Åslund, How Capitalism Was Built, privatization, oligarchs, Soviet bloc transformation, radical economic reform

Transformation:

The Soviet bloc unequivocally rejected socialism in 1989. However, Anders Åslund points out in "How Capitalism Was Built: The Transformation of Central and Eastern Europe, and Central Asia," the rates to reform of the 400 million people in 21 states varied generally by region and particularly by state.
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Corruption and weaknesses in rule of law remain widespread problems in all the states from the Soviet bloc.

East Germany received vastly more help - from West Germany - and its economic growth remains stunted as a result. Its produce was priced out of the markets by a strong mark and was rendered totally non-competitive.

The 3 small Baltic EU transition states - Estonia, Latvia, and Lithuania - have kept their governments small and thus enjoy high growth rates.

The kaleidoscope of economic, political and social change that has swept from Berlin to Vladivostok, is masterfully sketched and analyzed by Åslund drawing on extensive studies that have during the last decade substituted fact for mere theory or worse, mere ideological prejudgment.
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There are 21 states that are transforming out of the old communist Soviet bloc, plus East Germany that is now a part of a united Germany. There are now 18 market economies, 9 of which are European Union (EU) transition nations and 9 of which are Commonwealth of Independent States (CIS) economic reformers. Three of the CIS states - Belarus, Turkmenistan and Uzbekistan - have not reformed. All of the East and Central European states are fully democratic. The CIS reform states range from "mildly authoritarian" to "partially democratic." Corruption and weaknesses in rule of law remain widespread problems in all the states from the Soviet bloc.
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The EU has played a vital role in encouraging market and political reform and rule of law legal institutions in EU transition states. The EU provides its market, financial support and institutions, and security. Both democracy and rule of law remain weak at best outside the EU transition states.
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The EU, however, "exported its model of social welfare with high taxes, large social transfers, and overregulated labor and agricultural markets, which has delivered little growth both in the old EU and Central Europe." East Germany received vastly more help - from West Germany - and its economic growth remains stunted as a result. Its produce was priced out of the markets by a strong mark and was rendered totally non-competitive. It was the greatest "social welfare trap" of all time.
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Growth rates in the 4 major Central European states - Poland, Czech Republic, Slovakia and Hungary - thus remain constrained by their large public expenditures and constraining regulations, especially governing their labor and agricultural markets. The 3 small Baltic EU transition states - Estonia, Latvia, and Lithuania - have kept their governments small and thus enjoy high growth rates. The 2 Southeastern Europe EU transition states - Bulgaria and Romania - have not yet been caught in the "welfare trap," but have many other problems.

"The foremost problems for Central Europe are excessive taxes, large social transfers, and overregulation, leading to slow growth and high unemployment. The key threat to the CIS reformers is authoritarianism and corruption, which undermine property rights. The Baltic countries are threatened by little but overheating."

The provision of secure property rights has inspired sweat equity activities on a vast scale that do not show up in the GDP figures but that have literally transformed the landscape of the EU transition states for the better. See, "Observations in Central Europe," segment on "Property rights."

There was no understanding of private property or the functioning of a rule of law legal system. There was no civil society. Nobody had any experience with competitive capitalist markets. Rent-seeking through the state was the only route to wealth that anybody understood.

The potential for "rents," defined as "profits in excess of the competitive level," was enormous as socialist economies collapsed.

Nobody thought transformation would be easy, and it wasn't. The Communists had ruthlessly destroyed human capital throughout the bloc, so there was little understanding as to how to proceed. There was no understanding of private property or the functioning of a rule of law legal system. There was no civil society. Nobody had any experience with competitive capitalist markets. Rent-seeking through the state was the only route to wealth that anybody understood.

"Postcommunist transformation has been an intense battle. On one side of the barricades stood radical reformers, who wanted to build a normal society. Their main opponents were rent seekers, not old communists. The rent seekers' goal was plain: to make as much money as possible on transitional market distortions. Their endeavors led to a great misallocation of resources and slumping output. Their hunger for state subsidies and subsidized credits boosted inflation, disorganizing the whole economy. All their successes skewed income and wealth distribution in their favor."

The potential for "rents," defined as "profits in excess of the competitive level," was enormous as socialist economies collapsed.
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Mismanaged state enterprises had to be transferred to private ownership in a system that lacked private capital and managerial capabilities.

Democracy and rule of law legal systems were also objectives but would be tenuous at best in the absence of a legally, economically and politically empowered civil society that could give them popular support.

The sellers market of chronic shortages under socialism became a buyers market of competing goods and services.

The freeing of prices and trade was the obvious step required for a functioning market. However, the initial lack of goods in the market meant explosive inflation that had to be brought under control. Mismanaged state enterprises had to be transferred to private ownership in a system that lacked private capital and managerial capabilities. Massive change meant massive social dislocation that had to be cushioned by the state. Democracy and rule of law legal systems were also objectives but would be tenuous at best in the absence of a legally, economically and politically empowered civil society that could give them popular support.
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It was a time of rationalizing and reallocating capital invested in unproductive and even value destroying Soviet bloc industries. Infrastructure and housing were the main areas of under-investment. Education was wasted because the system did not make good use of its human capital. There was major over-investment in inventory due to the inefficiency of supply chains. Inevitably, reforms varied from state to state and a variety of legacies from the communist regimes managed to survive.
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Like other developing nations, growth in the transformation nations was export driven. Europe was the main market for EU transition nations, while Russia was the main market for the other CIS nations. Eighteen of the Soviet bloc states have successfully become ordinary market economies. "The essence of a market economy is economic freedom - the freedom of trade, prices, and enterprise." The sellers market of chronic shortages under socialism became a buyers market of competing goods and services.

"Transactions are monetary, reasonably free, and carried out on markets. In almost all of these countries, inflation has fallen to single digits, and nearly two-thirds of the national output is produced in privately owned enterprises."

CIS market economic systems have low taxes and liberal labor markets, whereas the 9 EU accession states struggle with the high welfare costs and rigid labor markets of the EU.

Political transformation was far less successful. Only the EU transformation states built democratic systems. They did this by adopting EU institutions. Rule of law legal systems proved even harder to create.
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Nine CIS transformation states are mostly authoritarian and pervasively corrupt. A few may be considered semi-democratic. However, their market economic systems have low taxes and liberal labor markets, whereas the 9 EU accession states struggle with the high welfare costs and rigid labor markets of the EU. Corruption levels are considerably lower, however, in the EU states. Belarus, Turkmenistan and Uzbekistan refused reform and remain impoverished Soviet-style tyrannies.
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The transformation contraction:

There was an immediate decline in economic output, as might be expected with the collapse of the previous socialist system. However, the extent of the collapse attributable to transformation has been grossly overstated, Åslund explains.
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Production had collapsed and there was literally nothing in the shops to purchase. Work ceased because the money was worthless. Assertions that subsequent economic transformation in post-Soviet Russia caused economic collapse are thus ridiculous.

Soviet economic statistics were awful. The economic collapse in Soviet Russia was already startlingly complete by 1991. Production had collapsed and there was literally nothing in the shops to purchase. Work ceased because the money was worthless. Assertions that subsequent economic transformation in post-Soviet Russia caused economic collapse are thus ridiculous.
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Åslund portrays a bewildering morass of dysfunctional production, domestic commerce and foreign trade within the Soviet bloc that all had to be reconfigured towards value creation instead of value destruction.

"Socialist states mostly exchanged goods nobody wanted, forcing substandard and overpriced merchandise on one another. The wrong things were traded for the wrong reasons between the wrong people in the wrong places at the wrong prices. The share of unsalable goods in mutual trade was probably even greater than in the domestic economies. Much of the intraregional trade consisted of exports of manufactured goods from the more developed countries to the energy exporters. Hungarian - - - exports to formerly socialist countries consisted predominantly of machinery and buses, which hardly anybody wanted in the West. Raw materials, on the contrary, were valuable, but their low prices meant that the energy exporters, Russia, Turkmenistan, Kazakhstan, and Azerbaijan, paid huge implicit export subsidies to other socialist countries. A lot of these raw materials were wasted and were not demanded at market prices under capitalism."

Most of the collapse occurred before transformation began. Much of the production decline that did occur - amounting to more than 20% of GDP - was in military production that was no longer needed.

Much of the rest of the decline was in output of such poor quality that nobody wanted it.

Gray market activities surged in Russia and the other CIS countries but were not counted in official statistics.

Soviet production was always grossly overstated - its economic statistics a farce created by pervasive incentives to exaggerate production. Soviet growth rate claims were ultimately abandoned by Soviet economists. Most of the collapse occurred before transformation began. Much of the production decline that did occur - amounting to more than 20% of GDP - was in military production that was no longer needed. Military spending was slashed from 25% of GDP to 5% of GDP. Military spending was slashed to between 1% and 2% of GDP elsewhere in the Soviet bloc transition states. No alternative uses could be found for most of the military production resources. Much of the rest of the decline was in output of such poor quality that nobody wanted it.

"Output did fall in almost all countries, but not nearly as much as officially recorded. The main real problem was the long delay in economic recovery in many countries, not the initial slump."

Although imports were very expensive, Russian goods were so shoddy that they could not compete, so half of official consumer output just vanished. "The share of unsalable goods probably amounted to 29% of GDP in the last year of communism."

"As few manufactured goods were worth buying even at extremely low prices, this contraction reflected a desirable reduction of value destruction, although it was recorded as a decrease in GDP."

