The Heritage Foundation

Backgrounder #870 on Economy

December 13, 1991

December 13, 1991 | Backgrounder on Economy

Economic Shock Therapy: Lessons for Russia from Eastern Europe

(Archived document, may contain errors)

L zT L j- i Deceiving Statistics. Russia is getting ready to introduce its economic shock ther py exactly two years after Poland became the first former East Bloc country to adopt sw eeping economic reforms. From most official statistics and independent economic zstimates the experience in Poland and the rest of Eastern Europe seems discouraging living standards falling anywhere from 20 percent to 50 percent, gross national product dr o pping between 10 percent and 20 percent, production down 15 percent to 30 per cent and skyrocketing unemployment. Similar statistics from Eastern Europe helped convince Soviet President Mikhail Gorbachev early last fall to abandon the 500-Day radical econ omic reform plan proposed by a Russian economic team led by Stanislav Shatalin and Grigory Yavlinsky.

Such gloomy statistics are deceiving. They hide,.for instance, the economic miracle sweeping Poland and Hungary. Thus while official statistics show decli nes in Polish production, these mostly measure only the output of state enterprises. In the budding private sector, by contrast, output is booming. Further distorting many widely reported statistics are the baselines used to determine growth or contractio n . These baselines are still the overblown estimates of the size of East European economies before the 1989 revolutions. Example: the United States Central Intelligence Agency (CIA) estimated East Germanys 1987 per capita GNP at 88 percent of West Germanys ; the real figure turns out to be less than 50 percent.

Alleged huge drops in living standards, meanwhile, fail to reckon the hard to quan tify improvement in living standards from the disappearance of lines, the higher qual ity products, and most of the e arnings from the growing private sector. Unemployment statistics also mislead. While under communism unemployment technically was zero, in fact it simply was hidden, with workers being paid for jobs that were not done. Today, however, Eastern European off icial unemployment figures overstate the scope of the problem. In Po1and;for example, over 50 percent of those collecting un employment earn outside income.

Real Hardships. There are, of course, hardships in switching from one form of eco nomic system to a nother. On the road to a market economy, many state industries will go bankrupt, unemployment will increase temporarily, prices will rise (at times abruptly and sharply) to market levels, and many people will lose some real income as the state sector of t he economy collapses. What will offset these pains will be the rapid growth of a private sector economy.

While some pain is certain, what is uncertain are the political consequences of the piiin. Yeltsin thus runs a high political risk in pushing his economic reform program.

To his a~dit, he has accepted full responsibility for its success or failure, assuming the post of Russian Prime Minister to see the reforms through himself. He must be aware that former Polish Prime Minister Tadeusz Maziowiecki was vo ted out of office a year after launching similar reforms Yeltsin will need all the help he can get from George Bush. Bush should recognize Yeltsins courage, urge him to stay the course, and offer solid advice on how to make 1 Various independent and gover n ment sources including the statistical offices in the East European countries, the World Bank, International Monetary Fund, and Plan Econ, a Washington-based consulting fm 2 his reforms work by taking further steps to remove regulations now stifling the & el opment of a strong market economy Specifically, Bush should recommend to Yeltsin that he Persevere with sweeping economic reforms. If Yeltsin falters and fails to carry through with his announced reforms, chances are high that the Russian economy will c ontinue to collapse. This would be an economic and political disaster, and court a return to authoritarian or totalitarian rule. This would be in neither Russias nor Americas interest. To guard against likely future harsh criticism of the reforms, Bush ca n help Yeltsin muster the evidence to debunk myths about the supposed failure of economic shock therapy in Eastern Europe. Official sta tistics that seem to show massively falling production, declining living standards and soaring unemployment in Eastern E u rope misrepresent the true economic pic ture there. In fact, Eastern Europe is in the early stages of an economic renais sance Press forward with further reforms to spur the rapid development of Russias private economic sector. The key to offsetting the e c onomic hardships imposed by a collapsing communist command economy is the rapid growth of a new private sector capable of creating jobs and boosting production. To spur the development of Russias private sector economy, Yeltsin should undertake fur ther r e forms, including Reform 1: Recognize and extend private property rights. Without a body of laws covering such basics as how to acquire and gain title to property, the risks of starting and expanding businesses in the Russia will remain high Reform 2: Crea t e a regulation-buster office to eliminate and cut through bureaucratic red tape. Countless regulations and bureaucratic im pediments remain a significant obstacle to the growth of private business in Russia Reform #3: Make business licensing nearly automa t ic. Bribes to bureaucrats and a wait of up to one year for a business license discourage would-be busi nessmen Reform #t4: Cut business taxes. High tax burdens on business discourage new business formation RUSSIAN ECONOMIC REFORM Russia encompasses three- q uarters of the area of the Soviet Union and accounts for 62 percent of Soviet output. Larger by a factor of ten than most of the economies of the other Soviet republics, Russia dominates in almost every category of production. It is endowed with plentiful natural resources such as oil, natural gas, and minerals 3 This vast potential, however, has not prevented the inefficiencies of commuhst cen tral planning from turning Russia into a pauper. Food shortages are predicted this win ter in major cities, inclu d ing Moscow and St. Petersburg. Inflation is running at 2 per cent to 3 percent a week. National income in the Russian republic decreased by 5.5 per cent last year and plunged another 11 percent in the first half of this year. Imports and exports are decli ning precipitously?

