Privatization and Central and Eastern Europe

By Joseph M. Doggett

            There are two pervasive themes that emerge from the privatization literature as it relates to Central and Eastern Europe.  One, there is a focus on the problem.  The problem identified by Western advisors is that the state system under which communist/socialist countries emerged was inefficient.  The identification of the solution necessary to overcome this deficiency was rapid privatization, divesture of state assets to the private sector, and a quick transition to a market economy.  The second theme that emerges from this literature is the impact of rapid privatization on employment.  The outcome of privatization on employment in Central and Eastern Europe (CEEC) was massive layoffs; which resulted in massive unemployment.  An unaddressed question within this literature was the ability of the CEEC to implement the policy recommended.  This body of literature fails to address adequately the need for institutions.  After reviewing this body of literature, there is a presentation of the outcome of the failure to address the need for institutions in the CEEC.

Literature

            Adams and Brock wrote a play that depicts the interchange between a Western advisor and a Prime Minister from the CEEC.  The advisor tells the Prime Minister that the Prime Minister must implement rapid privatization to overcome the deficient state apparatus that exists.  Only through rapid privatization can the country achieve economic efficiency and superior productivity.  The most important point that the Prime Minister can learn, according to the advisor, is that “the market works.”  The Prime Minister respects the advice of the advisor, but the Prime Minister asks the advisor if the implementation of rapid privatization is the best solution in the face of hyperinflation, hyper unemployment, and hyper chaos.  The Prime Minister begins to disbelieve in the “ideological” presentation of the advisor to the point that the Prime Minister begins to question the advisor’s ability to present proper advice.

Prime Minister: We used to say that religion comforts the masses by assuring them that there is life after death.  After conversing with our economic advisors, I am comforted by the thought that there is death after life.  (88)

            Frydman and Rapaczynski wrote that there is a need to implement rapid privatization in order to achieve economic efficiency in the CEEC.  The authors provide a road map to success.  The authors state that the lack of knowledge about a market economy forces the privatizers to implement mechanisms that will allow progress and “teach” the CEEC society about the market.  The authors advocate that intermediaries need to hold the stock of companies and implement structural reform in the CEEC.  The intermediary will act on behalf of the holders of stock; who are members of society who received stock ownership as a result of some kind of privatization method undertook by the governments in the CEEC.  The maximum implementation of institutions that need be addressed is a corporate governance structure that allows directors and shareholders to interact and begin to understand the market.  For these authors, institution building is a fruitless exercise given that no one is capable of articulately stating which institutions are necessary, how they are to be designed, and which are optimal given insufficient knowledge and information.  Therefore, these authors state that a market economy must be introduced, there should be a minimal set of institutions introduced that will allow a market to seed, and then one should wait and see what happens. 

            Lundberg performed a case study of the Treuhandanstalt, a holding company that aided in privatizing Eastern Germany.  The role of the Treuhand was to privatize, as quickly as possible, the 10,000 to 12,000 major enterprises and the 20,000 small enterprises in Eastern Germany.  The goal of the Treuhand was to turn these enterprises into viable, economic units that were capable of competing in the market place.  The obvious problem that the Treuhand experienced was the enterprises in Eastern Germany were antiquated and largely inefficient.  For example, 21% of industrial machinery was more than 20 years old; and 29% of industrial machinery was between 11-20 years old.  (9)  Given the Treuhand’s difficult job of privatizing outdated machinery, the second problem of causing social and economic hardship was also a difficulty that the Treuhand had to overcome.  However, the Treuhand overcame this second problem with complete absolvance of responsibility.  Rohwedder, the main director and chief architect of the Treuhand, stated

That a privatization agency’s overriding responsibility … was to privatize.  Dealing with social, political, or structural consequences of privatizing should properly fall to politicians.  (11, Author paraphrasing Rohwedder’s response.)

Van de Hoeven and Sziraczki and Kuhl wrote about the negative effects of privatization on unemployment.  Hoeven and Sziraczki wrote in broad terms that developing regions focused attention on improving efficiency and reducing public deficits.  The key to achieve these goals was privatization.  These authors found mixed results as to the effectiveness of privatization to achieve these goals.  In the CEEC, privatization resulted “in large-scale job losses.”  (10)  The authors conclude that privatization has mixed results; and in locations where it failed, the failure could be attributed to lacking structural supports or opposition by entrenched interest groups.  Kuhl wrote specifically about privatization effects on employment in Eastern Germany.  Kuhl studied how the Treuhand dealt with the employment issue.  He found that the Treuhand gave no attention to labor issues, preservation of qualified laborers, or industrial or regional structures of employment.

