Thirteen years after – gradualism turning bad
Institute for Civilization and Culture
This essay was prepared for the CRCE conference
Inhibited transition – Reasons and Remedies
25th – 28th September 2004
Prologue: Initial conditions and the path of transition process
Despite the fact that different ex-socialist countries started transition with differing conditions and in different years, there are some similarities in all transition countries. First, there was the allocation of labour force from tradables (industry) to nontradables (services) sector and a steep decline in GDP. GDP fell on average in all transition countries 40%, and it started to increase in most of these countries (20 out of 25) only in 1998. Second, high inflation in all transition countries developed a need for stabilisation programs; third, the current account balance remained negative throughout transition; fourth, foreign direct investments were increasing; fifth, equilibrium real exchange rates were appreciating (as a consequence of price changes); and sixth, the process of economic reforms was tightly followed up by democratisation.
Knowing initial conditions and common attributes of the transition process, there was little doubt about what had to be done: stabilisation of inflation, control over budget deficits, adoption of a single exchange rate, current account rate convertibility, price liberalisation, opening to trade and capital movements, building up banking and financial systems, establishing property rights, ending soft budget constraints, setting up market-based welfare systems (Wyplosz, 1999, p. 7). On the other hand, the timing of implementing these policies was unclear: either to reform in one go (Big Bang) or step by step (gradualism). The rationale for a gradualist economic policy was a fear of destroying the fragile equilibrium in transition markets resulting in high social costs.
While a Big Bang policy was established taking advantage of a particular political situation and uncertainty of willingness to reform when future policy actions are delayed, the gradualist policy built its case on high adjustment costs (Dewatripont and Roland), time needed to reallocate workers (Aghion and Blanchard), fluctuations in exchange rate (due to drastic price changes – Abel and Bonin) etc. None of the transition countries adopted a single strategy (just Big Bang or just gradualism), but combined both policies. Slovenia on the other hand pursued more gradualist than Big Bang policies. For example: privatisation started at slower pace and continued this way throughout transition; foreign investments became more decisive only in 2000 when administrative barriers were eliminated. Competition policies seemed to be non existent and most market structures took a monopolistic approach (with state-owned enterprises playing dominant role). Financial markets remained undiversified and were dominated by state-owned banks etc.
It is somehow logical that just after entering the EU (supposedly the institutional end of transition) the key question is whether this mainly gradualist reform approach from the start of transition gave the expected results, or did they just inhibit transition. We try to answer this question by considering two cases in the Slovene economy where gradualism predominated: industry–science relations and competition policy.
Case 1: Industry-science relations
There is little doubt that the key in increasing innovative potential of the economy lies in an active structural policy capable of optimising industry–science relations. As Slovenia is the most developed newcomer in the EU, one would expect that such a policy was constantly implemented and that growth was based primarily on the commercialisation of scientific output. But, was it?
As factors of innovation constantly change there is no indicator that could simply point to the trends and structural changes in the innovative capacity of transition countries. However, the share of high-tech exports within total exports could indicate depth and activity of structural policies in various transition countries throughout the transition process. A comparison of the share of high-tech exports within total exports among transition countries for 2001 shows that Slovenia (4.8%) is lagging not only behind the role models Ireland (40.8%) and Finland (21.1%) and EU average (19.8%), but also behind most of the transition countries: Romania (5.0%), Czech Republic (9.2%), Estonia (14.6%) etc. Indices of structural lagging in building innovation potential can be found also in reviews of dynamics of share of industries based on scientific research and industries of specialised suppliers in total exports of manufacturing industry. In Slovenia, this share has remained basically unchanged from 1993 to 2000, with only a shift from 22% to 26%. Shifts have been much larger in Hungary (from 38 to 54%) and in the Czech Republic (from 20 to 33%). The same grim picture could be observed when we compare dynamics of shares of medium and high-tech industries in total production. While the Hungarian share rose from 17 to 55% and Czech from 25 to 36%, Slovenian share rose only slightly in the same period of observation (1993 – 2000) – from 25.3 to 29.6%.
