Unders ding

sition
1917 and 1950 countries containing onethird of the world's population seceded from the
market economy and launched an experiment in
Between
constructing an alternative economic system. First in the
former Russian Empire and Mongolia, then, after World
War II, in Central and Eastern Europe and the Baltic
states, and subsequently in China, northern Korea, and
Vietnam (with offshoots and imitators elsewhere), a massive effort was made to centralize control of production
and allocate all resources through state planning. This vast

experiment transformed the political and the economic

map of the world and set the course of much of the twentieth century. Now its failure has set in motion just as rad-

ical a transformation, as these same countries change

course, seeking to rebuild markets and reintegrate themselves into the world economy.
The Communist Manifesto's portrayal of the turbulent
arrival of capitalism in the nineteenth century seems a
curiously apt depiction of today's transition landscape:

many other countries, and the transition experience is

therefore of interest to them as well. But most of their
reform programs pale in comparison to the scale and
intensity of the transition from plan to market.
This Report steps back from the bewildering array of
events and policy changes in twenty-eight countries to ask
what we have learned about the ingredients of any successful transition and how these should be pursued. This
is a transition still very much in progress; many important

questions do not yet have definitive answers. The fact

that so much remains to be done, however, makes it all
the more important to deduce the key lessons of transition
to date.
The legacy of planning

Karl Marx had reasoned that socialism would replace capitalism first in the most industrialized capitalist countries.
Indeed, the first part of the twentieth century was a period

of considerable social ferment, notably in Europe. But

revolutionary socialism took hold in more agrarian states,

Constant revolutionizing of production, uninterrupted disturbance of all social conditions, everlasting uncertainty and agitation. . . All fixed, fast.

frozen relations, with their train of ancient and

venerable prejudices, and opinions, are swept away,
all new-formed ones become antiquated before they
can ossify. All that is solid melts into air. . .
.

The long-term goal of transition is the same as that of

economic reforms elsewhere: to build a thriving market
economy capable of delivering long-term growth in living
standards. What distinguishes transition from reforms in
other countries is the systemic change involved: reform
must penetrate to the fundamental rules of the game, to
the institutions that shape behavior and guide organizations. This makes it a profound social transition as well as
an economic one. Similar changes have been needed in

where economic development and the advancement of

industry were concerns as important as equitable distribution. The achievements of the planned system were
considerable. They included increased output, industrialization, the provision of basic education, health care,
housing, and jobs to entire populations, and a seeming
imperviousness to the Great Depression of the 1930s.
Incomes were relatively equally distributed, and an extensive, if inefficient, welfare state ensured everyone access to
basic goods and services (Table 1). But the system was far
less stable than it seemed, for the intrinsic inefficiency of

planning was overwhelming. Planners could not get

enough information to substitute for that supplied by
prices in a market economy. Planning became largely a
personalized bargaining process, with connections (blat or

guanxi) an important element. This proved bad for

industry, worse for agriculture. Also, the suppression of
1

Table 1 The starting numbers

(percent except where stated otherwise)
Transition economies

Indicator

Population and income

Population, 1989 (millions)
GNP per capita, 1990e
(1990 dollars)
From World Bank Atlas
At PPP

Growth rate before transitiond

income.'

Comparators
MiddleIndia
income

64

1,002

850

1,105

773

404
1,000
4.9

188

320
1,086
3.4

380
1,090
5.8

2,220
4,289
2.9

20,170
15,615
3.0

58
31
40

18
35
48

19
16
23

28
21
28

27
24
29

62
25
36

77
22
31

0.91

0.71

0.38

0.14

0.21

0.41

0.31

26

24

24

30

36

46

34

45

33

71

69

70

70
31

66
12

56
41

60
52

68

17

77
<5

53

100

75

25

19

33

46

41

78

331

1,828

1,822

464

87

12

101

Other NIS
and
Mongolia

Low-

China.

CEE

Russia

122

149

139

1,102

2,268
4,647

4,110
6,440

1.5

1.9

2,141
4,660
2.3

61
34
51

74
34
50

0.81

Vietnam.

