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Creating Market Economy in Eastern Europe

Creating Market Economy in Eastern Europe

Annual Paper

of “World Economies”

“Creating Market Economy in Eastern Europe”

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The Summary


1. Meaning of market Economy and Tasks of the Transitions.

2. The Emergence of Market Economy in European countries.

1. . The Transition to a Market Economy.

2. Poland and Hungary as the best example of transition in the East


2. Moldova’s way to an open economy.



This paper is oriented toward the problems of transition and creating

in countries of Eastern Europe, namely Poland, Hungary, all of which are

attempting to make the transition under a democratic, parliamentary form of


The last new years have witnessed truly extraordinary events in the

formally communist societies. Under newly established conditions of free

speech and freedom of organization, communist principles of political and

economic control have been widely repudiated, and communist governments

have been swept aside, replaced by governments committed to democratic

principles and a market economy. While in some countries and parts of

countries former communist have not been decisively dislodged, in almost

all cases communism has lost whatever remaining legitimacy it possessed,

and it most of these societies the crucial economic issue has suddenly

changed from reforming the socialist planning system by the introduction of

market-like elements to moving to a market-economy with private ownership

of most of society's assets.

There are several reasons why the task of designing this transition is

fascinating, especially to economists.

First, the problem in new: no country prior to 1989 had ever abandoned

the communist political and economic system.

Second, the experience to date indicates that countries attempting

transition face a number of common problems and difficulties. While there

are important differences in the inherited situations and the choices made

by governments of these countries, the similarities in the problems they

face and the difficulties they are encountering suggest that there is logic

to the transition process.

Third, the absence of any close historical parallels and the limited

experience economics in transition offer an opportunity and a challenge for

development of normative transition scenarios. This turn out, however to be

extraordinarily difficult to construct.

Finally, the problems are not waiting for annalists' solutions;

decisions currently being made may lead to an evolution with irreversible


1. Meaning of Market Economy and the Tasks of the Transitions.

That economic system which brings together natural resources, labour

supply and technology and which is principally privately owned and were

government has to some extent always been involved in regulating and

guiding the economy, has been referred to as "Market Economy". Yet, despite

this history of government intervention, individuals in that country have

always been able to choose for whom they will work and what they will buy.

Now 3 groups make decisions and it is their dynamic interaction that

makes the economy operate. Consumers, producers and government make

economic decisions on a daily basis, the primary force being between

producers and consumers; hence, the market economy designation.

Consumers look for the best values for what they spend while

producers seek the best price and profit from what they have to sell.

Government, at state and local levels, seeks to promote the public

safety, provides social safety-net, ensures fair competition and also

provides a range of services believed to be better performed by public

rather include education, health service, the postal service road and

railway system, social statistical reporting and, of course, national


In this market economy system, economic forces are unfettered, supply

and demands build up the price of goods and services. Entrepreneurs are

free to develop their business unless they can provide goods or services of

a quality and price to complete with others; they are driven from the


By and large, there are three kinds of business:

1) those started and managed personally by single entrepreneurs;

2) the partnership where two or more people share the risks and rewards

of a business;

3) the corporation, there stock holders as owners can by or sell their

shares at any time on the open market; this latter structure permits

the amassing of large sums of money by combining investment, making

possible large-scale enterprise.

Innovations in economic theory in the last two decades undoubtedly

affect the way economists look at the transition problem and have probably

made them more pessimistic about the ease with which it can be

accomplished. Developments in transaction cost economics, the economics of

information, the new institutional economics, and evolutionary approaches

to economics have sensitized economists to the vital role that institutions

play in economic process. One way of thinking about a successful market

economy is that it is a set of convergent expectations in the population

about how other people will behave; these expectations support an extremely

elaborate division of labour or a high degree of specialization among

individuals, organizations, and geographic areas.

In recent decades many economists have returned to the Schumpeterian

view that the advantage of the market economy (relative to its

alternatives) lies more in its facilitation of innovative activity than in

its allocative efficiency.

The system of central planning is surely deficient in both respects

but it is shortcomings seem to be much greater in the area of innovation

than in allocative efficiency.

Another development in economics that has reduced the affractiveness

of the large conception of market socialism is the increased attention paid

to the motivation of government officials, both legislators and


In the 1950's and 1960's, much of economic analysis was focused on

market failures and government action to remedy these failures, under the

implicit assumption that government officials would follow the rules laid

down by the authorities. The analysis of the logic of collective action and

the formation of interest groups the theory of rent-seeking behavior, and

the study of the evolution of cooperation and norms have emphasized that

government failure as well as market failure must be taken into

consideration in designing institutions.

