The Heritage Foundation

Backgrounder #796 on Europe

November 13, 1990

November 13, 1990 | Backgrounder on Europe

Yellow Light for Eastern Europe: Beware Four Economic DevelopmentMyths

(Archived document, may contain errors)

796 November 13,1990 YEIXQW LIGHT FOR EASIERN ENROPE BEWARl3 FouREcoNoMlC DEVEIDPMENT MYTHS INTRODUCI'ION Socialism has left Eastern Europe in economic and environmental ruins.

Dilapidated 40-year-old factories grind out goods whose quality is vastly inferior to Western and even manyThird World products, all the while polluting the air and soil.

A traveler in Poland is unlikely to see any tractors in the course of a four-hour drive through the countryside, even though agriculture is the strongest sector of the economy. In the Soviet Union there are only 50 cars for every 1,OOO citizens. By comparison, eight decades ago in 1909, one out of every 34 farmers in Iowa owned an automobile, and by 1930 for all America that number had risen to one out of every 1.3 households.

The breadth of poverty and underdevelopment in Eastern Europe is greater than most in the West imagine.These cou ntries now face the daunting and unprecedented task of transforming centrally planned economies into free-market systems. How this can be done, in what sequence, and at what pace is not easily prescribed. Such a.radica1 transformation never before has occ u rred. Nations have .been transformed from capitalist to socialist, but not the reverse. Decades of Evidence. Yet some things are known about what works and what does not work in promoting economic growth. Decades of experimenta tion with statist developme n t programs by governments in Africa, Eastern Europe, and Latin America amply demonstrate that extensive state controls of the economy, state planning, and massive subsidies and credit for preferred industries do not work.These policies perpetuate poverty, not eliminate it. Variations of statist intervention and central planning produce equally poor results. As American government officials and American businessmen and economists head off to give East Europeans advice on how to restructure their collapsed e c onomies, they must keep in mind what has worked and has not worked in the past.The lessons of history should be like a flashing yellow traffic light warning of four myths of economic development that, if trans lated into policies, will keep Eastern Europe impoverished. The myths are Myth #1: Significant government spending on roads, tunnels, airports wastewater treatment, and communications is necessary for economic growth in Eastern Europe of capital and stock markets to develop necessary to set East Euro p ean countries on the road to the free market Myth #2: Privatization will not succeed in Eastern Europe because of a lack Myth #3: Massive Western financial assistance is needed for Eastern Europe Myth #4: Rigid austerity measures and prolonged economic pa i n are As with all myths, these simply are wrong. Unless they are exposed as such Western governments and development banks will dole out flawed economic advice along with their economic aid, prompting East Europeans to per petuate the mistakes of others. U nless the myths are exposed, the Internation al Monetary Fund (IMF) likely will urge East European governments to raise taxes to balance state budgets. This will constrain economic growth. So will the World Bank if it pursues government-to-government lend ing policies in Eastern Europe as it has done in theThird World.These loans will politicize East European economies further and increase their bloated government bureaucracies.

East Europeans have suffered enough. Their suffering should not be prolonged by economic policies that have been discredited by decades of ex perience. They should heed the warning of the blinking yellow light FOUR ECONOMIC DEVELOPMENT MYTHS As teams of economists formulate economic reform plans for Eastern Europe, and as the United States Congress debates foreign aid to the region policy decisions must be based on empirical evidence, not on myths. Other wise economic growth in Eastern Europe could be retarded and American taxpayers' money could be squandered.

The four prominent myth s that could impair economic development in Eastern Europe are Myth #1: Significant government spending on infrastructure like roads, tunnels, airports, communications systems, water systems and wastewater treatment plants is necessary for East European e c onomic growth 2 Too often politicians, academics, journalists, and other observers argue that East European governments need to invest massive sums of money to build an infrastructure of airports, bridges, communications systems, energy plants ports, road s, and water systems. They argue that with the help of Western aid East European governments must play the leading role in Eastern Europes economic development by spending heavily on this basic infrastructure.

