In 1989, a massive transition from central planning to market economies began in the formerly socialist countries of Central and Southeastern Europe. With the breakup of the Soviet Union in 1991, the former Soviet Union countries joined this transition. This is the most dramatic episode of economic liberalization in history. What role have changing policies toward international trade played in the transition?

Prior to 1989–1991, central planning by each government directed the economies in these countries. National self-sufficiency was a policy goal. Imports were used to close gaps in the plan, and a state bureaucracy controlled exports and imports. When trade was necessary, the countries favored trade among themselves and strongly discouraged trade with outside countries. They tended to use bilateral barter trade, with lists of exports and imports for each pair of countries.

The trade pattern had the Soviet Union specializing in exporting oil and natural gas (at prices well below world prices) and other countries exporting industrial and farm products.

As the transition began, these countries had a legacy of poor decision-making under central planning, including overdevelopment of heavy industries (like steel and defense), outdated technology, environmental problems, and little established trade with market economies. They needed to remove state control of transactions and undertake a major reorganization of production.

Transition involves accomplishing three challenging tasks: (1) shifting to competitive markets and market-determined prices, with a new process of resource allocation; (2) establishing private ownership, with privatization of state businesses; and (3) establishing a legal system, with contract laws and property rights. For success, the transition process must

• Impose discipline on firms inherited from the era of central planning.

• Provide encouragement for new firms that are not dependent on the government.

Opening the economy to international trade and direct investments by foreign firms can be part of both the discipline (through the competition provided by imports) and the encouragement

(through access to new export markets and to foreign technology and know-how).

Domestic and international reforms usually advanced together in a transition country, and success requires a consistent combination of reforms. We can identify several different groups of countries that pursued reforms in different ways and at different speeds.

The Central European countries (Czech Republic, Hungary, Poland, Slovakia, and Slovenia), the Baltic countries (Estonia, Latvia, and Lithuania), and the Southeastern European countries (Albania, Bosnia, Bulgaria, Croatia, Macedonia, Montenegro, Romania, and Serbia) pursued strong, rapid liberalizations

(except for Bosnia, Serbia, and Montenegro, which were involved in fighting). As we discussed in Chapter 12, the Central European and Baltic countries joined the European Union in 2004, Bulgaria Romania joined in 2007, and Croatia joined in 2013.

The members of the Commonwealth of Independent States (CIS, the countries that were formerly part of the Soviet Union, excluding the Baltic countries) have instead followed paths of less liberalization. Three countries, Belarus, Turkmenistan, and Uzbekistan, continue to resist enacting reforms. The other CIS countries (Armenia, Azerbaijan, Georgia, Kazakhstan, Kyrgyz Republic, Moldova, Russia, Tajikistan, and Ukraine) enacted partial reforms that were adopted slowly over time and that sometimes were reversed.

How do trade patterns evolve during transition?

One pressure is clear, toward rapid growth of imports, especially consumer goods, based on pent-up demand. Transition countries must export to pay for their rising imports, and Western Europe and other industrialized countries are crucial as major markets for expanding their exports.

However, exporting to demanding customers in the competitive markets of the industrialized countries was not going to be easy. Under central planning these countries had major deficiencies in their products and businesses, including poor product quality, lack of marketing capabilities, and lack of trade financing.

How successful have the transition countries been in reorienting their trade patterns? By 1998 the Central European, Baltic, and Southeastern European countries on average were selling over 60 percent of their exports to buyers in industrialized countries. Rapid and deep liberalizations, along with favorable geographic location close to the markets of Western Europe, have facilitated the shift by these countries to a desirable export pattern. They increased their exports of light manufactured goods like textiles, clothing, and footwear. They also used their low-cost skilled labor to expand export of such products as vehicles and machinery.

In contrast, most CIS countries did not reorient their exports much, and on average only about a quarter of their exports went to industrialized countries in the late 1990s. Many CIS countries resisted trade liberalizations and continued to produce low-quality manufactured products that could not be exported outside the region. As of early 2014, only 7 of the 12 CIS countries had become members of the World Trade Organization.

How does all of this combine to determine the success of economic transition? One broad indicator is the growth or decline of domestic production (real GDP). In the beginning transition is likely to cause a recession, as business practices and economic relationships are disrupted.

Only after reforms begin to take hold can the economy begin to grow. This process is like that of the shift from no trade to free international trade. As we saw beginning in Chapter 2, the gains from opening to trade are based largely on disrupting previous patterns of production and consumption activities.

The evidence indicates that the depth and speed of reforms matter for the success of transition.

In addition, as with developing countries generally, we see greater success for those countries adopting more open and outward-oriented trade policies.

The fast and deep reformers in Central and Southeastern Europe suffered through earlytransition recessions that were not that deep and not that long. The recessions in the Baltic countries were somewhat longer and somewhat deeper. Then, starting between 1992 and 1996, each of these countries has generally had substantial and sustained growth.

The nine partial-reform and less open CIS countries have broadly performed the worst, even compared with the three nonreform CIS countries. Most partial-reform CIS countries experienced deep early-transition recessions, and three (including Russia) did not return to sustained growth until 1998 or later. They seemed to be caught in a trap in which special interests, oligarchs, and insiders who benefit from the partial reforms gain the political power to block or slow further reform. One advantage of speed in reform is that the reforms are enacted and the increased international trade and greater market competition impose discipline and offer encouragement, before such special interest groups have time to coalesce and exert their power.

DISCUSSION QUESTION Based on the international economics of the situation, should a country like Ukraine strengthen its orientation toward the customs union that includes Russia and several other CIS countries or reorient itself more toward the European Union?