Was shock therapy really a shock?

Author:Marangos, John

The shock therapy model derived its name from Poland's stabilization and liberalization program, initiated on January 1, 1990, which became known as "shock therapy" or "big bang." The countries that followed with the shock therapy approach were Czechoslovakia (starting January 1991), Bulgaria (February 1991), Russia (February 1992), Albania (July 1992), Estonia (September 1992), and Latvia (June 1993). In summary, the shock therapy model was a neoclassical model of transition advocating the immediate implementation of the necessary reforms to establish a free market economy.

The shock therapy model of transition, the dominant model of transition, was attractive to transition governments, international financial institutions, and mature market economies due to its simplicity and narrow transition policies recommended. "Get prices right" and the remaining elements of a market capitalist system would, more or less, fall into place was an antithesis to an institutionalist approach to transition. The shock therapy approach abstracted from the more insightful and complicated institutionalist dimensions of the transition process.

The transition process was characterized by uncertainty and the absence of any historical paradigms. Hence the Economist's metaphor about the transition process was that there was no known recipe for unmaking an omelette ("No Halfway House" 1990, 18). Few economists attempted to approximate the initial conditions of centrally administered economies with the stabilization programs initiated in the mature market economies. For example, Jeffrey Sachs (1993, 3) argued "the prototypical case in Europe that I will refer to is that of Spain, which in many ways provides a kind of guidepost to the path that the economies of Eastern Europe should follow." Sebastian Edwards (1992, 131) argued "the large number of stabilisation attempts in Latin America during the last four decades provides a wealth of lessons-both positive and negative-on different aspects of anti-inflationary programs." Or, "an analogy is presented by what Central and Eastern Europe encountered just after World War I" (Aslund 1992, 26).

The attempt to approximate any of the initial conditions of the centrally administered economies with the experience of any mature market economy was, in my view, unwise. The stabilization programs initiated in mature market economies assume a well-functioning market with developed institutions and the dominance of private property and inflexible prices and wages in the short run and forward-looking economic actors motivated by individual material incentives. The initial conditions of centrally administered economies-such as the dominance of state property, central control of the whole economy, and the encouragement of non-material incentives-did not approximate the conditions of any mature market economy. As such, the experience of mature market economies was irrelevant for the transition process.

The Arguments in Favor of Shock Therapy

The shock therapy model highlights the interdependence and mutually supportive and interactive character of economic relationships, implying that reforms should be introduced simultaneously. Fragmented changes would have been ineffective. As one Polish economist argued, "you don't try to cross a chasm in two jumps" (Sachs 1990, 19). The program has been described as a "leap to a market economy" (Sachs and Lipton 1990, 48) and a "jump to a market economy" (Sachs 1993).

According to the shock therapy model, restructuring could not have taken place without an effective pricing system, and an effective pricing system could not have existed without a convertible currency. In turn, a convertible currency was impossible without opening the economy to international competition, and international competition could not have been effective without restructuring. The idea that there was a choice between doing one radical measure or another was simply misleading. There was no trade-off, but, on the contrary, complementarity (Aslund 1997b, 187; Ericson 1991, 24). The transition economies, experiencing such severe macroeconomic imbalances, could not have afforded to implement their reform policies slowly. "They need a strong dose of medicine quickly" (Thomas and Wang 1997, 223). Both the economic and political situation required a rapid and comprehensive reform (Lipton and Sachs 1990, 99): "[I]f a house is on fire, you do not tell the fire brigade to pour water slowly" (Aslund 1994, 37). "Shock therapy, on the other hand, means a person who, while putting in his first leg, cannot wait to put in his second one" (Woo 1994, 281). "Bitter medicine is easier to take in one dose than in a prolonged series of doses" (Balcerowicz 1994, 87). Hence, it was preferable to employ one shock instead of a series over a prolonged period (Dabrowski 1997, 47; Aslund 1997a, 16; 1994, 36).

