This paper analyzes the challenge of transforming a state-owned and centrally controlled economy into a private, decentralized market economy under initial conditions that tend to place the policies necessary to induce an adequate rate of private investment in conflict with those required to preserve political support for the transformation effort. The initial conditions generally include a state enterprise sector that requires large subsidies to cover production costs, a primitive stock of public “infrastructure” that makes it difficult for private enterprises to operate at a profit, and often an environment of macroeconomic instability (for example, large fiscal deficits) that further discourages private enterprise.
The analysis focuses on the feasibility of simultaneously sustaining macroeconomic stability, political support, and adequate private investment. Macroeconomic stability requires that expenditures on net subsidies to the state production sector, as well as public infrastructure investment, be financed by tax revenues from the private sector and external assistance. Political feasibility is assumed to depend on the income gains and losses experienced by the three population groups identified in the model--state sector workers, private sector workers, and private investors. This formalization captures the notion that the need to maintain domestic political support may constrain short-run reductions in the levels of state sector wages, transfer payments, and subsidies. The labor market is modeled in a manner that emphasizes the importance to the transformation process of the productivity gains unleashed by a competitive environment in which heterogenous workers are induced to make occupational choices consistent with their comparative advantages.
The analysis supports the following policy perspectives. First, attaining adequate private investment requires sufficient public infrastructure as well as the maintenance of macroeconomic stability. Second, political forces may limit the financial resources that governments can raise domestically to finance infrastructure investment without relinquishing macroeconomic stability. Consequently, the achievement of adequate levels of public infrastructure investment and private investment--and hence the feasibility of the transformation--may depend heavily on external assistance in the short run. However, the need for external assistance will diminish over time with the buildup of public infrastructure, the growth of the private sector, and the increasing employment flexibility of new entrants to the workforce.