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Reform in Eastern Europe

Olivier Blanchard, Rudiger Dornbusch, Paul Krugman, Richard Layard and Larry Summers

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Reform in Eastern Europe — Chapter-by-Chapter Outline

Authors: Olivier Blanchard, Rudiger Dornbusch, Paul Krugman, Richard Layard, and Lawrence H. Summers First published: 1991 (MIT Press, hardcover, ISBN 0-262-02328-8; paperback reprint 1993, ISBN 978-0-262-52181-9) Edition covered: First and only edition, MIT Press 1991. Originally prepared as a report of the World Economy Group at the United Nations University World Institute for Development Economics Research (UNU-WIDER), Helsinki, November 1990. The book is xix + 98 pages and contains three substantive chapters plus a substantial preface/introduction.

Central thesis

Five of the leading macroeconomists of the early 1990s — all associated with Harvard, MIT, or the London School of Economics — wrote this short, policy-aimed book in the immediate aftermath of communism's collapse to answer a single urgent question: what should Eastern European governments do, in what order, and why? Their answer is that successful transition from central planning to a functioning market economy requires three interconnected reforms — macroeconomic stabilization combined with price liberalization, rapid privatization of state enterprises, and structural economic restructuring — and that these must be pursued simultaneously and decisively rather than gradually or sequentially.

The book is a product of the "mainstream Western consensus" on transition economics. It draws on historical stabilization episodes (the 1920s European inflations, postwar European reconstruction, the Latin American stabilizations of the 1980s), orthodox price theory, and elementary corporate finance to derive concrete policy recommendations. It is unusual among policy documents for being openly prescriptive while also honest about the costs and uncertainties involved. The authors are explicit that stabilization will bring a painful contraction and that restructuring will create mass unemployment — they argue that these costs cannot be avoided, only managed and cushioned.

The book introduced into the policy vocabulary the metaphor of the "jumpstart" — the transition is not a repair of a damaged market economy but the creation of a market economy where none has existed in living memory — and this framing shaped how policymakers and international institutions approached the region for the decade that followed.

How can Eastern Europe "jumpstart" a market economy where none has existed, while managing the unavoidable social costs of the transition?

Chapter 1 — Stabilization and Price Liberalization

Central question

What macroeconomic policies must Eastern European governments adopt to stop inflation, restore price signals, and create the fiscal and monetary foundations for a market economy — and how can they do so while limiting the severity of the inevitable output contraction?

Main argument

The starting point: a collapsed system, not a distorted one

The authors begin by distinguishing the Eastern European situation from the typical stabilization cases in Latin America or elsewhere. In Eastern Europe the socialist economic system has already been effectively destroyed by the political revolutions of 1989. Prices are being liberalized, state subsidies are collapsing, and the old planning mechanisms are no longer operative. The immediate problem is therefore not whether to reform but how to manage the consequences of a reform that has already begun: rapid inflation, a fiscal crisis caused by the collapse of state enterprise profits (which were the primary tax base under socialism), and severe price distortions inherited from decades of administered pricing.

The Standard Stabilization Package

The authors identify what they call the Standard Stabilization Package — a set of policies that emerged from a "broad consensus" derived from three historical waves of post-inflation stabilization: Europe in the 1920s (Germany, Austria, Hungary, Poland), Europe after World War II, and the Latin American stabilizations of the 1980s (Bolivia, Israel, Mexico, Argentina). The package has two non-negotiable core elements:

  • Fiscal consolidation: Eastern European governments must eliminate budget deficits. The old fiscal base (revenue from state enterprise surpluses) has collapsed. New revenue must come from genuine taxation, and expenditures — above all, enterprise subsidies — must be cut. Without fiscal consolidation, any attempt to control money creation will fail.
  • Elimination of subsidies: The pervasive subsidy system of the socialist economy — to enterprises, to food, to energy — must be ended. These subsidies are the main mechanism through which fiscal deficits are created and through which prices remain disconnected from costs.

Beyond these two core commitments, the authors find less agreement and more genuine uncertainty about secondary details.

