"Gradualism" and "Big-Bang": a Consideration from Hayekian Perspective

比較経済体制学会会報第34巻 Bulletin of the Association for Comparative Economic Studies vol.34

On the Debate between "Gradualism" and "Big-Bang": A consideration from Hayekian perspective

Hiroyuki Okon Wakayama University

1. Introduction After the collapse of socialism in 1989, one of the hottest subjects in economics is concerning with the choice of strategy for marketization of once centrally-planned economies. Tow types of strategies have been considered: "Gradualism" and "Big- Bang" . Chinese success with Gradualism and Russian failure with Big-Bang have intensified the debate between two strategies. Thus so great efforts have been devoted to make sure superiority of one strategy over the other. However, they are almost all, in a sense, in the field of empirical studies. Theoretical analysis of the transition still remain waiting for more greater efforts. One of the reasons for this unbalance between empirical studies and theoretical analysis is the belief that there is no appropriate theory to deal with the unprecedented experiment of transition of socialist economies to market economies. So some "new economics" have been invoked on, including institutional economics, evolutionary economics, or economics of transition. After a brief survey of the arguments on Gradualism and Big-Bang, I would like to insist that, besides of these new economics, a theoretical framework to tackle the trade cycle presented by Friedrich Hayek can provide a useful model to understand the transition of the ex-socialist economy to the market economy. The main purpose of this paper is to direct researcher's attention to the structural problem during marketization of the ex-socialist system.

2. Gradualism and Big-Bang: Two different strategies for marketization As for marketization of the ex-socialist economies, there has been two different approaches. We may call very generally one of them 'Gradualism' and the other 'Big- Bang' respectively. From Gradualism's point of view, we should marketize the ex-socialist economies gradually and partially. It emphasizes the institutional factors in the process from socialist to market economies. Because of its paying much attention to time dimension of the marketization and growth of institutional settings, Gradualism can be replaced by

81 'Evolutionism' . China provides one of good example of such evolutional and gradual strategy. On the other hand, Big-Bang is a position according to which we should and can marketize the ex-socialist economies as radically and thoroughly as possible. That is, we must move as fast as possible on macroeconomic stabilization, the liberalization of trade and prices, monetary convertibility, privatization, and so on. The proponents of this position, for instance Jeffrey Sachs, insist the complete removal of all government regulations in micro economic level and restricted intervention into macro economic level. Russia and Poland, for example, have adopted this neoclassical-pro-market strategy.

3. Three phases of the Gradualism-Big-Bang debate As for the debate between Gradualism and Big-Bang so far, we can divide it into three phases. The first phase is characterized by the enthusiasm in Big-Bang as the most efficient route from the socialist to the market system. From this invisible-hand perspective, all agenda for marketization, their sequence and speed to implement, and the policy strategy were discussed. At this stage, Gradualism was dominated by Big-Bang market euphoria. After a few years then, the second phase came. The poor economic performance led both policy makers and economists to their recognition that marketization might be more difficult, more complex, and more time-consuming process than they thought. Against Gig-Bang, some insisted superiority of Gradualism. What characterizes the third and present phase is a fact that we have many statistical economic data to evaluate the aptness of two strategies. From these statistics, we can observe different performances among countries which have embraced different strategies. As Chinese success with Gradualism is contrasted with Russian failure with Big-Bang, it came to be thought that in order to marketize the ex-socialist system we must chose appropriate strategy in the light of its initial condition.

4. The present state of the debate (1): Some points at issue. With different economic performances observed in the post-socialist economies, the following problems have been presented. (1) How can we evaluate the performances of the ex-socialist countries? (2) Can we relate the different performances with different strategies? (3) If we cannot, what is the reason for the difference of economic performances? (4) What explains China's success and Russia's failure? (5) Is this contrast of performances a proof of Gradualism's superiority over Big-Bang? (6) Can it possible to prove mathematically the dominance of one strategy over the other?

In addition to these problems, we have another one. It is what Janos Kornai calls

82 'tra nsformational recession.' He observes that "All the postsocialist countries without exception are suffering from a grave economic recession." Thus we counts this homogeneous phenomena as the seventh problem.

(7) Why have all the postsocialist countries experienced transformational recession? Of course, with regard to transition from the socialist system to the market system, there are many other problems. In contrast with seeming simplicity of the transition problem which we concieved immediately after the collapse of socialism, after all, we have now very diverse problems to solve.

5. The present state of the debate (2): A survey of recent inquiries.

Here we shall survey some inquiries into the above problems.

