Development and transition

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JULY 2005Published by the United Nations Development Programme and the London School of Economics and Political Science

www.developmentandtransition.net

HUMAN DEVELOPMENT IN EUROPE AND EURASIA

Special Report: The Millennium Goals in the CIS

Development Versus TransitionLost in Transition: When is transition over?Linking Economic Development and TransitionPoverty During the Early TransitionProductivity, Prosperity and DevelopmentUkraine, the First Hundred DaysForthcoming Conferences

Kalman Mizsei, Ben Slay andLouisa Vinton .......................................Ben Slay....................................................Gwendolyn Sasse..................................Waltraud Schelkle.................................Nicholas Barr...........................................Andrei Sarychev.....................................Iryna Akimova...............................................................................................................

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EEddiittoorr’’ss NNootteeDear Reader,

Welcome to the Newsletter on Development andTransition in Europe and Eurasia, which will be pub-lished quarterly as a joint enterprise between UNDPand LSE. As the title suggests, the Newsletter aimsto be a forum for policy-oriented discussions anddebates about how the nature, evolution and chal-lenges of development and transition intersect inthese regions. Each issue will focus on a theme, andhave several related short contributions. Our aim isto discuss and think differently about policy frame-works by bringing together a variety of viewpointsand analytical approaches from researchers andpractitioners to explore and explain the core issuesand problems, and to extract the best practicesfrom lessons across countries. Our editorial policy isto promote innovative approaches to complexissues, irrespective of the orthodoxies in the aca-demic or policy worlds. It is not that we activelyseek to promote divergence and diversity in thecontributions to the Newsletter, it is simply that thisis a true reflection of the best thinking in the realworlds of academia and policy-making. To capturequality insights from different disciplines (econom-ics, political economy, political science, law, sociol-ogy) requires that we be as inclusive as possible. Wewill provide synopses of the latest UNDP reportsand papers relating to our themes, many of whichwill be produced by UNDP regional offices. We alsoencourage the inter-disciplinary exchange of ideas,and hope that our Newsletter will contribute tothis. In sum, our readers will have a menu of choic-es by which they can inform themselves of the

most important challenges of development andtransition, and draw out policy recommendations.

The first issue analyses and debates the commonlyused key terms and concepts of ‘development’ and‘transition’ from several perspectives. We demon-strate how these terms are understood differently,both between economists, and between econo-mists and political scientists. Subsequent issues willaddress other core themes in a similarly nuancedway, including: the management of minorities andmigration, the impact of EU enlargement, the rela-tionship between productivity and prosperity, andthe consequences of conflict for development andtransition.

My role as editor is supported by an editorial boardconsisting of Ben Slay and Jonathan Brooks forUNDP, and Gwendolyn Sasse and Andrei Sarychevfor LSE. The Newsletter will include a regular sec-tion of news about relevant events and confer-ences and links to freely available papers, reportsand articles that deal with our thematic priorities.The Newsletter is published in English and Russian,and is distributed widely within UNDP and LSE’sextensive international knowledge and alumni net-works. It is our goal that the Newsletter be an easi-ly accessible vehicle for communicating ideas thatwill assist key practitioners who are involved in pol-icy discussions for the Europe and Eurasia regions.

Comments on and submissions to Developmentand Transition should be submitted to:[email protected].

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JULY 2005 | issue 1DEVELOPMENT &TRANSITION

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Kalman Mizsei, Ben Slay andLouisa Vinton

Are the MDGs relevant to the CIS?

The Millennium Development Goals(MDGs) are at the heart of the inter-national development agenda. Thegoals have their origin in the Millen-nium Declaration, which appeals tothe universal values of freedom,equality, solidarity, tolerance,respect for nature and sharedresponsibility to rouse the world toan ambitious effort to eradicatepoverty and other social ills. TheMDGs were defined with an eye tothe development realities of theworld’s poorest countries, and analy-sis and policy thinking about themhas been oriented to a large degreeto Sub-Saharan Africa. This was thecase, for instance, with Investing inDevelopment: A Practical Plan toAchieve the Millennium Develop-ment Goals, the action plan toachieve the MDGs that was preparedby the Millennium Project led by JeffSachs and commissioned by the UNSecretary General and sponsored byUNDP.

But are the MDGs relevant to theRussian Federation and the variedcountries that comprise the Com-monwealth of Independent States(CIS)—some of them middle-income, some of them suf-fering from dire poverty? Are the goals relevant in their‘pure’ global formulations, or should they be tailored tosuit national realities? If the latter, how should concretetargets be defined so that pursuit of the MDGs is mostbeneficial for these countries? How can the CIS coun-

tries achieve these goals, as appropriately defined? Andhow should progress be measured?

These questions are at the heart of UNDP’s approach tothe MDGs in Russia and the rest of the CIS. UNDP’s expe-rience across the region underscores the relevance ofthe MDGs, both as an inspiration to energetic efforts onbehalf of the world’s poor and as a flexible frameworkwithin which countries can adapt the ‘global’ goals to

address their own specific chal-lenges. Much of the MDG effort restson the technical work of economists,statisticians and policymakers,whose job it is to map the main chal-lenges in poverty, education, health,and environment, and to plot solu-tions. But when dealing with thetechnicalities of goals, targets andindicators (something UN expertsproduce in large quantities), it isimportant not to lose sight of the val-ues behind the MDG effort.

An inspiration for social solidarity

The ideal of social solidarity is at thecore of the MDGs and the Millenni-um Declaration that inspired them,and this is what makes the Declara-tion such an important documentand, incidentally, such uplifting read-ing: “Those who suffer or benefitleast deserve help from those whobenefit most”, the Declaration pro-claims. This is the first time that thisfundamentally moral imperative hasbeen expressed with such clarity inan international context. Looking atthe MDGs from this angle, it is obvi-ous not only that the goals makeprofound sense in the CIS contextbut also that they address the spiritu-al vacuum that is a painful legacy ofthe Soviet system.

The Soviet Union enshrined an official ideology basedon social solidarity, yet this was violated in everydaypractice. Instead, Soviet reality promoted a cynical indi-vidualism that bordered on survival of the fittest. Thisoutlook has persisted after the collapse of communism.‘Oligarchic’ business elites are very different from the

GDP per headat purchasing power parity (US$)

Nigeria 860

Tajikistan 980

Kenya 1,020

Rwanda 1,270

Uganda 1,390

Moldova 1,470

Côte d’Ivoire 1,520

Kyrgyzstan 1,620

Uzbekistan 1,670

Sudan 1,820

Cameroon 2,000

Ghana 2,130

Angola 2,130

Georgia 2,260

Zimbabwe 2,370

Armenia 3,120

Azerbaijan 3,210

Swaziland 4,550

Ukraine 4,870

Namibia 6,210

Botswana 8,170

Russia 8,230

South Africa 10,070

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laissez-faire ideals of liberal pro-market advocates, andmarket institutions have developed without proper reg-ulatory underpinning or the safeguard of competitionagainst monopolistic profiteering. Income and assetinequality increased in the CIS in the early years of tran-sition. Hence the compelling need to reintroduce, in adramatically different institutional setting and with verydifferent consequences, the message of genuine socialsolidarity. For the poorest countries of the CIS in Cen-tral Asia, the Southern Caucasus and Moldova, the inter-national dimension of social solidarity is also com-pelling.

Applying the MDGs

The MDGs are relevant not only as a moral inspiration,however. The poorest CIS countries are much poorerthan is generally assumed, in part because of a widelyheld illusion that the industrialisation brought develop-ment to all corners of the Soviet Union. The traditional,‘global’ MDGs are thus directly applicable to parts of theCIS. The fit is best in the Central Asian countries, due tothe sub-region’s legacy of post-Soviet economic col-lapse, unfavourable landlocked geography, and gener-ally low per-capita GDP, but the Caucasus countries andMoldova are also impoverished. Income poverty isquite apparent in these countries, particularly in ruralareas. So are unfavourable trends in education, infantmortality, and other MDG indicators.

For these reasons, the Millennium Project report has rec-ommended that Kyrgyzstan and Tajikistan, as well asArmenia, Azerbaijan, Georgia and Moldova, put theMDGs at the centre of the national development agen-da by aligning them with poverty reduction strategypapers. Moreover, the report has classified Armenia,Azerbaijan, Georgia, Moldova, Kyrgyzstan, and Tajikistanas ‘MDG fast-track’ countries that could be eligible forincreased official development assistance. A closer lookat the plight of these countries explains why these aresound proposals.

