THE IMPACT OF ECONOMIC LIBERALISM ON THE RADICAL TRANSITION STRATEGY

Dawid Piątek,

Ph.D.

Katarzyna Szarzec,

Ph.D.

Poznan University of Economics

Department of Macroeconomics

Al. Niepodległości 10, Poznań

Phone number: +48 061 854 30 14

dawid.piatek@ae.poznan.pl; k.szarzec@ae.poznan.pl

Summary

The purpose of this paper is to reconstruct the attributes of a liberal economic agent and to present the radical transition strategy from this perspective. An agent is characterized by three attributes: freedom, property and rationality that are discussed based on the works of classical economists. The origins and arguments for the radical transition strategy are presented. The concept of a liberal economic agent is to have a crucial impact on the decision to implement the radical economic transition. Due to a completely different concept of economic man in the centrally managed economy, a choice of the radical transition strategy (the shock therapy) requires to introduce a liberal model of man as quickly as possible. The economy transition restores all the attributes of a liberal economic agent. One of the main assumptions of the radical transition strategy is that the attributes will appear immediately after implementing reforms. Radical stabilization, liberalization and widening of economic freedom are the only ways to spread private property and make economic processes more rational. A gradual way of transition would not provide the attributes so quickly and completely.

Key words: economic transition, economic liberalism, radical transition strategy.

1. Introductory Remarks

Liberalism is a composite, ideologically rich concept, composed of plethora of trends. It is treated as a conglomerate of political, social and economic ideas (often contradicting each other) which makes a relatively consistent concept of man and society, though. Liberalism can be considered at various levels: conceptual, chronological, subjective and objective. Therefore, when interpreting liberal ideas, it seems necessary to adopt a methodological directive that would reflect this differentiation. In this article we present its explication on the objective level, i.e. within the economic sphere and with the use of conceptualization of the idea of liberal economic agent. Accepting this research perspective allows for treating economic liberalism as a relatively homogenous trend, with a clearly marked theoretical conceptualization.

The economic transition which took place in the 1990s in Central and Eastern Europe, meant transition from the centrally planned economy to the market one. It entailed a full and radical change of general aims and conditions of all economic agents. It was not only a limited endeavor to reform the existing system but in character a qualitative (groundbreaking) change, which meant a definite departure from the previous economic rules. As regards the necessity of economic transition, there has always been a consensus – at least among economists. The differences concerned the very method of its application, as well as the pace and scope of changes. With a lack of comparable experiences from other countries that could be used as a beacon, the governments of the Central European countries had to implement their own, pioneering agendas of political and economic changes.

The aim of the article is to reconstruct the attributes of liberal economic agent, and then to present the radical transition strategy (shock therapy) from this model agent’s perspective. The agent is attributed the following three things: freedom, property, rationality. They are discussed based on the basic principles of political philosophy of liberalism, and the classical economists' writings, with the indication of the directions of modifications introduced by their continuators.

Together with the start of economic transition in the countries of Central and Eastern Europe the ideas of transition toward market economy gained more significance. They had already been developed earlier but it was the outset of transition that influenced their dynamic development. Among the theorists of the transition process there appeared a division into the supporters of gradual introduction of market economy (gradual therapy) and a sudden, the fastest possible, radical switch to the market rules (radical transition strategy or shock therapy). One of the main sources of arguments in favor of the radical transition is the concept of liberal economic agent. The views of the supporters of this transition strategy will be presented in reference to the three attributes of liberal economic agent. Particularly significant findings on the radical strategy of transition can be found in the writings of L. Balcerowicz, M. Dabrowski, W. Wilczyński and J. Winiecki.

