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Between Past and Future

Sorin Antohi

III. Vulnerabilities of the New Democracies

12. The Morals of Transition: Decline of Public Interest and Runaway Reforms in Eastern Europe

Kazimierz Z. Poznanski

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  • 1 George Soros, “The Capitalist Threat”, The Atlantic Monthly (February 1997); and George Soros, The (...)

1While the moral aspect of the ongoing transition to capitalism in Eastern Europe is largely ignored, rapidly growing numbers of those who analyze institutions of modern capitalism remind us of the significance of morals in organizing economic life. George Soros’s series of writings on the threats faced by contemporary advanced capitalism is one of the best examples of this line of thinking1. To him, modern capitalism, with the market as a core institution, is under threat from excessive individualism. Manifested in the unconstrained operation of the market, rampant individualism undermines morality, since morality means self-restraint out of concern for possible gain/harm to others, the public. The most destructive of these forces is at the global level, but they cannot ravage the worldwide capitalist system without first fracturing morals within national economies. However, the moral problems that Soros claims are faced by advanced capitalism pale by comparison with those experienced by transition economies that have embarked on the task of building genuine markets. Markets are emerging here under conditions of a severe decline of public virtues—perverse corruption of state officials and the indifference of private citizens. If Soros is correct that forces of demoralization can severely undermine the existing genuine state of developed capitalism, then it is very unlikely that such capitalism could emerge despite similar neglect of group (public) interests. This crisis of public virtues explains why reforms—while quite diverse in terms of speed and content—are failing badly, as manifested in the deep and yet unfinished regional recession. Even more, these reforms are failing to deliver a healthy economic system, for what has emerged in the midst of this economic distress is a system where ownership is mainly foreign. As a result, only a very weak—largely petty—domestic capitalist class is emerging. This means that the transition has basically failed to undo the major damage done by communism—the extinction of endogenous capitalist classes.

2In this essay I search for the most defining characteristics of capitalism-building in East European economies (inclusive of the European parts of the former Soviet Union—the Baltic states, Belarus, Russia, and Ukraine). I first identify a certain common quality in the initial stage of transition, which I call “the origins”. By this I mean the collapse of communism, the development that opened the door for subsequent capitalism-building efforts. The existence of some disparities between East European economies in terms of their endings to communism cannot be denied. For instance, Poland’s uniquely powerful opposition movement led by outspoken intellectuals stands juxtaposed to the situation in countries like Bulgaria or Russia, where the communist party faced no serious external challenge of this kind. In spite of many differences, the communist declines throughout the region shared one important feature: the collapses all happened in a very peaceful—almost uneventful—manner.

3Next, I turn to the second stage of the transition—the process of remaking the existing economic system itself. While recognizing numerous, even major, cross-country differences, I again find a critical commonality among transition countries. Poland and Bulgaria can again serve as examples of the differences. Poland has conducted a very bold and well-articulated reform program from the start, while Bulgaria has not, allowing instead for indecisiveness and the implementation of confused reform measures. Despite these discrepancies, the two economies in question—and, in fact, every country in the region—share the same fate. With the very launching of their respective systemic reforms, they have entered into an extensive, unprecedented recession, though admittedly quite uneven. Continuing with this pair of countries, it is quite apparent that economic adversities have been far less pronounced in Poland than in Bulgaria.

4Finally, I look at the third stage, the destination of the transition—an emerging form of capitalism—and again notice some obvious cross-country differences. For instance, Russia has established an economic system with overpowering criminal elements that substitute for the system of state and the rule of law. Such criminal forces are, however, not as pronounced in countries such as Hungary and Slovenia. Nevertheless, there are other aspects of emerging capitalism that are found universally in the region. The most important is the general pattern of ownership relations, or property rights. All of these countries are rapidly heading for systems of capitalism in which the majority of capital assets, in industry and banking, belong to foreigners, largely as a result of privatization. This is already the case in Hungary, and it appears that Poland and a few others are following close behind. Indeed, there is further evidence that even the countries that are the least advanced in terms of privatization of capital seem to be heading in a similar direction.

5After identifying these three special features of the transition from communist to capitalist systems, I attempt to provide a unified explanation for all these features. I do so by carefully examining a single variable—the status of morality in transition economies. I chose this approach because, as evolutionary economics informs us, a moral order is at the foundation of all institutions. Moral order is about self-restraint, specifically about a sense of respect by each individual player for the other actors involved. This moral outlook assures a cohesive operation of all members whose actions, when routine rather then deliberate, create a given institution. For this reason, no major institutional change can be understood without a reference to morals, those of both officials who form the state and citizens who constitute the society.

6Taking the evolutionary position, I conclude that a decline of morals was most critical for the initial stage of transition—the demise of communism. Specifically, officials—particularly the party cadres—decided to abandon the public agenda for private, often illegal, gains. Some may reject this statement as implying that communism at some point relied on public virtues, but to retain order for an extended period it had to have this quality. Otherwise, for instance, coercion will not be correctly applied by the rulers and approved by the ruled at a cost that the rulers can afford. Officials underwent this change of mind after realizing that the system that provided them with positions of great power offered them only mediocre material rewards and little protection against possible job termination. While the party/state members played the key role, society—the citizens—knowingly went along with the corruption of the officials, which helps explain, in part, why this collapse was so docile.

7This largely unnoticed and negative turn in public outlook at the conclusion of communism was difficult to reverse, since morals, given their inherent fragility, tend to further deteriorate once they are upset. This trend has not been reversed anywhere in the region. Instead, an antipublic spirit has been allowed to flourish. Unleashed under these conditions, reforms have been shaped by officials who above all have sought additional opportunities to attain personal gain through corruption. Given the insecurity of their positions—in part related to the prevalence of corrupt behavior itself—officials have preferred actions with immediate payoffs, even if such actions are clearly adverse to the public at large. This explains why the second stage of transition everywhere in the region assumed a radical and often misguided form. Radical reforms, in turn, mostly by means of creating financial adversities, have collectively forced the respective transition economies into recession.

8The collapse of public virtues also explains the third stage of transition, since only under these conditions of broad-based corruption by officials and indifference of the citizenry would these countries have engaged in a wholesale, rather than only selective, transfer of assets to foreigners. The same financial adversities—due to a crippled banking system and minimal protection from imports—that caused recession have reduced domestic buyers’ ability to make their acquisitions profitable. Unable to survive on their own, state-owned enterprises have been forced to seek foreign financing, which has been forthcoming almost exclusively in the form of payment for assets. This transfer typically has taken place under nontransparent procedures and without proper parliamentary oversight. Within this framework, state officials have been able to offer preferential access and discounted prices. In their search for illegitimate gain, they have favored foreigners, since most are more resourceful in providing payments and/or lucrative positions.

9The final judgment of transition depends less on the fact of recession, for recessions come and go, and more on the type of ownership, which will determine economic performance for decades to come. In such terms, the only conclusion to be drawn is that the transition has been a serious failure. By analyzing the whole process more carefully, we see that the ownership—and market—structure in Eastern Europe is basically left unchanged. Under the communist system, public property dominated, and under the emerging system of—let’s call it—“incomplete capitalism”, private property rules. This represents a major change, though at the same time foreign capitalists are replacing the party/state as the principal agents holding decision-making powers and claims on income from capital. This represents, of course, an important continuity, since in both cases, as a consequence of nationalization under communism and as a result of privatization during postcommunism, the domestic capitalist class is largely missing from the social picture (with the market continuing to be dominated by highly concentrated entities that enjoy monopolistic positions).

10Replacement of the internal agency by a foreign one is not without consequence for the economies of the region, and this consequence may ultimately be negative. When domestic agents—even those as inefficient as the communist party—are largely substituted by foreign agents, this provides an opportunity for an illegitimate and undeserved transfer abroad of income from capital. This particularly may become a reality if the states are too weak to resist undue influence from foreigners and/or are unable to enforce fair practices (for example, business accounting, profit transfers, product pricing). Given the enormous weakness of the East European states, related in part to the corruptibility of their officials, “incomplete capitalism” may indeed prove detrimental to regional wealth. In the extreme case, losses caused by the extraction of undeserved income—rents—for use abroad may exceed the efficiency gains from foreign ownership.

