Pointing Way to Prosperity for East Europe Countries

ALLAN H. MELTZER <i> is John M. Olin professor of political economy at Carnegie Mellon University and a visiting scholar at the American Enterprise Institute</i>

As we approach the second anniversary of the revolutions in Eastern Europe, it becomes clear that none of the countries has found an open road to prosperity. Their experience is mixed, but some general lessons can be learned.

First, no one knows how to plan the transformation of a command economy into a market economy. Thick plans that lay out a sequence of steps to be taken are worthless. The best course is to scrap the old system as quickly as possible. Delay doesn’t make change easier; it helps the Old Guard to grab the best properties for themselves.

Second, inflation is a serious risk. The risk is realized if the governments maintain the many subsidies to consumers and state enterprises and finance them by printing money. When prices are freed from controls, subsidies must be ended; the government must be willing to let living standards drop and enterprises must get rid of their excess labor to control costs. If enterprises match the increase in prices with increased wages, their costs will rise and they will demand more subsidiies. If they get them, inflation is almost certain to soar.

Third, markets are uncommon and competition is unknown. Even when companies are sold, they face little or no internal competition. To get more competition quickly, Eastern European economies must let world exports enter. This forces a wrenching adjustment as local products are forced to compete with foreign products at home and abroad.


Fourth, property rights are essential for efficiency, competition and a well-functioning market system, but property rights are badly defined in these countries. All of them have been slow to privatize large state enterprises, but several countries have sold off many of the retail stores and service businesses.

Fifth, statistics are unreliable, so they cannot be used to guide decisions. In Poland, and probably elsewhere, the measurement of production reports what is happening in the state industries. Private production and the output of new enterprises is estimated at 20% of the total but is not recorded in official statistics. Reported declines in output overstate the drop in production and living standards. Markets are growing in many of these countries, but market transactions are not recorded.

Sixth, several Eastern European countries agreed to make restitution of the property claims of former owners. Adjudication of claims takes time and delays the sale and revitalization of factories, businesses and housing. This, in turn, delays the recovery. Payment of compensation to prior owners, instead of restitution of property, allows the transformation to proceed.

Seventh, the breakdown of Comecon--the communist bloc’s trading arrangement--and the collapse of the Soviet economy have been a hard blow for Eastern Europe. These countries now demand hard currency payment and must pay hard currency for oil from the Soviet Union. Trade has slowed as a result, causing large losses of output and employment.


Eighth, setting the wrong exchange magnifies the cost of adjustment. Germany and Poland are opposite examples. The prosperous West Germans “helped” their East German cousins by exchanging East German marks at an effective rate of 1.8 to 1. This gave the East Germans a big boost in purchasing power that many used to buy Western goods. But, after the exchange, costs of products in East Germany were far above costs in competing countries. Many factories became uncompetitive and were forced to close. Poland took the opposite course. The Poles stabilized the currency at an exchange rate that favored exports in the first year of readjustment. Their pains were severe but less than in eastern Germany, where unemployment rates may reach 40% to 50% by year’s end.

Achievements and commitment to reform differ from country to country, but there are some common features.

Poland, Hungary and Czechoslovakia have made the most dramatic changes. All have made major transformations to establish democratic political systems and market economies. Currencies are convertible. Western goods are available and prices are decontrolled. Each has developed its own way of privatizing state enterprises.

Romania, Bulgaria, Albania and Yugoslavia have not freed themselves fully from communist rule, and they have not established stable, democratic political systems and other requisites for a market system. The evolution of these countries is uncertain. At best, they will drift downward.


The former East Germany is in a different position than the others. As part of Germany, it is able to export to members of the European Community. Once the union was complete, eastern Germany had established legal, accounting, financial and tax systems and developed social benefits and transfers. Yet despite these advantages, the transition has been one of the most difficult.

Why? There is no single answer. German law imposes high costs for social benefits and pollution control. Also important is the assistance eastern Germans get from western Germans. Eastern Germans know they don’t have to make the hard choices that the Poles and Czechoslovaks have made, so they are slow to adjust, demand wage increases up to 60% and collect transfers when they are unemployed.

There is a lesson there about aid to Eastern Europe. The West should help by opening markets, not by offering financial assistance and loans to central governments.