2. The Attributes of Liberal Economic Agent

The model of liberal economic agent was created and presented by A. Smith in An Inquiry into the Nature and Causes of the Wealth of Nations. In this work, A. Smith describes and analyzes the economic realities, on the basis of which he identifies some regularities and rules that influence the exchange of goods among people. They are believed to be the causes of their wealth. A very important role in the explanation of these rules plays the idea of “invisible hand” which directs the actions of economic agents (Smith, 1776). According to this concept, the result of the agent’s activity is not only meeting its planned ends, but also an increase of nation’s wealth, which is brought about through the exchange of goods. If all the agents behave accordingly, then – due to the social division of labor – everyone benefits to some extent and the general level of wealth in a society grows. To make the concept of “invisible hand” work and fuel the increase of the wealth of nations, economic agents have to be characterized by three attributes: freedom, property, rationality. They constitute the principles of the concept of man, characteristic of economic liberalism (Drozdowicz, 2005; Przybysz, 1997; Rau, 2000).

2.1. Freedom

Freedom is one of the fundamental political concepts, with philosophical, economical and religious references. Philosophy names two types of freedom (liberty): negative and positive. The previous one means freedom from some coercion; this is the “freedom from …”. It refers to the classical English liberalism, where liberty is understood as absence of state's intervening in decisions and actions of men (Kuniński, 2006). He or she exist as autonomous individuals who make their own decisions about themselves and the state – through the established laws – can, at the most, facilitate making use of their freedom. The latter one – the positive freedom – refers to a consideration what a human being should do with the freedom, i.e. how to make use of it.

J. Locke specified objective and inalienable natural rights that every man is entitled to, and they are the rights to life, liberty and property. He referred to them with a general term "properties", because they relied on the properties of man and property. They were given to men by nature and no one, another man, any state can deprive them of them (Locke, 1992). Giving up freedom or its limitation can occur only when exercising men’s rights (“life, liberty, property”) is threatened. Then, they may want to create a society, (an institution of) power (government), law which will be a safeguard of the rules of righteousness and justice (Locke, 1992). The concept of liberty created by J. Locke played a significant role in the development of the idea of liberty and determining the main directions in thinking about freedom, in particular in the fields of (Filek, 2002): accentuating the freedom of action of the agent and the relationship between liberty and property. Nowadays, it is the basis for thinking about the state and the agent.

A. Smith and other economists “used” the concept of liberty, referring to its interpretation adopted by political liberalism. In economics, freedom is treated as a natural law, typical of the agent, meaning the absence of outside coercion in a decision making process and in taking actions. The point of interest for economics, then, is the negative liberty rather than the positive one. (Filek, 2002).

In the theory of economics, the state is the factor of coercion, so the main aim was to establish its indispensible duties. As A. Smith put it: “(…) little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism but peace, easy taxes, and a tolerable administration of justice: all the rest being brought about by the natural course of things” (Smith, 1749). To this end, the state’s interference should be limited to the following three duties: “protecting the society from the violence and invasion of other independent societies”, “establishing an exact administration of justice” and “erecting and maintaining certain public works and certain public institutions” (Smith, 1776).

The factor that regulates the rules of economic cooperation between agents is, in the first place, law. On the one hand, it makes the coercion, because it interferes in the liberty of the individual, limiting some actions – it becomes the safeguard of security, liberty and property. J.S. Mill admits that men’s right to liberty can be limited in a way, if it is to be exercised, i.e. when the right to liberty of one man does not infringe the liberty of another. In his writings on the necessary functions of the government, he indicates the protection of persons and property – economic interests of a society (Mill, 1965).

J.S. Mill thought that “The degree in which the maxim, even in the casus to which it is most manifestly applicable, has heretofore been infringed by governments, future ages will probably have difficulty in crediting” (Mill, 1965). With history in mind, when we consider the establishment of the centrally planned economy and the increased state interventionism after the Great Depression and World War II, J.S. Mill's concerns proved to be unfounded. The struggle for liberty of the economic agent was begun by F. von Hayek in a well-known argument on socialism and capitalism, and opposition against the concept of enslaving the agent by a state with the centrally planned economy. M. Friedman, a famous promoter of free market and freedom of choice, argued that an increased intervention in economy not only threatens the rights and liberties of the agent and unconstrained economic activity, but is ineffective and has negative consequences for economy.