Discussion of the literature

            Authors who wrote within this body of literature state “what is to be done” or the impact of privatization on employment in the CEEC.  The method chosen by people who advocated privatization all agreed that rapid privatization was the answer.  The people who investigated the effects of privatization, in the CEEC, all agreed that massive job loss was the result of privatization.  What none of these authors address adequately is the need for institutions.

Although Frydman and Rapaczynski might come the closest in dealing with the institutions’ question, their actual dealing with the problem is far from complete.  These authors, given their loose writing style and seeming ability to touch on many points without addressing anything, could possibly claim credit for any of the successful outcomes in the CEEC.  However, further examination of their writing reveals incomplete detail, reversal of statements, and inconclusive assertions.  For example, the authors state that institutions need to exist.  The authors then state that the type of institutions to which they refer are corporate governance structures in which directors and shareholders understand basic rules of the game.  Following this assertion, the authors state that no one has complete information; no one knows for sure how to set up institutions; and therefore people should not waste their time looking at other countries to try and determine how to set up institutions given the nuanced differences that exist between and within countries that would evade analysis. 

The authors then present the case of the United States, Europe, and a workers’ self-management model as examples of institutional structures.  The authors conclude that the U.S. model and the workers’ self-management model are insufficient, and the European model, which relies on a close relationship between banks and companies, is the premier model to follow.  The justification for this finding, as well as other findings within this work, is that the U.S. model and workers’ self-management model are insufficient for “well-known reasons”.  Further, the authors justify their stance of the European model based solely on one example, in this case an example from Poland.  Although the Polish example might establish criteria for selection or could be used in support of statements by the authors, these authors do not make a case to support the European model.  Rather, they simply rely on the Polish example to support their agenda that the European model is superior.  Contradictions and justifications such as this are insufficient for dealing with the problems that exist in the CEEC.

Stemming from Frydman and Rapaczynski’s analysis, though, was the statement that some basic rules of the game should exist and then one should “wait-and-see what happens”.  Well, the “wait-and-see what happens” did occur.  The result was complete chaos.  The presentation that follows illustrates, more specifically, what occurs when the necessary institutional structures for a market economy are absent.

Institutions

            Institutions are the bed rock of any country, and, therefore, any economy.  D. North states that institutions define the rules of the game.  J. Commons states that the very existence of capitalism rests upon legal traditions that allow economic interactions to take place.  Campbell et al state that government allows for the emergence of markets by setting the stage for economic interactions.  Lindblom states that governments enforce private property rights and contracts, which are essential for any economic activity.  Fligstein writes that the state is an important actor in the economy because it defines the rules by which economic actions are carried out.  Finally, Roy states that corporations came into existence through the confluence of power, property, and institutions; with institutions shaping the rights, entitlements, obligations that the state would uphold.  The purpose of institutions is that they dictate what can happen and what can not.  For example: Why is tax evasion acceptable in Switzerland?  Why is prostitution illegal in the United States—except in Nevada?  Why is air pollution acceptable in India?  Why is there a federal-reserve limit that banks must follow in the United States?  Why does the Federal Reserve have the right to set interest rates?  Why do advertisers have to present truthful information?  The answer to the following questions could be because the government, via institutions, says so.

            The point is that institutions determine what behavior is acceptable and what behavior is not.  Although these points may seem obvious to some, the existence of institutions in post-communist states is not to be taken for granted.  In the presentations that follow, the lack of institutions coupled with reform efforts led to disastrous consequences and illegitimate behavior.

