by
Johannes F. Linn
[The Brookings Institute]
posted July 27, 2005
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 Preface : |
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The following is a revised and abridged-for-posting version of Dr.
Johannes F. Linn's keynote speech given at the International
Symposium on "North Korean Development and International
Cooperation," held in Seoul, Korea on July 6-7, 2005.
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The Econometric Evidence
A plan for North Korean economic transition should start with a
review of the findings of the many economists who have tried to
explain with quantitative rigor the different transition
experiences in Central Europe and the Former Soviet Union. Central
Europe suffered a much shorter and shallower recession and a more
rapid recovery than the Commonwealth of Independent States (or
CIS). Economists have run increasingly sophisticated regressions
with observations for the countries in the region, trying to
isolate the factors explaining the different country performances.
The common format of their analysis is to relate differing initial
conditions and market reforms to economic growth.
Initial conditions consist of country characteristics at the start
of the transition. They include three broad sets of variables:
first, a country's economic structure, such as the extent of
industrialization and urbanization and the endowments of natural
resources and human capital; second, the macroeconomic situation,
including the extent of an overhang of monetary balances held by
the population, fiscal deficits and indebtedness; and third, the
institutions required for an effective market economy, including
well-developed goods and factor markets, a price system that
reflects economic costs, an effective legal and judicial system,
and the like.
Market reforms are usually separated into two sets of variables:
"Stage 1" reforms consist of macroeconomic stabilization, price
liberalization, the opening up to trade and the privatization of
small and medium-sized enterprises. These measures can generally
be taken relatively quickly early in the transition process. In
contrast, "stage 2" reforms take much longer, since they generally
require the creation of new institutional capacity with complex
transactions or politically difficult measures. They include the
introduction of enforceable property rights, the creation of an
effective legal and judicial system and public administration, the
development of competitive and robust enterprise and financial
sectors, the privatization of large and strategic companies, and
the creation of social safety nets. Additional factors judged
relevant by various analysts include such variables as progress
with political reform, the prevalence of conflict, the extent of
external financial support and the existence of a "political
umbrella" (such as the prospect of EU accession), and variables
reflecting distance from Western markets, such as the simple
measure of "distance from Dusseldorf."
What have been the results of these quantitative econometric
analyses? Broadly speaking, they conclude that initial conditions
matter -- that is, the greater the starting hurdles, the deeper
and longer the economic recession and the slower the recovery --
but that they matter less and less as time passes. Most analysts
also agree that the extent and speed of market reforms matter --
generally, the more and the faster the reforms, the quicker and
stronger is ultimately the recovery, even if the initial recession
may be deepened by a "shock therapy" approach to reform. But not
all analysts agree about the appropriate speed and sequencing of
reforms. Some argue that early reforms in Central Europe and the
Former Soviet Union erred by rushing too quickly into wholesale
"stage 1" reforms while neglecting "stage 2" reforms. They see
China as the prototype of a successful gradual reformer who
judiciously liberalized her economy while building the needed
institutional infrastructure. A related argument is around the
political economy of reform, with some advocating "shock therapy"
as a way to lock in political and economic reforms against
opposing interests, while others argue that gradual reform permits
a less painful and ultimately more sustainable gradual build-up of
economic and democratic institutions.
Three Transitions in One
The econometric analyses have by now largely exhausted the scope
for quantitative cross-country research. Their conclusion that
market reforms work overall is welcome, but the econometric
analysis fails to do justice to the dynamics, politics and
complexity of country experience. It does not reflect that the
transition in Europe and Central Asia was really three transitions
rolled into one: 1) a transition in the economic system -- from a
centrally planned command economy to a decentralized market
economy -- is what the econometric evidence mostly captures; 2) a
transition in the political system -- from the authoritarianism of
communism to various forms of more pluralist democratic
governance; and 3) a transition in the spatial dimension -- which
started with a disintegration of the highly integrated system of
economic links across the vast Soviet bloc economy, and was
followed in turn by an integration into the world economy.
