Mass Privatization Put Former Communist Countries on Road to Bankruptcy, Corruption

Daniel Fowler

April 11th 2012

American Sociological Association

Bulgarian Communist Party HQ, decaying and defaced

A new analysis showing how policies advocated by western economists helped to bankrupt Russia and other former Soviet countries after the Cold War has been released by researchers. Authored by sociologists at the University of Cambridge and Harvard University, the study, which appears in the April issue of the American Sociological Review, is the first to trace a direct link between the mass privatization programs adopted by several former Soviet states, and the economic failure and corruption that followed.

Devised principally by western economists, mass privatization was a radical policy to rapidly privatize large parts of the economies of countries such as Russia during the early 1990s. The policy was pushed heavily by the International Monetary Fund, the World Bank, and the European Bank for Reconstruction and Development (EBRD). Its aim was to guarantee a swift transition to capitalism, before Soviet sympathizers could seize back the reins of power. Instead of the predicted economic boom, what followed in many ex-Communist countries was a severe recession, on par with the Great Depression of the United States and Europe in the 1930s.

The reasons for the economic collapse and skyrocketing poverty in eastern Europe, however, have never been fully understood. Nor have researchers been able to explain why this happened in some countries, like Russia, but not in others, such as Estonia.

Some economists argue that mass privatization would have worked if it had been implemented even more rapidly and extensively. Conversely, others argue that although mass privatization was the right policy, the initial conditions were not met to make it work well. Further still, some scholars suggest the real problem had more to do with political reform.

In their new study, Lawrence King, a Reader in sociology at the University of Cambridge, David Stuckler, a Lecturer in sociology at the University of Cambridge, and Patrick Hamm, a doctoral candidate in sociology at Harvard University, test for the first time the idea that implementing mass privatization was linked to worsening economic outcomes, both for individual firms and entire economies. The more faithfully countries adopted the policy, the more they endured economic crime, corruption, and economic failure. This happened, the study argues, because the policy itself undermined the state’s functioning and exposed swathes of the economy to corruption.

The report also carries a warning for the modern age: “Rapid and extensive privatization is being promoted by some economists to resolve the current debt crises in the West and to help achieve reform in Middle Eastern and North African economies,” said King. “This paper shows that the most radical privatization program in history failed the countries it was meant to help. The lessons of unintended consequences in Russia suggest we should proceed with great caution when implementing untested economic reforms.”

Mass privatization was adopted in about half of the former Communist countries after the Soviet Union’s collapse. Sometimes known as “coupon privatization,” it involved distributing vouchers to ordinary citizens which could then be redeemed as shares in national enterprises. In practice, few people understood the policy and most were desperately poor, and they sold their vouchers as quickly as possible. In countries like Russia, this enabled profiteers to buy up shares and take over large parts of the new private sector.

The researchers argue that mass privatization failed for two main reasons. First, it undermined the state by removing its revenue base—the profits from state-owned enterprises that had existed under Soviet rule—and its ability to regulate the emerging market economy. Second, mass privatization created enterprises devoid of strategic ownership and guidance by opening them up to corrupt owners who stripped assets and failed to develop their firms. “The result was a vicious cycle of a failing state and economy,” King said.

To test this hypothesis, King, Stuckler, and Hamm compared the fortunes, between 1990 and 2000, of 25 former Communist countries, among them states that mass-privatized and others that did not. World Bank survey data of managers from more than 3,500 firms in 24 post-communist countries were also examined.

The results show a direct and consistent link between mass privatization, declining state fiscal revenues, and worse economic growth across countries. Between 1990 and 2000, government spending was about 20 percent lower in mass privatizing countries than in those which underwent a steadier form of change. This was the case even after the researchers adjusted for political reforms, other economic reforms, the presence of oil, or other initial transition conditions. Similarly, mass privatizing states experienced an average dip in GDP per capita of more than 16 percent above that of non-mass privatizing countries after the program was implemented.

The analysis of individual firms revealed that that among mass-privatizing countries, firms privatized to domestic owners had greater risks of economic corruption. Private domestic companies were 78 percent more likely than state-owned companies to resort to barter rather than monetary transactions. This was revealed to be the case after the researchers had corrected the data for firm, market, and sector characteristics, as well as the possibility that the worst performing firms were the ones privatized.

The study also revealed that such privatized firms were less likely to pay taxes—a critical factor in ensuring the failure of the policy, which western economists predicted would generate private wealth that could be taxed and ploughed back into the state. However, firms that were privatized to foreign owners were much less likely to engage in barter and accumulate tax arrears.

“Our analysis suggests that when designing economic reforms, especially aiming to develop the private sector, safeguarding government revenues and state capacity should be a priority,” the authors said. “Counting on a future burst of productivity from a restructured, private economy to compensate for declining revenues is a risky proposition.”

This article was adapted from EurekAlert.