Shock therapy (economics)


In economics, shock therapy is the sudden release of price and currency controls, withdrawal of state subsidies, and immediate trade liberalization within a country, usually also including large-scale privatization of previously public-owned assets.

Overview

The term was popularized by Naomi Klein. In her 2007 book The Shock Doctrine, she argues that neoliberal free market policies have risen to prominence in some developed countries because of a deliberate strategy of "shock therapy". Johan Norberg of the Cato Institute criticized the book, saying that the concept of shock therapy is falsely attributed to Friedman. According to Norberg, Friedman's quote is taken out of context and misinterpreted.
The economist Jeffrey Sachs says he never picked the term "shock therapy", does not much like it, and asserts that the term "was something that was overlaid by journalism and public discussion" and that the term "sounds a lot more painful in a way than what it is". Sachs' ideas on what has been referred by non-economists as "shock therapy" were based on studying historic periods of monetary and economic crisis and noting that a decisive stroke could end monetary chaos, often in a day.
The first instance of shock therapy was the neoliberal reforms of Chile in 1975, carried out after the military coup by Augusto Pinochet. The reforms were based on the liberal economic ideas centered on the University of Chicago.
The term is also applied to Bolivia's case. Bolivia successfully tackled hyperinflation in 1985 under Gonzalo Sánchez de Lozada, using Sachs' ideas. In particular, Sachs and Sanchez de Lozada cited West Germany as inspiration where, during 1947–48, price controls and government support were withdrawn over a very short period, kick-starting the German economy and completing its transition from an authoritarian post-War state.
Economic liberalism rose to prominence after the 1970s and liberal shock therapy became increasingly used as a response to economic crises, for example by the International Monetary Fund in the 1997 Asian Financial Crisis. Liberal shock therapy became very controversial, with its proponents arguing that it helped to end economic crises, stabilise economies and pave the way for economic growth, while its critics believed that it helped deepen them unnecessarily and created unnecessary social suffering.
In Russia and other post-Communist states, neoliberal reforms based on the Washington Consensus resulted in a surge in excess mortality and decreasing life expectancy, along with rising economic inequality and poverty. The Gini ratio increased by an average of 9 points for all former socialist countries. Some countries that used shock therapy did better than those that did not. The average post-communist country had returned to 1989 levels of per-capita GDP by 2005, although some are still far behind that. To further cloud understanding, China made its highly successful transition in a gradualist fashion. According to William Easterly, successful market economies rest on a framework of law, regulation, and established practice that cannot be instantaneously created in a society that was formerly authoritarian, heavily centralised, and subject to state ownership of assets. German historian Philipp Ther asserted that the imposition of shock therapy had little to do with future economic growth.

History

West Germany 1948

Though the term shock therapy only came into existence after Bolivia's actions in 1985, both Gonzalo Sánchez de Lozada and Jeffrey Sachs were heavily influenced by West Germany's reforms in 1948.

Background

Germany ended the European Theatre of World War II with its unconditional surrender on the 8 May 1945. It faced war damage to its economy and the problems of mass migration due to the expulsion of ethnic Germans from areas east of the Oder-Neisse Line.
April 1945 to July 1947 saw the Allied occupation of Germany implement Joint Chiefs of Staff directive 1067. This directive aimed to transfer Germany's economy from one centred on heavy industry to a pastoral one to prevent Germany from having the capacity for war. Civilian industries that might have military potential, which in the modern era of "total war" included virtually all, were severely restricted. The restriction of the latter was set to Germany's approved peacetime needs, which were set on the average European standard. To achieve this, each type of industry was subsequently reviewed to see how many factories Germany required under these minimum level of industry requirements. In May 1946, the first plan stated that German heavy industry must be lowered to 50% of its 1938 levels by the destruction of 1,500 listed manufacturing plants. Restrictions on steel followed.
It soon became obvious that this policy was not sustainable. Germany could not grow enough food for itself and malnutrition was becoming increasingly common. The European post-war economic recovery did not materialise and it became increasingly obvious that the European economy had depended on German industry.
In July 1947, President Harry S. Truman rescinded on "national security grounds" the punitive JCS 1067, which had directed the U.S. forces of occupation in Germany to "take no steps looking toward the economic rehabilitation of Germany." It was replaced by JCS 1779, which instead stressed that "n orderly, prosperous Europe requires the economic contributions of a stable and productive Germany."
By 1948, Germany suffered from rampant hyperinflation. The currency of the time had no public confidence, and thanks to that and price controls, black market trading boomed and bartering proliferated. Banks were over their heads in debt and surplus currency abounded.
However, thanks to the introduction of JCS 1779 and the first Allied attempts to set up German governance, something could be done about this. Ludwig Erhard, an economist, who had spent much time working on the problem of post war recovery, had worked his way up the administration created by the occupying American forces until he became the Director of Economics in the Bizonal Economic Council in the joint British and American occupied zones. He was placed in charge of currency reform and became a central figure in events that were to follow.

