Research Paper On The Neo-Classical Economic Reform In The World Today – Shock Therapy
In the 20th century, most of the world's nations tried to create prosperity through government control of their economies, such as the totalitarian central planning of the communist world and nationalizing industries. However, those policies began to fail dramatically in the 1980s, and new leaders embraced the idea of “shock therapy” to converse to free-market capitalism. This essay exampled the collapse of the Soviet Union and its economic system transition, Chinese reform, Bolivia and Chile’s economic reform, shock therapy in Poland, and explained if the agony worth the reform and what economic policy should be adopted.
The Collapse of the Soviet Union
The Soviet system of central planning meant that the central government controlled every aspect of the economy. The aim was to make the Soviet Union self-sufficient. But it stressed so much importance on the heavy industry and light industry development and agriculture were backward. After then, the Communist administration reported that the economy was growing. It was not the case, because the economy started to drop down all the time, and the deficit was covered only with the help of the oil prices. Under socialism system, the people had no incentives to work, which caused the stagnate of economy. What’s worse, oil prices fell in 1986 and all possibilities to generate revenue crumbled. Additionally, the Soviet Union spent at least 50% of its economy on the military. These all lead to the collapse of the former Soviet Union’s economic system.
Russian Economy transition
Boris Yeltsin became Russia’s first elected president in June of 1991. Right away, he began implementing a number of radical economic reforms including mass privatization, price liberalization, and stabilization of the ruble known as a 'shock therapy'. There is much pain in transforming into the market system. First of all, the policies fueled inflation. The removal of Soviet price control even resulted in hyperinflation. The price of consumer goods increased dramatically and shortages of basic items were common. In response, the government printed more money, leading to further inflation. Secondly, many state-owned industries were auctioned off at low prices to investors, allowing a class of business owners to accrue large profits. A class of business owners known as oligarchs were therefore created and they were influential in politics and many had connections to organized crime groups. Under the government's cover, outrageous financial manipulations were performed that enriched a narrow group of individuals at key positions of business and government. Many of them promptly invested their wealth abroad producing an enormous capital flight. Finally, real GDP falling by more than 40% by 1999, and hyperinflation which wiped out personal savings; crime and destitution spreading rapidly. By the way, difficulties in collecting government revenues amid the collapsing economy and a dependence on short term borrowing to finance budget deficits led to the 1998 Russian financial crisis.
Chinese Reform
Russia suffered a lot from a “shock therapy” and Russia could not use “gradualism” approach that China used to reform. The Chinese decided to keep the political system of communism, but to get rid of the economic system called communism and go towards market socialism. With that, China kept political control, but also had the benefits of the marketplace. For Russia, it was an 80 percent urbanized, heavy-industrialized economy, whereas China was a peasant economy with 80 percent of the population in rural areas. In Russia, the non-state sector was 1 percent. The initial conditions were one of the deterministic factors for the decision on reform strategy. In China, the problem was with the economy and policies. There was no need to change the government but the managing style of the economy. But in Russia the main problem was the corrupted government and state authorities. At the last years of USSR government tried to 12 follow China’s strategy but was not successful at all. So, it was not considered to be impossible to carry gradual economic reform strategy in Russia and government had to be replaced. Other than that, as mentioned before, initial conditions in China can be characterized with very poor economy and people with very low expectations about life. It was easy to carry reforms with them opposed to Russian people who had much higher life standards and would oppose any policy that would make them worse off. It is easier to start from nothing and have a high growth rather than having a problematic economy which has come a long way during more than 70 years. Russia could not get to the core of the inflation problem without addressing the industrial core of the system. Gorbachev got stuck with economic reform, and he never touched the foundation of the planned economy.
Economic Reform of Bolivia and Chile
Many other countries in the world who adopted “shock therapy” also suffered long-term or short-term sufferings, however, these costs are necessary. For example, Bolivia was one of the poorest countries in Latin America and it was the seventh highest inflation in the history of man. For Bolivians, inflation jumped to triple digits in 1982 and quadruple figures in 1984. The root of the problem was government finances. The government was spending 30 times more than it received in taxes. However, in August 1985, Goni went public with a program called 'shock therapy.' Shock therapy spelled the death of “dependency theory”; government spending was slashed; price controls were scrapped; Import tariffs were cut; government budgets were balanced. By proceeding the “shock therapy”, the prices of essentials-transport, food, fuel-all shot up. The unemployment rate had risen steadily from 5.5 percent in 1978 to 20 percent in 1986. However, in the short term, the decree smothered hyperinflation. Within a few months, inflation had dropped to between 10 and 20 percent.
Chile's inflation was at 150% in 1972 (2001). Factors such as expropriations, price controls, and protectionism caused these economic problems. A large group of Chilean economists who collectively came to be known as the Chicago Boys, having studied at the University of Chicago where Friedman taught, applied great effects of the economic policies. The economic reforms implemented by the Chicago Boys had three main objectives: economic liberalization, privatization of state-owned companies, and stabilization of inflation. Central to its policies was the idea of import substitution industrialization (ISI), an approach aims to replace the import of goods by domestic products, therefore protecting domestic industry, strongly intervening in the market through exchange rates and fiscal measures and reducing a country’s dependence on foreign trade. The Chilean economy did very well, but more important, in the end, the Chilean military junta was replaced by a democratic society. Free markets did work their way in bringing about a free society. However, unemployment increased to over 25 percent in 1976, real wages and aggregated domestic demand dropped and income equality deteriorated. The inhuman conditions under which a high percentage of the Chilean population lives is reflected most dramatically by substantial increases in malnutrition, infant mortality and the appearance of thousands of beggars on the streets of Chilean cities. It forms a picture of hunger and deprivation never seen before in Chile. According to the Chicago Boys, the gain was worth the pain. Chile became the fastest growing economy in Latin America.