This ignores historical facts. Nobel Laureate economist Peter Bauer has written: The suggestion that a ready-made infrastructure is necessary for development ignores the fact that infrastructure develops in the course of economic progress not ahead of it M uch of the literature suggests that the world was somehow created in two parts; one part with a ready-made infrastructure of railways, roads, ports, pipe lines and public utilities, which has therefore been able to develop, and the other which the creator unfortunately forgot to endow with social overhead capital.This is not the way things have happened.

Western nations were not blessed with benefactors who laid down roads bridges, canals, and tunnels prior to economic development. Rather, in frastructure was developed in Europe, North America, the South Pacific, and South ast Asia, often by the private sector as the economic need for it arose 5 Turning to the Private Sector. To be sure, Eastern Europe needs water sys tems, wastewater treatment plants, air p orts, roads, telecommunications, and high-speed rail lines before the region will enjoy the economic prosperity common in the West. But to make the financing of these projects the respon sibility of Eastern Europes governments is to ensure that these proj ects will be inefficient, and thus a drag on development. Rather than rely on the state reformers in Eastern Europe should engage the private sector to modernize the infrastructure of their economies.

There are a variety of methods by which this can be don e. One is to sell a state-owned entity, such as an airport or a wastewater treatment plant, to the private sector Last year, for example, the British government sold its ten water utilities for 8.34 billion and the Dutch government sold the Ijmuiden Fishi n g Port Authority in the Netherlands. Another method is for the govern ment to offer a long-term franchise to a private consortium to design, finance build own, and operate a project for the life of the franchise.These are called Build-Operate-Transfer (BO T ) projects. The franchise generally runs for the 1 Peter Bauer, Dissent on Development (Cambridge: Harvard University Press, 1976) p. 111 2 Economic development should not be measured by the number of power plants or bridges a country has Forced Stalinist industrialization of primarily agricultural countries has impoverished Eastern Europe and blackened their environments. Economic development means simply economic growth, not industrialization 3 number of years it takes for the private operator to realize a return on his in vestment. A third method is for governments to contract with private firms to operate public infrastructure, such as a management contract to run an air port or a wastewater treatment plant.

Improved Services. There are many reasons why East Europeans should rely on the private sector, rather than the state, for developing a modem in frastructure. Private provision of infrastructure can improve service, induce competition to keep costs low and quality high, improve efficiency, make in f r astructure suppliers more sensitive and answerable to consumers, and decrease the costs of government torically, of course, typically has been the province of huge, public monopo lies. With these public monopolies, as with any government bureaucracies ser vice is often poor, new technology is slowly introduced, and business decisions tend to be based on political rather than economic considerations.

This need not be the case. Privatizing electricity monopolies and dividing them into numerous generating companies can bring competition into the in dustry.The same can be done for telecommunications and water systems.

Useful for East European water service may be the example of the oil in dustry because oil, like groundwater, is a resource that, without the ass ign ment of property rights, is subject to depletion and quality deterioration. In the oil industry, typically private suppliers extract oil though unitization agree ments, which are contractual arrangements and rules that allow many dif ferent operators t o pump oil from a vast underground oil pool. Each operator has an indivisible stake in the pool. Similar arrangements can be used for groundwater extraction in Eastern Europe. East European countries thus should avoid, whenever possible, replacing a publi c monopoly with a private monopoly. The introduction of competition decreases the need for extensive government regulation because competition checks monopolistic pricing.

Little Incentive for Quality. Governments in Eastern Europe and in the Third World h ave little credibility in developing infrastructure. This is ob vious from the dismal quality of basic services in Eastern Europe like clean running water, telephones, and heating and electricity. Not subject to market competition, those providing these s ervices have little incentive to deliver quality to customers.

