In 1995 we published Winds of Change to treat the key question for transition countries: ‘How to reform?’ In the meantime we can look back on more than ten years of transition experience. No country was able to jump-start its economy on market-based principles and converge rapidly. In all transition countries production fell after opening up. In some countries this fall was short-lived, but in most it lasted several years. In some the level of production is, twelve years after opening up, still below the level of 1989. There is no simple explanation of the diversity in transition performance, but starting conditions did play a central role.

Today, therefore, the question is no longer ‘How to design reforms?’ Rather, it is ‘Why have certain approaches worked and others not?’ This will be a major theme of this book. By implication, in many countries a lot still needs to be done. This is another major theme.

In this book we resist the temptation to produce a complete record of transition experience. We rather select the most significant experiences that may become, over time, classical reference cases. Of course, the overall experience in all transition countries will be presented, but it will not be pursued in depth for each country.

The outline of the book is as follows. In part I we start with a bit of history, an overview of communist experience.

We described in chapter 4 how the transition to a market economy is almost completed in those countries that are to become full members of the EU in 2004. But there are other parts of Europe where the transition is less advanced, and where the prospect of EU membership seems so far away that it does not provide a guide for political action today. This raises the question to what extent countries that have a ‘European vocation’ could benefit from the EU anchor even if membership is only a distant dream. This is the key policy issue for the countries in South-East Europe today.

We will concentrate on the particular case of the countries that emerged from the dissolution of Yugoslavia, avoiding a definition of the Balkans explicitly, as membership of this region is not considered a badge of honour. Moreover, each case in this region has specific problems. For our purposes the Balkans (or SEE – South-East Europe) is that part of Europe that is not included in the next wave of accession to the EU, but that is on the path towards EU membership in the long run. This implies that Slovenia is definitely not part of the Balkans and Croatia might leave this region if it can convince the EU that it has left its authoritarian regime behind. But a country like Romania, which is an official candidate for membership in 2007, risks slipping back into the Balkans if its regime does not start real reforms.

In this volume we have analysed the economic transformation of the Central and Eastern European countries, their struggle for economic (and indeed political) renaissance, their successes and their failures.

We started with an overview of the communist system, both as a theoretical construct (‘just an idea’ of Karl Marx) and the performance of the Soviet Union, once a serious challenger to the United States in superpower rivalry. We found that socialism was successful in producing certain basic goods that can be measured in physical units: tonnes of steel, kilowatt-hours of electricity, gold medals at Olympic games, etc. But since this system never grasped the importance of opportunity cost it turned out that a lot of this production was economically useless (or worse). The industries most cherished by social planners were usually the ones that had the greatest adjustment difficulties once market forces were allowed to work and economies were opened to international competition.

The extent to which socialism failed to deliver can best be seen in two real-world examples. Before Poland fell under communism its level of development was comparable to that of Spain. After forty years of communism Poland emerged in 1990 with a GDP almost ten times lower than Spain, which had also endured forty years of dictatorship, but one that left market mechanisms broadly intact. A similar situation can be found in the former Austro-Hungarian empire, where up to the Second World War Austria and Czechoslovakia were at a broadly similar level of development, with Austria slightly worse off because industry was concentrated in Czechoslovakia.

The year 1989 was christened ‘annus mirabilis’. Policymakers and their advisers were not trained anywhere to deal with miracles. In order to gain insights into the problems of transition, economists turned to related, but not strictly identical, experiences. Western Europe's post-war reconstruction; the problems of development and the success of certain emerging countries; China's drifting away from a centralised command economy; and Latin America's problems with institution building and inflation control. Now, over ten years later, we have much more experience and this is the topic of the next chapter. But it is still important to understand the mindset of the early 1990s to interpret what has happened.

From the start, transition countries fell into three categories. The first included only East Germany. With generous West German financial support and extension of West Germany's institutional framework to the east, the policy dialogue was closed. In the second class were all the other socialist economies outside the FSU. These were mostly small economies that could expect a lot of support from the European Union and to gain substantially from reorienting their trade from former Comecon countries to Western Europe. And the third class was composed of the successor states of the FSU. They first had to cope with the political job of creating a state and an administration and then look around for a place in this new world. Clearly, their job was the hardest.

This chapter evaluates the major concern and, ultimately, failure of communism: to catch up with the economic advance of the West. Section 1 discusses the motivation underpinning the major policy objective, common to all socialist economies at all times, namely their excessive emphasis on growth.

Despite the intertemporal injustice that heavily penalised the first generations under socialism through very high forced savings, later generations did not reap the benefits of their forebears' sacrifices. Socialist economies seemed doomed both to fail in their bid for sustained growth and to be quite unable to let their citizens enjoy the fruits of sacrifice.

