Market Reforms In PostCommunist Eastern Europe Essay

, Research Paper

A Study Of The Market Reforms In Post-Communist Eastern Europe With A Specific

Case Study of Poland

Introduction

Poland, as well as it’s fellow post-communist countries, face an arduous

task in re-inventing their economies to match the dominant Western style

currently dominating the world. The difficulties lie in the areas of ideology,

structural needs (massive changes required), world recession(current) and debt

load.

Communist Economics

Why did the economics of the communist bloc fail so miserably? Why has

every single socialist, fascist, communist and other non-democratic country had

to implement economic change in order to survive? This is due to some inherent

problems in the command economy idea.

Monopolies (in a command economy) tend to produce inefficiency, low

quality goods, lack of innovation and technological improvement.

Command economies tend to focus on growth rather than strength leading

to larger production and an evan. worse use of available resources.

The 1980’s marked a change in world markets meant that the communist

economies were faced with four challenges that would, if met, have meant the

continuation of the USSR.

Resource saving miniaturization requiring high technology and skill were

demanded (command economies have neither), Flexible production to meet a variety

of needs (command economies have large factories to keep production high – they,

thus, did not have the funds or ability to affect the necessary changes to their

means of production), the “information age” meant that the communist bloc had to

deny the new prevalent types of technology, which would spread Western ideas,

and thus they fell behind), and “software” became essential to the growth of

industry (the “hardware” focus of the East could not absorb this new approach.

As well, the changes are being attempted in a deep period of economic

crisis that make an already difficult process even more difficult.

Changing the Economy

Systematic transformation requires institutional innovations, the

internal liberalization of the economy, the external liberalization and the

adjustment of the real economy as well as the monetary system.

Not only does there need to be a different institutional framework for a

market economy but one has to remove most of the inherited structures and to

change the typical behavioral patterns in industry, state and private households.

Privatization

Privatization is a difficult task because of four main factors. Firm

sizes in post-communist countries tend to be large. This means that their

division or shrinkage poses difficulties for foreign investors, they are however,

not worthwhile at current sizes and must be reshaped. Expectations are running

high but attitudes ingrained in the workforce will need time to change. None of

the structure exists to deal with private firms and must be created along with

the labor needed to run it. There is very little knowledge and certainty about

the property rights issue and until resolved investors will be wary of the

situation.

However, not all countries have addressed the needed changes in the same

fashion. Poland has been a leader in foreign investment and involvement when

compared to it’s post-comminist counterparts.

Poland:Brief History

The name Poland is derived from that of the Polanie, a Slavic people

that settled in the area, probably in the 5th century AD. Poland is a nation in

east-central Europe. In the 18th century it was divided up by its neighbors and

ceased to exist until resurrected in 1918. Again partitioned by Germany and the

USSR at the beginning of World War II, it was reestablished as a Soviet

satellite state in 1945, and remained a Communist-dominated “people’s republic”

until 1989.

Mikhail Gorbachev’s appointment as Kremlin leader in March 1985 was the

signal that the Polish opposition had been waiting for. Exploiting the new

liberalization in the region, Lech Walesa and Solidarity, Pope John Paul II and

the church hierarchy, and ordinary citizens stung by the deepening economic

recession combined to force the Communists to sit down at roundtable talks in

1989. They secured far-reaching political concessions and exploited the

resulting opportunities for political competition to drive the Communists from

power

The new non-Communist government sought to bring about economic reform

through “shock therapy” in a scheme devised by Finance Minister Leszek

Balcerowicz. Introduction to Polish economic situation

Poland’s fundamental economic problem is that production and living

standards for it’s 38 million people is considered to be inadequate. With a GDP

about a third of the United States (on a per capita basis), Poland is considered

to be a middle income country.

During the 1970’s, the Gierek government tries to tackle the problem (of

economic distress) through a policy of rapidly expanding consumption coupled

with investment financed by foreign borrowing. For several years this economic

policy generated growth of about ten percent per year (The USA’s current growth

(In GDP) is between 2-3% with 4% being the goal).