Sporadic Reforms. Russias economic problems start with an inefficient holdover communist economy that has been stagnating for years. Economic woes have been compounded by the absence of a coherent, decisive program for transforming this de caying economic system into a modem free market economy. Until ve ry recently, re form pmeeded halfheartedly and sporadically.

To be sm, some important measures were undertaken. Late last year Russia began laying the legal framework for a market economy when the Russian parliament began enacting important laws on private property, housing, land and industry privatization foreign investment, and entrepreneurship. In early December 1990, the Russian parlia ment passed an historic land law that gives Russian farmers the right to obtain land from the Russian government and e stablishes private family farms; over 30,000 private farms have been created in Russia since January 1991.

Another important reform aimed at increasing economic freedom for Russian citi zens is the July 4,1991, Law on Housing Privatization. Most Russians n ow have the chance to become owners, free of charge, of their own apartments by applying for a voucher that can be used to purchase the apartment. In St. Petersburg, the privatization of shops, restaurants, and industry began this April. The Moscow city g o vernment plans to turn all state-owned shops up to 500 square meters in size over to private own ers within the next month. The workers of the shops will have first priority in owner ship. The equipment will be given away free and the storefronts will be a cquired through long-term leases lutionary they would have been a couple years ago, will amount to little as long as the Russian economy remains essentially a command economy, with prices fixed by the state, with a huge economic bureaucracy, and with coun t less restrictions on foreign in vestors. Yeltsin set about addressing these fundamental issues beginning with an Octo ber 28 address to the Russian Congress of Peoples Deputies. There he announced that his government will institute Polish-style economic s hock therapy to speed the transi tion to a market economy.

Under his plan, on January 2,1992, prices will be freed from administrative control on all but a few politisally sensitive goods such as coal, gas, oil, baby food, bread milk, salt, and vodka. Pric es on many goods are expected to increase between two fold and four-fold soon after prices are freed.5 3 Speeding the Transition. All of these reforms, as important as they are and as revo 2 Radio Free Europe/Radio Liberty Daily Report, No. 22, January 3 1 ,1991. p. 6 3 The Communists in the Russian legislam forced Yeltsin to place a ten-year moratorium on land sales. Yeltsin recently attempted to have this provision removed, but the Russian Congress of Peoples Deputies upheld the moratorium 4 Radio Free Eu r ope/Radio Liberty Daily Report, No. 209, November 4,1991, p. 2 4 Yeltsin also will slash the Russian government budget to bring the deficit to near zero. Freeing prices will go a long way toward this goal because subsidization of food stuffs alone eats up much of the bloated budget. The number of bureaucrats employed by the Russian govement will be reduced by 50 percent within months.