On the other hand, gray market activities surged in Russia and the other CIS countries but were not counted in official statistics. Estimates have been based on electricity consumption.

"Statistical agencies were not designed to measure the performance of small and private enterprises and failed to keep up with myriad new enterprises."

Contraction due to the elimination of waste is actually desirable, and "socialism was a system of waste."

Roughly 50% of the recorded Soviet bloc transformation slump was fictitious, with wide variations between nations.

Recovery could not begin until inflation was controlled.

Careful empirical analysis since the fall of the Soviet Union has revealed the gross statistical distortions that fooled academic and CIA analysts alike. In 1990, CIA figures for the Soviet GDP were 43% of the U.S. level at purchasing power parity. This was quickly lowered to 32% - and household per capita consumption to 24% - of the U.S. level. East German GDP turned out to be just half the reported amount - just 30% of West German per capita GDP.

"Even these GDP numbers are likely to be too high because the poor quality of goods and services were not fully accounted for, and shortages and resulting forced substitution were disregarded."

After all, contraction due to the elimination of waste is actually desirable, and "socialism was a system of waste."

"A Soviet factory needed about three times more input than a Western factory to produce the same output, because managers were insensitive to costs. Some of these losses represented inefficiency, others theft. With the introduction of hard budget constraints, managers started bothering about costs, reducing domestic demand for inputs, such as steel, metals, and chemicals. Communist regimes prided themselves on huge investment ratios, but the socialist landscape was scarred by unfinished construction projects."

Contraction from the elimination of hoarded inventory was also desirable. This, too, was huge - calculated at as much as two thirds of the reduction in Polish GDP in 1990, reducing the measured decline from 11% to less than 5%. Recognizing the unreliability of the statistics, Åslund reasonably estimates that roughly 50% of the recorded Soviet bloc transformation slump was fictitious, with wide variations between nations.
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The wretched statistics were no joke. They undermined support for radical reform and led many nations to adopt bad policies.
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Poland, with radical reform, resumed growth in three years. It may not have declined at all. Ukraine, with gradual reform, declined for eleven years. Generally, recovery could not begin until inflation was controlled. Monetary and fiscal stimulation were ineffective. Russia, plagued by hyperinflation and collapse of the Soviet state, suffered a decline that was both long and steep.
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Gradualism versus shock therapy:

Gradual transformation was actually attempted for two years by Mikhail Gorbachev until he realized that the omnipotent Party bureaucracy was capable of blocking all reforms in Russia.

China's ongoing successful gradual transformation looms large as an example of a less chaotic route to transformation. However, this route was actually attempted for two years by Mikhail Gorbachev until he realized that the omnipotent Party bureaucracy was capable of blocking all reforms in Russia. In Russia the political situation was radically different than in China, Åslund explains.

"In China, the bureaucracy had been disciplined by the Cultural Revolution and still obeyed the Center. The Soviet Union had experimented with gradual reforms in the 1920s, 1950s, 1960s, and 1980s, but all these reforms had been reversed. The dominant reformist conclusion was that reforms had to be more radical to become irreversible. China had successfully started with reforms in agriculture, but that sector was not very large in the Soviet economy, so any success would have had limited impact on the economy as a whole. Moreover, Soviet collective farms were large-scale and industrialized, rendering their reform far more complex than in the manual Chinese agriculture. Gradual price deregulation seemed to work in China, but in Russia it was a major source of disruptive rent seeking. The Soviet Union collapsed in hyperinflation, whereas the Chinese leaders never lost control over macroeconomic stability."

"All measures indicate that as radical and early a transition as possible yielded the best economic and social results."

"The evidence is overwhelming that early, radical, and comprehensive reforms constituted the best option. Almost all the arguments for gradual reforms - - - have been empirically disproved."

"Because of unwillingness to sell cheaply to local businessmen, large plants have most died in Central Europe either in the hands of inept foreign investors, more often in protracted, unproductive state ownership."

Transformation in the Soviet bloc was so onerous precisely because socialist management had failed so completely. Everything was falling apart. There were few economic assets worth saving. Nobody knew how to proceed, but transformation was essential regardless of hardship.

"Another reason for enduring hardship was that many rent seekers, who were prominent members of the old and new elite, could make fortunes on market distortions. They favored low regulated prices and restricted trade to make money on privileged foreign trade arbitrage. They insisted on low state interest rates because they benefited from ample access to state credits. As conditions altered, they swiftly found new means of extracting rents until the construction of a market economy had been completed. They did what they could to prolong the transition period because it was a window of opportunity for them. Meanwhile, the rent-seeking elite ignored the negative impact on output, not to mention on the well being of the population, of their shenanigans. All measures indicate that as radical and early a transition as possible yielded the best economic and social results."

The progress of economic reforms was always positively correlated with growth rates throughout the transformation states. The three nations that rejected transformation stagnated.
Inflation afflicted every transformation country along with large budget deficits and distorted foreign exchange markets. Inflation was always negatively associated with growth. Macroeconomic stabilization was thus "a necessary but not sufficient condition for economic growth." Large budget deficits in several nations forced maintenance of punishing real interest rates of 50% to 100% per year to control inflation.
Price liberalization was everywhere the most important single economic factor.

"The most fundamental structural reform was the deregulation of prices and trade. Liberalization is usually divided into internal and external liberalization. Internal liberalization comprises the freeing of domestic prices and the abolition of state trading monopolies, and external liberalization consists of the unification of the exchange rate, the introduction of currency convertibility, the elimination of export controls and export taxes, and the substitution of moderate import tariffs for import quotas and high import duties."

Privatization is strongly correlated with economic growth, but only after a significant lag. It took time for newly privatized enterprises to end inefficient practices and respond to competitive market opportunities. This led several economists to disparage privatization reforms that placed state assets in oligarchic hands. After 1999, however, rapid growth rates ended all such doubts. Growth rates were strongly correlated with the share of GDP in private hands.

"The evidence is overwhelming that early, radical, and comprehensive reforms constituted the best option. Almost all the arguments for gradual reforms - - - have been empirically disproved. - - - Radical reform led to less overall decline in output and accordingly to greater economic welfare than partial reform. The countries that undertook the most radical and comprehensive structural reforms also implemented the most far-reaching institutional reforms. [cite] They were also the most democratic."

While the conduct of the oligarchs was initially rent-seeking and parasitic, by 1999 the market economy had progressed to the point where the incentives were largely positive and so was their conduct.

"In Russia, Ukraine, and Kazakhstan, young, able, local businessmen have revived and restructured many a Soviet mastodon, especially in energy and metals. - - - Foreign investors have mostly proved helpless in the early restructuring of large Soviet factories. Local businessmen have excelled in these tasks: managing relations with both regional and central governments, defeating pervasive criminality at plants, handling the complex social rules while slashing the work force, utilizing the existing physical capital rationally, and securing both property rights and contracts. Because of the weak legislation and judicial system, which resulted in poor corporate governance, concentrated ownership has been superior to widespread [public shareholder] ownership. As a consequence of their concentrated ownership of large successful corporations, the oligarchs have become very wealthy. By contrast, because of unwillingness to sell cheaply to local businessmen, large plants have most died in Central Europe either in the hands of inept foreign investors, more often in protracted, unproductive state ownership."

State enterprises were hurriedly sold for a song in a privatization process that was rough and frequently corrupt, but these privatized enterprises have since paid far more in taxes than any conceivable original price that might have been realized.

The private sector provided most of the growth that followed transformation. State enterprises were hurriedly sold for a song in a privatization process that was rough and frequently corrupt, but these privatized enterprises have since paid far more in taxes than any conceivable original price that might have been realized. The longer assets remained in state hands, the more human and physical capital was destroyed by state mismanagement. "But it does matter that a privatization be perceived as legitimate, so that the resulting property rights are politically recognized" and publicly supported.
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Overall, the economic transformation has been a success, but the political future outside the EU nations remains dubious.
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Power was deconcentrated to lower levels of the Party and state hierarchy, rendering the Soviet Union a dictatorship of industrial ministers and regional first Party secretaries.

The slow, protracted decline of the Soviet system prior to its dramatic collapse is sketched by Åslund. In the end, Gorbachev took power in a system incapable of adjusting to modern technology or keeping pace with U.S. military modernization. The Soviet elite became increasingly aware of the system's failings. Various efforts at reform were attempted in Poland, Czechoslovakia and Hungary, but the Stalinist system thwarted Gorbachev's reform efforts in the 1980s. Stalin was indeed a totalitarian tyrant in complete control, but by the 1980s, all that had changed.

"Leonid Brezhnev succeeded in holding power from 1964 to 1982 by obliging the collective will of the Nomenklatura. Power was deconcentrated to lower levels of the Party and state hierarchy, rendering the Soviet Union a dictatorship of industrial ministers and regional first Party secretaries. The real distribution of power became evident when Mikhail Gorbachev was appointed secretary general of the CPSU. His endeavors at reform of the system were foiled by the bureaucrats."

Gorbachev no longer had the power to force reform from the top down into the Party bureaucracy. He thus had to attack and break down the influence of the Communist Party, which by that time had no public legitimacy or support. Unfortunately, this just left state enterprise managers in total control of their entities, and they proceeded to steal what they controlled. (See. Gaddis, "The Cold War," at segments on "The end of the Cold War" and "The end of the Soviet Union," and Kotkin, "Armageddon Averted,")
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When oil production began to decline and oil prices fell sharply in the 1980s, the financial situation in Russia became "beyond salvation."