The nominal anchor problem

One contested question is what should serve as the nominal anchor for the price level during disinflation — that is, which nominal variable should be fixed to signal that stabilization is credible. The main candidates are: fixing the exchange rate (as Poland did in January 1990), targeting the money supply, or imposing income policies (wage controls) as an additional anchor. The authors do not advocate a single answer. They note that exchange rate pegs have worked in some historical cases and failed in others, depending on whether fiscal consolidation is sufficiently deep. Money supply targeting is complicated by the uncertain relationship between money demand and output during transition. Income policies — temporary wage controls to prevent a wage-price spiral — can help break inflationary expectations but risk becoming permanent distortions.

The simultaneity requirement: price liberalization and stabilization together

The authors argue firmly that price liberalization and macroeconomic stabilization must be implemented simultaneously. The argument is both economic and political. Economically, price liberalization without stabilization will cause a one-time price-level jump that becomes entrenched inflation if monetary accommodation follows. Stabilization without price liberalization leaves the allocative distortions of the socialist system intact and prevents enterprises from facing real market signals. Politically, the pain of both reforms must be concentrated in the initial period of reform enthusiasm — delay dissipates the political capital available for difficult changes.

Eastern Europe is not Latin America

The authors carefully qualify how far historical analogies extend. Compared to Latin American stabilization experiences, Eastern Europe faces three aggravating factors: (1) price distortions are much larger, more widespread, and of much longer standing than in mixed economies; (2) the production structure is radically different from a market economy, with massive misallocation of capital and labor into industries that cannot be commercially viable; and (3) there is a substantial monetary overhang — households have accumulated financial savings they could not spend under rationing, which will generate an inflationary demand surge once prices are freed. These differences mean the initial price shock upon liberalization will be larger than in standard stabilization episodes.

The unavoidable output contraction

The authors are unusually frank: stabilization combined with price liberalization will produce a severe economic contraction. Enterprise subsidies will be cut; enterprises that were only viable because of suppressed input prices will face bankruptcy; real wages will fall as prices jump faster than nominal wages. "We see no way to avoid this outcome." The contraction is not a policy failure but a structural inevitability — the transition economy must shrink before it can grow again because so much of the communist-era capital stock and labor allocation was economically irrational.

A basic needs program — some form of social safety net providing income support to those hardest hit — is presented as a necessary complement to stabilization, though the authors acknowledge they give insufficient attention to the details of how such programs could be designed and financed in the conditions of a collapsing fiscal system.

Key ideas

  • The Standard Stabilization Package requires fiscal consolidation and subsidy elimination; everything else is secondary.
  • The nominal anchor problem (exchange rate, money supply, or incomes policy) has no universally correct answer; the appropriate choice depends on country-specific fiscal and institutional conditions.
  • Price liberalization and macroeconomic stabilization must proceed simultaneously, not sequentially.
  • Eastern Europe's price distortions are deeper and more pervasive than in typical stabilization cases, making the initial inflation shock larger.
  • The monetary overhang — excess household savings accumulated under rationing — aggravates the inflationary impulse at liberalization.
  • A deep output contraction is unavoidable; policy can cushion its social costs but not eliminate the contraction itself.
  • Income support mechanisms (a social safety net) are necessary to maintain political sustainability of the reform, though designing them under fiscal collapse is difficult.

Key takeaway

Macroeconomic stabilization and price liberalization are urgent and non-negotiable; the primary tools are fiscal consolidation and subsidy elimination; the pain of an output contraction is unavoidable and must be accepted and managed, not avoided.

Chapter 2 — Privatization

Central question

How should Eastern European governments transfer ownership of state enterprises to private hands, given that the capital markets to absorb them do not yet exist, that incumbent managers have both the incentive and the ability to loot enterprises during any prolonged transition, and that selling them at fair market value is politically and practically impossible?

Main argument

The privatization imperative and the "no unique path" warning

The chapter opens with the assertion that privatization is essential — state enterprises cannot be made to respond to market incentives while they remain under state ownership, because their budget constraints remain soft (losses will ultimately be covered by the state) and their managers lack personal incentives to maximize enterprise value. However, the authors immediately qualify this with a caveat that became widely quoted: "There is no unique path to privatization, nor is there any best structure of ownership." The chapter is therefore about identifying the constraints on any privatization design and deriving implications for what must be true of any workable plan, rather than advocating a single blueprint.