It is for good reason then that, throughout the world, the private sector in creasingly is being asked to build infrastructure. Privately financed high speed railroads are on the drawing boards in Bangkok, Southampton, Bar celona, Houston, and Miami. Private systems supply water in Britain, Chile Guatemala, France, Kuwait, Italy, Spain, and the U.S? Three bridges in Britain -the Dartford Bridge, the Second Severn Bridge, and a bridge link Provi d ing electricity, water, and even telecommunications to the public his 3 Fixler, Poole, Scarlett, and Eggers, AivuWon 1990 (Santa Monica: Reason Foundation, 1990 p. 28 4 ing Scotland to the Isle of Skye are being built, financed, and operated privately cia l s, at a time of tight budgets as the way to modernize decaying infrastruc tures. Robert Poole, Jr president of the Reason Foundation, a free-market research institute based in Santa Monica, California, writes that: the 1990s may well go down as the decade of privatized infrastructure. Around the globe, governments have begun a major shift of the responsibility for financ ing, building, operatin and, in many cases, owning major capital-intensive in Privatizing public works is being perceived increasingly by government offi frastructure projects. k Tunnels and Roads. Build-Operate-Transfer projects have financed tun nels and bridges in Europe since the 1950s. The majority of roads built in America during colonial times were private toll roads and most bridges were in private hands until shortly after the 1930s Depression. The $11.9 billion Channel Tunnel project, which will connect Britain and France, is the largest private infrastructure project to date. The only government participation is granting franchise s to private firms for rail operations and an auto tunnel.

Private tollway projects will be built in Asia, Britain, France, Mexico, and the U.S hrports. Privatizing airports also is underway. From Denmark to New Zealand, governments are planning to sell their airports to the private sector.

There is already interest in this in Eastern Europe. Poland is looking into the possibilities of privatizing airports. There are many advantages in this. Sales of airports generate revenues for the government, lead to a more efficient dis tribution of resources by introducing rational peak-hour pricing of runway use, increase investment in airport facilities because the private sector owner has an incentive to acquire new business, and reduce by half the time needed to build an airport.

Most important for the East European governments, no public funds are needed to create new airport capacity. The reason: new capacity is funded by private sector investors who earn a return on their investment by developing land adjacent to the airport. The most striking example of this has been the British Airports Authority (BAA) sale in July 1987 of 500 million shares worth $2 billion to private companies and individual investors. Since privatization, income per employee is up 10 perce n t, profits have risen 19 per cent, capital spending has more than doubled, and income from commercial enterprises such as parking and food service has grown faster than aviation charges to airport users. Also notable is that BAA is developing a $400 mil l i on rail link between London and Heathrow airport. Though need for the rail link has been apparent for the past decade, the government did nothing to address this 4 Ibid p. 27 5 New airport terminals and even entire airports can be created through Build-Op erate-Transfer arrangements An investment team is developing a 200 million, 18-gate terminal at Ataturk International Airport in Istanbul.

Once completed, the terminal will be operated for at least 15 years by Lock heed Air Terminal of Burbank, California. Lockheed also is involved in developing a $300 million, 24-gate terminal at Toronto International Airport.

New airports in Hong Kong and Macao will be built and operated by public private consortiums with majority private ownership Water Systems. Water u sed for drinking, bathing, irrigation, and other pur poses is supplied by the private sector in much of the world. Private com panies in France provide 72 percent of the water used by the French, while 13 percent f Americans receive water service from alm ost 16,000 private water systems. A privately financed water supply project in Lubuan, Malaysia, is now in operation. Britain sold its ten water utilities for $8.34 billion in 1989.

An improvement in Britains water quality, which has been among Western Europes worst, is expected from the increased competition among private water companies tor development of communications services and privatizing large state owned telecommunications m onopolies. Argentina, Britain, Canada, Chile Jamaica, and Japan have privatized their telecommunications sectors. Israel and Korea plan to do so.These serve as examples for Eastern Europe. One thing, however, that East Europeans need not do is replace gov ernment telecommunications monopolies with private monopolies as was done in Britain and Hong Kong. While the private BritishTelecom is better than when it was government-owned, it is not nearly as good as a fully, competitive industry would be.

