Creating Market Economy in Eastern Europe

the state took decisive measures to introduce a hard-budget constraint. In

addition to price changes and wage limitations, subsidies have been ended

and protection from foreign competition has been sharply reduced. This new

setting has encouraged enterprise managers to reduce costs by restricting

unnecessary output and reducing the labor force. However, the strong

commitment to rapid privatization was reinforced in June of 1991, when it

was announced that a major portion of state industry would be privatized

through creation of stock funds, with the population receiving vouchers.

Beyond these changes in the state sector, new guidelines have been

introduced to monitor enterprise performance. Furthermore, a new Industrial

Restructuring Agency will consider how remaining state enterprises should

be handled, to what extent privatization is possible, and what

restructuring should take place for those enterprises that are not viable

in the new setting. These new arrangements are designed to ensure a rapid

transformation of the Polish industrial structure, to make it similar to

and competitive with market economic systems, and to achieve this result

quickly and as openly as possible.

Note that these comprehensive reforms in Poland cover all the critical

areas discussed in Chapter 4 and earlier in this chapter. Moreover,

beginning from very precarious economic circumstance in 1989, these changes

were introduced simultaneously and rapidly. We will now do our best to

assess the early results.

4) The Polish Economy in the 1990s

It is clear that economic reform in Poland has been radical and has

moved sharply and swiftly away from the plan toward the market. In addition

to the expanded influence of market mechanisms, decision making has been

decentralized, private property introduced, and incentive arrangements

changed. By most standards, the initial results have been encouraging.

First, stabilization measures cut the rate of inflation sharply from a

reported 40-50 percent per month at the end of 1989 to roughly 4-5 percent

per month in 1990. At the same time output fell, though supplies of

consumer goods in stores increased. Employment in industry declined by 20

percent during 1989 and 1990, although it is reported that only a

relatively small portion of this reduction in the labor force was caused by

forced layoffs. The unemployment rate was reported to be 6.5 percent at the

end of 1990.

Another major positive facet of the Polish reform experience has been

the foreign trade sector. There has been a significant expansion of

exports, especially to hard-currency markets. This expansion resulted in

part from the devaluation of the zloty to market-clearing levels and in

part from the reorientation of trade away from the Soviet Union and other

East European trading partners. At the same time, as a result of

restrictive policy measures and the higher domestic cost of these imports,

import demand declined.

A third qualified success has been privatization. Although the initial

pace of privatization was rapid, this early privatization was largely that

of small-scale enterprises in the area of trade and services. Although

Polish reformers take seriously the need to pursue privatization of major

state enterprises, bringing this about will remain a critical task for the

next several years.

Can these achievements be sustained in the coming years? We discuss

this issue more generally in the next section, but the Polish case deserves

specific comment. Quite clearly, the continued success of the Polish

transition will depend on the continuing implementation of appropriate

stabilization measures. Although this may seem relatively straightforward,

it requires cohesion and commitment among policy makers and willingness

among the populace to pay the costs of the transition. Pressures for wage

increases must be resisted, and the process of privatization must proceed.

To the extent that the latter can be achieved, the contours of new market

arrangements can be defined. Finally, although uncertainty in foreign

markets remains, relief of hard-currency debt will unquestionably add a

measure of flexibility.

Another issue is the extent to which the Polish "success" (if we can

call it that) was promoted by Western assistance. In light of the Polish

leadership's commitment to rapid transition, the West has provided

considerable assistance in the form of exchange-rate stabilization funds,

debt restructuring, and government guarantees.

HUNGARY: THE NEW ECONOMIC MECHANISM AND PRIVATIZATION

Early works in comparative economic systems devoted little attention

to the Hungarian economy. Over the last twenty years, however. Western

economists have begun to pay more attention to Hungary.