The Theory: Morals (Public Virtues) and Institutions

11There are clearly certain economic issues that cannot be properly addressed without reference to morals, and most of these issues happen to be central rather than peripheral. Massive changes in institutions within which economic activity is conducted belong to this class of principal problems that call for bringing in morality. The transition to capitalism taking place in Eastern Europe is definitely such a case in point, but the current debate generally fails to focus on transition’s moral dimension. Formal aspects of reforms—rules of the game—are stressed, but informal aspects such as attitudes (values) practiced by economic agents are not. Consequently, a greatly distorted picture of the transition is offered, which adds to confusion among reformers and the public. Some major failings of the transition are either unnoticed or incorrectly viewed as insignificant developments or, in a more extreme version, they are seen as successes.

12While trying to introduce the moral dimension into the analysis of transition, it is important to note that the process of building capitalism in some form or another is not without precedent. History shows not only numerous successful attempts at establishing a genuine capitalist system but also numerous efforts that failed, leaving economies with inefficient institutions of a capitalist type. These diverse attempts have been carefully studied, particularly the positive experiences in building capitalism, such as the complex changes that led to the eighteenth century industrial breakthrough. Classical economists and other liberal thinkers (such as Hume, Locke, and Smith) have commented upon this historic period with particular insight. Therefore, it makes sense to borrow from their works in studying recent transitions to capitalism in Eastern Europe, or for that matter, elsewhere in the former communist economies.

  • 2 See Albert Hirschman, The Passions and the Interests: Political Arguments for Capitalism Before It (...)

13The classical thinkers understood—even took for granted—that capitalism successfully emerged in the eighteenth century as a product of people with strong moral convictions, solidly grounded in religious beliefs (a view that was later developed by Weber into a complex theory in reference to Protestant ethics). A principal figure among classical economists, Smith certainly believed that both religion and morality were essential in bringing about capitalism as an organizing principle. He believed, however, that religion, and not morality, would eventually be replaced by legal rulings. Smith also argued, overly optimistically, that the major justification for the capitalist system is its moralizing influence on fallible people2. Markets discipline people into decent behavior and material prosperity—which markets ensure—and thus make them less tempted to break moral rules as well.

  • 3 See Peter Berkowitz, Virtue and the Making of Modern Liberalism (Princeton: Princeton University P (...)

14Classical thinkers accordingly assumed a central role for morals, which were defined as powerful but fragile guidelines for actions that can benefit others—that is, the public. Thus, they firmly believed that economics as a social discipline is a moral science where morals are a central category in explaining behavior3. The classical thinkers also placed great emphasis on the role of institutions in guiding economic activities, with institutions understood by them subjectively—that is, as being formed by agents’ morally driven behavior. This was an individualistic, rather than collectivist, view of institutions, which are said to emerge when individual actions become both regular and routine in nature. In this way, the so-perceived institutions make up social systems, and when morals alter agents, they revise their mode of action. This revision, in turn, changes the whole social system.

15Taking one extreme case of such change, when morals collapse across the board and agents turn sharply away from the public good, the unavoidable consequence is that the respective social system collapses as well. But this eventuality was of no concern to the classical students of capitalism, not only because of their unshaken optimism, but also because their era was one of strong morals. Paradoxically, later in the development of capitalism when these moral foundations had been periodically fractured, followers of the classical school were no longer well equipped to address this aspect. The original classical perspective concerning the nature of institutions has been largely discarded or forgotten by its modern followers—neoclassical economists. This is true insofar as they assume morals (and institutions) to be given. Alternatively, neoclassical economists do not directly address the moral (and institutional) dimensions in their models at all.

16Interest in institutions, however, has not vanished from economics, as evidenced in the great currency recently earned by the so-called neoinstitutionalists, such as North and Williamson. They surely stand out in this respect, since they find institutions central to our understanding of economic processes. They also assume that institutions are external to agents, and as such, institutions impose norms on agents. In this collectivist approach, the genesis of norms in general and morals in particular is not explained. For this reason, norms are not afforded a truly independent status. With this approach, neoinstitutional theory is quite suitable for comparative-static analysis, including how economies operate under various forms of markets. It is not prepared, however, to engage in intertemporal—dynamic—analysis (for instance, one that tries to figure out how markets emerge and submerge).

  • 4 Joseph Schumpeter, Capitalism, Socialism and Democracy (New York: Harper and Row, 1942).

17Only the so-called evolutionary economists—following Hayek, Mises, and Schumpeter—continue the early tradition, in which values, both private and public, are an independent economic variable (paying less attention to Smith and more to Malthus, who preceded him). This attention to morality is especially clear in the work of Schumpeter, particularly in his examination of the origins and fate of the capitalist system4. He argues that the capitalist order was animated by rationally thinking and profit-seeking actors, but that this order could not have emerged if not for the moral tradition of feudalism. Capitalism needs feudal groups— aristocrats, clergy, and military—for their moral makeup, which is not a product of reason alone. These feudal values represent a protective shield against the self-destructive instincts of capitalist groups themselves. If the protective strata, as he calls the feudal groups, are undermined, the capitalist system will collapse, giving way to some form of socialism.

  • 5 Friedrich Hayek, The Fatal Conceit: The Errors of Socialism (Chicago: University of Chicago Press, (...)

18Hayek also argued forcefully that morals are critical for the working of economic institutions, though his most elaborate remarks on this point came late in his life. Hayek holds that there are certain principled rules of behavior that constitute a prerequisite for the survival of human beings. Most important among these rules are moral practices, and since institutions are formed to aid men in their struggle for survival, institutions have to conform5. There is only one general set of moral rules that assures a continuity of human life, which happens to be the one on which capitalism is based. Socialism, with its own rules of conduct, does not have this capability and for this reason is not feasible for any extended period. Most importantly, putting people under a collective—totalitarian—rule damages their ability to exchange information at an acceptable cost, and this in turn undermines economic calculus and leads to inefficient production.

19This view of Hayek is contrary to the more affirmative position outlined by Schumpeter, who argues that as long as people believe in socialist ideals, socialism, as a complex system, may actually work. Being himself a strong advocate of capitalism, Schumpeter agonizes over what he perceives to be a rather inevitable drift towards various forms of socialism. These forms, in Schumpeter’s view, include the labor-controlled system of Great Britain, the national socialism of Germany, and the state communism of Soviet Russia, all of which were contemporary to him. This possibility is particularly real for less extreme forms of socialism, such as the one in Great Britain. In such a system, ownership of assets remains private, but trade unions through the state control the appropriation of capital gains. According to Schumpeter, having an efficient state apparatus ready to execute any agenda, such as Great Britain had at the time, makes the working of socialism much more feasible.

  • 6 Karl Popper, The Open Society and Its Enemies (London: Routledge and Kegan Paul, 1945).

20The focus on morality was not shared by all of the early evolutionary scholars, including as critical a voice as that of Popper, who stayed away from moral issues his entire scholarly life. This fact has been recently highlighted by Soros in his effort to revive Popper’s theory of social change and of capitalism in particular6. Soros correctly observes that Popper takes the sound morals on which capitalism must be founded as a given. For this reason, Popper—like Hayek—was of the view that capitalism, as an “open society”, faces one threat—that of socialism. Socialism, as an irrational return to a “closed society”, represents a threat because it is based on a collective principle, a group dictate, rather than on an individualist principle, which calls for freedom of choice. But, as Soros argues, capitalism may also be mortally threatened from within, when individual freedom is taken to an extreme and markets take over, causing the moral order to deteriorate.

  • 7 Soros, Global Capitalism.
  • 8 Karl Polanyi, The Origins of Our Time: The Great Transformation (London: V. Gollancz Ltd., 1945).