The two-part problem: speed versus accuracy

Privatization involves two distinct and partially conflicting objectives: (1) assigning property rights quickly, to end the period of uncertain ownership during which managers have incentives to strip assets; and (2) assigning property rights accurately, placing enterprises in the hands of owners with both the ability and the incentive to run them well. Speed favors mass distribution (giving assets away for free or for nominal amounts); accuracy favors careful sale to informed buyers with long-term interests. The authors' central recommendation is that speed takes priority: the costs of delay — asset stripping, political reversal, managerial paralysis — outweigh the costs of imprecise initial ownership allocation.

Why selling at market prices is not feasible

The conventional privatization approach — selling state enterprises for their market value — is ruled out for three reasons. First, the capital market capable of absorbing the massive stock of state enterprises at reasonable prices does not yet exist in Eastern Europe. If enterprises were sold at auction in a thin capital market, the prices would be far below any reasonable estimate of long-run value — a give-away that would also transfer ownership to a tiny group of early buyers. Second, those with liquid financial wealth in the East have typically accumulated it either as members of the communist nomenklatura or through illegal activity; a market-price sale would transfer the industrial economy to precisely those whose enrichment was most politically delegitimized. Third, selling slowly leaves the enterprises in an intermediate state — nominally state-owned but with management uncertain about the future — which maximizes the horizon for asset stripping.

The window of opportunity and the looting problem

A central mechanism in the chapter is what the authors call the window of opportunity and the looting problem. In the immediate aftermath of communist collapse, reform has broad popular support. But this window is short: if privatization does not happen quickly, the managers and workers of state enterprises — who currently have de facto control even without legal ownership — will use their position to extract value from the enterprises for themselves, either by paying themselves above-market wages, selling enterprise assets to related parties at below-market prices, or otherwise appropriating what should become public equity. The longer privatization is delayed, the more value is destroyed and the more entrenched the interests opposed to privatization become. "Property must be assigned, not sold."

The ownership-control separation problem

A further complication is that effective ownership of a firm requires not just holding a claim to its profits but exercising control over management. Small, dispersed shareholders — the natural result of mass distribution to a population of 30 million or more — are classic free riders: individually each has too little stake to invest in monitoring management, so management effectively remains unaccountable. This is the standard corporate governance problem, magnified enormously by the absence of functioning capital markets, securities regulation, and corporate law.

The holding-company solution

The authors' proposed resolution to the ownership-control dilemma is the intermediary institution — typically described as a holding company or mutual fund-like vehicle. The mechanism works as follows:

  • State enterprises are transferred to one or more financial intermediaries (the authors call them "enterprise funds" or "holding companies").
  • Shares in these intermediaries are distributed broadly to the general population — either freely or at nominal cost — satisfying the political requirement that privatization benefit everyone, not just the wealthy or the nomenklatura.
  • The intermediary, holding a concentrated stake in a number of enterprises, has both the incentive and the scale to exercise real corporate governance over them — appointing and replacing managers, monitoring financial performance, and enforcing commercial discipline.
  • Over time, as capital markets develop, the intermediaries' shares become tradable, shares migrate to more concentrated ownership by informed investors, and enterprises gain access to genuine market finance.

This structure simultaneously achieves wide popular distribution (political legitimacy), concentrated control (corporate governance), and a plausible path toward genuine capital market discipline.

What about workers and managers?

The authors consider but are skeptical of the alternative of worker self-management (giving enterprises to their employees), which was attractive in some reform circles as a way to secure worker buy-in. The objection is fundamentally one of corporate finance: workers in a given enterprise are both poorly diversified (their labor income is already tied to the enterprise's fate) and have incentives to favor current wages over investment, leading to under-investment and eventual enterprise decline. Management buyouts at give-away prices are ruled out because they would transfer public wealth to the nomenklatura and create severe conflicts of interest during the privatization process itself.