However, the policy was to eventually fail due to mismanagement,

recession in Western export markets (i.e a lack of foreign investment), a bias

towards products in weak demand but costly to produce (in terms of energy input

and raw resources). These three factors produced an economic crisis that

resulted in negative growth rates in 1979,80,81 and 82. It also produced the

Solidarity movement in 1980 and the implementation of martial law the following

year.

During the 1980’s, Poland managed to regain earlier production levels,

at the end of this period of economic development there was some restructuring

of production, away from heavy industry towards lighter industry, food

processing and services. As well there was slight movement towards the movement

of business from state to private hands (with the goal of believed market

mechanisms for efficiency). The private sector, in Poland, now accounts for one-

third of the labor force (2/3 of that in agriculture).

However, former policies (as mentioned above) have created a basic

economic situation in Poland that is marked by inefficiency, foreign debt and

market imbalances.

Inefficiency

Agriculture

Agriculture accounts for 13% of national income, 28% of employment and

12% of export earnings. It is predominantly a private industry sector (about

75%) but productivity is low and development is stagnant. In this area Poland

has fallen progressively behind it’s east European neighbors.

This lack of progress is due mainly to an inefficiently small size of

farms (10 hectares or less), inefficient production methods, lack of investment

incentives and limited access to inputs such as fertilizers and pesticides

(which would increase productivity and reduce loss due to pests).

Industry

Industry (including energy and manufacturing) produces about half of GDP

and employs 29% of the labor force. The sector is largely biased towards heavy

industry and large state enterprises (classic approach of communist ethic). Over

90% of industrial output is produced by the 6000 (or so) state owned enterprises.

This outmoded productive base needs to be restructured. Industry is largely

over-manned and energy intensive. Energy consumption is 2-3 times higher per

unit of production in Poland than in the average Western Industrialized country.

There are significant energy reserves in Poland, in the form of coal, oil and

gas (in eastern Poland), but these reserves need modern technology to be tapped.

Poland is no longer a net energy producer and must import energy to maintain

production.

Incentives for management and workers have been distorted (includes

unrealistic prices-low energy and pollution costs, soft budget constraints and

employment guarantees.

Foreign Debt

Largely created during the 1970’s, this totaled more than 48 billion

dollars (US) before the more than 50% reduction of official debt in March of

1991. The remaining 30 billion dollars is still a heavy burden on the economy.

The debt service due (interest – simple maintaining of debt at present level) in

1991 amounted to 4 billion (40% of 1989 exports).

The government fell into arrears with many creditors (2/3 owed to

foreign governments, 1/3 to foreign banks). The debt was being traded on the

markets at 15 cents on the dollar down from 40 cents at the end of 1988 (meaning

that the creditors were not secure in the belief that Poland was a good debtor

and that their debts were unlikely to be paid in full – hence the drop in value

of holding part of their debt).

Market imbalances

Shortages and excess demand for consumer goods and factors of production

were deeply ingrained in the system until the reform of January 1990. Subsidies

accounted for 14% of GDP (down from 17% in 1983), and the budget was running a

deficit of 8% of GDP in 1989.

Summary

Poland’s economy was structured, in the same way systematic of communist

countries, in an inefficient manner. Production was large, state owned and in

usual monopoly, This meant that the economy was without the benefits of private

market mechanisms for economic efficiency. In attempting to compete in an

increasingly globalized world market Poland’s economic situation became dire.

This coupled with debt (and the needs of servicing it) meant that the economy

was in need of change on a grand scale if Poland was to emerge as an economic

force with reasonable success in comparison to her neighbors in Europe and the

world .

The Reform Process

Against the background , the Mazowiecki government adopted a rapid and

radical reform program for 1990. The aim, of this program, was to effect a

transformation of the Polish economy from a command to market economy based on

proven institutions with market determination of prices and convertible currency.

The program included measures for stabilization, liberalization and

restructuring.

Stabilization

A number of policy measures were directed primarily to stabilization

objectives.

1) Budgetary balance: increasing taxes by 50%, reducing government investments,

and reducing subsidies from 14% of GNP to 6% in 1990. (These measures were

designed to increase revenue while decreasing expenditures making for a balanced

budget and the ability to repay the national debt)

2) Tight monetary policy with positive real interest rates (interest minus

inflation = real interest rate) to eliminate hidden subsidies from household

savers to state enterprises via low interest rates in the banking sector that

were estimated to total 10-15% of GNP in 1988 and 1989.