21An important addition by Soros, not just to Popper’s theory but to evolutionary thinking, is his effort to demonstrate that the greatest risk to capitalism comes from global markets7. Global markets emerge when national markets are united. Such merger is possible only as a consequence of states giving up their prerogatives over national economies. This release would make no difference for the status of capitalism if nation-states were replaced with supranational agencies. Then such agencies could provide (political) restraint on markets that would assure those markets deliver outcomes that are morally acceptable. But it is much more difficult to design such controlling mechanisms at the global level than at domestic ones. Consequently, when capitalism becomes global as it has nowadays, the greatest internal threat to the system is expected to come from the operation of global markets (a point that echoes the arguments of Polányi8).

22Soros further argues that, if left without political restraint grounded in sound moral practices, global forces cause an unequal distribution of welfare gains from cross-border exchange. Financial capital is best prepared to take advantage of liberalization, followed by industrial capital, while labor is likely to gain the least. This is due to different levels of flexibility enjoyed by all three of these productive forces in terms of reallocating their activities around the world in search of the best yields. The differences in factor flexibility in part are purely technical, for clearly it is easier to move money than fixed capital, and labor is physically the hardest to move. This allows the countries that enjoy advantages in financial services to raid economies with underdeveloped banking. Stronger economies can be predatory on weaker economies through unfair—monopolistic—practices and, if necessary, by means of instigating costly financial crises in the latter.

The Origins: Peaceful Collapse of Communism

23Let me begin with a clarification of my evolutionary position by taking a closer look at the first stage of the transition, its initial conditions as determined by the collapse of communism. Given the general belief that the communist system was not only economically wasteful but also morally deplorable, its collapse should have resulted from forceful rejection, or revolution. That is what usually happens when morally inspired masses, their rage doubled by economic suffering, employ force to take power away from their rulers, seen as perpetrators of immoral acts. It is this highly morally charged atmosphere that leads disfranchised masses to suspend concern for the legality of their actions. By decisively ousting the rulers, the masses assume power, and in doing so, they infuse the state—in their view at least—with a sound moral understanding.

  • 9 Kazimierz Z. Poznanski, “An Interpretation of Communist Decay: The Role of Evolutionary Mechanisms (...)

24But there is no evidence to suggest that the cause of communism’s downfall in Eastern Europe was revolutionary in nature, and nowhere did the masses overthrow the party or, more correctly, the party/state. This was most apparent in places like Russia or Romania9. In these countries there were no real opposition forces, but merely small groups of vocal dissident intellectuals who posed no threat to authorities well equipped with coercive means. Here the masses remained passive even during political change, while in other places where there was no real opposition, as in Czechoslovakia and East Germany, people took to the streets only when the authorities were ready to abdicate. In Poland a broadly based and organized opposition movement failed to mobilize the masses for the final showdown with the party in 1989 (for example, appeals for a general strike were largely ignored).

25Not only were the masses universally passive at the time of power transfer, but there is no evidence that they succeeded in displacing the party cadres in the months following the collapse of the respective regimes. Retribution against former functionaries has been rather mild, even in east Germany, where massive legal campaigns to scrutinize former apparatchiks were launched. Elsewhere, sanctions simply did not materialize, even in Hungary, with its strong and painful memories of the brutally crushed 1956 uprising. In fact, many former cadres were allowed to engage in public activities, including political life, and nowhere, not even in east Germany, were the former parties prohibited from engaging in the new political process (not counting an episode in Russia in 1991, when the Communist Party was temporarily banned from politics but reinstituted after a successful legal challenge).

26In light of these facts, there seems to be little choice but to admit that in all probability the collapse of the communist systems was engineered largely by party/state officials themselves. In the minority of cases, the party monopoly ended through a relatively orderly process of negotiation, dragging the opposition along almost against its will, as was the case in Hungary and Poland (where through most of 1989 representatives of the opposition repeatedly rejected initial invitations to join talks with the communist leadership on reforming the political system). In the majority of cases, political change was contrived through intraparty power-brokers, usually without resort to violence (except in Romania, where the ruling clique was ousted in a bloody putsch by a military faction, and in Russia, where the ruling group lost power as a result of its failed, rather grotesque, and—most importantly—almost completely bloodless putsch).

27This explanation of the communist collapse would be incomplete if it didn’t also offer a plausible indication of what might have motivated the members of the party/state to relinquish their monopoly on power. The answer I propose is that, somewhat paradoxically, they did so because of the very power monopoly afforded to the party. To persist, such a monopoly required a commitment that at a critical point proved inconvenient to the interests of the officials themselves, the party cadres and state operatives. Some have speculated along these lines that at this juncture the party members came to realize that the existence of the communist system put them in an unattainable position. Namely, that the system made them solely responsible for the general welfare of the people while concurrently offering the masses only weak incentives to create the material wealth needed to continuously feed overblown social programs.

28In actuality, party/state officials found the communist regime inconvenient for another reason: namely, that at some point their perception of their own roles within the system dramatically changed. As long as the party cadres and state officials believed they were empowered to assure a better future for the people, they behaved as a more or less cohesive group to protect the powers of the party/state as an obvious precondition for meeting this objective. But this general attitude vanished when they individually chose to pursue the path of personal betterment, even through corrupt measures. In the new mode, they began to act as individuals indifferent to group power, and in so doing they began largely unintentionally, though systematically, the process of undermining the party/state.

29This was a predictable change of attitude on the part of officials insofar as it grew out of the worst flaw of the communist system: namely, the extreme concentration of power in the hands of the rulers. This power monopoly enjoyed by the party/state at least potentially gave officials immunity from social recourse for any corrupt behavior on their part. In the initial period of communism, officials did not engage in corruption on any substantial scale because the system of internal control had party members routinely policing each other. However, when the officials’ collective sense of public duty was replaced by the pursuit of private vices, the system of self-policing went with it. At the same time, the state and the party retained their immunity from society’s revulsion over the state’s neglect of public interest by officials.

  • 10 Kazimierz Z. Poznanski, Poland’s Protracted Transition: Economic Growth and Institutional Change i (...)

30The masses—those outside the party/state—could not be unaffected by the communist regime’s principal design either, for in their case the political system rendered them powerless. As such, communism drove citizens toward a sense of irrelevance, and inevitably that caused them to endorse the extreme selfishness of authorities uninterested in the public good. While the officials gradually turned away from public responsibility to casual corruption, citizens abrogated their public concern for the pursuit of narrow gain (only in some places, like Poland, was this trend mitigated from within dissident forces by elements appealing to a higher morality by, for example, Kurort and Michnik). Due to this inward turn toward individual consumption and a focus on private life, support for the party/state was undermined as well, which in turn accelerated its eventual political demise10.

31But the party/state was not only eroded through a spontaneous withdrawal of officials and citizens from public obligation. The party/state and society also engaged in a more or less systematic dismantling of the regime, though mostly without declaring their goal to be the complete disposal of the planning machinery. Whatever the declared goal, these changes were largely undertaken to ease the pressure for the legality of actions and equality of outcomes, for which the party/state, however deplorable its basic design, initially seemed to stand. Through this device, both sides—officials and citizens—acted in unison, though without explicit coordination, to expand opportunities for the unrestrained quest for selfish gains. This is how the rationale for the incessant, almost endemic, communist reforms should be understood.

  • 11 Ken Jowitt, “Soviet Neotraditionalism: The Political Corruption of the Leninist Regime”, Soviet St (...)

32Ample evidence shows that at the end of communism, the party/state had become exceedingly corrupt, most visibly in the former Soviet Union (adequately captured by Jowitt11). Already under Brezhnev, officials started haphazardly engaging in taking bribes and misappropriating public funds while introducing the nomenklatura system that reduced the risk of punishment. This was largely unnoticed by most experts in western academia who were preprogrammed to seek evidence of a technocratic evolution in the Soviet polity (consistent with modernization theory). They also failed to acknowledge that further institutional reforms under Gorbachev were aimed at expanding profit-oriented activities (for example, the formation of cooperatives) and thus indirectly increased the room for corruption by officials.

