The end of communism in Europe was the event of a lifetime. Suddenly twenty-eight countries with 400 million people had to choose their political and economic systems anew. Where should they begin? What was most important? What was possible? What theory should be applied? What policy corresponded to their interests? A frequent comment was that no book prescribed how to transition from socialism to capitalism, whereas hundreds elaborated on the opposite, no longer desired direction. A popular joke compared the transition from communism to capitalism to making an aquarium out of a fish soup.

The discussion became heated from the outset because so much was at stake. The fate of a large part of the world was up in the air. Could and should the former Soviet bloc be embraced by the Western world, or should it be shunned? How much economic and social hardship would people in those countries have to suffer? Which ideology would win? Could armed conflicts be avoided?

Intellectuals of all disciplines and convictions, governments, and international organizations geared up to answer the many questions. Although no clear goal was defined, a strong sense of direction prevailed. h e popular battle cry was, “We want a ‘normal’ society!” By “normal,” people in the Soviet bloc meant an ordinary Western society – a democracy with a market economy, predominant private property, and the rule of law. Because all these countries had far to go, the final destination did not appear very relevant at the outset of the march, and any specification of the goal could be politically divisive. In the havoc of a collapsing socialist system, Eastern and Central Europeans cared little whether their society would be a Western European social welfare state or a freer American market economy, both being evidently superior to their socialist ruins. These distinctions were let for later.

The collapse of communism and the Soviet bloc dominated public discussion all over the world in 1989. Many questions were raised: What relation would the postcommunist countries have to the West? What assistance did they need? What could and should the West do for them? Which organizations should be used? How much financing was needed, and was the West ready?

The West’s desire for the postcommunist countries’ success as democracies and market economies is often taken for granted, but western opinion was divided. Many favored democracy and market economies, even though most protagonists were doubtful about the prospects for democracy in the former Soviet Union. The West saw little threat from the former Soviet Union but also little gain. An important countercurrent argued that Russia was a patent menace best kept down and out. There was no consensus about what the West could or should do. In effect, the West as a whole adopted Central Europe, and Scandinavia adopted the Baltics. Southeastern Europe was left in a limbo, whereas Russia with the rest of the former Soviet Union was left out in the cold.

The qualitative contrast between Central and Eastern Europe and the former Soviet Union has widened in recent years. These rising discrepancies depend on the different choices of political regime and economic system, but these choices were preconditioned on the very different attitudes of the outside world toward these two groups of countries. History and culture were not as decisive as many believe, whereas they did influence western policy toward the region.

Law is too important to forego in a book about postcommunist economic transition, but we shall limit our observations to those of perhaps greatest importance for market economic reform: The rise in crime around the collapse of communism, the basics of establishing a new legal system, and the problems of corruption.

One of the key Soviet tenets was that the Communist Party must not be constrained by anything. Consequently, the party refuted the rule of law. With the bureaucratization of communist power, some law or rules became necessary, but the socialist legal system served the party. Its function was to enforce the commands of the government that was subordinate to the Communist Party. Formally, crimes against the state were judged more severely than crimes against individuals, although that idea never took root in public sentiment.

The socialist states had many rules that were alien to a market economy. Most private enterprise or entrepreneurship was criminalized as “speculation.” Unemployment was not pitied but prohibited as “parasitism” and was punished with labor camp. Because only a minimum of personal property was allowed, little legislation existed for the defense of private property rights. Nor did the state have any need for financial legislation. Still Central European countries maintained some prewar legislation on private enterprise on their books.

Sunday June 4, 1989, was a sunny day in Moscow. My host woke me up to tell me that Ayatollah Khomeini had died, but that was only the third item on the BBC World Service because on that very day the Chinese communist dictators massacred democratic protesters on Tiananmen Square, and Poland held partially democratic parliamentary elections. For me, the Polish elections were the most important news, signaling that communism ended on that day, whereas the Chinese massacre showed that a democratic outcome was by no means a given. Soon, one communist domino after another was to fall.

This was an extraordinary time. A complete ideological, political, economic, and social system was about to pass away, and a large part of the world with some 400 million inhabitants was to choose a new shape in every regard, including what countries they should divide themselves into. The Soviet bloc – from Berlin to Vladivostok – was struck by one of the greatest liberal revolutions of all times. Since then, society has changed profoundly. The rejection of socialism was unequivocal. A broad consensus aspired to build democracy and a market economy based on private ownership and the rule of law.

At the collapse of communism, liberal revolutionaries seized the political initiative. They aspired to build a “normal society” and to “return to Europe.” The petrified communist dictatorships had to give way to democracy and individual freedom, the state-controlled economy to markets, and public ownership to private property. Communism had rejected the rule of law, which now should be established. A total transformation was needed, and nobody thought it would be easy.

