Economies in Transformation: Limitations and Potential of the Transition Process
Chaired by Mr. Pierre Elliott Trudeau
6-7 April 1991
London, United Kingdom
1. On 6 and 7 April 1991, the InterAction Council convened in London a High-level Expert Group on "Economies in Transformation: Limitations and Potential of the Transition Process", chaired by Mr. Pierre Elliott Trudeau. The meeting was attended by five other members of the InterAction Council -- Maria de Lourdes Pintasilgo, Lord Callaghan of Cardiff, Miguel de la Madrid Hurtado, Jenoe Fock and Mitja Ribicic -- and 19 experts. The list of participants is annexed to this report as are the terms of reference.
2. The 1990s might be characterized as the period where, immediately following the end of the Cold War, "one world" bearing the features of a market economy was being formed. One way or another, all economies are always in transition aimed at achieving the most flexible and efficient system. However, the challenge posed by the economies of Central and Eastern Europe is unprecedented: the transformation of one system, predominantly based on central planning and state ownership, into another, predominantly based on market principles, private ownership and encouragement of initiative and enterprise. In previous history, radical transformations of this type took decades, if not centuries, such as Europe during the 1930s and 1940s and the Meji restoration in Japan. Today, the transformation must be accomplished more rapidly. Economic change of such a gravity demands above all also a tremendous cultural transformation, which must take place in the minds of people. To overcome psychological barriers, mentalities and values will have to be adjusted. This will take time, most probably a generation, before the changeover will be consolidated.
3. While concentrating on Central and Eastern Europe, the group drew also on the Latin American, Asian and Southern European experiences. The countries in Central and Eastern Europe -- while not being a homogenous group -- must not only cope with changes in the economic, but also in the political system. While a market economy is a condition, although not a sufficient one, for democracy, democracy in general is not a condition for a market economy. However, in present circumstances democratization is vital for any transformation to succeed. As Eastern European countries should be closely associated with the European Community, this will not be possible unless they are democracies. In order to gain acceptance of the new values and to create the civil society inherent in a democratic system, a series of political as well as economic reforms will eventually have to be put in place, safeguarding individual freedom and human rights, ensuring free elections and a parliamentary system based on political pluralism, popular participation and political accountability. The political and economic disintegration accompanying the current reform processes in Eastern Europe weakens these countries and their economies and places extraordinary demands on the skills and vision of the political leadership and the understanding, cooperation and tolerance of the population.
4. With the acceptance of the market mechanisms, "one world" is emerging where all countries may benefit from the division of labour and economies of scale through competition, freer trade and payments. During the transition process towards a market economy, three key tasks must be accomplished, which will be discussed later in more detail:
- The adoption and implementation of appropriate macroeconomic stabilisation policies aimed at removing disequilibria with a view to facilitating economic growth (see paragraphs 19-20 below);
- The introduction and guarantee of property rights and the initiation of structural reforms, namely price and trade liberalization (see paragraphs 21 and 22 below);
- A phased process of privatization and commercialization of industry and services, in order to replace the hitherto political management of the enterprises by bureaucracies (see paragraphs 23-29 below).
II. GENERAL OBSERVATIONS
5. Neither the capitalist market system nor the socialist command economy have proved to be perfect in satisfying individual or collective needs or bringing about a fair income distribution. The failure of the socialist model should not be taken as a pretext to advance a "theological" solution of pure capitalism as the only possible alternative. Even among countries with successful market economies, an amazing diversity prevails. The experience of Western countries and Japan shows that planning - though not centrally planned and authoritarian - is not stultifying per se. In these countries, Governments influenced the economy in the form of indicative planning by means of incentives and other forms of encouragement, forecasts and consultation. Regulation of markets proved desirable to guarantee product quality, consumer safety, institutional stability, market access and competitiveness.
6. No pure capitalist nor socialist system exists in the world. Most capitalist economies especially in Western Europe and Japan, are characterised by a mixed system, with a vigorous private sector and a strong and large public sector (averaging 40 per cent of GNP). Determining the nature of the most efficient mix is the key challenge for each economy. A bipolar economy also exists in China where the importance and efficiency of private initiative, production and enterprise as well as the market system are recognized, although state entrepreneurship and collectivisation are upheld as the basic condition. One irritant in previously centrally planned economies is that the process of planning remains in the hands of former Communist Party functionaries who do not believe in markets and have a lot at stake in preventing the success of the transformation. Although the distinction between both systems is blurred, the European Bank for Reconstruction and Development (EBRD) has set as prime conditions for assistance a strong embrace of the free market, privatization and strict adherence to market forces, as well as the adoption of some form of a parliamentary system. While it is the intention of EBRD to have these conditions fulfilled, it is clear that this cannot be an immediate process and will take time. Several years ago, even some OECD countries would have had difficulties meeting present EBRD conditionality.