Key ideas

  • Privatization is essential because state ownership preserves soft budget constraints and prevents genuine market discipline.
  • There is no universally optimal ownership structure; any workable plan must satisfy constraints of speed, political legitimacy, and corporate governance.
  • Market-price sales are infeasible: capital markets are too thin, the politically eligible buyers too few, and the delay too costly.
  • The looting problem — asset stripping during the ownership transition — makes speed a paramount consideration; property must be assigned, not sold.
  • The window of opportunity for reform is short and can be closed by the entrenchment of managerial and worker interests in the status quo.
  • The ownership-control separation problem requires an intermediary institution (holding company/enterprise fund) that concentrates governance power while distributing financial claims broadly.
  • Worker self-management and management buyouts are rejected on corporate governance and political legitimacy grounds.

Key takeaway

Privatization must happen rapidly through free or near-free distribution of state enterprise shares to the population via intermediary holding companies, because delay enables asset stripping and selling at market prices is politically and practically impossible.

Chapter 3 — Restructuring

Central question

How will Eastern European economies grow after stabilization and privatization — and how should governments manage the massive structural transformation, unemployment, and trade disruption that the transition to a market economy will necessarily produce?

Main argument

The sober prognosis: growth will be slow and painful

The chapter opens with a stark historical observation: "Looking at the post-stabilization performance of countries that have stabilized, one concludes that in most cases economic growth has returned only gradually and unimpressively." This is not optimism dressed as policy. The authors are forecasting that Eastern Europe, even after successful stabilization and privatization, will face a prolonged period of slow or negative output growth, high unemployment, and difficult structural adjustment before the benefits of the market economy become visible.

The scale of redundant labor

The authors present estimates that between 20 percent and 50 percent of the labor force in Eastern European state enterprises is economically redundant — employed in jobs that make no commercial sense at market prices. This is not cyclical unemployment to be resolved by aggregate demand stimulus; it is structural unemployment created by decades of distorted investment and production decisions under central planning. Resolving it requires physically moving workers and capital from unviable activities into viable ones — a process that typically takes years or decades, not months.

The CMEA trade shock

A major external shock aggravating the restructuring problem is the collapse of the Council for Mutual Economic Assistance (CMEA) — the trading bloc that organized economic relations among the socialist countries. The CMEA used artificial pricing (in "transferable rubles" at prices unrelated to world market values) and bilateral barter arrangements to sustain trade flows that would not have been commercially viable at world prices. When CMEA trade was dissolved and Eastern European countries attempted to move to world prices and convertible currency trade, the result was a severe terms of trade shock: energy and raw materials (which the Soviet Union had supplied cheaply) became dramatically more expensive, while many Eastern European manufactured exports (produced with Soviet-priced inputs for Soviet-bloc markets) lost their markets and their economic rationale simultaneously. The trade flows did not just change in composition — they largely disappeared, at least temporarily. This amplified the output contraction beyond what macroeconomic stabilization alone would have caused.

Comparative advantages and grounds for optimism

Despite the grim near-term outlook, the authors identify structural reasons for longer-term optimism. Eastern European wages are low by international standards — the consequence of a collapsed industrial economy — and are likely to remain low for some time due to limited labor mobility. Low wages create a comparative advantage in labor-intensive production. Additional favorable factors are:

  • Proximity to Western European markets: Eastern Europe's geographic location makes it a natural supplier to the wealthiest consumer markets in the world, with lower transport costs than competitors in Asia or Latin America.
  • High skills and education: The communist system, whatever its other failures, invested heavily in education and technical training; the workforce is relatively skilled by income-level standards.
  • Pent-up domestic demand: Decades of suppressed consumption have created an enormous latent demand for the consumer goods, services, and housing that exist in Western Europe but not (or not in sufficient quantity) in the East. Once incomes begin to recover, this demand provides a growth engine.

The authors suggest that if these advantages can be exploited — primarily through foreign direct investment and the transfer of technology and management know-how from the West — the potential for sustained growth is substantial. "The pent-up domestic demand for the services and commodities that exist in the West but not in the East" could, under favorable conditions, generate boundless growth potential.

