Point Counterpoint: Avoid Hubris but Acknowledge Successes

This paper highlights that for the IMF, July 2004 marked the 60th anniversary of the conference in Bretton Woods, New Hampshire, when delegations from 44 allied countries drafted and agreed upon the IMF’s charter. The IMF’s role and work have evolved in response, but like any large organization, its ability to change has been limited by its own rules and mandate and has been held back by inertia. This year’s anniversary offers an opportunity to reflect on how gaps between the reality and the ideal might be closed in the coming years.

Abstract

This paper highlights that for the IMF, July 2004 marked the 60th anniversary of the conference in Bretton Woods, New Hampshire, when delegations from 44 allied countries drafted and agreed upon the IMF’s charter. The IMF’s role and work have evolved in response, but like any large organization, its ability to change has been limited by its own rules and mandate and has been held back by inertia. This year’s anniversary offers an opportunity to reflect on how gaps between the reality and the ideal might be closed in the coming years.

Lessons from the postcommunist transition

JOHN McMillan gives a wide-ranging critique of market reforms around the globe, arguing that they have provided, on the whole, “spotty” benefits, in many cases at considerable cost. In response, I will not attempt to cast as wide a net; rather, with the humility of my more limited recent experience, I will focus on the postcommunist transition, showing that comprehensive and rapid reforms have led to greater success than a gradual, step-by-step approach.

The evidence of postcommunist transformation (China’s case deserves a brief but separate treatment) shows many successes, many mistakes—but rarely only in the economics of reform—and several cases where the process is unfinished and hence not subject to declarations of victory or defeat. I agree with McMillan that the experience of “big bang” reforms justifies the caution to “avoid hubris” because some mistakes—such as privatizing too fast—created a new problem of state capture and underdeveloped institutions, which I discuss later. Nevertheless, the insufficiently recognized successes of comprehensive and rapid reform can be a cause for pride.

A yardstick for progress

First, let me define how I measure progress and the countries that can be considered examples of the big bang approach. Many measures of progress in transition exist, such as indicators of economic growth, financial stability, democratization, and establishment of institutionalized rule of law. But, as I show elsewhere (Havrylyshyn, 2004), the index of transition indicators (TI), updated annually by the European Bank for Reconstruction and Development (EBRD), serves as an excellent proxy, despite certain shortcomings. Where relevant, I add measures of more direct benefits and costs of transition.

By this yardstick, how far have the transition economies progressed since the fall of the Berlin Wall? Chart 1 summarizes progress with reform on a TI scale of 1–4.3 (the last value representing a fully functioning market economy). It shows five distinct groupings: Central Europe (CE) is most advanced, with the Baltics at virtually the same level; Southeast Europe (SEE) is distinctly less advanced but, in general, somewhat ahead of countries in the Commonwealth of Independent States (CIS). The CIS cleanly divides into two groups: those with moderate progress (CISM) and those with very limited movement away from the Soviet economic regime (CISL). The latter comprise Belarus, Uzbekistan, and Turkmenistan.

Chart 1
Chart 1

Measuring up

Central Europe and the Baltics have made the greatest progress with transition, parts of the former Soviet Union the least.

EBRD Index of Transition 2003 (4.3=full market economy)

Citation: Finance & Development 0041, 003; 10.5089/9781451922530.022.A013

Source: European Bank for Reconstruction and Development.1CIS=Commonwealth of Independent States.

I am not aware of any effort to categorize systematically the countries that undertook big bang, as opposed to gradual, reforms. But the TI measure allows identification of “early reformers,” the ones with the highest scores by 1994, when the EBRD began its index. That list is identical to the leading Central European and Baltic groups shown in the chart I propose to identify these countries as big bang cases. Perhaps the only exception is Hungary, which had quietly done so much in the communist period that it was able to continue at a relatively gradual pace. I will therefore put Hungary in the “gradual reform” category (which hurts my argument and helps the critics of big bang reforms).