33This trend within party/state membership in Russia was paralleled elsewhere. This was quite certainly true in the familial, or kinship, version of communism found in Bulgaria and Romania as well as in embattled communist Poland. In Poland, major changes first took place under Gierek, when embezzlement became frequent, though less dramatic than in Russia. Instrumental was the introduction of open planning with flexible targets and limited supervision as well as the policy of concentrating production in the powerful middle-level industrial bureaucracies. This process largely accelerated after Gierek’s forced departure, with various import concessions conferred on the nomenklatura, and subsequently, during Rakowski’s brief rule, with the introduction of the largely unsupervised self-privatization of public assets by the nomenklatura.

34Thus, even with all the allowable and undeniable cross-country differences, the communist system in Eastern Europe did not collapse under any kind of frontal anticommunist assault by the masses, but from an internal rot (without denying the corrosive role played by external pressures, particularly the very costly arms race with the capitalist world). The system tumbled from demoralization, or retreat from public virtues, by both the party/state and the masses, which were mutually reinforcing. The fact that officials and citizens shared concurrent motives also explains why this collapse was devoid of violence directed at the party/state as well as a lack of vengeance toward its former members. This confluence of opinion also reveals why in the final days of the communist collapse there was no direct clash of ideas, morally grounded or otherwise, between the party/state and the masses.

  • 12 Ernest Gellner, “Homeland of the Unrevolution”, Daedalus 122:3 (Summer 1993).

35Those who hold a conventional view of communism may reject this analysis, since in their eyes it would imply that communism, at any point, relied on public virtues; hence, that it was grounded in some moral code. According to this view, communism was a system of arbitrary verdicts unconstrained by morality rendered by an overpowering party elite and by its leaders in particular. But any realistic student of societies will have to admit that to retain order for any extended period of time, communism as much as any other system had to have some type of moral authority. Specifically, moral restraint or guidance was necessary under communism to make sure that force, or coercion, was correctly applied by the rulers and approved by the ruled. The communist system can be questioned on moral grounds, but this does not preclude that for much of its existence, it was a moral order. And, as Gellner stresses, it was a moral order that had a remarkably powerful appeal12.

36It appears that Soros is among the few students of communism who, like Gellner, recognize the fact that communism was a moral order and that its demise was not caused by the lack of such a complex order. According to Soros, it was an uncritical (excessive) application of its organizing principle—primacy of the collective—that forced the system into decline. This is true, as Soros argues, about any kind of organizing principle if it is left without critical reevaluation in an open space, including the moral base on which capitalism is founded. The threat to capitalism comes from a similar lack of criticism that makes it impossible for people to comprehend the limits of its organizing principle—the primacy of the individual. But, of course, threats to communism or capitalism come not only from within these systems. These systems represent a direct threat to each other, for their organizing principles are exclusive or incompatible.

37However, while Soros’s theory posits that pushing the individualist principle too far is a destructive force for capitalism, he does not find excessive individualism responsible for the communist collapse. Since perverse individualism is synonymous in this theory with demoralization, this means that moral decay so understood is not to be blamed for communism’s demise. Excessive stress on the primacy of the collective was, as already stated, the underlying reason for the system’s agony, but it is necessary to understand how this itself could take the system down. Such a dogmatic application of the collectivist principle could drag communism to its final demise only by destroying any sense of collective (or public) responsibility. In other words, excessive collectivism becomes destructive when it eventually causes the release of its opposite—an unrestrained individualism, or demoralization.

38My alternative interpretation of the communist collapse leads to the view that among all the legacies of communism, or how communism has affected postcornmunism, the most relevant is the condition of moral decay. This negative legacy posed a serious risk to subsequent systemic reforms—the process of transition—certainly sufficient to the point of distorting or even permanently derailing them. The risk was indeed very serious, since once the process of moral decline begins, it tends to worsen, and reversing this moral deterioration becomes increasingly difficult. Behavior once judged immoral is redefined as moral. To make matters worse, things once considered moral are redefined as questionable. Human vices intensify, and yet people feel neither apprehension nor the desire to fundamentally rethink their own moral positions.

39This critical fact about the disintegration of public virtues in late communism, however, has been largely lost in the ongoing discourse. The romanticized version of events—the earlier identified claim that the collapse was brought about through a revolution—has won the day. This claim is certainly gratifying for those who see themselves responsible for overthrowing the communist system, mostly intellectual veterans of the old opposition. These individuals, in some confused way, ended their fight with the old regime by making the very same claim of revolutionary breakthrough as that manufactured by the communists when they originally instituted their authoritarian systems. However gratifying, this distorted and remarkably persistent view of the collapse of communist systems has greatly increased the risk of the postcommunist transition’s derailment.

The Process: Unprecedented Economic Recession

40Although the collapse of communism was uneventful, the same definitely cannot be said of that which followed. At the time when reforms were assumed to bring about capitalism, all reform economies saw their global production fall and unemployment rise in an invariably dramatic fashion. Collectively, the region saw its production decline by a weighted thirty percent at its nadir in 1994, and a one-fifth loss of jobs was not uncommon (with east Germany reporting an initial one-third loss and Poland a one-quarter loss). Many countries, including Russia and Ukraine, have not yet arrested their recessions, while some have moved strongly out of recession, as in the cases of Poland, Slovakia, and Slovenia. Other economies managed to reverse their decline only to enter a second, possibly briefer, recession, like Bulgaria in 1996-1997, the Czech Republic in 1998, and Romania in 1997-1998.

41With this kind of performance, Eastern Europe as a whole will not return to its prerecession level of production until fifteen—or even twenty—years after the initiation of reforms (though in Poland, for example, this whole cycle lasted only seven years). This means nothing less than the permanent loss of fifteen years of economic development, since at the point of return to the prerecession level these economies will be traveling along a different—and lower—trajectory than the one they would have followed had the region been spared the downturn altogether. Economic assessments of the current recession often miss this point, and it is omitted in assessments of the only case of recession under communism—namely, that of Poland from 1979 to 1982 (with a drop in output by twenty-five percent, compensated for only in 1989 when the lower growth trajectory—in this case, the first—was resumed).

42This recent recession in Eastern Europe is an incredible economic phenomenon, by all accounts the worst in modern history, even when compared to the Great Depression of the 1930s, which shaved ten percent off overall production but was over in about five years. During that period, no country saw its production fall by one-half, as happened recently in Russia and Ukraine, or by sixty percent, as in Lithuania’s case. The worst losses of the 1930s were in Germany and the United States, where production fell by about one-fifth (close to the least-affected East European economies, like the above-mentioned Poland and the relatively successful Hungary). While such quantitative comparisons with the Great Depression are made on occasion, there is still a great reluctance to treat them as comparable cases, usually on the grounds that each was driven by completely different forces.

43Since this economic downturn occurred everywhere in the region, it might really appear—and it does to quite a number of economists—as nothing but the legacy of communism. Such an explanation appears to many as a plausible answer due to the general perception that the communist systems were very inefficient, if not irrational. In fact, the systems allowed quite a bit of waste, even tolerating production that did not respond to real demand but was kept alive through unconditional state subsidies. Since elimination of these subsidies was a predominant component of post-1989 reforms, such misdirected—usually called “unwanted”—production had to be eradicated, implying the need to fire workers. For these reasons—absent during the Great Depression—the postcommunist recession must be viewed as inevitable, a view widely shared among economists, particularly those involved in the reforms.

44If the recent recessions were caused only by this destruction of unwanted production, there would be no reason for concern, since eliminating production for which there is no effective demand cannot lead to welfare loss. Moreover, the release of misused capital and labor from unwanted production would instantly translate into a gain in resources for the creation of wanted production, thus leading inevitably to economic recovery. But the statistical data, admittedly subject to some imprecision, shows rather unequivocally that actual production losses in the region were much more dramatic than the removal of unwanted production would imply, with much the same losses registered in both the subsidized, or presumably unwanted, and profitable lines of production.

45In Poland, production declined sharply in all three areas where households felt most deprived during the days of communism. Shortages of food were common, but agricultural production fell by at least fifteen percent from 1990 to 1992 and showed only a modest increase thereafter. Shortages were also prevalent in housing, but construction declined by seventy percent before 1993, falling back to the 1954 level and not yet rebounding. Automobiles were desperately sought during the communist years as well, but in 1990-1991 production of automobiles declined by one-third and, significantly, only started picking up when the domestic (internally designed) model was revived. This model, with only minor technological changes, represented the single best-selling car (mostly among farmers) until it was recently discontinued.

