Democracy Lab

Finding the Right Take-Off Speed

There's no one-size-fits-all approach to transition economies. But slow and steady often wins the race.

The following is excerpted from The Quest for Prosperity: How Developing Countries Can Take Off by Justin Yifu Lin. Lin, was until quite recently, the chief economist of the World Bank (2008-2012) -- and probably the first western-trained economist to serve a leadership role in the People’s Republic of China. Oh, did I neglect to mention his dramatic past?

Lin was born in Taiwan and while serving in the Republic of China’s army as a captain in 1979, defected to mainland China just as Deng Xiaoping was opening the country to capitalism. Received warmly, he rose quickly in academic ranks. He later studied in the United States (University of Chicago, Yale) where he was rejoined by his wife and children whom he’d left behind in Taiwan. Lin is the founding director of the China Centre for Economic Research and Beijing University.

The new book is especially interesting because it outlines a hybrid “structuralist” approach to the transition from planning to free markets. Perhaps not surprisingly, Lin contrasts the structuralism with both the “shock therapy” approach (that largely worked in Poland, but failed miserably in Yeltin’s Russia) and the neo-liberal Washington Consensus (stabilize prices, get market incentives right, privatize) that has a mixed record in developing countries.

You can read Lin’s book as a fine economist’s analysis of the growing pains of developing countries. Or you can read it as the product of China’s own pragmatic turn to capitalism. Actually, I’d suggest both.  -- Peter Passell 

Big Bang or Gradualism?

A crucial issue in economic transition has been the choice of strategies for sequencing reforms. Two broad options -- each with some nuances -- have been implemented by Eastern European and Asian countries in the move from plan to market: the Big Bang, or “shock therapy,” and the gradualist approach.

Proponents of the Big Bang wanted to eliminate government distortions in socialist and developing countries, setting up well-functioning market systems in their place as soon as possible. They expected that market competition and quick privatization of state-owned enterprises would increase efficiency.

Post-communist leaders in Poland were among the most vocal proponents of that approach. When Jeffrey Sachs (then an economics professor at Harvard) was invited to advise the reformist movement Solidarity in 1989, he was told: Give us the outline that you see fit, but make it a program of rapid and comprehensive change. And please, start the outline with the words: "With this program, Poland will jump to the market economy."

Perhaps because former Polish trade union leader Lech Walesa was an electrician before he entered politics, he had a lightning approach to policies that seems to have served him rather well. Only four years after creating Solidarity (the Soviet Bloc’s first independent trade union) in the suburbs of Gdansk in 1980, he challenged the military regime of General Wojciech Jaruzelski and was awarded the Nobel Peace Prize. His charisma and strong support from the Western world helped him topple the Polish government, and he became president in 1990. He brought with him a team of radical reformists, such as the brilliant economist Leszek Balcerowicz, who served as deputy premier and minister of finance in the first Solidarity-led government after the fall of communism.

Following the wisdom of 17th century Japanese martial arts master Miyamoto Musashi, who said, “You win battles by knowing the enemy’s timing and using a timing which the enemy does not expect,” Balcerowicz argued persuasively that the short period of euphoria and “extraordinary politics” after the demise of communist regimes presented a unique opportunity in which reformers had to move rapidly to put in place new democratic and market-oriented institutions and to dismantle the massive structural distortions and disincentives of the socialist economy. He therefore made a strong case for the Big Bang on both political and economic grounds.

Politically, he asserted that economic reforms were easier to adopt and implement through a comprehensive program than through a lengthy process of piecemeal and often painful measures, which would leave more time for old-liners and conservative forces with the opportunity to oppose it. Economically, Balcerowicz said, radical reform was more likely to control inflation, signal a new era, build confidence and generate new structures from which there could be no turning back. “Delay will only worsen the macroeconomic situation,” he said, while “a gradual or mild stabilization program will most likely fail to overcome inflationary inertia and expectations.”