Toward the end, inflation reached ruinous levels in the Soviet Union and Poland, and many of the Central European states fell deeply into debt. Nobody wanted to lend money to the hard-line government in Czechoslovakia, and Romania was squeezing its people to repay its debt. East Germany had no public legitimacy. Bulgaria was deeply in debt. Hungary succeeded in reforming itself into a socialist market economy with manageable macroeconomic policies, and Czechoslovakia managed to maintain a static but functioning "Brezhnevian economy." When oil production began to decline and oil prices fell sharply in the 1980s, the financial situation in Russia became "beyond salvation."

"In the end, the depth of the crisis varied considerably. The Soviet Union was in a profound macroeconomic crisis. It had lost control over its budget in 1986 and had run out of international financing. Tremendous shortages caused a dramatic fall in output, and hyperinflation was a near certainty. The Polish crisis was similar but not as deep."

After the fall:

There were significant political and economic differences in the six Central European transformation states and the 15 transformation states that spun off from the Soviet Union. Åslund describes the differences that played a major role in the various initial transformation experiences.
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Three states from the Soviet Union remained rigidly communist, the three Baltic states and Armenia and Georgia had well established national identities, but the Muslim states did not. Old conflicts and resentments surfaced immediately. The new republican parliaments refused to send tax revenues to Moscow, dooming the Soviet Union. By the end of 1991, the Soviet Union was gone - not with a bang, thank god, but with barely a whimper. Only in Tajikistan and Chechnya was there serious internal conflict. (The breakup could as readily have been like that in Yugoslavia - but it would have involved major military units, some of which possessed atomic weapons.)

The first two years of the transformation in Russia were largely wasted as Pres. Boris Yeltsin struggled with a disorganized parliament of predominantly communist members.
The Baltic states knew what they wanted and quickly transformed into independent democratic, free-market states reintegrated with the West.
In Ukraine and Moldova, communists became nationalists and stayed in power. There was practically no economic reform. Security and nation building were the predominant concerns.
The three Caucasus states, Georgia, Armenia and Azerbaijan, were quickly embroiled in conflicts of ancient origin that limited them to gradual market reform.
There was no real democratization in Belarus or the Central Asian states. All the Central Asian states have reverted to family run autocracies.
The old communist elites managed to stay in power as democratic parties in Bulgaria, Romania, Moldova, and Ukraine. They chose gradual market reform that initially generated poor results.
Kazakhstan also chose gradual reform.
The other autocratic Central Asian states initially maintained their Soviet-style economic systems.

Radical reform consisted of macroeconomic stabilization to halt inflation, deregulation of prices and markets to get people to produce goods and services again, privatization and a social safety net to cushion the inevitable economic turmoil and hardships as the economy worked its way out of its socialist morass.

It began in Poland with the liberalization of food prices in September, 1989, prior to the development of the Washington Consensus list.. There was an immediate 40% surge in inflation. Radical reform consisted of macroeconomic stabilization to halt inflation, deregulation of prices and markets to get people to produce goods and services again, privatization and a social safety net to cushion the inevitable economic turmoil and hardships as the economy worked its way out of its socialist morass. There was no idea of how best to implement privatization.
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Government had to discard socialist activities and develop the policies needed to facilitate free market commerce. Rule of law, registration and defense of private property rights, a responsible budget, central banking and regulation of banking and financial markets, and "targeted social support," had to be developed and implemented almost immediately. (This is an incredibly complex process to develop on the run. See, "Government Futurecast," Part I, "Economic virtues of the U.S. political system," for an account of the many policies devised by the U.S. Government over a period of two centuries to facilitate the operation of its economic markets.)

"The later, so frequent accusations that radical reformers had 'forgotten' about institutions and social policy had no base in reality. Indeed, the successful radical reformers undertook the greatest institutional reforms and spent greatly on social assistance."

The old communist state apparatus was an unmitigated disaster and had to be broken quickly and completely regardless of fallout. The state bureaucracy had to be stripped of economic power.

Only market prices could create accurate economic signals and production incentives, only imports could quickly end shortages. Inflationary expectations had to be quickly broken.

There were many tactical differences among these European transition states, as one would expect. Floating exchange rates predominated, but Poland, Czechoslovakia and Estonia quickly pegged their rates. Poland and Czechoslovakia adopted strict wage controls. The amounts of international assistance and the pace of privatization varied widely.
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It was widely understood that, at best, such complex reforms would take a decade to implement. However, the old communist state apparatus was an unmitigated disaster and had to be broken quickly and completely regardless of fallout. The state bureaucracy had to be stripped of economic power. The promise of economic prosperity would support public tolerance of hardships for a short while, creating a short period of maximum political opportunity. Only market prices could create accurate economic signals and production incentives, only imports could quickly end shortages. Inflationary expectations had to be quickly broken.
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Reforms had to be implemented quickly because even Gorbachev and the reform communists were having second thoughts and were turning against reform. Gradual reform efforts might be stopped in their tracks and even reversed as had happened before. Åslund provides an extensive and convincing list of reasons for radical reform.
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Gradual reform:

There were wide differences among those advocating gradual reform, also as might be expected. Most were in denial of the extent of economic failure of the Soviet system and many retained unspoken socialist views. (John K. Galbraith remained an apologist for Soviet economic performance well into the 1990s. See, "Modern Advocacy Scholars" at segment on "Ideological blinders.")
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Gradual market price liberalization in Russia was disastrous and led to "mass rent seeking by prominent members of the Nomenklatura." Free market prices would greatly reduce opportunities for corruption and rent seeking.

The economic fallout from gradual reform in China and Hungary had been much milder and provided support for proponents of gradual reform. There was also powerful support from the rent-seekers who permeated Soviet bloc economic elites and who wished to extend their period of maximum rent-seeking opportunities. However, only in Hungary had any effort at gradual reform ever been successfully maintained in the Soviet bloc.
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Gorbachev's agricultural reforms in 1985 had been co-opted by state farm management and had failed to achieve the results of reform that were achieved in the very different agricultural system of Communist China. Gradual market price liberalization in Russia was disastrous and led to "mass rent seeking by prominent members of the Nomenklatura." Free market prices would greatly reduce opportunities for corruption and rent seeking.
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It turned out that Marx had correctly predicted the withering away of the Communist state. However the result was not a stateless and classless society. It was rule by a large elite of corrupt, rent seeking upper level bureaucrats.

"Power was devolved both within the party bureaucracy and to state enterprise managers, but without accountability or responsibility. The Chinese Communist Party maintained some control over its bureaucrats, whereas the Soviet state fell apart. Soviet bureaucrats were relatively more numerous than Chinese bureaucrats and had more flawed incentives, rendering them more harmful. China and Russia are today deemed similarly corrupt, but Russian corruption is perceived as socially more costly."

To this day, corruption and rent seeking remains pervasive in China. The Chinese Communist Party is an organization of rent seekers. For the limits of central control over the Chinese bureaucracy, see, Perry & Goldman, "Grassroots Political Reform in Contemporary China."

Radical reform proved far less costly than expected by the gradualists, support for democratization was based on more than just economic prosperity and was sustained despite radical reform difficulties, and the capabilities of government administered alternatives to the markets never even remotely approached the levels expected by the gradualists.

The Soviet Party and state were beyond reform. Collapse was the only alternative. China and Russia were simply not comparable.
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Much of the Western intellectual support for gradualism is easily debunked by Åslund. The gradualist theories are riddled with false assumptions. (See, "Privatization of business entities," below.) These false assumptions were unsurprisingly rewarded with unrealized expectations.
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In fact, radical reform proved far less costly than expected by the gradualists, support for democratization was based on more than just economic prosperity and was sustained despite radical reform difficulties, and the capabilities of government administered alternatives to the markets never even remotely approached the levels expected by the gradualists. The collapse of major state enterprises was not a loss to the economy but a gain since they were "the greatest value detractors." The radical reformers did not neglect institutional reform. Inspired mainly by Fredrich Hayek, see, "The Road to Serfdom," they were actually heavily engaged in institutional reform.
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Western Keynesian economists like John K. Galbraith, Vassily Leontiff and James Tobin who supported state guided gradualism involving the continuation of the state planning apparatus and protection and subsidization of the industrial dinosaurs. They ignored the malfunctioning of the state and the corruption and rent seeking of its bureaucracy and instead blamed corruption on privatization.

Only East Germany adopted complete institutional reforms before economic reforms, since it came quickly under the West German system. However, "East Germany stands out as one of the most costly and least successful transitions."
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Transition political elites supported the the idea of proceeding first with constitutional reforms, but this was generally just a tactic to extend their own period of influence and perhaps to block economic reform altogether. The reform communists in Russia quickly turned against economic reform. They were joined by Western Keynesian economists like John K. Galbraith, Vassily Leontiff and James Tobin who supported state guided gradualism involving the continuation of the state planning apparatus and protection and subsidization of the industrial dinosaurs. They ignored the malfunctioning of the state and the corruption and rent seeking of its bureaucracy and instead blamed corruption on privatization.
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The delay in Russian and CIS economic reforms allowed state enterprise managers to continue their milking of state assets for several additional years. Privatization, when it came, favored insider privatization by state managers. Hyperinflation afflicted the CIS nations by 1993.