46It is also a mistake to assume that subsidies are always attached to unwanted output. Housing and automobiles were not subsidized, while farming was. Here, subsidies have been sharply reduced since 1990, which proved a grave policy mistake rather than a correction of communist errors. These were not subsidies for unwanted production, and Poland’s agricultural policy was not out of line with common practice among industrialized countries under communist rule. In both groups of countries, subsidies were at that time on average about fifty percent of production costs. Since 1990 East Europeans reduced such transfers to about ten percent on average, and in the Czech Republic and Hungary, both very strong food exporters, down to five percent. In most cases, subsidies have not increased since, and in a few countries transfers have been raised, though not to pre-1990 levels (for example, in Poland subsidies to farmers first went down to fifteen percent and then were raised to twenty-five percent in 1998).

47While the removal of subsidies cannot be viewed as a completely harmless measure, this reform alone could not explain the uniform, dramatic production downturn. This economic catastrophe has to be explained by reference to forces more powerful—and lasting—than a removal of subsidies, however radical and misguided. To provoke a recession of this magnitude, the whole economic system would have had to collapse, unless there were some comparable external shocks, which did not exist in this case. At the outset of the transition, the economic system in Eastern Europe was almost completely state-based, the state being the exclusive owner and production manager. Thus, systemic crisis would have to be preceded somehow by state crisis. This is what happened in the region, mostly due to the reformers themselves. The reformers provoked the state crisis by reducing the state’s capacity to govern beyond the levels required for other agents (producers and consumers) to act efficiently.

48The effects of this state overwithdrawal can be seen in the financial sector, where after rushed commercialization (that is, the introduction of independence in decision-making but also an advent of self-financing) banks lost adequate state insurance and even prudent supervision. Consequently, they refused to extend credit to producers to assist in their times of need (and turned instead to money-seeking states as more secure borrowers). Furthermore, the quick removal of import controls cost producers profits, worsening their financial condition. This deprotection—or tariff reduction—also resulted in increased uncertainty. Uncertainty over financial outcomes was further aggravated by the announcement of rapid privatization lacking a clear-cut design and timetable. This process, often combined with the rupture of existing organizational ties, left producers unsure of their continued ability to support their production. Faced with these two adverse developments at the same time—a liquidity crisis and additional uncertainty—all producers responded rationally by reducing production efforts.

49This argument suggests a direct link between the depth of the recession in Eastern Europe and the state’s inability to manage economic affairs (that is, aid market development). Indeed, ample evidence supports this correlation. The most radical reform countries are also those in which recession was the worst. Of all cases, east Germany is among the most radical—if not the most radical—with an instant opening of trade and a two-year complete privatization program that no other country has matched so far. By the same measure, Russia, despite all the obvious differences in the particularities of respective reform packages, can also be viewed as a very extreme case. Both have suffered some of the worst declines, with east Germany losing a third of its production in just one year and Russia losing half of its output during the first eight years (and most likely awaiting another decline in 1999).

50In this context and using the same indicators, Poland and Belarus have to be seen as less, but still quite, radical cases of transition. Contrary to common characterizations, Poland is not one of the most radical reformers, surely not in terms of privatization. Currently, Poland has divested less than half of its industry. After a quick restoration of relatively high selective trade barriers (for example, for cars and foodstuffs), Poland is one of the most protectionist economies in the region. Still,

51Poland had suffered a lesser, though year longer, recession than did east Germany, and Poland’s economic recovery has been far more impressive (with east German industry still one-fifth below its prerecession output). And, if one dares to be fair, Belarus, with even less-advanced systemic change than Poland’s, looks at least on paper much better than super-radical Russia (for example, the Belarusian economy lost not half, but about two-fifths of its national product).

52After this thorough analysis of recession, one important question remains: Why would the East European countries, one by one, engage in such radical reforms that would have such excessively adverse repercussions for the institution of the state? This question can be answered in terms of an underlying change in ideology. Specifically, after dropping Marxism, a new, liberal ideology has been adopted with an openly antistate attitude, perceiving reforms as a simple substitution of the state by the market. This explanation is typically offered by critics of the radical approach to transition that, in accordance with the liberal interpretation, called for a swift downsizing of the state agency. Such criticism is coming as much from those who represent a prostate (statist) position on the transition as from those who take the individualistic stand that characterizes the evolutionary approach to postcommunist reforms.

53At this ten-year point, it is quite clear that the ideological shift has undoubtedly been a factor in such countries as Hungary and Poland, where the transition approach has become an important issue for public debate. However, this is not the main factor responsible for the radical reform course taken, for surely some of this radicalism should be viewed as a consequence of insufficient experience by the reformers. Their knowledge of liberal theory was as insufficient as their preparedness to manage the economy indirectly, and they wrecked some of the vital elements of the inherited state-based system by mistake. Even more important, if not essential, for the initially excessive dismantling of the state has been the force of narrowly defined personal or political (party-related) interests of state officials themselves.

54Accepting this latter, less benign explanation, the main reason for the attack on the state was the fact that the largely unnoticed negative turn in the public outlook at the conclusion of communism was not reversed, but was allowed to intensify with the introduction of transition. Unleashed under these conditions, reforms have been shaped by officials who mainly sought additional opportunities to achieve personal gain through corruption. Given the insecurity of their positions— in part related to the prevalence of corrupt behavior itself—officials have preferred actions with immediate payoffs, even if clearly adverse to the public at large. This best explains why reforms—the second stage of the transition—assumed a radical and often misguided form everywhere in the region, negatively affecting the state’s capacity to assist emerging markets.

55For instance, rapid bank commercialization has disabled the state, making it unable to allocate money to needy companies. This step provided officials with some of the most lucrative jobs, where salaries are at their discretion and money is spent without close scrutiny (for example, on advertising campaigns for hefty kickbacks). Similarly, the removal of import tariffs, while depriving the state of income from duties, has enabled selected officials to benefit—for gratification—as importers or move themselves into jobs in the import sector. A perfect example is the abolition of alcohol tariffs and of the state monopoly for alcohol to enrich a few, while leaving the state, as in the cases of Poland and Russia, with a big hole in its budget (so much more damaging because of the serious inefficiency of tax systems).

56This is also true for privatization, which probably provided the greatest opportunities for the attainment of illegal proceeds, given both the enormous—accumulated over decades—volume of assets involved and the quick and relatively unsupervised, at least from the public point of view, manner of asset disposal. The fast pace of the divestment process has made it difficult to monitor if the state is actually getting fair prices for its assets. Under a short timetable, careful valuations of assets held by privatized companies are essentially impossible. However, these rapid sales provided officials with the tempting prize of becoming owners by taking over capital for nothing or at large discounts. Alternatively, officials assumed unrestricted control of remaining state property in order to plunder without regard for the value of capital. In other cases, divestment provided officials with the opportunity to become brokers, guiding public capital at favorable prices to others in exchange for kickbacks (that is, lucrative and secure jobs and/or monetary gratification).

The Destiny: Foreign Owned Capitalism

57Since so many countries are coming out of the recession, the negative impact of reforms on the economic system might be seen as subsiding and capitalism assuming a normal form. This should be particularly true in the economies that have been the quickest to establish the capitalist institutions needed for recovery: for example, in Hungary and Poland, where the share of private ownership is almost as high as in Western Europe. The sense of normalcy in Eastern Europe is very strong among economists, with some even extending this characterization to recession-ridden Russia, where private ownership also dominates. But the process of switching to private property in these countries, particularly those with the best economic performance, has created an abnormal form of capitalism where most private assets belong to foreigners and labor remains local.

