Transition Economy

What It Means

A transition economy is an economy that is shifting from a planned economy to a free-market economy. A planned, or command, economy is one in which the central government makes all of the decisions regarding how resources such as land, labor, and capital (money and other material assets) are allocated to produce goods and services. In a planned economy the government sets the prices for goods and services, dictates supply (the amount of goods and services produced), and tries to manipulate demand (the amount of goods and services that consumers want to buy) to match supply. This stands in contrast to a free-market economy, in which supply and demand are not regulated by the government. In a free-market economy, prices are determined by a variety of factors, including what consumers are willing to pay for goods and services and the number of businesses competing for consumer dollars. According to most experts, the transition from a planned economy to a free-market economy takes at least 10 years.

The transition to a free-market economy begins with a three-step process. First, there is a general liberation of all economic processes. Prices that were controlled by the government are freed and left to be set by market activity among suppliers and consumers. Other government-controlled economic factors, such as interest rates (the charge for borrowing money) and exchange rates (rates of converting foreign currency to local currency and vice versa), are also freed. Second, a stabilization program is installed to limit inflation (the general rising of prices), control the national budget, and minimize government debt. Third, the longer process of building the infrastructure of a free-market economy is initiated. This process includes privatization (putting formerly state-run businesses into the hands of individuals and corporations); eliminating the monopoly of a state-run bank and building a private sector based on the extension of credit (that is, making loans available to businesses); and establishing a stock market where individuals can buy and sell shares (partial ownership) in corporations. Another aspect of creating the infrastructure of a free-market economy is limiting government involvement in social programs such as health care and housing.

When Did It Begin

The term transition economy is normally applied to the 25 free nations that emerged in Eastern Europe and Central Europe after the fall of Soviet communism in 1991. The Soviet Union (U.S.S.R.) was founded in 1922 in the aftermath of the Russian Revolution of 1917 (in which the monarchy was overthrown and the radical socialist party, the Bolsheviks, ultimately seized power) and the Russian Civil War (1917–20). The U.S.S.R. reached its largest geographic size after World War II (1939–45), when it annexed large portions of Central and Eastern Europe. All of the peoples under Soviet control were forced to adopt a form of communism, an economic and political system in which the economy is under state control. The CPSU (Communist Party of the Soviet Union) controlled production, regulated trade, and set wages throughout the Soviet bloc (those nations under the rule of the Soviet Union).

Although Yugoslavia and Albania broke with the Soviet system in 1948 and 1961, respectively, Soviet domination of Eastern and Central Europe remained firmly intact until the mid-1980s. In 1985 CPSU leader Mikhail Gorbachev (b. 1931) instituted an economic restructuring plan called perestroika, which loosened the Soviet government’s hold on the economy. The reforms initiated under this plan notwithstanding, many historians trace the dissolution of the Soviet Union to the dismantling in 1989 of the Berlin Wall, which had divided the German city of Berlin into East Berlin (occupied by the Soviets) and West Berlin (occupied by Great Britain, France, and the United States) since 1961. Shortly after this event, single-party totalitarian states within the Soviet bloc were replaced by democracies, and private individuals and corporations took control of the factors of production. The Soviet Union officially disbanded in December 1991, when the presidents of Russia, Ukraine, and Belarus signed the Belavezha Accords, which established an international alliance called the Commonwealth of Independent States (CIS).

More Detailed Information

The 25 countries that have been attempting to establish free-market economies since the fall of the Soviet Union include 13 nations in Central and Eastern Europe (Albania, Bosnia and Herzegovina, Croatia, the Czech Republic, Estonia, Hungary, Latvia, Republic of Macedonia, Montenegro, Poland, Romania, Serbia, and Slovakia) and 12 nations in the CIS (Armenia, Azerbaijan, Belarus, Georgia, Kazakhstan, Kyrgyz Republic, Moldova, Russia, Tajikistan, Turkmenistan, Ukraine, and Uzbekistan). There are also transition economies in Asia, Africa, and Latin America. In Asia the transition economies include Cambodia, China, Laos, Mongolia, Thailand, and Vietnam. Transition economies in Africa include Mozambique and Angola, and in Latin America the economies of Brazil and Chile are considered to be transition economies.