"Although central planning had fallen apart, the CIS governments maintained state orders for much production. Privatization was slow, favoring insider privatization by state managers. As the state remained omnipotent, democracy was weak. Eventually, most of these countries became market economies, but a few reverted to socialist economies without ideology."

Transformation became a "war for and against rent seeking." The rent-seekers won in the CIS countries but lost in the Baltics and Central Europe.

It was the rent seekers, however, who were the most vocal critics of radical reform. Transformation became a "war for and against rent seeking." The rent-seekers won in the CIS countries but lost in the Baltics and Central Europe.

"They dominated in the former Soviet Union, where they hid their real agenda behind old Soviet reform communist economists and populists, the most ardent critics of radical reform. This politically most influential group consisted of rent-seeking state enterprise managers and Soviet officials, who benefited from the inconsistencies of the transitional system and wanted to perpetuate them. They did favor a market economy, but their aspiration was to prolong and complicate transition to maximize the market distortions, from which these people knew how to make fortunes."

Gorbachev's gradual, partial reforms created a "hothouse of rent seeking."

"Huge resources lay unguarded. Large rents arose from arbitrage between free market prices and the state-controlled prices, aggravated by multiple exchange rates. As inflation mounted, state interest rates remained low while huge interest subsidies became available. Large state enterprise subsidies persisted, and state enterprise managers privatized them through transfer pricing. Rents faded away with time, but successful rent seekers bought politics to impose new rents. A vicious circle of self-reinforcing rent seeking evolved. Finally, the rent seekers privatized the state enterprises, which ironically turned them into profit seekers and caused high economic growth."

Åslund explains how each of the Gorbachev reforms was undone for the benefit of the state enterprise managers.. By 1991, the Soviet budget deficit had exploded to at least 20% of GDP. It was financed by an explosion of monetary inflation resulting inevitably in price hyperinflation and economic and political collapse.
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"The most prominent source of rent seeking in the public mind was privatization, but rent seeking peaked in 1992 when privatization had hardly started."

Gradualism provided time for vested interests to generate support for remaining barriers to trade.

"The more partial and slow the reforms were, the greater the distortions and the larger the rents. The most prominent source of rent seeking in the public mind was privatization, but rent seeking peaked in 1992 when privatization had hardly started."

Ultimately, the rent seekers supported reform to secure their gains.

"Rents ended with privatization. The course of postcommunist transition was determined by what means policy makers chose to deal with rent seeking, and that choice depended on the political regime."

Russian transformation was hardly ideal by anyone's account, and its budgetary, monetary and exchange rate policies were clearly unsustainable.
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The financial collapse of 1998:

The market reforms of the transformation effort became a scapegoat for Russia's 1998 financial crisis. Economists like Joseph Stiglitz quickly pronounced Russian transformation a failure and rushed to blame a variety of transformation policies for the crisis - just as Russia began a remarkable eight year period of macroeconomic stability and 7% GDP growth. (A low GDP base at the start and rising prices for oil and other commodities that Russia exported were a big help in achieving this high growth rate. However, the achievement is nevertheless impressive.)
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The basic causes of the financial crisis were actually the large budget deficits and dysfunctional fiscal arrangements.

Scholarly studies of Russia's transformation period almost unanimously blame its 1998 relapse on gaps in its reform effort rather than on some blind "market fundamentalism" reform push.

Stiglitz blamed "market fundamentalism" and the radical reform effort. (See, Stiglitz, "Globalization and its Discontents," at segment on "Transformation economies and the Russian crisis.") The IMF and U.S. Treasury interventions were condemned. An overvalued ruble, barter systems that accounted for more than 50% of industrial sales by 1998 and facilitated tax avoidance and rent seeking, and the public and private debt burden were all blamed.

"The masters of barter trade were big companies selling natural gas, electricity, metals, and construction materials, which could all be sold on the market."

As so often in these financial crises, the basic causes were actually the large budget deficits and dysfunctional fiscal arrangements. The Russian budget was deeply in debt - by about 8% of GDP - and highly dependent on short term credits from abroad. With the preceding Asian Contagion financial crisis, servicing costs for this short term debt soared, and foreign money fled. The price of oil plummeted to $10 per barrel. After obtaining some initial international support, it became apparent that Russia's finances were untenable and default inevitable.
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Economic collapse inevitably became unavoidable not just in Russia but wherever in the Soviet bloc states that substantial budget deficits were permitted to continue. Deficits were inevitably financed through monetary expansion that caused high rates of price inflation. Even in the radical stabilizer nations, inflation proved difficult to subdue and double digit levels continued for many years. And high inflation was as always a disaster that had to be confronted.
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Scholarly studies of Russia's transformation period almost unanimously blame its 1998 relapse on gaps in its reform effort rather than on some blind "market fundamentalism" reform push. The greatest asset-stripping occurred in companies that remained under state control, while since 1998, the oligarchs have invested massively in the industries they gained control over. (Highly leveraged capital structures have left several of these industrial empires exposed to the Credit Crunch.) Even in many of the CIS countries, there was remarkable economic growth in the period after 1998, and intellectual criticism of economic reform has died away.

"[Contrary] to all gradualist arguments, a prolonged period of high inflation incurred far greater costs than the process of stabilization, because high inflation precluded economic growth, whereas rent seeking transferred wealth to the wealthiest. The early stabilizers became the first growth countries."

As government contracted, economic growth accelerated. Tax rationalization led to low, flat taxes. "As tax rates fell, tax administration was simplified, corruption diminished, and tax collection improved."

A wave of creative destruction was loosed upon the CIS states. The markets were, as always, ruthless and inexorable. Many of the CIS countries suffered financial crises in 1998 similar to that in Russia, and similarly had to drastically cut their budgets because they couldn't borrow any more. Budget cuts amounted to 25% or more in the midst of the economic contraction.
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CIS political elites were forced to accept market reforms that they hated for undermining their rent-seeking activities. The financial crash forced a system-wide cleansing of most subsidies and tax offset schemes and enabled the imposition of hard budget constraints that had been blocked by influential interests. Economic systems were thus freed and economic growth quickly surged above 8% per year. The competitive playing field became more level. State managers who knew nothing of operating in competitive markets were forced to sell to skillful new entrepreneurs who were able to revive many seemingly moribund factories.

"The crash itself lent credibility to the hard budget constraints that reformers had failed to deliver because of their political weakness. It brought about a flight to quality payments, that is, money. Cash became king in the aftermath of the crisis. A change of payments meant also a switch from the rent-seeking transitional economy to a more normal market economy. [cite] Paradoxically, the crash convinced entrepreneurs that the market economy had come for good."

Nine CIS countries became market-driven economies with about 64% of GDP coming from their private sectors. Public expenditures dropped to about 20% less than the Central European states. As government contracted, economic growth accelerated. Tax rationalization led to low, flat taxes. "As tax rates fell, tax administration was simplified, corruption diminished, and tax collection improved."
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A surge in oil prices from growing Chinese demand also played a role, but only four the the CIS countries had significant energy exports.

"In effect, the CIS countries have adopted the highly successful East Asian growth model lock, stock, and barrel, with low taxes and small social transfers, but an authoritarian and rather corrupt political system. The less dynamic Central European countries have adopted the EU model, which has not been conducive to high economic growth, even if some countries, mainly Ireland and the three Baltic countries have gone against the current."

Shock therapy was at last forced upon Russia - and the Russian economy began to thrive. "Suddenly, the Russian government undertook all those measures it should have carried out in 1992."

In Russia, the ruble plunged and inflation soared. There was no capital available for bonds. A reluctant Russian parliament was forced to make drastic spending cuts, and regional governments were forced to cut enterprise subsidies. Russian enterprise sector subsidies amounted to 16.3% of GDP in 1998, with similar results in Ukraine and Moldova. The worst 50% of the banks failed, and so the payments system improved. Shock therapy was at last forced upon Russia - and the Russian economy began to thrive. "Suddenly, the Russian government undertook all those measures it should have carried out in 1992."

"Russia took a decisive step to defeat rent seeking and cement a profit-seeking market economy with a reasonably level playing field. Russia's opening to short-term international financial flows exposed the country to the vagaries of world financial markets, which ultimately forced Russia to accept their discipline. With its open economy, Russia had little choice but to adjust to world market standards."

Russia's intractable budget deficit suddenly disappeared and was replaced by budget surpluses, "enterprise subsidies were cut and barter and offsets were eliminated." Social transfers were reduced and the central government began receiving a larger share of the tax revenues collected by the regional governments. Tax reform brought tax simplification and lower rates. There were a variety of other market reforms. International payments turned positive and Russia began accumulating substantial dollar reserves.

"Crises lead to the political activation of people as in Poland in 1989 and in Bulgaria and Romania in 1996. They render hard budget constraints credible for governments and enterprises. Crises force governments to make sound fiscal adjustments and render necessary expenditure cuts politically possible."

There is no substitute for business cycle contractions for forcing economically rational policies upon both political and private elites. Keynesian and monetarist economic theory to the contrary notwithstanding, administered alternatives that seek to avoid economic contractions always fail.

In Russia, however, there was a downside to such crises. The political elites have taken these opportunities to renationalize major economic entities. Banks were renationalized in 1998 (and major industries are being renationalized during the current Credit Crunch crisis).
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The benefits of market disciplines:

Gradual and partial deregulation was not designed to minimize social suffering, as its intellectual supporters expected. Instead, it was controlled by the ruling elites and designed to "maximize the rents of the select few in the ruling elites."
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Regulatory barriers create high transaction costs. Radical reform stripped away the regulatory barriers to permit a real market economy.

