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Process of Transition in Central and Eastern Europe: Its Revolutionary and Evolutionary Part

English Pages, 25. 3. 1998

Discussing Central and Eastern Europe in the spring of 1998, it seems appropriate to mention both the non-negligible and undeniable positive results which have been achieved in the transition economies of Central and Eastern Europe during the last eight years, and at the same time the not less undeniable problems connected with such a unique historical manouvre – the move from communism to a free society. There are many important, substantial similarities among the transforming countries but we know as well that it is sometimes difficult to discover them because of evident, apparent differences we see at first sight. I will, nevertheless, try to generalize and outline broader tendencies (or lessons) even if I have to build on the Czech experience more than on the experience of other countries.

At the very beginning, eight years ago, practically in all the countries in question, very optimistic forecasts and expectations prevailed. They helped to initiate radical domestic reforms and to attract investors from abroad. Even if the structure of the transformation process was not identical in all the countries, crucial reforms have been realized, and they were, I hope, basically understood. The transformation activity was directed to the following tasks:

- to liberalize (trade, investment and prices);
- to deregulate (markets);
- to privatize (state property)

as fast and as comprehensively as possible on condition that you are able to pursue sufficiently restrictive macroeconomic policies. Some of us knew that to loosen fiscal and monetary controls, when economic imbalances, inherited from the communist past, dominated the macroeconomy, would have been destabilizing and would have led us into what I used to call the reform trap.

Everyone was aware of the fact that there had to be a parallel evolution of the appropriate institutional infrastructure which – when in a functioning form - minimizes the inevitable transaction costs and makes the market economy efficient and “just”, but this evolution was not – for many understandable reasons – achievable as fast as the liberalization and deregulation processes.

With the benefit of hindsight, we know – now that

- the institution–building takes years, if not decades, which is a totally different time-dimension than in the case of price or foreign trade liberalization;
- the role of the government was - after our communist experience - so discredited that nobody believed in its capacity to do a positive constructivistic activity (and nobody possessed the knowledge how to do it);
- some of us believed in the Hayekian process of spontaneous evolution of “extended orders” (as opposed to “made orders”) and understood that it was impossible to stop this evolution, to stop the spontaneity of behaviour of millions of market “players” and to wait for the emergence of a perfect market infrastructure. It can be done – perhaps – in a laboratory, not in a real world.

As it is well-known, the ideas have consequences. In this respect it is relevant that the whole transformation process started at a moment when the economic profession believed in several, then fashionable ideas:

- a government failure is much bigger than a market failure (therefore, deregulate – or, in our case - do not start to excessively regulate);
- fixed exchange rates represent a reliable nominal anchor of a transition economy;
- privatization has no costs and can be done by means of standard procedures;
- politicians should be able to guarantee the rational sequencing of individual reform measures, etc.

It seems to me that some of these ideas survived the decade but some of them do not belong to the most fashionable ones now.

In the first stage, the reform steps “worked”. After a short and inevitable economic decline which lasted two-three years and represented the healthy shake-off of non-viable economic activities associated with the old economic system, the economy began to recover. The rate of growth of GDP reached 4-6% range in following years (three consecutive years in our case), investment ratio became extremely high, domestic spending visibly grew, import skyrocketed, foreign capital inflows were enormous (as a share of GDP).

I have to admit that I believed in the possibility of a longer continuation of such a relatively smooth development. Not in a fully linear way but with only modest fluctuations. The experience of the last two years, let´s call them the second stage, tells us, however, that we have underestimated the enormous vulnerability of such economy (even if I think that it was, probably, more our incapability to change the whole situation than our underestimation of this vulnerability). The economy was characterized by

- dangerously growing expectations of all economic agents (consumers as well as investors) and by our inability to slow them down without heavy political costs;
- overinvestment (from the macroeconomic point of view) both in directly productive and non-directly productive activities, which led to investment-saving disequilibrium;
- growing trade imbalance which was gradually accompanyied by balance of payments´ current account deficits;
- slow improvements in the institutional framework, by weak regulation of monopolistic or otherwise non-perfect markets and by unsystematic law enforcement;
- the disturbances connected with aggessive and merciless global capital markets, especially when they are confronted with weak domestic banking and financial intermediation.

As a result of that, the second stage led to an economic slowdown (or stagnation) and to a political crisis, which meant the interruption of the previous, relatively smooth economic development.

The whole problem was created by the underlying structural factors, but the trigger was the fact that markets became nervous about both the trade deficit and the strong currency (based on the nominal fixed exchange rate and on domestic inflation higher than in OECD countries). As a result of it, capital inflows stopped, interest rates rose, the economy slowed down, tax revenues declined, fiscal balance deteriorated, the state budget expenditures had to be dramatically cut, the economy slowed down even more, capital was pulled out of the country, the currency depreciated, some firms and banks got into troubles, the economy went into a very sluggish growth, etc. The anatomy of crisis was rather simple (and well-known).

This story could be presented in a more extensive version but the basic lesson is clear and straightforward. It was not identical in all the countries, but the most “clean” case was perhaps – to my great regret – the Czech Republic because of

- its higher degree of openess and deregulation;
- more extensive financial transactions connected originally with voucher privatization;
- the insufficiency of capital market regulation;
- its extremely high investment ratio (33% in 1996);
- 75 months of the stability of the nominal exchange rate;
- very restrictive step in monetary policy introduced in the middle of 1996;
- greater and faster growing expectations than elsewhere.

There is no doubt that we are slowly moving to the third stage. It will be characterized by consolidation and macroadjustment, by the residual privatization and by institutional maturing. It is the period when the “first generation” reforms are over (with only some remaining “residuals”) and when the “second generation” reforms will be realized. I have a moderate optimism in this respect, with two necessary qualifications:

I do not believe that the second stage could have been eliminated. I do not believe in the possibility of a smooth and stable transition path in politically and socially difficult, but highly democratic, pluralistic and open societies (and economies) of Central and Eastern Europe. We are not in a “brave new world” of perfect markets and of perfect governments. The current adjustment (or realingement) was necessary but I am not sure that the changes could have been made “voluntary”, that they could have been intentionally “introduced”. The adjustment had to be involuntary and therefore, enforced.

I agree with those economists who – now – say that “if anything has been relearned in recent years, it is that laissez-faire does not work in banking” (R. Hausmann) and in institution-building in general. This is true. But the second generation reforms will be less radical, less visible, less headlines-creating, less ideological, much slower, and much more influenced by lobbyism and rent-seeking, etc. It will be, therefore, connected with a serious danger which did not exist at the beginning: institution-building and regulation processes may be used for the creeping change of the whole system from free society to interventionism and neocorporativism.

It is our task to prevent it.

Václav Klaus, Notes for the keynote speech given at the Third Annual Eastern Europe/Russia Conference, Vail, Colorado, 25 March 1998.