Transition economics is the study of the economic transformation of formerly centrally planned economies into market-based economies. It is a relatively new field, having emerged in the early 1990s, and there is still much debate among economists over how to best approach the transition process.
In this article, we discuss the economics of transition economies and how these countries are adjusting to these economic changes. We discuss how the industrial sector is dominating the economies in transition, as well as some of the key Type II reforms that are underway. In the early transition economies, the main economic problem was inflation. Although this problem has been alleviated, the countries in transition still face the same problems that developed nations faced. The income gap figures refer to almost a decade after price liberalization.
Income gap figures refer to almost one decade after price liberalization
There is a pronounced income gap among the top and lower earners in Transition economies, and the growth in the middle and upper income groups is much faster. This inequality has been growing for four decades. The middle 50% earned an average of almost double the amount of the bottom 50 percent, while the top 0.001% earned more than three and a half times as much as the bottom 50%. Moreover, the top 10%’s share of total income grew at an even higher rate than the bottom 50%.
The main difference between the two groups of countries is the speed and nature of the transition process. Although all transition economies began with a fairly robust labor market, the speed and scope of implementing social institutions varied significantly. In all but a few countries, unemployment compensation schemes and social security benefits operated well. However, these benefits tended to be modest. In Russia, for example, benefits were low and often not paid.
The figures for the income gap between the two groups are comparable to those of a developing country and a capitalist nation. The central and eastern European data appear to reflect the reality of the situation, while the data for Ukraine and Russia may be understated. While the figures derived from the Russian Longitudinal Monitoring Survey (RLMS) are based on the wages that firms are supposed to pay their employees, many of them are not paid contractual wages.
Regardless of privatization methods, these countries have been under fiscal pressure. Privatization has generated very little revenue for governments in transition economies. In the former Soviet Union and central and eastern Europe, governments collected only five percent of their GDP through privatization. The most revenue-oriented privatization, in Hungary, was a modest 14 percent of GDP, which is small when spread over several years.
Industrial sector dominates in the economies in transition
Differences in the industrial sector’s capital intensity can be explained by the different technologies used in producing the sectors’ outputs. As production in industrialization involves the transformation of materials and mass production, it requires more machinery per unit output. The difference in capital intensity between the two sectors is often correlated with changes in energy costs. For example, the energy intensity of industrial production is higher than the one in the service sector.
The ‘humps’ are not as similar across countries, but the most advanced industrializers have experienced the highest peaks. France, Germany, UK, and Belgium were early industrializers, and their industrial share reached 40 percent or more of total employment. Taiwan and Mauritius, however, reached similar levels. The chart below highlights the differences in industrialization across these countries. In general, however, industrialization is associated with higher productivity levels and lower costs.
Labor productivity increases were greatest in the industrial sector. While this was not the case in most transition countries, the value added of services increased by a factor of 3.1. However, when adjusted for the effect of sectoral price inflation, the decline in the industrial sector’s value added was less pronounced. As a result, the industrial sector’s contribution to GDP increased in these economies. These findings suggest that a greater share of GDP should be allocated to the services sector in the future.
Economic growth is inextricably linked to structural change. In the early phases of economic development, the industrial sector dominates, with the agricultural sector shrinking. In contrast, the service sector consumes the largest share of value added. Although these changes are not necessarily detrimental to society, they may not be in the best interests of any one group. For example, the industrial sector may be beneficial to human survival, but at a cost to the environment.
Inflation was the main economic problem in the early transition economies
As the private sector increased in the early transition economies, inflation decreased. The share of private enterprises in GDP increased from twenty to twenty-five percent to more than sixty percent by 2000. However, private ownership was not uniform. Some countries were more private than others. There were many differences in the privatization methods used. The first phase of reform involved macroeconomic stabilization, price liberalization, and reduction of direct subsidies. Later phases of reform involved the development of a market-oriented legal system and the introduction of a social safety net.