The problem of financial intermediation

A major obstacle to restructuring is the absence of functioning financial intermediaries. Banks in Eastern Europe were not banks in the Western sense — they were accounting units of the state that allocated credit according to the plan, not commercial risk assessments. As a result, the banking system enters the transition with massive portfolios of loans to enterprises that are now insolvent. These bad loan portfolios prevent banks from lending to viable new enterprises, since the banks themselves are technically insolvent. This creates a credit vacuum in the economy: the old enterprises cannot get new investment finance, and the new private enterprises that should replace them also cannot get credit. Restructuring requires resolving this problem — either through bank recapitalization by the state (with the fiscal costs that implies) or through some form of debt write-down.

Foreign capital inflow and its limits

The authors see foreign direct investment as the primary mechanism for transferring capital, technology, and management practices to Eastern Europe. However, they are cautious about the scale and speed of capital inflow that can be realistically expected. Investors face significant uncertainty about property rights (especially before privatization is completed), legal systems, and political stability. "Unfettered market forces" may produce outcomes that are suboptimal from a social perspective: firms that are marginally viable under any plausible scenario may still go bankrupt in the short run because credit is unavailable, taking workers and capital with them in unnecessary closures.

The risk of excessive destruction

The chapter contains an important warning about the asymmetry between the speed of enterprise destruction and the speed of enterprise creation. Market forces will force unviable enterprises to close quickly once budget constraints harden — but the creation of new private enterprises, the migration of workers into new sectors, and the building of new institutions (commercial law, banking regulation, property rights registries) all take time. "The destruction is faster than the creation of new jobs." There is therefore a legitimate role for transitional measures — temporary subsidies, retraining programs, unemployment insurance — that slow the pace of destruction slightly to allow creation to catch up, without permanently protecting unviable enterprises from market discipline.

Key ideas

  • Post-stabilization growth in Eastern Europe will be gradual and unimpressive; unrealistic expectations must be corrected.
  • Between 20 and 50 percent of state enterprise labor is structurally redundant; this implies massive frictional and structural unemployment during the transition.
  • The CMEA collapse imposes a severe terms of trade shock that destroys existing trade flows and amplifies the output contraction.
  • Eastern Europe's comparative advantages — low wages, geographic proximity to Western Europe, high skills, pent-up domestic demand — provide a credible basis for long-run growth.
  • The collapse of communist banking leaves a poisoned financial system; bad loan portfolios prevent both banks and enterprises from functioning in a market-oriented way.
  • Foreign direct investment is the primary channel for technology transfer and capital inflow, but its scale is uncertain and will be limited by property rights uncertainty.
  • Enterprise destruction happens faster than job creation; transitional support mechanisms are needed to manage the social cost of this asymmetry without permanently shielding unviable firms.

Key takeaway

Restructuring will be slow, expensive, and socially painful; the authors are guardedly optimistic about Eastern Europe's long-run growth potential based on low wages, proximity to Western markets, and pent-up demand — but honest that the path there runs through prolonged unemployment and difficult institutional construction.

The book's overall argument

  1. Chapter 1 (Stabilization and Price Liberalization) — establishes that the socialist system has already collapsed and the immediate crisis is macroeconomic: pervasive price distortions, fiscal collapse, and incipient or open inflation must be addressed by simultaneous price liberalization and stabilization, using the Standard Stabilization Package (fiscal consolidation, subsidy elimination), with the nominal anchor question left contextually open — and that an unavoidable output contraction must be accepted and cushioned by a basic needs program.

  2. Chapter 2 (Privatization) — argues that macroeconomic reform alone will not create a market economy because state enterprises will remain unresponsive to price signals as long as their budget constraints remain soft under state ownership; rapid privatization through free distribution via intermediary holding companies is therefore urgent, since delay opens a window for asset stripping that destroys the public wealth that privatization is meant to allocate.

  3. Chapter 3 (Restructuring) — completes the argument by acknowledging that even after stabilization and privatization, structural transformation will be slow and painful; the CMEA trade collapse, the bad-loan overhang in the banking system, and the sheer scale of redundant labor mean that market forces will destroy enterprises faster than new ones are created; the authors are cautiously optimistic about long-run growth potential but insist that transitional support mechanisms are needed to prevent excessive destruction.

Taken together, the three chapters argue that these three reforms are interdependent, must be pursued simultaneously rather than sequentially, and that the costs — inflation in the short run, unemployment in the medium run, institutional scarcity throughout — must be honestly acknowledged and actively managed rather than wished away.