Given the complexity of interactions between these three
dimensions, which seems to go beyond the capacity of econometric
evidence alone, it is useful to compare the experience of specific
countries and country groups to sort out how these various
dimensions of transition have interacted, together with different
initial conditions, in producing the actual transition experience
we have observed and to draw lessons from it.
Country Experience
I start with a look at the transition experience of the Central
European countries as compared with the CIS as a group. The
dramatic differences in economic trajectories post-1990 were due
to several factors. First of all, Central Europe benefited from
better initial conditions and suffered much less from the
disintegration of the economic space of the former Soviet bloc.
It also faced a much easier task of integrating with the rest of
the world, and in particular with Western Europe. Central Europe
also generally went through relatively quick and effective "stage
1" reforms, followed by more gradual and sustained "stage 2"
reforms. Political reform, which established quickly a democratic,
pluralistic, transparent, and accountable government, allowed for
a broad-based alliance of winners from reform and integration and
thus supported progress with "stage 2" reforms. Intensive
financial and technical support from the international financial
institutions (or IFIs) in the early years, and then increasingly
the political and financial umbrella of EU accession, were major
drivers of sustained reform. Two special features are worth
noting: first, substantial debt relief was granted early on in the
case of Poland, but not so in the case of Hungary; second, Central
European countries made great progress with enterprise and
financial sector reform. Some countries in Central Europe were
able to raise the share of small and medium-sized enterprises in
total employment. Another aspect of their success has been their
ability to attract large amounts of direct foreign investment.
The countries of the CIS, in addition to worse initial conditions,
faced a much stronger negative impact of disintegration. The
small new countries of the CIS were hit hardest. Their industries
and agriculture were cut off from supplies and markets. They
suffered from interruptions of transport links and their subsidies
from Moscow were cut off. They had to introduce new currencies
and new governmental structures and in many cases they experienced
civil war or cross-border conflict. In addition, with their land-
locked location and distance from markets, the small CIS countries
faced the greatest challenge of subsequent integration into the
world economy. The large CIS countries, Russia and Ukraine, also
encountered substantial problems of disintegration and subsequent
integration, but less so than their small neighbors, given their
size and access to external markets.
The CIS as a group also implemented slower or less effective
"stage 1" reforms, including poorer macroeconomic management, and
less effective and sustained "stage 2" reforms. Weak enterprise
and financial sector reform is reflected in the persistently low
share of small and medium-sized enterprises in the CIS, in high
capital flight -- on the order of $20 billion per year for Russia
in the 1990s -- and in low per capita foreign investment. By
assuming all the Soviet debt, Russia provided effective debt
relief to all the other CIS countries; but in many cases they
incurred new debt quickly due to depth of their recessions and
poor macroeconomic management. As a result, some of the poor
republics in Central Asia and the South Caucasus ended the first
decade of transition with high levels of external debt.
The weaker economic reform performance in the CIS can be explained
by the lack of an external political "umbrella" -- although
international financial institutions helped shore up the momentum
of reform -- and by weak domestic political institutions. The
demise of Communist Party control in the late 1980s had been a key
factor driving the disintegration of the Soviet Union. But then,
powerful special interests -- oligarchs, state enterprise managers,
or holdovers from the Communist "nomenclatura" -- managed to
undermine both the emergence of democratic institutions and
progress with economic reforms.
It is also necessary, then, to dig a little deeper into country-
specific experiences, beginning with the case of East Germany,
which may be of special relevance for the Korean situation. On
the positive side, East Germany was very quickly integrated with
the West German and European economies, following the
disappearance of the old borders and the immediate and wholesale
adoption of Western market institutions. It also received huge
financial transfers from the West -- about 50 billion dollars a
year -- and benefited from intensive technical and institutional
support. On the negative side, East Germany started from mediocre
initial conditions and was hurt by the separation from the Soviet
economic bloc, followed by the adoption of a joint currency at
unfavorable rates, an inflexible labor market and a poorly adapted
labor force, all of which created serious price and wage
distortions. As a result, East German economy experienced a
relatively steep initial decline, and the persistent distortions
left the East German economy not performing better than the
average Central European countries to the East, and less well than
the more successful among them, such as Poland. The unification
and transition process also left substantial psychological scars
on both sides of the former divide, which time has yet to heal.
