Beyond Shock Therapy: Why Eastern Europe's Recovery Starts in Washington

Laissez faire was planned.
Karl Polanyi, The Great Transformation,1944

The collapse of Communism in Eastern Europe demonstrated the failure of a command economy. The subsequent crash in output and employment induced by "shock therapy" has suggested the limits of laissez faire. Rather than replace the excesses of communism with excesses of capitalism, it is time to lay extreme ideology aside and begin the practical work of economic reconstruction. Even more than in the West, which was viable capitalist institutions, this enterprise requries a mixed economy.

Beginning in late 1989, economic reformers in Eastern Europe began lifting controls on prices, foreign exchange restrictions, subsidies to business, and barriers to trade. Shortages of goods gave way to a shortage of purchasing power. The shock treatment did have some beneficial effects. Manufactured exports to the West have risen; small private enterprises have thrived; and unemployment in Warsaw, Budapest, and Prague has been practically nil.

That is the good news. The bad news is that in the rest of Poland, Hungary, Slovakia, the Czech Republic, and the less-developed nations of the former East bloc, tens of millions of people remain dependent on state-owned enterprises that are not competitive under free market conditions. It is not economically feasible simply to shut these enterprises down, nor is it likely they will be efficiently transformed solely by market forces. It is this reality that collides head on with the religion of laissez faire.

Eastern European intellectuals, even most social democrats, have tended to embrace shock therapy as part of a radical free market model. In part, their radicalism reflects their fears that if planning is not entirely exorcised, the ghost of Communism may revive. In part, it reflects the fact that most Western economic ideas that permeated the "Iron Curtain" before the reforms were ultra-market ones. Not even Keynesianism, let alone the new East Asian model of a capitalist "developmental state," was widely known. Shock therapy has also been mandated by the Bretton Woods institutions--the International Monetary Fund (IMF), which presides over bankrupt countries' cash flow problems, and the World Bank, which oversees their "structural adjustment." Loans from the Bank have been contingent on governments meeting stipulated conditions regarding market liberalization, deregulation, and privatization-- the holy trinity of World Bank policies. If these conditions are rejected, countries usually can't raise foreign private capital on their own.

No nation has ever built a modern industry under the conditions currently imposed on Eastern Europe. The world's fastest growing economies for the last three decades--Japan, South Korea, and Taiwan--have tended to follow dirigiste economic policies almost diametrically opposite to those commended to post-socialist Europe. The reconstruction of Western Europe after World War II likewise included a heavy dose of public ownership, capital controls, and other instruments of economic planning that are anathema in the World Bank's current recipe book. The economies of Anglo-Saxon nations with the greatest enthusiasm for the cold bath cure--the United States and the United Kingdom--have stagnated relative to West European and Asian economies with more interventionist states.

The point is not that Eastern Europe can or should mimic East Asia or even postwar Western Europe. The practical question is how to restructure the old economy while incubating a new one, without creating economic collapse in the interim. Though economic planning has an appropriately odious connotation east of the Oder, some form of planning now appears inescapable if Eastern Europe is to avert collapse.

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One key premise guiding the current ideology of Eastern European reform holds that subsidies must be withdrawn to see which state-owned enterprises are viable in a market economy. Survivors are expected to demonstrate their viability by cutting costs (especially wages) and raising productivity (by reducing employment). Another premise holds that no fundamental restructuring can occur until the public sector is privatized. The reasoning is that without private ownership to discipline the work force, shake up management, and modernize production, state-owned enterprises cannot meet international competition. Still another premise holds that most of the old, state-owned enterprises should wither away, to be replaced quite naturally with a burgeoning private sector.

But the generally rosy view from Warsaw, Budapest, and Prague reflects, in part, the awkward fact that all subsidies have not been pulled. Households still receive subsidized rents, fuel, and transportation. Nor have industrial subsidies been eliminated. Without such supports, the human misery would be much greater than it already is. Moreover, the view from Eastern Europe's capital cities (where most of the intelligentsia lives) obscures the national plight.