How should we consider Russia? Russia’s reform effort of 1992–93, in particular, is considered by critics as a big bang case, though most proponents argue that it was a far cry from Poland’s big bang approach, and, in any event, much of the reform was undone in 1994–95 and had to be recouped later (Aslund, 1995). Nevertheless, I will classify Russia as a big bang case, again helping the argument of the critics.

Within the CISM grouping, only Armenia made an early attempt at rapid reform, although it was soon stalled by civil conflict and a yielding to populist politics; all the others in the CISM category followed a gradualist path. Thus, I identify 9 rapid reformers, 15 gradual reformers, and 3 with very limited reforms.

What the record shows

How did these groups fare economically, socially, and politically? The already visible economic benefits of transition are summarized in Tables 1 and 2, which show the index of output recovery since 1989, latest inflation levels, and per capita values of foreign direct investment. It is evident that the economic performance rankings are much the same as the TI measure of progress in reforms, save, perhaps, for recovery of output. The CISL value of 96 is well above that of the CISM at 55. This is often a key piece of evidence against rapid reforms, with critics noting that these countries avoided a huge output fall by pursuing gradual reform. Even if true, this may mean only that the restructuring other countries experienced has not begun in the lagging group. Recent data in IMF reports for Belarus and Uzbekistan show much lower growth than in the CISM group. Furthermore, there is good evidence that growth in earlier years was considerably overestimated because of favorable barter terms and statistical issues.

Table 1

Fruits of transition

Central Europe and the Baltic states have made the most progress since the end of central planning.

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Sources: Unadjusted data from the EBRD’s Transition Report 2003; adjusted data from author’s calculations based on Aslund (2001).Notes: CISM = Members of the Commonwealth of Independent States (CIS) that have made moderate progress. CISL = CIS members that have made limited progress.

Many have argued that Soviet income accounting overstated GDP; hence, the recovery from 1989 levels has been much higher than simple arithmetic (Column 1) shows. I have made an arbitrary adjustment to the EBRD index value of 2002 as follows: Central Europe, 25 percent; Southeast Europe, 20 percent; Baltics and CISM, 35 percent; CISL, no change.

Table 2

Bleak spots

Soviet bloc countries that reformed the least had the highest inflation and attracted the least foreign investment.

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Source: EBRD, Transition Report 2003.Note: For definitions of CISM and CISL, see Table 1.

While it appears that only Central Europe has fully recovered and begun to see positive output benefits, this is not really the case because the official Soviet GDP in the 1989 benchmark year underestimated the value of services, overestimated unusable and unsalable products, and took no account of the frequent nonavailability of consumer goods or the time consumers spent standing in line for products. Aslund (2001) adjusts the output index for only some of these problems, finding that in Central Europe virtually no fall in output occurred and that most countries were well beyond the initial level by 2001. Though Aslund is surely correct about the direction of bias, one study is insufficient to be conclusive. Therefore, I have cut by half his implicit adjustment factors and calculated some illustrative values shown in the second column of Table 1. Even these smaller corrections suggest that, by 2002, Central Europe may have reached 150 percent of initial GDP; the Baltics, 111 percent; SEE, 97 percent; and CISM, 74 percent. For the CISL—essentially unreformed Soviet economies—the original index value is arguably appropriate. These conservative adjustments reinforce the evidence that more rapid reformers performed better than gradual ones. The conclusion is, surprisingly, even stronger if one looks at the social costs and democratization progress.

Grün and Klasen (2001) voice a common view of critics when they state that “socialist countries had enjoyed relatively high levels of well-being [but], in the transition, rising inequality and falling incomes have led to a dramatic deterioration.” There was undoubtedly a deterioration, but one should ask how big it was and, of relevance here, what differences can be found between rapid and gradual reformers. For this purpose, the Human Development Index (HDI) of the United Nations Development Program is a very useful tool. Its values for the period are shown in Table 3.

Table 3

Varying performance

From a human development perspective, Central Europe fared well, but moderate reformers in the Commonwealth of Independent States saw a sharp deterioration.

(average Human Development Index value; maximum 2001, Norway = 0.944)

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Source: UNDP, Human Development Report 2003.Note: For definitions of CISM and CISL, see Table 1.

