Over the past century, economists and other intellectuals have produced an enormous amount of literature on how to convert capitalist market economies into socialist centrally planned ones.  Among the better known contributors to it are Sidney and Beatrice Webb, Oskar Lange, Abba Lerner, Joan Robinson, Nicholas Kaldor, Paul Sweezy, Wassily Leontief, and J.K. Galbraith; but there are many, many others.

It is ironic that the reverse problem of converting socialist economies into capitalist ones has received scant attention.  The writings of Friedrich Hayek, Joseph Schumpeter, Milton Friedman, and P.T. Bauer are partial exceptions, but their focus has usually been elsewhere: namely, exposing the errors made by the advocates of socialism rather than charting the transformation.  Hence, there is no general theory to draw on in addressing the crucial economic policy problem of the 1990s: how to transform command economies into market economies.

Recognition of the failures of command economies and the need to transform them is the reason the rhetoric of "markets" and "marketizing" is fashionable in the 1990s.  But the unanimity and ubiquity with which markets are advocated--in the Soviet Union, Eastern Europe, China, and the Third World--obscure the profound divergences about what the terms mean and what they imply for transforming command economies into market-oriented ones.  These divergences are latent in such frequently used oxymorons as "market socialism" (a term invented by the Hungarian economist, Janos Kornai, but subsequently rejected by him), "regulated socialist markets" (a term favored periodically by Gorbachev and certain "conservative" Soviet economists), and what some Chinese leaders envisage as a system between capitalism and socialism which they describe as "socialism with Chinese characteristics."

The underlying disagreements concern the details about transforming command systems into market systems.  In this case, as in others, the details are crucial.  They relate to whether markets should be "free" or "regulated," competitive or "social"; whether the market's intended reach should be extensive and predominant, or partial and limited; whether transformation should be rapid or gradual; whether the emergent system should be open to international competition, allowing free movement of capital and commodities, or protected from it; and finally, whether the scope of the government sector, at the end of the process, should be extensive, or narrowly circumscribed.

That these divergences are so deep is not surprising.  The rhetoric of markets and marketizing has been adopted by a remarkably diverse group of advocates, including Communists, ex-Communists, erstwhile central planners, Social Democrats, "liberals," and "radicals," as well as new and aspiring entrepreneurs in the transforming command economies.  The advocates also include an ideologically mixed set of experts, advisers, consultants, and commentators in the West, including some--like Jacques Delors, secretary general of the European Community, and Jacques Attali, head of the new Bank for European Reconstruction and Development--who have until recently favored transformation of capitalist economies into socialist ones.

As a result of this diversity of views and viewers, the ensuing policy debate has often been muddled, the essentials of the transformation process frequently misunderstood, and its costs generally exaggerated.  Indeed, transforming command economies into market ones, although a challenging problem, is more tractable, and the costs and "pain" of the transition should be considerably less than much of the debate has implied--provided the transformation is pursued comprehensively and aggressively.

Transformation as a Systems Problem

The generic problems of transformation are essentially the same whether the locale is the Soviet Union, Eastern Europe, China, or any one of the centrally controlled economies of the Third World.  To be sure, there are differences in historical circumstances, cultural affinities, institutional antecedents, and the existing physical, social, and political infrastructures.  But the differences, while important, are incidental to an essentially similar task.  Transformation depends on implementing simultaneously, or at least contemporaneously, a package of six closely linked and mutually supporting elements:

-- Monetary reform to ensure control of the money supply and credit;

-- Fiscal control to assure budgetary balance and to limit monetization of a budget deficit if one occurs;

-- Price and wage deregulation to link prices and wages to costs and productivity, respectively;

-- Privatization, legal protection of property rights, and the break-up of state monopolies to provide for competition as well as worker and management incentives that reflect changes in relative market prices;

-- A social "safety net" to protect those who may become unemployed as transformation proceeds; and

--Currency convertibility to link the transforming economy to the world economy and to competition in international markets.