Consider then the experience of the Western Balkans, and in
particular the countries of the former Yugoslavia. Despite
relatively favorable initial conditions, they, too, faced a deep
recession, due to the conflict-ridden disintegration of the
Federal Republic of Yugoslavia. The recovery which started
already after 1993 was fitful and slow however, because of the
continuing conflicts and the blockade of Serbia. The Balkan
countries were also burdened by high debts and by lingering
difficulties with implementing market reforms and institution
building. The intensive engagement by the EU and international
financial organizations after the Dayton Agreement in late-1995
was a factor that helped the recovery. The prospects for an
eventual membership in the EU also have become an anchor for more
intensive progress with reforms.
Interesting conclusions can be drawn from the comparison of the
transition in three small, poor countries: Albania, Georgia and
the Kyrgyz Republic. Albania experienced a brief and relatively
shallow recession, followed by a sustained recovery, while Georgia
especially, but also the Kyrgyz Republic, lost large shares of
their economies and recovered only slowly. What explains these
differences?
First, Albania: Although the country had very poor initial
conditions in terms of its extreme communist heritage, it did not
have to go through a disintegration. On the contrary, from a
highly isolated command economy the country quickly opened up and
transformed itself into an entrepreneurial, private sector-driven
market economy, albeit somewhat chaotic and with weak governance
and institutions. The country received a lot of support from the
international financial institutions and from the EU, but mostly
it benefited from its ability to integrate quickly with the
European economy. As a result of a low initial debt, rapid growth
and reasonable macroeconomic management, Albania retained a
relatively low level of external debt throughout.
Georgia and the Kyrgyz Republic, like other CIS countries, also
started with relatively poor initial conditions, but probably
somewhat better than those of Albania. What really hurt both
countries severely were the economic disintegration of the Soviet
Union, the severe civil conflict in the case of Georgia, and the
extraordinary difficulties of gaining access to markets in the
case of Kyrgyz Republic, due to its land-locked situation. Both
countries had a reasonable reform record and benefited from
substantial IFI support, but neither enjoyed the political anchor
of the hope of one day joining the EU. Add to that weak
institutions and initially poor macroeconomic management and these
two countries became mired in debt, although they started out with
no debt to speak of.
Finally, I should briefly compare the experience of Russia and
China. Joseph Stiglitz compared the two in a well-known article
from 1999, in which he compared the rapid economic growth of China
with the seemingly inexorable decline of Russia from 1989 through
1997. Stiglitz attributed the dramatic difference between the two
trajectories basically to the failures of Russian reformers and
their external advisers. He particularly blamed an excessive
speed of liberalization and privatization and a neglect of the
need to build the necessary institutional capacities of a market
economy. Leaving aside the eventual strong recovery of Russia, I
believe the reasons for the early and protracted decline are more
complex than Stiglitz allows.
First, Russia was characterized by bad initial conditions,
including a strict command economy, a
large state-owned enterprise sector, little agriculture, and a
huge military-industrial complex. Second, it was severely hit by
the political and economic disintegration of the Soviet Union,
which not only created many disruptions in the traditional
economic links across the Soviet economic space, but also made it
impossible to consider a gradual process of liberalization, a
process that would have required continued strict political
control. Third, Russia was hit by a severe oil price collapse
with global oil prices reaching a long-time nadir in 1998.
Finally, rather than being the poster child of "shock therapy,"
Russia actually was not able to carry through aggressive and
systematic reforms during the 1990s. Its reforms were halting and
partial and were undermined by sustained fiscal deficits and
rising debts, all of which culminated in the financial crisis of
1998.