7. The role of Government in fostering economic development is essential, even in a capitalist system. Its function is to ensure an allocation of resources compatible with certain goals and values of society, to achieve a fair distribution of income (through taxation and a social security system), to provide infrastructure and to keep the economy stable by avoiding excessive fluctuations (inflation or deflation) -- while observing the principle of subsidiarity, namely that decisions should be taken at the lowest possible level at which they can be effective. However, if the role of Government in an economy increases excessively, that economy will tend to become less efficient, as is being experienced by many developing countries.
8. The goals and processes of development must be redefined beyond the simple indicators of GNP-measured economic growth and welfare. New sets of indicators should be introduced which are capable of reflecting diverse and normative cultural goals, along the lines of the Human Development Index (HDI) developed by the United Nations Development Programme (UNDP) or the Index of Sustainable Economic Welfare (ISEW) developed by the World Bank and others.
9. Time-sequencing is critical for the success of any economic and social transformation and for avoiding too high a cost of social dislocation. As every transformation is multi-dimensional and long-term in character, it must be addressed in multi-disciplinary ways and involve methodologies and policy tools drawn from economics, political science, ecology, sociology and decision and information theory. Above all, it must make haste slowly.
10. In a transformation, market discipline must be introduced at the enterprise level through import competition, insulation of management from political pressures, and controls over credit and subsidies. The goal is that all enterprises be managed in the same way as private enterprises in a competitive market economy.
11. Privatization entails a process of identifying those areas where economic activities should be organized and owned or controlled by the private sector in order to raise efficiency and productivity. Incidentally, this process can take place without necessarily involving the change-over of a system.
12. When the previous social order is being destroyed, standards of living are likely to decrease. Thus, this process must be smoothened by sufficient economic assurance and income security measures for the population, in order to maintain social stability of a country. To that end, essential social services should be preserved and social compensatory policies adopted.
13. The transfer of technology and capital from the West will be indispensable to facilitate the transformation and the related modernization process. The private sector, in particular multinational corporations, will have an important role to play in that respect.
14. All political forces of a country must display a clear and strong commitment towards the reform goals. The Government economic policy team must avoid sending different signals. The actual time-frame of the transition will be affected by political pressures and struggles and by the people's perception of the political legitimacy of new leaders and institutions which replace the old system. As transformations entail a high economic and political cost, societies must be fully informed of the programmes and their likely implications. The conclusion of social pacts with unions and entrepreneurs may bolster the tolerance and establish a consensus. Without strong political leadership, popular participation and pluralism, economic transformation is bound to produce undesirable results.
15. The experience with industrial and structural policies in industrialized countries -- and the role played by the state in a mixed economy as is the case in virtually all OECD countries -- may hold lessons for the development of comparable policies by economies in transformation. One of the essential features of Western industrial policies was that governments rarely engaged in creating industries, but nudged or strengthened industries of strategic importance in indirect ways by creating the necessary framework and conditions for the functioning of markets:
- as purveyor of public goods, Governments provided infrastructure, educational (re)training facilities and related employment schemes;
- Governments sought to encourage entrepreneurship, private initiative and innovation by a variety of indirect means, such as facilitating the emergence of strong and stable financial institutions and intermediaries and the adoption of a conducive legal framework and fiscal, tax and currency policies.
16. Industrial policies were tailored in accordance with the cultural peculiarities and the specific circumstances of each country. The formulation of all-encompassing blueprints or recipes would have served little practical purpose. Instead, countries in transformation have the opportunity to set their own priorities and establish guidelines from inside.
17. This experience underlines that capitalism does not necessarily entail the absence of planning. But it does not involve central planning of a whole economy.
III. GUIDING PRINCIPLES
18. Any transformation must take into account the political context of a country, the degree of education of its people, the specific circumstances and actual state of its economy, the size of its population and the existing infrastructure of institutions, especially in the financial field. Thus, there cannot be a universally applicable blueprint. Yet, a number of pragmatic elements or guiding principles emerged from the discussion which policy-makers should be aware of and take into account when charting the transformation of their economy. Eventually, a set of indicators should also be introduced capable of measuring the pace and magnitude of change to the new economic system.