            The all-important sector to any economy, the banking industry, failed in Central and Eastern Europe during deregulation “because of an ill functioning or completely absent legal framework, and deficiencies in the supervision system at the time when these countries started to liberalize their financial systems.”  (Keuscnigg, 1)  The investigator studied the banking sectors in Central and Eastern Europe.  He found that all the countries lacked sufficient regulation to guide banks during the transition process.  His recommendation is both the adoption of “prudential” regulation and the necessary enforcement structures to ensure the implementation of regulation by banks.  He states that without this adoption, there will only be continued chaos and turmoil.  Although

Keuscnigg’s findings are informative; Keuscnigg’s findings are not alone.  Borish and Ding studied Bosnia-Herzegovina’s banking sector and found that competitive legal reform is needed to ensure the viability of the banking sector.  Finally, Steinherr stated that Eastern Europe must adopt a system of rules in order to achieve sustainable growth and inclusion into the European Union.

            The most enlightening research was done in the Bulgarian-banking industry.  Koford and Tschoegl performed a qualitative analysis of Bulgaria’s banking industry.  They found that like bankers in developed countries, Bulgarian bankers made the same two, common mistakes—poor-lending decisions and loans to insiders who were not credit worthy.  However, unlike a banker in a “developed” country who would resort to the judicial system to retrieve funds from a debtor who is unwilling to pay, the Bulgarian banker does not.  The Bulgarian will state a claim in court, but the Bulgarian banker does not expect any results.  (143)  Rather, the Bulgarian banker will resort to using “strong young men” to encourage would-be defaulters to pay their loan.

            Moving from the banking sector of Central and Eastern Europe to extortion and market development in Russia, one finds that the ubiquitous nature of extortion exists given the lack of legal institutions to impede it.  Lotspeich performed a quasi literature/qualitative analysis of extortion in Russia and found that inadequate legal institutions, acceptance of extortion, lack of enforcement, and cooperation by government officials in extortion all led to the rising tide of extortion in Russia.  He found that a large proportion of new, private enterprises in Russia pay extortion fees.  (23)  Militia forces—government officials who are supposed to inhibit illegal activity—recommend that private enterprises pay extortion.  The justice system is corrupt, and corruption often allows extortionist to engage in their illegal behavior.  (24)  The consequences of extortion on economic development are: loss in human capital due to the enforcement of threats, loss of profits and reduction in economic efficiency due to payments to extortionists, and reduction in Foreign Direct Investment given the uncertain environment created by extortionist.  The obvious solution that the author promotes is that there needs to be a strengthening of the legal institutions necessary to inhibit this type of action.

            Although the existence of extortion is a problem, the overall problem of “shadow” behavior—meaning illegitimate behavior—is much more pressing.  Gurkov performed a study of Russian enterprises and found that involvement in shadow activities does occur, but there is a road map that would allow one to determine if an enterprise would engage in shadow activity or not.  The common characteristics of a firm that engages in shadow activity are: the director has no control over the firm, and the business is failing.  (73)  When these two points converge, then shadow governance and activity will emerge.  The result, though, is a reduction in economic efficiency, and more importantly, there is a massive layoff of workers.  (73)  Although complacency might seem like the obvious reaction by people, public opinion shows that people dislike the mafia and shadow-economic involvement by businesses.  (73)  Of course what allows this to occur is the lack of institutions, and that “there are no rules of the game.”  (75)  However, this marked absence is being addressed by some in Russia.

            Matloff found that some business people are tired of mafia/shadow activity in Russia.  A group of “reformers” who want to place ethics at the forefront of business are forming.  Their goals are to remove mafia, force people to honor contracts, and give notice to business leaders who are honest.  Accordingly, entire industries in Russia are talking about the need for regulation. 

            Although this presentation may give rise to a bleak outlook for the post-communist countries, there is a beacon on the horizon.  Poland is a country that emerged slowly during the transition process.  Poland adopted reform measures slowly and continues to embrace reform gradually.  However, Poland is a country that has an established and accepted institutional structure.  Some proponents, and critics, of Poland agree that the development and existence of an institutional structure is what allowed for Poland to adopt reform measures and begin to thrive economically.  What follows is a presentation of Poland’s establishment of institutions and its economic performance.