Democratic reforms followed radical economic reform, while nations that adopted economic reforms gradually fell into the hands of the elites who profited from "rent-seeking, arbitrage between regulated and unregulated markets, and extracting money from the state."

"The main drama of the early transition was whether a small group of vested interests focused on rent seeking were to dominate society or whether a broader constituency truly interested in the public interest, and thus economic growth, would assume political power."

Price liberalization was both essential and an immediate shock to the public. Price increases ranged from 70% in Poland to 250% in Russia, but shortages disappeared quickly where price deregulation was radical, and the public absorbed the blow. Where price increases were restrained and gradual, administered prices became a continuing morass of problems.
Import liberalization and exchange rate reform quickly brought an end to shortages and received strong popular support. It occurred quickly in all reformist countries. Import tariffs were sharply reduced and remain in a range of 3% to 12%. The reductions are strongly supported by importers and the growing urban middle class.
Export liberalization was much more difficult because of the powerful interests that profited from export licenses and arbitrage between world prices and the much lower fixed prices of oil, wheat and other export commodities. As usual, such interests employed fear tactics to gain public support, and many economists were taken in by fears of catastrophic domestic shortages. When macroeconomic austerity was finally forced by the need to stabilize systems beset with runaway inflation, it was the export liberalizing countries that adjusted best by means of sharp increases in exports.
Free enterprise zones were favored by many who supported government "industrial policy" economic guidance. They were attempted in several areas but rarely thrived and were mostly abandoned. They attracted organized crime and became giant tax loopholes for importers. One, in Kyrgyzstan, did thrive as a shelter from undue government interference.
Labor market developments also proved to be at variance with the expectations of many economists. The anticipated mass unemployment never occurred except in East Germany, strong trade unions actually depressed real wages, weaker unions were often bullied by ruthless managers, worker unrest was practically nonexistent, and the Central European labor markets became more regulated than in the former Soviet Union. The feared wage inflation failed to materialize in the EU transformation states.

"Unemployment reflects the severity of labor market regulations. As we would expect, Central Europe has steadily had the highest unemployment in the region" - as high as 20% in 2001. Because of the extensive subsidization and social regulation from West Germany, East German unemployment immediately rose to 35% in 1991. "A veritable social welfare trap had been created at a huge cost to West German taxpayers."

"[The] new EU members are experiencing competitive pressures to deregulate their overregulated labor markets and reduce payroll taxes, following the lead of Estonia, Slovakia, and Bulgaria, to reduce their excessive unemployment and boost their sluggish growth rates."

The labor market was freer but chaotic in the CIS states. Wage arrears, wages paid in kind and wages totally not paid were widespread. Skilled workers were in short supply and so fared well. However, socialism was controlled by the Nomenklatura and it was they, not the workers, who rose to dominate the workers and the state and to take control of their enterprises. "They pretend to pay me and I pretend to work" was a common attitude among the workers. Workers stayed put for the social benefits provided by their formal employers but sought temporary work in the underground economy. Eventually, deregulation and regulation that was not enforced liberalized labor markets in many CIS nations.

State monopolies remained in several industries in many transformation nations "at great cost to society." Oil, gas, coal, electric power and railway monopolies are common. Åslund describes the abuses and costs associated with these state monopolies. He compares the coal industry results in Poland and Kazakhstan - where losses and decline were reversed by privatization - with Russia, which didn't privatize and continued to suffer corruption, loss and decline. Management routinely milks state monopolies for billions of dollars.

"[Early] radical deregulation was of fundamental importance for a successful transition to a market economy. Any inconsistency caused problematic rents, and they were aggravated rather than resolved in the medium term as rent-seeking interests became entrenched. Several countries were trapped at suboptimal equilibria with high rents and low output. - - - After a certain set of economic rules had been established, a powerful group of beneficiaries arose, blocking all further reform. The winners did take all, both the economic system and politics."

All the transformation nations struggled to stabilize their finances with varying success. Rates of inflation ranged from 33% in Hungary to over 10,000% in Armenia and Ukraine. Åslund explains the difficulties of first creating the budgetary and financial institutions and then being forced to accept market disciplines after many stumbles along the way. There was in many states no human capital - no know-how - relevant to the operation of budgetary and financial institutions in a free market system. However, markets are inexorable and remorseless and eventually imposed the needed disciplines.

The cause of inflation was, of course, always government expansion of the money supply to finance government deficits, but propaganda successfully pinned the blame on the reformers and undermined public support for reform. Initial reform efforts in Russia failed for lack of Western stabilization assistance and insufficient political power to stand up to the Nomenklatura, Åslund asserts.
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As a result of the quick failure in Russia, the rest of the CIS delayed national stabilization efforts. Instead, they joined in a ruble zone scheme that lacked monetary discipline. The 12 nation "ruble zone" immediately descended into monetary chaos and inflation. There was capital flight, finance was reduced to speculative arbitrage, and the dollar became the currency of choice. In 1993, the Russian central bank was forced to terminate the ruble zone. and the CIS ruble zone states had to adopt national currencies. Inflation surged for awhile, but stabilization had at least become possible.
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However, stabilization was still doomed by budget deficits.

"A problem with these stabilizations was that they relied too much on monetary policy, resulting in very high interest rates, whereas the budget deficits of most CIS countries remained excessive."

"All the mistakes that had been made after the dissolution of the Habsburg Empire [after WW-I] were repeated with the ruble zone." All the CIS states that experienced ruble zone inflation failed to establish democratic systems. The 1993 split-up between the Czech Republic and Slovakia, on the other hand, was quickly followed by establishment of national currencies and monetary stabilization was maintained.
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Many countries were ultimately forced to implement austerity programs with real interest rates at extraordinary levels - 150% in Russia, 200% in Ukraine - to combat the ruinous levels of inflation caused by loose monetary policy. Strict monetary policy was thereafter rewarded with high economic growth rates.
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Keynesian prescriptions (as always) failed. "No large budget deficit has led to economic recovery, and the extensive advocacy of economic stimulation through fiscal deficit seems baseless."
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Only the market forced the budget discipline required for financial stabilization and economic growth. Price subsidies, enterprise subsidies and social transfers were maintained beyond affordable levels until financial crises developed and forced massive budget cuts in the midst of severe economic contraction. Recovery then followed quickly.

"Only after taxes have been reduced and simplified can tax administration be reformed."

Capital flight began during Soviet times and accelerated prior to deregulation and currency convertibility. Indeed, it was capital flight that forced deregulation and currency convertibility. Usually, it was the market pressures that ultimately caused financial crises and forced stabilization and brought capital flight to an end.

Estonia began the flat tax revolution in 1994. By 2000, Russia joined with a 13% flat tax that greatly increased revenues. It has spread broadly within the Baltic states and the CIS with positive results, but is resisted by the EU - and the IMF.

"Despite a slow start, most of the postcommunist region has realized that it can no longer live with West European taxation. It needs fewer, simpler, lower, and flatter taxes than West Europe. Low flat income taxes and corporate profit taxes are proliferating. Only after taxes have been reduced and simplified can tax administration be reformed."

A vast tax bureaucracy at multiple government levels enforcing a bewildering array of taxes had quickly developed as a force for corruption and extortion and as an obstacle to enterprise. When governments were forced by financial crisis to drastically cut expenditures, they were also able to drastically cut and rationalize taxation, and rapid recovery and faster growth rates soon followed.

"One country after the other rethought its taxation, opting for fewer, lower, and flatter taxes because it made no sense to have many taxes that bred corruption and little revenues but hampered growth. This wave of tax reforms did not come from the West but from the East."

Market discipline forced reform of dysfunctional banking systems, too. Financial crises wiped out many of the banks that arose out of the collapse of socialist systems. Frequently, foreign bankers brought in needed expertise. The Russian system was bailed out by the Russian government during the 1998 financial crisis and remains one of the least dynamic within the transformation states.

The absence of a functioning financial system remained an obstacle for transformation economies for several years. The simple receipt and making of payments became a severe problem. Sellers had to insist on prepayment because there were no legal tools for collecting claims, ineffective debt collection and unreliable courts and no bankruptcy laws. Except in Poland, payment by bank transfers was mandatory so taxes could be collected, but commercial banks slowed check clearance to profit from the float. Inflation expectation further induced delays in payments. Only after the socialist payments systems were abolished was stabilization achieved.

Various exchange rate strategies were attempted at various times, from floating rates to currency bands to managed pegs to fixed rates to currency boards. As long as budget deficits remained high, no pegged system could work. The small Baltic nations have opted for currency boards but Russia has a managed floating rate. The EU states are supposed to join the euro but have failed to meet its requirements. Åslund provides details of the differing routes taken to achieve stability and the various intermediate results prior to the achievement of monetary stability.

Slovakia from the Soviet bloc and Slovenia from Yugoslavia are euro members. Five ex-communist countries have pegged their currencies to the euro.

Capital flight was an immediate problem, but it was clearly not caused by deregulation - Joseph Stiglitz to the contrary notwithstanding. Capital flight began during Soviet times and accelerated prior to deregulation and currency convertibility. Indeed, it was capital flight that forced deregulation and currency convertibility. Usually, it was the market pressures that ultimately caused financial crises and forced the stabilization that brought capital flight to an end.
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Privatization of business entities:

Privatization was varied and often chaotic. It could hardly have been otherwise. Over 150,000 substantial and hundreds of thousands of small enterprises and millions of apartments and houses were privatized in a decade.
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Radical privatization reduced corruption while gradualness permitted elites to entrench themselves and block progress. Privatization generated support for the creation of rule of law legal systems which take years to mature. Radical reform economies grew fastest and quick economic radical reforms supported democratic reforms.