Agricultural privatization is being accelerated by privatizing the supply, retail, and distribution networks. In addition, the 1992 Russian budget also allocates over 24,OOO tractors and 22,000 trucks to the emerging private fanners.

Attracting Foreign Investors. Over the weekend of November 16 and 17, Yeltsin unveiled a package of additional measures designed to free foreign trade from central ized control. In a series of executive decrees, Yeltsin eliminated most govemment ex change controls on imports, exports, and foreign currency. Fixed exchange rates set by Gosbank, the Soviet central bank, no longer apply in Russia. En t erprises are free to buy and sell hard currency at rates set by the free market. As of January 1, foreign busi nesses will be allowed to convert their ruble profits to hard currency on free currency markets, and take them back to their home country. Terme d repatriation, this will make Russia a much more favorable place for fmign investment.

Individual Russian citizens will be able to open hard-currency bank accounts. Soviet officials no longer will be permitted to tax imports or exports within Russia. Thes e de crees, together with a November 15 announcement that Russia is taking over from the Soviet government control of its gold, oil, and other precious commodity reserves, will weaken the central government tremendously, leaving it without much ability to em hard currency.

In an effort to slow down the uncontrolled printing of rubles, and stave off hyperin flation and the economic and political chaos it would bring, on November 29, the Rus sian republic closed down Gosbank and took control of the money sup ply. Stabilizing the ruble will require massive budget cuts, higher interest rates, and pegging the cur rency to a Western hard currency such as the dollar or a basket of commodities. The Russian government also has taken over responsibility for financing the Soviet payroll and on December 1, Russia assumed control of the Soviet Ministry of Finance.

Political Support, Popular Opposition. Yeltsin now has broad political support in the Russian parliament for his sweeping economic reforms. Only seventeen depu ties in the Russian parliament voted against the measure to grant him the power to cany out his reforms. The Russian people, however, are rgt as supportive as the deputies of radi cal economic reforms. Most polls show the majority are opposed to a rapid t r ansforma tion to a market economy. Once the reforms are in place, opposition is sure to build as prices rise and official statistics begin to show ostensible further declines in wages and production. Communist Party members, for example, are sure to try t o sabotage the re forms. Gorbachev already is positioning himself as a critic of reform, as demonstrated by his November 4 speech to the U.S.S.R. State Council when he said Yeltsins re forms would hurt the poor. Such demagogic politicians as Vladimir Zhiri n ovsky, who 6 5 hyla Boulton and John Lloyd. Russia Braced for Massive Price Increases, Financial Times, London. October 29 6 Fred Hiau, Yeltsin Asserts New Powers on Economy, Washington Post, November 18,1991. p. Al 1991, p. 1 5 received six million votes in the election for the Russian presidency, has said repeat edly that he will capitalize on economic pain to rally support for a return to authoritar ian rule, a larger and stronger army, and the restoration of Russia's empire OFFICIAL STATISTICS HIDE THE TRUE STORY One weapon that Yeltsin's critics invariably will use against him are the same kind of data that now portray Eastern Europe's sweeping economic reforms as a failure.

Upon close analysis of the evidence however, it is clear that the honm stories about the impact of economic shock therapy in Eastern Europe are wildly misleading. These are based on statistics that show tremendous drops in production, national income, and living standards since market reforms were introduced, along with soaring une m ploy ment and inflation which dominated the East European economies in the communist era. Not appearing in the official statistics is the good news that some of the worst evils of these economies are disappearing: poor services hidden unemployment, shoddy consumer goods, and 3 long lines for basic necessities. The statistics also largely ignore Eastern Europe's eco nomic renaissance, as a new private sector begins to flourish In fact, these statistics reflect mainly the collapse of the inefficient state se c tor Living Standards Statistics on East European liv ing standards compiled before the 1989 revolutions are now recog nized having been seriously flawed. These statistics painted a vastly exaggerated rosy picture of life under communism. Not mea sured by the statistics, of course were the long food lines, poor quality products, massive short ages, empty shelves, and lack of purchasing power that people con fronted daily. The real East Euro pean living standards were much lower than generally assumed.