As one prominent observer of Hungary and other East European systems

has noted, "The Hungarian reform experience says as much about central

planning as it does about Hungary, and therefore an understanding of that

experience is important for those interested in the prospects for reform in

all of Eastern Europe, and indeed, in the Soviet Union. In other words,

Hungary is a prototype of economic reform for the former planned socialist

economic systems of Eastern Europe, and presumably elsewhere. These

thoughts, expressed some ten years ago, remain relevant in the 1990s as

Hungary, like other socialist systems, pursues a transition to the market.

However, the background of reform in Hungary is important to a proper

analysis of contemporary problems and prospects.

Prior to 1968, Hungary applied the Soviet model of centrally planned

socialism in a typical fashion. But then, in 1968, Hungary began to

introduce by far the most radical economic reform attempted in Eastern

Europe (with the exception of Yugoslavia). In the words of one early

observer of this reform, it clearly represents the most radical postwar

change, in the economic system of any Comecon country, which has been

maintained over a period of years and gives promise of continuity.

Although the reform program in Hungary met with only partial success,

the problems that have arisen (conflicts of objectives, for example, and

difficulty in persuading participants to change their ways) are fundamental

to the reform experience of planned socialist systems.

Hungary shares many features with other Eastern and Southeastern

European countries, such as Yugoslavia. It provides a refreshing contrast

to the Soviet Union, which in some important respects is atypical. Hungary

is a small country heavily dependent on foreign trade. The Hungarian

experience with reforming foreign trade, and in particular its efforts to

become integrated into the world economy both East and West, is

prototypical. The difficulties of reforming the foreign trade mechanism arc

crucial to the Hungarian economy as well as to the economies of many other

systems of Eastern Europe.

1) Hungary: The Setting

Hungary is located in central Europe. Its land area of approximately

36,000 square miles makes it roughly the same size as the state of Indiana.

Its population of about 11 million is comparable to that of the population

of Illinois. Although Hungary is not self-sufficient in energy, it docs

have supplies of coat, oil, and a number of minerals, including important

bauxite deposits.

Although it has some rolling hills and low mountains, Hungary is

basically a flat country with good agricultural land and a favorable

climate. As in other East European countries, the period since World War II

has seen the population flow from rural to urban areas and a changing

balance of industrial and agricultural activity. Today, approximately half

the population lives in urban areas.

Hungary is not particularly prosperous. Most estimates of its gross

national product or per capita gross national product place Hungary in the

middle of the East European countries. It is generally wealthier than

Bulgaria and Yugoslavia and certainly wealthier than Albania; it ranks

behind East Germany and Czechoslovakia. Hungary's per capita income appears

to be close to that of Greece. In this sense, economic development remains

a key issue in Hungary. By the standards of Western Europe, Hungary remains

relatively poor; by the standards of the Third World, Hungary ranks among

the more affluent countries.

2) The Hungarian Economy: Prereform

The postwar reconstruction of the Hungarian economy began quite

modestly in 1945. Before the implementation of a three-year plan in 1947

(1947-1949), the main policies included stabilization of the currency,

changes in the nature of rural landholdings, and the beginnings of

nationalization. The first three-year plan was designed primarily to bring

the economy up to prewar levels of economic activity.

During this time, a planning mechanism was created and the

share of national income going to investment increased sharply. The changes

were not radical, however, and balanced development was envisioned.

The era of balanced development came to an end with the introduction

of a five-year plan in 1950. The share of national income devoted to

investment was increased substantially, and the bulk of new investment was

directed toward heavy industry. This policy was partially reversed toward

the end of the plan period, but it was reaffirmed in 1955-1956.

A number of economic trouble spots cried out for attention. There was

an observed need to improve industrial labor productivity, especially

through the development of a better incentive system to offset the

declining supply of labor from rural areas. Supply-demand imbalances were

growing increasingly severe. Waste and imbalance in the material-technical

supply system created the need for a substantially modified coordinating

mechanism among enterprises.

In addition, excess demand for investment led to substantial amounts

of unfinished new construction and to the neglect of old facilities. Some

mechanisms for the more rational allocation of capital investment had to be

found. The adoption and diffusion of technological advances were seen as

inadequate. Technological improvement was considered crucial for continued

development of the economy.

