OP:5. Priorities of Economic Reform in Eastern Europe and the Soviet Union
Author(s): Rudiger Dornbusch
Publication Date: January 1991

Abstract: The new governments of Eastern Europe have inherited economies that are overmanaged, and which require the rapid introduction of markets to decentralize and depoliticize their economic decision-making. Policy-makers have a natural preference for gradualism, since the swift transition to an unplanned capitalist system will break up the existing economic structures overnight. But gradualism will open the door to an unstructured free-for-all if consumers and producers turn to the black market and deal in Deutschmarks and dollars, and those who are left out or fall behind will be radicalized. In this grey area between a control economy that no longer functions and a market economy that is not yet fully accepted, economic collapse is inevitable; so the transition must be achieved rapidly if it is to stand a chance for success.

Governments must set the 'rules of the game' from day one: these are the establishment of unlimited and unrestricted private property and of citizens' freedom to engage in all types of economic activity not specifically ruled out by new legislation. The German 'social market economy' may provide a suitable model for east European governments wishing to supplement laissez-faire liberalism with legislation to promote competition once their privatization programmes are complete and with a targeted social emergency programme to shelter the most vulnerable groups from the inevitable rigours of adjustment.

Reforming governments should not waste scarce administrative resources on the design of new institutional infrastructures: well-functioning legal, accounting and tax systems may be imported complete from the West. Property rights may play a vital role in promoting the efficient use of resources if priority is given to the privatization of firms over that of residential property. Recent German experience suggests that it is more important to achieve this quickly than to do it well, and that privatization will be more likely to succeed if conducted by several competitive funds than by a single agency. Governments that move fast in eliminating the substantial remaining uncertainties over property rights may also benefit from foreign direct investment, and from the twin bonuses of technology and know-how this will bring.

Macroeconomic management is harder once political repression is lifted, and monetary reform is required if Eastern Europe is to avoid the vast costs of inflation as experienced by Western Europe after World War II and by Latin America more recently. An outright write-off of the monetary overhang or a conversion of money into shares in future privatizations must be preferred to a freeze or the conversion of money into interest-bearing debt.

Introducing convertible currency trade will provide both an immediate reference system of world prices and a culture shock to consumers and producers alike; but it will also bring the domestic economy into contact with superior technology, processes and products, which may in turn enhance the competitiveness of domestic factors of production. There may be a case for limited countertrade within the former CMEA, but full liberalization of the capital account and the maintenance of realistic exchange rates are essential to the success of any policy of open trade with the West.

West European governments must respond with an equal opening of their trade to the East, if they are to avoid the alternative on a scale not witnessed since 1945. This may be supplemented by a more realistic view of the external debt, since the west has a greater interest in Eastern Europe's ultimate stability than in the punctual service of its debt. Western official resources should not be wasted on debt service if a major opportunity for reconstruction might be lost as a result.

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