China, in contrast, had better initial conditions, including a
less strict command economy, a smaller state-owned enterprise
sector, and a large agricultural sector. Moreover, it was able to
retain political control over its entire territory and its reform
process. This meant that China could avoid the disintegration
process that so badly hurt the countries of the former Soviet
Union and was able to pursue a gradual, but deliberate reform
course. This course included prudent macroeconomic policy, the
use of a two-tier pricing system, effective agricultural
liberalization, and the unleashing of its entrepreneurial
potential through the system of semi-private township and village
enterprises. In addition, China rapidly integrated itself into
the world economy with an export oriented strategy and welcoming
the large inflow of expatriate capital from its overseas Chinese
communities.
Lesson 1
Initial conditions matter, especially in the early years of
transition, but they do not determine the ultimate success or
failure. Among the key initial conditions are the following: 1)
the depth of the command system and the institutional "memory" of
prior experience with the market system -- the more extreme the
command system and the less "memory," the more difficult will be
the transition; 2) the economic structure at the start of the
transition -- a large state-owned industrial sector, a small
agricultural reserve, and a large military complex will make the
transition more painful; 3) the distance to major world markets --
ease of access to world markets will facilitate integration into
the world economy, which is a key to successful transition; 4)
natural and human resource endowments -- oil and gas wealth can
help or hurt, depending on their prices and on how the resources
are used, and a highly educated and healthy population makes the
transition easier; 5) the macroeconomic situation -- high initial
macro-imbalances and debt can be serious burdens.
Initial conditions can help or harm, but they do not condemn to
failure, as the Albania case has demonstrated; nor do they ensure
success, as the case of the former Yugoslavia has shown. Much
depends on what happens as the transition process unfolds, which
brings us to Lesson 2.
Lesson 2
Content, pace, and sequencing of market reforms matters. Here,
key dimensions need to be borne in mind as one plans for and
implements transition reforms. First, macroeconomic stability is
essential throughout the transition -- inflation undermines the
recovery and high fiscal deficits will create unsustainable debt
and financial crisis, as in the case of Russia and the highly
indebted poor CIS countries. Second, rapid stage 1 reforms cause
short-term disruptions, but permit rapid recovery later, as shown
by the case of Poland and the Baltics. Third, gradual stage 1
reforms also can succeed, but they require strong political
control, careful design and lasting commitment, as shown in the
case of China; the risk is that they can easily lead to corruption
and get derailed by countervailing interests, as in the case of
Russia and other CIS countries. Fourth, steady and sustained
stage 2 reforms are necessary under all circumstances to build
market institutions and social infrastructure; these reforms need
to start early and take time. Fifth and finally, a systematic
misalignment of prices and wages and inflexible market structures
can negate the benefits of integration and institutional
improvements, as the case of East Germany has demonstrated.
So far these first two are more-or-less standard lessons. I,
however, will add three more.
Lesson 3
The process of disintegration and integration matters. The
experience demonstrates that it matters whether or not a country
disintegrates as part of the transition process, and how it
integrates into the world economy during the process of transition.
For instance, economic disintegration was a major cause of initial
decline in Central Europe and the CIS. In addition, economic
integration matters for rapid, and sustained recovery is much more
difficult for land-locked countries distant from major markets
than for countries with good market access; the transition
countries and the international community can help with policies
that facilitate the integration process. Furthermore, political
disintegration makes gradual economic reform very difficult, as
the case of Russia has shown, and it can create conflict, as in
the case of the Balkans, the South Caucasus, and Tajikistan.
Lesson 4
The politics of transition are key. Managing the transition is
not just a matter of good economic and institutional design.