2.2. Property

In the political philosophy of classical liberalism the concepts of liberty and private property always remain in a close relationship (Kuniński, 2006). The agent has a right to private property which is attributed to them due to their liberty. Liberty is understood in two ways: as social contract, agreed and regulated on the basis of established laws, and amended by the state (political power) or as a natural law applied to men. According to the concept of social contract, one can speak about property when there is a state that regulates and protects – through a legal system – ownership relationships. Property as a natural law was described by J. Locke in his Second Treatise on Government. He argued that property is the right of men and its creation has nothing to do with creation of a state. Men have right to own and to use the fruits of their work in the form of new goods. But the guarantee of observing the ownership laws is enacted law and government. The concepts of liberty and property introduced to the liberal thought by J. Locke were quickly adopted by economics and treated as the foundation of free market economy. The question of property became particularly important, and it was connected with the growth of the wealth of nations and the development of a theory of economics. In economics it is the material results of human labor that is emphasized, and they contribute to the growth of people’s welfare and the entire economy through the acts of exchange. Without property there is no room for competition and free market.

The concept of property proposed by A. Smith fits into the tradition of natural law. The source of property was lack of or a limited access to resources. In the theory of economics and capital economy (because it is there that economics was created) one puts emphasis on the superiority of private property over state-owned one, because the previous one makes the bedrock of the existence, development of an agent and society. Failure to observe the ownership laws would be disadvantageous for economic development and state’s stability, so in this respect, state’s intervention is advisable.

According to J.S. Mill private property is a “primeval and fundamental institution” (Mill, 1965), which is almost always the mainstay of economy in a society. It is not only the result of the natural law, but also labor, skills and abilities of every agent (Koryś, 2006). Private property guaranteed economic development and thanks to it mankind could liberate itself from feudalism and mercantilism. J.S. Mill combined liberty with property and put emphasis on the utilitarian character of the latter one, since it increases the general welfare of a society. Importantly, it ensures material security for an individual, which gives them freedom in other realms of life (of opinion, action, beliefs).

Developing Marxist, socialist and communist thought which postulates the nationalization of means of production and domination of public property was criticized by liberal economists. L. Miles, F.A. von Hayek stated that the economic account is possible only in the environment of an unrestricted access to resources and free market prices, which are ensured by free competition and private property. According to L. Mises public-owned means of production in the socialist economy blocked its actual valuation, and what follows, calculation and rational management, so: “Every step that leads away from private ownership of the means of production and the use of money is a step away from rational economic activity” (Mises, 1959). F.A. Hayek warned against socialism, thinking that it is a system jeopardizing the liberty of an agent (Hayek, 1989). Replacing private property and free competition with public property and planning leads to enslavement of societies.

2.3. Rationality

Rationality of actions is a characteristic of liberal economic agent. An action is thought to be rational only when the agent pursuing an aim chooses – basing on their knowledge – the most effective means. The choice of the aim and its pursuit is a matter of free will and choice of the agent.

The rational economic agent – aka homo oeconomicus model – is to be observed in A. Smith’s writings, which refer to them when explaining the mechanism of “invisible hand”. According to A. Smith the economic agent is motivated only by one thing: personal interest (satisfying their material needs, achieving richness) which is singled out of many other.

In many schools continuing the classical thought, the emphasis was put on the character of actions taken by the agent (maximizing their economic ends with the use of available means) and knowledge. In the analysis of the neoclassical school we can see a substantial modification of the homo oeconomicus model in the respect of the purpose of action. The purpose was presented more precisely, i.e. one made more relative the evaluation of a desire for a given good and satisfaction arising from gaining it in the relation to the outlays involved. The agent is ascribed a purpose, which in the case of a consumer becomes the maximization of utility with a given income, and in the case of a producer – maximization of profit with a given outlay. Economic decisions depend on the analysis of the relation results-outlays, which reflects the point of interest of economics: the way to meet the aim, and not the aim itself.