The major problem in early transition economies was high inflation. Inflation rates were high in many early transition economies, and a flawed consensus held that these countries “needed” high public expenditures. Although some East-Central European countries managed to collect large state revenues, the post-Soviet economies were left with declining state revenues. As a result, finance ministries had to strengthen their government expenditures while central banks tightened their monetary controls and removed subsidized credits.
In the early transition economies, unemployment was high, but the global recession has caused much of this. Many transition economies experienced price inflation during this time, as newly privatized firms began charging their true costs of production. Some entrepreneurs even increased prices to take advantage of the situation. This situation led to a shortage of real capital, which exacerbated the economic problem. There was also a skills gap, which made it difficult to implement market capitalism and reform the economy.
The Volcker Fed had little success in bringing inflation under control, but the results were positive. It fought inflation with tighter reserve management and credit controls in early 1980. The economy was in a recession again, but this time the recession was more severe. Unemployment reached an all-time high of eleven percent. Inflation remained high during this time, but it was back under five percent by the end of the recession. After this period, the Fed’s commitment to keep inflation low gained credibility and the economy entered a period of sustained growth and stability.
Countries in transition have pursued a combination of key Type II reforms
A key part of implementing the OECD’s reform agenda is the development of a market-oriented legal system and the enforcement of market-friendly institutions. These reforms typically involve the privatization of large enterprises, the establishment of a commercial banking sector, and labor market regulation and institutions related to public unemployment and retirement systems. These reforms require the government to have sufficient resources to ensure market-friendly conditions without giving in to special interests.
Developing countries have the added challenge of deindustrialization, and many transition economies face large fiscal pressures. Tax burdens in central and eastern Europe have been relatively high, ranging from 35 to 42 percent of GDP. Most governments have relied on a combination of personal income tax, value-added tax, and payroll tax. While these tax burdens are significant, they have not prevented many transition economies from running budget deficits.
While the effects of social programs may be positive in the short run, the costs of such programs are likely to have a negative impact on economic growth. While these reforms may increase the living standards of people who are already employed, they may increase unemployment and exacerbate inequality in income distribution. The overall effect on economic growth depends on which of these two effects dominate. In the absence of social security reform, the pension system is likely to be the first sector to experience a financial crisis.
The first two years of transition in Indochina were marked by high inflation. However, tight macroeconomic policies and limited use of exchange rate pegs largely lowered the risk of deflation. In contrast, in China, which followed a gradualist approach, the monetary framework was quite different from that of its neighbours. The low inflation rate in China is primarily due to surges in aggregate demand and changes in exchange rate regime rather than on the lack of real capital.
Countries in transition have joined the global market
While the liberalization of consumer prices and imports was a relatively easy transition, the process of deregulating commodity prices proved to be more difficult. The well-connected and wealthy wanted to buy commodities at low state prices and sell them for multiples. It was only after a major crisis did these countries begin to accept deregulation of commodity prices. But now these countries have successfully joined the global market. How did they do it?
A report by the International Monetary Fund (IMF) on the determinants of growth in transition countries summarizes five lessons for countries. The most important lesson, and perhaps most vital, is to stabilize inflation. This is an especially critical first step for transition economies, as many of them suffer from inflation in the short-term. The IMF also suggests that some price control is necessary during this period. But there are a number of other lessons that governments should take from countries in transition.
Although a single policy recipe for economic transformation has been suggested, this approach has been controversial. Various factors influence the focus of development policies. The degree of importance given to macro or micro processes, as well as regional legacies, affect the formulation of these policies. As an example, a case study of Russia demonstrates the influence of these debates on the post-Washington Consensus. While largely positive, it fails to provide a complete solution to the challenges facing developing countries.
Historically, the transition process from central planning to a market-led economy was difficult. Transitional economies underwent a series of structural reforms before fully implementing socialism. One of the main markers of a transition period is the implementation of private property rights, the most basic element of a market economy. Liberalization, on the other hand, involves allowing prices to be determined in free markets and reducing trade barriers.
In conclusion, Transition Economics is an important tool for countries in the process of transitioning from a centrally planned economy to a market economy. It helps to ensure that the transition is as smooth as possible, and minimizes the negative effects of the transition on the economy and the population.
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