Section 2 deals with the preliminary issue of measurements, as Soviet accounting standards are not easily reconcilable with Western practices. Section 3 starts from a growth-accounting framework and shows the contributions of the accumulation of factors of production (labour, capital, land) and of productivity growth. If the Soviet economy had been able to put its immense accumulation of productive factors (extensive growth) to efficient use, it would have been at the top of the world's growth league. Unfortunately it was not. Section 4 provides an overview of the successes and failures of Soviet communism and section 5 concludes.

Growth: the overriding plan objective

In all poor countries, catching up with advanced nations is a top policy priority. Socialist revolutionaries came to power on a promise to achieve exactly that (and to redistribute income in favour of the working classes).

Evaluating Russia is not straightforward – and has never been. In 1925, Keynes summed up his impression of the new economic system as follows:

Keynes's statement remains valid today. Judgements on the effectiveness of the reforms in Russia from international institutions, academics and the press have ranged across the entire spectrum from very optimistic to extremely pessimistic. The best example of Russo-mania remains probably Layard and Parker's (1996) title The Coming Russian Boom. This boom had a rather short life, but predictions of descent into hyperinflationary chaos and disintegration after the crisis of 1998 proved equally wide of the mark. It is thus not easy to provide an overall judgement of the reforms in Russia as already anticipated by Keynes seventy-five years earlier. Hence, this chapter does not pretend to provide a comprehensive overview of developments in Russia over the last decade. Instead it concentrates on the most salient features of the reform process in Russia, often comparing them to what happened in Central Europe (especially Russia's largest Slav brother, Poland) in order to find some general features that can help in understanding how the Russian economy works in general, and where it might be going in the future.

The collapse of socialism in Eastern Europe transformed the economic and politic parameters of the European continent. Creating market economies was not the only hope that arose after the liberating events of 1989–90. Indeed, the basis for any analysis of the future of the transition countries must be that most of the countries west of the FSU made their choice early on: they wanted to join the European Union (EU). Since it was not possible for them to join the EU immediately, a transitional arrangement for trade was created in the early 1990s. Section 1 describes the transitional arrangements and section 2 provides a theoretical framework for judging their utility as a bridge to EU membership.

The EU is much more than a free trade area. If it were only that, the case for joining the EU rather than opting for worldwide free trade would be greatly weakened. The EU offers an integrated single market underpinned by a single currency – with free movement of capital and labour – supported by institutions that make the single market work and provide an indispensable common regulatory framework plus a solid monetary policy. How does this affect the choice of the applicant countries? The strength of this institutional framework makes membership particularly attractive for countries that have had only a decade to build market institutions, or, in some cases, simply did not exist before 1990.

Before 1990 nobody would have ventured to suggest that the Soviet Union might disappear. When it did in 1991 most observers saw it as a historical accident. We argued in Gros and Steinherr (1991a), written before the split, that the explosion was unavoidable and, in economic terms at least, desirable.

It is, in fact, interesting to observe that socialist states with a federal structure – the Soviet Union, Yugoslavia and Czechoslovakia – split up during transition. There are strong reasons for this dramatic failure. First, all three federations were composed of different ethnic groups with a history of painful conflicts. Adversity was reinforced in the Soviet Union and Yugoslavia by religious differences. Second, the Soviet Union and Yugoslavia were artificial, imperial creations. As argued in chapter 1, the Soviet Union just pursued Russian imperialism by adding the Baltic states, transferred entire ethnicities and subjugated dissonant people or countries, such as the Ukraine. Togetherness was maintained only by brute force in all three federations. Third, none of the three federations provided a harmonious balance of rights and responsibilities between the centre and the states of the federation. The federal structure was a paper construction, a Potemkin façade. All the power was with a Communist Party that had a monolithic structure. States of the federations had little real autonomy. Fourth, in market-based federations, such as Germany or the United States, income redistribution is achieved through budgetary transfers. Rich states keep most of their revenue, but support less prosperous states.

Chapter 4 concluded that transition as a sui generis problem is over in Central Europe. This does not mean, however, that all transition economies are already in a state of bliss. In some, particularly the successor states of the FSU and in South-East Europe, a lot of work still needs to be done to make them prosperous.

In this chapter we do not discuss problems specific to one or a few countries. We focus on one issue that, to varying degrees, applies to all: the task of institution building. Although economists were certainly aware of the need to create markets, laws and regulations and to reform public administration, they underestimated the difficulty of implementing the advice offered. If virtually all firms are bankrupt, a bankruptcy law is unhelpful; if property rights are not clearly defined or are not enforceable, banks will not lend. It is, therefore, not surprising that unfinished business mainly concerns those activities where institutional requirements are particularly demanding. The most visible shortcomings of institution building are in the political domain, conditioning shortcomings in the economic domain. Democracy and state institutions have not progressed significantly in many countries. As two insiders of Russian reforms observe (Braguinsky and Yavlinsky 2000): ‘… the economy was not freed from old Soviet-type monopolies; rather these monopolies were freed to pursue their own goals at the expense of the large society, almost without any restraint! Thus, the controls of the planned economy are diminished, but the accountability, legal framework and supremacy of a democratic society have not been established.’