The agents are attributed the knowledge of economic management, with pointing out also its limitations, as the cause of lack of optimum in economy. Among the important findings of the 20^th century economics we can list attributing agents with the ability to formulate expectations as for economic variables and interpretations of relations between the anticipated state and the actual one, which affects their economic decisions.

3. Economic Transition

Economic transition was one of the aspects of political transformation. In Central Europe its aim was to build market economy, which entailed the need to change three principal traits of the previous system: resources allocation mechanism, the type of superior property, and the role of money in the economy. Among the elements of economic transition one can usually find macroeconomic stabilization, microeconomic liberalization and a fundamental reconstruction of institutions coupled with privatization (Balcerowicz, 1997). There were strong correlations between them, and their simultaneous implementation could produce a synergy effect.

To the most often listed division criteria of a transition strategy belong the speed and radicalism of changes. According to them we can speak about the opposition of: radical transition vs. gradual transition. The shock therapy, also called a radical and comprehensive economic program, according to L. Balcerowicz, is a way of transition to market economy, in which stabilization, liberalization and intuitional reconstruction are undertaken more or less at the same time, and the process takes the fastest pace possible. The features of the shock therapy make the attributes of liberal economic agent appear shortly after embarking on the transition and they take possibly the most complete shape. The concept of liberal economic agent was accepted by the supporters of radical transition and made one of the sources of the transformation strategy (Piątek, 2005).

3.1. Freedom

The command, centrally planned economy was strongly nationalized, and the area of economic freedom was in practice limited to petty deals of everyday life. The transition to market economy brought substantial increase of economic freedom thanks to the liberalization of business activity, prices and foreign exchange. The liberalization, however sorry shock it was, was "a necessary and decisive step into a new reality", and the introduced rules of economic freedom and free market prices created qualitatively a new economic reality – the market economy (Lutkowski, 1999).

The radical transition supporters called for a fast liberalization of business activity regulations. The call stemmed from their understanding of market economy as an evolutionally formed system, based on the freedom of business activity and exchange. They accepted A. Smith’s concept of “invisible hand”. However, to make this mechanism work for economic agents, they cannot be restrained with too many barriers. The pressure on the biggest liberalization possible also arose from the recognition of the findings of the monetarist school and neoclassical economics (Lavigne, 1999; Roland, 2000). Therefore, the shock therapy supporters did not believe in the effectiveness of state interventionism and in the viability of gradual reforms introduced in an appropriate order. Such endeavors, in their opinion, had to lead to the occurrence of organized pressure groups. They were also impossible to conduct due to limited capacity of state’s administration (Dornbusch, 1991; Lipton, Sachs, 1990). V. Klaus believed that such concepts are a technocratic and rational project, based on a belief in social engineering, scientific control of the reform process and their precise tuning to the needs (Klaus, 1991).

The necessity of swift liberalization arose also from the interconnections between the areas of transition. Simultaneous introduction of changes leads to appearance of a synergy effect (Ahrens, 1994; Gelb, Gray, 1991; Guitián, 1994; Kornai, 1991). Negligence in any transition area will negatively affect the others (Balcerowicz, 1997). The liberalization of prices, aimed at abandoning the shortage economy and its poor performance, and removal of administrative price regulations hindering a rational economic account, required simultaneous introduction of stabilization measures to avoid the corrective inflation that could become a permanent phenomenon. Without liberalization it was difficult to eliminate subsidies and tax exemptions, which, in turn, undermined the possibility of accurate budgeting and jeopardized stabilization. The liberalization of prices was also indispensible to demonopolize (deregulate) economy and to pursue its privatization (also through de novo development of the private sector). The most important, however, was the fact that without liberalization one cannot eliminate shortage (Dąbrowski, 1996). Also liberalization of foreign trade, to urge companies to compete, had to be complemented by introduction of a convertible currency (Balcerowicz, 1997). Although the institutional reforms were also very important, their pace could not be as fast as the pace of stabilization and liberalization. However, one put emphasis on the necessity of taking measures in this respect. The interdependence between stabilization and liberalization, and institutional changes was mutual. The privatization and restructuring of companies was impossible without the liberalization of prices and elimination of shortage (Dąbrowski, Gomułka, Rostowski, 2001). And in the long term, it seemed unlikely to sustain stability without reconstruction of institutional economy (Antowska-Bartosiewicz, Małecki, 1991).

