A Decade of Conflicts in Czech Economic Transformation
Tomass, Mark, Journal of Economic Issues
Critics of economic liberalism insist that Western capitalism did not evolve spontaneously through the propelling forces of individual free market initiatives. Accordingly, they argued in the past decade that economic transformation in the formerly centrally planned economies cannot achieve desirable outcomes without government-led planning. They argued that the rejection of central planning has led to an institutional vacuum, which in turn caused re-industrialization and macroeconomic growth to fall below their potentials. They credited the poor economic performance of post-centrally planned economies to the failures of the reform packages prescribed by economic liberals and international lending institutions. The major components of these packages were a set of policies designed for macroeconomic stabilization, privatization of the means of production and distribution, and the establishment of self-regulating markets. Accordingly, critics of economic liberalism made recommendations of massive state intervention to reverse the current trend of liberalization.(1)
While this assessment of the current state of economic conditions is correct regarding most transformation economies, the recommendations prescribed for them are too sweeping and ignore the peculiarities of individual economies. To make this case, I present a retrospective analysis of Czech economic transformation as we approach the tenth anniversary of its "velvet revolution." By examining the intended and unintended outcomes of transformation policies, I conclude that massive state intervention in the Czech economy is unwarranted, unattainable, potentially devastating to wage earners, and politically unfeasible.
The rapid industrial and urban expansion of the 1840s in the Bohemian and Moravian provinces of the Austro-Hungarian empire was accompanied by increasing Czech participation in cultural and political life and, subsequently, by the rise of Czech nationalism that challenged Austro-German domination.(2) In the 100 years preceding the eve of the Nazi invasion of 1939, the population of Prague increased from 140,000 to 1 million with per capita income rivaling that of France.(3) However, in late 1989, on the eve of the transfer of power to the reformist government, Czechoslovak per capita income relative to the economy of France was one-fifth of its pre-1939 level.(4) The decline of the relative standard of living of Czechs left a scar in their memory, the consequences of which became apparent once they broke away from the Soviet orbit. The most important of these consequences were a disinterest in continuing economic ties with the Soviet Union, rejection of central planning, distrust of an omnipotent state, and sensitivity to foreign involvement in domestic industrial development. Under such conditions, along with fear of a counterrevolution, the reformist government's political objective to weaken the state apparatus could not be separated from its economic objective of a quick transformation of the economy from one where prices and output were set administratively to one that is governed by self-regulating markets.
On the supply side, the new government inherited an economy where industrial enterprises were wholly state-owned and agricultural output was produced by state farms and heavily regulated cooperatives. At the end of 1989, GDP growth was 1.4 percent, and unemployment was presumed to have been zero. While the economic objective of transforming the supply side was to improve efficiency, the political objective was to generate mass support for reform by making people actual shareholders through a voucher privatization scheme. On the demand side, the budget deficit was 0.9 percent of GDP, inflation was 2.6 percent, M-1 money supply growth was 4.7 percent, real wage growth was 0.9 percent, external debt was $5.8 bln ($0.4 bin per capita), and household savings were almost zero.(5) Although these figures presented an optimistic state of demand conditions, prices that would have prevailed with market rationing were nevertheless far above the administrative ones. The latter were determined by the bargaining power of enterprises and the planning boards, which also considered the cost of inputs and subsidies and required a margin of profit.(6) With administrative prices not fully reflecting supply and demand forces, intentions to liberalize prices aroused fears of social and political uncertainties that might arise from inflation and subsequently erode political support for reform.
With these prevailing conditions in mind, we can proceed to examine how policymakers attempted to resolve conflicts generated by their intentions to achieve desirable outcomes from the process of transformation. To demonstrate the rationale for the means chosen, for their intended outcomes, and for their unintended outcomes, this paper redescribes the transformation process within a framework of three kinds of conflicts and their resolutions. The three conflicts it presents include: between privatization and the managerial elite, between ownership and control, and between self-regulating markets and protective institutions.