19. The adoption of proper macroeconomic policies aimed at stabilization and at stimulating economic growth is of paramount importance, both for developing countries and Central and Eastern European countries. In the short run (nine to twelve months), a series of measures must be taken, if possible quickly and consistently, but not necessarily as "shock therapy" to enable the market to function: a move towards price liberalization to reflect the true value of goods and services; the introduction of an exchange rate policy to reflect its true value on the basis of purchasing power assessments (implying a movement towards some form of convertibility of currency -- e.g. in CSFR on current accounts only); and the adoption of restrictive fiscal and monetary policies (aimed at fiscal balance and the control of money supply). The main objective of such macroeconomic stabilization is to restore money to its normal role as a vehicle by which an economy can work in an optimal way. Ultimately, stabilization must be linked to the development of appropriate strategies for sustainable economic growth.
20. The period of implementation for such a programme -- normally agreed with the IMF -- is set, in the medium term, at three years. Stabilization has to imply a cut in real wages if consumption is excessive. But if the standard of living is to be protected and social hardship minimized, production and employment should not be allowed to collapse. Consequently, a number of regulations will need to remain in force, such as ceilings on prices and a prudent wage policy (e.g. indexing of minimal wage). The immediate key problem will be how to protect basic standards of living.
21. Price liberalization is aimed at eliminating a variety of price distortions and administrative impediments inherent in centrally-planned command economies: first, relative price distortions where prices and wages have been artificially kept low, e.g. in agriculture and certain sectors of industry; second, policy-based price distortions which served social objectives by heavily subsidizing e.g. housing, food, health care, education and public transportation.
22. Sustainable economic development and growth must be induced as quickly as possible through a set of consistent, interrelated policies: the development of a government industrial policy ("strategic view of future" drawing on the experience of Japan, the newly industrialized countries of South East Asia and Europe), the building of a reformed public sector (infrastructure), privatization, support to small- and medium-scale businesses and export promotion, especially to OECD countries.
Privatization and commercialization
23. Privatization cannot be seen as a goal in itself and in isolation from the overall transformation process. A privatization strategy, as one element of achieving a market economy, can be carried out with various instruments: the sell-off of companies and their assets; encouraging the creation of new private enterprises; the provision of the necessary underlying structure for the private sector, including the financial sector and internal capital markets to allocate capital, a labor market with functioning workers organizations, the legal framework (adjudication of claims, anti-monopoly law, consumer and environmental protection laws) and tax legislation, including enforcement. Care must be taken that previous public monopolies are not turned into private ones. Only privatization will guarantee a process of educating and settings, up a new managerial class. In practice, the biggest obstacles to privatization are the lack of an effective savings-mobilizing mechanism and of financial intermediaries, the absence of property rights and the need to settle problems of ownership, involving either restitution or compensation.
24. In several countries, such as CSFR and Germany, re-privatization of previously confiscated land and assets to their erstwhile owners or, as in Hungary, their compensation must be distinguished from the genuine privatization process. In Poland, restitution claims amounted to some 13,000 trillion Zlotys or 1/3 of the total budget revenues. In Germany, the slow pace of clarifying restitution claims has become a central issue delaying the badly needed flow of new investment.
25. The process of privatization involving the sale of companies should initially begin with small-scale shops and businesses and the service sector. In this case, the auction system may serve as an effective mechanism. It will be equally important to identify enterprises suitable for privatisation which have the capacity and potential to become operators in the international economy as quickly as possible. In the agricultural sector, land can be privatized or leased (while maintaining collective ownership, as in China) and has proved to raise productivity.
26. Most heavy industry and large-scale state enterprises will for some time remain protected given the lack of finance, apprehension about foreign control of key sectors and the inefficiency of production (high wages, high indebtedness). They will need to undergo first a process of restructuring, including de-monopolization, and of commercialization of their activities as a necessary precedent for effective privatization later, if that should be desired as these societies become more self-confident and democratically choose their future paths for development. Thus, a government-owned sector may exist for many years to come. The real issue will be how to manage it without political interference and pressures of agents of the state in accordance with market principles and requirements. Joint stock holding companies, owned 100 per cent by Government, may be a suitable solution as they can function like a company in a private market. As the commercialization process is also bound to cause bankruptcies and unemployment, such consequences should be taken into account when deciding whether inefficient industries should be (temporarily) preserved or closed.
27. A privatization of select large-scale businesses could be accomplished through a voucher system (which poses enormous logistical problems) or the sale to the public (which poses pricing difficulties and may suffer from lack of cash and savings). In terms of strategy, care should be taken that not only the most profitable enterprises or enterprises from a few sectors only (leaving other sectors entirely public) are sold off -- often at relatively low prices --, but also that a Government is not left with the least viable, least effective and technologically outdated enterprises which might represent a considerable fiscal drag on the budget. Such conversion will be difficult.