The CIA in 1989 estimated the per capita gross national product of Poland at $5,4

50. The Interna tional Monetary Fund, however now puts Poland's pre-refom per capita income at around $1,100 Official Estimates of Living Standards Under Communism Prove Exaggera ted Per Crplta QNP (tkouradr of Dollur 10 sa SI 04 2 SO Poland Noh Boin CIA ana world Bank llgures are from 1800 8ouroar Susan M. Collins ana Dan1 Roerick. Emtern Europe am tne Soviet unlon In tne mria conomy. 1801. na,,,a 0a Dat.Ch.,l 7 Peter Clark and C o nstantin Menges, Ph.D Economic Transition in Eastem Europe: A First Assessment Program onTransitions to Democracy, June 31,1991, p. 2 6 Supposed huge declines in Living standards are anived at by looking only at declines in wages. Wages declined by 40 per c ent in 1990 in Poland after increasing by 28 percent between 1988 and 1989 These numbers, however, had little to do with the actual liv ing standards of Poles as mea sured by their purchasing power In 1988 and 1989, Pol ish workers we= given mas sive wage increases in an at tempt by the government to appease labor unrest. The meaningless increases simply were eaten up by rampant hypa Year 1987 1988 1989 1990 1991 Month I y Wages Current Zlofy Real Z/oty Dollars 30,722 917 na 50,661 969 $32.68 130,454 1,304 $28.24 946,822 822 $98.38 1,7 13,300 945 $149.48 Since reforms were enacted in 1990, however, individual purchasing power in Po land in U.S. dollars, as measured by the black market exchange rate-which gives a ar better picture of the actual value of curr ency than oficial exchange rates-is up.

Example: in 1989, the average monthly wage of Poles was $28 at the black market rate; it now is nearly $1

50. Much of the presumed post-communist fall in East Euro pean living standards is pure illusion.

No More Panic Buying. With official statistics so unreliable, the quality of an individuals life is difficult to measure. But some improvements are clear enough.

Today in most of Eastern Europe, foods and goods once nearly impossible to obtain are plentif ully available at shops and market stalls. Gone is the panic buying that marked life under communism as households hoarded because of uncertainty over the future availability of basic goods. With prices now freed and shortages virtually elimi nated, panic buying and hoarding no longer are a part of everyday life. The disappear ance of panic buying causes demand to fall the short run, thus giving the appearance of a drop in living standards. In fact, the drop in demand due to the end of panicky eco nomic ac tivity reflects an improvement in everyday life.

Moreover, the high inflation in the late 1980s in Hungary and Poland caused people to spend virtually all their income on food and consumer goods rather than putting it into savings accounts where it simply would decline in value. With inflation much lower and interest rates higher, people are saving more of their income. Savings are four times higher in Hungary than two years ago, now equaling over 10 percent of earnings. This also shows up statistically as a drop in consumer demand, which looks bad on paper, but in fact it reflects the increasing confidence in the local currency, a sure sign of economic improvement.

Further refuting the claims that living standards have plummeted in Eastern Europe is the fa ct that actual household purchases have fallen only slightly. Evidence: Accord ing to oficial statistics, food sales in Poland declined between 30 percent and 40 per cent in the first half of 1990 compared to 19