"The state would have lost greatly if it had retained these companies and privatized them later, regardless of the eventual sale price."

Everywhere, remaining state enterprises soaked up vast subsidies from the state. Privatization generated functioning competitive markets while monopoly and restricted competition was typical for remaining state enterprises.

Criticism of privatization has been vitriolic, premature and usually wrong (and generally biased by left wing theory and ideology). Radical privatization reduced corruption while gradualness permitted elites to entrench themselves and block progress. Privatization generated support for the creation of rule of law legal systems which take years to mature. Radical reform economies grew fastest and quick economic radical reforms supported democratic reforms. There remains widespread envy for those who became wealthy, and a sense that not enough was paid for transferred assets that ignores the growing tax revenues flowing from those assets.
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For all its problems, privatization was a fantastic success. The private sector in East and Central Europe reached 70% of GDP within a decade and stabilized at 76% of GDP by 2006 - close to Western European levels. CIS reformers were slower but reached 66% by 2006. The three nonreformers rose to just over 30% within a decade and have remained there.

"Economically the Russian loans-for-shares privatizations were an unmitigated success. The state would have lost greatly if it had retained these companies and privatized them later, regardless of the eventual sale price. That was the fate of Central Europe's now moribund steel industry and coal mines. People detest privatizations more than straightforward theft of money because they can see privatized factories with their naked eye. They do not react when billions of dollars are spirited out of the state treasury because they do not see them."

For example, the majority stake in Yukos oil company was privatized for $310 million when perhaps $4 to $5 billion was feasible. However, by 2000, Yukos paid $6 billion in taxes and had a market capitalization in 2003 of $45 billion due to the success of its private management. (Oil price fluctuations played a major role in this outcome, but the point is nevertheless well taken.)
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All countries with a private sector of more than 60% are rated free or partially free by Freedom House. The EU transformation states are fully democratic. The three nonreformers remain tyrannies. There is also a close correlation between privatization and civil rights. Everywhere, remaining state enterprises soaked up vast subsidies from the state. Privatization generated functioning competitive markets while monopoly and restricted competition was typical for remaining state enterprises.
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Rapid change of management was one of the most beneficial results of economic reform.

New startups were the most aggressive in realizing the opportunities for growth.

New startups have performed best, firms privatized to outsiders performed better than those privatized to insiders, those privatized to employees were as bad as state enterprises. Outside managers performed better than inside incumbent socialist managers. Foreign ownership performed best among privatized firms other than the major industrial dinosaurs. Rapid change of management was one of the most beneficial results of economic reform.
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Economic reform imposed hard budget constraints even on state enterprises which thus rapidly dropped uneconomic activities and shed 30% of their workforce. While all responded to the threat of the markets, new startups were the most aggressive in realizing the opportunities for growth.
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There is a wild West aspect to transformation stock markets due to poor regulation. Most Russian and Eastern European stock trading has migrated to London where it facilitates financing and enterprise restructuring.

"Mass privatization was the greatest innovation of postcommunist transition, and it touched everybody. Little surprise that it has been so controversial and so differently assessed. Two major questions remain. One is the relationship between timing and quality of privatization, and the other is the durable respect for resulting property rights."

Justification for gradualism was based on several erroneous assumptions.

It assumed a strong state, which did not exist.
It assumed that opportunity was indefinite, but power elites quickly closed the window of opportunity not only for economic reform but also for political and civil rights reform. "All postcommunist countries with less than 60 percent of GDP arising in the private sector [by 2006] are classified as unfree by Freedom House."
It assumed there could be a choice between mass privatization or promotion of new enterprise, but they occurred together or not at all.
It assumed that time was required to assure the quality of the privatization effort, but quick and dirty privatizers turned out to be far less corrupt than the later privatizers.

"Countries that started their major privatization efforts late, such as Ukraine and Moldova, suffered qualitatively worse privatizations than in Russia because more stocks went to insiders, corporate governance and minority shareholder rights were more limited, stock markets faltered, and fewer market reforms occurred."

It also assumed far more freedom of choice for policymakers than existed in reality.

"[The] options of privatization have been severely constrained by initial claims on property, political power, legal and administrative capacity, prior privatization, and other reform policies. The harsher the prior dictatorship, the more dominant state ownership, and the worse both state and corporate governance have become. What works in one country might be detrimental or impossible in another, and the feasible methods have been fewer than usually understood."

The sanctity of property rights is crucial. The weakest aspect of radical reform was the widespread doubts about the legitimacy of the property rights gained. This has led to reprivatizations from oligarchs in Ukraine, and renationalizations of successful companies by Putin in Russia that greatly benefits the top officials in the Russian government.
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Speed was essential because it had to be completed before the communist power elites could recover enough to dominate or thwart the process. Theft and asset stripping by state management grew to alarming proportions, emphasizing the need for speedy privatization. "What is not privatized will be stolen" became conventional wisdom. ("What everybody owns, nobody owns" is another common version of this wisdom that manifests itself most notoriously in "the tragedy of the commons" situations.) However, without established markets or functioning accounting systems, there was no way to set reasonable prices. The results were necessarily chaotic.
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Transition governments retained a variety of substantial interests and rights and imposed a bewildering array of regulations that make any simplistic analysis misleading. Unsurprisingly, the meaning of private property and the extent of rights in private property were in confusion. However, the need to break state power over the economy was widely acknowledged, and private ownership was clearly understood as the foundation of freedom and democracy. Friedrich Hayek quickly displaced Karl Marx as the guiding economic theorist.
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The methods of privatization varied widely, and there was considerable and varied compromise and accommodation among the power elite. This often kept inept communist managers and inefficient labor arrangements in place. The old ministries and state enterprise managers transformed their power structure into monopolies and holding companies.
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However, competition, the disciplinarian of the market economy, was loosed widely upon the economic landscape. Creative destruction swept socialist dinosaurs away in great numbers. "For years, few companies went bankrupt, but many were compelled to sell underutilized assets, creating an asset market and breeding new enterprises."
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Intellectual support for efforts at applying equitable methods quickly broke down into the art of the possible that recognized the need to accommodate power elites.

The process of reallocating capital from political to economic hands was facilitated by the blossoming of stock markets and other financial institutions. Unfortunately, the risks of this financial chaos deterred the direct foreign investment that could have quickly brought in needed expertise. With the exception of Hungary where earlier reforms had already been effective, the best strategy was to simply give the state assets away. They had little value in the incompetent hands of the states, and successful private restructuring efforts led quickly to private profits and tax revenues that dwarfed the highest possible sales price.
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State power structures in Hungary remained in the best shape, so they did not engage in mass privatization. Neither did East Germany and Azerbaijan. There was a wide variety in scope and methodology among the transformation states that Åslund summarizes.
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Small scale shop privatization proceeded by sale or lease and purchase and was quick once started, but even here the lack of administrative agencies competent to act delayed the process for several years. Myriad regulations often put privatized entities at a disadvantage against newly formed competitors. Privatization of large entities posed far more daunting problems. Methods varied widely.

"Typically, one country opted for one primary method of large-scale privatization but pursued other options in parallel, and failure could abort the initial choice. Most strikingly, the Polish government opted for mass privatization but could not agree on its details for years, and liquidation became a major form of privatization by default."

Either sales to outsiders or mass privatization with vouchers predominated in most states. Management-employee buyouts predominated in four states and there was no privatization in Belarus and Turkmenistan. Intellectual support for efforts at applying equitable methods quickly broke down into the art of the possible that recognized the need to accommodate power elites.
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Spontaneous privatization by enterprise management was widespread. This was called "Nomenklatura grabbing." Transparency suffered and corrupt deals were widespread. Some initial public offerings (IPOs) were undertaken in Poland, Hungary and Estonia, which were the most institutionally advanced transformation nations, but were not feasible elsewhere.
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East Germany spent $243 billion to induce bidders to take over its industrial dinosaurs. It took in only $50 billion from the transactions. Subsidies and guarantees were massive. However, the results of direct sales to elites were unsatisfactory everywhere. They lacked transparency and were widely suspect and unpopular as giveaways to the rich and powerful.

"Still direct sales were preferable to leaving enterprises with the state. In the longer term, the economic results of the oligarchic groups improved spectacularly. The economic recovery in Russia, Kazakhstan, and Ukraine was driven by large financial industrial groups in energy and metals. But the political reaction against the oligarchs rendered their property rights insecure."

Voucher privatization was popular, widespread and far simpler than IPOs. Vouchers were distributed to the public to start a market for private property. In small firms, workers were sometimes made shareholders. Sales at market prices were widely opposed because only communist era power elites and outsiders had the financial capital needed.
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Even voucher privatizations were riddled with administrative and political problems. Ownership was too dispersed to provide the effective corporate governance desperately needed. Managers and employees often received major shareholdings leaving outsider voucher owners in the minority. The best assets were generally withheld from voucher programs. Results were widely disappointing and support for this method evaporated. However, any privatization was better than leaving assets in state hands, so voucher methods made a significant contribution.