Something is wrong, since a superficial view of Slovenia (Slovene BDP p.c. was US$19200, Czech US$15300, Hungarian US$13300, Estonian US$11000 and Polish US$9700) bears no relation to the in-depth picture, in view of the fact other transition economic structures aim at an essentially faster convergence The main problem is to discover the roots of these disparities between the state of the art Slovenian economy today and its future prospects.
At the start we pointed out those attributes in the transition process, which were the same in all transition countries. One was a steep decline of GDP that called out for the reconstruction of national economies. This had two goals in order to increase employment and international competitiveness: reconstructing inadequate size structure of the economy (the dominance of large and scarcity of medium and smaller enterprises) and increasing competitiveness of local enterprises (which was low due to the fact that socialist economies didn't penetrate global markets and therefore incentive for innovation was low and market pressure non existent).
Many of the policy makers started from transition point zero with a similar economic programme – while reconstructing the economy with the creation of small and medium size enterprises (either by dismantling large socialist enterprises to small and medium size enterprises, by privatisation or through appearance of new ones) they were forced to increase competitiveness of the domestic economies in order to enter global markets, a necessity if they wanted to reallocate the labour force from state owned to private sector, that is, if they wanted reconstruction of the economy to begin. To optimise transition, both processes should be parallel and both goals met somewhere along the way to the EU by increasing innovative capacity of transition economies (with creating small and medium high tech companies). Yet in some transition countries the processes were not parallel, converging in some and in other countries diverging.
Slovenia is more or less an example of the latter: it is a case where the goals of both processes were separated. Firstly, considering reforming the inadequate size structure of the economy we notice that lowering the tempo of privatisation directly influenced reconstruction – while the pace of privatisation become more and more sluggish, the economic policy of subsidising took place. In this respect, subsidised companies, mostly state owned, were sheltered and little pressure has been put on them to innovate, even more - subsidised companies retained their pre-transition structure and did not bother to enter international markets. The policy makers preferences were clear: to lower the social cost of transition at the cost of minimal changes to the economy. And basically this is the definition of gradualism according to, for example, Dewatripont and Roland and many others (cited elsewhere in the paper).
The consequences of departing from the primal transition point zero goal (building innovative capacities by reconstructing the economy) were obvious at the start of the transition process, with the downfall of the first generation of incubators, an instrument intended to support growth of small enterprises. There were dramatic consequences in some Slovenian regions where passive economic policies preserved of economic features pre-transition. In those regions economic structures remained biased towards large socialist enterprises with low level of competitiveness, for example the textile industry in the Prekmurje region and coalmines in Zasavje region. The Policy of subsidising, sheltering and slow privatisation (mixed with barriers for net foreign investments) has logically decreased any incentive for enterprises to innovate and create funds for research and development. This has prevented any possible co-operation between business and science as market pressure was non-existent on the distorted market formed by the gradualist policy was. This policy continues to cause difficulties for small high-tech firms to develop.
Thus it is not surprising to see the results of the WEF research (2002-2003) where the majority of respondents said state subsidies caused both the effect of preserving the non-competitive industries and effect of increasing productivity in subsidised industries. Despite relatively balanced results an international comparison shows that valuation of Slovenian respondents (31) ranked far behind the Czech Republic (21), Hungary (15) and Estonia (6) where respondents said subsidies were instrumental in improving productivity. Slovenia ranked even worse when respondents evaluated the statement “to create revenues permanent innovation is key” – by being placed 62nd, behind practically all transition countries and even behind some African countries, such as Zimbabwe. The effect of State policy is thus uniquely determined – support rather than development.
There is no doubt that preferences of economic policy formed through gradualism distorted the internal market and inhabited transition in Slovenia – while today government subsidies seem the only instrument of reconstruction, innovation policy is ignored.