89. Surveys of individual households, how e ver, demonstrate that household consumption dropped at most only by about 5 per 7 cent during the same period8 Further, even this relatively small drop fails to measure the great increases in the quality and quantity of food and other goods available Prod u ction and GNP leading pattern. Official govemment statistics document one-third declines in indus trial production and gross nati nal product (GNP), supposedly offering further proof of a decline in human welfare. Again, conventional wisdom simply is wron g duction figures they reported to the planning ministry, not for what was actually sold on the market. Production figures were highly inflated by factory managers hying to fill their production quotas. Termed prispiski in Russian, such cheating took place in over one-third of all enterprises in the Soviet Union." Also distorting measures of GNP in the communist countries was that output was only measured in quantity, not quality. These practices and others led to overestimates of at least 25 percent in est i mates of gross national product in Eastern Europe As prices have been freed, subsidies cut, and real interest rates introduced, the per formance of managers and the very existence of their enterprises is deterinined by what is sold on the market, rather t han what is reported to ministry officials. As a re sult, the phony output numbers simply disappear from statistics, thus leading to the horror stories of one-third drops in production. While there have been large -tion drops in the state sector, they are considerably lower than usually reported Business Hoarding. Another factor contributing to the apparent drop in production is the reduction in huge stocks of inventories traditionally maintained by communist enterprises. These enterprises typically have o r dered excess supplies and have kept huge stocks of inventories on hand because of uncertainty about whether the supplies would be available when needed. With free prices and the introduction of market forces, supply networks are becoming more reliable. Th e result: hoarding of supplies drops. With the forces of competition, at work, moreover, enterprises no longer can af ford the extra costs of excessive inventories. As a result, demand for inputs falls which corresponds to a statistical drop in production. Again, this statistical decline sim ply is indicative of an economy that on the whole is becoming more efficient Statistics concerning declines in production in Eastern Europe follow a similarly mis 8 Under communism in Eastern Europe, managers were paid a nd rewarded for the pro 8 Andrew Berg and Jeffrey Sachs Structural Adjusunent and International Trade in Eastern Europe: the Case of Poland preliminary paper prepared for the Economic Policy Panel in Prague, October 17-19,WIDER.Thei analysis is based on a number of Polish govemment surveys including flnforinucja o Wybranch Elementach Warunkow Zycio Ludnosci w 1990 R Polish Government Survey, GUS, Warsaw, Poland, April 1991 9 Gross National Product (GNP) is the sum of all economic transactions in a country i ncluding trade 10 Jan Winiecki The Inevitability of a Fall in Output in the Early Stages of Transition to the Market: Theoretical Underpinnings SOVIETSTUDIES, University of Glascow,Vol 43. No. 4 (1991 p. 670 11 Charles Wolf Jr Eastem Europe Can Avoid a Cr a sh Wall Street Journal Europe, November 21,1990 12 Berg and Sachs, op. cit estimate that GNP in Poland declined by at most 6.5 percent in 1990 8 Unemployment ward a market economy. Here again it is the statistics that are misleading. Ostensibly unemployme nt has risen from zero to nearly 5 percent in Hungary and hm 3 percent to 10 percent in Poland.

Officially all counmes of the former Eastern Bloc reported zero unemployment under communism. The zero unemployment figure was achieved by giving everyone a job , no matter how menial, and putting people on the state payroll whether work was done or not. The official statistic of zero unemployment thus hid gross overemploy ment in factories and elsewhere, resulting in wasteful duplication of effort, and wages pai d for work not done. Unemployment existed, but was hidden or repressed.

When former communist countries institute market reforms, this hidden unemploy ment is exposed.

Officially unemployment in Hungary rose from 1.7 percent in 1990 to 4.6 percent by this July and is expected to reach 9 percent next year. The number of registered un employed Hungarians has gone from 853 14 in 1990 to between 300,000 and 320,000 this year. These numbers show only part of the picture.

Supplementing Income. Ottilia Solt, hea d of the lobby on poverty in the Hungarian parliament, estimates that eight out of every ten individuals registered as unem ployed have other sources of income. Polish officials contend that about half of the registered unemployed in Poland have other sou r ces of income. Unemployed Poles include private entrepreneurs trying to augment their incomes or housewives supple menting the family income with unemployment benefits. Many of the registered unem ployed have jobs in the gray or informal sector of the eco nomy where their work es capes government detection and taxation.

Many workers in state enterprises, meanwhile, are voluntarily leaving the state sec tor for the much higher wages and greater opportunities in the growing private sector.

