Three broad reform strategies may be distinguished: shock therapy, rapid adjustment, and gradual change.

Vaclav Klaus, the then Prime Minister of the Czech Republic defined the basic principles of the strong variant by the following "Ten Commandments":

1. Reforms in postcommunist countries are the outcome of a complex social and political process and cannot therefore be preplanned or socially engineered by any one person or center.

2. The role of foreign aid is marginal.

3. An economic shock (a large fall in output) is inevitable.

4. Dramatic actions are required to impose a restrictive macroeconomic policy, liberalize prices and foreign trade, and establish a process for privatization.

5. A restrictive macroeconomic policy must be sustained.

6. The price shock resulting from price liberalization must be vigorously defended and continued.

7. Economic restructuring requires comprehensive privatization.

8. Transformation costs must be widely shared.

9. Successful transformation requires the opening of markets to foreign goods and the free flow of peoples and ideas.

10. Successful transformation requires successful politicians.

How valid are these prescriptions? The main initial objective of a stabilization policy (the sixth commandment) should be moderate inflation rather than stable prices. Once a country has moved from transformation to recovery and sustainable growth, macroeconomic stability becomes essential. This requirement applies, above all, to countries seeking EU accession.

A similar caveat can be made with respect to Klaus’s seventh commandment, concerning the need for rapid privatization. In Poland state-driven privatization has been slow. But rapid autonomous growth of the original private sector has ensured that the total private sector accounted for about 65 percent of GDP in 1999. Privatization of state-owned enterprises, while usually helpful, may thus not be as necessary as some reformers initially believed. The quality of privatization has proved to be very important, and there is a tradeoff between speed and quality.

The tenth commandment has also proved to overstate the case. Successful politicians can be helpful, but they are not necessary for a successful transformation. Reform must be legitimized through a democratic political process. From today’s perspective, it is clear that Klaus’ formulation understates the importance of creating a new legal and institutional environment and a new culture of habits and attitudes that a modern market economy requires. This task has been particularly important in the countries of the former Soviet Union.

The more successful transitions—in Central Europe and the Baltics—are associated with the strong variant of the rapid adjustment model. One of the most successful transitions has been in Poland, where real GDP was one quarter higher in 1999 than at the beginning of the transition in 1989—by far the best result in the region. After a contraction of about 15 percent in 1990 and 1991, the economy has grown at an average rate of 5 percent a year. Estonia, Hungary, Latvia, Lithuania, and Slovenia have also experienced rapid growth in the past few years.

The Polish model of transition consisted of the following major elements:

The Polish program was gradual in many important respects. It took 10 years to reduce inflation to less than 1 percent a month, mass privatization was limited to small enterprises, social transfers were large (pensions increased substantially in relation to wages), and budget deficits remained significant throughout the 1990s.

The Hungarian model has been similar, although implementation of the major elements of reform was somewhat more gradual and workers councils had little importance. Hungary’s bankruptcy law may be the strictest in Central Europe. The growth of the domestic de novo private sector tended to be in services rather than in manufacturing, where there was fairly rapid development as a result of foreign direct investment. A larger external debt burden and weaker macroeconomic policies meant that stabilization of the GDP contraction took longer than in Poland, and the beginning of rapid growth was delayed by five years (until 1997).

Slovenia was unique, because pretran-sition reforms were more substantial than elsewhere in Central Europe and the initial crisis more limited. A more gradual transformation was thus feasible and was adopted in the early 1990s.

In the Russian Federation the Gaidar plan—the 1992 attempt to achieve budget hardening and disinflation combined with full price, trade, and entry liberalization—failed. As a result, enterprises have been under less pressure to divest physical assets and shed labor they did not need, thus effectively denying new private firms the resources needed for their development. The failure to liberalize thoroughly kept the set-up costs for new firms high. For several years large subsidized credits and entry barriers undermined the credibility of the strategy, inducing capital flight, creating opportunities for tax avoidance and criminal asset stripping as well as slowing restructuring by old firms.