That same Big Bang thesis was advanced by many others, including Swedish economist Anders Aslund, who differentiated between “the developed socialist countries of Eastern Europe and the former Soviet Union” and “developing socialist countries like China and Vietnam.” Aslund first observed that Western-style democratization appeared to have been a precondition for a successful transition to a market economy. He then went on to suggest, “There are compelling reasons not only for the rapid destruction of the old order, but also for the speedy construction of a new democratic state.”

The slower the destruction of the old system, he argued, the more trouble and pain the transition would bring: “Given time, communist-holdover officials will find ways to transform their remaining power into property (whether by outright thievery or more subtle methods,) thus exacerbating inequalities, undermining public confidence in the state, and preparing the ground for potentially undemocratic populism.”

Such a prescription did not take into account the underlying viability problem in the economic system. Decades of central planning and forced industrialization created a massive structure of non-viable firms in the prioritized heavy industries. For the rapid transition to work, the economy would need to effortlessly reallocate resources from those industries to a market-oriented structure. However, equipment and workers in the prioritized heavy-industry sector could not be relocated immediately (or at all) to light industries and the service sector. The result would have been a collapse of the priority sectors, mass unemployment, and social and political instability.

A more nuanced approach to reform, quite different in practice from the typical Washington Consensus prescription but inspired by it, was advocated by a group of leading macroeconomists who argued that the economic transition from communism should proceed in sequence: stabilization, price liberalization and privatization had to be implemented rapidly, whereas restructuring should take time (a decade or more).

Almost all Eastern European countries entered the post-communist era with substantial fiscal deficits and excessive money creation. Drawing heavily on the Latin American experience with stabilization programs, the macroeconomists suggested that budget deficits and money creation had to be brought under control at the outset of transition and that prices had to be liberalized, because price controls would only perpetuate the shortages recorded under socialism. They also suggested that inflationary shocks be contained, where necessary by monetary reform involving partial confiscation of nominal assets.

Unfortunately, neither the Big Bang nor the more nuanced version of the Washington Consensus worked smoothly for post-communist countries. The prevailing wisdom embodied in their prescriptions often failed, and some countries could not come up with viable strategies for managing their structural transformation and guiding their industrial and technological upgrading. In Russia, for instance, most prices were liberalized in January 1992, but macroeconomic stabilization was not implemented because there was not enough political support among key policymakers for the unemployment that would have resulted.

In April 1992, the People’s Congress instructed the Russian government that the country’s priority was to “stabilize production,” meaning propping up employment in state firms through credit (and thus money) creation. As a result, inflation never fell below nine percent a month in 1992.

But in June the Supreme Soviet approved a plan for fast privatization. State capital was quickly sold at bargain prices to a small group of people, subsequently known as oligarchs, who had financial assets or political connections and could reap extraordinary gains. That, in turn, created new political-economy problems, which Russia is still struggling to address nearly two decades later.

Olivier Blanchard (an economist at MIT), who had recommended the nuanced version of the Big Bang, acknowledged that ambitious and clever plans have been disfigured by political compromises, bogged down in political fights, tied down by bureaucratic bottlenecks and foot dragging, sabotaged by those who would lose most from their implementation. The basic lesson is clear: privatization is not about the distribution of assets belonging to “the state,” which can dispose of them as it wishes, but about the distribution of assets with many de facto claimants: workers, managers, local authorities, central ministries, and so on. Unless these claimants are appeased, bribed, or disenfranchised, privatization cannot proceed.

The new structural economics that I introduce in this book provides an alternative explanation for the failure of both the Big Bang and its nuanced version.

Socialist economies that had adopted strategies inconsistent with their comparative advantage had a large number of non-viable enterprises in the government’s priority sector. Without government protection and subsidies, most of these enterprises were unable to survive in a competitive market. In some small post-communist countries such as Estonia, Latvia, and Lithuania that had only a limited number of such enterprises, the output and employment of those enterprises were limited and Big Bang reforms could realistically eliminate all government interventions at once.

With the abolition of government protection, these non-viable enterprises became bankrupt, but given their small relative contribution to the economy, the “transition costs” were small. The originally suppressed labor-intensive sector thrived, especially with inflows of foreign direct investment, and newly created employment opportunities in these industries could absorb labor and compensate for the losses from the bankruptcy of non-viable firms. As a result, the economy could grow soon after implementing the shock therapy, with a smaller initial loss of output and employment.

