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Reestablishing private business in previously socialist economies.

Privatization will proceed at differing

rates in socialist economies, depending on

prior experience with competition and with

private businesses. To be successful,

inefficient businesses must be allowed to fail.

Owners of firms must have proprietary

interests, adequate capital markets must be

developed, and a connection must be

established between effort and remuneration.

Capital infusions are needed, which may be

provided from outside. The West must open

its markets to Eastern European goods. The

time frame to accomplish this is limited, so

that assistance to speed the process would

be well spent.

MOST OF THE countries of Eastern Europe are now attempting to convert their centrally controlled socialist economies rapidly to a market system. This they believe is essential if their economic welfare is to approach the standards prevailing in the West. It is also the logical counterpart of the political democracy they have so recently attained. What is more, they are attempting to do this in a very short period of time lest the forces of populism or reaction force them back into a totalitarian mold.

This is an enormous task. Both legal and economic institutions need drastic alterations. Prices and exchange rates must be freed and currencies made convertible. Labor must be reoriented to the market system as well as trained in modern methods while capital equipment requires both modernization and to be supplied in greater quantity. These problems will not hinder a rapid conversion of most retailing and other small business. However, the transition for large ventures will be far from simple.

The problem confronting attempts to privatize significant sectors of the public economy vary tremendously, depending on the institutional setting. The recent sales of many banks in Mexico to new private owners has been highly successful. Contrast this with the bankers of Eastern Europe. Their bank-type institutions did not attempt to realize profit, rather they primarily subsidized vastly inefficient state-run enterprises. In their lifetimes, many of these individuals have not been familiar with private property, and they attached little meaning to the state-controlled prices on almost all goods. To them, profits and prices were not viewed as signals for action.(1) Competition was almost unknown, providing no guides to policy or stimuli for action.

The economies of Poland, Bulgaria, Hungary and Czechoslovakia were not as completely collectivized as that of the Soviet Union. Within the lifetime of at least the older citizens, private business had existed on a widespread basis, prices had some meaning and monetary incentives for production existed. In countries like Poland and Hungary, small shopkeepers and independent craftsmen had not been entirely displaced by state-owned enterprises and consequently were almost instantaneously available to expand the private sector once restrictions were removed. Although the obstacles to widespread privatization are still formidable in these countries, they do not rival those in the Soviet Union.

Another serious impediment to privatization was the preoccupation with supposed economies of scale in communist countries. In many instances, a single large plant was the sole supplier of a particular good to the entire economy. This, along with lack of incentives, contributed to extreme inefficiencies in the production process. As a result, before privatization could be successfully undertaken, substantial structural reforms were essential.


Many large socialist ventures were exceedingly inefficient but for political reasons were rarely allowed to fail. In Hungary, between 1986 and 1988 liquidation procedures were initiated with 121 companies but only six actual closures resulted. Funds to offset the losses had to be provided. They came from either the state, central banks, individual banks or trade creditors. In all of these cases, an effective increase in the money supply, real or de facto, resulted. In Yugoslavia in 1987, for example, the national bank of that country provided offsets to loan losses that amounted to 8.5 percent of GDP while the state treasury still showed a small surplus.(2) Similarly in Poland, subsidies to state enterprises in 1988 came to 10 percent of GDP.(3) Inter-enterprise credit through the buildup of receivables was also a very large source of loss offsets. In Yugoslavia, it amounted to 39 percent of all credit in 1987.(4) This buildup of credit not only generated great inflationary pressures but also interfered with the efficient allocation of resources. For privatization to proceed successfully, these sources of funds must be cut off and unsuccessful firms must be allowed to fail. The balance sheets of the banking system must also be purged of the past credit accumulation from this source.(5) In this way both the malallocation of resources and fiscal disequilibrium can be avoided.