OECD

Economic structure
Urban population as share of

total population, 1991

Investment share of GDP, 1989e
Industry share of GDP, 1989
Energy use (kilograms of oil
equivalent per dollar of GDP) f
Human resources
Gini coefficient, 1989g
Life expectancy at birth,
1989 (years)g

Illiteracy rate, 1991

Monetary and exchange
rate indicators
M2 as percentage of GDP
Black market exchange rate
premium, 1989

Not available.
Note: All measures for country groups are averages, weighted by population.
All data for China are for 1978, and those for Vietnam for 1986, except where specifically noted otherwise (i.e., for GDP growth, energy use,
Gini coefficients, and life expectancy).
Excluding China and India.
Data are for 1991 for NIS and Mongolia.
Average annual real GDP growth rate at market prices; data are for 1980-89 for CEE and comparators, 1980-90 for NIS and Mongolia,
..

1966-78 for China.

Gross domestic investment.
At PPP using 1992 dollars; data are for 1990 for CEE; 1992 for NIS, Mongolia, and comparators; 1980 for China (staff estimate).
Data are for 1980 for China, 1992 for Vietnam.
Source: IMF and World Bank data; International Currency Analysis, Inc., data.

individual incentives required in their place an intrusive

set of controls. At the outset these may have been based
on ideological commitment and a dedicated vanguard
party, but they frequently degenerated into cults of personality and abuses of position by nomenklatura elites.
The deep inefficiencies of planning became increasingly
evident with time. Heavy industries such as machine building and metallurgy were emphasized, while development of
consumer goods lagged. After posting high annual growth
rates in the 1950s (averaging 10 percent according to offi-

cial estimates), the Soviet economy decelerated: growth

averaged 7 percent per year in the 1960s, 5 percent in the
1970s, and barely 2 percent in the 1980s, and in 1990 it

contracted. This trend occurred despite high investment

ratesreturns to capital formation began a steady and

rapid descent in the mid-1950s (Figure 1). A similar stagnation infected Eastern Europe. As a major oil exporter, the
Soviet Union benefited from the price increases of 1973
and 1979, but severe shortages and the deteriorating quality of its manufactured goods relative to those of market
economies were clear signs of stagnation (Box 1).
Social indicators began to worsen as well, confirming

the troubled state of the system. After World War II

health indicators in Russia improved rapidly and began to
approach levels in the industrial market economies. In the

mid-1960s, however, they began to stagnate, and later

By the 1970s, Soviet investment was yielding

little or no return.

Figure 1 Investment and rates of return in

Soviet industry

mass of centrally planned economies was far from monolithic. It was composed of countries with different histo-

ries, cultures, and resource endowments. And whereas

political change toward multiparty democracy was a
prime objective in the post-1989 reforms in Central and
Eastern Europe (CEE) and the newly independent states
(NIS) of the former Soviet Union, neither China, which
initiated economic reforms in 1978, nor Vietnam has
experienced a political transition away from governments

dominated by the Communist Party. There is thus

25
20
15
10
5

1950

1960

1970

1980

Source: Easterly and Fischer 1995b.

tremendous variety in the departure points, strategies, and

outcomes of transition across countries.
Most of the world's economies, at one time or another,
have lifted price controls, opened trade, or privatized state
enterpriseswith varying degrees of success. But as noted
above, transition is different. It is not simply the adoption
or modification of a few policies or programs but a passage from one mode of economic organization to a thoroughly different one. The underlying habits and rules of
an economic system are often so pervasive and ingrained
that they are taken for granted; indeed, the better estab-

lished they are, the less they are consciously reflected

upon. Such institutions as the education system, youth
and labor organizations, the organization and supervision

of work in firms and on farms, and the availability of

information to the public were carefully cultivated to
serve the process of bureaucratic allocation and the
even to reverse: life expectancy fell by two years between
1966 and 1980. This was in marked contrast to the trend
in other industrial countries, which experienced increases
of some three to four years over a similar period.