In larger countries, where the number of non-viable firms was large, forceful application of the shock therapy resulted in large-scale bankruptcies and mass unemployment. To avoid such dire consequences and sustain the non-viable enterprises in the advanced industries for political or military purposes, the governments had no choice but to attempt the nuanced approach offered by the leading macroeconomists: immediate stabilization, price liberalization and privatization, but postponement of the restructuring.

But this approach was logically inconsistent and self-defeating. Stability could not be achieved if prices were liberalized and non-viable enterprises were privatized while the restructuring was postponed. First, most enterprises in the government’s priority sector had monopoly power and would have raised their prices once controls were lifted. Second, the private entrepreneurs had more incentive than the state-owned enterprise managers to use the viability issue as an excuse to lobby for more subsidies from the government because they could directly benefit.

However, government revenues declined in the aftermath of the transition. Rather than the stabilization its proponents intended, this approach could lead to hyperinflation in the transition. Indeed, that was exactly what happened in many Eastern European and former Soviet Union countries. The result was (in the words of NYU economist William Easterly) “shock without therapy.” Easterly has also documented the failure in Eastern European transition economies and provided evidence that it was part of a broader stagnation of developing countries that adhered to the Washington Consensus.

A different and much more effective strategy for economic transition recommended by the new structural economics is a gradual, pragmatic, dual-track approach that recognizes the endogeneity (self-perpetuating nature) of the distortions and the viability issue of enterprises in the priority sectors. It recommends that the government provide some transitory protections to non-viable firms in the priority sector to maintain their stability in the transition, but to liberalize private firms and FDI and facilitate their entrance into sectors in which the country has comparative advantages so as to improve resource allocation, tap the advantage of backwardness and achieve dynamic growth.

The capital accumulation resulting from rapid growth in the new sectors will make many firms in the old prioritized industries viable. Dynamic growth will also create the necessary conditions, including financial resources and job opportunities, for removing the distortions in a manner reminiscent of Kaldor’s (Nicholas Kaldor, the great Cambridge economist) characteristics of 20th century growth, which implies that the policy change will increase the total social welfare and that the losers will be compensated for their losses so no one in the economy loses from the policy change. In this way the policy resistance to the reform can be minimized.

The process is one of opening markets, while also providing government support to facilitate the growth of new industries. For example, special economic zones are fully compatible with this gradualist approach: reforms and supportive infrastructure are established initially in limited geographic areas and support specific sectors during the economic transition. Elements of this approach have been implemented successfully in transition economies around the world.

Reprinted with permission from Princeton University Press. All rights reserved.

Photo by Neha Paliwal


America's Other Army

Interviews with diplomats in the line of fire -- an exclusive excerpt from the new book America's Other Army: The U.S. Foreign Service and 21st Century Diplomacy.

The mob that had gathered at a soccer stadium descended on the U.S. Embassy in Belgrade, determined to avenge Washington's recognition of Kosovo -- a Serbian province until five days earlier -- as an independent state. On that day in February 2008, the Serbian riot police stationed in front of the embassy at the request of U.S. Ambassador Cameron Munter conveniently vanished just before the hundreds-strong horde arrived. "The police marched away, got on buses, and drove away, so when the hoodlums came there was no one there," Munter recalled.

A part of the embassy was soon ablaze. "One of the protesters who was drunk managed to get in and burned himself to death," Munter said. Several others climbed the fence. The U.S. Marines guarding the compound had every right to shoot, but they managed to drive the intruders away with warnings and instructions instead. "I was very impressed that the Marines knew how to make judgment calls as well as to be defenders," Munter, a Foreign Service officer since 1985 and until recently the U.S. ambassador to Pakistan, told me in an early 2012 interview in Islamabad.