In addition to the leaders, entrepreneurs, and laborers in each of these countries, there are three institutions that provide assistance to countries making the shift to a free-market economy. These are the World Bank, the International Monetary Fund (IMF), and the European Bank for Reconstruction and Development (EBRD).

Both the World Bank and the IMF were formally established in December 1945 to help countries rebuild their economies in the aftermath of World War II. Since that time, these two institutions have contributed to the growth of transition economies throughout the world. The World Bank was created to provide low-interest loans to developing countries to help finance education and health care; the building of roads, irrigation systems, and other important infrastructure; and the formation of legal institutions to limit corruption. The World Bank also helps countries establish and maintain environmental regulations to minimize air and water pollution, and it funds efforts to treat people with HIV/AIDS in developing countries. Despite its many successes, the World Bank has been criticized for its policies. Detractors argue that it often tries to create free markets too quickly in societies that are not ready for them. What often happens, they maintain, is that larger countries such as the United States and Japan benefit from having new markets for their goods and services, but the people of developing countries remain poor because their initial economic growth is unsustainable.

The IMF’s goal is to establish and maintain a global financial system by encouraging free trade among all economies, monitoring currency exchange rates and the balance of payments among nations (that is, tracking the funds each nation pays to and receives from its trade partners), and providing financial assistance to developing countries. In 1995 the IMF began instituting a set of standards that required all member nations to share financial information with each other. The IMF has faced some of the same criticism that the World Bank has, namely that its policies work to the advantage of economic superpowers rather than developing nations. It has also been accused of supporting military dictatorships that were on friendly terms with the United States.

The EBRD was founded in 1991 to help the new democracies in Central Europe and Asia construct their economies. The EBRD has focused its efforts on Central and Eastern European nations that have demonstrated a commitment to democracy. In the past the EBRD has loaned between 5 and 250 million euros for private-sector projects. To ensure the success of its projects, the EBRD has stringent criteria for loan eligibility. Those seeking loans must be able to show that their project will benefit the local economy, help develop the country’s private sector, and meet banking and environmental standards. Applicants must also be able to match the funds they seek from the EBRD. In other words, if a corporation requests 10 million euros to begin a project, that corporation must demonstrate that it will be able to commit 10 million euros of its own funds to the project.

Recent Trends

In June 1999 the IMF published a report titled “The Determinants of Growth in Transition Countries,” which outlines some of the lessons that the agency had learned about promoting free-market economies in developing countries. It summarizes its findings in five lessons. The first and most important lesson is that stabilizing inflation (the overall rising of prices in an economy) is crucial to the long-term success of any transition economy. Most transition economies experience an initial three- to five-year period of decline because of inflation before undergoing a sustained period of growth. Some amount of price control is therefore necessary during this initial period of decline. The second lesson is that it appears to be impossible to avoid this initial period of economic decline. The third lesson is that there is no formula for economic reform that will guarantee success. Entrepreneurs and politicians learned from the failure of Russian president Boris Yeltsin’s abrupt post-Soviet reforms that any transition plan must take into account the particular conditions of the region’s economy and that this plan must be subject to modifications as it unfolds.

The fourth and most surprising lesson is that unfavorable initial conditions do not rule out long-term success, because economic reforms can be effective in offsetting these conditions. The report points out that countries such as Latvia, Estonia, and Lithuania, which had seemed the least prepared of the former Soviet bloc countries to sustain free-market economies, achieved significant economic growth after implementing reforms. The fifth lesson is that, even though the governments of these new democracies are giving up control of the economy, they need to maintain strong legal institutions to fight the proliferation of organized crime that often accompanies economic liberation. Many of the new democracies struggled against the rise of criminal organizations that used robbery and extortion to secure and expand their private holdings.