Nor were living standards in China's less thoroughly

planned economy immune from stagnation. Overall (total
factor) productivity declined from 1955 to 1978 despite, or
perhaps because of, very high investment in heavy industry.
The famines of the Great Leap Forward (1958-60) and the
ten disastrous years of Cultural Revolution left Chinese

society exhausted by politics and the Communist Party

ready for change. Many regions had already begun to experiment with local reforms. Peasants in particular felt that
collectivist agricultural policies were harming productivity
and living standards. Their views carried weight because the

Party had a strong rural base, so that economic improvement became a more urgent goal. The impetus to reform
was different again in Vietnam, struggling to recover from
forty years of war, and in Mongolia. Unlike China, both
had deep links with the Soviet Union and depended on
Soviet subsidies. Both needed to break out of isolation.
In response, most of these economies have rejected all
or much of central planning and have embarked on a pas-

sagea transitiontoward decentralized market mechanisms underpinned by widespread private ownership. Not
all follow the same path. Despite common features, the

broader objectives of central planning. Paternalistic and

restrictive, these institutions delivered goods and services
to meet basic needs while setting severe limits on individ-

Box 1 Falling further behind in world markets

Beginning in the mid-1960s there were unmistak-

able signs that GEE and the Soviet Union were

falling behind the newly industrializing economies
in product quality. By 1985 CEE's engineering exports earned less than 30 percent of the average unit
value received by all exporters of similar products,
and these exports were often twenty years behind in

their technology. The quality gap was widest for

consumer goods, including electronics, reflecting
the scant influence that domestic buyers had on
product quality. One study found that by 1990
Soviet cars commanded a mere third of the price of
similar Western cars in the Finnish market. As with

high energy intensity (Table 1), declining quality

reflected the incentives created by the system and its

isolation from world markets and foreign direct

investment. Even large imports of Western capital
goods proved unable to make a major improvement.

ual choice and indoctrinating citizens with antimarket

propaganda. Thus, for transition to succeed it must transcend economic engineering, restructure the institutional
basis of the social system, and develop civil societyan
enormous agenda that will take many years to complete.

The economic challenge of transition is daunting in

itself. Planned economies were autarkic: some were bound

to each other through the trade links of the Council for

Mutual Economic Assistance (CMEA), but none traded
extensively with the world at large. Decades of bureaucratic allocation created serious distortions, with some sectors (particularly heavy industry) massively overbuilt and
others (light industry and services) severely repressed; per-

negative value; at world prices the costs of their inputs

would have exceeded the value of their output. The combination of dominant heavy industry, low energy prices,
and wasteful use of inputs caused energy intensity to rise
to several times its level in market economies (Table 1)
and had harsh environmental impacts (Box 2).
Transition must therefore unleash a complex process
of creation, adaptation, and destruction. Queuing gives
way to markets. The shortage economy gives way to an
economy of vast choice, with repressed sectors and activities growing rapidly and overbuilt sectors contracting or
adjusting. Property rights are formally established and dis-

tributed, and large amounts of wealth cease to be state

owned and controlled. Old institutions and organizations

haps as much as a quarter of the Soviet economy served

the military alone. Relative prices diverged greatly from

evolve, or are replaced, requiring new skills and attitudes.

market patterns, and this meant massive explicit or

And the relationship between citizens and the state

implicit subsidies among sectors. Energy, housing, public

changes fundamentally, with greater freedom of choice

but also much greater economic risk. True, changes of a
similar nature may be needed in many economies around
the world. But in the transition economies the magnitudes are exponentially greater. For example, transition
economies have privatized more than 30,000 large and
medium-size enterprises in five years. In the eleven years
between 1980 and 1991 the rest of the world privatized
fewer than 7,000. Countries will have completed their
transition only when their problems and further reforms

transport, and staple foods were extraordinarily cheap,

whereas consumer manufactures, if available at all, were
often shoddy. Pervasive shortages allowed firms to operate

in sellers' markets and reduced incentives to improve

quality. With near-complete state ownership, enterprises
lacked the defined property rights that spur work effort
and profitmaking in market economies. Firms had little
reason to use inputs efficiently and strong incentives to
hoard both labor and raw materials. Many firms added

Box 2 The environmental legacy of planning

For thirty years or more the planned economies

focused on raising output through quantitative production targets, with little regard for costs and with
severely underpriced natural resources and capital.
Expansion of traditional heavy industries, often using
coal as the main source of energy, was a high priority.
Industrial development on such a scale has been disas-

trous for the environment wherever it has occurred.