3) Eliminating controls on more than 90% of prices in the economy, with

exceptions in energy, public transport and housing. (This was designed to

eliminate state pricing that did not reflect accurate market pictures of cost

and demand)

4) Wage restraint, providing only mild wage indexation (indexation = change of

wages based on cost of living increases (i.e. inflation) – limited means that

wages would remain largely unindexed and thus workers would not (unless given a

raise) earn the same relative salary as years past and would experience a loss

in buying power). Excess wage payments were taxed at a punitive 500% enterprise

tax rate.

5) Foreign debt was rescheduled by an agreement with the Paris Club (Holder of

2/3 of national debt) in march 1990 and reduced by at least 50% in March 1991. A

structural adjustment loan of 394 million was obtained by the World Bank in 1990,

as well as an IMF (International Monetary Fund) stand-by of 569 million and

commitments from the G-24 stabilization fund (of 1 billion) and EC (economic

community) of financial aid.

Liberalization of Foreign Trade

This implies the lifting of most of the quantitative and licensing

restrictions coupled with the lowering of tariffs to between 15 and 50% for most

goods. Since 1982 an increasing number of enterprises have been granted

authorizations to conduct foreign trade activities, in addition to the 60 (odd)

specialized state enterprises (with the same privilege).

Export incentives include export related income tax reliefs, a foreign-

exchange retention system introduced in 1982 (this granted export enterprises

priority rights to buy foreign exchange for production related imports).

Restructuring of the Economic system

This was to mean measures of a more radical nature to be introduced in a

gradual nature.

1) Deregulation of state enterprises and enforcement of strict payment

procedures; new bankruptcy and anti-monopoly legislation intended to harden

budget constraints and to reduce monopoly power. The system of ad hoc, ex post

tax differentiation with respect to sectors, firms and factors of production

will be replaced by a uniform system of taxation (enterprise tax, personal

income tax). Abolishment of industrial associations, in order to, prevent

informal co-ordination of their activities.

2) Well defined property rights. The new government inherited a system under

which workers’ councils were directly involved in enterprise decision making and

the appointment of managers (the obvious lack of industry strength under this

system is obvious). A Major difficulty is the reconciliation of workers’ rights

and the privatization law of adopted in July, 1990 (this law envisages far-

reaching privatization).

State companies are being transformed into companies with shares owned by the

state to be sold later to the public. At most, 20% can be sold to worker on

preferential terms and 10% to foreign investors without certification. However,

larger scale sales to foreign investors are possible subject to government

approval (the process is expected to be mere formality). The obvious gain of

this is to increase government revenue (in the short term) and to create,

through foreign investment, a vibrant economy providing jobs and revenue n the

future.

3) A new monetary system based on a two-tier banking system. The monopoly bank

was split in February 1989. Interest rates are to reflect market forces,

government bond sales can be used to manage possible budgetary deficits, and

commercial paper will be issued (which can cope with the problem of inter-

enterprise arrears by turning them into tradeable securities to be discounted at

commercial banks).

This was designed to create better adjusting “natural” market forces and to

enable industry to better cope with the economic changes.

The Results of Reform

The reform program led to initial results that were no less than

remarkable. However these results have in most cases not been sustained over

time.

Inflation, after an initial jump, fell to a much lower rate; but it did

not fall as far as was hoped and the problem is not yet beaten (low inflation

has become a dominant economic policy in the last two decades). In 1990

inflation was at 585%, in 1991 it was supposed to drop to 36% (according to IMF

forecast) but only fell to 80%. (For perspective the “normal” inflation rate in

the Western world stands at between 1-3%).

Relative prices responded rapidly to the 1990 price liberalization and

shortages largely disappeared. Strong positive real interest rates were

established. The budget was initially in surplus (unheard of) but has since gone

back into deficit.

The economy remains in a deep recession. GDP fell by 8-12% and output by

12-18% in 1991. The deepest output decreases have been in textiles, coal, metal

and transport. Investment in 1991 was 15% below levels of 1990.

However, output in the private sector increased in 1990 by 17% (might be

due to the simple increase in the size of the private sector). Agricultural

output has not decreased, so far, despite a drop in fodder and fertilizer sales

to one-third of former levels.