Poland began biting the bullet and started the process of liquidating large but inefficient ventures in 1991. They announced that on August 5 of that year all of the 12,000 employees of Ursus, the state-owned tractor manufacturer, would be furloughed indefinitely. The end came when both the state and the banks refused to extend further the $106 million in loans that had been supporting this essentially bankrupt company. The effect of the closing will go beyond the 12,000, because 300 other companies supply Ursus with tractor parts. Altogether 100,000 workers in Poland depend on the tractor industry.(6) Other similar examples are occurring with increasing frequency.

Painful though they may be, such closings are essential if a private enterprise economy is to succeed. But are they either economically or politically tolerable? Thousands of workers lose their jobs. No replacements may be in sight. Many large state companies will unhappily never be attractive to private buyers. Privatization efforts with this type of venture are only beginning. At the present pace, a change to private ownership will take at least thirty years. Unfortunately, it may never be completed, and, while this process goes on, living standards have declined and are likely to decline still further. By the end of 1991, hopes for a quick change to a market system had dimmed. Bitterness and disillusionment were widespread. The prospects that the whole privatization process may never be completed are indeed very real. Many of these countries may end with only partial capitalism and retain many of the inefficiencies of central planning. Strong political leadership may stave this off for a while. There is no guarantee that it can do so indefinitely.


Owners of firms must have real proprietary interests. This means that they must be free to dispose of income or profits as they see fit. When this is not done, uneconomic results ensue. In Hungary, state control persisted while ostensibly private firms were operating. As a result, managers did not act like owners and continued to play their traditional role of advocates for the workers. They continued granting wage increases without considering whether this policy would ultimately pay for itself.(7) The appearance of free market action existed while its substance was almost totally lacking.

A plan has recently been announced to privatize 400 mid-sized Polish companies with individual sales of $15 million or more by incorporating them into about twenty investment funds. These funds, which would be run by Western investment managers chosen by the Polish government, would be owned by Poland's 27 million adult citizens, each of whom would be given one share in each fund. In total, enterprises with sales of $10 billion or more would be covered. Shares of the investment funds could be sold. A goal would be to have shares of these funds and some companies quoted on the Warsaw stock exchange within two years. The compensation of fund managers would be based on the performance of the companies in the funds.

This is an interesting novel idea but it may be fraught with difficulties. It does not solve the problem of the management of individual companies. Unless these managements have a real proprietary interest in their companies, serious questions about their performance present themselves. In addition, no answers have been provided to date about the resolution of conflicts between interested parties. It is a very real possibility that the funds would become in effect large conglomerates. In view of the questionable results with many conglomerates even here in the U.S., the outcome might well be a recasting of inefficient socialist enterprises into large unwieldy ventures, presumably capitalistic in nature, but with the dynamic spirit of capitalism lacking.(8) Many experts have warned against this type of excessive dispersion of ownership.(9)


It is essential that countries that seek to have efficient market economies develop effective capital markets. Some, like England where privatization efforts have been going on for some time, have well-established banking and security exchange systems. This has greatly simplified the privatization process. Almost all Eastern European countries have had longstanding banking systems, although some are primitive. Few Eastern European countries, however, have had adequate stock markets. It looks, however, as if the stock market problem will be relatively easily solved. Exchanges have sprung up in most cities where securities available for trading have appeared. In fact, exchanges have been organized in several Russian cities in anticipation of the future appearance of tradeable securities, even though none existed at the time of their founding.


The labor supply in socialist and communist countries often suffers from two serious shortcomings: inability to respond to price movements and technical inadequacy. In countries such as the former USSR, the connection between effort and remuneration has long been tenuous. The formula "from each according to his ability, to each according to his need" has done little to stimulate individual effort. This, combined with the Soviet preoccupation with the economies of scale and the resulting vast size of productive units, has led to a lethargic workforce that is more accustomed to putting in time rather than vigorous effort. Unhappily, this pattern has persisted for several generations and will be difficult to change quickly even if communist domination has ended.

