The transition process in Central and Eastern Europe can be easily described as the substitution of State property with private one through market mechanisms. But even the shock therapy approach hides the complexity of the real transition process: a drastic macroeconomic stabilization, through fiscal and monetary vinculums; market deregulation and liberalization to keep prices at a market level; the openness of the economy to trade and capital flows. In effect, these strategies created some controversies, generated by some unexpected consequences: the decrease in the level of production; the profound divergence between the economic performances of Central Europe and Baltics on one side, and CIS Countries on the other side; the rise of crime organizations; the Chinese and the Asian Tigers’ miracle in the last twenty years. On the contrary, an institutional approach suggests gradually developing adequate institutions in order to sustain the market economy. It focuses on the creation of a juridical environment for enterprises; the rule of law and property rights; political stability; the development of a net of enterprises within markets; the building of strong trade relations in the long run. In order to reach efficient institution development in the transition economies, a high-level juridical system, an equal and transparent fiscal system, and political stability are highly required. And all the main institutional changes concerning: governance, the enterprises’ restructuration, and the reform of the financial sector.
After 1989, the Baltic States, such as the other Central and East European Countries, represented a testing ground for the Neoliberal economic reforms at the heart of Communism.
First of all, it was noticed that Communist enterprises were often run by capable people who struggled with serious structural problems: their production levels and prices were dictated by the central planning office, while the government ministry to whom they belonged frequently took their profits in order to reallocate them to less efficient businesses. In effect, finances were allocated by the State, production inputs often did not arrive on time, neither with sufficient quantity nor quality: in so doing, most of the workers couldn’t be highly motivated either.
When Communism collapsed in 1989, a debate broke out over the best way to transform centrally planned economies in Central and Eastern Europe: radicals believed in a sudden jump to the market economy, while gradualists believed that shock transformation would cause too much social dislocation, increasing inequality among economic sectors and population. A radical approach to the transition risked a sharp economic decline because the old system would stop operating effectively in the absence of subsidies, government spending, and fixed prices. Unemployment would rise, but the implementation of a rapid privatization process would result in the emergence of a new private sector: transferring and allocating assets among those firms that could use them most efficiently. The whole production level would increase, while new technologies and know-how would flow over the frontiers, and both growth and consumption would rise. In Neoliberals’ higher expectations, radical reforms could be painful for the population but would work faster, while gradual reforms might cause less pain, thus resulting in slower and less efficient growth as well.
In the Baltic States, authorities imposed shock programs of economic reform, including tight monetary austerity, removal of subsidies, rapid privatization, and liberalization of trade and investments. This bankrupted thousands of companies that were oriented to the Soviet and the COMECON markets and forced companies to compete with Western firms, their experience, and technology. In so doing, liberalization and privatization created opportunities for new businesses, where the demand had been depressed for so many years.
At the beginning of the economic transition, FDI to Baltic Countries was attracted by the availability of low-cost resources, in particular, a qualified and relatively cheap labor force in labor-intensive industries, like food, wood, and textile products, while the privatization of public utilities (e.g. telecommunications) and the liberalization of the banking sector, in addition to the strategic geographical location, attracted more efficiency-seeking FDI, in particular in trade and logistics. The FDI inflows can be considered as the net flows of equity capital, reinvested earnings, and other capital, mainly inter-company loans: equity capital and reinvested earnings are indicators of one Country’s attractiveness for foreign investors, while inter-company loans depend on the internal decisions of a corporation (e.g. in Latvia foreign banks made sizeable loan repayments to their parent companies in 2001, which resulted in a considerable drop of FDI). FDI inflows in Latvia and Lithuania have been dominated by equity capital, mostly in the form of acquisitions or greenfield investments, while Estonia had a higher share of reinvested earnings, thanks to the reform of the corporate tax system in the year 2000 when the tax rate on reinvested earnings was brought down to zero. In addition to the competitive advantage in democratic implementation, Estonia succeeded also in the progress towards control over corruption more than its neighbors.
But as a result of the deregulation of prices and the accumulated distortions in the industrial structure during the period of central planning, and the collapse of state institutions during the transition period, the structural reforms in the Baltic States caused a heavy and predictable transitional recession that these economies struggled to exit for more than one decade. This increased the poverty and mortality rates (especially in Latvia and Lithuania), while the fertility rates declined dramatically. Men’s population, in particular, suffered the most: losing their jobs, struggling to reconvert to new skills and industries, and no longer being able to feed their families, many refuged themselves into alcohol.