Demand for skilled labor is very strong in most ectors, accounting for almost zero un employment in many of Polands largest cities Much has been made of a reported unemployment crisis as Eastern Europe moves to 3 Dynamic Private Sector Growth The main reason that official s tatistics about East European economies are mislead ing is that they scarcely begin to take account of the tremendous increase in private sec tor activity this year and last. Most private sector activity simply goes unreported be cause the government stil l lacks the administrative capability to measure it. Many busi nesses, moreover, do not register to avoid heavy taxes. Much of the economic value added to East European economies by the hundreds of thousands of new private com panies will take a few years to be fully realized, while enterprise failms in the state sector show up immediately.

Rapid Private Sector Growth. According to the latest private figures for Poland over 1.15 million new private small businesses and 30,000 private companies have 13 Polan & Facing a Dual Economy as Elections Approach, Deutsche Bank Economics Deparhnent, Focus Earern Europe. Deutsche Bank, Washington. D.C p. 121 9 been created since market reforms were introduced. AS in the U.S many of these new businesses and companies hav e failed, but many also have succeeded. l4 According to these figures, the private sector added 26 percent more to the Polish economy in 1990 than in 1989." Private sector retail sales more than quadrupled last year, representing over 40 percent of total r etail trade. In early 1989, less than 10 percent of all retail stores were in the private sector. Now around 85 percent of all retail outlets axe pri vately oged Private sector induseial output also is way up; increasing by 8 percent in 19

90. The 'vate sector now accounts for about 20 percent of total industrial sales in Poland economies, but the destruction of the inefficient state sector and the parallel rapid growth of the private sector This new sector is the driving farce behind econo m ic expansion. Most of Hungary's 40 percent growth in irade with the West this year has been driven by newly created i small- and medium-sized private Hungarian companies. In Romania, new private busi nesses exported over $168 million in goods in the first half of this year. The race is on to see if the private sector can grow quickly enough to absorb the workers, production and services hm the falling state sector w What thus is happening in Eastern Europe is not the wholesale collapse of national FORGING A PATH TO GROWTH Russia today finds itself at an economic crossroads. Voices within Russia-former communists, some populists and authoritarians-and even in the West will be begging Yeltsin to turn back, warning him that the road of sweeping reform is potho l ed with danger and will lead to economic ruin. In choosing to press ahead, Yeltsin shows tre mendous personal courage. He also demonstrates a deep understanding that this is Russia's chance, perhaps its only chance for decades, to make a complete break wi th its failed command economy and to move toward a Westem-style free market and the growth and prosperity that it can bring to his country.

It is in America's interest as much as Russia's that Yeltsin succeed A he market and democratic Russia is America's best guarantee that the Cold War and its dangers will never return. For America's sake and for Russia's, George Bush actively should encourage Yeltsin's reforms and advise him on further measures he should take to en sure the rapid growth of a private sec t or economy I 14 Poland: International Economic Report 199Oll991, World Economy Research Institute, Warsaw School of Economics, 1991.p 64 15 Jehy Sachs Accelerating Privatization in Eastem Europe paper prepared for the World Bank's Annual Conference on Dev e lopment Econom'cs, Washington, D.C April 1991, p. 3 16 Pad Hare and Irene GrosfEld Privatization in Hungary, Poland and Czechoslovakia Centre for Economic Policy Research, Discussion Paper Series, No. 544, p. 12 17 Deutsche Bank, op. cit p. 1 10 Bush shou l d encourage Yeltsin to Persevere with sweeping economic reforms Yeltsins sweeping reforms, due to take effect on January 1,1992, are essential to dismantling Russias failed command economy and creating the conditions for a new free market economy to grow. These reforms inevitably will impose a degree of eco nomic pain as inefficient state enterprises begin to fail, leading to falling production and rising unemployment.