The first two elements (monetary reform and fiscal control) and the fifth (the social safety net) create the broad macroeconomic environment that enables the incentive mechanisms of the other three to move resources toward more efficient and growth-promoting uses.  The government's role is both crucial and paradoxical: crucial in initiating all of the elements, yet paradoxical because the process that the government initiates is intended to diminish its ensuing role, displace its overextended functions, and reduce its size in favor of market mechanisms.

Each of the six elements is less likely to be effective without the reciprocal support provided by the others.  Hence, attempts to reform non-market economies by piecemeal steps are more likely to founder than to succeed.

Consider, for example, the link between the first two elements.  Monetary reform is necessary to limit growth of the money supply to a rate that accords with the growth of real output.  It is also a necessary means of providing access to credit on the basis of borrowers' economic capabilities and their associated risks, rather than on the basis of their political connections or credentials.  A competent entrepreneur with a good idea should be able to obtain credit not available to someone whose principal distinction is membership in the governing political party or kinship to a government official.

Fiscal reform requires a budget process that constrains government expenditures to a level close to revenues, and precludes or limits "off-budget" subsidies and other transactions that would disrupt monetary discipline, as well as budgetary balance.  Recourse to extra-budgetary subsidies to bail out deficit-ridden state enterprises has been standard procedure in the Soviet Union, China, and other command economies.  Fiscal and monetary reform should preclude its recurrence.  Usually, the complementarity between monetary and fiscal reform is facilitated by institutional separation between the finance ministry (or treasury), and the central bank or banking system.

In turn, the third element--deregulation of prices and wages--requires monetary and fiscal restraint if prices and wages are to be linked to real costs and productivity, while avoiding general inflation.  Goods that are in short supply or are costly to produce should experience price increases relative to those that are more abundant and less costly.  In turn, these price increases provide signals and incentives for increased and more efficient production.  Similarly, wages paid for more productive labor and skills should be expected to rise relative to those that are less productive.  The newly established parities among costs and prices should operate in the public sector as well as the private sector.

For deregulation of prices and wages to promote efficient use of resources, the fourth element--privatization, legal protection of property rights, and the break-up of state monopolies into competing entities--must be implemented at the same time.  This requires an appropriate legal code and appropriate procedures for resolving disputes over property transactions and acquisitions, as well as litigation associated with prior ownership claims.  It also requires a choice among several ways of changing from state ownership to private ownership--an issue about which there is considerable controversy among policy-makers, economists, lawyers, and financiers.

For example, equity shares in state enterprises can be issued to workers and management, while reserving some of the shares for local government and foreign investors (resale of the shares with or without a specified holding period can also be invoked).  This method, favored by Paul Craig Roberts among others, has the advantage of simplicity and clarity; its putative disadvantage is the ostensible unfairness of a process in which some of the new shareholders would be losers while others would realize gains, due in both cases to the arbitrary circumstance of where they had been previously employed.

Another mode of privatization is to issue enterprise shares to the general public on a random basis rather than determining enterprise ownership on the basis of employment.  In this case, everyone has an equal chance of picking a winner or loser among the hundreds or thousands of state enterprises that typically exist in command economies.  Windfall gains that result from a random process are, it can be argued, more equitable than those that result from the accident of prior employment.

Perhaps the simplest method of privatization is to auction enterprises to the highest bidder--limiting or excluding participation by non-nationals.  This method, favored by Czechoslovakian economist (and Finance Minister) Vaclav Klaus and others, has sometimes been criticized on the grounds that those most likely to have ample funds to win the bidding are black marketeers and former Communist Party nomenklatura.

Still another method is to issue public vouchers representing potential claims on the shares of enterprises to be privatized.  Foreign bankers or mutual fund managers would be invited to bid for the public vouchers.  The public would then trade their vouchers in return for shares in the mutual funds that appealed to them.  Variants of this method of privatization have been advanced by Jeffrey Sachs and several Polish economists.

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