Lessons from a Decade of Transition in Eastern Europe and the former Soviet Union

• Author: Pradeep K. Mitra and Marcelo Selowsky
• Position: Chief Economist of the World Bank's Europe and Central Asia Region/Assistant Director of the IMF's Independent Evaluation Office. He was Chief Economist of the World Bank's Europe and Central Asia Regional Office when the study on which this article is based was done

A decade after the dissolution of the Soviet Union in late 1991, some transition economies are performing far better than others. A recent World Bank study finds that poor incentives for the creation of new firms is the single biggest obstacle. But reducing barriers to entry is not enough-hard budget constraints must also be imposed on the old money-losing state-owned enterprises.

The 1990s witnessed one of the most dramatic economic transformations in modern times, as the countries of Eastern Europe and the former Soviet Union abandoned central planning. Initially, output declined sharply, followed by a period of recovery in the late 1990s. But progress was extremely uneven across countries. In Central and Southeastern Europe and the Baltics (CSB), real output fell 22 percent from its 1990 level before it recovered in 1993. In the Commonwealth of Independent States (CIS), it plummeted 50 percent, not to begin recovering until 1999. By 2000, countries in the first group had more than restored their original output levels, while those in the second group were still 35 percent below. Moreover, progress varied greatly even within each group. Bulgaria and Hungary experienced the same initial output decline but, by 2000, Hungary's output was 10 percent higher, while Bulgaria's was still 13 percent lower. Moldova and Armenia had a similar initial drop, but while Moldova's output remained stagnant at that level, Armenia's output almost doubled thereafter.

Why have some transition economies performed better than others? If reforms bring benefits, why have some governments been so reluctant to accept them? Should the policy prescriptions originally advanced now be revised, especially for those countries lagging behind? To answer these questions, the World Bank recently undertook a comprehensive study of the first 10 years of transition for this region. This article summarizes its findings.

Why some did better

By reviewing the economic literature, including additional econometric analysis undertaken for this study, we asked what explained the differences in economic performance: initial conditions, policy reforms, or external shocks, such as war and civil strife? Initial conditions were further disaggregated into several dimensions: the structure of the economy (share of industry, trade dependence on other communist countries), initial distortions (repressed inflation, black market exchange rates), and institutions (experience of markets and nationhood prior to transition). The extent of reforms was measured by combining the World Bank's liberalization index with the transition indicators of the European Bank for Reconstruction and Development (EBRD)-which include policies to increase the role of markets in resource allocation and reforms ensuring an efficient functioning of markets. What are the key findings?

* Initial conditions are more important in explaining differences across countries during the earlier period of output collapse than over the full 10 years of transition.

* Some initial conditions have a stronger impact at the start of transition, others at later stages. Initial distortions are better explanatory variables at the start of transition, while the strength of initial institutions is more important as time passes.

* Correcting for initial conditions and external shocks, reform policies do have a strong impact, particularly as the transition progresses, and they seem to operate with a lag, particularly in the CIS countries. In fact, in the CIS countries, reforms may even have a temporary negative impact on output-they can be seen as an up-front "investment cost," with payoffs in terms of growth later on.

* The...