A comparison of GDP per head provides some strikingresults. Tajikistan’s GDP per head, US$980 at purchasingpower party, is lower than that of many of Africa’s poor-est countries, including Kenya (US$1,020), Rwanda(US$1,270) and Uganda (US$1,390). In the EuropeanCIS, Moldova’s GDP per head (US$1,470) is lower thanthat of Sudan (US$1,820), Ghana or Angola (both atUS$2,130). Even Russia’s GDP per head, the highest inthe CIS, is only 80 percent of that of South Africa, Sub-Saharan Africa’s richest country. While the nature and

genesis of poverty in the CIS may be very different fromthat in Africa, its magnitude is actually, and sadly, com-parable.

Against this background, the world community’s indif-ference to the plight of the poorer countries of the CISoften seems outright discriminatory. PresidentVladimir Putin of Russia recently called attention to thisdiscrepancy when, while endorsing UK proposals toincrease international aid to Africa, he remarked on theneed for international assistance to the CIS.

The Millennium Project has, to a limited extent, reck-oned with this issue by including Tajikistan into the firstround of pilot projects of its ‘needs assessment’, along-side Asian and African countries (Bangladesh, Cambo-dia, Ghana, Tanzania and Uganda). This methodology,whereby the government, with the support of externalexperts, sets poverty reduction goals for 2015 and thendrafts a programme of how to achieve them, includinginternational donor support, should be applied to all CIScountries with extremely low levels of GDP per capita.The compelling reason for this is that these very poorcountries will need large-scale international assistanceas well as economic growth and sensible social policiesto achieve the MDGs.

Adapting the MDGs

What of the wealthier countries of the CIS? Official statis-tical data in Russia, as well as in Belarus and Ukraine, do

Millennium Development Goals:

1: Eradicate extreme poverty and hunger

2: Achieve universal primary education

3: Promote gender equality and empower women

4: Reduce child mortality

5: Improve maternal health

6: Combat HIV/AIDS, malaria, and other diseases

7: Ensure environmental sustainability

8: Build new global partnerships for development

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not point to widespread or extreme poverty. Likewise,poverty reduction strategy papers are not used asmechanisms to coordinate macroeconomic and socialpolicies, or to structure official dialogue with the inter-national development community. Poverty nonethelessremains high on the agenda of even middle-income CIScountries. Mr. Putin has declared that, in addition todoubling gross national product over the next 10 years,Russia’s development priorities include reducing pover-ty and income inequalities, as well as improving livingstandards and the quality of social services. Other CISleaders have expressed similar sentiments.

Regional variations in the depth and breadth of poverty,as well as in the other areas covered by the MDGs,nonetheless put a premium on tailoring the goals tospecific national needs. Doing so often means disaggre-gating national statistics, in order to reveal pockets ofincome poverty, unfavourable health and educationtrends, or other manifestations of social exclusion thatmay be hidden by national averages. A goal-by-goalreview of how Russia and the CIS countries are doing inthe main areas covered by the MDGs is an indicator ofjust how useful such tailoring could be.

The good news: Growth and income poverty (MDG 1)

Recent GDP trends suggest that the threat of absoluteincome poverty in CIS countries is receding. Annualaverage GDP growth during 2000-2004 in Azerbaijan,Armenia, and Tajikistan—some the region’s poorestcountries (measured in per-capita GDP terms)—aver-aged 10-11 percent. Russia, Ukraine, and Moldova, withaverage annual GDP growth rates of 6-8 percent duringthis time, were ironically among the CIS ‘laggards’. Eventhese rates were roughly double GDP trends for theseyears in the Central European economies that joined theEuropean Union (EU) in May 2004. In addition, CentralEuropean rates were in turn significantly above those forthe EU as a whole.

A growing body of evidence shows that this robust eco-nomic expansion has helped to bring about a fall inpoverty rates. Recent World Bank data show that Russiahalved absolute income poverty from 42 to 20 percentduring 1999-2002. Tajikistan—the region’s poorestcountry, in per-capita GDP terms—reduced the share ofthose living on less than $2.15 per day (in purchasingpower parity terms) from 83 percent to 64 percent dur-ing 1999-2003. Armenia cut poverty overall from 55 per-cent in 1999 to 43 percent in 2003; extreme poverty fellin the same period from 23 percent to 7.4 percent—alevel that the government had not expected to reachuntil 2013. In Kazakhstan, the percentage of the popu-lation classified as living below the subsistence mini-mum dropped from 39 to 24 percent during 1999-2002,and has almost certainly declined further since.

These trends suggest that some good things are hap-pening in the CIS countries, in terms of MDG 1. Unfortu-nately, this rising tide is not lifting all boats equally: largevariations in poverty remain apparent across and withincountries. In 2002, Russia’s poverty rate varied from 3percent in the richest region (Moscow city) to 56 percentin the poorest. Much recent economic growth hasbeen concentrated in urban areas: Russia’s poverty ratewas 30 percent in rural areas versus 16 percent in urbanareas in 2002.

Relative inequality in the CIS has in fact risen sharplyduring the past fifteen years. In Soviet times the Ginicoefficient, a measure of inequality, was around 0.25, orat Scandinavian levels. It is important to remember,however, that this tool is at best a very rough measure ofinequality in Soviet times, given the concealed nature ofmany privileges and benefits under communism. Still,by the late 1990s, income disparities in some CIS coun-tries had reached levels more commonly found in LatinAmerica and Sub-Saharan Africa. This contrasts with thenew EU member states, where Gini coefficients havegenerally remained at European levels.

Promisingly, recent evidence suggests that growth mayalso be causing inequality to recede. In Armenia, theGini coefficient for income fell from 0.535 in 2001 to0.438 in 2003, and for consumption from 0.344 to0.275—and the latter is a value typical of many Euro-pean countries. In Russia, inequality increased until1998, but then declined somewhat subsequently. TheGini coefficient for consumption increased from 0.370 in1997 to 0.392 in 1998, before declining to 0.368 in 2002.In both countries, it’s worth noting that inequality inexpenditure, incomes, or assets is substantially higherthan consumption inequality.

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Rapid economic growth combined with continuing highlevels of inequality suggest that social assistance pro-grammes in many CIS countries are not as effective asthey could be. Recent World Bank data indicate thatRussia has one of the least effective social assistanceprogrammes in the world: half the benefits of targetedsocial assistance go to the richest 60 percent of the pop-ulation. Social policy reform, to build the capacity need-ed to effectively target social assistance to those most inneed, can help reverse these trends. Reforms introducedin the Central European countries as part of their prepa-rations for EU accession were key to building this capac-ity. This is apparent in the large differences betweenpoverty rates before and after the payment of socialtransfers. Armenia’s recent household survey datapoint to progress in targeting: some 40 percent ofhouseholds classified as ‘extremely poor’ receive poorfamily benefits and pensions, compared to 27 percent ofthose classified as ‘poor’ and 19 percent of those classi-fied as ‘non-poor’. In fact, the IMF recently creditedArmenia’s "increase in social transfers through a well-targeted family poverty benefits programme” with help-ing to reduce inequality.

Social sphere: Unsettling education, health, anddemographic trends (MDGs 2-6)

The second Millennium Development Goal in its globalform concentrates on ensuring universal primary educa-tion. This goal is often redefined in middle- and upper-income countries to focus on issues of secondary andtertiary education and their links to labour markets.Such redefinitions seem quite appropriate in CIS coun-tries, where problems of adapting the generally highlevels of Soviet-era human capital to post-Soviet labourmarket trends are compelling. However, the issue of pri-

mary school enrolment may be becoming increasinglyimportant in some of the poorer CIS countries. In Tajik-istan, primary school attendance fell to 88 percent in2003.

The post-1999 economic growth reported in many CISeconomies has not yet reversed declines in publichealth, life expectancy, and disease. (This is not surpris-ing, since a number of these problems predate the Sovi-et collapse.) Along with gender, these issues are at theheart of MDGs 3-6. Male mortality trends reported inmany CIS countries are both unusual and disturbing: lifeexpectancy for men in Kazakhstan dropped by sevenyears during 1989-2002, while rising by three years inHungary and Poland during this time. Life expectancy at

birth in Russia is among the lowest for industrial coun-tries: 65 years on average, compared with 79 years inWestern Europe. Moreover, the gender gap is huge: lifeexpectancy is just 59 years for Russian men, against 72years for Russian women. If 2000-2001 mortality trendswere to continue, only 58 percent of Russian men then15 years old would live to be 60. In Poland this figurewould be 77 percent.

These unfavourable demographics make the epidemio-logical trends in terms of HIV/AIDS, tuberculosis, andother infectious diseases reported in many CIS countriesparticularly worrisome. HIV prevalence rates in Russiaand Ukraine (as well as in neighbouring Estonia) are ris-ing above 1 percent of the adult population, and are onthe verge of entering the general population. Reportedtuberculosis cases in Russia (at 134 per 100,000 inhabi-tants) exceed those reported in China (113 per 100,000)and Brazil (64 per 100,000), not to mention the countriesof the European Union.