This background seems familiar: a small country, the Soviet

(Stalinist) model of industrialization, overcentralization, emphasis on

extensive growth, rigidities of the plan mechanism, incentive problems, and

the resulting difficulties. Against this background, the New Economic

Mechanism first promulgated in a party resolution in 1966 was put into,

practice in 1968. Over twenty years later, it remains one of the most

important reform programs of planned socialist systems.

3) Intent of the New Economic Mechanism

There is disagreement about the importance and effect of the Hungarian

reform program. The New Economic Mechanism (NEM) has generally been

interpreted as leaving the power to control the main lines of economic

activity (volume and direction of investment, consumption shares) with the

central authorities, while relying on the market to execute the routine

activities of the system. The NEM called for substantial decentralization

of decision-making authority and responsibility from upper-level

administrative agencies to the enterprise level. In a general way, NEM

bears a close resemblance to the Lange model. Let us consider the original

blueprint of NEM.

The objective of NEM was to combine the central manipulation of key

variables with local responsibility for the remaining decisions. The first

change was a significant reduction in the number and complexity of the

directives firms; for large state-owned firms, the traditional problems

remain. Valuation is difficult, especially in loss-making enterprises.

Moreover, it is hard to find buyers for these types of enterprises, let

alone to arbitrate the potential rights of past owners. And just as

elsewhere, privatization in Hungary is likely to become slower and more

difficult as the focus shifts to the less attractive, large enterprises.

In addition to privatization per se, Hungary has addressed the

creation of infrastructure (for example, a stock market) and new rules

designed to change the guidance of enterprises. Accounting procedures have

been refined and bankruptcy laws strengthened so that state subsidies can

be curtailed and hard budgets introduced into large state-owned

enterprises.

Hungary has also pursued a variety of stabilization measures and has

liberalized policies in the sphere of foreign trade, though to a lesser

degree and certainly more gradually than Poland. Domestic price controls

have been substantially removed, and enterprises are permitted to enter

into and benefit from foreign trade transactions. Although there are limits

on the holding of foreign exchange, the Hungarian forint is substantially

convertible for business purposes. However, the Bank of Hungary has

maintained controls such that it has access to foreign exchange earnings to

serve as repayment of the Hungarian hard-currency debt. (Hungary has a per

capita hard-currency debt roughly twice that of Poland). Hungary has

followed a tight monetary policy designed to create a balanced budget and

also to exert financial pressure on enterprises.

Hungary has very liberal laws regarding foreign investment, including

the possibility of full foreign ownership with permission. Moreover,

repatriation laws are liberal. Not surprisingly, Hungary has been

considered a leader in the quest to attract foreign investment, though the

magnitude of this investment and its overall impact on the Hungarian

economy probably remain modest.

The initial results of the transition process in Hungary have

generally been positive when judged against the sorts of expectations that

we discussed earlier. At the same time, it is proving difficult to sustain

popular support as the inevitable costs of the transition process take

their toll.

4) The Hungarian Economy in the 1990s

In spite of a tendency to compare the processes of economic reform in

Poland and Hungary, there are important differences between the two

systems, and especially in the degree to which prior reform had taken

place. Although some would argue that the New Economic Mechanism was quite

limited compared to contemporary reforms, nevertheless the reform process

has a significant history in Hungary. The differences between the Hungarian

and Polish cases are important.

Inflation has been much less serious in Hungary than in Poland. The annual

rate of inflation for 1989 has been estimated at roughly 17 percent.

Although the inflation rate increased to about 29 percent in 1990, this

performance has been viewed as positive. In addition, wage increases have

generally been controlled. Largely because of a shift away from trade with

former CMEA trading partners, the volume of Hungarian trade has declined.

