Economic Principals

The US is embarking on a round of nation-building in Iraq. A team of exiles, organized in Washington, has begun returning to Baghdad to join the temporary American-led government there. It is a good time, therefore, to consider a little bit of what has been learned in recent years about implementing institutional change in non-market economies.

It's an old story -- Russia vs. China and all that. Presumably it will become even more complicated with Islam. Moreover, some important new evidence has just turned up in Beijing.

As good place as any to get the flavor of the current controversy is an interesting and partisan article by David Ellerman in the forthcoming issue of Challenge magazine. In some sense, it is simply the latest salvo in the debate, for Ellerman possesses a credential that makes him of more than passing interest.

For two years, he was adviser and occasional speechwriter for Joseph Stiglitz at the World Bank. Their critique of international financial institutions evolved in synch. Stiglitz has moved on to Nobel Award celebrity (and become famous for his IMF-bashing book, Globalization and Its Discontents). Ellerman is Stiglitz spelled out in greater detail. And Ellerman is a fiery writer.

Not that it would be easy to get your hands on the piece itself. Challenge is a little magazine read mainly by leftish economists. The new issue will appear in a week or two. Find it at your library, or on a big-city newsstand (perhaps), subscribe, or go to an earlier article in the same vein by Ellerman, which is now posted on the Web.

The question he raises is the usual one: which worked better -- the institutional shock therapy applied to Russia, or the step-by-step approach of the Chinese?

His preference, in no uncertain terms, is for the incremental reform of the Chinese. It was more just, he says. And because it was more just, it was more effective.

A little background: "Country doctoring" in its present-day sense -- departments of economics seen as storehouses of engineering knowledge waiting to be acquired or dispensed -- probably began with the "Chicago boys," the economists who reworked the Chilean economy after a 1973 coup displaced the socialist government of Salvador Allende.

Then again, the Chicago boys were not Americans but Chileans -- students who had traveled north to get advanced degrees, in part because a leading Chicago economist, Arnold Harberger, was married to a Chilean woman.

That system changed abruptly in the 1980s, when Harvard economist Jeffrey Sachs undertook a high-profile mission to advise the Bolivian government on its transition to market capitalism. Later, Sachs lamented the short shrift he gave the most elementary facts of Bolivian geography -- it is landlocked, for example. But in short order, on the strength of his apparent South American success, Sachs was advising the government of Poland on how to make what gradually was coming to be known as "the Transition" to a market economy.

Soon, most of the nations of Eastern Europe had a team of economic advisers from the fanciest American and European universities. Chief among them was the Soviet Union, at least under Boris Yeltsin after Mikhail Gorbachev was thrust aside.

The premise was (as MIT economist Stanley Fischer described it) that Russia was "trying to return to a system that was well understood by the rest of the world." So why not have as architects those who understood it best?

Various warnings were sounded at the time. In 1990, the German sociologist Ralf Dahrendorf urged governments "to work by trial and error within institutions." He called his book Reflections on the Revolution in Europe, after Edmund Burke's famous 1790 caution to the revolution in France.

The same year saw the publication of The Road to a Free Economy by the Hungarian economist Janos Kornai, and The Nature of Socialist Economies by the University of Maryland's Peter Murrell. A highly technical paper appeared as well, "Economic Reform and Dynamic Political Constraints" by Mathias Dewatripont and Gerard Roland, later rendered in more literary terms as "The Virtues of Gradualism and Legitimacy in the Transition to a Market Economy." Ronald McKinnon of Stanford University published The Order of Liberalization the following year.

Whatever the perspective -- political, clinical, evolutionary, strategic, financial -- the authors' message was essentially the same. The past matters. So does the sequence of reforms. The authors argued in their separate ways that there were many reasons to believe a gradualist strategy tailored to a particular country was likelier to produce a good outcome than was "shock therapy." Legitimacy might be more important than democracy. There was even some strong historical precedent for the approach, often cited by journalists. The Marshall Plan in Germany and the MacArthur regency in Japan both took account of time and local custom.

So much, then, for the road not taken. In general, the first Bush Administration preferred not to offer support to reigning institutions in the communist countries. (A conspicuous exception was its support for the bold reunification of Germany.) In Eastern Europe and the former Soviet Union, the "big bang" approach gathered momentum.

Under President Clinton, it became the reigning dogma. Technocrats who preached "shock therapy" took over the top jobs in virtually all the apparatus of development -- at the International Monetary Fund, the World Bank, the US Agency for International Development and the Treasury Department. And in the next few years, ambitious privatizations were undertaken in many nations, including Russia itself.

So now to David Ellerman.

When the 1980s began, Ellerman was working as an itinerant college professor in the Boston area, somewhat handicapped among economists by his Boston University PhD in math, but cheerfully teaching economics, math, computer science and operations research to all those who wanted to learn. His enduring affiliation was with the Industrial Cooperative Association, an activist group formed in 1978 to promote worker ownership of firms.

Then, as the world-wide Turn to the Right unfolded (surprising so many Americans who identified themselves with what might be loosely summed up as "the Movement"), the ICA and similar organizations involved in workplace democracy discovered that their opportunities abroad growing much faster than were those at home.