Economic freedom was extremely important also for the radical strategy supporters. Without it, it would be impossible for the market economy to work well, and its restrictions often lead to pathological situations (rent-seeking groups, monopolies). Liberalization had a positive impact on changes in other areas of transformation. The choice of a radical strategy led to a fast widening space of economic freedom.

3.2. Property

The issue of property was very significant in the process of transformation. The characteristic feature of the centrally command economy was the domination of public ownership, which consequently led, among others, to the soft budget constraints, deficits and excessive employment (Kornai, 1992). Privatization of economy was the key issue, because private property was one of the most fundamental features of market economy, and privatization was the absolute requirement to eliminate the above mentioned pathologies.

As regards an appropriate pace of privatization, the economists vary in their opinions. The supporters of radical transformation pointed out that a state is a bad owner, so there is a necessity to find a private owner for government property. They understood the fact that privatization of economy takes place through a bottom-up rise of the private sector as well as the privatization of public-owned companies. The development of private companies was possible thanks to lifting bureaucratic and fiscal restrictions. However, to gain greater momentum, there was a need to change some legal regulations to ensure security of doing business and execution of agreements. What was important for to the development of private property, and was backed by the supporters of radical approach, was to conduct simultaneous and fast changes in all areas of transformation.

Gradual development of the private sector was not an argument for suspending privatization of public companies. Transition to the free market economy founded only on the development of private sector would be very time-consuming. At the same time, the remaining considerable dimensions of the public sector could threaten to become dangerously politicized. This could lead, in turn, to designating managers according to other than businesslike criteria, which could bear requests for subventions to cover losses or remit the overdue taxes, and economic development would be hindered (Balcerowicz, 1997). These threats partly troubled the Polish economy, because in the 1990s, the slow privatization of public companies gave rise to a distinct division into the public and private sectors (systemic dualism), both of which had entirely different rules of managing business (Wilczyński, 1995).

The supporters of the radical agenda saw a connection between the pace of shrinking the inherited public sector and the speed of growth of the private sector. The decline in output in the public sector meant decumulation of inventories, which could be taken over by newly established private companies. It was a phenomenon of so-called “creative destruction” (Mujżel, 1994). As a result subsidizing ineffective public companies in order to sustain output levels had an adverse effect on the private sector (Winiecki, 1999).

The above mentioned arguments reasoned the swift privatization of public companies but they did not determine a method. J. Kornai did not believe in the possibility of emergence of an appropriate ownership structure that would ensure right management if stocks were directed to the general public, therefore he opposed the program of mass and comprehensive privatization (Kornai, 1991). However, majority of the radical therapy supporters accepted various, not only traditional, methods of privatization (i.e. using vouchers, coupons, share certificates or investment funds).

The supporters of radical transformation attached a lot of attention to private property. For them, it was the condition of rational management, therefore they accepted other than traditional methods of privatization that led to fast transition of government property into the private hands. Also they put emphasis on the role of bottom-up privatization. In their opinion, the development conditions of private companies became more favorable with the faster decumulation of inventories from public companies. That is why it was postulated to cease assistance for poorly performing public companies. They also realized the synergy effects in economy, which led to another postulate of rapid changes in all areas of transformation. The development of private sector required appropriate institutional reforms (modernization of finance sector, economic regulations, and efficient judiciary), so the pace of changes was very important. The choice of transition strategy led to quick emergence of property as an attribute of economic agents.

3.3. Rationality

Behavior of economic agents in the command, centrally planned economy were diametrically different from the one typical of market economy. The entrepreneurs sought to maximize the likelihood of accomplishing the plan, so they wanted to receive the biggest allotment of means of production with possibly small production tasks. Transition to market economy meant abandoning this logic of management.