The supporters of Neoliberal reforms asses that shock therapy, despite the high costs for the population, had no alternatives: slower reforms would only empower Communist and bureaucratic elites into keeping these Countries in a “partial-reform equilibrium, where the average person would suffer”. Moreover, the EU membership gave to Baltic States enormous growth prospects by making their markets and trade relations much more efficient and secure: in 2007, before the explosion of the financial and debt crisis, the worst-off East European Countries were the ones that failed the accession to the EU or were lying on a situation of civil strife.
According to the market advocates, the transformation from a centrally-planned economy to the capitalistic one leads to an increase in the effectiveness and willingness of individuals and social groups to cooperate, and at that point, people will be ready for life-long learning and competing with each other: that’s why it’s important to adapt the institutional system to the technological and demographical changes, realizing the historical and cultural background where each economic system is based on. This means that the implementation of new political rules is strictly connected to the changes of both formal institutions, represented by the legal norms, and the informal ones, which include customs and mentality: in order to make a State function, then efficient, formal and informal institutions have to be in harmony with each other. If the formal rules correspond to the informal ones, they have the tendency to consolidate, and that leads to a reduction in the transaction costs related to the establishment and maintenance of the system, because “the smaller the conflict between the rules of capitalism and the mentality of society, the lower the transaction costs and the higher the efficiency of the economy”.
From that perspective, one social group can be described as a voluntary contract concluded by people who have rationally calculated that will be more profitable to achieve their own goals through cooperation. The systemic transformation in Baltic economies gave the groups of interest many opportunities, and many tried to improve their status, through rent-seeking. This has been extremely dangerous and inefficient, taking the whole region to a sub-optimal equilibrium during the years of the transformational recession. The only way to eliminate the perverted action of lobbies is represented by limiting state control to the minimum and increasing cooperation with foreign countries, improving information flows, and transparency, and stabilizing the concept of subsidiarity as the main system of governance. And these institutional changes can be strongly consolidated only through a major economic integration: by this point of view, Estonia, Latvia, and Lithuania, together with the Central and East European countries that joined the EU, performed much better than the CIS ones in both economic and social terms.
An analysis of the transformational changes in Baltic economies can’t miss the relationship between democratic institutions and economic growth. But does it exist? And if so, is it a positive one?
On one hand, democracy makes pressure on immediate consumption, reducing investments, and “only states that are institutionally insulated from such pressures can resist them, and democratic states are not”. In effect, one of the keys to the brilliant economic performance of the Asian Tigers is represented by the capacity of these Countries to pursue growth policies through their “insulation” from particularistic pressures. “When the state becomes permeated by private pressures, policies lose internal coherence”: groups of interests compete for rents, through the maximization between benefits and costs of lobbying, resulting in a sub-optimal equilibrium since a certain amount of factors is wasted, generating losses for the whole system. Hence it seems that only if democracy is characterized by transparent information among citizens, perfect competition among parties, and an optimal macroeconomic agenda, it will be able to provide law, order, defense to the private property and the contracts from external threats, and to complete those production inputs that cannot be efficiently supplied by the market. But history shows that perfection exists only in textbooks.
On the other hand, there’s no evidence that authoritarian rulers have any interest in the maximization of total output and the population’s well-being. Groups of interests and lobbies have always existed since power and inequality characterizes human qualities and relations. The only way to lead them to efficient goals that involve the whole society comes from the limitation of both the perverted action of lobbies and the state control, in favor of openness and cooperation with foreign countries, increasing information flows, transparency, and stabilizing the concept of subsidiarity (any kind of decision must be taken at the level of the population involved) as the main system of governance, whatever the political system.
It’s important to understand the profound consequences implied for the political and economic environment in Europe: in effect, nowadays many officials express doubts about the results obtained. Even the EBRD has recognized the difficulties in the simultaneous implementation of both economic liberalization and a shock political agenda.
China, which can be taken as a comparative example of the systemic transformation that took an agricultural country to become one of the most successful export-oriented economies in the world, learned from the inefficient experience of the Cultural Revolution in the middle of the Twentieth Century and decided to base its transition economy on its political and social institutions. The Chinese way to the market economy was possible thanks to a gradual political process, characterized by incremental pragmatism. Europe rejected the incremental reforms: their main critics feared the re-affirmation of the same groups of interests, without any definitive break from the past political and bureaucratic lobbies.