and drove inflation higher. The Central Bank accommodated this expansion. A central bank that is not independent of the business world can be as destructive to monetary stability as a central bank overdependent on the government. In the course of 1991, in the last days of the U.S.S.R., for instance, the Central Bank advanced credits of Rub 600 billion to Soviet banks.⁹⁰ At times, the Central Bank saw its responsibility as lying in increasing money supply as fast as possible, in order to finance the pace of social change. The head of the money supply department of Gosbank, Yuri Balagurov, was quoted as having said that “the only limit to the money supply in the Soviet Union today is the capacity of the money presses.”⁹¹ Such attitudes, inherited from the conditions of the Soviet economy, often simply carried over into the new state. At the beginning of their existence as new states, all the essential elements of economic reform still lay ahead for the former Soviet republics. No one could be completely confident of the success of reform: it required a reorientation on a scale far greater than that of Central Europe, where radical reform had been preceded by a long period of experimentation and reflection. On the other hand, failure would bring a certain prospect of further economic collapse, and widespread social and political destabilization.

The integration of the former U.S.S.R. into the world economy was a task of such magnitude that the only historical parallels seemed to lie in the postwar reconstruction of Western Europe. Then, as after 1991, some questioned whether the institutional management of such a transformation was best left in the hands of an agency whose responsibilities were global.

The experience of the reform process in Central and Eastern Europe had taught a number of important lessons, regarding the timing and extent of reforms, the external framework, and the likely behavior of output during the transition. First, small-scale or half-hearted attempts at reform could not succeed. The great historical designers of reforms—Sergei Witte or Ludwig Erhard—as well as a more recent example—Lesiek Balcerowicz—realized not only that a wide range of liberalization measures had to be undertaken within a very short space of time but also that the process of liberalization requires a large number of steps and is best understood as a self-sustaining process rather than a single dramatic gesture. This is an experience that in the meantime had become familiar in many developing countries. Macroeconomic adjustment could not work without previous or simultaneous structural reform: the two processes are inseparably connected. In particular, monetary stabilization required more than simply appropriate monetary policy on the part of central banks. It depended on individuals and corporations whose credit would be self-controlled as a consequence of the establishment of property rights. This, in turn, however, was unlikely to occur without a firm control on the part of the monetary authorities.

In order to make such a traumatic transition, a secure external framework was required. The outside world would offer support in the form of resources and advice, and would also serve as a disciplinary mechanism of the kind provided by a borrowing program under the surveillance of international institutions. There is a fascinating difference in views when the inhabitants of formerly centrally planned economies express their opinions on the contribution to reform made by international institutions. In the pre-reform era, when factional disputes occurred within the administration and the ruling party about what type of reform could or should be undertaken, outside agencies, and especially the IMF, played a crucial part as allies of reform-minded administrators, and even, in the later stages, of some political figures. After the reforms were implemented, when there was a general and widespread agreement that little alternative existed to continuing with the reform course, this role clearly fell away. Most of the politicians engaged in sustaining the structural transformation now prefer to minimize the role of external agencies, and of the IMF. They are right to think that they themselves hear the ultimate responsibility for making national policy, and that they deserve acclaim for its successes. Most figures in the business world, however, claim that the existence of a support and control mechanism from the outside increases the extent of domestic confidence in the reforms, and thus makes these more likely to succeed in what may well be very volatile political conditions. In this way it provides a critical element in determining the success of the transition.

A further lesson lay in the observation that in halting an inflationary process, and in introducing a price mechanism, some output decline was unavoidable (see Figure 16-1).⁹² Yet quick adjusters typically faced a less serious collapse than slow reformers. In addition, slow reforms were much more likely to be shaken off course by the political repercussions of the earliest and bleakest moments of the reform. Quick reforms worked best, when supported in the appropriate framework.

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Stylized Representation of Crisis, Adjustment, and Reform

Source: Michael Bruno, “Inflation and Growth in Recent History and Policy: Applications of an Integrated Approach,” in Understanding Interdependence: The Macroeconomics of an Open Economy, ed. by Peter B. Kenen (Princeton, New Jersey: Princeton University Press, 1995).

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There was also another, quite crucial, element necessary in the implementation of reforms, as the most successful reformers had known. Too few Russians at the turn of the century had supported Witte for his policies to stand much chance of success. Reforms would only work where they were supported by a broad popular consensus, as in the case of the Polish “shock therapy” of 1990. When imposed by a government uncertain of its authority, they were bound to fail (as in Poland or the U.S.S.R. in the 1980s), or if implemented, to lead to inflation (as in Yugoslavia in the 1980s). But if they could not be instituted through government diktat, it was equally futile to think that they might be launched simply on the say-so of a multilateral institution. The Managing Director of the IMF, Michel Camdessus, insisted again and again on this point. Confronted by a statement by President Yeltsin to the effect that Russia would not allow itself to be dictated to by the Fund, he replied that “this shows that Mr. Yeltsin has fully understood how the Fund operates.” He told an interviewer from Izvestia “We don’t impose conditions on governments. Russia is a great country, but if you were a small country, my attitude would be the same. If a program were to be imposed from outside, its chances to be fulfilled, to be implemented, would be minimal. For a program to have its chances, it has to be seen as really the program of the country, elaborated by the country. But, it also has to be credible to the international community.”⁹³

This reflection provided an appropriate verdict not just on the Russian reform process, but on the whole experience of the aftermath of centrally planned economies, and the role of international institutions. To a much greater extent than most commentators realized, the pressures to adopt market systems, to look at prices as a source of guidance for economic decisions, and to reform the law of ownership, rested on an internal dynamic. It was less a case of a “Western victory” in an economic war that accompanied the Cold War of the strategic planners than of an evolution and adaptation by societies that became capable of expressing their own demands and realizing their own interests. In this process, however, a substantial amount of external help was required: not only financial, but most importantly the provision of a disciplinary framework and the supply of technical assistance. This required a quid pro quo, and in this regard we may learn a lesson of history.

One of the most destructive mistakes of international institutions in dealing with many planned economies in the 1970s and 1980s was a reluctance to appreciate that effective help necessarily depends on the extent of self-realization of the extent of a problem. Such self-analysis on the part of a country contemplating reform was reflected in the availability (or nonavailability) of genuine rather than distorted economic data, to the outside world but also to internal decision makers. This issue remained central after the political transformation. After 1989, the process of transition could be regarded as a particular instance of the implementation of surveillance: moving the world economy toward openness, currency convertibility, a lowering of protectionist barriers, and, in general, toward the adoption of market mechanisms, as a result of advice backed by funds. Financing would be made available in case of need, and in response to the soundness of a reform concept, rather than simply to political desirability.