The Russian reform was nevertheless radical, since by and large prices and wages were liberalized quickly. As a result, markets started to develop, taking over the informational and coordination roles from planners. A large-scale privatization program was also initiated early on and implemented quickly. This embarking on privatization before full liberalization (involving not just product prices, exchange rates, and interest rates but also trade and entry terms) and the hardening of budget constraints for enterprises and disinflation were the key characteristic features of the reform strategy adopted by Russia and most other CIS countries in the first few years of transition.

To be conducive to investment and growth, the macroeconomic environment in a transition economy should meet several criteria:

What have policymakers learned over the past decade of transition? Ten lessons emerge:

1. Most former state-owned enterprises, especially large ones, have suffered from the British Leyland/Rover syndrome: the accumulation of structural problems of such magnitude that they are not amenable to significant "strategic" restructuring and growth, whatever their new ownership and regulatory framework. Given the financial, managerial, and other constraints and poor positive incentives, such enterprises are capable mainly of only "defensive" restructuring—unless they are taken over by large foreign investors.

2. The success of transition depends above all on the rapid creation of institutional, legal, microeconomic, and macroeconomic conditions conducive to the development and growth of a new private sector, domestic and foreign.

3. Development of this new private sector should be facilitated by increasing competition by liberalizing prices, permitting state-owned enterprises to sell capital assets, imposing hard budget constraints on them, encouraging foreign direct investment, and lowering entry barriers for new businesses. (In industrial countries small and medium-size enterprises account for about 50–60 percent of GDP.)

4. The inflation rate need not—and initially should not—be very low, but it must not exceed 40 percent a year and it should be seen as converging to the average level in the EU.

5. A disinflation policy should involve all the key macroeconomic components: fiscal, monetary, and exchange rate policy and (when applicable) wages and benefits. Given the close link between budget deficits and monetary growth in transition economies, tight fiscal policy is necessary. But it may not be sufficient, and other policies should be used in supporting roles. The cost of disinflation is lower if the monetary authorities are politically independent. Although an extreme solution, currency boards can be useful.

6. The choice of an exchange rate regime is not too important from the point of view of an anti-inflation policy, but a moderately or even fully flexible regime can provide the private sector with better information about exchange rate risk and so establish a better defense against speculative capital inflows and the growth of excessive private foreign debt.

7. In addition to an independent central bank and a solid regulatory framework for financial institutions, the essential institutional basis for a stable macroeconomic environment includes banks, insurance companies, pension funds, and stock exchanges.

8. External credibility is vital to attract foreign direct investment and eliminate capital flight. The exchange rate should thus be competitive to ensure that international reserves are high relative to imports and foreign debt, especially short-term debt.

9. Fiscal policy should aim to meet the Maastricht budget deficit and public debt limits, as well as keep taxes (and therefore public expenditures) low relative to GDP. Public expenditures should favor spending on education and infrastructure at the expense of social transfers, defense, and subsidies.

10. The high rate of structural unemployment requires changes in the labor code to increase labor market flexibility (by reducing hiring and firing costs, for example). It also requires an active role of the government in education and training.

In most countries of Central Europe and the former Soviet Union, GDP per capita was about 15–30 percent that of the United States at the beginning of the 20th century, just as it is at the beginning of the 21st century. The economic transformation of those economies in the past decade has contributed significantly to helping those countries realize their strategic goals and creating economic systems that should enable them to remove this income gap in the twenty-first century.

Stanislaw Gomulka is professor of economics at the London School of Economics. Tel.: 44-20-7955-7510, fax: 44-20-7831-1840, email: c/o p.nutt@lse.ac.uk. This article is based on the author’s recent paper, "Macroeconomic Policies and Achievements in Transition Economies, 1989–1999," presented at the UN Economic Commission for Europe Annual Seminar, held in Geneva in May 2000. The paper will be published in Economic Survey of Europe, December 2000.

*ppp=purchasing power parity.
Sources: World Economic Outlook, IMF 1999 and Transition Report, EBRD 1999.

Note: Early liberalizers—defined as countries that had achieved "complete price liberalization, full current account convertability, and almost complete small-scale privatization"— receive a ranking of 5. Late liberalizers—countries that achieved these thresholds after 1993—are given a ranking of 3. All other countries receive a ranking of 1. Early stabilizers (countries that stabilized before the end of 1993) receive a ranking of 5. Late stabilizers (all other countries) receive a ranking of 3.