Central Europe's Mass-Production Privatization

By Stuart M. Butler, Ph.D. All over Central and. Eastern Europe, millions of people live in the wrong place, go to the wrong job, a nd make the wrong things. In addition to reinforcing or creating a sense of private property in the region, the purpose of privatization is to rearrange the factors of production now used so inefficiently into a structure in whicb.peoplc@ live. andwork,in the right places and make the right things. Undertaking the necessary degree of privatization in Central and Eastern Europe is an enormous and complex task. The scale of the task is daunting and the political problems staggering. But privatization must be accomplished swiftly if the countries of the region are to move towards dem- ocratic capitalism without huge short-term economic costs. It is for this reason that the experiment in what one might call "mass-production privatization" now being launched in P oland and Czecho- slovakia is of such immense importance, not just to those two countries but to all the countries and republics of the collapsing eastern Soviet bloc. Consider the scale ofthe privatization task In 1985 the state-controlled sector in the U nited Kingdom accounted far about 11 percent of the economy. In Poland, however, the proportion was 82 percent, while in Czechoslovakia it was 97 percent. During the 1980s, the U.K. attracted world- wide attention because it undertook a privatization stra t egy of historic proportions. Yet in eleven years Margaret Thatcher privatized only twenty major firms, representing about 5 percent of the economy. By contrast, in Czechoslovakia and Poland there are thousands of major firms that must be shifted to the pr i vate sector, and in the former Soviet Union there are tens of thousands. Thus, it is perhaps understandable that the privatization ministers in Prague and Warsaw say bluntly that the British model is of virtually no use to them. Urgent Task. Consider also the urgency of the task. Private ownership is the cement holding democratic capitalism together. Moreover, major firms in Central Europe are in a twilight zone be- tween communism and. capitalism. Managers lack the crude central direction of a command eco n - omy that at least told them what to do, and yet managers also lack the incentives of a market econ- omy. Thus they are subject to perverse incentives to become even more inefficient and to run down the assets they control. With eventual bankruptcy a pro b ability in many instances, and with the future in any case so uncertain, managers and employees of -these fiAms have tended to focus only on short-term benefits, such as giving themselves huge wage increases, and selling off stocks rather than investing f o r new production. In many instances managers and workers are engaged in the wholesale looting of their firms. Thus the positive incentives of private ownership and a mar- ket system must be applied to these companies as quickly as possible. What has been t he progress so far towards privatization? Understandably the greatest success has been with small firms, or at least firms that can be sold to one purchaser. In Poland the govern- ment claims that about 80 percent of the retail sector, 50 percent of trans p ortation, and 40 percent of construction has been transferred to the private sector. The privatization of small firms in Czechoslovakia also has been proceeding apace. The process has been far slower, however, in the case of larger firms. In all the count ries of Cen- tral Europe, British-style one-at-a-time privatization has only limped along, and in some cases vir- tually ground to a halt. There are several reasons for this.

Stuart Butler, PhD. is Director of Domestic and Economic Policy Studies at 11e H eritage Foundation. He spoke at the 1991 regional meeting of the Mont Pelerin Society, beld in Prague, Czechoslovaida, on November 5,1991. ISSN 0272-1155. 01991 by IMe Heritage Foundation.