Technological inadequacy can be dealt with in a number of ways. Obviously new educational programs can be introduced in both the schools and at the workplace. Often on-the-job training can only be introduced along with new capital and unit-wide production techniques. New job methods and modern capital equipment may be specified by teams of experts from the West and introduced with funds supplied by the state. These often will be borrowed from foreign sources if international lending channels are open. The capacity of former socialist states to conduct vast reeducation programs is very limited, however.


Most of the large state-owned firms of the socialist world need substantial capital infusions as well as guidance toward market behavior. They also must be introduced to modern technology and management techniques. All of these objectives can often be accomplished by inducing foreign firms to enter into partnership with domestic producers.


Technology, capital and modern management techniques may also be supplied by totally foreign-owned operations. In eary July 1991, the national parliament of the Soviet Union passed a law permitting direct foreign investment. Although many foreign companies have been reticent to act because of economic instability, some movement is now underway since the unsuccessful coup of last August. A short time ago, IBM announced that it had established a wholly owned subsidiary to conduct business in the Soviet Union and is considering building an assembly plant there for personal computers. IBM has also expanded its operations in other countries in Eastern Europe. It has established a subsidiary in Czechoslovakia recently and is attempting to broaden its base in Poland and Yugoslavia. It has had a subsidiary in Hungary, even in the days of communist rule.(10) Gillette hopes to begin producing razors in a $50 million plant in Leningrad while in June Procter and Gamble bought Rakona, the biggest soap maker in Czechoslovakia. Unfortunately, the total flow of Western capital to the former socialist area has been small. It in total is not likely to exceed $20 billion in any of the next five years. Most funds must come from the domestic economies of the Eastern European countries. Only East Germany has a western counterpart to bankroll its redevelopment.


It is now recognized that local industries in Eastern Europe must be able to compete in world markets and must ultimately be integrated into the global economy. As well as providing capital and know-how, the West must open its markets to goods from Eastern Europe. The fortunes of Western Europe and the European Community are inextricably tied in with those of the countries in the East. The protectionist barriers of The European Community must be let down to accommodate their neighbors. Now, for example, most of Poland's exports to the West encounter significant tariffs.


Although concrete statistical evidence is still relatively scarce, some indications of the results to be expected are available. Under the "contract responsibility system" in China, agricultural output increased substantially as workers responded enthusiastically to what amounts to piece-rate compensation for part of their output. With this system, farmers contract to sell to the state certain quantities of produce at official low prices. Anything over the contracted amount can be sold on the free market at market prices. Gross farm output increased 138 percent in the ten years following the agricultural reforms in 1978 under this system. This was only possible, however, because collective farms had largely been abandoned in that reform.

In Britain, profits and margins in privatized firms have grown and employment has declined. This, however, has usually also occurred with public firms. The causality in much of the British experience seems to run from growth and profitability to privatization and not the other way around.(11) In the cases of British Steel and British Coal, however, the productivity gains have been very large.(12) The British experience, is not necessarily typical nor to be expected elsewhere. Britain at the height of its socialist experiment was largely a capitalist country. Also, its civil service tradition has long been far above average.

Perhaps a far better indication of what can be expected comes from an analysis of resource utilization in socialist countries compared with modern capitalist economies. From this we know that the same amounts of product can usually be produced in market economies with many fewer resources. The large state-owned ventures frequently consume resources that at market price have greater value than their output. This means the "value added" of these institutions is negative. This could not persist for long in market economies. Individual examples of dramatic production gains from the introduction of market mechanism are numerous. A good example is Krosno, a Soviet manufacturer of low voltage electrical goods as well as satellite dishes. In just one year after assuming control of the 1905 Revolution Plant, the joint stock company produces each month what it used to produce in a year under the old order.