Lifestyle and behavioural factors seem to be part of theproblem, particularly in terms of alcohol consumptionand diet, as well as car accidents and violent crime. Buthealth care systems also seem to be to blame: the high-

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er personal incomes associated with economic recoveryare not always translating into the provision of adequatemedical services. High-cost curative care is too oftenemphasised over lower-cost preventive care, and theproliferation of ‘informal payments’ for medical serviceshas limited access to quality health care for low-incomehouseholds.

These considerations suggest that MDGs 2-6 are quiterelevant for CIS countries. In contrast to the situation indeveloping countries, responding to these challengesneed not require massive injections of external assis-tance in those CIS countries with higher per capitaincome. Social policy reform via the appropriatedecentralisation, restructuring, and modernisation ofstate administrations is the key. In the poorer CIS coun-tries, massive external assistance is inevitable.

More good news: MDGs 7-8

MDGs 7 and 8 concern environmental issues and globalpartnerships for development. To be sure, nationalenvironmental policies in CIS countries are often incon-sistent with best international practices. The regioncontinues to struggle with the development legacies ofSoviet-era environmental disasters in the Aral Sea Basin,Chernobyl, Semipalatinsk, and the like. Access topotable water is a serious issue in a number of the poor-er CIS countries, particularly in rural areas.

On the other hand, Russia’s ratification of the Kyoto Pro-tocol enabled the protocol to come into force. The CISis likely to, and should, emerge as one of the world’smost active carbon trading regions, due in part to thelarge reductions in greenhouse gas emissions experi-enced during the economic declines of the 1990s.Regional leadership in Kyoto implementation will servenot only to protect the global environmental commons;it can also work to provide innovative new fundingmechanisms for financing green economic growth inthe CIS.

CIS countries are contributing to global partnerships fordevelopment in other ways as well. Russia is now mov-ing to expand its technical assistance for some CIS anddeveloping countries, with an initial focus on Armeniaand Tajikistan. Azerbaijan, Armenia, and other CIScountries, while remaining recipients of official develop-ment aid, provided humanitarian assistance to theSoutheast Asian countries that were devastated by theDecember 2004 tsunami. And, as the new EU memberstates have already demonstrated, Russia and the otherCIS countries may also have broader lessons and transi-

tion expertise to contribute to the international devel-opment community.

How UNDP can help

As in many other regions, UNDP can help government,NGO, and private-sector partners in CIS countries toachieve the MDGs. Survey research conducted withinthe framework of the intergovernmental ‘Decade ofRoma Inclusion’ has identified pockets of poverty andsocial exclusion among Roma, refugees, and internallydisplaced persons in Central and Southeast Europe. Thismapping and measurement of poverty among vulnera-ble communities, and the development of MDG-consis-tent indicators to track poverty trends over time, under-scores the relevance of the MDGs in middle- and evenhigh-income countries.

UNDP is likewise assisting the Russian government indevising national indicators to measure the effective-ness of social policy. UNDP since the late 1990s has beenhelping the governments of the new EU member statesto become more effective donors, and increase theregion’s role in international development cooperation.It stands ready to do the same for Russia and other CIScountries, as they move to increase their technical assis-tance efforts.

Last but not least, UNDP’s climate change expertise andcountry office infrastructure can offer governments ofthe region the opportunity to move quickly to capturethe economic and environmental benefits of the Kyotoprotocol.

UNDP’s global mission is to provide countries with assis-tance in meeting the MDGs. The best way to apply theMDGs differs from country to country, even withinregions sharing similar histories, as is the case with theCIS. In some cases, particularly where extreme povertyremains a widespread threat, the MDGs in their tradi-tional, global formulation are entirely applicable. In oth-ers, where poverty is confined to specific regions orgroups, a more tailored approach is appropriate. As theexperience of Russia and the rest of the CIS makes clear,however, the message of the Millennium Declaration—the ideal of social solidarity—is relevant everywhere.

Kalman Mizsei is Director of the UNDP Regional Bureau forEurope and CIS in New York (RBEC)Ben Slay is Director of the UNDP Regional Centre for Europeand the CIS in Bratislava [email protected] Vinton is Senior Programme Manager, RBEC

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Development VersusTransition

Ben Slay

One of the ironies facing the international developmentcommunity working in the countries of Central Europe,the Balkans, and the Commonwealth of IndependentStates (CIS) lies in the fact that these countries do notface traditional economic development challenges perse. First and foremost, they face problems of economictransition. When differences between development andtransition are not fully understood, conceptual and pol-icy mistakes can— and sometimes do —occur.

What is economic development?

Various definitions of economic development can befound, reflecting different methodological and ideolog-ical perspectives. In some sense, all countries and socialsystems are always in the process of development: evensmall quantitative changes of population or wealth canlead to major systemic qualitative changes. But in itsclassical sense, economic development can be reducedto the problem of capital accumulation. Developingcountries typically have extensive reserves of labour and(in some cases) natural resources, but possess smallendowments of capital. Physical capital consists largelyof residential, agricultural, and commercial buildings,and stocks of grazing and farm animals. Human capitalis limited by the absence of well-developed educationsystems: attaining universal primary education andbasic literacy are major challenges. Only a small percent-age of the population has access to higher education,and a good number of university graduates migrate todeveloped countries where the return on their humancapital is higher.

Acquiring this missing capital is not easy: low incomesand high propensities to consume typically limit domes-tic savings and force developing countries to tap intoforeign savings. Populations are young and rapidlygrowing, endowing developing countries with relativelylarge but unskilled labour forces. The education systemsneeded to generate human capital cannot be estab-lished overnight. Underdeveloped medical systems andunhealthy lifestyles keep life expectancies low.

Economic development is also about tradition. Devel-oped economies are characterised by extensive special-isation and division of labour, which is coordinated by

markets and/or (before 1990, at least) planning mecha-nisms. Individuals’ career decisions are influenced byincentives created by market signals or central labourallocation. Developing countries by contrast are charac-terised by a less extensive social division of labour. Self-sufficiency and tradition play a greater role in the provi-sion of food, shelter, and other basic needs. Career deci-sions are influenced by family, gender, and social tradi-tions: if your parents are farmers, you will be a farmer aswell.

No developing country fully conforms to this model.Still, the challenges posed by rapid population growth,the importance of tradition, and the imperatives ofacquiring capital and modern technologies are majorfeatures of such developing economies as China, Indiaor Brazil. Highly developed countries like Germany andJapan, on the other hand, have aging, shrinking popula-tions, and are major exporters of capital and savings tothe developing world. As skilled work forces in devel-oped countries seem uninterested in performing manu-al labour, they import labour – the gastarbeiter phe-nomenon – from less wealthy countries. Whereas devel-oping economies typically seek to import capital andexport (unskilled) labor, developed economies do theopposite.

Are they developing economies or transitioneconomies?

Seen from this perspective, the Balkan and CISeconomies are most definitely not developingeconomies. They do not suffer from capital shortages:socialist development left these countries with universalprimary education, 100 percent literacy rates, welldeveloped rail (and, to a lesser extent, road) infrastruc-tures, and developed public health systems. Uzbek-istan—whose per-capita GDP in 2002 (in purchasingpower parity terms) was only $1670—was a major pro-ducer of aircraft and agricultural machinery during theSoviet period. Traditional subsistence, family-basedagriculture in the region was largely destroyed by col-lectivisation, and replaced by large, mechanised (and, inCentral Asia, irrigated) farms that were integrated with

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food or cotton processing industries. Of the 20 Balkanand CIS countries, only seven (Albania, Azerbaijan, Kyr-gyzstan, Tajikistan, Turkey, Turkmenistan, and Uzbek-istan) are reporting population growth. The typicaldemographic profile in this region is instead one of ashrinking, aging population, with particularly sharpdeclines in fertility rates and numbers of children mov-ing through primary and secondary education systems.Most of these countries are exporting (unskilled) labourand importing capital.

Some—Russia, Ukraine, and Uzbekistan, for example—now consistently report current account surpluses, indi-cating that they are net exporters of capital. And Russiais a major recipient of migrants within the CIS.

The challenges facing these economies are not issues ofdevelopment — they are challenges of mis-develop-ment arising from the large-scale misallocation of phys-ical and human capital during the socialist era. Before1990, millions of people in the Socialist bloc weretrained to use inefficient managerial and technologicalsystems to produce goods that could not be sold onworld markets. Factories built to produce Wartburgs,Zhigulis, and Trabants in the protected markets of short-age economies could not compete with imported usedcars once foreign trade was liberalized. Education sys-tems that pumped out the engineers needed to ‘buildsocialism’ are unable to train the legal, business, andinformation specialists for a market economy. Publichealth systems that were constructed to eradicate dis-eases like cholera and measles must now provide pre-ventive care and empower patients to adopt healthierlife styles.