Sachs (1996) and others present 'Initial Conditions Matter Hypothesis'. According to this hypothesis, the contrast of economic performances between China and Russia must be explained by the different initial conditions which those countries had at the beginning of marketization; Russian economy has been industrialized and 'advanced', Chinese economy is a less developed one. Big-Bang, according to Sachs, is only possible option in Russia. Big-Bang policy is also defended from monetarist point of view. Aslund (1994) criticizes Gradualism of its approval of inflation. He ranks combating against inflation as the most important object to be pursued first. Yavrinski and Braguinsky (1994) explain the Russian failure with Big-Ban by their 'Hysteresis Effect Hypothesis'; because principle -agency relation before marketization has remained and made hysteresis effect, production declined. Dewatripont and Roland (1995) present a mathematical proof that, under conditions of high learning ability and low cost of collecting relevant information, Gradualism dominates Big-Bang. Because they consider the situation in which only two policies are implemented, we can not accept their proof as general propositions. But they have shown that the Gradualism-Big-Bang debate can be treated in more exact manners. Big-Bang is backed by neoclassical economics. After asked and examined its usefulness as the underpinning for marketization, Peter Murrell (1991) answers negatively. Instead, he picks up evolutionary economics for that paprt. It is then Gradualism that can be linked to evolutionary approach to transformation of the ex-socialist system. As for the problem (7) listed above, Kornai himself gives an explanation. We can call it '80% Keynesian -20% Hayekian Hypothesis .' According to this hypothesis, we can understand the transformational recession as follows. Inflation after the price liberalization and restrictive monetary policy eliminated potential effective demands. This decrease in effective demands caused the recession. To this Keynesian factor Kornai adds Hayekian one that marketization is a process of creative destruction which will coordinate demand structure and supply structure.

83 6. A criticism of present researches Although value of these researches can not denied, some criticism may be attempted. (1) Marketization must be analyzed explicitly as a "process." (2) Marketization is a process from socialist system to market system. (3) Although Dewatripont-Roland's conclusions shows a possibility for us to argue some general propositions about the proper strategy, they do not reflect specificity of marketization. (4) Is it necessary to seek for 'new' economics to analyze the process of marketization? And if we take into account a fact that, after the transformational recession, almost all countries show economic recovery (Figure 6-1), we should have the following as very important question to be tackled first.

Figure 6-1 Gross Industrial Production. Source; Countries in Transition 1995. ed. by W•¬•¬W, 1995 * All 1994 data are prelimiuary.

84 important question to be tackled first. (5) What is to be explained is a kind of business cycle that happened during transition from the socialist system to the market system. In the light of these criticism, we must keep in mind the following points for our analysis of marketization. (a) The model is needed to be able to analyze marketization as a process. (b) The model is needed which considers the process as from the socialist system to the market system. (c) The model is needed to reflect main characteristic of the socialist system. If we take these points into account seriously, then we had better, I believe, treat the transition as "traverse" between two states with different structures of production.

7. The distorted production structure of the socialist system What is the characteristic feature of socialist economies? Especially what characterizes the structure of the socialist economic system? Although these problem are scarcely discussed in the process of the Gradualism-Big-Bang debate, I believe that they are one of the most important aspect of the transition process.

85 Table 7-1 Average Annual Growth Rates, 1950-79

Source: Kornai (1992), p. 168, table 9.2.

Table 7-2 Industrial Investment as a Percentage of Total Investment

Source: Kornai (1992), p. 175, table 9.3. *Annual Averages at Constant Prices. As for the former question, Richard Ericson points out following nine salient characteristics; (1) a hierarchical structure of authority, (2) rigid, highly centralized planning, (3) a commitment to maximal resource utilization, (4) formal rationing, (5) exhaustive price control, (6) the lack of a true money, (7) the lack of legal alternatives to assigned relationships, (8) absolute and arbitrary control by superiors, (9) incentives to meet the plans and desires of evaluating superiors. These characteristics as a whole has made the socialist system an united organism. Jan Winiecki pays more attention to the latter problem; the structural problem of industrial sector in the socialist system. The industrial sector in the socialist system had been continuously enlarged and overgrown. And the structural balance between heavy industry and light industry was distorted. The most obvious characteristic of the production structure of the socialist system is a fact that the structure was heavily distorted. The socialist system was physically very distorted one. This distorted feature can be also evidenced by the investment policy of the socialist system (Table 7-1 and 7- 2). In the process of transition from the ex-socialist economy to the market economy, we must 'straighten' up such a distorted structure of production. But it can change only slowly. This is a problem which both Gradualism and Big-Bang have neglected in their debate. And this is the problem to which Hayek made a great contribution with his trade cycle theory.