Common misunderstandings

Misunderstanding: The book advocates "shock therapy" as opposed to gradualism.

The book does favor rapid action on all three fronts simultaneously, and it is skeptical of gradualist approaches that would sequence reforms or introduce them slowly. But it does not use the phrase "shock therapy" (a term associated more closely with Jeffrey Sachs's work on Poland and Bolivia) and it is careful to acknowledge that the correct sequencing and speed of specific measures depends on institutional conditions. The key claim is about the interdependence of the three reform areas, not about mechanical speed.

Misunderstanding: The book proposes a single privatization blueprint (vouchers).

The chapter on privatization explicitly states that "there is no unique path to privatization, nor is there any best structure of ownership." The holding-company/intermediary-institution proposal is the authors' preferred approach, but it is presented as one workable design satisfying the relevant constraints, not as the only possible solution. The book's primary contribution is identifying those constraints — speed, legitimacy, governance — rather than mandating a specific voucher scheme.

Misunderstanding: The authors were indifferent to the social costs of transition.

The book acknowledges explicitly that stabilization will produce an output contraction ("we see no way to avoid this outcome") and that restructuring will produce mass unemployment (20–50 percent redundancy estimates). It calls for a basic needs program and transitional support mechanisms throughout. The authors are not indifferent to social costs — they are honest that costs exist and that policy cannot eliminate them, while arguing that a welfare-oriented social safety net is a necessary component of any viable reform program.

Misunderstanding: The book's framework applies uniformly to all Eastern European countries.

The review literature points out that the book treats "Eastern Europe" as a unit, covering all countries except the Soviet Union with the same framework. This is a deliberate methodological choice — the authors want to identify general principles, not country-specific road maps — but it means the framework abstracts away from very large initial condition differences between, say, Poland (already partially reformed, with private agriculture) and Romania (still heavily Stalinist in economic structure).

Misunderstanding: The privatization proposals were actually implemented.

The holding-company/enterprise-fund model proposed by the authors was largely not adopted in practice. Poland, Czechoslovakia, and Russia pursued various voucher privatization schemes that differed substantially from the authors' intermediary-institution design. The book's proposals served as a reference point in the policy debate rather than as an implemented blueprint.

Central paradox / key insight

The central paradox of the book is that the precondition for building a functioning market economy is the very thing that markets cannot provide: the institutional infrastructure — property rights, banking systems, corporate governance, social insurance — without which market forces will destroy faster than they create. The authors are unequivocal that market prices must be freed, state enterprises privatized, and subsidies ended. But they are equally clear that "unfettered market forces" in the absence of institutions will produce outcomes that are socially and economically suboptimal: bank failures, enterprise closures that destroy viable productive capacity, unemployment that persists because credit markets do not exist to fund new businesses.

The book's practical resolution is that government must simultaneously withdraw from the economy (ending subsidies, freeing prices, privatizing) and construct new institutions (social safety nets, financial intermediaries, holding companies, property rights registries) — two things that are in tension and must happen at the same time. As the review "Eastern Problems and Western Solutions" observes, the authors "feel the ideological responsibilities of economists, which is to give hope where science fails." The tension between the book's commitment to market orthodoxy and its acknowledgment that markets without institutions produce destructive outcomes runs through all three chapters and is never fully resolved — deliberately so.

The transition requires simultaneously creating a market economy and building the institutions without which a market economy destroys rather than creates wealth.

Important concepts

Standard Stabilization Package

The set of macroeconomic policies that the authors argue formed a consensus from historical stabilization experiences: fiscal consolidation (elimination of budget deficits) and elimination of enterprise and consumer subsidies. These are the non-negotiable core of any stabilization program; all other measures (nominal anchor choice, income policies, sequencing details) are secondary and context-dependent.

Nominal anchor

The nominal variable that is fixed during a stabilization program to signal credibility and coordinate expectations around low inflation. The main candidates are the exchange rate (fixed to a convertible currency), the money supply (with a target growth rate), or wages (through an incomes policy). The authors do not advocate a single choice, noting that the right anchor depends on fiscal conditions and institutional capacity.