Ellerman signed on as part of a team advising the government of Slovenia, newly broken away from Yugoslavia, on how to privatize its state-owned firms. By 1990 he was operating his own consulting firm in Slovenia and traveling throughout Eastern Europe.

In 1992 Ellerman was hired by the World Bank. He became increasingly critical of voucher privatization schemes with investment funds, which became the preferred vehicle for the corporate restructurings, from Slovakia to Mongolia, especially after the Czech experiment in 1993 appeared to go smoothly.

Under a voucher privatization, vouchers are distributed to citizens, who use them to buy shares in newly-established mutual funds. Fund managers in turn use the large sums of vouchers that they collected to buy share in companies being privatized in state-run auctions. And the result is supposed to be a rough approximation of managerial capitalism as it had evolved in the industrial West over the previous hundred years.

Every country that used the voucher mechanism has its own story of how it worked and failed to work to create a system of corporate governance while equably flowing out government-owned assets to the citizenry. In his Challenge article, Ellerman argues fiercely that such market reforms had just the opposite effect. Their whole purpose was to deny the de facto property rights accumulated during the "communist past," he writes.

"Outside of a small elite, most Russians encountered the market not as something that strengthened their capabilities and empowered them to do more but as something that took away what they were capable of doing and left them in a position where the rational choice was to grab what they could in the face of a very uncertain and uncontrollable future," he writes. The reformers' Big Bang approach "wiped the slate clean of people's accumulated de facto property rights and capabilities in favor of vouchers worth a few bottles of vodka…."

"Today, the comic-book version of the Russian debacle that is promulgated for public consumption is not the farcical nature of trying to legislate five linked agency chains overnight. Instead, the story is that 'It didn't work as planned' because of the rapacious managers and state officials who did not respect property rights. Thus the fault lies not in the architects of the absurdly designed chicken coop but in the rapacious nature of the foxes."

In contrast, Ellerman holds out China as an example of successful step-by-step reform, in which past conditions routinely have been taken into account, especially in the successful experiments in company-growing known as "township village enterprises." First look at the parties who have to cooperate, in order for a particular enterprise to succeed, says Ellerman. Then "shrink-wrap" the ownership around them (the idea was contributed ten years ago by Harvard professor Martin Weitzman, a Russia specialist and expert on worker ownership.) The result may be a "reform without losers," in Gerard Roland's phrase.

Examples of these bottom-up reforms include the Polish government's privatization-by-liquidation (sometimes called "Polish leasing"), the short-lived Soviet lease buy-out program and the Chinese TVEs. In 1999, Stiglitz lumped them together as "stakeholder privatizations."

When the technocrats expect that the national and regional watchdog agencies they have devised -- highly centralized mutual funds and banks -- will do a better job searching out opportunities and acting on them than will stakeholders working close to the action, then the experts "have failed in their understanding of the core elements of a market economy," he wrote. Thus did Stiglitz sum up the various objections to shock therapy-tactics that had first been raised a decade before.

Was Russia really a debacle? Is China really a success? These are monumentally complicated questions. Witness the fact that it was from China's Guangdong Province that the frightening new respiratory disease known as SARS escaped -- because political commissars declined to heed the advice that medical doctors were giving. Previously Guangdong was the Chinese Communist Party's shining example of the success that comes when economic change precedes political change. Will it now become a symbol of the perils of that arise when the old top-down order-keeping political institutions remain in power?

It will take many years before these big questions can be answered with any certainty. But already more balanced critiques by cooler heads have begun to appear. As far back as 1995, Maryland's Murrell memorably sifted the claims for shock therapy in "The Transition According to Cambridge, Mass.," in the Journal of Economic Literature. And in a recent issue of the Journal of Economic Perspectives, Berkeley political economist Roland surveys the scene last year (a working paper version is posted on his Web site) and concluded that "Economists have often gone astray in their analysis of transition factors by examining only economic factors and ignoring deep institutional transformations." Already a shift in their thinking has taken place, he writes, away from markets and price theory in favor of thinking about the legal, social and political environment in which promises are made.

That doesn't mean we can afford to wait. All these issues are on the table in Iraq, where for fifty years almost everything that wasn't run by a family firm was owned by the government (itself a kind of family firm). So who is giving advice to the White House on the economic transition in Iraq?

Interestingly, many of the key figures in the Bush administration have their own experiences of shock therapy -- at one point or another in the course the quarter-century restructuring of the American economy that began with the "May Day" deregulation of Wall Street in 1975. Dick Cheney ran an energy services company, Donald Rumsfeld a pharmaceutical house, Bush himself sought to make money in oil and gas. These policymakers don't need economists to inform their innermost convictions about building and dismantling incentive systems.

So pay close attention to what is going on now. Perhaps the most interesting portent to emerge so far is the phenomenon of US Marines working closely with Iraqi police to re-establish order in the cities. The design of a new national oil company will provide more clues.

So far, the American occupation of Iraq seems to resemble more nearly that of Germany than anything that happened in the 1990s. Perhaps that is inevitable. After all, a war was required to displace Saddam Hussein. Still, wouldn't be ironic if the relatively close-quarters, gradualist approach to reconstruction that underlay the Marshall Plan, dismissed by President Bush in 1989, turned out to be the strategy that his son quietly embraced in 2003?