8. Marketization as frustrated traverse (1): An application of Hayek's trade cycle theory Usually a move from the socialist system to the market system is called Transformation'. However it is very complex notion. It includes such divers factors as property right, institutions, organizations, laws, power, ideology, norm, convention and so on. "T raverse," which I would like to analyze here, is included in this notion. It is defined as a move from one stationary state to another stationary state. Here each stationary state is characterized by particular structure of production. Then we can define traverse as a move between two states with different structures of production. But what is to be explained is a kind of business cycle that happened during transition from socialist system to market system, not an once for all change. Here we can find Hayek presenting a possible model to understand the traverse from once planned economies to market economies. A theory of trade cycle which Hayek outlines in his Price and Production can be considered as 'frustrated traverse', that is, incomplete move from one stationary state to another state. The following is a very famous story to understand Hayek's main idea on frustrated traverse.

"The situation would be similar to that of an isolated i sland if, after having partially constructed an enormous machine which was to provide them with all necessities, they

87 found out that they had exhausted all their savings and available free capital before the new machine could turn out its product. They would then have no choice but to abandon temporarily the work on the new process and to devote all their labour to producing their daily food without any capital".

Against our intention, some may insist that Hayek had analyzed the market economy, not the socialist economy or its marketization. But as Hicks comments on Hayek's theory of trade cycle, the problem which Hayek's theory itself tries to solve might be concerned with the effect of over-ambitious investment in the centrally-planned economies". As justification for our project, we can cite Cottrell's expansion of Hick's point.

"[T]h e authorities start up a grandiose investment project without due attention to the curtailment of consumption implied in the medium run. At first things seem all right, because consumer goods already in the pipeline continue to come forward; but then there comes a point where the completion of the project requires a further diversion of resources away from consumption. Either the authorities press on regardless, or they relent and hence fail to complete the project. The visible result is an unfinished or under- utilized capital project, but this does not reflect general over-capacity -a problem which might be cured by an expansion of demand; rather it reflects a structural imbalance which could be corrected only if consumers were willing to tolerate a reduced real standard of living for a longer period".

9. Marketization as frustrated traverse (2): A tentative model How can we formalize the above story into a model? Unfortunately as long as I know, there is no such formalized model of Hayek's idea yet. We have only Allin Cottrell's numerical example and Desai-Redfern's one so far. Without developing a formalized model ourselves, we should use a much simplified version of Cottrell's example as a tentative 'model' and try to interpret it as illustrating traverse from socialist system to market system . Assumptions of our model are the followings. (1) Production by a linear sequence of stages: input of the first stage is only labor, the other stages use labor and output of the previous stage although it is not explicit in the model. (2) Fixed input-output relation. (3) Simultaneous progress of each stage. (4) Except for the final consumer goods during transition, we assume labor theory of value. Under these assumptions, we can make a numerical model of marketization as frustrated traverse (Table 9-1).

88 Table 9-1 Marketization as Frustrated Traverse

89 L denotes labor input, ƒ° L the number of total labor employed, and Y the value of the final consumer good respectively. Although it is not explicitly demonstrated in the model, the longer the production process is, the more productive it is. This superiority of more roundabout method is a familiar assumption in Austrian economics. The model must be read as follows. First, in period O, the economy was in stationary state in which five stages from 6 to 10 were used to the final product. Each stage employed 7 units of labor. Then in period 1, without deliberation, the authority became much more ambitious, leading to more roundabout method which needs ten stages to the final product. So 5 units of labor was moved to the 1st stage. In period 2, more 5 units of labor moved to the 2nd stage. And in period 3, more 5 units to the 3rd stage. The movement of labor continued until period 7. During this movement, the former method of production has been used in reduced scale. While the economy was moving to the one which would use more roundabout method of production, the consumer goods had to decrease in both value and its real volume in period 5 and 6. In period 7, the economy produces no consumer good at all. It is because, although the old process disappeared completely, the new more longer process has not reached the state to be able to produce the final product.

Period 7 is in a very critical situation. Dissatisfaction and discontentment of labors who can not consume what they want is about to be vented. The authority must decide to discard its socialist ambition, and to move more suitable production system, that is to the market economy. Period (8) is the first year of marketization. But the traverse to the market economy, that is, the movement to the structure which is shorter than the former one but longer than the first one, can not be performed instantaneously. In this example, it will need seven periods from (8) to (14) to be able to produce the final consumer's good and to be a stationary state. In order for the traverse to get started, some lag is needed; the investment-wage lag or the wage-consumption lag. As Cottrell discusses with his example, the former lag is not consistent with the Austrian theory of production. Although, then, the latter is an only possible lag, it assumes consumer's behavior as follows; '(a) they are satisfied with their original level of real consumption, and do not try to spend any more when their wages rise; but (b) when consumer goods eventually appears in short supply and prices rise, then people starts spending as much as possible. 'We can accept this Hayek's assumption of lag since, in centrally-planned economies, the allocation of resources to investment is decided by fiat of the planner, while wages are also centrally controlled.