In Hungary and Poland, the two Eastern European countries where reforms have gone the farthest and where ethnic nationalism is least divisive, officially recorded national unemployment rose from nil to as much as 9 percent and 13 percent respectively by early 1992. Unemployment in Warsaw since Communism's fall has been below 2 or 3 percent, but it has easily exceeded 25 percent in the mining region of Silesia and the textile district centered in Lodz. The registered unemployment rate was only 1.8 percent in Budapest in September 1991 but nearly five times that in areas with heavy industrial concentrations. Exacerbated by market forces, income disparities among different regions of Czechoslovakia contributed to its dissolution and threaten to destabilize Hungary and Poland.

Industrial output in Hungary and Poland in 1990 and 1991 fell by 24 percent and 36 percent respectively, as indicated in the table on this page, and continues to fall in former Czechoslovakia and Hungary, which have the brightest future. Shock therapists claim Poland has "turned the corner" because industrial output in 1992 was positive. But this apparent "increase" was calculated in relation to the 36% output decline in 1990 and 1991.

Ironically, the devastation in the former German Democratic Republic has been the worst. Although the GDR was most economically advanced among the former centrally planned economies, the dismantling of its borders with West Germany deprived it of any buffers against free market competition, both in industry and nontradable services. With a total population of only 16 million, unemployment in eastern Germany in 1992 was estimated at 2 to 4 million, depending on whether unemployment was defined to include workers on involuntary "short-time."

The eastern German plight bodes ill for the rest of Eastern Europe, where the full force of foreign competition has not yet been felt due to the fact that depressed domestic incomes have dampened demand for foreign imports and where subsidies from West to East on the German scale are unimaginable. Shock therapy will probably be pronounced a success in eastern Germany in a decade or so--but only because the German Federal Republic will have provided about a trillion dollars of subsidy. Unfortunately, there is no West Hungary or West Poland to play a similar role.

Declines in output and employment were probably inevitable, given the dislocations inherent in the transition, but economic deterioration has exceeded all expectations. As I will argue, this is due to the faulty logic of shock therapy. None of the cures is working as advertised. The record since 1989 indicates that it is naive to expect a surge of foreign investment, utopian to expect rapid national privatization, and wishful thinking to imagine that the burgeoning private sector can offset the huge losses of state-owned enterprises.

While state-owned industry once competed unfairly with small private enterprises, the evidence from Poland suggests that fledgling private manufacturing enterprises now depend for both their inputs and final demand on a healthy public sector. Moreover, research I undertook for the Organization for Economic Cooperation and Development (OECD) shows that some of these state-owned industrial enterprises are potentially viable if they are properly restructured before privatization. In Poland, these number roughly 500 (out of a total of more than 8,000). Foreign consultants have identified them as promising properties for foreign takeover. The 500 account for roughly 20 to 25 percent of total industrial output.

The mere exposure of such promising enterprises to market forces, however, cannot trigger their recovery. Market forces in Eastern Europe may be underdeveloped, but they have already begun to act with characteristic ruthless impatience. As such, they have not provided potentially productive state-owned firms with a long enough time horizon to restructure.


An opening of free trade with Western Europe should increase the demand for Poland's skilled workers who are now earning (at around $1) about one-tenth to one-fifteenth of what comparable skilled workers earn just 500 miles to the West.
--Jeffrey Sachs and David Lipton
Brookings Papers on Economic Activity, 1990

The policy of opening the Polish market to all imports (i.e., not subject to quota, etc.) without having time to train and educate local industry as to how to react and the necessary quality requirements has been a high-risk strategy and has put the domestic industrial base in great difficulty.
--Consultants' Report on the Uniontex Textile Company, Lodz, August 1991

For at least two decades before the 1989 transition, the centrally planned economies bordering on Western Europe were already moving gradually towards more market-oriented policies. The 1970s saw massive imports of technology and capital in an effort to modernize production and introduce Western levels of consumption. The 1980s witnessed decentralization of decision making and greater autonomy at the enterprise level in matters relating to investments, production, and prices. Of course, all state-owned enterprises continued to enjoy a "soft budget constraint," in Janos Kornai's term, meaning they could rely on the state to bail them out if their investments soured; thus they were not bona fide capitalists.