At one tim e, because of the so-called natural monopoly characteristics of telecommunications service, an argument could be made for a huge, regu lated private monopoly.This no longer is the case.Technica1 innovations, like fiber-optic cable, multilateral connectivi t y, and electronic intelligence, give East Europeans a luxury that the West did not have in setting up modem telecommunications systems. With these revolutionary advances, competition is appropriate and valuable in most telecommunications services in Easte r n Europe. There. are over 200 separate suppliers of long-distance telephone ser vice in the United States! Competition between these firms has brought down long-distance telephone prices, improved customer service, and in creased the clarity of telephone t ransmissions. Competition will do likewise for Eastern Europe s Telecommunications. There is a widespread movement toward private sec 5 hid 6 Gabriel Roth, The Private Provision of Public Services: paper prepared for the 1990 International Privatization C o ngress, Saskatoon, Saskatchewan, Canada, May l3-16,1990, p.7 6 WasteEnergy. Most privatization of waste-energy projects, which con vert refuse into energy, has occurred in the U.S. Most American waste-ener gy plants are privately operated and many are pri v ately owned. Wheelabrator Technologies Incorporated, for example owns and operates 19 waste-energy Myth #2: Privatization will not be successful in Eastern Europe because of the lack of capltal or stock markets East European countries obviously lack devel o ped capital markets, stock exchanges, and similar institutions. This constrains privatization because capi tal markets allow savings to be transferred efficiently into investment. Yet privatization can be successful without developed capital markets. In f a ct privatization in Eastern Europe can prompt development of a capital market infrastructure. So long as the state owns nearly all factors of production, there is very little in which to invest and thus no reason for a capital market to develop.This is wh y Hungarys stock market has been so sluggish since its es tablishment in 19

87. With 85 percent of Hungarian industry still state-owned stock investors have little opportunities for investment demand explodes when the huge amount of securities and stock shares are is sued when state industries are sold to the public.

Chilean Example. A striking example of how privatization prompts the rapid development of capital markets is what occurred in Chile in the 1980s.

Chilean capital and financial markets were in ruins after the inflation of up to 500 percent annually in the 1970s and the debt crisis of 1982-19

83. In fact, the Chilean situation was similar in a number of respects to that of Eastern Europe today. Nearly all the Chilean financial institutions were owned by the A capital market cannot be created if there is no demand for it.This 7 state and operated on fixed credit from the state.The country also had severe Foreign debt problems reaching a peak of 19.6 billion in 19

86. As in Eastern Europe now, es sentially the entire financial system was state-controlled Iko-Round Privatization. Despite this, Chile has pursued one of the worlds largest-scale privatizations. This came in two separate rounds. The Erst round of privatization consisted primarily of re t rnin the enterprises Free of charge to the previous private sector owners. The second round began in 1984 and sought to spread share ownership, mainly in giant public senrice and infrastructure companies. A number of the state-owned enterprises SOEs) wer e sold to joint foreign and private investors such as M.Trust and Austin Powder. Pension funds, such as the Provida and Santa Maria Corporations, were privatized via public capitalism, by which Chilean citizens who purchased shares in the privatized compan i es received long-term loans from the government at zero interest.They also received very Favorable investment tax credits Privatization and the Development of the Chilean Stock Exchange Yg 1984 1985 1986 1987 1989 41.9 na 59.7 20.6 337.1 43.8 542.8 61.0 6 5 4.4 61.5 7 During the 1970-1973 period, the S&t government of President Salvador Allende took control of all banks, large public utilities, and numerous large and medium-sized corporations 8 Rolf Luders, Chiles Massive Divestiture Program: 1975-1990, Fail u res and Successes, unpublished paper presented to the Conference on Privatization and Ownership Changes in Eastern Europe,The World Bank Washington, D.C June 13 and 14 9 Santiago Stock Exchange 8 stocks of privatized state-owned enterprises increased from under 21 percent to over 61 percent of the total.The sale of the state enterprises meanwhile created over 114,000 new shareholders in Chile.