At the same time, the Hungarians have experienced growth in exports to

Western markets and a generally weak domestic demand for imports — both

important developments for the overall trade balance. The good news on the

exports side, however, tends to be sector-specific. Hard-currency debt

remains a serious problem, and the movement toward a convertible currency

has been much slower than in the Polish case. Finally, the Hungarian budget

deficit has increased.

The Hungarian economy was projected to shrink by approximately 3

percent in 1991, and associated declines in consumption and investment were

anticipated. The state property agency is moving ahead with privatization.

The overall relatively slow pace of reform in Hungary may well dictate less

sharp downturns and less severe fluctuations during the periods of downturn

but, at the same time, rather slower recoveries and a longer time in which

to achieve normalization. As with Poland, the effectiveness of the

macroeconomic policies being implemented, world market conditions (such as

the price of oil), and domestic structural change through privatization

will all affect both short-term and longer-term outcomes.

EASTERN EUROPE: THE REFORM SCENE

The transition from plan to market in Eastern Europe is important, not

only for those who live with and implement the transition, but also for

those interested in the subject of comparative economic systems. For a

variety of reasons, if the transition cannot succeed in countries such as

Poland and Hungary, it is unlikely to succeed elsewhere.

Obviously, it is too early to render any definitive judgment on these

cases, let alone on the more general issues of transition. Indeed, it is

difficult to chart even basic day-to-day changes in these countries. That

having been said, let us try to assess the outcomes that have occurred so

far.

Judged in terms of our earlier discussion of economic reform and

projected outcomes in the early stages of transition from plan to market,

there is room for guarded optimism as we examine the early results in

Hungary and Poland. At the same time, there remain a number of basic forces

that will heavily influence future economic trends.

First, although initial political transformations are substantially

complete in Eastern Europe (with important exceptions such as Yugoslavia),

there are cases (such as Romania) where political instability and a lack of

cohesion (derived in part from the political legacy of the communist era)

make agreement on reform very difficult. Clearly, in these cases, the path

of reform will be slower and much more difficult than in the leading cases

that we have examined.

Table 2. Political and Economic Developments in Eastern Europe: A

Summary

|Status |Country |

|of | |

| | | |and | | | |ia |

| | |1968 |1968 | | | |market |

| | | | | | | |m |

|Per |4607 |6303 |7922 |3610 |3154 |n.a. |3409 |

|GNP - | | | | | | | |

|1989, | | | | | | | |

|S | | | | | | | |

|Percent|-8.9 |-3.6 |-3.2 |-3.6 |-11.3 |n.a. |-6.9 |

|1989-90| | | | | | | |

|Officia|3387 |276 |120 |363 |186 |n.a. |761175 |

|l | | | | | | | |

|in | | | | | | | |

|1989, | | | | | | | |

|1980 = | | | | | | | |

|100 | | | | | | | |

|Real |116 |115 |115 |126 |121 |n.a. |114 |

|per | | | | | | | |

|ble | | | | | | | |

|in | | | | | | | |

|1989, | | | | | | | |

|1980 = | | | | | | | |

|100 | | | | | | | |

| |s |to trade |in |trade |and |and | |

| | | |positive| |nt | | |

Second, the initial results of the transition have been generally as

expected. In Table2 I summarize a number of useful indicators. As

anticipated, in all cases there has been a downturn in output —

occasionally a downturn of significant magnitude. Inflation has been very

uneven and in some cases (such as Yugoslavia and pre-reform Poland) very

rapid. However, post-reform inflation rates generally leave some room for

optimism, especially in those cases where stabilization policies have been

developed and applied.

Third, we have noted that initial privatization usually proceeded

rather quickly but that, after the privatization of small firms (especially

in the service sphere), the pace of change decreased significantly. This

latter development reflects the onset of major difficulties: the private

sector must now absorb large, state-owned, loss-making, and often

technologically backward enterprises. The privatization of these firms

presents serious problems, as does a setting where valuation is fraught

with difficulties, buyers are hard to find, claims from the past must be

handled, and contemporary management skills are wanting.