One reason is -that there is no way to measure-or even -to guess -the value of large, sophisti-: cated firms. Because they have existed in, a regime of artificial prices, enormous subsidies, and - Kafkaesque regulation, there is no-way to determine their market. value using normal accounting principles. That is why so m any Western investment bankers have been charginglarge amounts of money to conduct evaluations and yet have produced figures that are literally meaningless. We. know that some of the firms are valuable, and we know some of them are junk'. The problem is w e .. don't know which is which. That makes finding a buyer at a reasonable price rather difficult. The second problemi. with- British-style -privatization is that-the privatization agencies simply are overwhelmed by the numbers of sales they must conduct. T h roughout Central Europe, the pro- cess is in gridlock. That has led in. turn to widespread "spontaneous privatization," in which desper- ate privatization agencies have been forced to accept takeovers by existing managers with virtu- ally no paymenL In. e f fect the agencies stand by powerless as massive looting takes place. Third, there am competing political pressures that make privatization even more diffidult and uncertain. In Czechoslovakia, for instance, political pressures mean that the privatization s trategy must be linked to a policy of restitution. There is also a desire by reformers to create a strong mid- dle class. Moreover, some of the easiest methods of privatization, such as allowing worker buy- outs, conflict with basic notions of fairness. T h us the methods of privatization that might be used, were the objective only to shift firms to the private sector as quickly as possible, cannot be used because of other political concerns or goals. Fourth, the region lacks the basic financial institutions and legal framework that make large- scale privatization so much easier in the WeSL It is to cut the Gordian knot represented by such problems and limitations that the Poles and Czechs have introduced the radical innovation of privatizing through free dis t ributions of shares in the state sector. This innovation is an attempted dash to the fire market by dramatically increasing the volume of privatization. It is a drastic step with uncertain consequences. As the London Economist has de- scribed the strategy , "Free distributions are desperate acts to solve desperate problems." The aim is to change the politics of privatization, accelerate the speed of transfers, and to achieve far broader political objectives than simply reducing the sizLe of the state sector . . In short, free distribu- tions are the public policy equivalent of a parachute drop behind enemy lines. And as any military expert knows, a mass parachute landing can have one of two effects. It can change decisively the course of the entire battle in o n e's favor. Or the paratroops can be wiped out. The risks of the innovation underway in Poland and Czechoslovakia are enormous, the potential' benefits equally significant. There are also certain important differences in the approaches used in the two coun t ries. In Poland, the population will receive free shares in a set of mutual funds. These,. mutual funds in turn will gain title to most of the state sector. In Czechoslovakia, by contrast, the population will receive, vouchers with which they can purchase shares in individual companies. Each of these approaches has potential benefits but also major risks. Mutual Fund Strategy. In Poland, the government is essentially trying to privatize the very process of privatization. It will rely on the mutual funds to undertake the massive task of reorgani-- zation that in British-style privatization generally occurred before the change of ownership took place. This has two advantages. The first is that it speeds up the transfer process by allowing major private agenci e s to undertake the massive task of valuation and restructuring now suffocating state privatization agencies.. The Poles -intend to speed up this process further by bringing in some for- eign managers to help operate these mutual funds. The second advantag e is that the reorganization itself -will be. market-driven because it will.take place in-the privatesector and by organizations op- erating,:under.the- incentives.of the. market -system. ThusAhe reorganization is more likely to result.

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in an effici ent outcome than would be true if the government attempted to reorganize firms before selling them. But obviously there are also great risks in the strategy. These huge mutual funds in Poland will have great economic and political power. They will have a s trong incentive to engage in what economists call "rent-seeking," that is, they doubtless will attempt to extort political and financial favors from the government. One can imagine, for instance, that if a mutual fund is faced with the prospect of widespr e ad bankruptcies and layoffs among its portfolio of firms, it might use the po- litical impact of mass unemployment. in,affected communities to mvin -subsidies from the state. On the other side of the coin, the state itself may use regulations -and subsidi e s applied to the mutual funds to try to micromanage the private sector as part of an industrial Policy. Vducher Program.-The Czechoslovak voucher program, by contrast, has the virtue of allowing people to invest directly in individual companies, rather th a n in a holding company. Thus the Czechs will have a sense of real ownership that the Poles probably will not. On the other hand, will these individual shareholders have enough knowledge and clout to force a change of manage- ment, or to press existing man a gers to behave in a more efficient manner? It is not clear that they will. To be sure, the Czechs have encouraged the emergence of brokers and mutual funds to act as Western-style intermediaries in the share-owning process, and these can be expected to ha v e a sig-. nificant impact on the management firms. Thus, the Czech government has sought to provide le- verage for individual shareholders. Still, it is an open question whether this will be sufficient to offset the inside infonnation and inherent power p o ssessed by existing managers. So what will be the results of the remarkably innovative form of privatization represented by the Polish and Czech governments? Before making any judgment on the strategy of free share distribu-. tions, one must recognize tha t the issue is not which method of privatization is guaranteed to be successful, but which one that is more likely to succeed than the. others. In this context, I suspect that the Czech and Polish approach may tum out to be, as Churchill said of democracy, "the worst system except for all the others." It will certainly be chaotic. Mr. Triska, the official conducting the Czech voucher symm, has remarked, "It will be like the Wild West." He is right. And the fac- tors influencing the privatization process are much too complex for an outside advisor even to at- tempt to disentangle. Given that, the advice of outside privatization experts may not be of much use to the Poles and the Czechs. The best we can say perhaps is, "Good luck!" Now, that advice may not be o f much help, but at least it is honest. And it is free.'So it fits with Czech Finance Min- - ister Vaclev Klaus's dictum, "Don't pay hard money for soft advice.,' Two Caveats. Yet while it is unwise for outside observers like myself to offer much advice o n your voucher program-even if we don't charge you anything-we can perhaps offer two import, ant caveats about privatization. The first is that you must pay close attention to the privatization of housing. As I mentioned at the beginning, most Czechs and P o les live in the wrong place. That is because rents and construc- tion have been highly controlled-and generally still are. As massive restructuring takes place in the economy, there will be heavy demands for labor in some places, and there will be huge la y offs in other places. If there is not to be enormous unemployment in some cities, and chronic shortages of labor in others, labor must be as mobile as possible. The immobility of labor is one of the most damaging legacies of the command economy and could m ake reconstruction extremely difficult. Thus, you must take urgent steps to free up the housing market. Even more important, you must take action to privatize the construction of new homes. The problem, of course, is that housing is a very sensitive polit ical issue. It is very hard to con, dudt a swift privatization -strategy with controlled rents. The long process of restitution now being undertaken in -Czechoslovakia also makes it hard to deregulate housing. But if you do not tackle