Chile is not the only example of how a country with dormant capital markets can privatize state-owned enterprises. Privatization of the Kenya Commercial Bank is another example. It demonstrates, moreover, the ability to privatize even if there appears to be almost no pool of private savings.

This is the situation in much of Eastern Europe. Savings in Poland is es tim ated at no more than 2 percent of the book value of all property. Yet the experience of a number of developing nations, where few savings were presumed to exist, suggests that as long as the privatization stock offering is well-publicized and attractive, d omestic savings will appear from outside the formal banking sector Savings from Nowhere. This happened in Kenya, the 26th poorest country in the world. When 7.5 million shares of Kenya Commercial Bank stock were offered to the public in 1988, there were f o ur times as many bids to purchase shares of the stock as there were shares available.This was wholly unan ticipated by economists and Kenyan government officials. The savings needed to purchase the stocks seemed to appear from nowhere. In fact, they came from the underground sector of the economy.

There are more domestic savings in Poland and other East European Countries than is commonly presumed. Such savings may be in the form of stockpiles of lumber or bricks in peoples backyards or as merchandise smug gled from the West. East Europeans have put their capital in art, precious stones, coins VCRs, personal computers, appliances, and other so-called physical resources because these goods retain their value during high infla tion.

These physical resources could become a source of capital when a country makes its currency convertible, as Poland has done and when there is low in flation. Poles could be tempted to transform their physical resources into capital for investment in privatized industries if they c onclude that such in vestments will give them a greater return Popular Capitalism. Another possibility for privatization in the absence of developed stock markets is known as popular capitalism. By this, bonds or coupons are sold to citizens at very low p rices or given to them free. With the coupons, shares can be bought in the privatized state-owned enterprises.

Markets soon develop, of course, as people buy, sell, and trade coupons and stock shares.This approach is what the Czechs and Poles plan.

As a first step toward popular capitalism, holding companies are created.

These are shells that own state enterprises.The second step is to give holding company shares to each adult citizen.This encou rages saving because many people purchase more shares in the companies or, as people sell their 1 Savings in East European countries likely will appear from similar sources 9 coupons, encourages the development of a stock market. Most significant this spe e ds privatization of the economy Management Contracts. Another option for privatizing without capital markets is contracting with a private firm to manage the state enterprise prior to full privatizationThe majority of privatizations in Africa have been in the form of management contracts and leasing. Putting the enterprise under can improve the efficiency of the enterprise significant ly, which, in turn, decreases the cost of the enterprise to taxpayers A state-owned bicycle factory in Z a mbia, for example, in 1983 was operat ing below capacity and in the red, and its equity for investment was depleted As a last-gasp effort to save the enterprise, the Zambian government privatized the management of the factory.The deal negotiated with the private company made the private manager financially liable for 100 percent of the enterprisess losses under private management. However, if the factory became profitable, the management firm received 20 percent of all profits.

Within a few years the bicyc le factory began making a profit.The reason: The change in incentive structure gave the private company a financial stake in quickly turning the factory around. East European countries can try similar arrangements as interim measures on the way to full pr i vatization World BMk Myth #3: Massive Western financial assistance is needed for Eastern Europe to develop 14 Many economists and Members of Congress believe that the reconstruc tion of Eastern Europe requires great sums of cash from the West. Harvard eco nomist and advisor to the Polish government Jeffrey Sachs, for instance calls for a 30 billion Western aid package to the Soviet Union during the IYF transition to a market economy.

House Majority Leader Richard Gephardt, the Missouri Democrat, also calls for a large scale aid pro gram to the Soviet Union.

