(Reprinted from HKCER Letters, Vol. 1, March 1990) 


The Preconditions for
Economic Recovery in Eastern Europe

John G. Greenwood


Two models of reform

During the past few years, academics and political observers have frequently discussed two alternative models for the reform of communist societies. The first model, pursued by Mr. Gorbachev in the Soviet Union, starts with political reforms and follows with economic reforms. This pattern is now being repeated across much of Eastern Europe, although Hungary, which has experimented with some degree of economic liberty over the past twenty years, is an exception. The second model, best represented by China, starts with economic reform and then moves to political reform only later. However, in the case of China, the political reform movement was snuffed out abruptly on June 4th with the massacre in Tienanmen Square and the subsequent campaign of repression.

Economic freedom and political freedom

These two models are naturally somewhat simplistic. Economic freedom is only one component of a broader concept of freedom which includes political freedom. There is also, in practice, much overlap between these two areas of freedom. For example, a country which accorded its citizens both political and economic freedom would presumably permit an individual to buy or sell a copy of a book by either Mao Tse Tung or Milton Friedman. It is hard to envisage a situation where it is permissible to buy copies of such books without also being allowed to advocate the ideas contained in them. Therefore, economic freedom is probably not feasible without some degree of political freedom. Conversely, the overthrow of communist regimes in Eastern Europe and the emergence of greater political freedom suggest that there will be growing pressures for economic reforms, that is, greater economic freedom following from political freedom. To date, this is largely untested, although five years of glasnost in Russia does not appear to have achieved very much perestroika (economic restructuring). It is therefore quite likely there will be considerable opposition from vested interest groups to extensive economic reforms in other parts of Eastern Europe. Also, political freedom alone is not enough to ensure economic success. At one level, political freedom implies the ability to participate in the democratic process of selecting government representatives. However, equally important for the protection of economic freedoms is the existence of civil liberties and private property rights protected by the rule of law. For example, Hong Kong has never enjoyed democracy, yet under British administration, its people have enjoyed a high degree of civil liberties and private property rights which have enabled the economy to grow at an astounding rate for over four decades.

Foundations of economic prosperit

These initial observations suggest that the introduction of democracy may in fact be the easy part of reform in Eastern Europe. To judge from the record of Hong Kong and other successful economies, economic prosperity is built on five fragile foundations:

1. the rule of law,
2. a relatively incorrupt bureaucracy and independent judiciary,
3. predominantly private ownership of property,
4. free market prices, and
5. a stable monetary system.

Using this framework, one can set up some simple measuring rods against which to monitor progress in Eastern Europe over the next few years.

1) The rule of law implies equality of individuals or companies before the law. The legal framework may be based on common law or civil law, or alternatively, on more feudal concepts such as in Japan during the 19th century, but in all cases it must be clear what the freedoms, rights, and obligations of individuals in that society amount to. The legal system defines and provides for the protection of those freedoms, and for the protection of property rights. Most communist societies virtually abolished the rule of law as we know it in Western society, and have relied upon the arbitrary rule of the Communist Party, which has typically shifted its ideological base as one leader followed another. Before the Second World War, most of the countries of Eastern Europe enjoyed the benefits of a legal system, but with the adoption of communism after the War, the law and respect for it atrophied. For a fundamental revival of liberty and prosperity in Eastern Europe, the legal systems will have to be rebuilt around such basic concepts as individual liberty and the notion that politicians and governments are not above the law. This task will not be rapidly accomplished.

2) The rule of law also emphasizes the supremacy of law itself rather than of men. To achieve this requires a relatively incorrupt bureaucracy and an independent judiciary. These are implicit in the rule of law, but their existence is so important as to justify separating the two of them for the rule of law itself. Other agencies charged with law enforcement, such as the police, require similar attributes of independence from the people or party in power, and a relatively high level of integrity. Their loyalty must be to the law or to the system itself, not to a particular party or governing group of individuals. Those societies which have been successful economically are typically also those societies where every individual is equal before the law or where firms have an equal opportunity to secure government contracts through open competition. Where there is discrimination on the basis of ideology or personal contacts, or where there is outright corruption based on the amount an individual is willing to pay under the table, the process of government has seldom worked to the advantage of the people as a whole. Yet, in communist societies, where the wish of the Party was absolute, there was no room for decisions based on objective rules or for open competition with state-owned enterprises. Party members, bureaucrats, and sometimes judges were above the law. In the economic arena, it was inconceivable that government contracts would be allocated on the nondiscriminatory basis of the best price at tender. Communist societies virtually abolished these mechanisms for enforcing the rule of law and substituted instead a powerful machinery for ensuring that the wishes of the Communist Party were not countered in any area of activity - political or economic. For Eastern Europe to prosper in the years ahead, it will be necessary to reconstruct the machinery for the maintenance of the rule of law; without that, there is a risk of reversion to the rule of the Party or the rule of men.