"It facilitated the fastest, biggest, and least corrupt privatization at minimal administrative costs. It was also comparatively equitable, and after some delay, it has facilitated substantial industrial restructuring. Most important, the resulting property rights are widely accepted as legitimate."

The same can be said for insider manager and employee privatization. Only in Poland did employees gain significant advantages. Managers paid little for their "buyouts." Russian energy companies became the basis for huge private fortunes. However, these privatizations were fast and easy and created legitimate property rights. Unfortunately, they also entrenched incumbent incompetents.
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Entrepreneurs:

Small enterprise was already flourishing in Hungary and Poland in the 1980s. It blossomed quickly in the EU transition states. In CIS states, governments insisted on "helping" small entrepreneurs - in exchange for commissions, fees, regulations and corrupt practices. Small enterprise was kept stunted by ubiquitous corrupt CIS bureaucracies.
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"As much of the socialist production was value detracting, much of the socialist organizational capital was negative."

Entrepreneurs in Central Europe quickly built substantial companies, contributing 33% of GDP as early as 1995. Economic liberalization with a low lump sum tax began in Kyrgyzstan in 1996 and Ukraine in 1998 with immediate success. Wherever heavy restrictions remained, the underground economy thrived.

"Because everything socialist enterprises had done was wrong from a market economic standpoint, it was so difficult to transform them that it was better to start anew if they did not possess extensive physical capital. Firms needed to produce better products; develop marketing that had been rudimentary and reach out to new markets; establish proper accounting, with cost controls and adjustment to a different cost structure; cease hoarding excessive supplies of input and labor; and change suppliers of inputs and often equipment. At the same time, they needed to stop the piecemeal theft that was institutionalized at state enterprises and introduce a mentality of honesty and service-mindedness. Most companies needed total change, but then new firms were likely to do a better job, which explains the success of startups. As much of the socialist production was value detracting, much of the socialist organizational capital was negative."

Social, political and legal transformation:

A brave attempt is made to describe societal impacts, but Åslund candidly acknowledges the unreliability of the statistics. He discusses impacts on incomes, living standards and inequality; health care, longevity and infant mortality; demographics and migration; education; welfare, pension systems and subsidies.
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The possibilities for individual advancement in a market economy probably played a major role in dividing the Russian Communist Party and bringing down the Soviet Union.

It took severe economic crisis to drive market reforms in the autocratic transformation states, but where economic reform had been slow or delayed, power elites were able to prevent democratization.

The picture is complex but widely improving in reform transformation states, rendering incompetent all instant analyses by transformation critics. The old power elites and rising middle class reap most of the social spending benefits, much of which disappears into the bureaucracy. In the low income CIS countries, remittances from abroad far exceed welfare spending. Everywhere, government social agencies prove harder to reform than private economic entities.
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The varying results of political transformation in the Soviet bloc transformation states are analyzed by Åslund. The possibilities for individual advancement in a market economy probably played a major role in dividing the Russian Communist Party and bringing down the Soviet Union.

"The fundamental problem with the communist state was that it worked for the Nomenklatura rather than for the people. Democratization meant making the state work for the population instead. At this time, however, able members of the old elite exploited the weakness of the political and economic institutions to enrich themselves at the expense of society through extraordinary rent seeking. Defeating rent seeking and democratization were two sides of the same coin. They both required an early and radical break with the old system. Otherwise the Nomenklatura could amass sufficient fortunes to purchase political power for the foreseeable future."

Democracy proved crucial for early market reform. Democracy has served as an effective if hardly absolute check on corruption and rent seeking. Democracy proved to be the best guarantee that the interests of the people would take precedence over the interests of a rent seeking power elite. During the initial half decade, the extent of democracy coincided with the extent of market reform. It took severe economic crisis to drive market reforms in the autocratic transformation states, but where economic reform had been slow or delayed, power elites were able to prevent democratization.
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By 2006, the nine full democracies in East and Central Europe had all established normal market economies. They are EU states. They have peaceful transfers of power. Incumbent governments almost always are turned out of office in each election. Bulgaria and Romania needed the spur of severe financial crises to complete market reform. The three states with Soviet-type economies are thoroughly autocratic.
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Russia and several Central Asian states - Azerbaijan, Kazakhstan and Tajikistan - were driven to market reform by the 1998 financial crisis but remain politically and economically dominated by their rent seeking power elites. Three of them are afflicted by the "oil curse."
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Five states - Armenia, Kygyzstan, Moldova, Ukraine, Georgia - remain limited and highly unstable democracies with highly distorted market economies suffering from pervasive corruption. In all the democracies that are dominated by their political elites, incumbent governments almost always win elections.
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Through 2000, no communist party in the 15 countries rated free or partially free by Freedom House has ever won one third of the popular vote or become the dominant party in some coalition government, even when assuming a new social democratic name.
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Communists "stayed both strong and unreformed where market-oriented economic transformation was slow."

There is little appetite for a return to communism despite all transition difficulties, In Hungary and Poland, where old communist parties receive more than 20% of the vote, they have become thoroughly market oriented. Elsewhere, they help block the completion of market reforms and support the interests of the rent seeking elites. Communists "stayed both strong and unreformed where market-oriented economic transformation was slow."
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Romania, Bulgaria, Russia and Ukraine were caught in what Åslund calls an "underreformed trap." The opposition to unreformed communist parties remained weak and were thus driven into the arms of the oligarchs. Ultimately, financial crises broke this "trap" and forced further market reform, but left political control in elite hands. Then, fraudulent elections sparked "color" revolutions in Georgia, Ukraine, Kygyzstan - as well as in Serbia - leading to gains for democracy except in Kygyzstan. In Russia, Kazakhstan and Azerbaijan, democracy was undermined by an increase in central state power controlled by power elites.
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Where political parties were forbidden or slow to form, democracy was weak.

Nationalism was a strong contributing factor when tied to economic reform.

The formation and participation of strong political parties has proven to be an essential feature of successful democratic reform. Where political parties were forbidden or slow to form, democracy was weak. Proportional representation encouraged the formation of parties, but a threshold of about 5% was essential to weed out groups with minimal support. After a couple of years, the initial hardships of transformation splintered reformist parties and drove them from power.
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Ideological beliefs that favor economic and political freedom proved vital in guiding nations through the inevitable turmoil of transformation from communism. There has to be a sense of direction. Nationalism was a strong contributing factor when tied to economic reform.

"The importance of ideology is best illustrated by a society with no sense of ideology, such as Belarus. When society has no evident purpose, all that is left is interests in a society dominated by a small elite, rendering dictatorship and the prevalence of rent seeking the natural outcomes in line with Ivan Karamazov's thesis in Fyodor Dostoyevsky's The Brothers Karamazov: 'If there is not God, everything is permitted.'"

There is actually little academic guidance for the creation of a sustainable and effective democracy. There are no widely held professional views among political scientists. They did not rush to Soviet bloc countries to offer political transformation advice as did the many economists who offered economic transformation advice. Only support for and monitoring of democratic elections was widely offered. Only imposition of EU institutions on EU transformation states proved widely effective.
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In the event, nations that held quick elections did better at political reform than those that postponed initial elections for a couple of years. Delay gave communist elites a chance to regroup. Proportional representation with about a 5% threshold did better than majoritarian representation. Parliamentary systems did better than presidential systems since power was frequently consolidated over time in the presidency.

The market is the same everywhere and imposes certain absolute requirements for efficiency and effective economic policy. However, all governance is idiosyncratic and must be shaped to suit the peoples and organizations involved. Even where democratic systems have been imposed from abroad - as in Japan after WW-II - constitutional interpretation and political development have been quickly shaped by domestic considerations.

Lawlessness has since declined, but has in essence been taken over by increasingly effective but still corrupt police forces. Judicial systems remain ineffective.

Lawlessness and corruption quickly exploded in the CIS states with the breakup of the Soviet empire, as might be expected. Lawlessness has since declined, but has in essence been taken over by increasingly effective but still corrupt police forces. Judicial systems remain ineffective. As with democracy, there was no rush of legal experts from the West offering advice on how nations with no relevant knowledge or traditions could establish an effective and independent legal system. Only the American Bar Association offered any advice and help. The EU transition states had EU civil law legal traditions to fall back on.

"Nobody presented a relevant theory for the transformation of the legal system, and few were working on it. Consequently, no appropriate set of policy advice could be available. Some local lawyers were admirable reformers, but they were few. The absence of international organizations focusing on the legal transition was striking. Interpol is a minimal organization for the exchange of police information. There is no international supreme court. Lawyers' associations are usually very national, apart from those dealing with international commercial law. In recent years, the EU, USAID, and the World Bank have engaged in legal issues, but none with the single-mindedness of the IMF in its pursuit of macroeconomic stability. Considering all these shortfalls, it is no surprise that the development of the legal system and legality has been the weakest part of the transition."

Judicial independence was unfortunately accompanied by judicial corruption, but throughout East and Central Europe, the public is using its courts, transparency is improving - and so are the courts.

Legislation was different. A vast array of legislative initiatives blossomed quickly with intense advice from U.S. and EU sources. Legal rights and protections for property and investments in some instances now exceed those available in the West. Enforcement through the courts has improved most in the EU transformation states. There are 170,000 pages of EU legislation that is required for EU states. Still, enforcement in the courts remain well below EU standards.

"[The] idiosyncratic variations from country to country are most striking, suggesting that a few legal reformers did wonders where they existed. The disconnect between legislation and efficacy of laws is equally astounding [cite]. Courts are persistently rated among the most corrupt bodies."