Nonetheless, the perception from afar that all Communist companies are hopeless wrecks has proved overdrawn. Even discounting technically proficient defense-related firms, many state-owned companies have managed rather ingeniously to stay afloat by dint of cost-cutting and an inter-firm credit market. Their survival has been primarily responsible for preventing the wholesale disintegration of industry under shock therapy. Notwithstanding the rapid growth of private enterprise (from a very small base), state-owned firms still dominate the industrial sector, and the industrial sector still accounts for a larger share of total output than in more service-oriented countries of the West.

Some state-owned companies even appear to hold promise as global competitors. At the time of the transition, the Hungarian pharmaceutical and agro-nursery sectors had world-class firms. Well before the transition, Hungarian, Polish, and Czechoslovakian firms in a wide array of industries were exporting to the West. According to OECD estimates, by 1989 the share of Polish manufactured exports to non-COMECON countries (nonsocialist countries outside the Council for Mutual Economic Assistance) was 64 percent, with a high of 91 percent in food processing and a low of 45 percent in engineering products. While these exports may have been subsidized and probably cannot be sustained without enterprise restructuring, they are a sign of the potential competitiveness of some state-owned firms.

Labor in East Central Europe, while needing new incentives, is well-educated. For example, in a succession of international high school competitions in chemistry, the teams from Hungary and Poland have ranked in the top five (ahead of the United States). All state-owned enterprise managers lack financial and marketing skills, but some are evidently lucid and eager to learn.

Even the best state-owned enterprises, however, face structural bottlenecks of size, technology, quality, and capital. Although Communist planning was properly faulted for creating enormous industrial dinosaurs, it sometimes did the reverse. In many cases, regional policy under central planning produced a multiplicity of small enterprises in a single industry, sprinkled in locations chosen more for reasons of social welfare, politics, or access to the Soviet market than for reasons of profit maximization. Such fragmentation left many firms after the transition too small to become global players, their reputation for being elephantine in size notwithstanding. For example, the Polish detergent industry operated with seven firms (with too-small plants), whereas the entire nonsocialist detergent market was dominated by a handful of oligopolies. Poland, with a population roughly equal to that of South Korea, has close to 20 integrated steel mills, compared with Korea's two (both owned by the same public enterprise). Postsocialist industries with firms that are either too large or too small require rationalization before they can function efficiently.

COMECON, Eastern Europe's coerced common market, led to chronic bottlenecks of quality and technology. The postsocialist spinning and weaving industries of East Central Europe, for instance, have generally been estimated to be cost-competitive internationally. But in subtle ways, their product quality is below par--their fabrics lack sheen, their designs are dowdy. Technology in the region's bloated engineering sector is usually outdated. Although a few engineering firms are only slightly behind the world frontier (as in the case of a Hungarian supplier to the Soviet oil fields of process control equipment), they need time to restructure and find the right foreign partner to catch up.

Expansion has also been jeopardized by capital bottlenecks. Some potentially viable companies have suffered from a single outdated piece of machinery. For example, in an otherwise modern process flow, the Huta Katowice steel mill in Poland lacks a continuous caster. Other companies lack a shortage of "supplier credits" to offer customers of large equipment purchases. The former Lenin Shipyard, for example, had by early 1992 built a two-year order backlog but was still utilizing only 40 percent of its capacity. All firms have suffered from an acute shortage of working capital.

The collapse of COMECON worsened the severe deflationary effects of domestic budgetary cuts and monetary stringency. Companies in Poland, Hungary, and Czechoslovakia that were dependent for customers on the Soviet market became technically bankrupt overnight. Unable to meet their tax obligations or pay creditors, Eastern European industry began to experience mass indebtedness, financial instability, and shortages of short-term capital needed merely to continue production.