Conflict One: Privatization and the Managerial Elite
Privatization involved three kinds of assets. First, the restitution of assets that were confiscated from private parties after the Communist takeover in 1948. Second, the auctioning of small enterprises. These were bought by private individuals, most of whom paid for them with bank loans. The third and most significant transfer of ownership was of large-scale, state-owned enterprises.(7) The objective of privatizing large-scale, state-owned enterprises was economic as well as political. The economic objective was to rationalize production; the political objective was to reduce the power of the state. Yet, a process of privatization that adversely affects the interests of those depending on state enterprises for their livelihood may jeopardize the reform process. Thus, the real, but implicit, aim of the reformers was to privatize quickly before interest groups were formed to reverse it.(8) Publicly, however, quick privatization was justified by arguments that echoed the Austrian school of economics: Once private property is created, spontaneous forces will be unleashed to restructure and optimally allocate resources within and across industries.(9) The mere existence of an inefficient state sector, it was argued, would demand state subsidies that the state could not politically resist.
What distinguished the prospect for Czech transformation from that of neighboring countries was that the emerging political elite who took charge of designing the transformation scheme were newly established and reasonably distant from the Communist elite and the associated managerial class that had presided over Czech industrial and commercial enterprises. A major component of the reform process was the privatization of state-owned enterprises through which reformers intended to introduce individual incentive within the governance structure of enterprises. This, it was thought, would cause these enterprises to respond to market forces in ways beneficial to the economy at large. A conflict between the reformers and the managerial class was therefore inevitable.
With the absence of serious defenders of a Communist ideology under attack, opposition to large-scale privatization came from managers who presided over state-owned enterprises and for whom reform brought uncertainties that threatened their privileges. They had the incentive to influence the reform process in ways that would maintain their privileges, even if it essentially led to the continuation of the same system. While these managers had no direct political power to oppose privatization, their non-cooperation was nevertheless an obstacle to successful privatization. For the newly elected, pro-reform government to proceed with the process of privatization, accurate information was needed about the actual condition of the state-owned enterprises that were practically under the full control of the enterprises' managers. To maintain the status quo, managers resisted cooperation with the privatization board by withholding vital information on the enterprises' operations. By not cooperating, they hoped to maintain the status quo or at least to bargain for maintaining their positions.
With this conflict in mind, the reformers introduced a privatization scheme intended to appease the public as well as the managerial class. Large-scale enterprises were offered to the public by means of vouchers, whereby an equal number of vouchers were distributed to each adult at an average price of one week's pay. Enterprise shares were subsequently rationed after several rounds of bidding. With their equity claims on the enterprises, the public was given a stake in the reform process and might now provide the political support necessary for its continuation. The managers also were content with the scheme, for they hoped that the dispersed ownership structure that it created would have little or no effect on their hold over the enterprises' power structures, and they would therefore remain free of public scrutiny. Yet, their cooperation with the reformers was still crucial for success.
Realizing the importance of the managers' cooperation, the reform-minded architects of transformation designed a plan that offered incentives for the enterprises' insiders to facilitate the privatization process. The state announced an open competition to allow the selection of the best privatization project submitted by various parties for each state-owned enterprise. Since insiders were the most informed about the actual state of their enterprise, they were in the best position to offer the most feasible equity distribution schemes, and they appeased the Privatization Ministry by favoring voucher privatization.(10) The outcome was indeed favorable to enterprise insiders, who acquired full control of almost half of the enterprises and maintained their managerial positions. However, since ownership became widely dispersed, it created problems for corporate governance, thus setting the stage for the second kind of conflict.
Conflict Two: The Principal-Agent Problem
A classic and predictable problem emerged on two levels from the dispersed ownership of shares to which voucher privatization gave rise in January 1992. The first level involved the principals representing private individuals who purchased voucher booklets with which they bought shares and the agents represented by enterprises' managers. The managers did not own a significant part of the shares (less than 5 percent of the total outstanding shares) and did not have the same incentive to maximize the enterprises' value as the owners did. Because they lacked information on how to assess the value of the enterprises, and because there was no stock exchange (it was not established until 1993) through which shares could be traded in favor of well-performing enterprises, the public was reluctant to participate in the scheme.
