December 5, 2015

Is Shock Therapy the Savior of Economic Slowdown?- Case Studies of Poland, Russia, Chile and India

Recently, I have been researching on shock therapy and how the post-Soviet Russian economy could have been better handled! As a research document as present this post in which I have tried and analysed the failures and successes of shock therapy and its comparison to gradualism. This post also tries to answer the big question of determining when and where shock therapy must be adopted and where it mustn't ! In order to accomplish these objectives, this post draws a comparison between different economic recovery models. Hope you like it! 

Shock therapy basically refers to sudden liberalization and end of a state controlled economy. Within a very short period of time, the state's control over the prices and the market is omitted. This is usually done to hasten the process of transition from a socialist economy to a capitalist style of economy with the prices of commodities being dependent on the market forces like demand and supply. Though shock therapy has had diverse effects  from country to country, a certain pattern is identifiable as a result of certain research on the aftermaths of shock therapy in different countries.

According to this pattern, shock therapy has initial thumbs down! As a feature of the immediate impacts of shock therapy, unemployment mounts up and inflation rises. As PSUs are privatized and foreign companies enter the market, efficiency increases and hence, some jobs are initially destroyed. Also, if the country has formerly been a socialist country with a right to employment, the citizens of such a country fail to win a job in the competitive environment. However, over certain time, the graphs take a U-turn according to my research. Employment grows as more companies enter the market and create more jobs. Inflation goes down as a result of competition. Also, the quality of  products improves as privatization shows thumbs up!

However, as mentioned above, there have been certain versions of the pattern in different countries. In the post-Soviet Russia, shock therapy turned out to be a disastrous whereas, post- soviet Poland led a very successful shock therapy model. Chile (Pinochet's Regime) is an epitome of shock therapy worldwide. It is astonishing that all three of these examples are of shock therapy implementation at approximately the same period of time. Pinochet's regime extended from 1973 to 1990, post-soviet Poland during the initial 1990s and Russia from 1992-93. All three cases transited from a socialist economy, all three economies were in doldrums. Poland and Russia in fact where identical cases, both recently freed from the USSR. But the reason why the latter was failure lies below. 

Pinochet's Chile was a military dictatorship where Pinochet was the military dictator unlike Russia where democracy had taken birth and freedoms were being given in the 1990s during Yeltsin years. The difference in the political regime poses a significant impact on the economic conditions. While in Chile, Pinochet was free to take any actions of his choice and was unaccountable, Yeltsin in Russia was repeatedly questioned on his economic policies and criticized upon them. Within merely an year of introduction of the shock therapy, the Russian cabinet ended up in a constitutional crisis reasoned to the conflict between the President and the Cabinet over his policies. Yeltsin also had a constant constrain of the impact of his policies on the people as he was a part of a democratic government. this resisted Yeltsin to successfully lead the shock therapy model and his policies were supplemented by criticism and disfavoring. Yeltsin was not even given a chance to experiment with the economy. 

However, having said that, I would deny that shock therapy cannot be implemented in a democracy. Poland was a democracy like Russia, newly born country like Russia, part of the erstwhile Soviet Union like Russia and with its economy in shambles like Russia. It also experienced the same kind of international pressure and international economic conditions as Russia because both of them led their shock therapy models at approximately the same time. Then why did Poland succeed and Russia didn't? 

The answer lied in Poland's action plan. The sudden impacts of the shock therapy model hold paramount importance especially in a democratic nation. While in Russia, there was an immediate relaxation of influence of state on commodity prices, in Poland, prices of essential commodities like oil and gas were controlled by the government. Though other commodities had price rise, since the prices of essential commodities were kept low, subsistence wasn't endangered and the immediate impacts didn't have an extreme effect on the lives of common people. 

Another very important and significant policy of the Polish government was monetary contraction policy. The Polish government increased the interest rates on domestic loans and stopped printing more money. Since the interest rates on loans increased, people had less money and hence, they spent less. This controlled inflation as due to monetary contraction, the demand dropped.

Another very predominant fact behind the success of shock therapy in Poland was that the Polish population was relatively more experienced and educated. On the other hand, as Russia moved towards privatization, the Russian workforce couldn't earn jobs in the competitive environment where efficiency was held high unlike the former Soviet economy where everyone had the right to employment. Due to both of these reasons the predominant Russian population remained unemployed.

The growth of unemployment and inflation at the same time made shock therapy very unpopular. If the Russian government at that time would have adopted the monetary contraction policy along with the partial price controls and had launched a plan to educate and train its  workforce to earn jobs, the immediate shock of the therapy would have been diminished, if not vanished. 