58The major vehicle for the rapid expansion of foreign holdings in Eastern Europe has been privatization and not the establishment of new (green-field or joint-venture) entities, the process of which already has been completed in east Germany. In this undeniably special case, the west German state agency sold almost all capital directly to outsiders— west German investors—in the remarkably short timeframe of two years. A similar process has taken longer in Hungary, with most of the direct sales concentrated during the 1996-1998 campaign to rapidly dispose of public capital. While privatization has not yet come to a close, nonetheless, foreigners already control seventy percent of Hungary’s industry and banking (with the balance of assets left with mostly loss-making entities that are kept alive by the state through steady bailouts).

59As for the Czech Republic and Poland, the respective proportions are thirty and thirty-five percent for industry and twenty-five and fifty percent for banking, and these numbers are steadily increasing in both cases (with Poland ready to sell its last major viable bank to a foreign strategic investor in 1999 and with Czech leaders on the verge of doing the same with their few remaining major banks). In the Czech case privatization has been much faster than in Poland, for the former resorted to a voucher, free-of-charge distribution of assets to citizens while the latter resisted such a method. Poland has relied mostly on leveraged buyouts for smaller units and sales for larger ones, but Czech reformers also allowed sales to take place. It is acutely through direct sales that they transferred some of the most valuable assets to foreigners even before voucher privatization started.

60Presently, foreign ownership in other East European economies is not as widespread; though indications are that these states are also on their way to establishing foreign majority-owned capitalism. This is certainly true of Russia, where after fast privatization (comparable with that of the Czech Republic) the state holds only small equity in some key sectors. The situation in Russia is very nontransparent due to the fact that many legal titles remain unclear. There is even evidence of such titles not always being available, making it is quite difficult to gauge the extent of foreign involvement. However, there is enough evidence to suggest that foreign holdings in industry, particularly in the extraction of natural resources (for example, many oil companies have large foreign stakes), are sizable and expanding. Another such case is banking, where reportedly as much as twelve percent of assets are in foreign hands (with banks largely engaged in asset acquisitions).

61Where privatization has been delayed, foreign penetration has been even slower, with Bulgaria and Romania being good examples. Both countries tried to engage in divestment, contemplating Czech-style distribution as well as Polish-style fast paced sales, but with limited results. However, the newly elected governments have quickly made clear that they are ready to engage in massive divestment to close the lag. The new coalition government in Romania has already sold many assets, often in some of the most critical sectors (which typically are to be considered for privatization at a later date). Romania began its spurt with one such sector: telecommunications, with a big chunk of the state phone monopoly going to a foreign buyer. The automobile industry is another case in point, with the only passenger car plant—one of the flagship industrial companies—sold to a single foreign investor. And most recently, the only major bank—accounting for one-quarter of the domestic market— has been designated for sale to a foreign strategic investor.

62Furthermore, it will be hard for any country to escape the trend, since no variant of privatization attempted thus far has produced different results. The best evidence comes from Poland where, unlike in most other places, all major methods have been tried, including the sale of assets either directly or through subscription. This method undoubtedly gave officials leeway in determining which domestic and foreign buyers would get the assets, but invariably, and from the very beginning, it was the foreigners who clearly had the upper hand. This bias in favor of foreign investors did not meet with much contempt from the workers, who were coopted by officials through attractive equity packages (initially contributing up to ten percent of the initial offering at a discounted price and more recently up to fifteen percent for no payment).

63The Polish experience also demonstrates that investment funds created in connection with voucher privatization programs (also called “democratic capitalism”) have turned into another vehicle for transferring assets to foreigners. Intended to block foreigners, Poland’s own limited approach to the Czech style of free distribution did little to thwart foreign acquisitions. Unlike in the Czech case, the Polish program required that vouchers be deposited with the state-appointed fixed pool of funds. These funds were directed to find new owners for the assigned pool of about five hundred companies. By now it is clear that, at least among the viable units, a majority has been handed over to foreign buyers, though usually after complicated negotiations. These extended talks were needed to ensure that shares, which were initially dispersed among funds, are consolidated into packets sizable enough for foreign buyers to accept them.

64Nor is there evidence thus far to suggest that the political orientation of respective reformers has mattered much for access to assets by foreign owners. Apparently, even major shifts on the political scene do not affect decisively the pattern of privatization in the respective countries described here. True, there is considerable evidence that reformers linked to the former communist—now mostly renamed and turned socialist— parties tended to be less willing to turn assets over to foreigners. But there is at least one striking exception: Hungary, where privatization started slowly under the anticommunist (conservative) opposition government, but was greatly accelerated under the 1994 coalition government built around the former communist party. During this latter stage, the value of privatized assets doubled in just a few years, and at the same time the majority of state capital—particularly in the financial sector— was turned over to foreigners.

65In the Polish case, the post-1989 coalitions linked with the anticommunist opposition, with Balcerowicz as their main champion, have presided over the most aggressive period of selling assets to foreigners. In contrast, while positively predisposed to divestment, the forces rooted in the old-time parties were rather reluctant to pursue sales that benefited mostly foreigners. When these parties were elected in 1993, the pace of privatization was slowed and efforts were made to favor domestic buyers, allowing for the solidification of domestic capital groups (also called holdings) within industry. Preparations were also made to consolidate banks that were still owned by the state to make them less vulnerable to foreign takeover and to further fortify them by merging them with domestic capital groups. With all these efforts, the majority of privatized capital was still being sold to foreign buyers (for example, cement, tobacco, and household chemicals).

66This trend has not reversed since 1997, when the former communists (and their Peasant Party allies of the old days) lost a very close parliamentary election. The election was won by a coalition of forces led by a union-based cluster of parties allied with the smaller party of Balcerowicz that represented the core of the first postcommunist government. The union-based forces were widely expected to take an even harder position on foreign takeovers, but nothing of this kind has happened. In fact, the pace of privatization has greatly accelerated, and no serious effort has been made to fulfill the election promise to begin a large scale, Czech-style distribution of state assets. The coalition, with Balcerowicz again as the main reform architect, has been pursuing a radical program expected eventually to quadruple state revenues from sales by the end of 1999. At the same time, most assets have been targeted to foreign buyers, including assets in the most capital-intensive sectors (for example, telecommunications, steel, energy).

67If all countries, despite the various privatization methods adopted, seem to be converging on the same end point, some common underlying forces must be at work. This common factor is that the initial reforms have seriously undermined the financial health of most domestic companies, leaving many of them with no profit and burdened by heavy debts. New domestic investors seeking to turn these companies around would require a massive infusion of money that, with the damage done to banking systems and endemic problems with state budgets, has not been forthcoming. This liquidity crisis has extended beyond the early stage of the transition, even in the economies that are recovering. Here as well, banks have remained reluctant to issue credit to private parties, and states have not assumed more active financial policies.

68Many states could administer some form of import protection to help domestically owned companies to start generating healthy profits. Instead, most states early in the transition implemented an open trade policy through official tariff reductions, driving down tariffs to levels hardly known among most other countries at a similar level of development. Alternatively, massive smuggling, often assisted by the state (as in Russia and Bulgaria) has opened respective transition economies to severe import competition. This has only added to the financial difficulties faced by domestic investors. It is important to note that this situation has not been reversed; strong import exposure has continued and often has even been intensified. This is particularly the case in the Czech Republic, Hungary, and Poland, the three countries that have aggressively pressed for entry to the European Union.

69With internal systemic conditions largely unchanged, regardless of the privatization technique selected, domestically owned companies, public or private, have come to realize that they have no better choice than to seek foreign money. Companies that were still state-owned usually pressured privatization officials to allow for the transfer of assets in hope that new owners would bring fresh financing. However, privately owned ones typically sought buyers for their equity as a source of recapitalization, too (as in the case of the short-lived Polish-owned holdings, mostly led by the former state trading companies). With both state and privately owned companies, the preference has been to find strategic investors willing to buy a majority share of equity, for only then will a proper financial commitment result.

70This sense of desperation has provided foreign buyers with a very favorable bargaining position, making it easier for them to demand controlling or exclusive equity positions and to drive down the price of assets. This has been well documented in Hungary, where about one third of the companies taken over by foreigners are under nearly one hundred percent foreign ownership. Pricing is not as well documented, but there can be no doubt that asset prices were low, with foreigners paying about $7-8 billion for all assets acquired through 1998. This represents fifteen percent of the estimated book value of all assets in industry and banking as reported at the outset of the privatization program, or twenty percent of the portion of the book value that was actually dispersed through sales.