Resolving these challenges does not require replacingtradition with markets or importing foreign savings.They require transforming the human and physical cap-ital that is frozen in socialist-era factories and skill pro-files into forms and structures that can produce goodsand offer services that are competitive on the worldmarket. Resolving these challenges also means develop-ing the political, social, and cultural conditions requiredfor an effective market economy, in which workers aswell as entrepreneurs are empowered to think for them-selves and defend their interests. A functioning marketeconomy not only requires private enterprise — it alsoneeds effective state structures that regulate withoutdisempowering, that correct for market failure insteadof causing it, and that can partner the private sector andcooperate with NGOs to offer communities the right mixof public services and private choices. For CIS andBalkan countries with weak pre-1990 traditions of state-hood, and which had to introduce national currenciesand economic policy institutions from scratch in the

early 1990s, creating these state structures has provento be more difficult than the mass privatization of stateenterprises.

Do differences between economic transition anddevelopment matter?

The past fifteen years have shown that this transition isneither simple nor easy. When combined with the socio-political conflicts and disruption associated with the col-lapse of the Soviet and Yugoslav federations, as well asthe misguided macroeconomic policies that producedhyperinflation during the early 1990s in most of the CISand the Balkans, the difficulties posed by privatizingthousands of state enterprise, taming severe macroeco-nomic imbalances, and creating new governance insti-tutions from scratch, have in some cases been over-whelming. Notwithstanding contested data, the bulk ofthe 20 CIS and Balkan economies have low GDP growth.In 2004 only four countries (Albania, Belarus, Turkey andUzbekistan) were reporting GDP levels that exceeded1992 levels.

These trials of transition have generated voluminous lit-eratures documenting ‘mistakes’ made by economicpolicymakers in these countries — and by the interna-tional financial and development institutions that haveadvised and supported them. Many economic policymistakes clearly were made in these countries, particu-larly in the early 1990s. It is also clear that at least someof the critiques of transition in the Europe and CISregion suffer from the failure to fully distinguishbetween challenges of economic development andtransition. Comparisons with ‘more successful’ transi-tion economies in East Asia (like China and Vietnam),countries that avoided sharp declines in GDP duringtheir transitions from plan to market, are cases in point. At the start of their transitions in the 1970s and 1980s,China and Vietnam were quintessential developingeconomies. They were endowed with young, rapidlygrowing, predominantly rural populations that wereabundant in unskilled labour and (some) naturalresources, but in little else. Relatively little physical capi-tal or skilled labour was trapped in unviable farms andfactories created by socialist planners. Huge increases inlabour productivity and household incomes were there-fore generated via de facto agricultural de-collectiviza-tion, as capital-poor collective farms were turned over topeasant families with minimal losses of physical andhuman capital.

In contrast to the European and CIS cases, economicreformers in China and Vietnam did not have to face thechallenges of value-subtracting state enterprises andstate banks drowning in bad loans. They could simply

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wait while these problem sectors became shrinkingislands in growing seas of private enterprise. For Chinaand Vietnam, successes in economic development haveto date dominated problems of economic transition.Not being developing economies, and possessing largeamounts of mis-developed human and physical capital,the countries of the Balkans and the CIS simply did nothave this option.

The good news . . . and the bad

In Europe, arguably, a policy regime that is capable ofgenerating successful economic transitions hasemerged in the form of the EU accession process. TheCentral European and Baltic countries that becamemembers of the EU in May 2004 have restructured andmodernised their economies, attracted billions of dol-lars in foreign direct investment, and reoriented theirforeign trade toward one of the global economy’sgrowth engines. In contrast to their eastern and south-ern neighbours, the Central European economies todayreport GDPs that are well above pre-transition levels.Their economic policies, institutions, and problems nowclosely resemble those of the other EU countries; chal-lenges of transition are giving way to challenges of con-vergence.

This is not a coincidence. In part, this was because EUaccession required the adoption of policies promotingmacroeconomic stability and private enterprise. Moreimportantly, EU accession required the public sectorreforms needed to create effective but accountablestate structures that are subject to democratic controls.Preparing to adopt the body of European law and regu-lations known as the acquis communautaire meant thatthe accession countries had to reform state administra-tions and judiciaries, introduce independent butaccountable sub-national governments, and create thespace needed for the third sector to flourish. The acquiscommunautaire may not be an optimal remedy for suc-cessful transition and sustainable development—but ithas proven to be robustly superior to other strategies for

repairing socialist mis-development, while simultane-ously introducing democratic rules of the game.The “European anchor” may yet prove to be sufficientlystrong to pull the candidate and aspiring candidatecountries of the Balkans toward the ‘made in Brussels’solution to the challenges of transition. It is somewhatless likely (although still possible) that the financial,political, and market access benefits of the EuropeanNeighbourhood Policy (ENP) to be introduced during2007-2013 will be sufficient to put at least some of thecountries of the Western CIS (Ukraine, Belarus, Moldova)and the Caucasus (Armenia, Azerbaijan, and Georgia)onto the track of integration with the EU. But the ENP isrejected by the government of Belarus, and does notapply to the Russian Federation and the Central Asiancountries (Kazakhstan, Kyrgyzstan, Tajikistan, Turk-menistan, and Uzbekistan). The potency of the ‘made inBrussels’ solution to the problems of transition weakensas it moves east.

Moreover, traditional problems of economic develop-ment may be reappearing in the poorest transitioneconomies. This is apparent in terms of primary educa-tion and infant mortality data: in Tajikistan, enrolmentrates in the first nine grades had dropped from near 100percent in 1990 to 88 percent by 2000. In Turkmenistanand Kyrgyzstan, only one 18 year-old in three is inschool. In each of the Central Asian countries (and inAzerbaijan), infant mortality rates remain above 50deaths per every 1,000 births. Tajikistan’s under-fivemortality rate in 2002 was higher than in 1970, standingat 116 cases per 1,000 births. The longer the transitioncontinues in these countries, the more the physical andhuman capital that is trapped in socialist-era forms andstructures depreciates, and the less valuable it becomes.Transition economies with vastly depreciated capitalstocks may be converging towards . . . developingeconomies. If so, this would be one of the greatestironies of transition.

Dr. Ben Slay is Director of UNDP’s Regional Centre forEurope and the CIS in Bratislava [email protected]



10

LLoosstt iinn TTrraannssiittiioonn::WWhheenn iiss ttrraannssiittiioonnoovveerr??

Gwendolyn Sasse

Transition is a term used by political scientists to refer tothe interlude between the overthrow of a regime andthe consolidation of a new regime. There is no require-ment that the new regime bea democratic one, but inpractice since the early 1970sthe use of the term transitionhas generally assumed a‘transition to democracy’.Evaluating how and whentransition processes begin isas contested as judgingwhen they come to an end.

When do transitions begin?

Political scientists generallyhave two main explanationsfor the causation of transi-tions to democracy. Firstly,democratisation is seen as aproduct of long term socio-economic modernisationand structural adaptation ofthe political system to devel-opments in the socio-eco-nomic structure – the emer-gence of capitalism, thespread of education and lit-eracy, urbanisation, andmass communications. Somesocial scientists, notably Sey-mour M. Lipset and Barring-ton Moore, focus on structural aspects such as the abun-dance of wealth that is generated by capitalism and itskey role in sustaining the position of the middle class asthe bedrock of democratic societies. In contrast, thework of Samuel Huntington argues that modernisationrenders autocratic or authoritarian regimes obsolete.Leaders choose to democratise because it is the mostefficient means of managing capitalism, and thusstrengthens their capacity to compete in the interna-tional system. Huntington developed the concept of the

‘King’s dilemma’ to explain this process – authoritarianleaders who reform will perish, and equally those whodo not reform will still perish.

Secondly, democratisation is seen as the product of elitepacts and institutional engineering irrespective of a spe-cific socio-economic background. Dankwart A. Rustowfamously stressed the role of elites and their decisioncalculus in the making of transition – it occurs whenthere is an agreement among elites to institutionalisedemocracy.

Political scientists have tended to treat transition as anendogenous development rather than focusing on theexternal factors and pressures that may induce and

shape transition. The inter-national dimension hasbeen particularly evident inthe case of Eastern Europewhere Gorbachev’s pere-stroika unleashed unman-ageable pressures for polit-ical change. It was onlywith the revolutions of1989 and the collapse ofcommunism that seriousattention was paid to therole of international factorsin the transitions across thewhole Soviet bloc. Oncerevolutionary processeserupted in Eastern Europethey spread with demon-stration effects. The geo-graphical proximity to theEU, the role of public andprivate external aid andinvestment, and the inter-national conditionality andincentives set by theWestern states and EU forintegration into the demo-cratic world have been crit-ically important exogenousfactors in the post-commu-

nist transitions. The continuing importance of the inter-national factor of transition has been reiterated morerecently in the ‘coloured’ revolutions in Serbia, Georgiaand Ukraine.