Though there were some mistakes that Russia committed here and there with the shock therapy it might have worked out and would have brought fruits within 2-5 years with some consistent support from the Russian populace and the government. However, even this couldn't happen. Even as the Yeltsin and his set  of economic advisers along with the IMF and World Bank insisted him to continue with the shock therapy, Yeltsin had a great political pressure. He was becoming very unpopular and there were  attempts of coupe against him alleging him for his 'reckless and baseless' economic policy and 'authoritative' attitude. The scenario was such that the whole cabinet along with the majority of Russian population were against him merely, one year or so after the shock therapy was introduced. This brings me to an altogether different debate though, but the inference is that another drawback of the shock therapy in Russia was the waning control of Yeltsin over Russia and rising dissent against him. 

Therefore, a weak action plan with corruption, oligarchy and the waning control of Yeltsin over Russia along with the possession of a very poor populace and a negative feeling about the investment scenario in Russia and not to forget, frequent coupes brought the GDP growth of Russia in negatives in the years after 1991 disintegration of USSR. The failure of shock therapy in Russia can hence, be reasoned out to a set of things happening in post-Soviet Russia, all at the very wrong time and the success of shock therapy can be reasoned out to a set of things that just worked out at the very right moment. However, from none of the examples can we infer that the concept of shock therapy in itself reflects negatively on economic growth. 
Therefore, in order to understand whether shock therapy as a model is the savior of economic slowdown, lets take an example of India's transition from a State-controlled economy to a mixed economy by a gradual approach. In 1991, India's economy was at an all time low. After having about 40 years of rule by the Gandhi family, India's economy had become a Russia-like economy, with all kinds of state controls imposed, specifically during Indra Gandhi times. The people were starving and national debt was mounting up. Majority of the population was struck by poverty and India's GDP was worth 310.08 US dollars. There was an immediate need of change in economic policy and voila! The prime minister of India (at that time), P.V. Narasimha Rao and his finance minister and soon to be PM, Manmohan Singh, led one of the most successful and idealistic financial reforms in the country. 

The Rao-Singh reforms were also based up on relaxing market barriers and state control over the economy and facilitating foreign investment. The introduction of FDI was considered as the key to economic betterment and well, no doubt, it worked out. However, all the prices were not relived at once which eliminated the 'shock' element of the reforms.

However, even these economic reforms, which Shashi Tharoor  gave full marks to Rao for were criticized in democratic India as while these reforms benefited a majority of the Indian citizens, it arguably hurt the overprotected businessmen and their corrupt friends in bureaucracy. An end to subsidies directed towards state owned industries gave a chance to the political opponents to play politics. 

There is no doubt that the economic reform face serious political obstacles, resources have to be generated , investment privileged over consumption, higher prices are paid for many goods, sacrifices are made in the hope of later rewards but to a middle class Indian, it meant that he or she couldn't afford his/her favorite food item in the market or as Sandeep Waslekar puts it: 
A few million urbanites, white collar workers, large farmers, blackmarketeers could now drink Coke, watch Sony television, operate Hewlett Packard computers, drive Suzuki and use Parisian perfumes, while the rest would live in anguish!
Prime Minister Rao took all this into account, unlike President Yeltsin in Russia and adopted the strategy that he would undertake only those reforms that would be politically accepted to the public at large. This strategy of Rao could be summed up in words of a publication by The Economist which said: 
Rao appears to have reckoned that shock therapy would create losers straightaway, while creating winners only in the medium turn, and decided to leave some reforms to later, when winners had emerged.  
Therefore, the Rao-Singh reforms didn't allow the prices of oil and petroleum to fluctuate as per market forces which continue till even today. Even today, the prices of petroleum and other oil products are decided by the government though they are kept close to the actual market price. These reforms brought down inflation from 17% in 1991 to 7% in 1992 and a further 5.6% in 1993. Indian economy was saved and we continue to see the positive effects of those reforms even today in India. 


Determining whether gradualism or shock therapy is a savior of economic slowdown is subjective and depending on the situation. Shock therapy, if implemented, must supplement a plan to dampen its immediate effects. Howsoever strong the action plan for implementing shock therapy might be, there is always a risk or to some extent certainty of a having a negative impact in the immediate years however, the years that follow would also be equally or sometimes more rewarding. On the other hand, gradualism might not have a 'shock' element, but at the same time, it extends over years to deliver all its merits. 

In 1991 Poland, the GDP growth rate was -1.7% and that in 1991 India was 1.1%. Within four years 
of shock therapy implementation, Poland's GDP growth rate had increased by 14% from what it was before. At the same time India's GDP growth rate from what it was 4 years before 1995 had increased by only 6.5% by 1995. However, at the same time, 22 years from 1991, Poland's annual GDP growth rate stood at 1.7% whereas that of India stood at 5%. 

The inference that we can draw from this study is that over 3 or 4 years, the results of shock therapy are more overwhelming than the results of gradualism, however, over 20-30 years, gradualism would turn out to be a more stable approach than shock therapy (if considered in singularity). Therefore, shock therapy reforms are a short term reform mechanism, more volatile but immediate and gradualism is a long term reform strategy, not immediate but better over time and are less volatile with less risk of failure.

Thanks for reading! Yours truly, Abhimanyu!
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