U.S. diplomats saw the embassy attack coming. And as a result of their preparations, no Americans were hurt during the incident. Only a small crew, including the ambassador, was still in the building at the time of the assault. As soon as the protesters tried to penetrate the compound, some of the Americans began destroying millions of dollars' worth of communications equipment, which is a standard procedure in such cases, Munter said. The next day, about three-quarters of the embassy staff and all family members were evacuated out of Belgrade. "We were fairly sure there would be an angry reaction" to the recognition of Kosovo "and had made all necessary preparations," he said. "We had already arranged for hotel rooms and space at the embassy in Zagreb," the Croatian capital. "We even had space at the American school in Zagreb for our kids."

Most diplomats, however, aren't so lucky. Preparing for a specific attack on a U.S. diplomatic facility overseas is almost never possible, and evacuations are rarely as orderly as the one in Belgrade. The events in Libya on the night of Sept. 11 this week were a tragic reminder of that reality. When the U.S. Consulate in Benghazi came under attack, Ambassador Christopher Stevens was trapped in the burning building and reportedly died of smoke inhalation. Three other U.S. officials were also killed during the assault. A breach of the U.S. Embassy in Cairo that same day did not result in any deaths, but the incident significantly heightened tensions between the White House and the Egyptian government.

Munter, who didn't abandon his embassy in Belgrade in 2008, wanted those responsible for the attack to be punished. Once evidence surfaced that Serbian Prime Minister Vojislav Kostunica had personally approved the assault, Munter decided that he was "going to ensure the prime minister was gone" and that "the best revenge was making sure this guy lost the next election," which was less than five months away.

Munter determined that the key to weakening Kostunica's 2008 reelection chances was taking away the support of the Socialist Party of Serbia, once led by former Serbian President Slobodan Milosevic. Its new leader was Ivica Dacic, who had once challenged Milosevic for the top post. "We got him to flip over and join the pro-Europeans," Munter said. "We didn't pay him off; we just persuaded him. What he really wanted was international legitimacy. So we got [José Luis Rodríguez] Zapatero, the Spanish prime minister at the time, and George Papandreou, the future Greek prime minister, who ran Socialist International at the time, to invite Dacic to visit them abroad, where they wined and dined him. They told him they would let him in [to the Socialist International] if he joined the pro-European forces, and he did. He put a knife in Kostunica's back."

Munter got his revenge: Kostunica's party lost the election. Dacic's party didn't join Socialist International, the global organization of left-of-center political parties, but he became deputy prime minister and rose to prime minister four years later.

Like Stevens and thousands of other U.S. diplomats, Munter has served in places much more dangerous than Serbia, including Iraq and Pakistan. As he prepares to retire from the Foreign Service after 27 years, the longtime diplomat would like Americans to know that modern diplomacy is not all glitz and glamour.

While U.S. diplomats still spend time in the company of kings and queens, presidents and prime ministers -- and remain some of the most sought-after people in foreign capitals -- they also contend with security threats, the stresses involved in constant relocation, and the challenges of being a jack-of-all-trades in a foreign land. I have interviewed some 600 Foreign Service members at more than 50 embassies and consulates in the course of research for my new book, America's Other Army. While most said they could not imagine doing anything else, many also added that being constantly on the move and far from home means giving up much of what most Americans take for granted.

American diplomats risk their lives just by showing up for work every day. During my travels researching the book, I heard many stories about carjackings, kidnappings, robberies, and diplomats being held at gunpoint. Some have been murdered. On New Year's Day in 2008, John Granville, a 33-year-old officer with the U.S. Agency for International Development (USAID), was fatally shot in Sudan while returning from a holiday party at the British Embassy. In 2002, Laurence Foley, 60, also with USAID, was gunned down in front of his home in Jordan. In 1968, John Gordon Mein, 54, became the first U.S. ambassador to be assassinated while in office when he was shot by rebels in Guatemala. Stevens in Libya was the first ambassador to be killed in the line of duty since 1979, when Adolph Dubs died in Afghanistan.

Philip Frayne, a Foreign Service officer whom I first met in Cairo in 2003, said he was driving to a meeting in Yemen in 1993 when his embassy vehicle was carjacked by "three guys with Kalashnikovs" pointed at him. "I asked them in Arabic if I could get my bag from the back seat, but by then they were already in the car and driving away," Frayne recalled. "About six months later, someone from the embassy security office saw the car in the parking lot of the presidential palace -- the diplomatic license plates hadn't been changed. I don't think it was taken by the president's men, but it was probably taken by tribesmen and later traded or confiscated by the presidential forces." That same year, Frayne's boss in Yemen, public affairs officer Haynes Mahoney, was kidnapped for a week.