Most political scientists engaged in the study of transi-tion concentrate on the role of institutional design inthe consolidation of democracy. There is a huge field ofdebate as to which institutional choices are optimum fortransition: presidentialism or parliamentarism? Cen-

Transition

The term ‘transition’ refers to an interim period ofregime change. It implies a linear development froma point of departure towards a clearly defined endgoal: a liberal democracy and a market economy. Thestudy of transition (transitology) shares many of theassumptions of the theories of modernisation of the1960s and 1970s, which saw socio-economic devel-opment as the precondition for democratisation.From the 1980s studies emphasised more the contin-gent role of elites, and the importance of institution-al engineering for successful transition to democra-cy. Samuel Huntington saw the transitions to democ-racy of Eastern Europe and the USSR as a logical con-tinuation of the ‘third wave’ of democratisation inSouthern Europe and Latin America. The politicaland economic changes taking place in post-commu-nist countries, however, are distinguished by beingmore far-reaching and by the so-called ‘dilemmas ofsimultaneity’. Post-communist transitions, especiallyin the Former Soviet Union, are best understood as‘triple transitions’ involving political reforms, eco-nomic reforms and state- and nation-building. Thepost-communist experience demonstrates thatdespite a shared socialist legacy transition paths canvary considerably.


11

tralised or decentralized government? What kind ofparty system? What kind of electoral system? The ques-tion of institutional choices is framed by bigger ques-tions such as whether one thinks it is preferable to haveshock therapy reforms or gradualism, what one’s viewsare as regards the sequencing of political and economicreforms, and how much importance one attaches to thestability of government-state-society relations.

When do transitions end?

If transitions may begin incrementally as a long-termprocess, or can be triggered by some sudden revolution-ary eruption, we can view their ending in similar terms.Some transitions may end in a long drawn out process,where an end-point will be difficult to demarcate. Someargue that the entry of the Central and East Europeanstates into the European Union is a dramatic signal thattheir transitions are indeed over. The difficulty of finalis-ing the end-point of transition has led political scientiststo employ the term ‘consolidation’ in order to distin-guish the early transition phase of fundamental regimechange and reform from the subsequent deepening ofthe reform process The distinction between ‘transition’and ‘consolidation’ is a fluid one, and creates a furtherdefinitional conundrum. It highlights the divergencebetween post-communist countries and other ‘normal’European countries.

Can transition be over when voter turnout in nationalelections drops well below 50 percent only a decade

after 1989, as in Poland? Can it be over when there areserious government crises as in Poland or the CzechRepublic , when 10-20 percent of the population of Esto-nia and Latvia are stateless residents, and when thesocial costs of transition are still running high. It is a fal-lacy to argue that a transition is over when a country hassecured EU membership. Transition can only be judgedto be over when there is an elite and public consensuson the fact that it is over, both domestically and interna-tionally. In each case this recognition is based on anobjective and subjective measure of political stability,economic well-being, societal cohesion and the imple-mentation of the rule of law. Equally, the multi-dimen-sional nature of transition means that progress may beuneven across these measures. Some countries, forexample, may do better on democratic reform than eco-nomic reform, and vice-versa.

Ultimately, also, the question ‘when is transition over?’ isa question about the stability of the new democracy andits potential for backsliding. According to Juan Linz andAlfred Stepan, democracy is successfully consolidatedwhen there is no significant domain of power or actorschallenging the state from outside the democratic struc-tures, and when a strong majority accepts the legitima-cy of the new democracy. When there is little or nopotential for reversion to authoritarianism, then, weshould say the transition to democracy is over.

Dr. Gwendolyn Sasse is a Lecturer in Comparative EuropeanPolitics in the European Institute and Department of Govern-ment at LSE

LLiinnkkiinngg EEccoonnoommiiccDDeevveellooppmmeenntt aannddTTrraannssiittiioonn

Waltraud Schelkle

Is the challenge of economic transition specific and dif-ferent from economic development? How has the tran-sition experience enriched development economics?Which mistakes in transition policies could have beenavoided if insights from development economics hadbeen taken on board earlier?

Economic transition poses some specific challenges informer Soviet bloc countries which set them apart fromtraditional ‘development’ cases. They did not suffer from

a lack of real capital, if anything, transition economieswere over-capitalized following decades of plannedheavy industrialization. Health and education levels ofthe workforce were generally quite good and in somerespects, such as gender equality, even surpassed OECDstandards. The government was fundamentallyinvolved in all economic activity while governments indeveloping countries often fail to provide even basicservices.

The social implications of transforming the employmentsystem are likely to make for lasting differences in polit-ical economy terms between former transition coun-tries, such as Hungary or Russia, and other emergingmarkets, like South Korea or Brazil. While workers indeveloping capitalist economies always lived in precari-ous employment situations, relying primarily on thesafety net of the family and community, the socialistenterprise provided job security, vocational training andsometimes even housing or childcare facilities. This low-standard, yet robust, social security has been largelydestroyed by the establishment of the price and profit


mechanism in labour allocation during transition. Theprivatisation of employment risks to allow for massivesectoral and regional shifts of jobs created persistentproblems of poverty and income inequality. Theseproblems make the Millennium Development Goals rel-evant for even the EU accession countries among thetransition economies. Low levels of trust in governmentin countries like Poland, despite the spectacularachievements of transition, suggest that the politicalimperative to provide social security has not disap-peared with the demise of the socialist state. Therestructuring of social welfare and its profound politicalimplications will make the political economy of transi-tion a distinct field of study for some time to come.

The transition experience was immediately relevant fordebates about the role of the financial system in devel-opment. The policy debate revolved around the ques-tion of how to create a functioning dual banking sys-tem, with a central bank stabilising the macroeconomyand commercial banks sustaining hard budget con-straints, both for themselves and for borrowing firms.This required dealing with the monetary overhang toensure the solvency of the banking system and to con-tain inflationary pressures. The complex linkage ofmicroeconomic, macroeconomic and institutionalreforms during transition was in stark contrast to tradi-tional views of the role of finance in development. Thedominant perception was that developing countrieslacked financial resources, even though the debt crisisof the early 1980s and currency crises caused by largecapital flow reversals demonstrated that too much cap-ital can sometimes stall development. This message waslargely ignored. Early structuralists diagnosed marketfailure causing ‘under-banking’ and an inherent dearthof credit, and called for interest rate ceilings and for cen-tral banks to act primarily as development banks. Theneoclassical counter-revolutionists diagnosed govern-ment failure in the disguise of ‘financial repression’, call-ing for interest rate liberalisation to mobilise savingsand a central bank confined to strict money supply con-

trol. Alas, the structuralist recipe created sickly banks,not strong ones, while neoclassical shock therapies fos-tered endemic financial crises. The transition experiencethus bolstered innovations in development economicsthat analysed indigenous financing arrangements notas symptoms of failure but as credit instruments adapt-ed to the risks and constraints borrowers and lendersface in volatile markets.

Every transition economy had its banking crises andstock markets did not flourish as expected. If insights

Economic Development and EconomicTransition

Development means structural change of the econo-my and qualitative improvements in the use of pro-ductive factors. The founding model of developmenteconomics, which won Arthur Lewis a Nobel Prize,conceptualised economic development as transitionfrom a predominantly agrarian, rural economy to anindustrialised, urban one. The role for the governmentand external aid was to raise agricultural productivity,both to sustain the increasing non-agrarian workforceand to finance a higher capital-labour ratio in thedeveloping economy. Moreover, the industrial work-force had to be trained to be able to use the scarcecapital stock profitably. Later accounts build on thisunderstanding even if they tend to see a more modestrole for government and a greater role for marketmechanisms. Transition, by contrast, was not aboutindustrialisation but about privatising and downsizingindustry; not about creating the skills for more gainfulemployment but about reorganizing the employmentsystem; not about state intervention but aboutstrengthening market forces. The fundamental differ-ence between development economics and the eco-nomics of transition hinges on the balance betweenthe state and the market in the economy.

DDeevveellooppmmeenntt oorr ttrraannssiittiioonn?? 12


PPoovveerrttyy dduurriinngg tthheeeeaarrllyy ttrraannssiittiioonn

Nicholas Barr

According to World Bank data, two percent of the pop-ulation of Central and Eastern Europe and the SovietUnion were poor in 1988, based on a benchmark of $2.15 per day; by 1998, the figure was about 20 percent.The number of people living on less than $4 per dayincreased more than tenfold, from 14 million in 1989 to168 million in the mid 1990s. Poverty rose substantiallyin radically-reforming countries, from 6 percent to 20percent of the population in Poland between 1989 and1996, and from 1 percent to 37 percent in Estonia (seeTable overleaf). The increase was even sharper in lesssuccessful reformers, in Romania from 6 percent to 59percent, in Russia to 50 percent and in Ukraine to 63 per-cent.