Shock treatment means you have a very sick patient and you have to operate before the patient dies. You have to get cancer out, or you have to stop the infection. That's why economists coined the phrase that inflation is like a tiger and you have only one shot; if you don't get it with that one shot, it'll get you. You have a credibility that you have to achieve. If you keep to gradualism, people don't believe you, and the hyperinflation just keeps roaring stronger. So shock therapy is getting it over, get it done, stop hyperinflation, and then start rebuilding your economy so you achieve growth.
“Shock Therapy” in Poland
Poland’s transition to the market economy after its political liberalization in 1989 is generally regarded as one of the most successful transitions of all post-Soviet economies. This success is commonly attributed to “shock therapy,” a drastic neoliberal package of liberalizing economic reforms that Poland quickly adopted as it emerged from Soviet domination. Shock therapy was successful because it was the right policy set at the right time for Poland. Shock therapy’s wide package of social and economic reform came at a considerable short-term cost. Income levels fell, unemployment rose, and national output and inflation levels all suffered. Rising unemployment was one of the most obvious costs of Poland’s economic reforms, with unemployment reaching 11 percent in 1991. Additionally, many of the state-owned enterprises’ inefficiencies had been hidden by the central planning quotas that provided an artificial demand for their goods; liberalization removed this market and revealed their inability to compete in an open economy. These losses, combined with rising energy costs sparked by the end of Soviet energy subsidies, led to the failure of many obsolete state-owned enterprises. Poland’s levels of economic output fell sharply in the years immediately following economic reform. Despite short-term costs, Shock therapy’s introduction of a stable, convertible currency, control of inflation, encouragement of private industry and foreign investment and trade all contributed to economic activity which in turn stimulated job creation and rising incomes. There can be no doubt that Poland greatly benefited from its transition to a market economy, and shock therapy was successful. Poland’s successful experience with shock therapy is not a replicable model for the former Warsaw Pact countries.
The Balcerowicz Plan achieved such long-term success because Poland was fundamentally a developed nation circumvented by mismanagement and oppression; shock therapy merely removed these obstructive economic and political structures. Prior to Soviet domination, Poland was a democratic, market orientated European nation. Furthermore, Poland did emerge from the shadow of the USSR with valuable assets: developed infrastructure, an educated and industrially skilled workforce and established, though largely inept, social and governmental institutions. The fact that Poland already possessed the basic capital needed to compete in a global economy eased its transition into the free market. Many developing nations, especially those without an industrial past or tradition of democracy, have none of these assets, particularly the human capital so necessary for success in an open economy. Additionally, Poland benefited from its geographic proximity to one of the world’s biggest markets and centers of economic activity, a location that guaranteed a rapid flow of capital, investment, and trade. Unfortunately, most of the Eastern European Communist nations aren’t so lucky. While economic liberalization and democratization can be a pathway to development, Poland is not the standard by which developmental success should be judged, but should rather be viewed as an extraordinary exception. Ultimately, the liberal model prescribed by shock therapy is helpful, but meaningful long-term growth rests more on geographic and institutional factors than immediate macroeconomic policy.
Conclusion
The dominant method of neo-classical economic reform in the world today – shock therapy, though worth the agony, creates institutional problems for new democracies. It is more than the specific set of economic measures summed up in the slogan 'stabilization, liberalization, privatization.' As Jeffrey Sachs has explained, and as the experiences of countries that have undergone it affirm, shock therapy includes a political strategy for implementing radical economic measures. This strategy emphasizes the speed in pushing reform through a 'window of opportunity' created by extraordinary political events. It suggests that reformers be isolated from political pressures during the planning and implementation of their program and be granted the power of decree when necessary to overcome opposition by entrenched interest groups, like Chile. This lack of accountability is thought to enable shock therapy reformers to impose socially-optimal policies more effectively than normal democratic procedures. Otherwise, special interest groups linked to the old system could use democratic institutions cynically to undermine reform. Therefore, apart from the ethical issues, shock therapy may simply be politically infeasible, then gradualism is a sensible policy alternative: it achieves the same goal in the long run – the elimination of the inherited distortions – but does so in a fashion which wins over the dissenters to shock therapy.
References
- “Americas | Pinochet's Rule: Repression and Economic Success.” BBC News, BBC, 7 Jan. 2001, http://news.bbc.co.uk/2/hi/americas/63821.stm.
- Belka, Marek and Stefan Krajewski. 1995. “Polish Transformation After 5 Years- Some General Remarks.” In Economic Transformation in Poland: Reforms of Institutional Settings and Macroeconomic Performance, ed. Marek Belka and Hans-Georg Petersen. New York: Campus Verlag.
- Poznanski, Kazimierz Z. 1996. Poland’s Protracted Transition: Institutional Change and Economic Growth 1970-1994.
- Cambridge, UK: Cambridge University Press.