However, the implementation of microeconomic liberalization without macroeconomic stabilization would have been a shock without therapy (Woo 1994, 278). Thus macroeconomic and microeconomic reforms had to be concurrent (Sachs 1990, 21). This was why the reform program needed to be sweeping and expedient. The negative consequences associated with the transition program, such as reduced living standards and the rise in unemployment, could have been minimized as long as the reform program was comprehensive and consistent. The transition countries should have borne the necessary recession and endured the radical reform because in the long run economic growth prospects were guaranteed (Sachs and Lipton 1990, 63). Otherwise, the period of output reduction would have been extended unnecessarily (Sachs and Woo 1994, 274). The speed of the transition process would have been negatively correlated with the continuance of output decline and positively correlated with the intensity of output recovery (Parker, Tritt, and Woo 1997, 14). Official data tended to overstate the decline in output and failed to recognize the benefits associated with increased quality of products and the eradication of queues (Balcerowicz, Blaszczyk, and Dabrowski 1997, 139). The negative outcomes were not the result of the reform process as such; rather they were due to the inconsistencies inherited from centrally administered socialism. "This mistaken attribution results in an overstatement of the 'costs' of the reforms, and therefore an undue pessimism about the reform policies themselves" (Lipton and Sachs 1992, 214). There was no foundation for criticism of the shock therapy process, which was "politically motivated rather than analytically sound" (Lipton and Sachs 1992, 214). In fact, more radical reforms would have resulted in a smaller fall in output, ceteris paribus (Aslund, Boone, and Johnson 1996, 236).

Maintaining distorted prices and entry barriers, as the gradualists recommended, would only have encouraged activities such as speculation, diversion of state supplies, and corruption. Gradualism would have resulted in an environment of ill-defined property rights, badly operated markets, distorted investment, an uneven distribution of wealth, reduced social welfare, a closed economy, high inflation, shortages, recession, social dissatisfaction, and possibly unrest (Aslund 1995, 267; Boycko 1991, 41-2; Dabrowski 1997, 54; Ericson 1991, 25). Regulation, which was really what a gradual process involved, would only have resulted in corruption by politicians and bureaucrats (Aslund 1995, 78). Once regulation is in place, it keeps expanding to repair the perceived damage caused by the original regulatory framework. Thus, self-interested groups should not have been allowed the necessary time to coordinate and change the course of the reform (Frydman, Rapaczynski, and Turkewitz 1997, 89; Aslund 1995, 99). The shock therapy process was believed to be the only efficient course, as it provided benefits quickly, with minimum private and social costs. Gradualism has not been confirmed as superior to the shock therapy approach (Aslund, Boone, and Johnson 1996, 252; Samonis and Hunyadi 1993, 20). Importantly, the longer the transition process, the more the time available for self-interest pressure groups to regroup and use their monopoly and political power to oppose the reforms. For example, the bureaucracy in Russia resisted with all means the implementation of any real reform (Aslund 1995, 91). In summary, a gradual process would have substantially undermined the credibility of the reforms. "Move too slowly and the consensus that supports the reform can collapse. It is uncertainty, not speed, that endangers a reform program and casts doubt on the government's credibility to carry it out" (Macesich 1991, x). Only comprehensive programs implemented rapidly and vigorously had any chance of succeeding. Boris G. Fedorov (1992, 108), who initially supported a gradual approach, changed his mind and argued that a gradual reform was politically unacceptable. He became one of the most important supporters of applying shock therapy in Russia.

Most importantly, a gradual process would have resulted in the wastage of the precious reserve of political capital developed after the collapse of centrally administered socialism. At the time, people were willing to accept radical solutions to the difficult economic problems they faced. A gradual process would have resulted in political competition between parties based on self-interest and, thus, disillusionment of the public. Leszek Balcerowicz, Barbara Blaszczyk, and Marek Dabrowski (1997, 135) argued that, according to social psychology, people are more willing to adjust their behavior in an environment that is going through a radical change than during a gradual change. People conceive that the initial crisis is less significant as long as there is a positive outlook for early benefits in the future (Aslund 1992, 32). In contrast, the longer it takes to implement the necessary reforms, the more the public's...

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