But in the planned economies the pollution effects
were intensified by the underpricing, and therefore
overuse, of energy and raw material inputs. The system

promoted a mindset that saw new investment as the

solution to all industrial problems. The philosophy of
implementing many small improvements to increase

efficiency and product qualitythe heart of good

industrial managementwas almost unknown. Visitors
to industrial plants in transition economies invariably
see scope for good housekeeping measures to reduce
spills, leaks, and wastegood industrial and environ-

mental performance go hand in hand. Even where

plants had pollution controls similar to those in estab-

lished market economies, poor maintenance and operating practices meant that they rarely operated at more

than a fraction of their design efficiency. Environmental improvement is likely to be a long process involving changes in managerial culture and enforcement of regulations.
The environmental liabilities created by haphazard
disposal of wastes are mostly unknown but could be
large. Some environmental damage may be irreversible:
the destruction of the Aral Sea is an ecological disaster

that stemmed from the same desire to raise physical

output, in this case of cotton. Pollution of the Black
Sea is another serious problem. An issue of particular
concern in the NIS is contamination from nuclear
waste. Unsafe nuclear reactors and the remnants of the
destroyed Chernobyl reactor are additional concerns.
Discussion of these issues has stalled because of differences over the severity of the risks and the costs of alternative measures. Limited steps have been implemented

to improve controls and safety equipment, operating

procedures, and maintenancebut nothing more.

come to resemble those of long-established market

economies at similar levels of income.
Taking stock

This World Development Report tries to distill the lessons

of transition by analyzing two sets of overarching ques-

tions in detail. The first set, the subject of Part One, relates to the initial challenges of transition and how these
have been tackled by different countries and might be
tackled by others.

Do differences in transition policies and outcomes reflect different reform strategies, or do they reflect primarily country-specific factors such as history, the level

Chapter 3 reviews the process of creating an economy

dominated by the private sector. It discusses the role of
entry by new private business and, in particular, the priva-

tization of state-owned firms, farms, housing, and commercial real estate. It analyzes why quite different
approaches to ownership change and divestiture can be
associated with positive economic results, and it draws out
the policy fundamentals that should prevail. The lessons of
transition to date are that new entry is vital, that privatization is important, and that the way it is done matters. But

different countries will launch privatization at different

moments. Moreover, once adopted, privatization should
be seen as the beginning, not the end, of a process of reorganizing the ownership and incentive structure of firms.

of development, or, just as important, the impact of

political changes taking place at the same time?

Must there be a gulf between winners and losers from

transition? How can social policies ease the pain of

This question deals with the broadest theme of transition. Given the wide range of reform strategies and outcomes across transition countries, it is naturaland
importantto ask what accounts for this divergence. The
Report's core message is that firm and persistent application of good policy yields large benefits. But the Report
shows as well that history and geography matter: that what

leaders can accomplish, or even try to accomplish, is

strongly shaped by the inherited structure of the economy,

by administrative or institutional capacity, and by the

ways in which the political system mobilizes and channels

public opinion. This interplay between choice and circumstance affects not merely the outcomes of the early
stages of transition, described in Chapter 1, but also
approaches to other dilemmas that have dogged reformers.

transformation while propelling the process forward?

