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Economies in transition: Common negative and positive characteristics

Updated on October 29, 2014

Introduction

The term “economies in transition” refers to the economic processes taking place in the economies which move from a central planned economy to a free market. The late 1980s and early 1990s witnessed the fall of The Union of Soviet Socialist Republics (USSR) and the chain of socialist countries in Central and Eastern Europe, and also observed a sharp increase in the number of countries abandoning their central planning economy models and moving towards market-based economies. The transition from socialism to market based economies in the formerly communist part of the world is a unique historical process, and likely to be remembered as one of the major economic events of the twentieth century. Although the transition processes were different from countries to countries, they all shared some common negative and positive characteristics as explored in this hub.

Danang, Vietnam, a city in a transitioning country where the old and the new intersect
Danang, Vietnam, a city in a transitioning country where the old and the new intersect

Common negative aspects of the transition process

High inflation

First, immediately following the start of the transition process, there is often a tremendous jump in the prices of all goods and services, resulting in an extremely high inflation rate. The first reason explaining the high inflation rate is because as the transition economies open their borders to market economies, old price-setting mechanisms established by the government are removed. The government takes control over only prices of some strategic goods. For the rest of other goods and services, prices are now decided by market forces. Because in the command economy, people are provided with only a limited amount of goods and services, they have not been able to consume as much goods and services as they desire. When the economy is opened and people are free to purchase what they want, the demand for goods and services rises remarkably while the supply of goods and services is still limited. As a result, inflation escalates in the short run according to the demand-pull inflation theory.

The second reason accounting for high inflation rate is because of the immature financial and banking system, and the government’s inability to recognize the severity of inflation. Most governments perceive inflation as a natural and unavoidable disaster, not a monetary phenomenon, so that they keep resorting to printing money as a way to finance their deficit spending (Kornai, 1999).

From 1986 to 1994, big increase in inflation rate was observed in all transitioning economies
From 1986 to 1994, big increase in inflation rate was observed in all transitioning economies

High unemployment

Second, high unemployment rate appears as another unwanted consequence of the transition process. Under the command economy, the government has obligations to provide jobs for all of its citizens. However, with the decline of command economies, the case now is that the workers have to find jobs for themselves, which can be a difficult challenge. On the other hand, in order to reduce costs to compete in a more competitive environment, businesses need to reorganize, and lay off unnecessary laborers. Additionally, the privatization of state-owned enterprises forces businesses to relocate, or fire inefficient workers, and increases the demand for more skilled and educated workers. Consequently, unemployment rates increases dramatically at the onset of the transition process.

High unemployment rate was common among transitioning economies
High unemployment rate was common among transitioning economies

Decrease in total gross domestic product (GDP)

Third, all of the transition economies observe a tremendous decrease in GDP. The forces of privatizing state-owned enterprises and embracing new labor management, new government laws and regulations, and operating in a completely new competitive environment definitely lower the productivity, at least in the short run. At the beginning, the state economic sector’s activities fail and decline while the private economic sector has not developed yet. The familiar economic organization undergoes many changes, pressing workers, businesses, and the authorities to learn to adapt and compromise with it. Obviously, it takes them some time to fully understand how the new system works. However, after that, GDP of all countries showed signs of recovery and constantly increased.

GDP in transitioning countries decreased then rose again
GDP in transitioning countries decreased then rose again

Undesirable social consequences

Finally, there are some undesirable social consequences accompanying the transition process. First, social inequalities increase, and the gap between the rich and the poor broadens. Gini coefficient is used to measure the inequality of income distribution or inequality of wealth distribution. A low Gini coefficient indicates a more equal income or wealth distribution. The transitional countries witness a deterioration of Gini index. For example, according to the Nation Master, in Romania, the Gini coefficient rose from 23.32 in 1989 to 28.2 in 1994, and 30.25 in 2000. Similarly, the Gini coefficient for Poland increases from 26.89 in 1989 to 32.39 in 1993, and 34.47 in 2002. For China, the Gini index increased from 26.71 in 1989 to 35.17 in 2001.

Secondly, more corruption and violence has been observed in these transitional countries. Corruption rose in most of the East European countries, Russia, China, and Vietnam after the transition process began. In addition, marriage rates tended to decline in transitioning countries while there was evidence that divorce rate accelerated (Svejnar, 2002).

