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Economic Transformation in the Czech Republic: Challenges Faced and Lessons Learned

English Pages, 21. 2. 2006

The collapse of communism in the Czech Republic (then Czechoslovakia) produced an extraordinary euphoria among the Czech people. It created a relatively unique and great unity in the whole country. As reformers, we knew then that that unity was explicitly negative. The people were united “against something,” not in “favor of something.” Fortunately that was enough to allow us to look for the way forward. It seems almost unimaginable today, but for the majority of people the alternative to communism in our country was not capitalism. A utopian “third way” was being sought and promoted.

Proponents of the third way opposed the establishment of political parties, defended the so-called non-political politics and claimed an exceptional role for intellectual and cultural elites in the running of the country. They represented a neo-collectivist vision of society and a rejection of a liberal democracy. In essence, promoters of the third way advocated “postdemocracy.”

The proponents of the third way did not want to change the existing economic system, but merely to deepen “perestroika.” They wanted to put into place the ideas of the 1960s that argued for the convergence of the economic systems of socialism and capitalism. They did not trust the market. Instead, they believed in an enlightened economic center, which would, with the internet at hand and with popular managerial pamphlets, wisely organize the economy. They wanted to privatize only small businesses and give the larger ones to their employees. They feared selling “the family silver” abroad and so on.

When it came to foreign policy, the proponents of the third way intended to make the Czech Republic a bridge between the East and the West and create a new world that would eliminate the faults of both. They wanted to abolish the Warsaw Pact and the North Atlantic Treaty Alliance (NATO) at the same time. They were idealists without a realpolitik understanding of foreign policy, who mocked the long-term national interests of the Czech Republic.

It is also necessary to remember that the conflict at that time was not between authentic reformers on the one hand and apologist of old order or former communist officials on the other hand. The communists knew very well that they had lost and for that reason they did not have any or only very small political ambitions – at least in the short run. The communists did not have any influence on the discussion at the time when the Czech economic transformation began.

Those who hindered a thorough overhaul of the Czech economic system, belonged to two influential groups. The first group consisted of the communist reformers of the 1960s, who were expelled from the Communist Party after the Soviet invasion in 1968. Their wish was to implement their 20-year-old reform agenda. The second group consisted of the anti-communist dissidents from the cultural and intellectual sphere. Led by Vaclav Havel, my predecessor as the President of the Czech Republic, the group wanted to create something new – something without the faults of both, liberal democracy and communism. The world, they reasoned, was supposed to be governed by a chosen few. They considered market forces demeaning. It is not an accident that Mr. Havel recently said that “the invisible hand commits various clearly visible crimes”.

A different and a relatively small group of people was not afraid to say that the goal of transformation in the Czech Republic was capitalism and a parliamentary democracy. That group knew that it was necessary to say where they want to go, outline how to get there and convince the Czech public about that direction. That group and I was a part of it, pushed for the adoption of the Scenario for Economic Reform by the Federal Parliament of the then-Czechoslovakia in the fall of 1990. A compromise document, the Scenario for Economic Reform contained the main policies needed for the liquidation of the institution of the centrally planned economy, not just partial adjustments that were advocated by others. Those policies included annulling thousands of orders and bans, and allowing private and foreign subjects to enter the market, liberalization of prices and of foreign trade, and privatization of state enterprises.

All the while, we kept in mind that the two accompanying preconditions for the success of economic transformation – macroeconomic stability and gradual creation of the infrastructure needed for the functioning of the market – were indispensable. All of us, who were thinking about the economic reforms at that time, knew that it was necessary to do all of those things simultaneously. We did not consider any of them to be less important. However unbelievable it might sound today, we had to fight hard over every sentence contained in the Scenario for Economic Reform.