Poland

            Kolodko, former Deputy Prime Minister and former Minister of Finance of Poland, wrote that the Washington consensus of shock therapy was wrong, because shock therapy that involved the rapid transition to a market economy failed to take into account the necessity for institutions.  Institution building is important for a transition economy, because transition economies lack even the basic institutions that allow a market economy to function: regulation of commerce, central bank, and tax administration.  Poland implemented these types of institutions.  Rather than following the shock-therapy advice of the Washington consensus, Poland embarked on a strategy of creating these institutions.  In other words, Poland rebuked market-reform advice and began a building project.  The outcome is that the creation of these institutions allowed Poland to avoid the adverse experience of other economies, and the creation of these institutions was important to Poland’s revision.  (243)

            Although it is easy for the former Minister of Finance in Poland to say that institutional reforms in Poland led to Poland’s financial success, other writers agree.  Borish, Ding, and Noel [1] compared the restructuring of banks in Central Europe.  They found that Poland allowed for the creation and development of institutions in the banking sector.  This process has had the impact of placing Poland in the best economic  position compared to Hungary, Czech and Slovak Republics, and Slovenia.  Although the authors agree that Poland is a success, it is important to note that they continually harked about Poland hindering quick privatization.  Therefore, the success of Poland can be attributed to institutional reform.  However, quick privatization is still advocated and a point of contention for these reformists.

            Montes-Negret and Papi [2] wrote exclusively about the Polish restructuring of the banking sector.  They found that Poland allowed for institutional creation and development.  They state three points that led to the success of Poland’s banking-sector reform: government dealt with the problems, the creation of institutions prior to reform, and there was an acceptance that the process would take years.  Again, rather than trying to implement privatization quickly, the authors of this study conclude that successful transition takes the establishment of institutions and time.

            Although speaking about success in the abstract is useful, actually implementing a reform program is what matters.  As Wiatr wrote, Poland created a Weberian neutral civil service.  To achieve that goal, Poland recognized that the bureaucrats of the past had to overcome their political baggage of communism, and they had to make a transition. [3]   This transition involved re-thinking how bureaucrats perform their tasks to allow for the development and creation of a market economy.   The introduction of laws and regulations of a market economy to people who maintained a communist ideology would result in disaster, according to Wiatr.  Therefore, according to Wiatr, Poland embarked on a program that worked with altering the mindset of the bureaucrat.  Based on this accepted pre-condition, Poland decided on its objectives for reform.  One, the state agreed that reforming the administration was a precondition for efficiency.  Two, there was a need to decentralize and allow for bureaucrats “on-the-spot” to make decisions.  Three, there was a need to modernize the agencies through computerization.  Four, there was a need to modernize the people such that Poland would create a neutral civil service.  Five, there was a consensus that the use of public funds must be allocated in the most efficient manner.  The point of these reforms and the altering mindset is that Poland changed the administration from a system of communist bureaucrats to a system of market-minded people.  This transition did not occur overnight.  Rather, there was a planned intervention by the state into the creation, development, and solidification of necessary institutions for the development of a market economy.

            The dichotomy between those states that adopted institution building and those that did not is striking.  Poland embarked on a reform effort that included the development of institutions prior to the implementation of market reform.  Poland received, and continues to receive, negative “press” for its failure to privatize quickly.  However, Poland is now one of the few countries amongst the transition economies that enjoys success and avoided many of the adverse conditions that plagued and continue to plague transition economies.  On the other hand, most countries did not implement institutional reform.  Those countries, unfortunately, deal with the existence of poor judicial systems, extortion, mafia-run enterprises, and thugs who collect loans.

Conclusion

            The writers who described “what is to be done” all pushed for rapid privatization.  The balanced conversation that Adams and Brock presented showed a dialogue between an economic advisor and a Prime Minister.  The economic advisor presented a case that called for a divesture of state assets and an allowance for the market to reign.  An interesting and subtle point that Adams and Brock make in their presentation is that the advisor makes the point with only words.  The advisor’s presentation is based on an ideology.  The Prime Minister, however, makes the argument that, perhaps, the country is ill prepared to undergo the type of transformation that the advisor advocates.  The Prime Minister points to several charts that depict inflation, unemployment, or investment.  The Prime Minister is a “well-grounded” person who wants to implement reform that is very structured and is given the opportunity to succeed.  The unfortunate outcome is that the Prime Minister was correct.  Adams and Brock wrote their book in 1992.  The material presented about the failure of institutions to exist in the CEEC and the resultant chaos were from works that were generated in 1999 and 2000.  The Prime Minister, who is more real life than some would probably like to cede, was the person who “had it all correct.”  I am sure that the Prime Minister takes little solace in that “fact.”