Yet, ex perience in 10 7 163;~ww a) i Multilateral Aid to Eastern Europe Since April 1990 o 0.1 1 1.1 2 2.1 a 8.6 4 4.5 8 blllloM lOJeffrey Sachs, The U.S. and the Economic Future of the Soviet Union and Eastern Europe, lecture at Progressive Policy Institute forum, September 24,1990 10 dozens of developing countries demonstrates that generous foreign aid is not the answer to Eastern Europes economic problems. In fact in most cases foreign aid has done m o re harm than good. Over 50 percent of Yugoslavias 20 billion debt was squandered on uneconomic projects or used to subsidize consumer consumption in the 1970s and 1980s. For instance, over $300 mil lion in loans and grants from Western governments and loa ns from Western financial institutions were poured into a nickel smelting factory in Feni Yugoslavia, from 1982-19

85. While the factory was a technical wonder, it proved a commercial failure and closed International Bank for Reconstruction and Development (IBRD) Loans to Polish Government February 1990 -July 1990 National Bank of Poland National Bank of Poland Environment Management Republic of Poland, Transport General Polish State Railways The Polish Oil and Gas Company Republic of Poland mlllion z 260. 00 100.00 18.00 8.00 145.00 250.00 300.00 Totals I 1,081.00 DIU IBRD Foreign aid, moreover, allows recipient countries to delay needed economic reforms, prop up state-owned enterprises, and sustain economic policies that stunt development.

The Internationa l Bank for Reconstruction and Development (IRBD) already has allocated over $1 billion in loans to Poland.The overwhelming bulk of this money is going to such state-owned enterprises as Polish State Railways and the Polish Oil and Gas Company.

These government loans to government entities will add to Polands huge debt burden and allow government bureaucrats to delay privatization.

Without foreign aid, Sub-Saharan Africa years ago would have had to aban don socialist economic policies Harmful Relief. Even food relief, though frequently prompted by ad mirable humanitarian impulses, often harms the recipient country by under pricing locally-grown foodstuffs and ultimately bankrupting local farmers.

The U.S. General Accounting Office finds that food aid to In dia, Indonesia governments to 1) postpone essential agricultural reforms 2) fail to give and Pakistan in the 1960s restricted agricultural growth by allowing the 11 Rate of Foreign Direct Investment as a Share of Gross Domestic Product agricultural invest ment sufficient priority, and (3 maintain a pricing system which gave farmers an inade quate incentive to increase produc tion. 9, l1 aid given to Poland in 1989 and 1990 by the Emergency food U.S. and other Western countries has distorted badly Poland's agricuhral market. Polish farmers, unable to compete against the free food dumped from the West, have gone out of business.

Foreign aid, meanwhile, further politicizes economies because government to-government transfer of resources allows government burea ucrats to deter mine who gets the aid.These are almost always political decisions. Writes James Bovard, associate policy analyst at the Cat0 Institute, a Washington D.C.-bSed free market research organization Even when it is ultimately ladled out to priva te businesses, foreign aid weakens the comparative position of the private sector y increasing the government's revenue and power. 1 s Foreign aid creates incentives for long-term dependence on the benefactor.

Haiti, Israel, Sudan, Tanzania, and Zaire, among many others, have become almost completely economically dependent on foreign aid for survival.

Saturating the Economy. Undermining the case for foreign aid to Eastern Europe is the fact that the region already is attracting substantial private in vestm ent from the West. Over 1,400 joint ventures have registered in Poland within the past year and the number is increasing daily. Hungary is attracting more private investment per day as a proportion of its gross domestic product than France or Spain. In Hu n gary, such investment funds as the Austro-Hun gary Fund, First Hungary Fund, and the Hungarian Investment Company and others have more than $600 million worth of private funds to invest in private ventures. The trouble is that most of the money is not bei ng spent.