The economic dislocations that have been taking place recently in the socialist countries are well known. GNP dropped 11 percent in 1990 and is expected to fall 14 percent this year in Bulgaria. The figures are 5.6 percent and 3.1 percent for Hungary, and 13 percent and .2 percent in Poland.(13) Similar or worse conditions exist elsewhere as prices are decontrolled and ventures must compete in broader markets. The immediate problem is that socialism, the system from which they are emerging, and the market economy are incompatible. Consequently, if severe hardship is to be avoided, the transition must be rapid. There are also powerful political reasons for speed. With every passing day, pressures for populist wage increases grow. Eventually they will be irresistible, especially with the democratic governments that are replacing totalitarian regimes. Strong leadership of the type provided by the Walesa government in Poland can hold back the tide for awhile but not forever. In addition, once the commitment to a market economy has been made, expectations about what this new system will be like will do a great deal to shape what emerges. In all probability only two or three years remain for most of the job to be done. The drastic changes in the Soviet Union also create an immediate opportunity for decisive action.


Many have taken the position that significant aid should not be extended until the commitment to reform is clear and the process is well underway. This approach may well be shortsighted, especially in the case of the former Soviet Union now that Communist reactionaries are on the run. If the governments of the republic or the central union fail to survive short-run shortages, control of some republics or the entire country may well revert to some type of hard-line conservatives or worse. The military cost of this to us would be enormous. We must not forget that there are nuclear warheads in some areas the former Soviet Union. Clearly, there are really two reasons for aid: (1) to keep the governments that are likely to undertake reform from falling prematurely; and (2) to help the process itself once underway. The amounts needed to accomplish this are small indeed compared with what we now spend on NATO and the outlays of $300 billion for defense overall. Total developmental aid by the West to all areas except East Germany is not expected to exceed $21 billion by 1995. This sum is ridiculously small considering what is at stake. Privatization will produce successful small business sectors all over Eastern Europe if not suppressed by oppressive central regions. The outcome with heavy industry is far less favorable. At best it will be a tedious, painful and long-drawn-out process. It may leave Eastern Europe as a "poor" capitalist area. The pain and disillusionment may herald the return of totalitarian systems, which may pose military as well as economic threats. Prudent well-directed developmental aid could well prove to be a monumental bargain.


(1)Borensztein, Edwardo and Kumar, M.S., "Proposals for Privatization in Eastern Europe," Staff Papers, IMF June 1991. (2)Rocha, Roberto de Regande, "Structured Adjustment and Inflation in Yugoslavia," World Bank EMTTF Division, May 1989, p. 6. (3)Saldasha, Fernando, "Interest Rate Subsidies and Monetization in Poland," World Bank EMTTF Division, April 1989, p. 2. (4)Rocha, op cit, p. 31. (5)Brainard, Lawrence J., "Reform in Eastern Europe Creating a Capital Market," Finance and the International Economy, Vol. 4, Oxford University Press, 1991. (6)"Poland Plant Sets Furlough," Wall Street Journal, July 1, 1991, p. 8. (7)Tardos, Marton, "Property Ownership," Eastern European Economics, Vol. 28, No. 3, Spring 1990, p. 15. (8)"Poland Unveils Privatization of 25% of Firms," Wall Street Journal, June 28, 1991, p. A8 and J. Sachs, The Margin, Fall, 1991, p. 10. (9)Borensztein and Kumar, op cit. (10)"IBM is Forming Totally-Owned Unit in U.S.S.R.," Wall Street Journal, June 18, 1991, p. A3. (11)Bishop, J.R. and Kay, J.A., "Privatization in the United Kingdom: Lessons from Experience," World Development, Vol. 17, No. 5, 1989, p. 653. (12)Vickers, John and Yarrow, George, "Economic Perspectives on Privatization," Journal of Economic Perspectives, Vol. 5, No. 2, Spring 1991, p. 125. (13)"Financing Eastern Europe. A Study Group Report," Group of Thirty, 1991.

Robert H. Wessel is a Professor in the Department of Economics, McMicken College of Arts and Sciences, University of Cincinnati, Cincinnati, OH.
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Author:Wessel, Robert H.
Publication:Business Economics
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Date:Jan 1, 1992
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