Monetary overhang

The stock of involuntary household savings accumulated under the socialist system because goods could not be purchased even with money income (rationing, queues, shortages). At price liberalization, this overhang represents a potential burst of inflationary demand. Managing or eliminating the monetary overhang is one reason stabilization and price liberalization must proceed together.

Soft budget constraint

The condition, identified by Hungarian economist János Kornai, in which a firm knows that losses will ultimately be covered by the state rather than leading to bankruptcy. Under soft budget constraints, enterprises have no incentive to respond to market price signals, cut costs, or seek profitable activities. The central purpose of privatization, in the authors' framework, is to harden budget constraints by making enterprises answerable to private owners rather than the state.

Window of opportunity

The brief period after communism's collapse during which popular support for reform is high enough that painful measures are politically feasible. The authors argue this window is short: delay allows managerial and worker interests to organize around protecting the status quo, and the window closes. Both stabilization and privatization must therefore move rapidly rather than awaiting better conditions.

Looting problem

The incentive for incumbent managers and workers of state enterprises, during any prolonged period of uncertain ownership, to extract value from the enterprise for themselves — through above-market wages, asset sales to related parties, or other means — rather than maintaining it for eventual private owners. The looting problem is the primary practical argument for why privatization must be fast and why property must be assigned (given away) rather than sold.

Intermediary institution (enterprise fund / holding company)

The ownership structure proposed by the authors to resolve the tension between wide distribution (political legitimacy) and concentrated governance (corporate accountability). State enterprise shares are transferred to holding companies; the public receives shares in the holding companies, not directly in the enterprises. The holding company has concentrated enough stakes to exercise real corporate governance over the enterprises, while the public holds widely distributed financial claims.

CMEA (Council for Mutual Economic Assistance)

The Soviet-era trade organization that structured economic relations among socialist countries through bilateral trade agreements, artificial prices (in "transferable rubles"), and barter-like arrangements. The CMEA's effective dissolution as Eastern European countries sought world prices and convertible currency meant the destruction — not merely restructuring — of existing trade flows, adding a severe terms of trade shock to the other transition costs.

Structural unemployment

Unemployment that arises not from deficient aggregate demand but from a mismatch between the skills and locations of workers and the skills and locations required by viable enterprises. The authors estimate 20–50 percent of state enterprise employees are structurally redundant — employed in jobs that make no commercial sense at market prices. This form of unemployment cannot be resolved by demand stimulus; it requires workers to move to new sectors, skills, and sometimes locations.

Bad loan portfolios

The toxic balance sheets of Eastern European banks entering the transition, loaded with loans to state enterprises that are now commercially insolvent. Because the banks themselves are effectively insolvent, they cannot perform the function of channeling savings to viable new enterprises. Resolving bad loan portfolios — through write-downs, recapitalization, or restructuring — is a necessary precondition for a functioning credit market and thus for enterprise restructuring.

Primary book and edition information

Background and overview

The key review essay

  • Tichy, G. "Eastern Problems and Western Solutions." Review of Income and Wealth, Series 40, Number 2, June 1994. A detailed review of the book alongside related transition works; provides the most thorough published description of the book's chapter-by-chapter arguments available in accessible form.

Related scholarship on transition economics

  • Bruno, Michael. "Stabilization and Reform in Eastern Europe: A Preliminary Evaluation." Reprinted from IMF Staff Papers 39:4 (December 1992). Chapter in: Blanchard, Froot, and Sachs (eds.), The Transition in Eastern Europe, Volume 1, University of Chicago Press/NBER, 1994.
  • Blanchard, Olivier, Kenneth A. Froot, and Jeffrey D. Sachs (eds.). The Transition in Eastern Europe, Volume 1. University of Chicago Press, 1994.

Sequel and companion volumes

  • Blanchard, Olivier J., Maxim Boycko, Marek Dabrowski, Rudiger Dornbusch, Richard Layard, and Andrei Shleifer. Post-Communist Reform: Pain and Progress. MIT Press, 1993.
  • Layard, Richard, Olivier Blanchard, Rudiger Dornbusch, and Paul Krugman. East-West Migration: The Alternatives. MIT Press, 1992.

Additional chapter summaries and study resources

These are secondary sources and should be used alongside, rather than instead of, the original book.