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this with the sense of urgency and with the bold innovation you have demonstrated in the privatization of companies, there will be long-lasting problems. I suspect the best course would be to move as quickly as possible to establish clear ownership rights for vacant sites on which new buildings can be erected: and to institute swift permitting procedures for construction as well as the rapid privatization of the construction industry. That at least will allow new homes to become available where new wcarker s are required. Dealing with rent control can come later-we in the West have not even solved the political problems associated with decontrolling rents. The second.point Lwouldemphasize is that prosperity. comes from new. enterprises, not from re- arrangin g old ones. The evidence is overwhelming that new jobs and new wealth come dis- proportionately from new ventures, not from efficiency improvements in existing firms. Thus while the privatization of existing firms is extremely important, that should not be c ome an obses- sion at the expense of instituting tax, regulatory, legal, and monetary policies to spur the creation of new firms. The fact is that most of your existing large firms are junk. The more quickly these can be broken up and their assets made av a ilable to new entrepreneurs the better. The economic landscape in five years -will be completely different from today's. Such creative destruction is the sign of a strong econorny. In the West, there is a big enough turnover of enterprises. Here in Cen- t r al Europe you can expect the turnover to be even greater in the short and mediurn term. Thus you should understand that - . atization is simply part of the creative destruction and formation of en- priv terprises that is life blood of capitalism. Do not m a ke the mistake of thinking that privatized indus- trial dinosaurs will be the cornerstone of a vibrant market economy. Beneficiaries to-the East. Finally, let us consider who has most to gain or lose from your gam- ble to accelerate the process of privati z ation? When it comes down to it, while academics and advi- sors such as myself have an emotional stake in what you- are doing, ultimately the experiments in Poland and Czechoslovakia simply will go into our inventory of case studies for future use. We wil l not have to live with@ the results. For you here in Czechoslovakia, and for the people of Po- land, the impact will be, more personal. However, a walk around Prague indicates clearly that the chances are you will come out of all this with a strong privat e market and a free society. It may be a long road, and you may take some wrong turns, but you will get there. And if your privatization innovation does not live up to expectations, or even if it fails, it will only mean a delay in your journey. Yet the pe o ple who in fact have most to gain or lose from your bold privatization gamble live many miles to the east. In the remnants of the Soviet Union, the problems of transition make your difficulties appear as nothing. Thousands upon thousands of firms need to b e privatized. Some eco- nomic purpose has to be found for a huge military/industrial complex. A despondent and jittery military needs to be demobilized and integrated into the private sector. And while for Czechs and Poles there are still strong memories o f an economic system based on private enterprise, most resi- dents of the former Soviet Union have little inkling of what a market really means and how they should behave in it. It is they who have most to gain or lose from your innovation in privatizatio n. For their sake, I hope your experiment works.

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