Private arbitration courts provide a widely used and effective substitute for resolving commercial disputes. Judicial independence was unfortunately accompanied by judicial corruption, but throughout East and Central Europe, the public is using its courts, transparency is improving - and so are the courts.
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Democracy, deregulation, transparency, privatization and reductions in public expenditures and subsidies all tend to reduce opportunities for corrupt practices in the bureaucracy. The tax system and budget practices generate numerous opportunities for corruption that require constant attention.

The corruption and crime that quickly afflicted transformation states is analyzed at some length by the author. Democracy, deregulation, transparency, privatization and reductions in public expenditures and subsidies all tend to reduce opportunities for corrupt practices in the bureaucracy. The tax system and budget practices generate numerous opportunities for corruption that require constant attention. Åslund provides clear advice concerning effective reform, but the politics of reform inevitably has many pitfalls.
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In Russia, KGB officials have taken over the state and established a thugocracy. Police forces dominate racketeering throughout the CIS. Even the EU transformation states still struggle with high levels of corruption, with Estonia an impressive leader in combating corruption. Here, too, there was a dearth of advice from the West.
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Oligarchs:

In the Hobbesian transition environment, as in the 19th century U.S., a few men were shrewd enough to acquire and rationalize vast industrial empires.
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Oligarchic control of major enterprises is far more common around the world than the diffuse corporate ownership in Anglo-Saxon nations.

Such men were called "robber barons" in the 19th century U.S. In Russia, Ukraine and Kazakhstan, they were mostly engineers and are called "oligarchs." Åslund analyzes the similarities. He points out that oligarchic control of major enterprises is far more common around the world than the diffuse corporate ownership in Anglo-Saxon nations. The ability to navigate the corrupt relations with government agencies and rationalize vast assets make the oligarchs especially useful in transformation economies.

"The combination of - - - large economies of scale, vast economies, fast structural change, the prevalence of rents, and poor legal systems - - - led to the concentration of fortunes in oil, metals, and railways in the United States in the nineteenth century, as well as in the same industries in Russia and Ukraine today. It is difficult to see how a market economy could be introduced under these conditions without generating super-rich businesspeople, and the emergence of oligarchs seems nothing but a natural consequence of the development of capitalism under the prevailing conditions."

Oligarchs respond rationally to their economic, political and legal environment. The problem is how to eliminate their abusive behavior without undermining property rights generally. Only competition achieves any substantial disciplinary success, and competition was the weapon of choice of Theodore Roosevelt a century ago. Regulation is a comparatively weak reed and is subject to industry capture. In Russia, renationalization of major financial and industrial entities repeats all the failures of socialism.
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Criticism of the oligarchs has been less than rational and is highly ideological.

"The shadier the machinations through which oligarchs made their money, the safer they are from public condemnation. The more productive and transparent they become, the more criticized they are, and the more taxes they pay, the more exposed they become, as Yukos so well illustrates."

It is populism, not socialism, that is now the main threat to political and economic freedom - capitalism and democracy. (This is always true for capitalist and democratic systems.) For the present, the requirements for macroeconomic stability are not the primary populist targets, as they are in Latin America. This generation of transformation peoples has had its lesson in runaway inflation. The primary populist target in transformation states is property rights. But the success of Western capitalism is based on the acceptance of property rights.

"[Populism] agitates for redistribution of property. As usual, populism is driven by a combination of forces. Some suffer from the lack of justice, and others want to make fortunes by undermining property rights of others. No sound capitalism can develop without respect for property rights, however.

Russia:

Putin's popularity is at present the only source of legitimacy for the Russian government.

"At the end of 2006, Russia looked frail because of its overcentralization of state power. Despite its high growth and large financial reserves, the state is petrified, possessing little ability to handle social crisis. All institutions but those preserving macroeconomic stability have been undermined. Political competition has been eliminated. No checks and balances remain. Economic reforms have ended, and property rights are in limbo."

The reform administration of Yegor Gaidor under Boris Yeltsin quickly fell from power in June 1992. The Bush (I) administration had failed to provide the financial support that might have kept it in power. The Gaidor administration was replaced by old-style Soviet industrialists headed by Viktor Chernomyrdin.
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Åslund asserts that the West had blown a brief, once in a lifetime opportunity to draw Russia into the Western world. However, at best, the reform prospects in Russia were always dubious. As Åslund points out, Yeltsin was inheriting the results of Gorbachev's "naïve reforms," which had built "one of the most formidable rent-seeking machines the world had ever seen."
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The CIS states:

Longer periods under communism, lack of access to outside markets, the "oil curse," and a legacy of autocratic governance are all contributing factors undermining democratic prospects in CIS states.
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Within a decade, except for the three non-reformers, all transition countries were under IMF supervision and had inflation under control. Most IMF funds have been repaid and most transition nations maintain relations with the IMF.

Within the 12 CIS nations other than Russia, trade autarky prevailed. There were repeated efforts to create trade and customs unions, but they were defeated by domestic protectionist interests. Trade within the CIS dropped 70% by 1994. Not until 2005 did the EU offer some CIS members closer economic and political relationships under its European Neighborhood Policy. The outcome remains to be seen, but by that time CIS international trade levels had already begun to increase.
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Financial stabilization failed initially in the CIS nations, but within a decade, except for the three non-reformers, all transition countries were under IMF supervision and had inflation under control. Most IMF funds have been repaid and most transition nations maintain relations with the IMF. Crititicism of economic transformation is now untenable beyond questions of early effectiveness and initial social cost.
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Political elites have regained autocratic authority in most CIS states and now dominate both mafia gangs and oligarch industrial empires. This power, however, is used for the benefit of the elites, not the people.
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At present the populist wealth transfer policies of the democratic transformation states obstruct economic growth more than the high corruption levels in the CIS oligarchies. In the past, economically successful autocratic states - like S. Korea and Taiwan - have eventually become functioning democracies. Also, competition is pressuring EU states to lower tax rates and reduce regulatory burdens. So beneficial change is not an unlikely outcome.

Both democratic and autocratic capitalist systems have their strengths and weaknesses. Broadly speaking, autocratic capitalism has weaker defenses against corruption, and democratic capitalism is more vulnerable to economic demagoguery. Although both systems suffer from both afflictions, the differences are sufficient to be more than just a matter of degree.
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The competition between these two systems - hopefully not translated into military conflict - is the primary challenge of at least the first half of the 21st century. This has been a persistent FUTURECASTS theme. Compare, Perry & Goldman, "Grassroots Political Reform in Contemporary China," and "Heedless Government."

Property rights and a widespread understanding of the benefits of capitalism are essential for economic prospects, Åslund points out. At present, both are very shaky in many transition states. Competition and pluralism are essential for both political and economic rights. Privatization and deregulation are essential for the control of corruption.
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"All the region's greatest shortfalls today are related to state failure: lack of democracy, a weak judicial system, poor law enforcement, corruption, slow public health care reform, and tardy public education reform."

Financial assistance from the West was woefully inadequate, Åslund asserts. However, after 1993, there were great inflows of foreign direct investment. Also of great help were Western consultants on economic policy and legal reforms. Hundreds of new laws were drafted in every transformation nation. "Foreign advice was controversial because it was effective." The IMF and World Bank played major positive roles.

"The IMF received so much public criticism that a cursory newspaper reader might have got the impression that the IMF is a global government in charge of postcommunist transformation. This critical publicity reflected how active and effective the IMF was under the leadership of Michel Camdessus and Stanley Fischer. It acted much faster and more aggressively than any other international organization. It had highly qualified staff, and its centralized hierarchy worked swiftly like an army. The IMF also possessed sufficient funds to make a difference. With its total disbursements of credits to the transition countries of $38 billion from 1990 to 1999, the IMF was by far the most important provider of financial support to transition countries, and it offered large credits early when countries were in their deepest crises."

The World Bank and USAID provided assistance with the complex tasks of privatization. The inevitable corruption and scandals notwithstanding, 65% of the Soviet bloc economy was successfully privatized. Here, again, the effectiveness of the assistance is reflected in the criticism the World Bank and USAID received. Ineffective agencies don't draw criticism, because they are not taken seriously.
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Non-governmental organizations - especially the Soros foundations - played a major role, especially in the creation of a civil society and local NGOs. Education and democratization were major concerns of Soros. He has been immensely effective in establishing quality schools and providing text books. However, a lack of local political reformers concerned with education, health care and the legal system left outsiders with little to work with. In the CIS, this generally included lack of local political interest in democracy.

"All the region's greatest shortfalls today are related to state failure: lack of democracy, a weak judicial system, poor law enforcement, corruption, slow public health care reform, and tardy public education reform. Either our knowledge of how to reform the state is too limited or the task is not solvable on this scale. Whatever the explanation, the obvious conclusion is that a greater reliance on private enterprise is the best way forward."

In the West, there is still no consensus about the extent of the role of government. The predominant intellectual and political view favors an increasingly intrusive government implementing a wide variety of social policies, but whenever tried, this is repeatedly undermined by market failure characterized by inflation and economic disarray and disappointing results that brings conservative views back into prominence. In the absence of consensus, the West is in no position to offer any authoritative advice beyond the mechanical basics of democratic institutions.

Soviet bloc transformation	Fall of Soviet system	Shock therapy vs. gradualism
Financial collapse of 1998	Impacts of market disciplines	Privatization
Social, political and legal transformation	Oligarchs	Russia and the CIS