A vivid analogy stated by Vladimir Benachek of Charles University is

that the socialist economics are at the top of a small hill (the planned

economy), and they want to get to the top of a larger hill (the market

economy). But in between the two hills is a valley, which may be both wide

and deep. The analogy illustrates the point that the centrally planned

economics did have a coherent economic system (i.e. they were at the top of

their hill). One might add that the smaller hill was being eroded by the

strengthening of special interest groups and was perhaps, settling due to

the seismic rumblings that shattered the communist authority. The band of

travelers must settle their differences, agree on a route, and avoid the

pitfalls and chasms along the way.

Perhaps economic analysis can facilitate the journey by designing a

bridge between the two hills. Given the absence of close historical

parallels and the severe limitations of economic models of society it is

clearly beyond the capacity of social engineers to draw up very precise

plans for the bridge.

The Tasks of the Transitions

The list of activities which governments which governments must

undertake in countries attempting the transition to a market economy is

truly staggering. The list given here is designed to convey something of

the enormity and complexity of the job. First, there is a group of

activities related to creating a new set of rules:

1. Setting up the legal infrastructure for the private sector:

Commercial and contract low, antitrust and labour low, environmental

and health regulations; rules regarding foreign partnerships and wholly

foreign-owned companies; courts to settle disputes and enforce the laws.

2. Devising a system of taxation of the new private sector:

Defining accounting rules for taxation purposes, organizing an

Internal Revenue Service to collect taxes from the private sector.

3. Devising the rules for the new financial sector:

Defining accounting rules for reporting business results to banks and

investors; setting up a system of bank regulation.

4. Determining ownership rights to existing real property:

Devising laws relating to the transfer of property, and laws affecting

landlord tenant relations; resolving the vexatious issue of restitution of

property confiscated by communist governments.

5. Foreign exchange:

a) setting the rules under which private firms and individuals may esquire

and sell foreign exchange and foreign goods;

b) setting the rules in the same area for the not-yet-privatized


Next there are some tasks related to managing the:

6. Reforming prices:

Enterprises that have been privatized will presumably be largely free

to set their own prices, but early on in the process, the demands of the

government budget will require raising prices on many consumer goods that

have been provided at prices for below cost.

7. Creating a safety net:

Setting up an emergency unemployment compensation scheme; targeting

aid in kind or in cash to those threatened with severe hard ship by the


8. Stabilizing the macroeconomic:

Managing the government budget to avoid an excessive fiscal deficit

and managing the total credit provided by the banking system.

Finally there are tasks related to privatization:

9. Small-scale privatization:

Releasing to the private sector trucks and buses, retail shops,

restaurants, repair shops, warehouses, and other building space for

economic activities; establishing the private right to purchase services

from railroads, ports, and other enterprises which may remain in the public


10. Large-scale privatization:

Transferring medium and large-scale enterprises to the private sector;

managing the enterprises that have not yet been privatized.

An abstract Model of the Transition consist of three main phases:

Phase 1: The cabinet-level negative phase

In this phase members of the central government interact with

nationally representative interest groups. The tasks are organized into two

categories: they will determine the general institutional structure of

society and set guidelines that will be used in phase 2 to assign each

enterprise to one of many alternative "transition regimes".

Phase 2: The assigned phase

In this phase state-owned enterprises are matched with transition

regimes. One can assume that each state-owned enterprise is completely

described by some vector of attributes. These attributes specify such

diverse aspects of the enterprise as:

a) the nature of the products produced by the enterprise, a description

of its plant and equipment, and technology it utilized;

b) a description of its financial states;

c) the place of the enterprise within its industry, including its

market share and the nature of its competition;

d) some indication of the risk profile of the firm;

e) the distribution of information within the enterprise;

f) the nature of "measurement errors" in monitoring the performance of

the enterprise;

g) the relationship between the enterprise and the state bureaucracy;

h) the "distance" between the enterprise and founding ministry;

i) any potential synergies between the enterprise and some prospective

foreign investor.

Phase 3: The enterprise-level negotiation phase

In this phase participants at the participants at the level of each

enterprise play an MB game (multilateral bargaining). For each enterprise

the structural parameters of the game are included in the characterization

of the transition regime to which the enterprise is assigned.

2. The Emergence of Market Economy in European Countries.

2.1. The Transition to a Market Economy

1) The Successes and Failures of Central Planning.

Before considering the transition to a market economy, we must

consider the need for such a transition. Today the need is clear: socialist

and communist systems have failed to deliver (in a liberal sense) anything

like the standard of material advance so often promised.