Right now, however, Russia is in the midst of a severe economic decline, with no hope of arresting it in sight. If the Russian government fails to act decisively, as the So viet government has failed to do over the past few years, the decline will continue and accelerate. As it is, the economic uncertainty is keeping foreign investors from i n vest ing in Russia. The ruble is virtually worthless, forcing many economic transactions to be conducted by barter. The country is on the brink of hyperinflation. Yeltsins eco nomic reforms will not solve these problems immediately, but unlike the present course of inaction, they offer tremendous hope for turning around the Russian econ omy in coming months and years. Bush can help Yeltsin move in this direction by pro viding him with the economic facts he needs to debunk myths about the putative fail ure of economic shock therapy in Eastern Europe. Against the chorus of doomsayers spouting horror stories about economic shock therapy in Eastern Europe, Yeltsin must offer the facts. Gloomy offEial statistics hide Eastern Europes economic renaissance.

On the ruins of Eastern Europes crumbling state sector, a thriving private sector is growing, creating jobs, products, and services for domestic consumption and export.

Alleged drops in living standards fail to account for the disappearance of lines, intro ducti on of higher quality products, and most of the earnings from the growing private sector. Unemployment statistics also mislead. Under communism, unemployment was hidden, with workers being paid for jobs that were not done; today unemployment is real, but j o bs are being created rapidly in the fast expanding private sector. Moreover official East European unemployment figures overstate the scope of the problem; in Poland, over 50 percent of those collecting unemployment earn outside income Press forward with further reforms to spur the rapid development of the private economic sector.

In Russia, as in Eastern Europe today, sweeping reforms will doom many giant state enterprises that fonn the backbone of these economies, even if state enterprises be come privat e companies. This will cause some hardships. But the main lesson of eco nomic shock therapy in Eastern Europe is that the key to offsetting these hardships are reforms that spur growth in the private sector. With the state sector in decline, only a growin g private sector can offer displaced workers jobs, extra income to state factory workers, job opportunities to college graduates, higher quality consumer goods, and world-class information, communication, and distribution services to help attract for eign companies and their capital.

Yeltsin and Yegor Gaidar, his new economics minister. If they fail to push these new measures, shock therapy simply may shock the old command economy into collapsing more quickly than the new market economy can grow. This would be a disaster Such reforms to trigger private sector growth will have to be a top priority for 11 Among the new reforms needed to rapidly build a private sector in Russia are Reform 1: Recognize and extend private property rights When a government restri c ts access to property, it removes a primary incentive for the creation of new businesses or improvement of existing businesses. People have little incentive to improve their land or invest in new machinery unless they have gyrante& that their property wil l not be arbitrarily confiscated by the state. Unlike the ineffectual Soviet parliament, the Russian parliament has proclaimed the inviolability of property rights This is an important ht step. But this also does not secm property rights. To do this, an en t ire set of rules and institutions to facilitate property arrangements must be developed quickly. These include: a titling system that makes ownership of property unambiguous; adoption of legal mechanisms for transferring property; contract law that allows parties maximum leeway, secure in the knowledge that contract terms will be enforced by the courts; tort law to protect property from trespass and nuisance; commercial codes that contain real rules governing the sale of goods and property; and the e blish m ent of systems of collateral, that protect debtors and Creditors.'Such basic legal rules, which allow businesses and individuals to interact predictably, are needed if new businesses are to be created and thrive Reform 2: Form a "regulation-buster" of'fic e to eliminate and cut through bureaucratic red tape If the private sector is to grow in Russia, the government immediately must remove burdensome government regulations that hinder the creation and profitability of private business activity. A simple rule should be adopted: everything not expressly forbidden should be permitted To enforce this rule against the entrenched communist holdover bureaucracy, a high-powered deregulation office with powers to push aside bureaucratic opposition is needed. These "re g ulation busters" would have the power unilaterally to eliminate bureaucratic and regulatory impediments to private enterprise creation, like burdensome permit and paperwork requirements and arbitrary government restrictions and regulations on private sect o r employment, wages, hours, sick leave vacation, and output. The Mgulation office would be the chief advocate of private enterprise in the government and could keep Russian businessmen and entrepreneurs informed of their new rights 18 Edward Hudgins Priva t e Property: the Basis of Economic Refom in Less Developed Countries Heritage Foundation Buckgrounder, No. 770, May 24,1990 19 For a summary of some of the obstacles facing private businesses in post-socialist countries, see "Poland Small Business Project O utline of Recommendations GEMIM and IRIS report prepared for the U.S. Agency for International Development (AID Washington, D.C March 15.1991 12 Reform #3: Make business licensing nearly automatic Despite the good intentions of such Russian laws as the La w on Enterprises and Entrepreneurship, adopted in December 1990, business licensing in Russia remains a lengthy process and thus a formidable barrier to private enterprise. It now takes most Russian entrepreneurs at least two months to fill out the forms a n d obtain the necessary signatures to start a business; in most of America, by contrast, it takes a matter of hours. It is common for businessmen to wait for up to a year for a license in the Soviet Union. It should be no surprise, therefore, that bribing o fficials to obtain licenses is an accepted part of the system. Business licenses should be granted automatically unless within fourteen days the government denies the request for a legitimate reason. In most cases obtaining a business license should take no more than one day I I Ref0rm.M: Cut business taxes.

