Transitions from Communism to Markets

If You Asked Me in the mid 1980s When the Berlin Wall Would Fall

In 1991

• The Soviet Union, in a peaceful fashion, split up– There was the breakup of the Union of Soviet

Socialist Republics (USSR)• Population of 290 million in 1990• Biggest successor state was the Russian Federation with

a population of 150 million in 1990• Second biggest was the Ukraine at 50 million in 1990 • 15 different countries—Estonia, Latvia, Lithuania,

Belarus, Ukraine, Moldova, Georgia, Armenia, Azerbaijan, Uzbekistan, Turkmenistan, Tajikistan, Kyrgyzstan, Kazakhstan, Russian Federation

And The Loss of Political Control

Economics of Transition

• Obviously there is a big political history, but the goal here is the economics of transition– A transition away from a centrally planned

communism to a market-friendly system• We will use Russian and Poland as our 2

example counties

Depression and Political Freedom• Included a big expansion of political and

economic freedom—including real elections• Freedom House puts together an index of

political freedom and democratic rights—measures voting, participation, turnover of politicians– Most of there countries were at about 25% of the

US level of democratic freedom in 1989– By the mid-1990s, they were at about 60% of the

US level

Economic Freedom

• Also have indices—how free are markets. How controlled are their prices, how free is foreign trade, how easy is it to start a business

• 0 is pure socialist and 100 a market economy– Countries like Russia went from a 3 in 1989 to a 70

by the mid-1990s

Depression

• Huge economic decline• A mild US recession has about a decline in real

GDP of between ½ an 1 percent in a year• A deep recession could be 2 percent in a year• The Soviet economy fell by roughly half, which

was worse than the Great Depression in the US

• Fortunately, growth restarted by 1994

Growth

• The graph show a dramatic fall, but it also show the subsequent rise

• Often as high a 7 % per year for a decade• Question we need to ask—was that fall as bad

as it looks

Government, Quantity, & Quality

What Changed?

Other Indicators

• Electricity demand only fell by about ½ as much—bad, but not as bad

• Note that many businesses use electricity and now that they had to pay market prices, the businesses may just be using it more efficiently

• The average living space per person rose from 15 square meters in 1990 to 19 square meters in 2000

Other Indicators• Private ownership of cars doubled– 14 cars per 100 households in 1991– 27 cars per 100 households in 2000

• Tourism rose from 1.6 million going abroad in 1993 to 4.3 million in 2000

• Percentage with running water increased from 66% to 73%

• Share with hot water increased from 51% to 59%

• Share with central heating increased from 64% to 73%

Economic Shocks Brought Related Social Problems

• Crime doubled from 1991 to about 1995—and roughly double again by the early 2000s

• The average business paid 10 – 20% of revenue as protection money to local gangs

• From 1991 to 1993, the marriage rate declined by 20%, and the birth rate fell by 12%

• Life expectancy for men has fallen from 64 years in 1989 to 57 years in 1994—heart disease, suicide, alcoholism, murder

US Census Bureau

• Our census bureau also provides estimates of the population of other countries– 147 million in 2000– Predict 140 million by 2010– Predict 109 million by 2050– That is a drop of ¼ in 50 years– ?? All in a period that is not plague or warfare

Demography is Destiny

• Smaller countries tend to mater less on the world stage

• Don’t believe me—ask someone from Ecuador or New Zealand

Why Was the Economic Transition Away From Communism So Hard?

• Most think that a transition to markets should spur more transaction and more growth– It has now that we are a couple decade out, but

why so harsh at the beginning • One reason—the market economy has an

invisible market infrastructure

Difficult

• Soviet systems just followed orders from the planners

• Many firms were supported with subsidies in the Soviet system and now were facing reality for the first time

• Soft budget constraint

Difficult

• A worker in a market economy know that pay and even the job depends on how hard you work

Story

• A group of Soviet economic planners visited a vegetable market in London.– Walked around and were incredibly impressed– Why? No huge lines. No shortages. No

mountains of spoiled veges that nobody desired

I, Pencil

Culture Change

• This is probably the reason for the increased death rate of men

• Alcohol, violence, and stress

Another Difficulty

• Russian and many other countries experienced a hyperinflation

• Took off and often reached 1000% per year• Many said that if you take away price controls

you should expect crazy prices

Why Hyper?

• You do not get a hyperinflation of that magnitude with just a readjustment of prices– There must also be a surge of buying power– People had large savings from the old days that they

had not been able to spend• Often called a monetary overhang

– Government was also running huge budget deficits and handing out many subsidies

– The central bank had not been reformed so it was also handing out large loans

For an Economy to Work

• To get an economy to work you do not need to get the inflation rate all the way down to 0– Some studies suggest that if you can get it below

40% the economy can at least begin to function– When these countries got their inflation down to

lower double digits, they could get started a year or two later

– By the late 1990s, inflation in Russia and Poland was running at around 10% a year

Privatization Process

• How can you move from state ownership to private ownership

Transition

• In Russia, 120,000 firms went from state to private control between 1991 and 1993

• In Poland, about 1,300 firms were privatized this is about 1/6 of the total firms

• In the Czech-Republic, they sold all state-owned firms in a voucher system

All Had Problems

• In Russia, the difficulty was that the sell off was rigged so that the existing managers and employees had the best chance to own the company

• I can see why they would want to do that, but in practice it translated into a few rich investors gained control of most of the firms and did it very cheaply

In Many Eastern European Countries• They got their voucher, used it to buy some

stock, and immediately sold the stock to someone else.