71If this way of estimating the extent of underpricing is not convincing, one can try another approximation: comparing the revenues from foreign sales with the value of capital derived from capital/output ratios. If we assume that both industry and banking account for thirty-five percent of Hungarian national income, which is approximately $50 billion, then these two sectors produce $17.5 billion in revenue. If we further assume that the capital ratio for industry and banking is three to one, then the value of their capital stock should equal $52.5 billion. Since foreigners control seventy percent of it and own, say, sixty percent, it means that they paid $7-8 billion for a stock of capital whose estimated value is about $30 billion—or about one-quarter of the value.

72These payments are indeed a strikingly low figure for an economy whose annual savings rate is twenty percent and annual (mostly personal) savings represent at least $10 billion. This would simply imply that, theoretically speaking, Hungarians save enough to be able, in a course of one year, to purchase at their actual prices all privatized assets—those already sold and those that are left for sale. It is highly ironic that at the outset of privatization, Hungarian economists claimed that the value of assets for divestment was so high and personal savings so low that it would take about three decades to sell all the capital at market prices. These estimates were very instrumental in shifting public sentiment to support a radical approach to privatization.

  • 13 Béla Greskovits, “Progress in Hungarian Transition” (conference paper, Warsaw, 1998).

73In fact, asset pricing may be even lower than just indicated, since the above estimates are based only on revenues from privatization and ignore related state expenses. Additionally, Hungarian sources provide information on expenditures its privatization agency has incurred in connection with asset sales, such as subsidized credits, presale recapitalization, tax privileges, etc. A significant case is that of banking, which prior to privatization brought about $2 billion in sales, and for which two waves of recapitalization were required to rescue the system at a total cost to the state budget of approximately $2 billion. Total expenditure on privatization of industry and banking was reportedly close to the total revenue incurred from privatization by 199713, which would imply that assets were essentially transferred free of charge (following the earlier completed east German privatization, which generated a $60 billion deficit for the privatization agency).

74The pressure to attract foreign owners has come not only from companies, managers, and workers, but from state officials, and not simply— or even mainly—out of concern for bolstering faltering economies. Seeking personal gain, officials have found foreign buyers more suitable than domestic buyers. One quite perverse reason for this preference is the public’s suspicion of domestic transactions. One of the major fears has been the concern that assets will be handed over to the former nomenklatura, including managers of major state-owned companies. Such individuals are typically despised by the public for their political past. This feeling has been particularly strong in countries where the dissident movement during the communist period was relatively strong, Poland being a good example (the first postcommunist Polish government even passed a law to curtail this form of privatization).

75However, concern for public image has not been the most critical variable in shaping preferences among officials. More significant has been the fact that officials have looked for private gain under either the pressure of severe time limits on action or the threat of being phased out of their positions of influence. Transfers of assets have thus provided officials with opportunities to collect kickbacks. These transfers required a timely mobilization of large sums, something foreigners have been better able to produce. At the same time, foreigners have been no less prepared than domestic buyers to gratify officials either with cash payments or lucrative jobs. Moreover, foreigners correctly have been seen by officials as more “reliable” than domestic buyers both in terms of keeping their questionable dealings discrete and holding up their end of the bargain.

76There cannot be a greater contrast between the pattern of divestment described above and the manner in which West European countries have conducted their own privatization, for among the latter, divestment invariably favored mostly domestic buyers. In Austria, for instance, privatization did not lead to the takeover of any major state companies by foreigners. Likewise, the more recent privatization in Great Britain also focused on putting assets into domestic hands, with cheap credit extended to those willing to purchase assets. To take an even more recent case of a less developed country, state-owned capital in Turkey (like the East European countries, an applicant to the European Union) has gone mainly to domestic buyers, especially large family-owned conglomerates.

77Although there has been some significant foreign penetration in West European industry, nowhere have the levels reached the emerging East

78European standards. An extreme case is Ireland, where fifty percent of industry but only ten percent of banking is in foreign hands. In Austria, where thirty percent of industry is foreign owned (since 1975), banking is almost exclusively in domestic hands, largely for reasons mentioned above. In most West European cases, foreign ownership of industry is under twenty percent (for example, in Germany it remains around ten percent), and in banking the average share for the whole European Union is close to ten percent (including the two nations most comparable to Eastern Europe: Portugal and Spain).

79Does the fact that Eastern Europe is building, in an unusual manner, an unusual type of capitalism in itself have to mean that something is wrong with the direction that the transition has assumed? Unfortunately, it does. It could be argued that the rapid shift of most capital resources to foreigners, while unusual, might have been rational because foreign owners, with undeniably greater experience, increase capital efficiency. With the likely divergence of interests, however, these gains may prove to be much smaller than what might be generated were decisions made by well-established local capitalists. This lack of representation for domestic capital interest makes the emerging system of foreign owned majority capitalism a potentially disturbing proposition.

80It would be biased to evaluate the effects of a strong foreign presence only in terms of efficiency gains, since there is also an important distributive aspect related to the allocation of income from capital. This latter aspect should be of no concern for the host economy as long as the system under which foreigners operate is perfect. In such cases, foreigners pay not only the full price for the assets but also earn legitimate, deserved profits, leaving the local wage-earners with a fair, market-driven share of whatever efficiency gains foreigners can produce. These conditions, however, never apply in real life; as a result, the host economy faces a real risk of losing a portion of its wealth to foreign owners due to various rents. At present in Eastern Europe, the conditions required for a fair and legitimate distribution of efficiency gains are critically violated on more than one account.

81In order to examine the distributive consequences of foreign takeovers for East European welfare, it would be useful first to consider conditions under which assets are acquired. There can be no doubt that these conditions are not particularly suitable for careful asset valuations, which create opportunity for rent collection either by domestic or foreign buyers. Among the complicating factors is the lack of developed capital markets, including the backwardness of investment banking and the nascent nature of emerging stock markets. Other negative factors include obscure accounting methods, general liquidity shortages (hampering restructuring), and very limited supervision of valuation procedures and, in fact, the entire privatization process.

82Opportunities for rent collecting go beyond asset acquisitions mainly because foreign investors are by and large able to establish oligopolistic positions or, more accurately, to extend them. As a rule, sales of assets involve basically unbroken monopolies that were formed by communist planners before 1989. The fast paced sales have not permitted any major reorganizations, and states have not been prepared to execute such changes. Foreign investors have not been interested in the partial acquisition of existing state-owned companies, and importantly, they have been able as a rule to secure dominant equity positions (for example, one-third of the foreign controlled companies in Hungary are, as said before, one hundred percent in foreign hands, and in all companies sold to foreigners by Poland through public offerings, foreigners secured at least small majority stakes).

83Such large holdings of capital provide a basis for the transfer of income abroad unless such transactions are restricted or prohibited by the host-economy state. Currently, most East European states allow for the uninhibited transfer of income, Hungary being a good case in point. But even if such restrictions were put in place, it would be difficult for well-intended and resolved states to enforce some sort of effective control over capital-income outflows. Various types of financial operations that are currently allowed, including foreign exchange operations, facilitate escape from such controls and allow for tax evasion. Transfer pricing is another way of avoiding controls, for trade is being turned over mainly to foreign controlled companies (for example, eighty percent of manufacturing exports in Hungary and sixty percent in the Czech case).

84It is difficult to estimate the amount of such undeserved income, but until now the potential for draining undeserved income has been largely ignored, in part because most profits in foreign owned companies were reinvested or even augmented by money from abroad. But this clearly cannot go on forever, since all investors spend money to eventually collect income. Hungary offers the first such evidence. Starting in 1997, when most assets were already sold, large transfers of income from capital apparently began, reaching the official figure of $1.5 billion in 1998. These overt outflows, mostly through profit remittance and consulting fees, were large enough to neutralize the net inflow of direct investment in 1998 (and made the government officially complain to a group of major foreign companies that their behavior damaged the country’s balance of payment).