10. Some implications What the model suggests us is a possible idea that transition from the socialist to the market system can and must be analyzed as a continuous process or traverse between

90 two very different structures of production . The model also suggests that the marketization of the ex-socialist system is the process of structural change. Sharp reduction of

production and unemployment, which we observed in the process of marketization, are due to the legacy of socialist system; the structure of production created during the

periods of socialism. And this very structural process of systemic change has been neglected in the debate between Gradualism and Big-Bang.

As for the debate, we can draw some implications from our exercise. The above analysis depends on our interpretation of the transition as "traverse ." It looks at only changes of structure of production. However if there are fundamental differences between realized socialism and realized market economy, our analysis may be inappropriate. Here is room for "new economics" to be sought for. And usually those who invoke on it are, implicitly or explicitly, proponents of Gradualism. These proponents of Gradualism assume, however, implicitly that they know the fundamental difference between socialism realized and the market economy, and that they know what is to be needed and what is to done. It seems a form of "Pretence of Knowledge." But our knowledge is limited, and our rationality is bounded, especially as for the transition . This is in line with Balcerowicz's recognition in his 1995 book. We may need rather Big-Bang strategy than Gradualism if there are fundamental differences between realized socialism and realized market economy. This is because, with Big-Bang, we can make use of competition as a discovery procedure. Merit of competition is, as Hayek argued, to have relevant agents discover what to do. Therefore if Big-Bang has superiority over Gradualism, the reason exists in that it can make competition as a discovery procedure work. In this sense, the transition from the socialist to the market system is a spontaneous process. But this spontaneity does not mean that we can not understand the structural problem during marketization. As our exercise shows, it is really possible. And its significance for the production and employment, which the model suggests, seems make the analysis of structural change of production have priority over mutual criticism between Gradualism and Big-Bang.

11. Conclusion. In a sense, Hayek is standing at the center of the debate between Gradualism and Big-Bang. The former pays great attention to evolutionary aspect of his economic thinking. To the latter his firm faith in market mechanism appeals. But as for the transition of centrally planned economies to market economies, our consideration shows that there is another relevant idea in Hayek's economics; his theory of trade cycle as frustrated traverse. It is no doubt true that our analysis of marketization is nothing but only a possibility. Nevertheless I believe that we began to walk in the right direction.

91 Notes 1. Faculty of Economics, Wakayama University. Correspondence via e-mail would be welcomed; [email protected]. 2. Kornai (1995), chapter 7. 3. op. cit., p. 161. 4. For example, Balcerowicz (1995). 5. Russia must be excluded from this group. 6. Ericson (1991). Kornai (1992) Part Two gives more detailed examination of the socialist system. 7. Because of this, Ericson insists that step-by step reform, that is Gradualism, are likely to fail. According to him, we must change these characteristics simultaneously, we must adopt Gig-Bang, if reform can be effective. However, he also seems recognize that it takes some long period to transform physical structure of the economies. 9. Winiecki (1988/1991) Part 2. He asserts that the structural problem stems from the characteristics of the system and the double specialization policies; import-substitution and self-sufficiency. 10. Hayek(1931), p. 84. 11. Hicks (1967), pp. 208-9. 12. Cottrell (1994), p. 211. 13. The reason why I don't use Desai-Redfern's example is that their example does not express any process. As a matter of fact, it is a sequence of equilibrium states which are separated from each other. 14. From period (8) on, the numbers are parenthesized in order to indicate that the system has changed. Thus we can think of the period (8) as the first period for marketization. 15. Cottrell (1994), pp. 210-1. 16. Balcerowicz (1995). 17. Klaus (1994) (1996).

References. Balcerowicz, Leszek (1995) Socialism. Capitalism, Transformation, Budapest, London and New York: Central European University Press Cottrell, Allin (1994) "Hayek's early cycle theory re-examined." Cambridge Journal of Economics, Vol.18, pp. 197-212. Desai, Meghnad and Paul Redfern (1994) "Trade cycle as a frustrated traverse: an analytical reconstruction of Hayek's model," in Colonna, M and H. Hagemann eds., Money and Business Cycles, The Economics of F.A. Hayek Volume I, Edward Elgar, pp. 121-143. Dewatripont, Mathias and Gerard Roland (1995) "The Design of Reform Packages under Uncertainty", American Economic Review, Vol. 85, No. 5, pp. 1207-1223. Ericson, Richard E. (1991) "The Classical Soviet-Type Economy: Nature of the System and Implications for Reform." Journal of Economic Perspective, Vol. 5, No. 4, pp. 11-27.

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