3) Incentives are the key to material progress. Private property ownership offers the strongest incentive, linking work and reward. If the government takes 100 percent of a man's output, what incentive is there for him to work? Moreover, the incentive to maintain assets in working order, and to create new wealth derives from people's ability to acquire assets (farms, homes, factories, businesses, etc.) by their own labor. Since communist societies generally abolished private property ownership, incentives for work and innovation were largely destroyed.

It therefore follows that unless Eastern European economies introduce private property ownership on an extensive scale, it is highly unlikely that they will achieve very significant reforms in their economic systems. Hungary offers a case study of this problem. Despite 20 years of economic reforms (1969-89), economic growth has averaged a miserable 1.6 percent per annum since 1980. State-owned enterprises still dominate the economy, and little real competition has been allowed. Access to credit and capital equipment by private operators has been so restricted as to prevent any significant threat to state-owned enterprises.

4) Free market pricing is essential for the efficient allocation of resources and to ensure that the income which people (and capital) receive reflects their contribution to society. More fundamentally, prices act as a crucial signalling device conveying information about the relative abundance or scarcity of goods and services, labor, and capital to everyone in the system. This information is so widely dispersed that no one person or central government agency could ever conceivably coordinate it sufficiently to set prices at the levels necessary to produce the right amounts and quality of goods and services.

Yet communist systems by and large abandoned free market pricing in favor of centralized control. As a result, they have never produced what consumers demanded, and suppliers have never been able to obtain adequate supplies or distribute their output to meet demand. Some communist countries have experimented with free market prices but without private ownership. This, according to Warren Nutter, is the great delusion of socialism. For without the ability to buy and sell factories, farms, trucks, and machinery, no producer can adjust the quality or scale of his output in accordance with the needs of the market. China has attempted a partial reform of prices without permitting private ownership (except on the farms) and ended up with the disastrous dual-track pricing system. With some prices fixed at artificially low prices and others floating freely at more realistic prices, it became a great temptation for bureaucrats and local government officials to appropriate state property, buying in the official market and selling in the free market. As always, communism bred corruption. Eastern European economies will therefore need to privatize on a massive scale and move to free market prices if they are to achieve a major leap forward in terms of efficiency.

5) Finally, a stable monetary system is essential if long-term investment contracts are to be entered into and honored in any society. If the value of money is allowed to depreciate rapidly at unpredictable rates, individuals will seek to protect themselves in any way they can - particularly by removing their wealth from the country, or hoarding it in the form of jewellery, etc., instead of investing it in productive resources. As Eastern European societies shift from fixed price regimes to market prices at world levels, all of them will suffer from an enormous, once-for-all shift in the level of prices, which will discourage many would-be reformers. (Thus, for example, prices in Poland have already risen 540 percent over the past year.) At the same time, their currencies will depreciate sharply as these countries abandon overvalued, artificially fixed exchange rates and move to more realistic free market exchange rates. In addition, if their governments continue to run budget deficits which are financed by the creation of money and credit instead of by borrowing, then there is the real possibility of Eastern Europe sliding down the slippery path followed by Latin American countries (where hyperinflation is endemic) or the path followed by Yugoslavia (where political pressure from six semi-autonomous republics has led to credit creation sufficient to generate inflation of 530 percent per annum.).


Against the current background of elation, of euphoria, at the collapse of the totalitarian regimes which have suppressed human dignity and economic progress in Eastern Europe for so long, these assessments may seem rather negative. There is undoubtedly much to hope for, and a huge range of possible outcomes. One set of possibilities is that East Germany and Hungary introduce Eastern European equivalents of the Chinese Special Economic Zones, along with a legal framework which permits and encourages not only foreign investment but high rates of domestic investment. No doubt, foreign aid and foreign investment will be an important factor in the early stages of Eastern Europe's economic recovery, but in the long run, countries have to depend largely on their own efforts. To achieve real, self-sustaining progress over a number of years, Eastern European countries will need to adopt most, if not all, of the five essential preconditions listed above. It will be worthwhile in the excitement - and in the inevitable phases of disillusionment - during the years ahead, to make reference of the five fragile foundations to see whether these delicate devices are being put in place or not. If they are, the upside potential is obviously enormous; if they are not, frustration, disillusion, and even the reversal of the reform movement will be all too probable.

Mr. John G. Greenwood is Chairman and Chief Economist of G.T. Management (Asia) Ltd.


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