Central Europe’s performance is even better when measured by the HDI than by standard economic indicators, with HDI showing no decline even in the first half of the decade. As one goes down the groups, an increasing deterioration is seen. In the Baltics, a strong deterioration is evident, but, by 2001, it is fully recouped and surpasses the initial value; the same applies to Southeast Europe. The sharpest deterioration is seen in the CISM group of moderate reformers, though a partial recovery has taken place since 1995. The CISL group did not avoid social costs, but less adjustment meant that costs were lower; I leave to future analysts to determine if this means a successful minimization of social costs or merely a postponement. On balance, it seems clear that the correlation between rapidity of reforms and social costs is not positive but negative.

On progress toward democracy, political scientists are as divided as economists. But the important prediction of Przeworski (1991) that market reforms can be effectively implemented only in a less than fully democratic regime does not seem to be upheld. As McFaul (2002, p. 221) explains 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 view that economists and others can understand is the striking result in Chart 2, showing a strong positive relationship between the degree of democracy and progress in market reforms, rather than a negative one. There is room for discussion on the endogeneity of the relationship, but recent Freedom House indicators of democracy, showing deterioration for many CISM countries after an initial improvement, suggest the causation is not in all cases simply from democracy to reforms, or from gradual reforms to democracy.

Chart 2
Chart 2

A market for democracy

The more progress made toward market reforms, the greater the likelihood that democratic institutions are taking root. Conversely, the more partial the reforms, the less likely is continued progress on democracy.

Citation: Finance & Development 0041, 003; 10.5089/9781451922530.022.A013

Source: European Bank for Reconstruction and Development, Transition Report 2003.Note: The Constitutional Liberalism Index represents the unweighted average of four indicators: the Freedom House freedom of the media score; the World Bank’s rule of law governance indicator; the World Bank’s control of corruption governance indicator; and the protection of property rights score from the Heritage Foundation’s index of economic freedom. These indicators have been standardized and, in the chart, 0 represents the lowest and 1 the highest levels of constitutional liberalism.

The pitfalls of privatization

McMillan seems to accept the reformist contention that privatization is generally beneficial economically; this is especially valid for transition economies where very recent microlevel studies nearly always show that some benefit comes even from privatization to insiders. I have summarized these findings (2004) but offer two important caveats. First, the benefits of privatization without a proper accompanying climate of open competition and rule of law may be very small or even zero (Zinnes, Eilat, and Sachs, 2001). This is probably why the empirical studies for CIS reformers do not show as strong results as in Central Europe. Second, where privatization has resulted in a strong concentration of ownership, a class of rent-seeking vested interests develops and “captures” the state to ensure that policies work in their favor, prevent competition, and slow further institutional and democratic development (Hellman and Schankermann, 2000, reporting a World Bank study). These unintended consequences of speeding up privatization by co-opting insiders, an approach common to many gradual reformers (CISM and SEE), may have been the most important error of reform advocates and certainly one area where humility is called for.

Notably, state capture by large vested interests did not occur primarily in rapid reformers. In the World Bank studies designating 10 captured states in 1998, only 2 were clearly early, rapid reformers—Croatia and Slovakia—and both have experienced a major political change since then that has arguably reversed the situation. If, for the sake of avoiding bias, Russia is defined as a rapid reformer, then at most three captured countries might be big bang cases, whereas at least seven pursued gradual reforms.

Emulating China?

McMillan, like many critics, suggests that China’s gradual reforms and its far superior economic growth performance would have been the better path to follow. There certainly are some lessons from the Chinese experience, but, for the most part, it is difficult to imagine it could have been repeated to good effect in the European cases, given the different political environment. Centralized control did not, as McMillan (adducing Karl Popper) suggests, lead to a Utopian approach in China but, on the contrary, afforded it the luxury of a piecemeal approach. In Europe, the collapse of communist polities made gradualism politically risky.