But more recent rasy assessments of central planning abound. Even as

late as 1979 the World Bank published a long and detailed study of Romania

– the most Stalinist of the eastern block. The Bank found that from 1950 to

1975 the Romanian economy had grown faster than any other country in the

world (9,8 percent per annum). The Bank attributed this startling

performance to the fact that government, through its system of central

planning, had control of all resources. The Bank forecast a rasy future for

Romania – growing at 8,7 percent per capita to 1990. Nor was Romania an

aberration. The Bank published in that same year of 1979 a most rasy

history of, and prognostication for Yugoslavia. Studies up to 1984

continued to show that central planning, albeit somewhat modified in

places, delivered the goods.

This review is not intended to score paints, but simply to remind us

of the long addiction of economists to planning and regulation.

2) Transitions

The transition to a market economy always and at all times involves a

familiar list of policies.

First is financial stabilization reducing the budget deficit and the

monetary emissions of the central bank. This stabilization may involve many

complex policies – almost certainly a fax reform and expenditure controls,

particularly in the reduction of subsidies. There is no consensus on pegged

versus free exchange rates.

Second is deregulation, elimination a myriad of government controls

and establishing the framework for free contractual relationships. This

priority involves the recognition of property rights and the development of

a legal system suitable for a market economy. It also implies a diminished

role for the central planners as more room is provided for private

initiative and enterprise. But oddly enough it is widely recognized that

there is a need for more restraint on industry, particularly the heavy

state owned firms, to reduce pollution. Other areas of deregulation include

trade reform and currency convertibility.

Third is the reform and privatization of state- owned concerns to this

list should be added the reduction in monopoly power not only of industry

but also of trade unions, and in particular the reform of labour laws. The

reform of the banking system and the development of commercial rather than

planning criteria in banking it also of the utmost important.

3) The Political Economy of Transition in Eastern Europe:

Packing Enterprises for Privatization.

An abstract model of the transition from a centralized command economy

to a market economy focusing on privatization is a novel orientation for

this chapter. In much of the literature on privatization in central and

Eastern Europe, either a case is argued for a particular transition

proposal or specific aspects of the privatization problem are isolated and

considered in detail.

The model focuses on the way in which government policies and

enterprise-level decisions are made and relatively less on the specific

content of these policies and decisions.

The conceptual model has been designed with five basic premises in

mind: multilateral bargaining, political economy, heterogeneity,

decentralization, and pluralism.

4) Multilateral bargaining

In a world in which economic rights are ill designed, a bargaining

problem naturally arises. Throughout Central and Eastern Europe, this

problem can be conceptualized as a multifaceted conflict between multiple

interests representing workers, management, claimants to property rights

based prior ownership, foreign investors, representatives of different

group in the distribution chain, etc.

It is useful to distinguish two different kinds of bargaining

problems. There are issues that must be negotiated at the level of central

government: for example, what will be the nature the regulatory and legal

infrastructure within which these privatized enterprises will operate?

Other issues concern the disposition of individual state-owned enterprises

and must be negotiated on a case-by-case basis. In particular what will be

the precise nature of each corporate entity that is being packaged for sale

to private buyers? Who will control it? How will it be structured? What

kind of compensation schemes will be in place for management and workers?

What special provisions will be in place that affect the relationship

between the privatized entity and other firms, including established and

new competitors, firms that are up and down stream in the distribution

chain, etc.? In the discussion that follows, the focus will be on

bargaining problems of the latter kind. One presumes that, because of the

complexity and diversity of the issues during the transition, the state is

not in a position to resolve them by fiat rather, over the transition, the

state is presumed to be one negotiator among many.

Bargaining problems of this kind can be resolved in a variety of ways.

At one extreme, an explicit institutional structure may be established by

the state to facilitate an orderly negotiation of the issues. This

institution would specify:

a) the interests that should be represented in the bargaining process;

b) the space of issues over which these interests can negotiate;

c) what degree of consensus is sufficient to conclude negotiations;

d) who will represent "the state" the founding ministry are some

agency established specially to deal with privatization;

e) what will happen if negotiations break down?

At the other extreme the state may provide no procedural guidelines

whatever as to how the issues should be resolved in this procedural vacuum,

the economic rights in question may simply be expropriated by whichever

party - typically the current management - is strategically located to do


Relative to the general trend that appears to be emerging in Central

and Eastern Europe, there should be made opportunities for decentralized


Our process-oriented perspective does suggest an indirect, "hand off"

way to exercise some control over this phase of the process, the government

can introduce some checks and balances into the negotiations. For example,

of the three "primary" parties at the bargaining table-management,

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