What is noteworthy about all these bottlenecks--size, quality, technology, and capital--is that they cannot easily be rectified by the shock introduction of market forces. Shock therapy's main answer to raging inflation and industrial stagnation has been to lower wages. As expected, falling aggregate demand and the freeing of restrictions on firms to lay off workers have led to rising unemployment, which, in turn, has further depressed pay rates. Despite lip service to "free" markets, Eastern European governments have also intervened with special measures designed to hold nominal wage increases below price increases. Such controls in Hungary and Poland have been imposed on state-owned enterprises only. Such selectivity has been designed to induce public-sector workers to become champions of privatization as the only way to end restraints on their pay.

Real wages have, in fact, fallen steeply in all countries. Due partly to worker protests and strikes, however, wages have sometimes fallen more slowly than output (see the table on page 89). Since lower wages are not the cause of poor product quality or old technology, wage cuts do nothing to remedy these bottlenecks. Even if lower wages enable firms to cut prices, demand from the West (and now East) for shoddy goods does not necessarily rise.

Moreover, the heavy emphasis free marketeers place on lowering wages to buy competitiveness is also misplaced insofar as labor costs have traditionally been a small share of enterprises' total costs. This is a stylized fact about Eastern Europe due to extremely low money wages and a broad welfare state. Before the transition the World Bank estimated that the direct labor-cost share in Hungary averaged no more than 15 percent.

Nor has the market mechanism done a very good job of providing Eastern European industry with capital to restructure. The failure of the banking system to finance restructuring has been attributed by shock therapists to its immaturity. Many banks operating after the transition in Poland, for example, were formerly branches of the state Central Bank that became partly privatized. They have little experience with commercial or investment banking and have been burdened with nonperforming loans from big, technically bankrupt state corporations. On the demand side, firms have been reluctant to borrow from banks because of high real interest rates.

Nevertheless, at the same time, in true capitalist fashion, newly privatized banks have rapidly become more interested in maximizing their own short-term profits than in underwriting long-term national industrial recovery. Under the conditions of tight money and high inflation characteristic of the early transition, private banks have quite rationally wanted to remain as liquid as possible and, therefore, to invest short term. Polish bankers have told me that they prefer lending to, say, pizza parlors with quick payback periods and high initial rates of return than to, say, paper manufacturers with huge debts, a costly restructuring period, and an uncertain future. A Polish paper industry, however, is a perfectly reasonable proposition from the theoretical standpoint of comparative advantage and from the practical standpoint of future output, employment, and export growth. The conflict between short-run private profit maximization and long-run national development has arisen precisely because markets have begun to "work," not because they are immature.

Yet another example of a market "working," albeit perversely, concerns the inter-firm credit market, which deepened throughout East Central Europe when demand fell sharply as a consequence of shock therapy and COMECON's demise. To prevent going bankrupt, state-owned enterprises extended credit to each other in exchange for goods. On one hand, the inter-firm credit market represents resourceful crisis management on the part of public sector managers. On the other hand, it exhibits "adverse selection" in the sense that it permits inefficient state-owned enterprises to postpone bankruptcy while plunging potentially healthy ones into the morass of debt.


Privatization is seen by Eastern European free marketeers as a necessary condition for the market mechanism to work. Privatization also holds the promise to governments of generating revenues through sales of public property. And privatization will supposedly help create a new entrepreneurial middle class that values hard work and liberal political democracy.

Given the inadequacy of domestic household savings, privatization involving some or all foreign ownership once seemed the best way to provide state-owned enterprises with the resources they needed to restructure. The ideal was the total integration of Western and Eastern Europe, with ideas and capital flowing from west to east and finished products flowing from east to west (the mass migration of workers from east to west was strictly verboten, except in Germany).

Privatization in Poland, Hungary, and Czechoslovakia has made some impressive headway. However, it has fallen short of lofty expectations about the amount and advantages of foreign investment, the ability to privatize the vast public sector, and the time horizon necessary for private enterprise growth to offset declining state-owned firms. Hungary's State Property Agency has succeeded in privatizing only 14% of the choicest state properties already transformed into joint stock companies.

Privatization has worked tolerably well in the small-scale service sector. Restaurants, shops, construction and transportation facilities in Poland, Hungary, and the Czech Republic now tend to be in private hands. Hungary has also succeeded in privatizing part of its stock of public housing. Estimates for Poland suggest that by the end of 1991, there were more people employed in the private sector (8.8 million) than in the public sector (8.2 million).

