6 - Markets in transition

Summary

History's biggest experiment in economics is unfolding in the formerly planned economies of eastern Europe and Asia. Markets are being created from scratch. Novel incentive mechanisms are evolving. Watching the new market institutions grow can teach us much about how markets work. Economics has been used - for good or for ill - as the basis of advice to reforming governments. I shall reverse things and ask what the transition experience says about economics.

The starting point of the transition, the legacy of planning, was an economy with missing markets and unproductive firms. Financial markets were non-existent, product and labor markets rudimentary. Industry was monopolized by the notoriously inefficient state-owned enterprises. Reform means inducing the existing firms to become more productive; creating new firms; and developing financial, labor, and product markets. The catchphrase “getting prices right” - or Arrow-Debreu general equilibrium theory - tells only part of what is needed. Getting prices right requires mechanisms for setting prices. Prices do not encapsulate all the information markets need in order to function, and institutions must emerge for channeling the non-price information.

The market system is a system. “Everything is connected to everything else,” as Lenin said. Reforms are interlinked. The various incentive mechanisms that constitute a market system can complement or substitute for each other. Incentives are complements if one has a larger effect when the other is already in place (Holmstrom and Milgrom (1994)). A reform may have little effect if implemented singly. Complementary with the internal restructuring of state-owned firms, for example, is the introduction of a competitive product market, so policies to foster new firms aid the restructuring of the existing firms. Restructuring requires also a managerial labor market to reveal talented managers, as well as a financial market to monitor the managers.