Fourth, although inflation and unemployment have necessitated a

growing concern for safety-net measures of various types, there is also a

sense that the availability of consumer goods and services has improved.

All of these considerations seem to support a measure of optimism

about the eventual outcome of the transition process. At the same time,

there are important dimensions where change must be sustained if the

transition is to be successful. Stabilization policies must be maintained —

a tall order in those cases where consumer patience is lacking.

Privatization must proceed, and it must increasingly reflect the contours

of new market arrangements, including the infrastructure required for

markets to function effectively. These changes must be sustained even in

the face of political dissension, consumer dissatisfaction and an uncertain

international economic environment. These restraining forces will in large

part dictate the pace and ultimate success or failure of the transition

process.

3. Moldova’s way to an open economy.

Moldova has faced significant and escalating economic difficulties

since its acquisition of independence in 1991. This situation is reflected

in the main macroeconomic indicator for the republic - Gross Domestic

Product (GDP) -, which has dropped by nearly 60%.

The agricultural sector has been strongly impacted by the nation’s

economic difficulties, as well as by adverse environmental conditions. In

1993 Moldova’s agricultural harvest was adequate, a considerable portion

remained uncollected and unprocessed due to lack of fuel, transportation,

and financial resources. In addition, due to early November frosts,

hundreds of thousands of tons of fruit, vegetables, and tobacco were

damaged beyond use. In the summer of 1994, a simmilar stream of natural

disasters, including a drought, followed by a hurricane, followed by a

flood, caused even greater losses than those experienced the previous year.

The devasting flooding in August 94 alone brought about losses totaling US$

= 220 million, which exceeded the amount of Moldova’s industrial activities

include: refrigerator, television furniture, clothing, and agricultural

machinery production. The Republic’s threatens the productivity of this

sector. Of the republic’s 262 production enterprises, 60% experienced

production declines. Over all in 1993, many industrial enterprises operated

at levels 50% lower than their full potential.

The decline in production has negatively influenced the budgetary

capacity of the Moldovan Government to address social and other issues. In

November 1994, for example, budget areas reached a level of US$ 70 million.

As a result sizable delays exist in payments of mages, pensions, stipends

and other allocations. Natural resources within the country are few. The

situation in Moldova’s energy sector is strained, therefore, more so as

nation’s capacity to import energy continues to deteriorate. All types of

fuel, including coal, oil and natural gas, delivered from the Russian

Federation, equaled US$ 250 million as of late 1994.

Nevertheless, despite the above mentioned difficulties, economic

reform -including privatization and the transition to a market economy - is

being actively pursued in Moldova current economic crisis and into a more

healthy economic state.

Building of the state and its sovereignty has allowed Moldova to

accomplish some important achievements in economic reform, i.e., financial

stabilization on a macroeconomic level and a lessening of the economic

crisis and its social impact.

The success of macroeconomic stabilization has also helped to increase

the level of confidence and trust in Moldova amongst the international

community. The reforms are being supported by foreign creditors and by

technical assistance from donors, including the United Nations, the

European Union, USA, Germany and Netherlands.

In order to further development the private sector, it is necessary to

continue reforms and to improve mechanism supports and stimulating them.

Further-more, macroeconomic stabilization will not last unless the reforms

reach all parts of the national economy.

Although the hand code contains some contradictions, new important

measures on agriculture have been taken, such as the liberalization of

economic activity and privatization of the industrial sector of the

agroindustrial complex, contributing to a relative stabilization of the

market for food products and to an increase in imports.

Success in promoting economic reforms in Moldova - privatization of

the state property, liberalization of prices in the real estate market

liberalization of intern, trade, establishment and development of the

banking system and of the financial market - allowed Moldova to be placed

in the 11th position amongst the 25 countries of Central and Eastern

Europe, the Baltic states and the Commonwealth of Independent States (CIS)

in a classification made by the European Bank for Reconstruction and

Development.

