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Successful Transition to Market Economy: Necessary Conditions and Policy Requirements

A transition economy can be described as a state of the economy which is changing from a Government regulated/centrally planned economy to a free/open market economy. The process of transition essentially undergo economic liberalization, where prices of the commodity are set by market forces rather than a central planning organization as well as trade barriers are removed, privatization of state-owned enterprises and resources and the creation of a financial sector to facilitate the movement of private capital. A country transitioning to a market economy often must face a low rate of employment and lengthy periods of unemployment.

During the period of transition, the government has to reduce its intervention in the marketplace and promote the development of a free market mechanism. However, these tasks are somewhat at odds. Therefore, searching for a policy that addresses both has been a challenge for both researchers and policy makers. A primary task is discussing the effects on the duration of unemployment of a passive employment policy (e.g., providing unemployment insurance) and of an active employment policy (e.g., providing occupational training for unemployed workers).

Although a passive employment policy provides social security for a more successful transition, it increases government intervention and spending, which degrades economic efficiency and seduces the moral hazard of unemployed workers. Although an active employment policy promotes the labor-marketing effort, whether the unemployed can be reemployed depends somewhat on the effectiveness of the training. A discussion of the factors affecting the unemployment duration should provide basic information useful to the development of an appropriate policy.

In my opinion five conditions are necessary for a successful transition to a market economy: (1) economic stabilization, (2) a market infrastructure, (3) property ownership, (4) a change in mentality, and (5) public support. Let us consider each of these in turn. 

Economic Stabilization

First, a market economy must be preceded by a period of economic stabilization. In a crisis, when the economy is deteriorating drastically, it is impossible to switch at once to a market economy without first arresting the economic decline and securing a period of economic stabilization, Such economic stabilization can be secured today primarily by activating both administrative and economic levers that I would characterize as emergency mechanisms. We could go so far as to spend certain government reserves and stockpiles, including some of our gold reserve. We must also drastically curb government spending—both domestic spending and expenditures to maintain our government’s offices abroad, revise our foreign aid policies, stop government spending on large-scale economic projects that do not yield immediate benefits, sell off “frozen” uncompleted units to private owners, and so forth. 

Market Infrastructure

Second, parallel to economic stabilization, we must take measures to create the market infrastructure. The Soviet economy today is extremely primitive. It is represented by huge, monopolistic state enterprises and amalgamations. But it does not have the infrastructure required for a market economy to function. What I have in mind is a labor market, a capital market, and, as a necessary condition, numerous small and midsize enterprises that will fill the gaps in the economy and create the possibility of competition among producers and, most importantly, the possibility of economic maneuvering. The recent bread and tobacco crises are a good example of a primitive economy. They occurred mainly because most of the state-run factories producing bread and tobacco products have obsolete and shabby equipment. Either most of these enterprises had to be shut down for repairs or retrofitting, or they are facing the threat of a shutdown because their equipment will break down or need preventive repairs.

Property Ownership

Third, the transition to a market economy requires a well-developed stratum of commodity producers who own property in different forms. To de-monopolize and get the state out of the main sectors of the economy, we should create a multi-tiered economy primarily by privatizing trade, eateries, household services, and a major part of the state-run industry. We should also privatize agriculture as a necessary condition for providing the country with adequate food supplies. The program of privatization and the establishment of mature sectors of collective; including cooperative, ownership and of individual private ownership will take time.

Change in Mentality

The next condition for the transition to a market economy means a profound, fundamental revolution in more than just the industrial and economic conditions of our society. What is necessary is a far reaching change in the structure of life itself, in our way of life, in people’s thinking, and in the way they see their place in the system of social production. For decades, we have fostered a beggar mentality: The state will provide and decide everything for you—poorly, perhaps—but it will provide equally for everyone and supply all the basic necessities. This parasitic mentality is very widespread here. In contrast, a market economy, in order to function, requires a very different type of mentality: responsibility.

Public Support

The last condition is perhaps one of the most important. A change as fundamental as the transition to a market economy can be accomplished only when it is carried out by a government that enjoys the full support and confidence of its people. Without such support, one can say in advance that any program of transition to a market economy—no matter how good it may look in theory and in the abstract—is doomed to failure.