Today, the case for socialism is no longer persuasive, but this was not always so. In order to understand the history of Eastern Europe, we must realize that once many intelligent people considered socialism not only morally but also economically superior to capitalism and democracy. They thought that a benign and enlightened state would pursue higher ideals than a petty democracy and execute them more effectively. Marxist-Leninist ideas and socialist institutions conditioned the postcommunist transition. To provide some background, I review the essence of the Soviet-type system.

REAL SOCIALISM

Karl Marx, Friedrich Engels, Vladimir Lenin, and other communist theoreticians presented many ideas on how to develop a socialist state, but Josef Stalin formed the classical communist economic system with the first five-year plan of 1929–33. This system remained intact until his death in March 1953, and he imposed it on all countries in the Soviet bloc. Despite many reform attempts, the lasting changes were remarkably small. This system was the least common denominator of all the countries discussed in this book. The institutional barriers it built to reform were formidable.

Politics were crucial for the success of market economic transition. The collapse of communism was both a political and an economic process. This book focuses on economics, so we shall deal only with politics as it influenced economic policy rather than as an aim in itself.

An important reason for the breakdown of the communist dictatorship was a split in the old elite, the Nomenklatura. Some in the old establishment thought they would be better off economically and freer under a more liberal regime. Many “members of the old elite were now discovering that they could maintain their privileged positions in society even without the ideology.... the party was no longer a monolith. And once it ceased to be a monolith, it was no longer viable” (Dobbs 1997, pp. 373–4). The reformers within the Communist Party were opposed by dogmatic hardliners who wanted to maintain the old order, and the escalating struggle between these two factions made it possible for outside reformers, often true democrats, to start playing a political role (McFaul 2001).

When communist power collapsed, the political situation changed in a revolutionary fashion. Usually, two dominant forces emerged, a broad popular movement embracing democracy and freedom, opposed by the reformist part of the old elite, whereas the hardliners simply disappeared. A dilemma for rising democrats was whether to opt for a full defeat of the old system or to compromise with its more progressive members.

A fundamental but poorly understood issue of postcommunist economic transformation is what happened to output. There is no agreement on the fundamental facts, and the statistical uncertainties are too great for any consensus to emerge any time soon. Throughout the region, transition started with huge recorded falls in output. Some argued that a unique devastation was taking place; others saw a combination of measurement problems and “creative destruction” in Joseph Schumpeter’s (1943/1976) sense.

The universal output slump after communism has been greatly exaggerated. Output did fall, but not nearly as much as officially recorded. A substantial part of the big recorded decline, probably about half, was not real but can be explained with factors such as mismeasurement, an expansion of the unregistered economy, and the elimination of value detraction. In addition, several countries lost substantial subsidies and many implicit trade subsidies. The main economic concern was the long delay in economic recovery in many countries rather than the initial slump.

The initial development of output was closely correlated with reform policies. The output fall lasted much longer and was steeper in the former Soviet Union than in Central and Eastern Europe. The two extremes were the neighbors Poland, which returned to growth in its third year of transition, and Ukraine, which experienced ten years of economic decline. Radical reformers soon returned to growth, whereas partial and nonreformers experienced a long period of contraction. The covariation between many possible causes makes it impossible to distinguish the decisive reason, but hyperinflation and the general collapse of the state are strong candidates.

The essence of a market economy is economic freedom – the freedom of trade, pricing, and enterprise. Deregulation transformed socialism’s shortage of goods and services to a scarcity of money, which is the predicament of capitalism. The sellers’ market became a buyers’ market, transferring economic power from producers to consumers. The growth analysis in Chapter 3 indicated that the liberalization of prices and foreign trade were the most forceful structural reforms. Because economic freedom is the very foundation of a market economy, I discuss liberalization before macroeconomic stabilization and privatization.

Although deregulation was the most important systemic reform, for a long time it received little scholarly attention. One reason is the paucity of relevant economic indicators, such as the degree of shortage, regional price dispersion, relative prices, product quality, and market structure. Economists had to create their own data sets, complicating empirical work.

Another reason was that economists tended to look on liberalization as something simple, something that could be done quickly, requiring little afterthought. Initially, liberal politicians and economists harbored an excessive belief in the spontaneous formation of markets, reckoning that it was enough to eliminate central planning, destroy the administrative command system, and introduce private property (Akaev 2000, p. 39). Deregulation of the domestic economy was usually discussed as price liberalization, taking the equally important deregulation of domestic trade for granted. With few exceptions, the vital freedom of enterprise was not even on the agenda. Economists preferred sophisticated issues, such as financial markets and corporate governance, rather than tedious bureaucratic impediments.