Economic reforms

In spring of 1948, the Allies decided to reform the currency. In preparation for this, a new central bank system was established in West Germany with independent Land Central Banks and the Bank deutscher Lander with headquarters in Frankfurt am Main.
Currency reform took effect on June 20, 1948, through the introduction of the Deutsche Mark to replace the Reichsmark and by transferring to the Bank deutscher Lander the sole right to print money. Each person received a per capita allowance of 60 DM, payable in two installments and business quota of 60 DM per employee.
Under the German Currency Conversion Law on 27 June, private non-bank credit balances were converted at a rate of 10 RM to 1 DM, with half remaining in a frozen bank account. Although the money stock was very small in terms of national product, the adjustment in the price structure immediately led to sharp price increases, fuelled by the high velocity of money through the system. As a result, on 4 October, the military governments wiped out 70% of the remaining frozen balances, resulting in an effective exchange of 10:0.65. Holders of financial assets were dispossessed and the banks' debt in Reichsmarks was eliminated, transferred instead into claims on the Lander and later the Federal Government. Wages, rents, pensions and other recurring liabilities were transferred at 1:1.
On the day of the currency reform, Ludwig Erhard announced, despite the reservations of the Allies, that rationing would be considerably relaxed and price controls abolished.

Results

In the short term, the currency reforms and abolition of price controls helped end hyperinflation. The new currency enjoyed considerable confidence and was accepted by the public as a medium of payment. The currency reforms had ensured that money was once more scarce, and the relaxation of price controls created incentives for production, sales and earning this money. The removal of price controls also meant shops filled up with goods again, which was a huge psychological factor in the adoption of the new currency.
In the long term, these reforms helped set the stage for the Wirtschaftswunder in the 1950s.

Chile 1975

Chile's reforms under the government of Augusto Pinochet are held as the origin of neoliberal shock therapy.

Economic reforms

The government welcomed foreign investment and eliminated protectionist trade barriers, forcing Chilean businesses to compete with imports on an equal footing, or else go out of business. The main copper company, Codelco, remained in government hands due the nationalization of copper completed by Salvador Allende, however, private companies were allowed to explore and develop new mines. Copper resources were, however, declared "inalienable" by the 1980 Constitution.
In the short term, the reforms stabilised the economy.
In the long term, Chile has had higher GDP growth than its neighbouring countries, but also high gini index, expressed in a noticeable inequality.

Bolivia 1985

The term shock therapy originates from Bolivia's tackling of hyper-inflation in 1985, and was thought to have been coined by the media. On 29 August, just three weeks after the election of Víctor Paz Estenssoro as President, and the appointment of Gonzalo Sánchez de Lozada, the architect of shock therapy, as Planning Minister, Decree 21060 was passed. This decree tackled all aspects of the Bolivian economy and ended the hyper-inflation.

