Shock therapy (economics)

This article is about the economic term. For other meanings of "shock therapy" or "shock treatment" including the psychological one, see shock therapy (disambiguation).

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

The term arose after Bolivia successfully tackled hyperinflation in 1985 under Gonzalo Sanchez de Lozada, and was heavily influenced by prominent economist Jeffrey Sachs. Sachs became shock therapy's foremost proponent after studying historic periods of monetary and economic crisis and noting that a decisive stroke could end monetary chaos, often in a day. In particular Sachs and Sanchez de Lozada cited West Germany where, during a period over 1947-48, price controls and government support were withdrawn over a very short period, kick starting the German economy and completing its transition from an authoritarian post-War state.

Later, Sachs' ideas were applied to the post-communist states in their transition to capitalist systems, with very mixed results. Economists now understand that Western economies rest on and take for granted a framework of law, regulation and established practice that cannot be instantaneously created in a society that was formerly authoritarian, heavily centralised and subject to state ownership of assets .

In recent times, shock therapy has also become associated with neoliberalism, which argues that government intervention is the cause of all economic and monetary chaos, and therefore shock therapy is always the best answer to such chaos. As a result, shock therapy has been used retroactively to refer to any significant program of pro-market reforms, such as Chile in 1975, and as a response by the IMF to economic crises, for example the 1998 Asian Recession. Neoliberal shock therapy has been much criticised, especially by prominent economist Joseph Stiglitz .

History

West Germany 1948

Although the term shock therapy only came into existence after Bolivia's actions in 1985, both Gonzalo Sánchez de Lozada (the architect of the policy in Bolivia) and Jeffrey Sachs (its economic architect) were heavily influenced by West Germany's reforms in 1948.

Background

Germany ended World War II with its unconditional surrender on the 8th of May, 1945. It faced war damage to its economy and the problems of mass migration due to the expulsion of ethnic Germans from areas east of the Oder-Neisse Line.

April 1945 to July 1947 saw the Allied occupation of Germany implement Joint Chiefs of Staff directive 1067 (JCS 1067). The aim of this directive was to transfer Germany's economy from one centred on heavy industry to a pastoral one, in order to prevent Germany from having the capacity to wage war. Civilian industries which might have a military potential, which in the modern era of "total war" included virtually all, were to be severely restricted. The restriction of the latter was set to Germany's "approved peacetime needs", which were defined to be set on the average European standard. In order to achieve this, each type of industry was subsequently reviewed to see how many factories Germany required under these minimum level of industry requirements. In May 1946, the first plan stated that German heavy industry was to be lowered to 50% of its 1938 levels by the destruction of 1,500 listed manufacturing plants. Restrictions on steel followed.

It soon became obvious that this policy was not sustainable. Germany could not grow enough food for itself and malnutrition was becoming increasingly common. The European post-war economic recovery did not materialise and it became increasingly obvious that the European economy had depended on German industry.

In July 1947, President Harry S. Truman rescinded on "national security grounds" the punitive JCS 1067, which had directed the U.S. forces of occupation in Germany to "take no steps looking toward the economic rehabilitation of Germany." It was replaced by JCS 1779, which instead stressed that "[a]n orderly, prosperous Europe requires the economic contributions of a stable and productive Germany."

By 1948, Germany suffered from rampant hyperinflation. The currency of the time (the Reichsmark) had no public confidence, and thanks to that and price controls, black market trading boomed and bartering proliferated. Banks were over their heads in debt and surplus currency abounded.

However, thanks to the introduction of JCS 1779 and the first Allied attempts to set up German governance, something could be done about this. Ludwig Erhard, an economist, who had spend much time working on the problem of post war recovery, had worked his way up the administration created by the occupying American forces until he became the Director of Economics in the Bizonal Economic Council in the joint British and American occupied zones (which would later, with the addition of the French occupied territory become the basis for West Germany). He was placed in charge of currency reform and became a central figure in events that were to follow.

Economic Reforms

In Spring of 1948, the Allies decided to reform the currency. In preparation for this, a new central bank system was established in West Germany with independent Land Central Banks and the Bank deutscher Lander with headquarters in Frankfurt am Main.

Currency reform took effect on the 20th Jun 1948, through the introduction of the Deutsche Mark to replace the Reichsmark and by transferring to the Bank deutscher Lander the sole right to print money. Each person received a per capita allowance of 60 DM, payable in two instalments (40 DM and 20 DM) and business quota of 60 DM per employee.

Under the Conversion Act of the 27th of June, private non-bank credit balances were converted at a rate of 10 RM to 1 DM, with half remaining in a frozen bank account. Although the money stock was very small in terms of national product, the adjustment in the price structure immediately led to sharp price increases, fuelled by the high velocity of money through the system. As a result, on the 4th of October, the military governments wiped out 70% of the remaining frozen balances, resulting in an effective exchange of 10:0.65. Holders of financial assets (including many small-time savers) were dispossessed and the banks debt in Reichsmarks was eliminated, transferred instead into claims on the Lander and later the Federal Government. Wages, rents, pensions and other recurring liabilities were transferred at 1:1.

On the day of the currency reform, Ludwig Erhard announced, despite the reservations of the Allies, that rationing would be considerably relaxed and price controls abolished.

Results

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

In the long term, these reforms helped set the stage for the Wirtschaftswunder (German for economic miracle) in the 1950s.

Bolivia 1985

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

Background

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

Prelude to Decree 21060

Decree 21060 was the famous decree that covered all aspects of the Bolivian economy, later referred to as shock therapy. In the run-up to the decree, Gonzalo Sánchez de Lozada recalls what the new government set out to do:

People felt you couldn't stop hyperinflation in a democracy; that you had to have a military government, an authoritarian government to take all these tough steps that had to be taken. Bolivia was the first country to stop hyperinflation in a democracy without depriving people of their civil rights and without violating human rights.