28. An overall review and reorientation of safely nets should accompany the privatization and commercialization processes with a view to reforming and adapting them in line with the requirements of the new situation and not necessarily emulating Western models which by themselves are now affected by changes. Safety nets may be achieved through income security measures (e.g. by assuring social security or unemployment benefits), albeit at lower levels, the launching of labor-intensive infrastructure projects and the introduction of a creative labor market policy, including retraining and skill enhancement schemes aimed at bridging the qualification gap and generating sufficient employment opportunities.
29. New small business development should be encouraged, especially in the relatively over-industrialized countries of Eastern Europe, which lack trade and services. Such enterprises require little capitalization, absorb labor and meet real existing consumer demand ("cafe society").
Internal and external levels of financing
30. The destruction of the old and the management of the economic system requires a massive transfer of capital, technology and resources. There is a simultaneous need to produce sufficient levels of internal savings in order to support privatization and new investment. In the past, planned economies held debt accumulation, both public and private, to petty levels compared to the West. As many capital assets (land, housing, factories) did not trade in any markets, there was no corresponding debt reflecting financing or refinancing. Instead, investment was financed from current budgets.
31. Internally, the mobilization of capital and savings for productive investment and capital formation through savings institutions becomes a critical element. A system of institutional investors must be built up to provide for a regular savings effort. Moreover, stock exchanges should be established. This will require time and patience. Given the relative lack of professional skills in this area, outside expertise and assistance will need to be enlisted.
32. There is an absolute necessity to reduce Government balance of payments debt in order to mobilize and dynamize private and institutional savings for the purpose of ensuring higher production. To this end, public revenues and taxes must be increased, while public expenditures must be cut. Governments that are bankrupt are unlikely to attract foreign investment. The awesome magnitude of this task can be illustrated by the fact that during the first three months of 1991, the budget deficit of the USSR is already bigger than that planned for the entire year. This type of policy is bound to cause hyperinflation.
33. One way of generating a stream of income for the public budget may be the monetization of the vast Government-owned housing stock that has no market value, after problems of ownership have been settled. This might eventually lead to the emergence of a home equity loan market which could form a new source of capital formation for investment.
34. External finance from public sources, including international agencies, and the Western private banking sector will be required for long-term private and public investment in order to let the countries and their markets (with a population of 400 million in Eastern Europe) emerge as viable economic players and partners. However, there is doubt whether sufficient excess capital exists in the West to support such transformations. The fact that the real rate of interest is higher than ever, suggests that there is currently no surplus of savings that can be redirected. Germany and Saudi Arabia no longer provide savings to the world economy. The requisite level of resources required worldwide (for developing countries, debt-reduction policies, demands by Eastern European countries and the Soviet Union and the requirements of the United States) could thus only be secured through fiscal policies by Western countries. This will only be feasible and acceptable if the entire range of problems and their full implications are openly discussed and understood by the public. An extraordinary situation has already arisen where private Western creditors are no longer prepared to extend credits without full guarantees by their respective governments.
35. The catastrophic and rapid increase in external debt of the countries in transformation must also urgently be solved through effective debt reduction and relief packages. Recent debt rescheduling agreements with Poland and Egypt will undoubtedly hasten the process of debt reduction along. The way how the debt of countries in transformation is managed will determine whether they will be able to access markets for new financing.
36. The end of the cold war has made reductions in military expenditures by all countries possible, which should provide another source for long-term domestic and external finance. Further, as military expenditures continue to decline in relative terms in the United States and USSR, more attention is needed to accomplishing conversion of military production facilities. This would help meeting vast civilian needs for infrastructure and innovations, such as more energy-efficient technologies.
37. The trade picture for the Central European countries in transformation is rather bleak caused by two major shocks. The first was the complete collapse of the Soviet system which is speeding up the need for transformation by the former member countries of the Council for Mutual Economic Assistance (CMEA) in order to compensate for the loss of trade with the USSR. The switch to the convertible ruble in the CMEA trading system as of 1 January 1991 constitutes another burdensome change. The second main shock was the disappearance of the German Democratic Republic, which was the second most important trading partner for CMEA countries. The immediate task is to re-establish trade among the former CMEA countries, where market connections and technological fits already exist. Western assistance for long-term intra-regional trade financing will be crucial.
38. The liberalization of foreign trade cannot be unilateral. Free access to markets cannot be imposed on countries without reciprocity by OECD countries. If there is no adequate reciprocity, the solution will be inefficient and will lead to the demise of GATT into regional trading blocs. The openness of Western markets to exports from the countries in transformation will be critically important for the success of the transformation process. For Eastern Europe, existing quotas for steel, textiles and other products could be reduced and a different type of trading arrangements may have to be devised in order to avoid the erection of a "new iron curtain in reverse". Adequate provisions must also be made to enable the acquisition of new technologies and goods. Better market access for agricultural goods from Eastern European countries will boost the transformation process. To that end, the European Community's Common Agricultural Policy, in particular, requires urgent review and adjustment.