Background

Between 1979 and 1982, Bolivia was ruled by a series of coups, counter-coups, and caretaker governments, including the notorious dictatorship of Luis García Meza Tejada. This period of political instability set the stage for the hyperinflation that later crippled the country. In October 1982, the military convened a Congress elected in 1980 to lead choose a new Chief Executive. The country elected Hernán Siles Zuazo, under whose term the galloping hyperinflationary process started. Zuazo received scant support from the political parties or members of congress, most of whom were eager to flex their newly acquired political muscles after so many years of authoritarianism. Zuazo refused to take extra-constitutional powers and concentrated on preserving the democracy instead, shortening his term by one year in response to his unpopularity and the crisis racking his country. On 6 August 1985, President Víctor Paz Estenssoro was elected. He appointed his President of the Senate, Gonzalo Sánchez de Lozada, as Planning Minister with a mandate to fix the economy.

Prelude to Decree 21060

was the famous decree that covered all aspects of the Bolivian economy, later referred to as shock therapy. In the run-up to the decree, Gonzalo Sánchez de Lozada recalls what the new government set out to do:
In the three weeks between the inauguration of the President and decree 21060, he notes:
Once they had decided to act, de Lozada recalls that
It is notable that de Lozada viewed shock therapy as an issue of political credibility, and less an economic issue as Sachs, its economic pioneer, did. Like Sachs, he was strongly influenced by the German government in 1947, but noted that they, like the new Bolivian government of Victor Paz, were a new government that acted decisively in the first 100 days, resolving the economic situation.

Decree 21060

Decree 21060 included the following measures:
In the short term, the decree smothered hyperinflation. Within a few months, inflation had dropped to between 10 and 20 percent. The crash of the tin market in October of the same year and the reforms led to an estimated unemployment rate of 21.5 percent by 1987.

Post-Communist states

The next important chapter in the history of shock therapy was the collapse of communism in Europe in 1989. This left many post-communist states in central and eastern Europe with centralised authoritarian economies that had to transition to decentralised, market-orientated capitalist economies.
Inspired by Bolivia's example, and advised by institutions like the International Monetary Fund and individuals like Jeffrey Sachs, many countries chose shock therapy to shake off the economic lethargy of the communist era and transition to the capitalist systems. These transitions provide an interesting and important view into shock therapy and its consequences, especially when contrasted with China, which began a gradualist transition in 1978 under Deng Xiaoping.
Advocates of shock therapy view Poland as the success story of shock therapy in the post-communist states and point out that shock therapy was not applied appropriately in Russia, while critics point out that Poland's reforms were the most gradualist of all the countries and compare China's reforms with those of Russia and their vastly different effects.

Background

After the failure of the Communist government in the elections of June 4, 1989, it became clear that the previous regime was no longer legitimate. The unofficial talks at Magdalenka and then the Polish Round Table talks of 1989 allowed for a peaceful transition of power to the democratically elected government.
The economic situation was that inflation was high, peaking at around 600%, and the majority of state-owned monopolies and holdings were largely ineffective and completely obsolete in terms of technology. Although there was practically no unemployment in Poland, wages were low and the shortage economy led to a lack of even the most basic foodstuffs in the shops. Unlike the other post-communist countries, however, Poland did have some experience with a capitalist economy, as there was still private property in agriculture and food was still sold in farmers' markets.
In September 1989 a commission of experts was formed under the presidency of Leszek Balcerowicz, Poland's leading economist, Minister of Finance and deputy Premier of Poland. Among the members of the commission were Jeffrey Sachs, Stanisław Gomułka, Stefan Kawalec and Wojciech Misiąg. The commission prepared a plan of extensive reforms that were to enable fast transformation of Poland's economy from obsolete and ineffective central planning to advanced capitalism, as adopted by the states of Western Europe and America.