We can, therefor, conclude that 1995 was the first year of transition,

following the first destructive stage of the reforms, to a better stage.

However, although macroeconomic stabilization is encouraging the

continuous evolution towards a market economy, it does not guarantee an

increase in the national economy. These problems will require a longer

period to solve than that required for achieving macroeconomic

stabilization.

Economic Performance in Moldova 1989-1995:

| |1989 |1990 |1991 |1992 |1993 |1994 |1995 |

|Annual Output |8,8 |-1,5 |-18,0 |-29,1 |-1,2 |-31,2 |-3,1 |

|Annual |4,5 |110,0 |162,0 |1276,4|788,0 |329,4 |30,2 |

Conclusion

In conclusion to all said I want to present a brief survey of the

present stage reached in the transformation process in the various

countries of Eastern Europe. As an initial, superficial impression, it can

be said that the farther west the countries a located, the more advanced

the process now is.

- The transformation process is at its most advanced in Poland,

Czechoslovakia and Hungary. All three countries now have stable

parliamentary democracies in which non-communist parties hold the

majority. Although the initial situations in the three countries

were very different, they have also all set about establishing a

market economy system with considerable energy. Since it is thus in

these three countries that the most experience has now been

gathered, I have considerate my remarks on them (later on).

- In the political sense the situation in the three Baltic countries

is similar to that of Poland, Czechoslovakia and Hungary. They too

have completed the change to parliamentary democracy. However,

economic transformation is especially impeded by the fact that

owing to their histories as Soviet republics their economics are

particularly closely interwoven with thus of to rest of the former

Soviet Union.

- Romania, Bulgaria and Albania have so far made less progress than

their counterparts to the north and west both in the political and

the economic transformation process. Here too, though, freely

elected parliaments have now undertaken the first legislative steps

towards crating a market economic order. However, it is still early

as yet to assess the political stability of these countries or the

success of the economic reform they have so far embarked upon.

- What path will be taken in future by the successor states to the

former soviet Union and those of former Yugoslavia is, in my

opinion, still a totally open question. Neither the geographical

borders of these countries nor their political or economic systems

can be foretold with any degree of certainty.

- Finally, the former East Germany occupies a special place, amongst

the transforming countries. On the one hand, reunification with

former West Germany has ensured that the conditions for political

and economic transformation are now absolutely secure. On the other

hand, the fact that income levels for those in employment have been

rapidly catching up with those in the west has also crated

considerable growth and employment problems. In the real world, the

transformation process has proceeded very differently in the three

furthest advanced countries of Poland, Hungary and Czechoslovakia.

In Poland and Hungary, the planned economy system had gradually

been shot through with various holes during the past ten years, in

stark contrast to Czechoslovakia and East Germany.

1. Clague Christpher : The Emergence of Market Economics in Eastern

Europe, 1992

2. Blanchard O., Layard R. : Economic Change in Poland, 1990

3. Kornai I. : The Road to a free Economy

4. Rausser G.C. : A Noncooperative Model of Multilateral Bargaining

5. Schumpeter I.A. : The Theory of Economic Development

6. World Bank : World Development Report, 1990

7. Giersch H. : Tawards a Market Economy in Central and Eastern

Europe, Berlin 1991

8. Kahtzenbach Erhard : Problems of Reconstructuring in Eastern Europe

9. Gregory P.R., Streart R.C. : Comparative Economic Systems

10. Hartmats R: Making markets: Economic transformation in Eastern

Europe and the Post Soviet States.

-----------------------

Micro

- Prices

- Wages and Safety Net

- Enterprise Guidance

Macro

- Money

- Budget

- Incomes

- Trade

Privatization Emphasis:

Markets and Infrastructure

Short Term — Small

Firms

Long Term — Large

Firms

Problems: Valuation, Identifying New Owners, Updated Capacity, Loss Making

Transition Policies Emphasis: Stabilization

Economic Reform Program

Political Reform

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МЕНЮ

Creating Market Economy in Eastern Europe

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