Notwithstanding major and well-known problems withdata and methodology (see Box), the trend is stark andundisputed. Why, with historical hindsight, is there anawful inevitability about such an outcome? The move-ment to a market economy had three initial effects:falling output, declining job security, and wideninginequality of incomes.

Output fell. Output fell on a scale not seen in the Westsince the Great Depression of the 1930s. In Poland andHungary the countries least-badly affected, output fellby 18 percent over the first three years of transition, andin the Baltic countries by up to half. By 2003, EBRD datashow that output in the countries of Central and EasternEurope – mainly those which joined the EU in 2004 –

Who are the Poor?

Due to conceptual and measurement problems,there is no unambiguous definition of who is and isnot poor. Defining poverty faces three sets of prob-lems.

h What indicator of welfare – income, expen-

diture or consumption? None is definitive. And noneallows us to separate choice from constraint: some-one may eat no meat and have low expenditure andincome, and so be poor according to all three meas-ures; but if he is a vegetarian Ascetic, looking at out-comes overstates poverty.

h What choice of income unit – the individual,

family, or extended family?

h What concept of poverty – related to subsis-

tence (absolute poverty), to living standards in thesociety in question (relative poverty) or to people’sperceptions about their living standard (subjectivepoverty)?

None of these questions has unambiguous answers.Measuring poverty is difficult even in advancedeconomies. Transition countries face additionalproblems. Data are inaccurate, and interpretation iscomplicated by large changes in relative prices, andby the increased availability of goods as market sup-ply took root.

Even where a definition has been agreed, measure-ment is problematic. Policymakers are interested inhow many people are poor (the head count), how farbelow the poverty line they fall (the poverty gap),and for how long –whether their poverty is transientor long term.

from development economics had been taken onboard, perhaps the banking crises, the misguided focuson stock market development and other failures of tran-sition policy could have been contained. These failureshave their roots in a simplistic application of the Coasetheorem. It states that what matters for efficient marketoutcomes is only that property rights are defined; it isirrelevant who exactly gets the rights as long as transac-tion costs of exercising them are negligible. Develop-ment economists, in contrast, did not disregard the dif-ficulties of exercising property rights or the distribution-al relevance of their allocation. They looked at how insti-tutions not only lower these transaction costs but also

help to adapt property rights to the circumstances ofdeveloping markets. This turns the Coase theorem on itshead: who gets the property rights matters immensely.Where transition policy ignored this simple insight it ledto disastrous voucher privatisations, little regard forsupervision of financial enterprises or their role in corpo-rate governance, and misguided policies based on theassumption that the distributional effects of price liber-alisation were temporary. It is high time therefore toreview the lessons of development for transition, andvice versa.

Dr. Waltraud Schelkle is a Lecturer in Political Economy in theEuropean Institute at LSE

13


had recovered, by then averaging nearly 20 percentabove 1989 levels. In contrast, across the CIS, outputwas only three-quarters of its level before transition.

Job security ended, creating particular problems forwomen with family responsibilities, older workers,unskilled workers and ethnic minorities.

Income disparity increased. While falling output isunambiguously adverse, a wider income distributioncan be good or bad. Economic liberalisation meant thatpeople with skills valued by the market could commanda market wage, assisting quality and encouraging work-ers to move to more productive jobs and to acquire newskills. Of course workers also have important non-finan-cial motives, notably job satisfaction, but the issue dur-ing the early transition was to put right an inheritancewhere wages were almost completely unrelated to indi-vidual performance. Separately, liberalized propertyownership increased the incomes of wealth holders andcontributed to the growth of new enterprises.

But not all income differences are beneficial. A risingtide of unemployment, poverty and insecurity accom-panied liberalization. Exploiting a monopoly positioncan – and in some countries did – prevent competitionand hence harm growth. Even more malign, criminalbehaviour, often backed by violence, increased duringthe early transition and remains a problem in somecountries. As the rule of law strengthens, inequalitiesfor these latter reasons – it is to be hoped – will decline.

In many circumstances market forces improve incen-tives, hence labour-market efficiency, hence economicgrowth – one of the core purposes of transition. Thereis increasing empirical evidence that excessive inequali-ty can harm growth, but the communist experienceshows that too little inequality is also harmful. Thus awider distribution of earnings and income is not just afeature of transition but a permanent part of the post-communist landscape.

Why was rising poverty inevitable? As a proposition inpure logic, falling output coupled with a wideningincome distribution increases poverty. To explain why,suppose that the distribution of income widens butaverage income remains constant. It must then be thecase that there are more people with lower incomes aswell as more with higher incomes. If economic growthis positive, the effects of rising income might outweighthe effects of rising inequality, i.e. the entire income dis-tribution might shift enough that poverty falls. In con-trast, if inequality widens and growth is negative, it mustbe the case that there are more people with lower

Poverty rates, selected transition countries, 1987-8 and 1993-5

(percent of population)

Poverty headcount

1987-88 1993-95

Central and Eastern Europe and the Baltic countries

Bulgaria 2 15

Czech Republic 0 <1b

Estonia 1 37

Hungary 1 4

Latvia 1 22

Lithuania 1 30

Poland 6 20

Romania 6 59

Slovakia 0 <1b

Slovenia 0 <1b

CIS

Belarus 1 22

Moldova 4 66

Russia 2 50

Ukraine 2 63

Average CEE & CIS withoutCentral Asia 3 43

Source: Milanovic, Branko (1998), Income, Inequality andPoverty during the Transition from Planned to Market

Economy, Washington: World Bank. (Table 5.1).

Notes: a) The poverty line is 120 international dollarsper capita per monthb) Care is needed interpreting the figures.Richer countries, e.g. the Czech Republic,Slovakia, and Slovenia, had few people withincomes below $4 per day in either the late1980s or mid-1990s and, on that measure,experienced little increase in poverty. Thatdoes not mean that people did not experiencea fall in income — merely that, relative to abenchmark of $4 per day, poverty increasedvery little.

14


15

PPrroodduuccttiivviittyy,, pprroossppeerriittyy aanndd ddeevveellooppmmeenntt

Andrei Sarychev

The 70-odd years of socialism were the biggest man-made experiment in economics. The ideas of Marxinspired the creation of socialist systems, but also plant-ed the seeds of their ultimate demise. The reason for thedemise was the failure of socialist economies to keepproductivity growth on a par with Western economies.From the 1950s the productivity gap steadily grew,eventually resulting in the inability of the Socialist blocto finance the arms race with the West and containinternal pressures due to stagnating living standards.Many of the problems which the former socialist coun-tries are now facing in the social, demographical andpolitical spheres are the consequences of their lowproductivity or are impossible to resolve withoutincreases in per capita GDP, and hence in productivity.

Diagnosing the problems involved in raisingproductivity is a tricky undertaking. The reason for this isthe emphasis made in neo-classical economics (whichused to be the dominant paradigm for explainingincome disparities across the world) on the accumula-tion of factors of production, such as physical andhuman capital. A textbook developing country pos-sessed little of both; it was easy to conclude that invest-

What is Productivity?

Economists use the concept of total factorproductivity (TFP) to measure productive efficiency ofan industry or a whole country. This is the extent towhich output is affected by everything other thanmeasurable factors of production. Countries withhigher TFP produce more given the same levels oflabour, physical and human capital.

h Specific investment is an outlay made by

the firm that enhances its productivity in a particularuse or in a particular relationship with another firm,but may be worthless in the market. When this invest-ment is irreversible, courts do not have leverage overa deviant firm.

h Social norm is a coordinated way of reacting

to particular activities, e.g. a collective boycott offirms/individuals that committed a breach of trustthat is beyond the reach of courts to prosecute.

h Market institutions is the umbrella term for

social norms, networks, thick markets, the distributedexpertise of arbitrators, independent analysts andjudges that permit the economy to function at fullsteam.

incomes. Since the early transition was characterised bynegative growth and widening inequality, an increase inpoverty was inevitable.

Poverty relief is thus a core part of the reform agenda. Aremedial strategy includes poverty relief specifically,through benefits aimed at poor people via an incometest or in other ways; policies to assist labour markets toadjust, including unemployment benefits and better

information about available jobs; and broader socialpolicies, notably education and training.

Nicholas Barr is Professor of Public Economics, EuropeanInstitute, LSE. His most recent book is Labor Markets andSocial Policy in Central and Eastern Europe: The Accession andBeyond, Washington DC: The World Bank 2005.