The view that the salvation of Eastern Europe lies in the substitution of small-scale, private enterprises is epitomized by two eminent scholars, Professors Janos Kornai and Peter Murrell, who are dismissive of the possibilities of planned rationalization of leading public sector firms. These "substitutionists" insist that the public sector is largely beyond redemption owing to its inefficiencies, the inherent difficulties in changing institutions quickly, and most of all, the state's lack of integrity owing to its continued domination by the nomenklatura. Therefore, substitutionists advocate a posture of benign neglect toward state-owned firms that must, with few exceptions, expire painfully and slowly. Government efforts instead should be directed towards removing all barriers to the private sector's growth.

Nevertheless, whatever the virtues of private enterprise, its growth performance has tended to be exaggerated--except possibly in the greater Budapest area and Bohemia. Outside the few parts of Eastern Europe with a prewar history of flourishing private entrepreneurship, new small-scale enterprise is almost entirely confined to services. There is little sign that it has begun to flourish in manufacturing. The economic importance of this distinction arises from the fact that services are typically non-traded and cannot be exported to earn the foreign exchange urgently needed to import new technology and capital goods. In Poland it is estimated that the private sector accounts for only about 20 percent of total exports. On the other hand, it accounts for as much as 46 percent of total imports. The privatization of approximately 100,000 small and midsize retail and wholesale stores has been associated with the rising share of consumer goods in total imports, which has more than doubled in two years, according to the OECD.

If private manufacturing activity is to occur at all, its development is closely linked with the recovery of state-owned manufacturers. Public and private manufacturing activity appear to be complementary rather than competitive. One sobering piece of evidence comes from an unpublished study of the Industry Division of the World Bank undertaken in 1991. The subject was 3,000 private Polish manufacturing firms. When the time came to interview them, half had already gone bankrupt. A sub-sample of 120 enterprises was then chosen for further study. But even among this especially promising sub-sample, 40 went bust and another 40 were dying. Most died because they depended for either their final demand or their inputs on state-owned enterprises that were themselves going bust. To cradle healthy private manufacturers, therefore, it is apparently necessary to heal the ailing public sector, or at least to salvage its major limbs.


The World Bank and IMF, unfortunately, have operated without any apparent fallback if their policies should fail. Clinging to ideology in the face of contradictory evidence, they have refused to pursue privatization in parallel with a more interventionist, planned approach to industrial restructuring. One way to accelerate privatization is to adopt a libertarian approach to the dismemberment of state-owned enterprises--merely allow their best sub-parts to fall into private hands. This, in fact, happened in the earliest days of the transition, when state-owned enterprise managers appropriated sub-divisions of their own firms, sometimes legally, in joint ventures with the state.

Whatever the economic merits or demerits of such "spontaneous" privatization, it caused intense political opposition because the resourceful managers in question were invariably the nomenklatura and acquired public property for a song. Thereafter the privatization process became more regulated and, hence, expensive and time-consuming, involving foreign and local consultants in the valuation of state property and the search for legitimate buyers.

Essentially, privatization can take one of two forms: liquidation, where the assets of an enterprise are sold off piecemeal and the enterprise ceases to exist (it is formally bankrupted); and auction, where the enterprise is sold to a buyer and continues to exist as essentially the same firm. Buyers can be syndicated, involving both foreign and local private interests, the state, as well as managers and workers of the firm in question (up to a stipulated legal maximum for workers of around only 20 to 30 percent of equity, depending on the country).

Neither liquidation nor auction has progressed very far in Poland, Hungary, or the Czech Republic, where the state-owned industrial sectors remain ubiquitous. Liquidation has stalled because the state has been unwilling politically to target the worst bankrupt enterprises, let alone the rest. The auctioning of state property to local buyers has made little headway because the economies of East Central Europe are depressed, and even if the nouveau riches have money to invest, they prefer buying service enterprises with quick paybacks than more risky manufacturing ventures.