Transition produces winnersthe young, the dynamic,

the mobile, the connectedbut it also imposes costs on
visible and vulnerable groups, and in many countries it
has been accompanied by a surge in measured poverty.
Chapter 4 considers social policy reforms and, in particular, the direct measures to alleviate poverty that need to
accompany the shift to market-determined wages,
increased labor mobility, and the delinking of social services from enterprises.
The second set of questions considered in the Report
looks beyond these early reforms to analyze the longerterm agenda of their consolidation: developing the institutions and policies that will help the new system develop
and prosper over time. Each transition country is at a dif-

Are strong liberalization and stabilization policies

ferent stage in the reform process, but nearly all have

needed up front, or can other reforms progress equally

well without them?

made a decisive break with central planning. They have an

Chapter 2 surveys the range of macroeconomic reforms

in transitionliberalized prices and trade regimes, hard

budgets, and freedom of entry for new businessesand
discusses the interplay of liberalization, stabilization, and
growth. The chapter concludes that both extensive liberal-

ization and determined stabilization are needed for

improved productivity and growth and that sustaining
these policies requires rapid structural change as well as
institutional reform.

Must a market economy instantly be a private one? Or

can privatization take a back seat in the early years of

even greater challenge ahead, that of consolidating the

basis for a thriving market economy. There is no unique
blueprint for them to follow; indeed, one of the strengths
of the market economy is its variety and adaptability
across cultures. Yet essential institutionslegal systems,
financial systems, and governmentsmust be adapted or
created. Also, the human capital base that is so essential
for long-run growth needs to be strengthened, and countries must carve out for themselves a fully integrated position in the global economy. These issues are taken up in
Part Two of the Report.

How should countries in transition develop and

strengthen the rule of law?

reform?

Chapter 5 examines why governments need to be

The proper functioning of markets requires clear

incentives, which flow from defined property rights.

strong enough to take the lead in defining the new rules

of the game and creating the tools for their enforcement.

But the rule of law cannot be created top-down, by

decree. It also requires demand from below, stimulated by

8, the inherited health and education systems need extensive reform to increase their effectiveness and flexibility.

the growth of market activities. Building trust in a new

system also means demonstrating that politicians and officials will themselves abide by its rules and constraints.
How can countries develop effective financial systems?

Countries started their transition with weak, passive

banking systems endowed with little capacity to assess

credit risk, and with nonexistent capital markets. As

Chapter 6 explains, financial sector reform cannot be pursued independently of other reforms, such as macroeconomic stabilization and enterprise reform. However, handling the problems early and decisively can reduce their
impact and plant the seeds of a more effective system.

How must government restructure itself to meet the

needs of a market system?

Chapter 7 considers the problem of achieving fundamental changes in government, both in terms of how it
manages spending and revenue collection, and in terms
of how it apportions responsibilities among central and
local authorities. Both the range and the nature of government's activities must change, with the state more
often seeking to facilitate private sector activity than to

Why is international integration so vital for transition,

and what are the implications for trading partners and
capital flows? How can external assistance best support
countries in transition?

These topics are considered in Chapter 9. Integration

into world markets benefits both the rest of the world and
the transition countries themselves, in part by locking in
their other reforms. The timing and composition of foreign assistance to transition ought to reflect differences

between countries: some face more pressing long-term

development needs than others. The challenge for donors
is to provide assistance that encourages and facilitates the
move to the market rather than substitutes for it.
Chapter 10 distills the key messages of the Report.
The Report's focus is on countries in CEE, the NIS,
Mongolia, China, and Vietnam. These countries are now
dispersed across a wide reform spectrum, but only one or
two of the most advanced reformers are approaching the
point at which transition issues are fading into the normal
problems of established market economies. The countries
examined are far from being the only ones that have had
extensively nonmarket economies. A comprehensive list

How can countries preserve and adapt their human

would include Algeria, Cambodia, Cuba, the Lao People's

Democratic Republic, Nicaragua, the People's Democratic Republic of Korea, and Tanzania, among others. Many
other countries have market or mixed economies resting

capital base?

on weak foundations and have at one time or another

Countries embark on transition with relatively strong

adopted parts of the planning model. The process of transition is therefore of interest to a wide-ranging set of countries and peoples.

supplant it.

endowments of human capital. Yet as discussed in Chapter