Common positive aspects of the transition process

The most positive aspect of the transition process is that all of the negative consequences are expected to be only temporary. As indicated by the tables above, the transition economies experience a hazardous slowdown with a sharp decrease in GDP, high inflation, and high unemployment rate. However, after these economies hit the bottom, they start recovering continuously. Consequently, after the transition process, the economy is anticipated to prosper in the long run.

Increase in entrepreneurial activities

In addition, the transition process also brings in various advantages, which are expected to be permanent, and help to reduce the negative effects. The benefits include an increase in entrepreneurial activities, a more efficient capital allocation system, a better business decision-making process, and a rise in foreign capital investment (Young, 2002). At the earlier stage, privatization of small state-owned enterprises was conducted through local auctions, leading to an increase in small and medium-sized companies across the country. In addition, people were allowed to start their own businesses in some unconditional sectors to serve niche demand, and these firms competed with existing enterprises, making the market more competitive.

Reform in the institutional and regulatory system

In order to stabilize the macroeconomic and implement micro-economic reforms, in many former Eastern European and Baltic countries, policymakers carried out various institutional and political changes including reforms in the legal and regulatory system. There were generally two types of strategy for reforms: big bang reform and incremental reform (Svejnar, 2002). The nature and speed of reforms varied from countries to countries and most of them faced with initial difficulties. Research indicated that countries depending more heavily on natural resources for growth and being under socialism for a longer period of time were less open to political and institutional change. Moreover, comprehensive institutional restructure would be likely to involve complete overhaul of social norms and business practices, which were difficult to perform. Nevertheless, progresses were observed in all fields of institutional reforms across countries especially in the private property ownership rights (Fischer & Sahay, 2004).

Increase in domestic and foreign investment

Most transitioning economies experienced a growth in FDI inflow into the countries. Factors that were deemed as essential to the success of a transition from a closed economy to a market-oriented economy are the same as the ones essential to FDI attraction. The new institutional and regulatory systems were friendlier to foreign investors and foreign firms flocked to these newly-opened markets to take advantage of their rich natural resources, cheap labor costs and big domestic markets. FDI typically results in rapid and profound restructuring, including "organizational restructuring, technology transfer, worker training, transfer of Western management structures and practices, and new production strategies and organization" (Pavlinek,2004), which in turn accelerates the transition process.

FDI inflow in China rose sharply
FDI inflow in China rose sharply
FDI accounted for an increasing proportion of a country's GDP
FDI accounted for an increasing proportion of a country's GDP

Changing in people’s mindset and attitudes

Along with the open economy, people have more opportunities to travel abroad, interact with people outside their country, learn about the more developed world outside, which bestows them with incentives to innovate and reform their country’s economic and political system. Also, as income per capita is improved, people can have more money to spend on education, entertainment and other activities to improve their living conditions.

When do you think the transitioning process in a country is over?

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A lecture on the transitioning process

Conclusion

In conclusion, the short period following the onset of the transition was very painful with high a huge increase in inflation rate, a steep decrease in GDP, and the bankruptcy and decline of the state-owned enterprises. Transitioning economies might also undergo some unwanted consequences such as the growing gap between the rich and the poor, corruption and more social tensions. However, after that, more positive consequences are observed such as an increase in entrepreneurial activities, more foreign financial investment, the acceptance of private sector as part of economic force, the approval of some private property ownership rights, and trade liberalization.

References

Fischer, Stanley and Ratna Sahay. "Transition economies: The Role of Institutions and Initial Conditions." Calvo Conference. 2004.

Kornai, Janos. The Road to A Free Economies Shifting from A Socialist System: The Example of Hungary. 1st Edition. New York: W.W. Norton & Company, Inc, 1999.

Pavlínek, P., 2004, Regional Development Implications of Foreign Direct Investment in Central Europe, European Urban and Regional Studies, Vol. 11, No. 1, pp. 47–70 (2004).

Svejnar, Jan. "Transition Economies: Performance and Challenges." Journal of Economic Perspectives (2002): 3-28.

Young, Allan, Teodorovic Ivan and Peter Koveos. Economies in Transition: Conception, Status, and Prospect. World Scientific Publishing Co., 2002.

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