[email protected]; http://econ.lse.ac.uk/staff/nb


16

ment in machines and more education for the workforcewas all that was required. It was recognised thatenforcement of contracts and private property protec-tion could be a concern for development, but the stan-dard prescription was limited to the need for a strongindependent judiciary and a transparent and liberal setof laws.

Superficially checking the levels of available inputs, onewould then expect the transition economies to do quitewell. The newly adopted laws are as good and some-times better than those in OECD countries. In practice,however, private firms often create mediocre value-added even with cutting-edge western equipment andhighly trained workforces. Why is productivity low intransition economies?

The reason is the lack of market institutions (a factorneglected in the neo-classical analysis) which in devel-oped economies have evolved together with the capitalstocks. The transition economies have factor endow-ments roughly similar to the market ones, but vastlyinadequate institutions to match those endowments.

Listed below are the problematic areas specific to thetransition economies in which improvements can bemost productive.

Contract enforcement (in dealings among firms). A firmwill not undertake specific investment that generateshigh returns without the assurance that it will berewarded. Contrary to the simplistic view that courts caninstill contractual discipline, most of the enforcement inreality is provided by informal institutions. These are acomplex mesh of social norms, information-sharing inbusiness and social networks, and expert agencies thatwork outside the legal enforcement mechanisms. Whenthese institutions are in their infancy, fear of ‘hold up’may cause firms to forgo the most specialised and prof-itable contracts where cheating is most lucrative.

Corporate governance. Hired managers may be tempt-ed to engage in asset stripping. When the market formanagerial labour is undeveloped, managers are hardto discipline. Similarly, in publicly held companies themajority shareholders have incentives to expropriateassets from minority shareholders. Regulatory interven-tion in the stock market can go a certain length in pre-venting the most blatant forms of such expropriation,but the bulk of enforcement (by means of coordinatingmarket reaction to breaches of fiduciary duty) is provid-ed by informal institutions. When these are undevel-oped, companies have severe problems attracting

finance for restructuring or investment in the stock mar-ket.

Barriers to entry. Many formerly state-owned enter-prises are notoriously inefficient because their produc-tion processes were devised under the distorted stric-ture of pre-transition prices. Production efficiency isimproved by the destruction of the old inefficient firms,the creation of new efficient firms, and the reallocationof labour and capital from the former to the latter. Fur-ther innovations and increases in productivity also tendto happen in newly created small businesses. However,especially in the Former Soviet Union countries, thereare huge costs of entry due to predatory taxation andextortion by the authorities. If a new firm decides toavoid official entry barriers and enter the shadow econ-omy instead, it loses recourse to courts and other gov-ernment agencies and falls prey to protection rackets.Rackets tend to expropriate all surplus from furtherinvestment/expansion, thus ridding the firm of theincentive to invest or innovate.

Human capital obsolescence and frictions in the labourmarket. A degree in rocket science is not worth much ifthere is no demand for rockets. Retraining workers tomatch the market demand for skills is subject to a pro-longed intermediate phase in which advanced skills arelost and the educational attainment falls temporarily.This is due to the frictions in the labour market prevent-ing retrained/new specialists from getting returns totheir human capital.

Regional segregation and worker mobility. Particularly in the larger FSU countries, regional segre-gation is important. As a legacy of socialism, regionallabor markets are often monopsonistic, with employ-ment provided by a single mammoth enterprise. Get-ting workers to move on from the enterprise impliesgetting them to move out of the region. This is difficultin the undeveloped housing and personal loans mar-kets, as workers lack liquid resources to move to themarkets paying good salaries.

The transition experience demonstrates how countriesmay fail to prosper even when they seem well endowedwith physical and human capital. What matters are mar-ket institutions. These institutions are for the large partinformal and take time to emerge. Studying the biggestexperiment in economics helps us to understand theway market economies function and what is needed fordeveloping countries to catch up.

Dr. Andrei Sarychev is a Lecturer in Economics at [email protected]

17


UUkkrraaiinnee’’ss TTrraannssiittiioonn::TThhee ffiirrsstt 110000 ddaayyss oofftthhee nneeww ggoovveerrnnmmeenntt

Iryna Akimova

Ukraine’s Orange Revolution brought an ambitious gov-ernment to power. The revolution also imprinted itselfon the policies of the incoming government, namely inthe call for more democratisation, a tougher fightagainst corruption, and faster integration with Europe.The government’s first 100 days in office marks anappropriate moment to take stock. What have been theeconomic and social priorities and achievements of thenew government? What are its key challenges?

Achievements

Domestic Reform

In the area of state reform, important steps have beenmade: local government reforms have been pursued inorder to create powerful local self-governmental unitswith well-defined responsibilities for delivering publicservices and sound revenue sources. Territorial reformhas concentrated on reducing the number of local self-government units and restructuring at the regional andlocal level. Judicial reforms have got underway but are along-term task. An ambitious administrative reform,aiming to increase functional efficiency of the ministrieswhile reducing corruption, has been launched, though itlacks a clear strategy and resources. So far the govern-ment has chosen a quantitative approach to administra-tive reform, which manifests itself in the exchanging ofalmost 17,000 civil servants at the central and regionalgovernmental levels. Some aspects of the reformprocess, however, are contradictory, for example thepresidential veto on the Code of Administrative Justice.

EU Integration

Ukraine’s new leadership has played its cards well. Itheld back on its participation in the Common EconomicSpace with Russia, Belarus and Kazakhstan while signingan Action Plan with the EU under the European Neigh-bourhood Policy. This Action Plan is meant to helpUkraine implement EU-approved reforms, such as the

adoption of market-friendly legislation in various areasand an improvement in the efficiency of state agencies.It extends various European education and researchexchanges to Ukraine. Most importantly, it offers an as-yet vaguely worded prospect of a free trade agreementwith the EU and a special agreement on steel. Ukraine isalso on course for WTO membership before the end of2005. The progress in Ukraine’s relations with the Westultimately depends on the implementation of sounddomestic economic and social policies. In this area thereis a clear gap between the liberal intentions expressedin the government’s programme ‘Towards the People’and the non-liberal instruments of implementation thatthe government has adopted.

How Reformist is the New Government?

Economic policy did not feature prominently in theOrange Revolution. The new government inherited ahuge pension bill of 16 percent of GDP – easily the high-est in the world – from the outgoing government whichhad doubled pensions on 1 September 2004. Budgetexpenditures have further grown as a result of addition-al social obligations accepted by the new government:social expenditures are 160 percent higher in the 2005

budget compared with 2004, and social transfers (46.1percent) are higher than salaries (42.1 percent) as ashare of personal income. This situation has three seri-ous consequences for economic policy in 2005.

First, the scramble for additional budget revenues hasshifted the attention of the government away fromstructural reforms. In current conditions, a tax reductionand the completion of a major tax reform are impossi-ble. Despite the government’s good intentions toincrease the transparency of financial markets and pro-mote the further development of financial institutions,moves in this direction have been postponed, therebylimiting investment and preserving the speculativenature of the stock market.

18


Second, the parliamentary elections scheduled forMarch 2006 already overshadow government policy. It ispolitically difficult to start complex social reforms in apre-election year. The popular goal of raising living stan-dards remains closely tied to government spending inthe social sector. Little attention has been paid so far tothe sustainability of social services provision, in particu-lar the development of a system of private provision andan increase in the efficiency of public expenditures byusing a pay-for-service approach to the distribution ofpublic funds among social service providers.

Third, the macroeconomic situation, which lookedfavourable before the elections of 2004, is a concern.The annual GDP growth rate peaked at 14.2 percent inthe third quarter of 2004 and then decreased rapidly to9.1 percent in the fourth quarter of 2004, and fell to 5.4percent in the first quarter of 2005. While the exception-al political circumstances at the end of 2004 affected theeconomy negatively, the data for 2005 definitely signalsa downward trend. The 2005 budget deficit can beexpected to be 4-7 percent of GDP rather than the offi-cial estimate of 1.5 percent. It will be extremely difficultfor the Ukrainian government to maintain a single-digitinflation rate.

The new government has declared that it will not facili-tate the trade in land, and the re-privatization of enter-prises has become the hot political topic. For fivemonths Ukrainian officials have discussed the scope ofre-privatization (between 29 and 3000 enterprises). Boththe government and some parliamentarians have draft-ed several versions of a law on the re-evaluation ofassets. The plethora of drafts allow the reversal of muchof Ukraine’s privatisation without offering transparentprocedures and credible protection of good faith pur-chases. The main goal of privatisation – the creation ofefficient owners – may be lost in the political infighting.Instead, the re-privatisation debates promote populist

ideas of a fair re-distribution of assets, while the govern-ment’s aim of raising additional budget revenues fromre-privatisation is only weakly disguised. The extensivediscussions about re-privatisation have contributed tothe marked slowdown in investment and productionduring the first quarter of 2005.