In the three weeks between the inauguration of the President and decree 21060, he notes:

We spent one week saying, "Do we really need to do something? Do we really need radical change?" and then another week debating shock treatment versus gradualism. Finally, we took one week to write it all up.

Once they'd decided to act, de Lozada recalls that

there was a big discussion whether you could stop hyperinflation or inflation, period, by taking gradual steps. Many people said you had to take it slowly. You have to cure the patient. Shock treatment means you have a very sick patient [and] you have to operate before the patient dies. You have to get the cancer out, or you have to stop the infection. That's why we coined the phrase that inflation is like a tiger and you have only one shot; if you don't get it with that one shot, it'll get you. You have a credibility that you have to achieve. If you keep to gradualism, people don't believe you, and the hyperinflation just keeps roaring stronger. So shock therapy is get it over, get it done, stop hyperinflation, and then start rebuilding your economy so you achieve growth.

It's notable that de Lozada viewed shock therapy as an issue of political credibility, and less an economic issue as Sachs, its economic pioneer, did. Like Sachs, he was strongly influenced by the German government in 1947, but noted that they, like the new Bolivian government of Victor Paz, were a new government that acted decisively in the first 100 days, resolving the economic situation.

Decree 21060

Main article: Decree_21060

Decree 21060 included the following measures:

• Allowing the peso to float against the dollar
• Cutting two thirds of the employees of the state oil and tin companies and implementing a freeze on
• Ending price controls and eliminating subsidies to the public sector
• Liberalising import tariffs by imposing a uniform 20% tariff
• Stopping the payment of foreign debt under a deal negotiated with the IMF

Results

In the short term, the decree smothered hyperinflation. Within a few months, inflation had dropped to between 10-20%. The crash of the tin market in October of the same year and the reforms led to an estimated unemployment rate of 21.5 percent by 1987 (the unemployment rate had risen steadily from 5.5 percent in 1978 to 10.9 percent in 1982, 15.5 percent in 1984, and 20 percent in 1986).

However, in the long term, the picture in Bolivia matched much of the rest of Latin America, where the reforms did not bring long term benefits.

Application

As a result, during the early 1990s Sachs recommended to the newly emerging economies of Eastern Europe, the former Soviet Union and Latin America that they end all price controls and subsidies, sell off state assets and float their currencies in order to shake off the economic lethargy of the communist era. The shocks took the form of sudden drastic radical changes to the structure and incentives within economies. As a consequence of reforms, Poland and other countries reached a level of economic development consistent with the membership in the European Union.

Results

Sudden changes to economic structure and incentives require changes to behavior, financial flows and the structure of the economy that are not as rapid as the shocks that initiate them. It takes time for firms to be formed and built up; it takes time for human capital to change (to acquire the skills) to exploit new circumstances. Critics say that a developed Western economy rests upon and tends to take for granted a framework of law, regulation and established practice (including between parts of the domestic and international economy) that cannot be instantaneously created in a society that was formerly authoritarian, heavily centralised and subject to state ownership of assets. Even re-defining property law and rights takes time.

Ex-USSR

Since the USSR's collapse, the post-Soviet states faced many problems. Among other things, provision of healthcare and social services had declined, life expectancy had fallen, and the GDP was halved. Poverty in the region had increased more than tenfold. The economic crisis that struck all post-Soviet countries in the 1990s was twice as intense as the Great Depression in the countries of Western Europe and the United States in the 1930s.

However, it has not been established whether these adverse outcomes were due to the general collapse of the Soviet economy (which began before 1989) or the policies subsequently implemented or a combination of both. Some research suggests that the very fast pace of 'shock therapy' privatization mattered, and had a particularly harsh effect on the death rate in Russia. Sachs himself resigned from his post as advisor, after stating the he felt his advice was unheeded and his policy recommendations were not actually put into practice.

Poland

Poland has been cited as an example of the successful use of shock therapy. When democracy came to this central European nation, the government took Sachs' advice and immediately withdrew regulations, price controls and subsidies to state-owned industries. However with respect to the privatization of the state sector (which may or may not be considered as part of shock therapy depending on the definition being used) the change was much more gradualist. Whereas many economic factors were immediately applied, privatization of state-owned enterprises was delayed until society could safely handle the divestiture, as contrasted with the 'robber baron' state of affairs in Russia.

Productivity increased although at the same time unemployment rates rose as well. As of 2008, the GNP was 77 % higher than in 1989. Moreover, inequality in Poland actually decreased right after the economic reforms were implemented, although it rose back up again in later years. Today, although Poland is confronted with a variety of economic problems such as double-digit unemployment, it still has a higher GDP than during communist times, and a gradually developing economy. Poland was converging towards the EU as regards the income level in 1993-2004.

New Zealand

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

See also

People

• Ludwig Erhard, architect of the West German post-War recovery
• Gonzalo Sánchez de Lozada, architect of shock therapy in Bolivia
• Jeffrey Sachs, chief economic proponent of shock therapy
• Leszek Balcerowicz, architect of Balcerowicz Plan for shock therapy in Poland
• Yegor Gaidar, architect of shock therapy in Russia

Economic Plans

• Bolivian Decree 21060, the original shock therapy reforms in Bolivia
• Economy and Free Market reforms in Chile under Pinochet, a.k.a the Miracle of Chile
• Russia under Yeltsin and the History of post-Soviet Russia
• Reaganomics
• Rogernomics

Other

• The Shock Doctrine

External links

• PBS - Commanding Heights: Shock therapy
• The Shock Doctrine | Naomi Klein