Laura Clerici, a now-retired officer I met in Mexico City in 2003, said she was "ambushed by bandits" in Guatemala in the late 1970s while driving with three colleagues and six children. "When they saw that the guy from the defense attaché's office had a handgun, they started shooting at us," Clerici said. "Fortunately, all they wanted was our money, but when we got back, I absolutely fell apart." Still, work in such places gave "richness to my life that would have never happened, no matter what I had done in Washington," she said. "I've had one of the most exciting lives anybody could possibly want."

Top diplomats are the U.S. government's version of firefighters: They move around the globe rapidly, from flash point to flash point. Just when they have managed one crisis, it's on to the next assignment. Two years before taking up his post in Serbia, for instance, Munter had led a team that taught Iraqi provincial authorities how to govern effectively and trained local judges how to conduct trials and other court proceedings -- amid frequent shootings, roadside bombs, and rockets.

U.S. diplomats are charged with an extraordinarily diverse array of assignments -- and they have the stories to prove it. In 2008, around the time Munter worked to evacuate the Belgrade Embassy, Yuri Kim was in North Korea. She accompanied the New York Philharmonic during a rare concert tour in the communist country. Kim had helped negotiate the unprecedented visit, which Washington hoped would improve Pyongyang's cooperation in efforts to dismantle its nuclear weapons program. She was involved in those efforts as well. This year, now in Turkey, Kim tried to persuade Ankara to use its influence over Syrian President Bashar al-Assad to end the Damascus regime's violent crackdown on anti-government protesters.

Also this year, in another one of Turkey's neighbors, Iraq, David Lindwall worked on deals to sell U.S. military aircraft and other equipment worth billions of dollars to the government in Baghdad. A few years earlier, on the other side of the world, Lindwall had participated in successful efforts to reform Guatemala's previously corrupt child-adoption system, which many Americans use, and to improve child nutrition. In Haiti in 2010, he managed the search for missing U.S. citizens after the country's devastating earthquake and helped the local government recover from the disaster. Lindwall's house collapsed from the seismic shock -- had he been there at the time, he would have certainly been crushed to death

Gavin Sundwall's first time in a Panamanian jail was in 1998. Two Satanist killers sat across from him -- one staring at Sundwall with menacing green eyes, as if sizing him up for execution. Fortunately for Sundwall, he was just visiting the criminals, who were U.S. citizens, to make sure they were being treated humanely and to relay any messages to their families back home. Early this year, Sundwall, now in Kabul, worked to put out major public relations fires after U.S. service members burned copies of the Quran and another soldier killed 16 Afghan civilians, mostly women and children, in cold blood.

It's hard to imagine how all these people can be diplomats. How can teaching effective governance, participating in nuclear negotiations, organizing a cultural event, reforming a child-adoption system, selling weapons, recovering from a natural disaster, visiting prisoners, and fixing public relations problems be part of the same profession?

Welcome to the U.S. Foreign Service.

Given the United States' expansive global role, it should come as no surprise that America's diplomats have to take on an ever-wider variety of tasks during their careers. The most recent U.S. National Security Strategy lays out the core national interests that an American diplomat is charged with upholding -- the security of the United States, the country's prosperity, and the values it stands for (human rights, democracy, and equality). These interests are so fundamental that there is usually political agreement on them regardless of which political party is in power. Another document, the first-ever Quadrennial Diplomacy and Development Review issued by Secretary of State Hillary Clinton in 2010, elaborates on the importance of the international system to U.S. interests. It says that to ensure the security of the United States, the entire world has to be secure and stable because today's threats, such as terrorism, transnational crime, climate change, and pandemic disease, are "global, interconnected, and beyond the power of any one state to resolve."