China’s large agricultural sector at the outset (about 70 percent in the late 1970s compared with 20 percent in 1989 for the Soviet Union) allowed a costless gradualism. The Chinese situation was clearly akin to Arthur Lewis’s famous development model in which surplus labor from agriculture was available for transfer to new industrial activities with no loss of agricultural output. For the Soviet bloc economies, labor for a new private sector could come only from a sharp reduction of the state industrial sector. As the differences between Central Europe and the CIS show, where gradualism was applied, if anything, it made things worse, because the conditions for new enterprises to take root and create new jobs were slow in coming.

Don’t sell the big bang short

How does all this relate to the criticism that the big bang approach leads to greater output losses, higher social costs, and slower introduction of good institutions? The updated statistical evidence suggests the contrary. A major error of many critics, including economists like McMillan and Joseph Stiglitz and political scientists like Peter Reddaway and Dmitri Glinski, has been to concentrate too much on Russia, its institutionally inimical privatization process, and early dramatic declines in well-being, and too little on the successful cases of big bang reforms. These should include not only the well-studied and well-publicized first case of Poland but also most of Central Europe and the Baltics. Even if one cedes to the critics that Russia was a case of big bang and Hungary followed a gradualist path, the cross-country facts remain that, of nine rapid reformers, eight have done very well. Most of those that chose a more gradual path have had fewer economic benefits and, surprisingly, higher costs, manifested in the deterioration in indicators of well-being and stalled progress in democratization.

Could the recent surge in growth in many CISM countries to annual rates of about 5 percent reverse this conclusion? Perhaps, but only if these rates are sustained for a long time. This is still a big if: a key determinant will be whether the vested interests (or oligarchs, in popular parlance) that developed under slower reforms and through insider privatization will continue to wield their strong influence on state policies to protect their privileges or will be willing to give these up and press to ensure their rights over property already acquired. Establishing the general rule of law, without special privileges, would benefit entrepreneurs as a whole and contribute to the welfare of society at large. Until that happens, the evidence indicates that rapid reform has generally been better.

References:

  • Aslund, Anders, 1995, How Russia Became a Market Economy (Washington: Brookings Institution).

  • Aslund, Anders, 2001, “The Myth of Output Collapse after Communism,” Working Paper 18 (Washington: Carnegie Endowment for International Peace).

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  • European Bank for Reconstruction and Development, 2003, Transition Report 2003 (London: EBRD).

  • Grün, Carola, and Stephan Klasen, 2001, “Growth, Income Distribution, and Well-being in Transition Economies,” Economics of Transition, Vol. 9 (July), pp. 35994.

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  • Havrylyshyn, Oleh, 2004, “Uncharted Waters, Pirate Raids and Safe Havens: A Parsimonious Model of Transition Progress,” paper delivered to the 10th Dubrovnik Economic Conference of the Croatian National Bank, June 2326, Dubrovnik, www.hnb.hr.

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  • Hellman, Joel, and Mark Schankermann, 2000, “Intervention, Corruption, and Capture,” Economics of Transition, Vol. 8 (November), pp. 54576.

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  • McFaul, Michael, 2002, “The Fourth Wave of Democracy and Dictatorship: Non-Cooperative Transitions in the Post-Communist World,” World Politics, Vol. 54 (January), pp. 21244.

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  • Przeworski, Adam, 1991, Democracy and the Market: Political and Economic Reform in Eastern Europe and Latin America (Cambridge: Cambridge University Press).

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  • United Nations Development Program, 2003, Human Development Report 2003 (New York: UNDP).

  • Zinnes, Clifford, Yair Eilat, and Jeffrey Sachs, 2001, “The Gains from Privatization in Transition Economies: Is Change of Ownership Enough?” IMF Staff Papers, Vol. 48 (Special Issue), pp. 14670.

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Finance & Development, September 2004
Author: International Monetary Fund. External Relations Dept.
  • View in gallery

    Measuring up

    Central Europe and the Baltics have made the greatest progress with transition, parts of the former Soviet Union the least.

    EBRD Index of Transition 2003 (4.3=full market economy)

  • View in gallery

    A market for democracy

    The more progress made toward market reforms, the greater the likelihood that democratic institutions are taking root. Conversely, the more partial the reforms, the less likely is continued progress on democracy.