Balcerowicz Plan

On October 6 the program was presented on public television and in December the Sejm passed a packet of 11 acts, all of which were signed by the president on December 31, 1989. These were:
  1. Act on Financial Economy Within State-owned Companies, which allowed for state-owned businesses to declare bankruptcy and ended the fiction by which companies were able to exist even if their effectiveness and accountability was close to none.
  2. Act on Banking Law, which forbade financing the state budget deficit by the national central bank and forbade the issue of new currency.
  3. Act on Credits, which abolished the preferential laws on credits for state-owned companies and tied interest rates to inflation.
  4. Act on Taxation of Excessive Wage Rise, introducing the so-called popiwek tax limiting the wage increase in state-owned companies in order to limit hyperinflation.
  5. Act on New Rules of Taxation, introducing common taxation for all companies and abolishing special taxes that could previously have been applied to private companies through means of administrative decision.
  6. Act on Economic Activity of Foreign Investors, allowing foreign companies and private people to invest in Poland and export their profits abroad.
  7. Act on Foreign Currencies, introducing internal exchangeability of the złoty and abolishing the state monopoly in international trade.
  8. Act on Customs Law, creating a uniform customs rate for all companies.
  9. Act on Employment, regulating the duties of unemployment agencies.
  10. Act on Special Circumstances Under Which a Worker Could be Laid Off, protecting the workers of state firms from being fired in large numbers and guaranteeing unemployment grants and severance pay.
Privatization of companies was left until later.

Results

In the short term, the reforms smothered the building hyperinflation before it reached high levels, ended food shortages, restored goods on the shelves of shops and halved the absence of employees in the work place. However, the reforms also caused many state companies to close at once, leaving their workers unemployed, and government statistics show this change as unemployment rose from 0.3% in January 1990 to 6.5% by the end of that year, and a shrinking in the GDP for the next two consecutive years by 9.78% in the first and 7.02%.
In the long term, the reforms paved the way for economic recovery, with the GDP growing steadily to about 6–7% between 1995–7, falling to a low of 1.2% in 2001 before rising back up to the 6–7% region by 2007, often led by small service businesses, long suppressed by the Communist government. However, despite GDP indicating prosperity for Poland, the unemployment rate continued to rise steadily, peaking at 16.9% in July 1994 before steadily falling down to a low of 9.5% in August 1998 before rising once more to a high of 20.7% in February 2003, from which it had fallen until the year 2008. During the early years, the unemployment rate is thought to have been lower due to many of those claiming unemployment working in the grey economy, although this can account for no more than 5% of the unemployment rate.
The long-term results of shock therapy point to both a rise and a fall in living standards. Ownership of consumables boomed, as did consumption of fruit and vegetables, meat and fish. However, the huge economic adjustment Poland underwent created massive anxiety.

Applications

This section records all known applications of shock therapy in the world not mentioned under the history section above.

New Zealand

The economic reforms of New Zealand's 1984 Labour government, collectively known as Rogernomics, constitute an example of shock therapy. In this case, the previous economic direction and management of Rob Muldoon was portrayed as leading the country into a desperate fiscal crisis, and this crisis was the continued reason given for the necessity of economic shock policies. The 'shock' element of the New Zealand experiment, can be considered as such, because the Labour Party initially complied with its policies, not withdrawing its support until later in Roger's term.

Post-Soviet

Since the USSR's dissolution, the post-Soviet states faced many problems. Poverty in the region had increased more than tenfold. The economic crisis that struck all post-Soviet countries in the 1990s was twice as intense as the Great Depression in the countries of Western Europe and the United States in the 1930s.
However, it has not been established whether these adverse outcomes were due to the general collapse of the Soviet economy or the policies subsequently implemented or a combination of both. Some research suggests that the very fast pace of 'shock therapy' privatization mattered, and had a particularly harsh effect on the death rate in Russia. Sachs himself resigned from his post as advisor, after stating that he felt his advice was unheeded and his policy recommendations were not actually put into practice. In addition to his criticism of the way in which Russian authorities handled the reforms, Sachs has also criticized the U.S. and the IMF for not providing large-scale financial aid to Russia, which he felt was integral to the success of the reforms.

Poland

has been cited by some as an example of the successful use of shock therapy, though this is disputed. When economic liberalism came to this nation, the government took Sachs' advice and immediately withdrew regulations, price controls and subsidies to state-owned industries. However, with respect to the privatization of the state sector the change was much more gradualist. Whereas many economic factors were immediately applied, privatization of state-owned enterprises was delayed until society could safely handle the divestiture, as contrasted with the 'robber baron' state of affairs in Russia.
Productivity increased although at the same time unemployment rates rose as well. As of 2008, the GNP was 77% higher than in 1989. Moreover, inequality in Poland actually decreased right after the economic reforms were implemented, although it rose back up again in later years. Today, although Poland is confronted with a variety of economic problems, it still has a higher GDP than during communist times, and a gradually developing economy. Poland was converging towards the EU in regards to income level in 1993–2004.