The reason: the economy cannot absorb all the available capital because the snail-like pace of privatization has not created enough private ventures. An economy that cannot use available private capital does not need foreign aid llGeneral Account ing Office, Disincentives to Agriculfuml Mction in Developing Counbies, November 26 1975 12lames Bovard, The Continuing Failure of Foreign Aid Cat0 PolicyAncrEysis No. 65, January 31,1986, p5 12 Private investment spurs economic growth much more than fore i gn aid because it is attracted to market op portunities, rather than to a govern ment bureaucrats pet projects. If East European reforms such as a convertible currency, low taxes secure private property rights, and lit tle or no inflation create an econom ic climate favorable to private enterprise then private foreign invest ment will come and foreign aid will not be needed. If the climate is in hospitable to private enterprise, then foreign aid will not help.

It is even possible, moreover, for Eastern Europe to develop economi cally without Western private invest ment. Even if capital, land, minerals and infrastructure are in short supply development can be driven by human capital. This, after all, is the less o n of the dramatic development of rural China in the decade following 1978 Writes Kidder, Peabody Co analyst Scott Powell: economic grovkh is lar el a function of human creation, drive, and willingness to sacrifice An economic environment of low taxes, non i nflationary fiscal and monetary policies, and few regulations becomes a hot house in which entrepreneurs will begin generating capital internally. This is what happened in Hong Kong, an island and some nearby territories barren of all resources but human c apital by Myth #4: Rigid austerity measures such as tax increases to balance state budgets, currency devaluation, trade surpluses, wage controls and high interest rates are needed in Eastern Europe Most discussions about the transition from socialism to t h e free market in variably include a sermon that the medicine needed for the transition is bitter and that the citizens will suffer severe economic pain for a prolonged period of time. Many East Europeans today cannot be blamed if they look at the hardship s brought about by the Polish economic reform program and then 13scott Powell, The Entrepreneur as the Mainspring of Economk Growth, Hoover Institution, Stanford University 1990, p. 4 13 resist the movement to capitalism.They associate capitalism with plum meting living standards, massive unemployment, and harsh austerity.

The mistake is to assume that the Polish program is the only way to move swiftly to a market economy. It is not.

The Polish shock therapy program primarily has emphasized controlling cons umer demand to halt runaway inflation. In some ways this shock therapy or big-bang approach has succeeded. The currency is now convertible. Idla tion has been cut sharply from 79 percent monthly this January 1990 to 3 per cent this September. The state bu d get has been trimmed and state industries can no longer obtain easy credit. Interest rates were raised to 40 percent in January by the government to discourage heavy borrowing by inefficient state industries Unnecessary Pain. These reforms were all necess a ry. What is not necessary is the tremendous accompanying pain. Poland has been in a severe recession since the beginning of this year, and thousands of small businesses closed within the first months of the program Much of the reason for this painful econ o mic contraction is that, though prices have been deregulated, communist bureaucrats and state-owned in dustries have remained firmly in place. Thus, large government monopolies have simply made fewer goods, charged higher prices for them, and bypassed the market by trading among themselves for supplies. This squeezes the private sector, which still must rely on state-owned industries for materials.

Without extensive privatization and deregulation there can be little com petition. Without competition, price deregulation will not work To make mat ters worse, prices were freed in Poland ahead of such essential structural changes as laws ensuring unambiguous property rights, enforcing contracts and cutting taxes to encourage the growth of private business was h alted not by increased productivity and economic output but by a deep recession and a drop in real earnings. For another, taxes, which were in creased to balance the state budget, are too high. Private firms must pay a 20 percent tax on all business (up f r om 8 percent under the communist govern ment a 40 percent tax on profits, and a social security tax of 40 percent of wages. These prohibitively high taxes on business raise employer costs, caus ing decreased employment, investment, and output. It is no wo n der then that there was only a small net increase in the number of private businesses registere from this January to July, according to Polish government reports. Businesses remain unregistered because entrepreneurs wish to evade these prohibitively high t axes, and business licenses are still difficult to obtain There are other problems with the Polish program. For one thing, inflation 3 14Krysztof Ostaszewdci, The Boldest Social Experiment of thewntieth Century, unpublished paper, p.16 14 'ho Programs for Economic Development Currency made convertible Supply-side Development. There is a free-market alternative to the Polish shock therapy program. This could be called "supply-side development It has many of the same goals as shock therapy, like low inflatio n , tight monetary policy, and currency convertibility, but it emphasizes first creating the foundations of a market economy and balancing supply and demand through economic growth, rather than cutting consumer demand from the marketplace and creating incen tives for individuals to engage in economic activity by cutting government taxes, regulation, and spending.