"We cannot expect to be protected by our geographic position, which historically has been such an advantage for America -- I think Sept. 11 demonstrated that conclusively," Clinton told me. "In order to maximize the chances that we will enjoy security and tranquility here at home, we have to be in effect the chairman of the board of the world -- to try to get friends and allies to work with us, to mitigate problems, to bring about solutions that neutralize or prevent nonstate actors, as well as rogue states, from taking actions that put the lives and property of our people and our friends and allies at risk."

Got that? For the United States to be truly secure and prosperous, the whole world has to be secure and prosperous -- and that is "the world we seek," according to the National Security Strategy. At the same time, the White House recognizes "the world as it is" and acknowledges that the U.S. government must deal with it. This is where the U.S. diplomats come in: It's their job to reconcile the sometimes contradictory goals of protecting American interests in the short term while also -- somehow -- working to reshape the world into a more secure and prosperous place for future generations.

Munter's mobile phone rang at 3 a.m. Sleep was the last thing on his mind, so he answered the call. "We hear there has been a helicopter crash. Was it one of yours?" the high-ranking Pakistani official asked. Munter, now the U.S. ambassador to Pakistan, could not answer the question -- not because he was uninformed, but because he was sworn to secrecy, at least for another few hours.

It was May 2, 2011, and Munter had just watched a live video feed of the raid that killed the world's most notorious terrorist, Osama bin Laden, just 30 miles from Munter's location in Islamabad. But he was not allowed to say a word about it to the Pakistani government -- as had been the case for months -- until the official announcement by President Barack Obama in Washington.

Keeping the secret had been easy compared with Munter's next challenge -- repairing the already tense U.S.-Pakistan relationship. Those ties had already been strained to their breaking point about three months earlier, when an undercover CIA contractor, Raymond Davis, fatally shot two Pakistanis in what he claimed was self-defense. In the days after bin Laden's death, it fell on Munter and his colleagues at the embassy to explain to the Pakistani government and military why they had been kept in the dark about a foreign military operation on their own territory.

Several days after the operation, Munter was in the office of Gen. Ashfaq Parvez Kayani, the Pakistani Army's powerful chief of staff. Kayani was seething. Munter had just handed him a démarche from Washington with "a list of things" the Obama administration wanted the Pakistani Army to do in the wake of the bin Laden raid. The U.S. government felt that now it had more leverage to secure better cooperation from the Pakistanis in the fight against extremists hiding in Pakistan, Munter said. The Pakistani government, having been kept in the dark, was still stunned by the raid, and Kayani knew that accepting the U.S. demands would be seen as capitulating to the Americans.

So he "tossed the piece of paper" at the ambassador and asked him to leave. "I've rarely been insulted to my face as a diplomat, but he just threw me out of his office," Munter said. "'Is this the way you treat people when they are down?" he recalled the general asking. "He is not a rude man, but it was about as rude as he gets."

A U.S. diplomat's relations with his host country do not have to be good at any cost -- but they should at least be business-like and respectful, so the two countries can work together when necessary. The key ingredient in any relationship, of course, is trust. That was exactly what Munter had tried to build with Kayani for months before the bin Laden raid -- not for the sake of having a good relationship, but because the Pakistani Army's cooperation could help save American lives. Thousands of al Qaeda militants are believed to be hiding in Pakistan's border areas with Afghanistan, posing a threat to the U.S. troops on the other side of the border. Because al Qaeda "can attack the homeland," it is "vital" to eliminate the threat, Munter said.

The bin Laden and Davis episodes are telling examples of how short-term U.S. goals in a foreign country can clash with the United States' long-term mission. Similar examples can be found around the world, including in Russia and China, where Washington has to play a careful balancing act between its advocacy of human rights and democracy, and the help it needs from Moscow and Beijing to address strategic issues, such as the North Korean and Iranian nuclear programs.

"I would do the bin Laden operation exactly the same way again," Munter said. "It was worth it, and the president had made the calculation that it was worth it. But let's not kid ourselves: It did damage the relationship very badly. There is a set of assumptions when you build a relationship, and when you talk with people, there has to be someone willing to listen. When that collapses, running an embassy and trying to get things done is very difficult, which is why this job is the hardest I've had in the Foreign Service by orders of magnitude."