Western financial consultants, including Harvard's Jeffrey Sachs, have devised ingenious methods of accelerating privatization by distributing to the general public free or at nominal prices shares or vouchers of state-owned enterprises. But even if these schemes succeed logistically, avoiding hyper-inflation and financial swindles, they won't necessarily overcome the problems of capital shortage and technological obsolescence. Moreover, as the director of the Privatization Agency of Slovenia pointed out, restructuring requires a coherent group of private investors rather than thousands of small owners.

After almost three years, 1,125 of Poland's small and midsize enterprises had been liquidated. Only 32 firms had been auctioned--two by leveraged buyouts, 8 by public flotation, and 22 by regular purchase. There remained 8,273 state-owned enterprises for sale, according to the OECD.


The easiest way to get capital and know-how is through foreign equity investment. When such investment has come to Eastern Europe, it has taken one of two forms. The East Asian model involves foreign investments oriented towards export. For example, in the Polish apparel industry's "putting out" system, German merchants provide cloth to low-paid workers in Poland who cut, trim, and sew the cloth, which is then re-exported to Germany (or other parts of Europe). While growing very rapidly, such exports accounted for only 2 percent of total Polish exports in 1992. The Latin American model, on the other hand, involves foreign investments oriented toward the domestic market; international oligopolies maintain global market share by manufacturing and marketing in Eastern Europe such consumer products as cigarettes, detergents, and cars.

The OECD estimates that over 70 percent of total direct foreign investment to Eastern Europe has gone to Hungary. Hungary has been the preferred locale of foreign investors because market reforms before the transition went farthest there and political stability and technological skills are now relatively advanced. Moreover, Hungary has accorded foreign investors handsome incentives, some would say to a fault. Special tax breaks have induced Hungarian firms to shift as much of their domestic output as possible into newly created joint ventures with foreign partners.

The paucity of direct foreign investment in Poland and its poorer eastern and southern neighbors has not been for want of effort. According to one unpublished study by the World Bank's resident mission in Poland, 68 percent out of a sample of 75 large-scale state-owned enterprises reported long-lasting cooperation with foreign partners. Another 12 percent were actively seeking a foreign tie-in. Nearly all the firms in the sample had been visited by potential investors, but after preliminary contacts, almost all investors withdrew.

Even in Saxony, one of the most developed parts of the former GDR, the energetic Treuhandanstalt, the German agency responsible for privatization, has been able to sell only 5 percent of 900 state-owned enterprises to foreign, non-German buyers. The 30 percent of firms sold to West German companies have mostly been in services. If this is the Saxon record, what can Poland realistically expect to accomplish with its 8,000 state-owned firms?

To put their money in Eastern Europe, foreign companies want assurances of political stability. They also apparently want policies that make their investments more profitable than what is possible under laissez faire. For example, General Motors (Europe) bought a large, antediluvian auto company, FSO, on the outskirts of Warsaw on the under-the-table condition that the Polish government provide it with 30 percent tariff protection. The Korean Goldstar Electronics Company also made protection a prerequisite for its establishment of a new television assembly plant in Hungary. Thus shock therapy under the auspices of laissez faire is quite incompatible with the privatizers' goal of foreign investment.

In the far more dynamic economies of East Asia, foreign capital has never been an important factor. In Taiwan, a country highly respected by foreign firms, international investment in any single year never accounted for more than 2 percent of total gross domestic capital formation. Generally, foreign capital in East Asia tended to lag rather than lead economic development--it accelerated but did not trigger growth.


A vicious circle has paralyzed Eastern Europe. The steady decay of state-owned enterprises reduces tax revenues, which creates widening budget deficits, which necessitates continuing macroeconomic austerity, which depresses demand and further erodes the industrial base. That, in turn, creates more pressure to cut wages, which continues to depress demand. And the capital needed for modernization is not forthcoming, either from domestic or foreign investors.

