How Eastern Europe was transformed

What a difference 25 years can make. In 1989, Central and Eastern Europe embarked upon a historic transformation, from authoritarian communism to democratic capitalism. With memories of the old system already beginning to fade, it seems fitting to look back at the region’s achievements, review the lessons learned, and examine the challenges ahead.

It would be a mistake to assume that the success of the region’s transformation was inevitable. At the close of the Cold War, Central and Eastern Europe’s economies were burdened by pervasive state ownership and concentrated investments in heavy industry. Fiscal and monetary policies had focused on boosting industrial growth, without regard to macroeconomic balance, resulting in chronically excessive demand and widespread shortages. To make matters worse, most of the region – Czechoslovakia being a notable exception – was plagued by unsustainable external debt and soaring inflation.

Meanwhile, few economists or policymakers had the background needed to tackle the complex tasks ahead. Such was the scale of the necessary transition that neither modern macroeconomics, nor the International Monetary Fund’s nearly 50 years of experience, offered much guidance. The challenges to be overcome were daunting, and many thought it would be impossible.

Instead, four key ingredients contributed to successful transitions. First, courageous politicians and policymakers took on the challenge of designing crucial reforms and explaining their consequences to a public that was understandably wary. They understood the historic nature of the task and embraced the challenge.

Second, the reform strategies focused squarely on the essential: the liberalization of prices to reflect scarcity and facilitate the allocation of resources; stabilization of finances to end shortages and inflation; and privatization of state-owned companies and assets in order to improve corporate governance and performance. Countries that implemented these policies generally made the quickest and most complete progress.

Third, the allure of rejoining Europe after years of isolation, together with the European Union’s commitment to enlargement, provided a gravitational pull – and a legislative template – that helped policymakers justify and implement difficult reforms. Unpopular laws sometimes brought down governments, but the ultimate litmus test for any new policy remained: “Will it lead us back to Europe?”

Finally, external support helped the region’s heavily indebted countries face the twin tasks of implementing structural reforms and coping with financial instability. Financing from the IMF, the World Bank, the European Bank for Reconstruction and Development, and bilateral lenders, along with debt relief from official and commercial bank creditors, helped relieve the pressure. Technical assistance, capacity building, and support for privatization – of banks, in particular – further smoothed the way.

Overall, the progress has been impressive. Several Central European countries have achieved per capita GDP levels (measured in terms of purchasing power parity) that place them on the lower rungs of the eurozone’s income ladder. Standards of living in the region have improved dramatically – even if full convergence with Western Europe is far from achieved.

Unsurprisingly, however, the picture is far from rosy everywhere. Some countries, especially in the Balkans and the Commonwealth of Independent States, are far from completing the transition and have gone through repeated cycles of hope and crisis. As elsewhere in the world, growth in the region has slowed sharply since the global financial crisis erupted in 2008. The pace of reform has slowed in many countries – and reversed in a few. Geopolitical considerations have complicated matters further, as the conflict in Ukraine demonstrates.

Looking ahead, one can envision two broad scenarios. In the first, the region risks a cycle of weak growth, retreat from market-oriented policies, and increasing disillusionment. As a result, convergence with Western Europe could slow, with many countries lagging far behind – a far different outcome from that envisioned during the boom of the mid-2000s, when convergence within a generation seemed almost like a birthright.

In the second, brighter scenario, rapid convergence to advanced-economy income levels continues, supported by a focus on two priorities, detailed in a new IMF report. A renewed commitment to macroeconomic and financial stability allows governments to rein in persistent deficits and growing debts and address their economies’ increasing volume of bad loans. Meanwhile, deeper structural reforms improve the business and investment climate, strengthen corporate governance, expand access to credit, free up labor markets, control public expenditure, and bolster tax administration – all of which puts their economies on track for sustained rapid growth.

The IMF, for its part, has been a committed partner to Central and Eastern Europe and its transformation throughout the past 25 years. It stands ready to help countries in the region make the next quarter-century just as impressive.

Published in collaboration with Project Syndicate

Author: David Lipton is First Deputy Managing Director at the International Monetary Fund.

Image: West Berlin citizens atop the Berlin Wall in front of the Brandeburg Gate in this November 10, 1989 file photo. REUTERS