We knew that there was nothing to wait for, because the euphoria that followed the collapse of communism would not provide us with an unlimited time and room for unpopular and painful steps. We knew that it was necessary to take the advantage of the temporary weakening of all the various interest groups, which, as Professor Mancur Olson explained, would under normal circumstances obstruct change and promote their own special interests. We knew that any fundamental change in a free democratic society does not represent an exercise in applied economics, but a real social process which cannot be designed and gradually implemented by constructivists. (Thus, the advice given by Professor Joseph Stiglitz – that we should have made our transformation more gradual as the Chinese have done – is laughable.) Also, we had to avoid partial reform, because partial reform creates new disequilibria that harm the economy as a whole. It was, therefore, essential to take a big step and create a “critical mass” of reforms that signaled that there would not be a return to the past.

We also knew that we could not destabilize the economy and with it millions of people’s lives. We had to minimize inflation as well as the unavoidable losses of output – some of which, unfortunately, was irretrievably lost. We tried to achieve the best possible shape of the proverbial J-curve. If we were to draw our own “Tobin’s” index showing the losses suffered by the Czech economy due to transformation, I am confident that it would be the most favorable of all the transforming countries.

The key to minimization of those transformation losses was a cautious fiscal policy – in particular a surplus budget in 1990 – and cautious monetary policy. That allowed us to avoid the risks resulting from price and foreign trade liberalization, from price-wage spiral, and exchange rate spiral. It can be said that we did avoid them even though – especially when we were looking for the correct rate of devaluation of the Czechoslovak Crown at the end of December 1990 – we did not sleep for a few nights.

In the end, we did only what we were allowed to do by the social and political consensus of that time. But, it was far from being all that we dreamt about and that we considered to be correct. Alas, other evolutionary, but not revolutionary, changes would follow and the system would be fine-tuned in the future and within the framework of the intricate process of parliamentary democracy. (I believe that nothing concerning the challenges we faced was and is known to those who criticized us then and those who criticize us today.)

Over the years, we were criticized for price liberalization in the environment of a monopolistic structure of the economy. But we knew that that monopolistic structure of the economy was the main reason for parallel liberalization of foreign trade. Essentially, we had to “import” competition. The results corroborated our hypothesis and our country had the lowest rate of inflation of all countries where the liberalization of prices had been done.

We were also criticized for the extent of the crown’s devaluation, but our rate of devaluation secured our main aim – equilibrium of the balance of payments. We also won our fight with the International Monetary Fund when we refused to accept an even greater devaluation that they advocated. The exchange rate survived at the level chosen by us in December 1990 for a long 6 years.

We accepted the dominant doctrine at that time that argued in favor of a fixed exchange rate as the only possible anchor of a sharply fluctuating transformation economy – even though I feared that measure. We wanted to liberalize prices and trade, and fix the exchange rate afterwards. It came out well. Unfortunately, after a couple of years, we missed the right moment when we should have left the fixed exchange rate. That mistake was partly responsible for the exchange rate problems of 1997. (I consider a recent criticism that I promoted the fixed exchange rate at that time, but today I do not want to fix our exchange rate by accepting the euro, to be funny. In 1990, the fixed exchange rate was a key element in the stabilization of our economy, whereas today it would lead to our economy’s destabilization.)

Moreover, we pushed for privatization of businesses as we found them and not, as some of our critics wanted, after bailing them out financially first. If we were to wait for the financial bailouts to happen, transformation would be stopped. Calls to postpone the beginning of transformation until the economic institutions and the rule of law were perfect (and they never are) were similarly wrongheaded. We knew that institutions and legislation are endogenous rather than exogenous. We knew, therefore, that they would have to evolve gradually. We recognized that the faster that happened the better, but we also recognized that institutions and the rule of law cannot be created in the offices of a few reformers.

Václav Klaus

Published in Cato Institute Economic Development Bulletin, no. 6, February 14, 2006

This essay is based on a longer paper delivered at a conference sponsored by the Center for Economics and Politics in Prague on January 10, 2006, to commemorate 15 years since the beginning of the Czech Republic’s economic transition.

Also available on
http://www.cato.org/pubs/edb/edb6.pdf