Nevertheless, the expensive consultants' studies financed with World Bank loans to advance the cause of privatization have unwittingly provided evidence in support of a way out of this impasse. These and other micro-level investigations corroborate the existence of a small but promising subset of state-owned enterprises. These are the enterprises that the government has pressured to "commercialize" as a first step toward showcase privatization. It is difficult to estimate precisely these firms' share of total national output (given the dislocations of shock therapy), but as noted earlier, they probably account for about one-quarter of total industrial production in Poland. They comprise firms of all sizes, including major large-scale producers of, say, chemicals, refined copper, and ships. All 500 promising Polish state-owned enterprises tend to suffer from one or another bottleneck, but together they represent a starting point for re-industrialization.

The road to recovery in Eastern Europe must begin in Washington for two simple reasons. First, it is here where the World Bank is located, and the World Bank has exerted a dominant influence on Eastern Europe's restructuring policies. If Eastern Europe is to chart a new course, Bank policies must change. The bank is a major lender and often administers the special credits extended to Eastern Europe by sovereign governments. The conditionality the Bank attaches to its structural adjustment loans has effectively prevented supposedly independent postsocialist governments from supplying investment credits to their own state-owned firms or departing from the model of shock therapy. The Bank's large economic staff and its privileged access to data by dint of its lending operations also give it monopoly power to manipulate information. "Confidential" Bank reports have on occasion been leaked to the press with unverifiable claims that, as the New York Times reported, Eastern Europe has "stood on the brink of hyperinflation" unless, it "slashed social spending, raised taxes, and ended the role of workers in managing state-owned factories." The high salaries the Bank pays local consultants reinforces their free market ideological preferences.

Second, Washington appoints the World Bank's president and influences its policies, owing to the fact that the U.S. remains the largest single contributor to Bank funding. The Reagan-Bush Treasury was instrumental in determining the Bank's neo-conservative approach to economic development. With new Clinton Treasury appointments, the door is open to a possible change in regime, although the new Clinton-appointed undersecretary of the Treasury for international affairs, Lawrence Summers, was previously a World Bank vice-president and chief economist.

The U.S. would find Japan a willing ally for change in World Bank policy. The Japanese Delegation to the Bank has publicly attacked Bank economists for being "simpleminded" in their faith in the free market. The head of the delegation said in a press conference in late 1991 that many of the policies that East Asia followed are precisely those that the Bank prohibits other countries from adopting. The policies of Japan and its neighbors have been "market friendly," according to the delegation's chief, but when necessary have included cheap credit, protection of infant industries, and targeting of promising firms.

Given the U.S. budget deficit, it would be naive to think that Washington can create anything as grandiose as another Marshall Plan to revive Eastern European growth. Given past history, it is also unlikely that Eastern Europe can follow a restructuring model closely resembling that of East Asia. Nevertheless, the Clinton administration can alter World Bank conditionality and help Eastern Europe develop more pragmatic restructuring plans. The East Asian model may be inappropriate in its entirety, but many of its principles are transferable.

The specific details of a possible restructuring plan are laid out in a report on Polish industry I helped prepare for the OECD. The highlights follow:

First, the argument of Janos Kornai and other substitutionists that Eastern European governments cannot act as agents of reform because of their nomenklatura taint is outdated. For all practical purposes, the nomenklatura of Poland, Czechoslovakia, and Hungary (where they were never entrenched) have jumped ship and are now the respectable pillars of the private sector. In this respect state institutions have, in fact, changed fast.

With the nomenklatura out, most government bureaucracies have limped along with skeleton staffs of inexperienced university professors and the like. As a first step towards restructuring, more resources should be invested in training government officials responsible for restructuring and in raising their salaries to levels competitive with those of the private sector. That it is not an impossible task to mass-produce competent bureaucrats in a relatively short time is indicated by the acceptable quality standards reached by the bureaucracies patronized by the Bank (privatization ministries) and International Monetary Fund (finance ministries).

Second, given bureaucratic weaknesses and huge budget deficits, subsidies in Eastern Europe to help select state-owned enterprises to restructure must be cheap and simple to administer. The two most effective subsidies are debt relief (largely for tax arrears owed to the government) and credit guarantees (provided by the government to assure overseas lenders that their loans will be repaid). The former will help state-owned enterprises gain access to working capital while the latter will help them tap cheap foreign sources of finance for long-term investment.