Concluding Remarks: Three Stages of Crisis

85Within the evolutionary position, given its individualist and subjective outlook, focus is placed on morality as the guiding force that organizes human actions. No society can survive without solid morals that make individuals respect the needs of a collective—family, community, or nation. Everything of real importance in societal life is, basically speaking, an affirmation of such public morals. Consequently, it is assumed that moral practice forms the basis on which institutions rest. In other words, institutions are manifestations of routine actions by morally driven individuals. These are not perfectly fixed rules; there is some margin to allow morals to be tested for their enduring value. Since institutions have to be rooted in morals, once individuals—largely unintentionally—develop them, they are as stable and helpful in assisting people as morals are.

  • 14 My full-length examination of Soros’s interpretation of the open society concept by Popper as well (...)

86The above methodological approach to institutions derives from an evolutionary position, itself stemming from a broad range of scholarship including the work of two major Viennese thinkers—the philosopher Popper and, even more so, the economist Hayek. These ideas have been employed by a small group of economists working on the postcommunist transition mostly to give a critical assessment of the actual process of change. This line of thinking has gained another major voice with the recent statements on the transition by Popper’s intellectual follower Soros, who offers a rather critical account of the state of emerging capitalism in Eastern Europe (particularly addressing the case of Russia, about which he has very good direct knowledge). But Soros’s remarks on advanced capitalism are most relevant to the study of postcommunist transition as well, as far as the underlying methodology applied in this analysis is concerned14.

  • 15 See Timothy McDaniels, The Agony of the Russian Idea (Princeton: Princeton University Press, 1997)

87Taking this position, where morality becomes the central explanatory variable, makes sense, of course, mainly in the context of an analysis that deals with some major (secular) shifts in institutions that structure social life. Such an approach is suitable for the study of transition, but only if one has the courage to take a serious, impassionate look at this process15. Within this perspective, there is no choice but to argue that the former communist countries entered transition in the midst of an institutional collapse—that of communism. This important phase of the transition is best understood as a consequence of a major deterioration in morals, the pervasive corruption of state officials, and civic indifference. In fact, this was only the first stage of a lengthy demoralization process, one in which negative social forces had just begun to come into the open.

88My account may appear inconsistent with Soros’s explanation of how the communist system collapsed, for in his direct statements on the subject, Soros adopts a conventional line of thinking. In his view, communism collapsed from excessive collectivism, which like excessive individualism comes from dogmatic thinking (which he calls “closure”). While excessive collectivism is not sustainable, so that a system based on such a principle eventually has to crack, such fracturing manifests itself in excessive individualism. Under late communism it was not that collectivism was cut to some workable size, but that it degenerated into a system in which rampant individualism began to rule. Excessive individualism may not just be a threat to capitalism, as in Soros’s theory, but also to communism, for—as Soros will certainly agree—the collapse of morals may damage any type of social system.

89Since the collapse of public virtues is exactly the force that destroyed the communist system, it is under the conditions of this moral crisis that the postcommunist transition had to be initiated. When these reforms began, this crisis of public values was not confronted, and rather than be reversed, the crisis entered into an even more intense second phase. One of the unfortunate consequences of this negative turn is that East European states lost much of their capacity to aid emerging markets through proper regulations, law enforcement, and necessary assistance. This observation is consistent with Soros’s understanding of how demoralization manifests itself. As he argues, demoralization involves an excessive shift from collectivist states to individualist markets with adverse consequences for those in need of state protection. In the context of the transition, the most devastating effect of such state corrosion is the unprecedented post-1989 recession that has benefited a few but hurt the majority.

90Introduced under conditions of low concern for public good, reforms have not only resulted in an economic recession, but also, more importantly, allowed the majority of capital to be transferred to foreign owners. Even if large-scale entry of foreign investors had proven positive in reducing economic adversities—and there is no reason to doubt this— such a divestment strategy is not without economic cost. Such unusual ownership structures, particularly when combined with such high concentrations, may permit the collection of undeserved income from monopolistic rents that may be transferred abroad. Foreigners, in fact, have been gaining considerable market power, since private owners typically recreate communist era monopolies (even strengthen them, adding new layers of influence, for example, through integration of production with sales and/or through advertising).

91Importantly, such a property system seriously thwarts the emergence of a local capitalist class, which may actually prevent a full articulation of domestic economic interest. It would be very naïve to think that domestic and foreign interests have to coincide, particularly when the parties involved represent economies that are at vastly different levels of development. Besides, without a strong domestic capitalist class it is hardly possible for transition economies to recover from the crisis of public virtues. It is not necessarily the case that its substitute, foreign owners, will be more vigorous in fighting corruption of the state and in energizing citizens for civil action. Instead, these economies may easily slip into a third stage of the crisis where strong public disinterest exists in a reduced but chronic, firmly institutionalized form.

92Given the potentially negative economic consequences of turning over the majority of capital to foreign hands, it is necessary to reconsider the commonly held perception of the relative success of the transition economies. Hungary, Poland, and (until recently) the Czech Republic are heralded as the most successful not only because they have managed to privatize more of their assets, but also because they have enforced property rights relatively well. It is said also that their success is evidenced in the fact that they have received the most foreign investment, which in turn raises their productivity growth above rates found in most other countries. The flip side of the coin is, however, that these economies are also leaders in terms of building this quite awkward version of capitalism, in which a majority of capital is foreign owned. By the same token, where ownership reforms are less advanced, as in Russia, there is also less foreign investment, and some room still exists for the possible retention of large units of capital in domestic hands.


1 George Soros, “The Capitalist Threat”, The Atlantic Monthly (February 1997); and George Soros, The Crisis of Global Capitalism: Open Society Endangered (New York: Public Affairs, 1999).

2 See Albert Hirschman, The Passions and the Interests: Political Arguments for Capitalism Before Its Triumphs (Princeton: Princeton University Press, 1977

3 See Peter Berkowitz, Virtue and the Making of Modern Liberalism (Princeton: Princeton University Press, 1998).

4 Joseph Schumpeter, Capitalism, Socialism and Democracy (New York: Harper and Row, 1942).

5 Friedrich Hayek, The Fatal Conceit: The Errors of Socialism (Chicago: University of Chicago Press, 1988), 6.

6 Karl Popper, The Open Society and Its Enemies (London: Routledge and Kegan Paul, 1945).

7 Soros, Global Capitalism.

8 Karl Polanyi, The Origins of Our Time: The Great Transformation (London: V. Gollancz Ltd., 1945).

9 Kazimierz Z. Poznanski, “An Interpretation of Communist Decay: The Role of Evolutionary Mechanisms”, Communist and Post-Communist Studies 26:1 (March 1993

10 Kazimierz Z. Poznanski, Poland’s Protracted Transition: Economic Growth and Institutional Change in 1970-1994 (Cambridge: Cambridge University Press, 1996

11 Ken Jowitt, “Soviet Neotraditionalism: The Political Corruption of the Leninist Regime”, Soviet Studies 35:3 (July 1983).

12 Ernest Gellner, “Homeland of the Unrevolution”, Daedalus 122:3 (Summer 1993).

13 Béla Greskovits, “Progress in Hungarian Transition” (conference paper, Warsaw, 1998).

14 My full-length examination of Soros’s interpretation of the open society concept by Popper as well as of Soros’s own contribution to the analysis of modern capitalism is contained in a separate essay (Kazimierz Z. Poznanski, Openness and Wealth: Revisiting the “Capitalist Threat” Argument (Seattle: University of Washington, 1999). More on my effort to extend Soros’s method to the study of postcommunist transition can be found in my essay review of his recent book The Crisis of Global Capitalism (Kazimierz Z. Poznanski, “The Crisis of Modern Capitalism in Post-Communist Eastern Europe”, East European Politics and Societies (forthcoming 1999

15 See Timothy McDaniels, The Agony of the Russian Idea (Princeton: Princeton University Press, 1997).


Kazimierz Z. Poznanski is a professor at the Henry M. Jackson School of International Studies, University of Washington, Seattle.

© Central European University Press, 2000

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