Shock Therapy Versus Gradualism : The End of the Debate (Explaining the Magnitude of Transformational Recession)

The conventional explanation for the dynamics of output during transition is associated with "good" and "bad" economic policies, in particular with the progress achieved in the liberalization, as measured by the liberalization index, and with the success or failure in macroeconomic stabilization, as measured by the rates of inflation. This paper seeks to provide alternative explanation to the differing performance during transition: the supply-side recession, which in turn is caused by reallocation of resources needed to overcome disproportions inherited from the era of central planning. It is shown that over 60% of the differences in the economic performance can in fact be explained by uneven initial conditions, such as the level of development and pre-transition disproportions in industrial structure and trade patterns.After controlling for these non-policy factors, the impact of liberalization becomes insignificant. However, variations in inflation rates and institutional capacities of the state (as measured by the change in the share of government revenues in GDP and/or by the ratio of the rule of law to the democracy index) remain important determinants of performance - together with non-policy factors they explain over 85% of differences in GDP change in 28 transition economies. It is therefore argued that the debate between shock-therapists and gradualists that dominated professional discussions for the whole decade of the 1990s was interesting, but to a large extent misfocused and misguided. The crux of the debate – the speed of transition - turned out to be a secondary issue for performance, whereas the primary issue – the strength of institutions – was overlooked by both schools of thought