Slovenian research and development policy was also diverging - a consequence of gradualism. Despite the fact that it was to be the key policy to bring together reconstruction of the pre-transition economy and rebuilding its innovative capacities. In the same way, as the economic policy subsidised that part of the economy which could not survive the market, it also prevented structural changes and the opening to the market of science *** by allocating to it a relatively constant part of financing. Science established that it could comfortably earn its living by publishing in view of no targets for the effects of scientific-research activities. Science did not look for partners in the economy, but there was little opportunity since large enterprises were falling apart and there was no State policy to support science-based entrepreneurship. It was simply by chance and the will of entrepreneurs that R and D took place in enterprises. This led to a lock-in on the science market, where a monopolistic rent has been preferred to creating a market for R and D with different size structure and market niche of research institutions. Consequently there was lack of reconstruction in the science sector and science output depended solely on budget funds.
According to European commission data in 2000 institutes and faculties (32.2% institutes and 30.7% academia) employed only 33.6% of all Slovenian researchers worked in industry. This is exactly the opposite to that prevailing in countries with which Slovenia tends to converge, and it implicitly shows that Slovenian transition did not fulfil any of its goals set in the pre-transition period: neither has the economy been reconstructed nor has innovative potential of an increase in industry as a consequence of a transition in science. For example, Austria has a ratio of 62.6% of researchers engaged in industry, Ireland 55.1%, and the EU15 average stands at 49.7%.
Adaptation of scientific production function in accordance to the preferences of economic and R&D policy makers was, as already stated, biased towards scientific publications on the cost of patent activity. An EU- commission study confirms this: with only 22 patents per million population Slovenia is the lowest in Europe (EU average stands at 135 patents per million of population), while the production of science publications per million of population stands around EU average (Slovenia 516, EU15 613).
In conclusion to the question how far has Slovenia advanced in transition by integrating transformation and building innovative capacities, we will use the IMD (2003) survey where respondents ranked parameter how basic, technological, scientific and human resources meet needs of the business sector: Slovenia was placed behind Hungary (23), Estonia (22) and Czech Republic (20), in 27th place.
The roots of lagging behind and disappointing progress of transition can be found in the gradualist economic policy, which left things unchanged at the expense of improving industry–science relations which are essential to building innovative capacity.
The other example of gradualism turning sour we would find where more and more markets deviate from competition oriented market structure to monopoly, where dominant market players are state-owned enterprises.
Case 2: Market structure and competition policy
Even though policy makers throughout the transition process were constantly announcing privatisation and withdrawal of the state mechanisms from the economy, not much has happened. Privatisation in some areas (telecommunication system (Telekom), electric industry, large enterprises, insurances, banking sector etc.) has not yet started. This has directly influenced overall monopolisation of markets. There are more examples where monopolistic structure of markets has prevailed but competition policy has not reacted properly (or has not reacted at all). Firstly, there was a cartel agreement on interest rates in the banking sector where state owned banks were the majority and other banks just followed suit. Even today state owned banks still represent most of the market, while privatisation seems to have halted completely after the first steps in privatising the largest bank (NLB) has been marked as a so-called matter of national interest (“a bank should not be sold to foreigners”). So the impression remains that more should be done to diversify financial markets now represented by only the banking sector. An even more extreme case of monopoly is the insurance sector, where practically only one state owned insurance company dominates the whole market. Another is the retail sector where one player has gained a dominant position and has been able to conquer what he could not take over by imposing silent agreements on geographic segmentation of the market with other remaining competitors. Needless to say, the number of enterprises in this market has decreased significantly. The same goes for the mobile phone market, where the state owned company holds 80% of the market share and has locked-in the whole market by imposing high barriers for the other two players to compete as off–net prices are too high. The problem arose because there was no willingness to privatize. Now the situation in the market is such that the state owns the biggest market player, which may abuse market power (its two competitors claim this is what it does) and at the same time the state is a market regulator (through an agency whose actions so far have been criticised). The argument of monopolising markets and imposing higher costs on consumers as well as to other non state owned enterprises goes even further: there have been no price setting models in providing public goods. Slow (or better: non-existent) privatisation caused distortion of market structures biased towards state owned monopolies on the costs of private initiative and decrease of consumers surplus (as it is paying either higher transaction costs of making alternative choice or excepting monopolistic price). Doubtless there are spillovers from monopolised markets to those where market structure is less monopolised, but there has been little done and lack of data is significant.