In early 1992, investment funds started to emerge, apparently to resolve this conflict. They stimulated public participation but only by creating new problems. The funds functioned as financial intermediaries, some promising 1,000 percent return on the purchase value of the voucher books within one year. It was believed that investment funds could address the principal-agent problem by holding large blocks of shares in each enterprise that would allow them to sit on their boards of directors and therefore closely monitor management's activities. Investment funds would then be able to earn profits because of their monitoring activities, which reduce the information cost to shareholders and thereby improve the efficiency of the enterprises. By the end of the privatization process in late 1993, 50 percent of Czechs held shares, 70 percent of which were allocated by approximately 500 financial intermediaries known as "privatization investment funds," 15 of which collected and managed 60 percent of all shares. Ironically, some of the largest funds are now controlled by four major banks, 43 percent of the shares that are owned by the state through its National Property Fund. This maintained the relationship between the state and enterprises, which privatization was intended to abolish.(11)
New problems arose on several levels. First, government rules were such that each investment fund could not hold more than 20 percent of the shares of one enterprise, which reduced the incentive for funds to effect a change toward more efficient enterprise management. Second, enterprise shares are traded as closed-end funds, thus reducing incentives to improve profitability and issue new shares. Third, about 65 percent of enterprises need short-term credit to maintain their operations, which banks, through their ownership of funds, satisfy. Since it is not in the interest of investment funds to let an enterprise (the shares of which it holds) descend into bankruptcy, they extended credit to failing enterprises. This led some of the banks themselves into bankruptcy in 1996, thus prompting massive government bailouts of failing banks.(12) Fourth, bank ownership of shares in insurance companies that guarantee enterprise loans also made them less hesitant to extend loans to enterprises. Enterprise defaults may cause a chain reaction of bankruptcies that will eventually affect the banks themselves. In summary, the structure of control brought about by voucher privatization favored stability over restructuring as seen in Figure 1.
The consequence of such an interconnected ownership structure involving the public, the investment funds, the banks, and the state slowed considerably the pace of enterprise restructuring toward more efficient operations and resulted in low dividends for shareholders or, in some cases, worthless shares. However, it maintained a 2.5 percent unemployment rate for almost a decade after the process of transformation began. Shares continue to be a negligible source of income and an insignificant portion of people's portfolios; remember that each individual acquired them with one week of pay. It is not surprising therefore that the 50 percent of Czechs who own them are more concerned about stable employment and prices than with massive restructuring that may increase their dividends but put their employment at risk. Accordingly, in a country where government machinery is sensitive to public opinion, the political fallout of potential bankruptcies and structural unemployment forced the economic liberal architects of transformation to sacrifice their ideologies and slow the process. Indeed, it was not until early 1998 that the least efficient of enterprises began to respond to pressures to restructure from investment funds. Some investment funds were able to dominate their boards of management through informal agreements with other funds in ways that allowed each fund to have a larger stake in individual enterprises. This led to shedding of labor predominantly in mining and related industries that experienced a considerable fall in demand after the collapse of economic ties with Eastern bloc countries. As a result, in January 1999 the unemployment rate in mining regions rose to 15 percent while the metropolitan regions maintained a 1 percent rate, leading to a national average of 7.5 percent.
Conflict Three: Self-Regulating Markets versus Protective Institutions
To complete the process of transformation, policymakers intended to create self-regulating markets. The most essential of markets intended for self-regulation was the product and labor markets. In 1990, all product prices were administratively set, and labor was practically immobile because residential permits and employment opportunities depended on each other. The creation of self-regulating markets was intended to accomplish two aims. First, it intended to allow for the emergence of a private sector to meet consumer demand that state enterprises could not satisfy. Second, it was intended to subject existing enterprises to market forces, whereby newly formed private ownership wood respond to profit incentives and induce management to eliminate inefficiencies and modernize their operations.
In the product market, a scheme of price liberalization was introduced between 1991 and 1992 that liberalized 94 percent of commodities comprising GDP. As a result, prices in the product market rose in 1991 by more than 50 percent but were subsequently brought down in 1994 to 10 percent through a combination of a contractionary monetary policy and wage controls. Apart from low and decreasing unemployment benefits, no particular measures were directly aimed at the creation of free labor markets. However, policies intended for different purposes, such as privatization and wage and rent controls, had implications for labor markets. Excess labor shed largely as a result of small-scale privatization was absorbed through government public works creation programs, a 10 percent decline in women's participation in the labor force, and employment in neighboring Austria and Germany.(13) While wage controls were intended to curb aggregate demand, they prevented market forces from fully determining wage differentials. Rent controls, in turn, were intended to provide affordable housing in a state of severe housing shortages, but they indirectly contributed to labor immobility. For although labor was free to seek country-wide employment, private rental housing was scarce. Consequently, as regular market salaries fell far short of market rents, workers' inability to afford rents or swap their rent-controlled apartments for other lodging prolonged uneven unemployment rates that ranged from zero in the capital city to 10 percent in some regions until late 1997. As pointed out above, the restructuring of 1998 exacerbated this unevenness.