IV. ACTION IN SUPPORT OF ONGOING TRANSFORMATION PROCESSES
39. The InterAction Council could call for a series of concrete action and measures which could contribute to the processes of transformation currently under way.
40. By introducing market mechanisms, Eastern Europe is joining not only Europe, but the Western industrialized world as a whole. In this global process, which is much more significant than the Marshall Plan aid after World War II and will have far-reaching global effects, the InterAction Council should call on the United States and Japan to assume a larger financial share in assisting Eastern Europe as do the other Western European countries in the context of the US$ 22 billion programme of the Group of 24, coordinated by the European Community. The West should channel its assistance in relation to the fundamental economic - not political - objective of using resources efficiently in the interest of people. Current G-24 assistance is aimed at providing balance of payments loans and supporting the macroeconomic reform processes in Eastern Europe. Mere policy agreements and compromises on the contents of future assistance will not be enough.
41. The InterAction Council should urge OECD governments to support and finance a massive programme of infrastructure investment which is an effective conveyor belt for employment and technological change, readies economies for privatization and encourages service sector growth. The European Bank for Reconstruction and Development (EBRD) should, in its public sector finance, concentrate on the outright transfer of infrastructure (both traditional and information-related) on a massive and large scale.
42. The market-oriented reform process in Eastern Europe is not uniform. In Germany, the transformation took place virtually overnight. This did not allow for a convergence of the two Germanies over time, with all its consequences. In Central and Eastern Europe, the process evolves under a certain degree of protection and adjustment possibilities. The Soviet Union is lagging behind as its old administrative system is being destroyed without being replaced by a new system. A very gradual approach has begun towards marketization/commercialization rather than privatization. The InterAction Council should urge the sustained conduct of a real and continuous dialogue -- on the proper way towards a market-based economy between all countries undergoing transformation, including, the Soviet Union, and the Western industrialized countries. Although most Central and Eastern European countries have already become members of the Council of Europe, they should, like Yugoslavia earlier, therefore also be offered association with OECD as an additional institutional link to promote constructive dialogue. To underpin this dialogue, EBRD, the International Bank for Reconstruction and Development (IBRD - the World Bank), the International Monetary Fund (IMF) and the European Investment Bank should establish resident advisory offices in the capitals of the countries concerned. Such arrangements will lead to the emergence of a new network of cooperation which will help establish new and stable foundations for future cooperation, understanding and trust.
43. The InterAction Council should endorse the report on "The Economy of the USSR" by the staffs of the IMF, World Bank, OECD and EBRD. As no follow-up dialogue has yet been initiated on this report, the Council should call for, or even organize, a meeting (in Moscow on ways in which the report and its recommendations could be realistically implemented. The Soviet Union cannot escape the necessity of an urgent, strong programme of economic stabilization and reform. The question is not whether a shock approach or a gradual programme should be adopted, but whether the Soviet Government is ready to accept the need for a real transformation of the economic system and a full programme of implementing the reforms, which may extend over a number of years. This should include an explicit commitment to aim at the establishment of a market economy, a commitment to invest in labor-intensive infrastructure and services and to privatize. Some problems can only be dealt with by shock (e.g. hyperinflation), others must not be (esp. in terms of social costs). The alternative to such a measured approach will be chaos and political repercussions on a broad scale which can be in the interest of no country.
44. The InterAction Council should also renew its earlier suggestion that, after a special transitional status, the USSR be admitted to full membership in the World Bank, IMF and GATT.
45. Given the present serious economic situation in Eastern Europe and the Soviet Union, it is not expected that private business will direct substantial investment in those countries. Thus, the Council should call for public sector aid, including large-scale technical assistance programmes, by OECD Governments and should emphasize that such aid not be withheld pending the introduction of adequate political reforms. In these circumstances, it is critical that, without further delay, both sides start the proposed dialogue on policies, identify investments feasible without full reform (e.g. in the energy sector) and consider liberalization of (agricultural) imports.
46. The Council should urge Western countries, international financial institutions and the private banks to assist countries in transformation in the development of a functioning system of savings and capital formation, the establishment of a system of financial intermediaries and in the gradual development and establishment of a social security system. The Council should also call for a substantial transfer of knowledge and skills from the Western private sector to support the transformation process in a variety of specific areas, e.g. banking, capital markets.