The agenda of shock therapy facilitated rapid change of the base, and also assumed rationality of economic agents. The supporters of this program believed that the radical change in business conditions was possible, because the reformers had the knowledge of market economy and knew how to use it. Moreover, the laws of economics are treated universally, which meant possibility to copy at home the institutions that functioned well in other market economies. The concepts that reflect economic reality well are the neoclassical theory of prices, standard macroeconomics and the model of homo oeconomicus.

Rational economic agents adjust their behavior to new conditions if only they are subjects to appropriate incentives (Murrell, 1997). In this context, reformers’ credibility was critical and could be attained only through radical measures. Lack of credibility and hesitation in taking appropriate steps caused futility of the attempts to reform the command, centrally planned economy. Economic systems are characterized by a logic of operations which ensures their consistency (Kornai, 1990). It means that introduction of some elements of market economy to a functioning centrally planned economy could not be successful (Kornai, 1992). Changes must reach some critical mass if they are to be effective. The internal logic of economic systems functioning makes it impossible to arbitrarily choose and join elements that are specific for different economic systems.

The radical character of the introduced changes, including the radical stabilization agenda in the first place, was consistent with the findings of the neoclassical economics. In the process of formulating inflation expectations, rational economic agents had to take into account the government declaring to contend with inflation with radical means. Government’s decisive actions lent credibility to its declarations. The frequently heard argument against the shock therapy supporters about using monetarist solutions when stabilizing economy, in this context, seems to be unjustified (Balcerowicz, 1997).

As regards people’s behavior, J. Winiecki noticed that the centrally planned economy influenced not only the formal rules of management, but also the informal ones. As a result, the economies of the post-communist countries characterized of high transaction costs in comparison to mature market economies (Winiecki, 1999). In the opinion of this economist, however, in the transition strategy, taking into account formal and informal rules existing in these economies and people’s inertia cannot be the argument for rejecting the radical transition. Economic agents adjust their behavior if the changes are credible and sufficiently important (Winiecki, 1999). Slow and gradual reforms can be insufficient to signal an intention to reform economy, especially if government lacks credibility due to previous failures in introducing changes (Funke, 1993). L. Balcerowicz presents similar arguments. He agrees that the economic transformation dynamics can be much higher than the pace of changes in social attitudes and behaviors. At the same time, invoking the theory of cognitive dissonance, he asserts that customary and habitual behavior can be overcome quite quickly under the condition that the change in the agents’ circumstances will be important enough, and what follows, treated as irreversible. Psychologically speaking, it seems more beneficial to apply radical reforms that would allow changing the attitudes of the economic agents fairy quickly. (Balcerowicz, 1990).

The supporters of radical transformation assumed that agents’ behaviors are rational. Therefore, they recommended the radical stabilization of economy. Only a radical change of conditions supported by reformers’ credibility could lead to the breakthrough in economic agents’ habits. Radical transition to market economy gave the greatest chances of success.

4. Closing Remarks

The liberal economic agent is characterized by personal freedom referring to choice, will and action. Their actions are the result of their decisions, resources at hand and rational management. If a state intervenes too much in the actions, it restricts their freedom, distorts information that flows from the free market, which in consequence can lead to anything but optimal accumulation of inventories.

In the centrally planned economy the agents were deprived of the liberal economy agent attributes. Economic transformation restored them anew. The radical transition strategy assumes that these attributes appear almost immediately after the onset of changes or in a very short time afterwards. Radical stabilization, liberalization and institutional restructuring widened the scope of economic freedom, made the private property widespread and rationalized management processes. Gradual transition did not allow the agents to achieve freedom, property and rationality that quickly.

The supporters of the radical transition believe that the role of a state is to restore the market economy logic as soon as possible. A state is to create the appropriate rules of game for the decisions made by free and rational agents, who have the right to private property. Comparing the economic situation of the transformed countries which were reaching market economy either shock-like or gradually, one can prove that the previous one, referring to the attributes of the liberal economic agent turned out to be more efficient.

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