Businesses in Russia are taxed at a rate up to 35 percent under a complicated business tax system which taxes different types of companies differently. High and complicated taxes on business discourage new business development. The Russian government could remove most tax barriers by replacing carporate profits taxes with a simple, low, flat business tax with no deductions or exemptions, except for money invested back into the business.

Russian tax law s, moreover, unwisely favor joint ventures with foreign corporations over domestic entrepreneurs. Such joint ventures granted either lower tax rates or a two-year tax holiday from the .government. This creates an incentive for Russian entrepreneurs to see k out foreign partners to avoid taxes, even if the partner has no real role in the venture. The Russian government should put Russians and foreigners on equal footing preferably by granting Russian firms the same incentives as foreign firms for starting ne w businesses, or by eliminating the incentives for foreigners CONCLUSION Boris Yeltsin has made a courageous decision in following the lead of such East Eu ropean countries as Poland in adopting sweeping economic refms. Yeltsin also has taken a risk. In co ming months, opposition to his refonns will mount as short-term eco nomic hardships are felt. Communists, authoritarians, and populists will play on fears of change, and accuse the Russian government of imposing severe hardship on the Rus sian people.

Alre ady, Yeltsins critics are pointing to dire official statistics that appear to show a sharp drop in production and living standards and a precipitous rise in unemployment where radical free market reforms have been undertaken in Eastern Europe. In fact the s e statistics mask an economic rebirth that rapidly is propelling Eastern Europe to ward a new prosperity 13 Help for Yeltsin. In answering his critics, Yeltsin will need help. George Bush can ielp him. Bush can start by treating Yeltsin with the respect h e retofore reserved for the nore timid Wail Gorbachev. Bush should backyeltsins economic reform plan pub icly, and urge him to stay the corn. He further can help Yeltsin by axming him with he facts about economic Ieform in Eastern Europe, which belie the gl o omy picture minted by official statistics. These statistics do not capture the tremendous increases in mduction in a booming private sector, nor do they document the tremendous in mases in the quality of life for East Europeans, including the end of short ages, disap pearance of long lines at shops, availability of varied and high quality goods, better ser vices, and technological advance.

Bush also has a role to play in advising Yeltsin on the future course of reform. Mea sures already announced by Yeltsin undoubtedly will cause some short-term economic problems. These only can be offset by a growing and dynamic private sector. Bush should advise Yeltsin to undertake additional reforms to dismantle quickly obstacles to private enterprise. These include the expansion of property rights, establishment of a regulation-buster office to eliminate and cut through red tape, streamlining the pro cess of issuing business licenses, and cutting business taxes succeeds, he has a decent chance to lead Russia toward demo c racy, free markets, and certain prosperity. If he fails, Russia might return to authoritarianism and perhaps ex pansionism. It is in Americas interest as well as Russias that he succeed Russias fate rests on the success or failure of Yeltsins economic ref orms. If Yeltsin William D. Eggers Policy Analyst Heritage internTodd Leeuwenburgh, a graduate student in the Elliot School of International Affairs, at George Washington University assisted in the preparation of this study 14

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