Another aspect of the distorted market structure in Slovenia is the existence of many different associations and chambers that directly, or indirectly, practice regulation of market entry or market conduct. Such associations and chambers include notaries, lawyers, accountants, pharmacists, architects etc. that usually regulate markets by using concessions, numerus clausus, mechanism of preferred prices (maximum and minimum prices), restrictions on advertising etc. Market segmentation and silent agreements are not uncommon but the actions of these competition policy makers remain on an anecdotal level such as the case on cartel agreement on the price of burek, a cheese pie made by Albanian street sellers prices.
There are also many markets that the economic policy promised to activate but failed to do so. The real estate market practically does not exist, which, much like the financial market, is dominated by state owned banks. The same goes for health service market, education market, R&D market and many others where the state is the biggest player, and source of financing and regulator.
Recent research on competitive policies in Slovenia (Mrkaić, Pezdir, 2004) in the case of the retail market shows that instruments of competition policy were either inefficient or non-existent as market structure in retail markets remains highly concentrated (measured with Hirschman–Herfindahl indices), or the concentration was increasing. The same research suggests that the classical reason why regulating some services (to guarantee quality of services) does not stand. On the contrary, it is possible that when the market is distorted and price as a signal (or information) of quality is regulated there is less incentive to offer quality services and products. Moreover, the asymmetry of information is such that consumers receive lower quality despite all regulations being met.
All these practices reduce efficiency of the private sector by imposing higher costs on conducting business and decreasing both surplus of consumer and producer.
Conclusions and policy implications
Both case studies show that despite the good initial conditions present in Slovenia pre-transition, the pace of reform and structural change has slowed down. Not only in comparison to those countries Slovenia is converging towards, but also to other transition countries. Considering similar macroeconomic attributes we can confirm that the choice for a more gradualist oriented economic policy thirteen years ago was not the best choice. The consequences are obvious: processes of reconstructing and increasing innovative capacity were not going hand in hand, therefore the initial aims to rebuild competitiveness do not seem to be achieved. Even worse: today both processes look as if they never took off. Particularly science that seems locked-in.
The influence of gradualist economic policy (slow privatization) is also obvious in forming market structure on different markets. In markets where state owned enterprises are the biggest players distortion of market structure towards monopoly is not unusual. Besides, since the state plays the role of the regulator there is much doubt about willingness of the state either to privatise or conduct fairly. Many markets behave illegally, obstructing the competition yet little has been done to penalise this behaviour.
To conclude, one of the reasons why the current trends are unsatisfactory in Slovenia lies in the constantly repeating mantra of gradualist policy. Gradualism mixed with interventionism in the manner of self-managing socialism and isolationism has gone sour after thirteen years, and if some radical switch of policy approach does not occur very soon, the lagging behind other transitional countries could become a grim reality. More should be done in bringing industry and science together by halting the practice of redistributing budgetary funds that have no specific object aims. Privatisation should start and competition policy be taken more seriously. There needs to be a policy mix of internationalisation, inviting foreign direct investments and innovation policies, competition policies and regional development.
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 More in: Vstop v EU: konec gradualizma v Sloveniji (Entrance in EU: the end of gradualism in Slovenia?), Institute for macroeconomic analysis and development, 2003.
 Based not only on lower labour costs but also on inovation and technological improvement.
 World Economic Forum.
 Data is from year 1999, which is last accesible year.
 Still quallity of this publications are low, since at rankings of highly citated scientific papers Slovenia hits bottom again, implicitly showing that even when production of publication ins prefered, the quallity of output is low.