Hungary the Central and East European country that suffered the smallest economic contraction at the start of transition, has had the worst growth performance subsequently, running some way behind Poland, Slovakia, Slovenia and the Czech Republic. Conventional wisdom suggests that this relative failure has arisen from two major mistakes: Hungary has opted for a ‘gradualist’ approach to economic policy, allowing inherited distortions to drag on; and it has refused to negotiate a rescheduling of its huge inherited external debt. The result has been comparatively slow growth coupled with high inflation.

But according to László Halpern and Charles Wyplosz, while gradualism and external debt have played a role, they tell only part of the story - and possibly not the most important part. In the introduction to a new CEPR volume, Hungary: Towards a Market Economy, they argue that in contrast with other transition countries, most of which focused initially on macroeconomic stabilization, Hungary was pursuing microeconomic reforms. At the same time its macroeconomic position was slowly deteriorating. Thus, until 1995, it was not yet in a position to reap the benefits of its microeconomic reforms, and then suffered from the temporary effects of the March 1995 stabilization package. Under this interpretation, Hungary is now poised to grow fast and catch up with the other successful transformers.

Halpern and Wyplosz note that Hungary’s experience has been unique in several dimensions. For example, its external debt problem continues to constrain the authorities. And privatization has been slower than in the other successful transforming countries but – and this is a key difference – it has been much more outward oriented. Most transition countries decided that they would not ‘sell to the foreigners’ and the result has been mass privatization - the distribution of state assets practically for free.

Hungary’s openness to foreign ownership has brought a number of important benefits. Since privatization has required the careful evaluation of asset values and negotiations with potential buyers in the context of limited know-how, progress has been slow. But on the positive side, foreign ownership brings with it technology transfers and fresh capital. Indeed, for some time, foreign direct investment into Hungary has matched the total foreign direct investment into all other European transition.

This in turn has led to the establishment of a deeper stock market than seen elsewhere in Central and Eastern Europe. In addition, the resulting structure of corporate ownership is much sounder. This is particularly evident in the banking sector: after several expensive and ultimately failed attempts at rescuing the domestically-owned banking system that emerged from the early phase of transition, foreign banks have been allowed to come in. These foreign banks have contributed to the establishment of what is arguably the least fragile banking structure in the region.

But despite these achievements, in early 1995, Hungary’s gradualist approach was perceived to be in a serious crisis. Both the external and internal balances were in a critical position, privatization was slowing down, and international organizations and credit rating institutions were classifying the country as prone to follow Mexico into an economic crisis.

This situation led to the policy package adopted in March 1995, a classic macroeconomic stabilization programme. The package included a determined effort to curb budget expenditures so as to reduce the deficit to a size that could be financed by the market, thus eliminating central bank financing; a commitment to contain nominal wages; and the adoption of a crawling peg after a strong devaluation.

Over two years later, the Hungarian economy is at last growing. Its budget is improving and the external deficit is clearly sustainable. The economy has responded. Part of the response is due to the macroeconomic medicine administered in 1995. But it now appears that another part is the consequence of the deep microeconomic restructuring and institution building that took place during the period 1990-3. These achievements have long been clouded by macroeconomic imbalances and the image of gradualism cultivated by Hungarian policy-makers themselves.

In fact, Hungary’s industrial restructuring has been more shock therapy than gradualism. The very tough bankruptcy law adopted in 1991 has been vigorously implemented, resulting in the closing down of thousands of firms, with clear incentive effects on the surviving ones. In just a few months, more than 10% of the country’s firms went bankrupt. This may not have been optimal but with hindsight, it may well turn out to be preferable to the kind of slow death that has been allowed, at high cost, in most transition countries.

No other transition economy has closed down so many firms so quickly; no other has taken the risk of letting go of potentially profitable companies rather than the alternative of letting firms survive that will eventually go bust. For this reason, Hungary is probably furthest down the transition path. Similarly, Hungary may be the most advanced transition country in terms of restructuring its welfare system - primarily health and pensions.

Although Hungary prides itself on its gradualist policies, it is rapidly changing. It is not yet a full blown market economy, but it is moving in that direction. Why then have all of these positive developments failed to materialize in superior growth performance?