Where industry-level subsidies are warranted, they should be finite in time and carefully customized to a specific industry's needs. For example, a good case can be made to subsidize Eastern Europe's spinning and weaving industry while it improves its quality and designs. But rather than protect it from foreign competition with tariffs, it would be better to give garment makers subsidies to buy locally made (rather than foreign made) cloth from specific textile companies of their choice. This, of course, violates conventional free trade--but it is better than leaving these potentially competitive industries to the wolves. And it is not unlike the networking strategies so successfully pursued in East Asia. Whatever strategy is pursued, there will be difficult decisions involving necessary reductions in capacity--painful under the best of circumstances but excruciating if left to the vagaries of markets.

Third, Eastern European restructuring requires strict criteria for subsidies. Even modest subsidies, such as debt relief and credit guarantees, risk perpetuating inefficiencies and dependence on state largesse. East Asian offers a relevant lesson because it has subsidized firms extensively but with generally positive returns. I have argued that an important reason for East Asia's success lies in the discipline attached to its subsidy allocation. (See "East Asia's Challenge to Standard Economics, TAP, Summer 1990.) Whereas countries in Eastern Europe and Latin America allocated subsidies willy-nilly, in East Asia subsidies have used concrete and monitorable performance standards. Taking their cue from the East Asians, postsocialist debt relief and credit guarantees should be given only in exchange for monitorable performance targets related to restructuring (including human resource development and improvements in management practices). Subsidies must be withdrawn in the event of noncompliance--this can be made a new condition of World Bank loans to Eastern European governments.

Fourth, given limited resources, probably not even all promising state-owned enterprises can be subsidized to restructure. The very thought of "picking winners" sends shivers down the spines of free market economists. Yet shock therapists "pick winners" whenever they identify firms supposedly ripe for early privatization. Moreover, they now realize that if bankruptcy is to be a credible threat, they must "pick losers," and force specific firms into liquidation. Both choices are risky, but picking losers is politically destabilizing and holds less promise of stimulating growth than picking winners.

The best approach is to put subsidy-seekers in competition with one another. That is, state-owned enterprises wishing debt relief, credit guarantees, and other supports should be obliged to develop a restructuring plan stating how they intend to become more competitive and what performance standards they expect to attain. This strategy is more likely to enlist workers (who want to keep their jobs) as constructive allies in the process of restructuring.

No conceivable method is altogether exempt from the efficiency problems economists obsess over, but an important principle to observe is transparency. To minimize corruption, the final selection of subsidy recipients should be made in open committee meetings, by top bureaucrats from several ministries who can then keep an eye on one another. This is the procedure that has been followed successfully by the Board of Investment in Thailand, for example, a country with a long history of corruption.

The distribution of output by firm size in many Eastern European countries is such that a large share of output is accounted for by a small number of firms. But what to do with the remaining smaller state-owned enterprises (numbering some 6,000 in Poland) that do not qualify for restructuring assistance and that do not find private buyers even among their own employees?

Arguably, the best approach to these firms is simply to hand ownership over to their employees for a nominal sum. In most cases these firms are already controlled by their employees, so the responsibility of ownership should go along with such control. At least through self-ownership such firms will have access to the same government incentives that private entrepreneurs now enjoy--clear ownership rights, de facto exemption from many if not all taxes, and easier access to bank loans, depending on the country. If restructuring proceeds along these lines, postsocialist economies in the foreseeable future will be characterized by a mixed-ownership structure, involving the co-existence of both private and public enterprises. This will resemble the mixed economies of Western Europe that countries to the east so admire.

Diehard free market economists in Eastern Europe and their Western consultants argue that if any form of planning is introduced, Communism is likely to return through the back door. It seems more plausible, however, that if some planning is not introduced and economic conditions continue to deteriorate, then some sort of political extremism is a certainty.

One would hope that the political defeat of American neo-conservatism and three years of postsocialist suffering should discredit the idea that laissez faire is an absolute law of capitalist development. Then, perhaps, Eastern Europe will be helped to rebuild a viable mixed economy rather than a capitalist utopia that exists nowhere but in the minds of wayward free marketeers.

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