Theory

This section presents the various theories that are used to explain shock therapy and its effects.

Hyperinflation

first proposed shock therapy when he noticed that most periods of hyperinflation had been ended in a decisive stroke, often in a day. Therefore, it is important to look at the theoretical basis for hyperinflation to understand why Sachs noticed shock therapy proved so successful in fighting it.
There are two main models used to explain hyperinflation, the confidence model and the monetary model. Hyperinflations see a rapid increase in the money supply and the velocity of money. Either one, or both of these together, is the root cause of hyperinflation and in both models, one follows from the other.
In the confidence model, some event, or series of events, such as defeats in battle, or a run on stocks of the specie that back a currency, removes the belief that the authority issuing the money will remain solvent—whether a bank or a government. Because people do not want to hold notes that may become valueless, they want to spend them in preference to holding notes that will lose value. Sellers, realizing that there is a higher risk for the currency, demand a greater and greater premium over the original value. War is one commonly cited cause of crisis of confidence, particularly losing in a war, as occurred during Napoleonic Vienna, and capital flight, sometimes because of "contagion" is another. In this view, the increase in the circulating medium is the result of the government attempting to buy time without coming to terms with the root cause of the lack of confidence itself. A crisis of confidence is particularly damaging to a fiat currency, a currency whose value is unrelated to any physical quantity, as fiat money is typically backed by future tax revenues and its acceptability to the government for payment of taxes and charges.
In the monetary model, hyperinflation is a positive feedback cycle of rapid monetary expansion. It has the same cause as all other inflation: money-issuing bodies, central or otherwise, produce currency to pay spiraling costs, often from lax fiscal policy, or the mounting costs of warfare. When businesspeople perceive that the issuer is committed to a policy of rapid currency expansion, they mark up prices to cover the expected decay in the currency's value. The issuer must then accelerate its expansion to cover these prices, which pushes the currency value down even faster than before. According to this model the issuer cannot "win" and the only solution is to abruptly stop expanding the currency. Unfortunately, the end of expansion can cause a severe financial shock to those using the currency as expectations are suddenly adjusted. This policy, combined with reductions of pensions, wages, and government outlays, formed part of the Washington consensus of the 1990s.
Ending hyperinflation depends on which model is the main cause. In the confidence model, the method of ending hyperinflation is to change the backing of the currency—often by issuing a completely new one. Also, if possible, any action that restores confidence in the government can help end the hyperinflation. In the monetary model, the issuer of the currency must stop expanding the currency.

Shock therapy as an artificial economic shock

A shock in economics is defined as an unexpected or unpredictable event that affects an economy, either positively or negatively. Recessions are often modelled as negative economic shocks in which the current state of the economy is untenable and the economy tries to restore itself to a new equilibrium position. In the short-run, as the economy adjusts to the shock but before it reaches the new equilibrium, the shock often causes productivity to fall, unemployment rise, and closure of firms that are now non-viable in the new environment. The new environment enables new kinds of businesses and people must learn new skills and exploit new opportunities to achieve long-run equilibrium.
Shock therapy can be largely understood by thinking of it as an artificial shock imposed by government policies. Neoclassical theory provides a very useful tool in trying to describe an artificial shock theoretically, in that neoclassical theory provides an idealised view of an economy based on certain assumptions, most of which are made true through market institutions, law, culture or historical practise, and is very useful in explaining most situations. Even when some of the assumptions required for neoclassical theory are not in place resulting in an imperfect market and the results of neoclassical theory becoming distorted or failing, comparing the result with neoclassical theory can prove useful. Other, slightly different formulations of economic thought strive to describe shocks, the most important of which is economic liberalism.