• That is nice, but it does not create broad ownership. They have different incentives when they are not owners

• Others held on to the stock, but then voted for the firm to pay huge dividends and prevented the firm from investing for the future

• More interested in quick money—not growth

Privatized Firms Are More Efficient

How To Recreate The Basics Of Government

• The main functions of taxes and spending needed to be updated

• Old Russian tax system was a mishmash– Most was a payroll tax on wages– They would pay you wages and then tax back 40 or

50%– The had this complicated web of cross-subsidies– Remember the government can set some prices

high and others low and them pocket the difference

As the Planned Economy Fell Apart

• As the planned economy fell apart the method of taxing fell apart– Tax collections had been 42% of GDP in about 1989– Collections were down to 32% of GDP by the mid-

1990s– Remember that this is not just 10 percent point less

it is also from a much smaller GDP– By the late 1990s, Russians were collecting only

about half of what was due because of tax evasion

Need a Basic Tax Code

• Something like a sales tax to get things started• Everyone will pay and this will help so that the

government can administer the tax code• This is what happened slowly in Eastern

Europe, but Russian remained chaotic and used oil revenue in place of a well-functioning tax code

Change in Public Spending

• Under the old Soviet system basically everyone got subsidies for everything

• The is what low state control prices meant• Government spending was often ½ of GDP in a

planned economy– About 20% went to defense– Another big chunk went to food and housing

subsidies

Examples

• Bread prices were not allowed to rise since the 1950s

• Housing was so subsidized that in the early 1980s they were trying to give away Moscow apartments for free. And nobody wanted them because if you got the apartment you would need to pay to keep up the building

Changes

• This has been a difficult transition• In a market economy you can not subsidize all

of the people all of the time• That means they need to pull back on the

subsidizes that benefit the middle class and the wealth and focus in on helping the poor and elderly

Elderly

• The elderly people really suffered in the transition– There was an economic downturn– The hyperinflation made their savings worthless– Pension were too low to live on– Too old to work

Could They Have Done This With Fewer Problems

• Russia and most the successor states had a rapid transition also now as a big bang transition

• China has used a more gradual transition and had better results so far

• Of course, I am comparing apples to oranges

A Few Notes About China

• China is vastly poorer than Russia• Much more ag than Russia• China had a crazy social and political situation

in the decades leading up to the change• The government of China was not as fully

developed and, therefore, need less dismantling

• Plus, they did not grant political freedom

Easy to Understate What Happened

• If someone in 1985 had said the USSR would – Liberalize their economy– Liberalize their politics– Sold off the privatize companies– Gone through a hyperinflation and a depression– Stabilized it all and started rapid growth

– CRAZY

What is the Likely Trajectory for Transition Economies?

• Starting point—what is the base line?– Compare Russia to the US– Compare to Africa– Compare to USSR

• Andrei Shleifer—A Normal Country (2005)– Compared to other counties with similar economic

development, they look about average

Russia’s GDP in International PerspectiveRanking Economy Total GDP

(millions of Dollars)

1 United States 13.200

2 China 10.000

3 India 4.200

4 Japan 4.100

5 Germany 2.600

6 United Kingdom 2.100

7 France 2.000

8 Italy 1.800

9 Brazil 1.700

10 Russian Federation 1.700

11 Spain 1.200

12 Mexico 1.200

13 South Korea 1.200

14 Canada 1.100

15 Indonesia 900

Think About it in Per Capita Terms

• Russian is an upper-middle-income country

Transition Economies

Population(Millions)

Per Capita GDP

Other “Upper Middle Income”

Countries

Population(Millions)

Per Capita GDP

Russia 142 $12.000 Argentina 39 $15.800

Ukraine 46 $7.600 Brazil 188 $9.000

Kazakhstan 15 $8.900 Venezuela 27 $7.500

Poland 38 $15.400 Malaysia 26 $11.700

Hungary 10 $19.600 Turkey 73 $9.000

Czech Republic

10 $22.800 South Africa 47 $12.000

Romania 21 $10.100

Upper-Middle Income Issues

Why Am I Stating This

Russian Strengths

• Inflation under control• Good education system• Good science and technological system

• The real question is what will they do with the strengths they have

• They have grown strongly since the late 1990s, but that has been fueled by oil

Oil and Gas Production

• 13 percent of Russia’s GDP in 1999• 32 percent of Russia’s GDP in 2007– A much larger share of a much larger GDP

Rule of Law

• Ownership, contract, and debt need to follow a rule of law

Alternatives

• If you want alternatives, look all across Eastern Europe

• Those countries have fostered strong ties with Europe– Poland and a number of neighbors have joined the

European Union– Why? Trade! They want to sell to high-income

countries– Why? They can borrow the culture and institutional

infrastructure of Europe