Understanding and managing the politics of transition are as
important. This means that reformers must consider explicitly who
are the winners and losers from the transition; the presence of
social safety nets for those negatively affected helps in managing
the politics of transition. Experience also shows that in the
short to medium term, political control helps with orderly
economic transition and allows gradual reforms, as in the case of
China, and in some CIS countries with authoritarian regimes. But
in the medium to longer term, concentration of economic and
political control risks the emergence of entrenched, non-
transparent, unaccountable, special interest-driven political
control; this in turn results in poor governance and high
corruption, and a great potential for political and economic
instability. The recent developments in the Central Asian CIS
countries vividly demonstrate this risk.
Lesson 5
External financial and political support can help, but it is no
panacea. The transition process brings with it substantial
transition costs and uncertainties. External financial and
technical support can cushion the costs and can serve as a
commitment mechanism, if it is conditioned on effective reform, as
was the case in Central Europe, the Baltics, and in Albania.
However, external support can also result in uncoordinated
assistance and advice, and heavy debt burdens, as has been the
case in some of the poorer CIS countries.
It is also important to note that the EU accession "umbrella" has
served as an important political commitment mechanism and as a
source of financial support, but such can also impose
inappropriate rigidities in labor markets, in tax and regulatory
systems, and in social security systems. The current efforts by
the new Central European EU members to achieve flexible market
conditions certainly go in the right direction.
Finally, the German experience shows that the combination of
transition and unification is an immensely complex economic,
institutional, political and even psychological process that
requires much careful planning, as well as patient and sensitive
implementation.
Conclusion
The bad news is that there is no blueprint, no single set of
necessary and sufficient conditions for success. Much depends on
the specific country conditions and on a complex interplay of
political and economic variables. Also, political and economic
disintegration, if they occur along with the transition, will make
the process much more difficult to manage.
The good news is that there are some key common elements to
success. In the short to medium term, prevention of conflict,
maintaining macro stability, elimination of major price
distortions, and creating space for entrepreneurial activity in
small and medium-sized firms will help tremendously. Maintaining
basic social services and social safety nets and avoiding the
concentration of too much political and economic power are
important ingredients to create the political underpinning for
sustained reforms. In the medium to longer term, it is necessary
to develop effective public institutions. This includes effective
public administration and judicial systems, a transparent and
accountable political system, a sound investment climate and
financial sector, and the maintenance of flexible market
structures with sound corporate governance.
The international community and the immediate neighbors can play a
key role in helping a transition country in the overlapping
processes of transition and integration, which ultimately need to
go hand in hand for lasting success. It is my hope and optimistic
expectation that the Korean people will achieve such a success.
References
Campos, Nauro F. and Fabrizio Coricelli. "Growth in Transition:
What We Know, What We Don't, and What We Should." Journal of
Economic Literature 40 (September 2002): 793-836.
EBRD. Transition Report 2004. London: European Bank for
Reconstruction and Development, 2004.
Fischer, Stanley, Ratna Sahay and Carlos A. Vegh. "From Transition
to Market: Evidence and Growth Prospects." Working Paper 98/52.
International Monetary Fund, April 1998.
Havrylyshyn, Oleh. "Recovery and Growth in Transition: A Decade of
Evidence." IMF Staff Paper 48. The International Monetary Fund,
Special Issue, 2001: 53-87.
Linn, Johannes F. Transition Years?Reflections on Economic Reform
and Social Change in Europe and Central Asia. Washington, D.C.:
The World Bank, 2004.
Linn, Johannes F. "Economic (Dis)Integration Matters: The Soviet
Collapse Revisited." Paper presented at a conference on
"Transition in the CIS: Achievements and Challenges" at the
Academy for National Economy, Moscow, September 13-14, 2004.
Stiglitz, Joseph E. "Whither Reform? Ten Years of the
Transition." Keynote Address at the World Bank Annual Bank
Conference on Development Economics. Washington D.C.: World Bank,
April 28-30, 1999.
World Bank. Transition: The First Ten Years: Analysis and Lessons
for Eastern Europe and the Former Soviet Union. Washington, D.C.:
The World Bank, 2002.
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