The record of the past decade is thus one of progress by the transition countries, but it also underscores the challenges that still lie ahead. Although several countries have generally managed to reduce inflation and to experience a recovery in output, their situation remains fragile. There is potential for a resurgence of inflation, a weakening of output performance, and an intensification of external sector pressures. In this regard, the main challenges that were identified at the conference included fundamentally transforming the role of the state, moving enterprises into the market economy, pursuing banking sector reform, addressing the sharp inequalities in income, and strengthening the macroeconomic situation.

First, the role of government needs to be radically transformed.

  • To function well, market economies need governments that are efficient and evenhanded in establishing and enforcing essential rules for promoting widely shared social objectives, for raising revenues to finance public sector activities, for spending these revenues productively, for bringing required corrections to and controls over the working of the private sector, and for enforcing contracts and protecting property.
  • Governments will need to establish rules of the game that are appropriate to market economies as well as regulations in such areas as private pensions and competition while eliminating most discretionary regulations, which are often relics of the command economy.

Such actions would create an environment conducive to the efficient functioning of market forces, and would therefore be critical to fostering the growth of the private sector and shrinking the underground economy. They would also reduce the perception of risk, thereby helping to attract foreign direct investment. The great difficulty of creating basic institutions should not be underestimated, however.

Second, the process of privatization has to be improved.

  • A strong institutional framework, as well as openness and transparency, are the keys to success in this area.
  • Numerous actions have to be taken to streamline privatization.
  • Downsizing and restructuring could take place through a reallocation of ownership and control, which could be facilitated by involving foreign investors.
  • The transfer of labor and social obligations of old firms to new owners would need to be avoided.

These steps would have to be reinforced by reorienting the role of the state to promote market discipline and putting in place effective bankruptcy procedures, while ensuring that financing be made dependent on a well-regulated and supervised financial sector and on good business practices. Such actions would effectively harden the budget constraints on enterprises.

Third, financial sector reform is fundamental to promoting growth, by improving the inter-mediation process and increasing efficiency in the allocation of financial resources. The progress made in giving greater autonomy to central banks represents a step in the right direction. However, creation of a competitive system open to foreign financial institutions and the enactment and effective implementation of strong prudential regulations are key components that still need to be addressed in many transition economies.

Fourth, severe income inequalities have to be tackled. Over time, institutional change and increased competition should help reduce economic rents and income inequalities. This process will take time, however, and governments will need to put in place well-targeted social safety nets for the most vulnerable segments of their populations.

Fifth, macroeconomic stabilization is essential to underpin structural reform and the recovery of economic activity and sustained growth. The empirical evidence shows that lower inflation rates are, indeed, associated with faster economic growth. Moreover, transition countries with persistent moderate inflation, as well as other advanced transition countries, now enjoy favorable circumstances for further disinflation. The threshold above which inflation involves significant output costs is now comparable in the transition countries to what it is in the industrial countries; therefore, a commitment to slowing inflation to industrial country levels over the medium term would be appropriate, especially in those countries aspiring to join the European Union.

In addition to the political, socio-psychological, and economic conditions needed for the transition to a market economy, there are also legal conditions that must be met. To create the legal foundation for the functioning of the market requires a fundamentally different approach to the legislative regulation of the economy than we have had in Soviet legislation up to now. Until now, the major share of legal norms has consisted of administrative rules, that is, direct regulation from above of all economic relations and all economic ties in the country.

It is natural that the transition to the market economy should require a fundamentally different approach, a transition to economic ties based on horizontal relations. If our economy today is dominated by vertical relations, that is, legal-administrative regulation, then tomorrow we must have relations of a civil and legal nature. These are horizontal relations, that is, economic interaction between independent economic agents—between free producers of commodities.

This change requires eliminating the existing hierarchy of enterprises, so that enterprises will not be subordinate to Union, republican, or local authorities. We must make changes in the way that enterprises are launched and closed down. If the overwhelming majority of enterprises in our country today are opened and closed by administrative decision, tomorrow it should be done on a contractual basis. That is, enterprises will be created by agreement between interested parties and will cease to function, once again, by agreement between the shareholders, or, in the event of incompetence, by a court decision.


About Md. Moulude Hossain

FinTech | AVP, Business Development KONA Software Lab Limited


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