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October 07, 2005

In Defense of "Shock Therapy"

Leszek Balcerowicz of Poland's central bank defends the Polish escape route from Really Existing Socialism:

The Wealth of Nations: [I]t is so important to analyze which policies work and which ones fail, to generate lasting convergence -- and to bring poor countries out of poverty.... Communism, an extreme form of statism, went farthest to suppress markets and criminalize entrepreneurship. The opportunity costs of this organized folly were enormous: relative per-capita income in Poland, for example, declined from about 100% of that in Spain in 1950 to only 40% in 1990. And with the collapse of the communist system, a great natural experiment began. Looking at its results, one is struck by the huge differences among countries of the former Soviet bloc:

  • In 2004, GDP had increased, relative to 1989, by 42% in Poland, 26% in Slovenia, and 20% in Slovakia and Hungary. In contrast, it declined by 57% in Moldova and 45% in Ukraine. If the shadow economy were included in the calculations, the differences in output would be smaller, but they would still be large.
  • All transition economies have made considerable progress in lowering inflation, yet better long-run growth performance went hand in hand with lower inflation. This confirms that in countries that inherit high inflation, successful disinflation is conducive to long-term economic growth.
  • Foreign direct investment usually follows past economic success and strengthens future economic success. Between 1989-2003, the Czech Republic attracted $3,700 per capita in FDI, Hungary $3,400, the three Baltic countries $1,000-$2,400 and Poland $1,300. FDI inflows per capita to Ukraine and Moldova were only $128 and $210, respectively.

Countries with better economic outcomes tend to achieve better non-economic results as well... energy efficiency... life expectancy... infant mortality....

In terms of GDP growth, it is tempting to look at differences in the initial conditions.... [D]ifferences in initial conditions, however, can explain only a part of the difference.... [D]ifferences in longer-run growth are largely due to more extensive market-oriented reforms and more successful macroeconomic stabilization....

Postcommunist countries that moved more toward a market economy achieved better economic (and non-economic) results than those that implemented fewer market-oriented reforms or none at all.... [N]o poor country has achieved lasting convergence under any of the statist or failed-state systems.... [T]he acceleration of growth does not have to wait until "good" institutions emerge... growth may accelerate during the reform process... [if] reforms increase output and productivity in previously repressed sectors (agriculture in China or the service sector in the Soviet system), or because the previous incentive structure encouraged massive waste (command socialism)....

The common features of the "miracle countries" include low tax-to-GDP ratios due to a lack of extensive welfare states. This tends to increase labor supply and promote private savings.... An extensive welfare state crowds out the voluntary forms of human solidarity, and -- especially in poorer economies -- can obstruct economic growth. This is a warning to those poorer economies which have now much higher public-spending-to-GDP ratios than Sweden, Germany or France did when they had similar income per capita....

Reforms are frequently announced, but not implemented, or they may be implemented initially but then reversed or seriously amended. In such cases, criticizing the failure of market reforms is misplaced. Market-oriented reforms may well fail -- if they are incomplete in critical ways. One example would be introducing a fixed exchange rate regime without fiscal discipline. Argentina's recent collapse reminds us that fiscally irresponsible politics may undermine the results of genuine market reforms. Market-oriented reforms may also fail to generate lasting convergence if some of their crucial elements are badly structured, e.g. a serious miscalculation of the initial level of a fixed exchange peg or a bad incentive structure in the bankruptcy law. None of these problems validate the search for a "Third Way" solution.... They are merely hurdles to be overcome on the path to a full-fledged market economy.

There does seem to be a certain amount of koolaid-drinking going on. The growth costs of the taxes levied to support a social insurance state need to be weighed against the benefits from social insurance. But only somebody who has forgotten the first principles of economics can believe that "voluntary forms of human solidarity" are a good substitute: there is a collective-action incentive problem here, after all.

Posted by DeLong at October 7, 2005 01:14 PM