As well, bankruptcies have been rare, new firms have been established

(net increase in firms in 1990 of 362,000). Enterprises have been cushioned, so

far, by decreasing investment expenditure, sale of capital assets and stocks,

and have used their resources to secure short-term survival and avoid lay-offs.

Unemployment is also low compared to the drop in production levels (May

1991 – 8% of labor force jobless).Real wages have fallen sharply (25%

immediately after reforms in 1990) and continue a downward trend.

Problems of Reform

The ultimate aim of the reform process is to infuse a dynamic element

into the economy by means of marketization (making economic agents responsive to

real prices) of production and privatization of the means of production. The

full range of the necessary conditions for growth is not clear (economists

rarely agree) but it is clear that there exists a minimum requirement for

successful reform. This includes political, cultural and economic sustainability.

Popular Attitudes

Initially, both the government and the population were fully committed

to the reform process. In the first months of 1990, the government could claim

an unprecedented degree of legitimacy and support from the population. In the

public opinion polls the proportion of people who felt that their economic

situation was at least “not bad” rose from 13% in autumn in 1989 to 20% in

January 1990 and up to a high of 27% in March of that same year.

Since then, however, this spirit of success has become tarnished. Polls

in mid 1991 showed that most people expected tensions to increase. In 1991 the

CBOS polling firm recorded (in March) a 48% difference between optimist and

pessimist (54% pessimist versus 6% optimist).

The likely reason for this is that expectations rose faster than the

possible economic gains and the populations expectations were not (nor could not

be met).

Institutional Reform

A huge amount of new economic legislation is required to establish a

general rule of law and institutions appropriate to a market economy.

A crucial aim of reform is to improve incentives for private and state-

owned enterprises. Property rights are to be clearly defined and contracts and

payment procedures strictly enforced. Privatization has a high priority, however,

there are still issues of timing, scale and foreign investment that need to be

worked out.

The Polish people are eager for quick reforms and a fast rise in living

standards. There are, however, risks to endeavors such as quick privatization.

This type of project (mass privatization) is costly in terms of consultants,

administration (to monitor the new owners rights) and is dangerous in terms of

insider acquisitions.

Privatization policies are also difficult in an environment where the

home populace is unable to afford a stake in the new firms. During the initial

phase of reform individual Polish financial strength has diminished. This has

meant that foreign investment was needed to buy the once state owned firms. This

might create problems in the future with little or no control exercised by the

Polish themselves in their own country.

Adequate labor market institutions are absent, worker still appeal (in

general) to the state authorities rather than to enterprise management when

claiming higher wages and other improvements. A system of collective bargaining

is needed, and the private enterprise needs representative organizations.

Supply Response

Institutions that can transmit market signals to producers are lacking.

Should the signals pass there is often structural rigidities that prevent the

necessary changes needed to capitalize on consumer demand.

World Environment

This is crucial to the success of reform in accelerating economic growth.

Poland has had the misfortune of four recent blows to the economy. The reduction

of the former GDR market after the German reunification (this has meant the loss

of job for 35,000 Polish migrant workers), severe cuts in exports to other parts

of the former CMEA (especially Russia) (Poland’s exports for reasons of quality

and price cannot compete with Western exports), increases in world oil prices

(Poland imports energy) and finally the world recession of the past 4 years

which has forced Western economic concentration on itself and thus world aid has

been reduced.

Conclusion

Poland has been the unlucky recipient of economic and political freedom

in terms of timing. The Western world is in a debt crisis and can no longer help

as much as they once would. As well, the end of the Cold War has meant that

Poland is no longer as important as it might have been as a lever for the

democratic countries of the West. It’s pursuit of democracy does not have the

same impact as it would have had under Cold War circumstances.

From an economic point of view Poland, and every other East European

country in this situation, is faced with a lumbering giant of an economy

littered with inefficiency, waste, bad management and technology decades behind

the countries they are now in competition with. This means that Poland will need

to effect a complete reconstruction of it’s economy in order to be able to, in

the future, compete on an even level.

Poland has the ability to emerge from this economic recession and emerge

as an solid economic power capable of providing good living standards for her

people.

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