Finally, land use has been subject to strict control. While land owners are free to trade land at market prices, most land under private ownership is used for agricultural production, and owners of small plots surrounding the major cities built cottages on their land for occasional retreats. The remaining land is subject to strict zoning laws and is rented to the public for either private cultivation, pastures, or preservation. Some municipalities offer plots of land for sale to local residents, the use of which is always subject to strict regulations.
After examining the current state of the Czech economy, the outcome of the most successful case of transformation to capitalism for which economic liberal ideology takes credit turns out to be an economy where the state controls much of economic activity. A decade after Czech economic transformation began, only a small segment of land, labor, and housing is fully exposed to self-regulating markets. Prevailing cultural norms, in conflict with the rules of self-regulating markets, prompted the maintenance of protective rules that were responsible for the Czech economy's performance in the past decade. Therefore, calls by Alice Amsden, Jacek Kochanowitcz, and Lance Taylor  for massive state intervention are unwarranted because the state has not been absent. Massive state intervention is also unattainable and potentially harmful because the meager resources at its disposal will leave the state no option but to finance an undertaking through inflationary measures that will jeopardize current safety nets secured for wage earners. Moreover, massive state intervention beyond its current level is politically unfeasible because experience with totalitarianism has generated such public skepticism.
However, there is still more that the state can do. It can be more instrumental in instituting rules that cultivate the development of more efficient financial markets and corporate governance, whereby meaningful voting rights for individual shareholders threaten managerial complacency. Currently, managers are not sensitive to the market price of their enterprises' shares because of their entanglement in the web of relationships discussed above. With an educated public eager to exercise its political voting fights, well-intentioned politicians can find the necessary political support for the state's design of rules that tip the scale to its advantage. The question remains that of will, not of lack of means.
1. A sample of these views is expressed in Amsden et el. .
2. The most notable of Czech cultural activities were in music and architecture. Czech architects adopted the ideas of Western schools to make the capitals of Bohemia and Moravia showcases of late nineteenth- and early twentieth-century Western architecture.
3. When the Austro-Hungarian Empire collapsed in 1918, Bohemia, Moravia, and neighboring Slovakia united to form Czechoslovakia. The union was interrupted by the Nazi invasion and then ended on January 1, 1993, when Slovakia broke away.
4. For detailed data on comparative levels of income, see Kaser and Radice , Begg [1991, 245], and compare with OECD .
5. World Bank  and United Nations, Economic Commission for Europe . For data and a detailed account of the macroeconomic and microeconomic conditions that prevailed between 1989 and 1992, see Frydman, Rapaczynski, and Earle [1993, 40-91]. See also Frydman, Rapaczynski, and Turkewitz  for a comparative study of Czech and Hungarian privatization.
6. On ways in which administrative prices were set for small and large firms in the preceding years, see Mejstrik and Hlavacek [1993, 54-57].
7. For details and data on the stages through which privatization was carried out, see Mejstrik and Burger .
8.See Triska  for an explicit expression of this view.
9. Being among the few who established credibility with the public about economic matters, Vaclav Klaus combined his skills as an educator with his positions as finance minister and subsequently as prime minister to vigorously market the idea of quick and comprehensive privatization as an aim in itself after which all other matters will be "spontaneously" resolved by the market forces that it sets forth [1994a, 1994b].
10. See Hazlett  for details.
11. The data are from Mladek .
12. See Graham [1998, 224-227] for more details on the problems of corporate governance.
13. The data are based on various quarterly publications of the Czech National Bank (Ceska Narodni Banka).
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Mark Tomas is Visiting Research Scholar, International Studies, Harvard University and Visiting Assistant Professor, Department of Economics, Trinity College. This paper was presented at the annual meeting of the Association for Evolutionary Economics, New York City, New York, January 3-5, 1999.…
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Publication information: Article title: A Decade of Conflicts in Czech Economic Transformation. Contributors: Tomass, Mark - Author. Journal title: Journal of Economic Issues. Volume: 33. Issue: 2 Publication date: June 1999. Page number: 315. © 1999 Association for Evolutionary Economics. COPYRIGHT 1999 Gale Group.
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