Poland, for example, would be developing faster and with less hardship if cut ting taxes and eliminating controls on foreign trade were recognized a s being more important than trade and budget surpluses. Entrepreneurs should be freed from excessive government regulation and taxation so they can begin generating wealth. Rather than controlling demand, economic reforms should be structured mainly to un l eash the supply mechanism by cutting government intrusion in the form of controls, high spending, regulations restrictions, and taxes into the economy Structural Reforms. It should be recognized, moreover, that immediate structural reforms are as importan t as macroeconomic reforms. Legislation on securing property rights, contractual rights, privatization taxes, invest ment, and business licenses should be the first priority of economic reforms.

Once these are in place a private economy parallel to the sta te-dominated economy rapidly develops.This, in turn, introduces competition to the state enterprises. With the supply-side approach, entrepreneurial Poles could see swift improvements in their living standards because the deregulated, low-tax The basic te net of the supply-side approach is removing the government 15 environment would provide opportunities and rewards for risk-taking, wealth generating behavior.

In the supply-side plan, economic reforms should favor private entrepreneurs rather than the stat e-run sector of the economy.This can be done by freeing wages and prices on private enterprises and offering favorable credit terms for private firms while maintaining tight credit for state industries.Taxes on private business during the transition perio d to a market economy should be eliminated and business licenses should be ap proved within days of an application ment and new opportunities, not controlling consumer demand. Eastern Europeans, like people worldwide, will work hard if they are rewarded fo r their work by increased and improved consumer items such as automobiles televisions, appliances, telephones, and radios, or in the form of a thriving business Supply-side economic reform plans should emphasize economic empower CONCLUSION East European ec o nomic reformers can avoid the mistakes made in Africa and Latin America if the reformers reject the development myths that have kept much of theThird World impoverished. Myths that economic growth re quires substantial government spending on basic infrast r ucture and massive foreign aid are a prescription too for a continued impoverishment of Eastern Europe. These myths and others are mobilized by liberal Congressmen who argue for vast Western aid to .Eastern Europe and by old guard communists in Eastern Eu r ope who want to scare their fellow citizens away from the free market by arguing that the transition to a free market economy must be pain ful teaches realities very different from these myths.These realities are ports, bridges, electricity, ports, roads, telecommunications, water systems and other infrastructures 2) Privatization of state industries is possible without developed capital markets 3) Western investment capital will flow to countries that protect private property, establish the rule of law, h a ve attractive joint venture laws, low taxes, and a stable political climate. For those countries to which private in vestment is not attracted, foreign aid can not help them 4) Economic hardship and rigid austerity measures, like high taxes, high interest rates, and wage controls on private business are not needed to make a transition to a market economy economists, politicians, and even businessmen could derail Eastern Europes Experience from developed and developing nations around the world 1) An economy can grow without substantial government spending on air Advice about economic development provided by many Western 16 economic liberalization. Multilateral institutions such as the International Monetary Fund and the World Bank unintentionally have contri b uted to Third World poverty and underdeve1opment.They do this by propping up state-owned industries and advocating state economic planning, currency devaluation, and increasing taxes to balance budgets. These same institutions and a new development bank, t he European Bank for Reconstruction and Development (ERBD now seem determined to force these failed policies on the East Europeans Setting the Record Straight. Before Eastern Europe suffers the fate of Africa and Latin America, the record should be set st raight. Westerners should stop giving East Europeans bad advice about economic development.

If the proper advice is given and heeded, East Europeans can speed their economic development, while American policy makers can avoid throwing away taxpayer dollars on misguided foreign aid programs.

William D. Eggers Policy Analyst 0 17

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