The non-liberal approach to privatisation is comple-mented by policies based on the preservation andstrengthening of the state sector, for example by post-poning privatisation or nationalizing ‘strategic’ enter-prises. While the latter is not feasible for fiscal reasons,privatisation plans have stalled. The government aimsto raise the efficiency of state enterprises by changingthe managers and increasing incentives. Profits of stateenterprises are considered to be an important source ofbudget revenues, as demonstrated by a governmentdecision to transfer 50 percent of the net profits of statecompanies to the state budget. The ideology of a strongstate sector that contains the most important firms isunproductive and will harm a country’s growth poten-tial.

The government’s capping of prices and profits for meatand gasoline is further evidence of an interventionistapproach to markets. The policy resulted in shortages.State regulation of prices of this kind endangers thegovernment’s target to secure market economy statusfor Ukraine by the end of 2005. President Yushchenkofinally intervened and abolished direct price regulationin the oil market by decree, however, the episode castdoubt over the cooperation between Yushchenko andPrime Minister Tymoshenko.

Despite a rhetorical emphasis on market reforms, com-petition policy has been surprisingly low on the govern-ment’s agenda. No attempt has been made to increasethe powers and political independence of the Anti-Monopoly Committee. Instead, the Ministry of Economy

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has been charged with preparing a concept to preventcollusion among firms in selected markets (predomi-nantly oil). The development of independent regulatorsin infrastructure industries has yet to be discussed. Theabolishment of tax privileges in free economic zoneswas yet another money-raising exercise without anyattempt made to simplify or lower taxes. The discussionof the Draft Law on State Aid, which is of crucial impor-tance for WTO accession, has been postponed. Themoratorium on the bankruptcy of state-owned compa-nies underpins doubts regarding a level playing field forall companies. The small business sector, whichdepends on stable and simple tax rules, has come underpressure by a tax reform that removed simplified taxa-tion for a range of activities, established an additionalpension contribution (which previously was a part ofunified tax), and decreased the annual turnover thresh-old for the registration of an entrepreneur as a ValueAdded Tax payer.

The Way Forward

Several policy mistakes have to be corrected in order torestore investors’ confidence. If for political reasons re-privatisation cannot be reversed, it should be limited inscale and quickly implemented. The process must allowfor voluntary action, and the protection of those whopurchased assets in good faith, while not hinderingongoing privatizations. State interference in price set-ting has to be ruled out. Competition policy has tobecome a government priority, and the simplified sys-tem of taxation, accounting and reporting should berestored. Moreover, the enforcement of the Law on thePrinciples of Regulatory Policy in Economic Activities isof the utmost importance. All regulatory bodies, includ-ing the government, must adhere to transparent stateregulatory principles in order not to hamper the privatesector. Ukraine needs fiscal adjustments, including acomplex social reform easing the pension burdenthrough an increase in the effective retirement age, theelimination of various privileges and the targeting ofsocial benefits to the most vulnerable. There is an urgentneed to initiate discussion on pay-for-service systems inhealth care and education.

Without a sound fiscal adjustment, the recentexchange-rate policy geared at revaluing the Hryvna inorder to reduce inflationary pressure has few chancesfor success. In the medium term, the National Bank ofUkraine faces a fundamental choice: either float theexchange rate and concentrate on controlling monetary

aggregates (which is tantamount to adopting an infla-tion targeting strategy), or resort to a hard peg (prefer-ably to the Euro). Resorting to the tax system to performfiscal functions is a dangerous path that can hampereconomic growth. Already in the short term, the govern-ment should pay attention to putting the relationshipbetween tax authorities and taxpayers onto a normalvoluntary service basis by decriminalising most tax vio-lations and abolishing the tax police. Ukraine needs toadopt modern corporate legislation, notably a law onjoint stock companies. The Economic Code should beabolished since it contradicts the Civil Code, and theCivil Code needs to be further developed. Finally,administrative reform has to be linked to the anti-cor-ruption campaign. The powers of different executiveauthorities and agencies responsible for administrativereform, including the National Security and DefenseCouncil, have to be more clearly defined.

The new government’s performance so far has been dis-appointing. The government continues to enjoy wide-spread popular support, but given the economic situa-tion this may ebb during 2005-06 and its window ofopportunity for reform is closing fast. Consequently, thecurrent honeymoon period must be used more effec-tively. Short- to medium-term priorities and appropriateimplementation mechanisms must be well defined. TheUkraine-EU Action Plan offers a sound strategic basis fordesigning, implementing and monitoring reforms.Whether the government will adhere to it is an openquestion.

Iryna Akimova is Chief Technical Advisor, UNDP Ukraine

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Development & Transition is published for the UnitedNations Development Programme at the LondonSchool of Economics and Political Sciencewww.developmentandtransition.net

Editor: Jim Hughes: [email protected] Executive Editor:Ben Slay Deputy Editors: Gwendolyn Sasse, AndreiSarychev Managing Editor Horatio Mortimer AdvisoryBoard : Nick Barr, WIllem Buiter (chair), Stanislaw Gomulka,Mary Kaldor, Dominic Lieven, Margot Light, Kate Mortimer

Houghton Street, London WC2A 2AE, UKwww.lse.ac.uk

The VII World Congress of the International Councilfor Central and East European Studies will take placeat the Humboldt University in Berlin, Germany, from25th-30th July 2005. The theme of the Congress is"Europe - Our Common Home?" Some 15 years after thechange of regime in the countries of Central and EastEurope, the Congress offers an opportunity for academ-ics and policymakers from across Europe and Eurasia toexamine the state of the continent concerning all apectsof European integration processes. How far has the ideaof a common-home-Europe already been realised?Which are the new common features and values withinEurope, and where are new divides? www.iccees2005.de

Workshop on Developments and Patterns ofMigration Processes in Central and Eastern Europe 25 - 27 August 2005 in Prague, Czech Republic. The Mul-ticultural Center Prague and Faculty of Humanities ofCharles University in Prague will hold a three-day work-shop on 'Migration Processes in Central Eastern Europe'.The aim is to bring together researchers and expertsfrom academia and non-governmental organisations todiscuss current migration patterns and related issues inthe countries of Central and Eastern Europe (CEE). Theworkshop will incorporate debates about migration the-ories, presentations of empirically based research in the‘region,’ and experiences of non-governmental repre-sentatives dealing with the issue of migration in CEE.www.migrationonline.cz/workshop.shtml

UACES 35th Annual Conference and 10th ResearchConference: ’The European Union: Past and FutureEnlargements’. The 2005 University Association for Con-temporary European Studies (UACES) conference willbe hosted by the Faculty of Law at the University ofZagreb, 5-7 September 2005. The conference will lookat past and future enlargements of the EU. As well asresearch sessions, there will be three plenary sessionswhich will focus on the key themes of: Identity andDiversity; Enlarging Europe; Croatia, South EasternEurope and the EU.www.uaces.org/

Conference on The Social Economy in Central, Eastand South-East Europe: Emerging Trends of SocialInnovation and Local Development. This conferencewill take place on 22-23 September 2005 in Trento, Italy.It seeks to build on the interest registered at the Capac-ity Building Seminar in November 2004 to furtherexplore the trends, opportunities and challenges thatsocial economy actors face in countries of the BalticStates, Central, East and South-East Europe. This event isorganised by the LEED Programme of the OECD and itsCentre for Local Development based in Trento. For moreinformation please visit the following webpage:www.oecd.org

Parliamentary Roundtable on Security SectorOversight to take place on 24-26 October 2005 inPrague. UNDP's Regional Centre for Europe and the CIS,in partnership with the Czech Government, will sponsora regional parliamentary roundtable on democraticoversight of the security sector. Parliamentarians fromArmenia, Georgia, Kazakhstan, Kyrgyzstan, Moldova,Tajikistan and Uzbekistan will discuss techniques andobstacles for security sector oversight, and exchangeexperience with distinguished experts and specializedinstitutions, including the Geneva Centre for the Demo-cratic Control of Armed Forces (DCAF). For more infor-mation contact: [email protected] or [email protected]

FFOORRTTHHCCOOMMIINNGG CCOONNFFEERREENNCCEESS

UNDP Bratislava Regional CentreGrosslingova 35Bratislava 81109Slovakia

Tel: +421 2 59337 111Fax: +421 2 59337 450www.undp.org/europeandcis

http://www.oecd.org/document/29/0,2340,en_2649_34417_34450717_1_1_1_1,00.html

http://www.uaces.org

http://www.migrationonline.cz/workshop.shtml

http://www.iccees2005.de

Development and transition

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