Neoclassical shocks

In neoclassical theory, large negative shocks cause unemployment in the short run, and the larger the shock, the larger the unemployment. As a result, large shocks can lead to grave social problems, political unrest and, in the worst cases revolution. However, the market is already adjusting itself to return to the new equilibrium, causing job creation and opportunities. If there is no interference to prevent the markets adjusting to the new equilibrium, the markets immediately correct themselves with new firms and full employment, providing workers can acquire the new skills to exploit these new jobs, or are able to move to areas where they can find new employment.
In response to a shock created by bad government policies, sudden market liberalisation can allow the free markets to reach the equilibrium that the bad government policies prevented them reaching. If the response originates in the markets or other external factors, government intervention slows the free market's path to optimal recovery and liberalisation of the economy speed recovery. However, if the shock is large—causing social and political conditions that destroy or prevent the recovery —government intervention to slow the recovery using gradualist policies and spreading the pain is justifiable.

Imperfect market shocks

The most important type of nearly neoclassical shock is due to market failure and imperfect markets. Sudden free market liberalisation in the absence of free market institutions or in which a Western-style economy is unnecessarily liberalised are both examples of imperfect market shocks.
The nature of the imperfect market shock depends on what assumption of the perfect market is voided. The most important assumption for all markets is the idea of property rights. The free market doesn't just depend on the exchange of commodities, but on the rights to use them in particular ways for particular amounts of time. Markets are institutions that organize the exchange of control of commodities, where the nature of the control is defined by the property rights attached to the commodities. Property rights are the most important because they can have the most dramatic effect on the results, and are thought to be behind the most important causes of market failure.
Another important assumption is perfect competition, which has many smaller assumptions tied to it. These include perfect information, no barriers to entry and many competitors. Again, there are different imperfect markets depending on what assumption is relaxed.
Many competitors assumes that there is more than one firm producing any commodity. In the event of large-scale privatisation of a state-owned company as part of shock therapy, privatising such a company without waiting for a competitor creates a monopoly where the company can use its pre-eminent position to create barriers to entry, control prices and maintain its monopoly. Also, in post-authoritarian systems with fragile legal and democratic systems, such pre-eminent companies can also influence the government and the legal system to help maintain its monopoly.
Perfect information assumes that prices and product quality is known to all consumers and producers. The idea of imperfect information '' has many ramifications for markets. The most important one concerning shock therapy is international trade and financial liberalisation. Because international banks possess better information about other international firms than they do about local firms in a country, liberalisation of trade and finance never leads to an even playing field for local firms if international investment is high. Hernando de Soto Polar also notes that in conjunction with imperfect property rights, local firms may not be able to access foreign capital when borrowing against their own capital, which may have imperfect property rights, while local lenders know more about the conditions under which something is owned and can be borrowed against.
Imperfect market failure in Russia
Prominent economist Joseph Stiglitz ties all these ideas together to explain the reason why shock therapy failed in Russia.
Through the idea of property rights, Stiglitz uses the idea of Adam Smith's invisible hand to explain that, in the presence of severe corruption, a lack of institutionalized law and order and artificially depressed exchange rates, the free market created by shock therapy in Russia created a race to the bottom to asset strip the country and remove the capital abroad, rather than the mutually beneficial race to control the market in commodities that would otherwise happen. Competition meant that if the nominal owner of the capital didn't asset strip the capital first, someone else would.
Likewise, with the previously large Soviet nationalised industries being privatised quickly created a situation where major markets operated in a monopoly owned by a few individuals who had links with the government of Boris Yeltsin.
Illusionary shock
Illusion therapy refers to the imposition of shock economic policies on economy in a way that the society doesn't feel the shock or assumes that the dramatic change in policies is not as shocking or radical as it is in the real world. The situation of "illusion" can be created using a wide range of sociopolitical tools and techniques including information blackout on national statistics, imposing repeated false news shocks before the final shock, spreading misinformation, rewarding the society with interim exogenous rents and promoting them as the benefits of the shock, etc. Illusion therapy is used to soften or elude the potential social backlash during the shock. The first experience of illusion therapy has been documented after the implementation of Iran's subsidy reform project.

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