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.

As shock policy, the term was coined by economist Milton Friedman. In time, it became absorbed into the group of ideas about economics, that are sometimes referred to as neoliberalism. The economist Jeffrey Sachs coined the expression of shock therapy. The alleged difference between the two shock expressions lies only in the degree of economic liberalisation. Sachs' ideas were based on studying historic periods of monetary and economic crisis and noting that a decisive stroke could end monetary chaos, often in a day. Whereas, Sachs' shock therapy notion views liberalisation as a necessary evil, a fast—as well as nasty—way to achieve economic stabilisation.

The first instance of shock therapy were the neoliberal pro-market reforms of Chile in 1975, carried out after the military coup by Augusto Pinochet. The reforms, dubbed a shock policy at the time by Milton Friedman, were based on the liberal economic ideas centred around the University of Chicago. Many of the Chilean economists who drafted the reforms came from there and were collectively dubbed the "Chicago Boys".

The term was truly born after Bolivia successfully tackled hyperinflation in 1985 under Gonzalo Sanchez de Lozada, using Sach's ideas. In particular Sachs and Sanchez de Lozada cited West Germany as inspiration where, during a period over 1947-48, price controls and government support were withdrawn over a very short period, kick-starting the German economy and completing its transition from an authoritarian post-War state.

Neoliberalism rose to prominence after the 1970s and neoliberal shock therapy became increasingly used as a response to economic crises, for example by the International Monetary Fund (IMF) in the 1997 Asian Financial Crisis. Neoliberal shock therapy became very controversial, with its proponents arguing that it helped to end economic crises, stabilise economies and pave the way for growth, while its critics (like Joseph Stiglitz) believed that it helped deepen them unnecessarily and created unnecessary social suffering.

Sachs' ideas were applied to the post-communist states in their transition to capitalist systems with very mixed results. Some countries that used shock therapy (e.g., Poland, Czech Republic) did better than those that did not. To further cloud understanding, China made its highly successful transition in a gradualist fashion. An opinion is that successful market economies rest on a framework of law, regulation, and established practice that cannot be instantaneously created in a society that was formerly authoritarian, heavily centralised and subject to state ownership of assets.

History

West Germany 1948

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

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

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

In July 1947, President Harry S. Truman rescinded on "national security grounds" the punitive JCS 1067, which had directed the U.S. forces of occupation in Germany to "take no steps looking toward the economic rehabilitation of Germany." It was replaced by JCS 1779, which instead stressed that "[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 spent much time working on the problem of post war recovery, had worked his way up the administration created by the occupying American forces until he became the Director of Economics in the Bizonal Economic Council in the joint British and American occupied zones (which later, with the addition of the French occupied territory, became 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 June 20, 1948, through the introduction of the Deutsche Mark to replace the Reichsmark and by transferring to the Bank deutscher Lander the sole right to print money. Each person received a per capita allowance of 60 DM, payable in two instalments (40 DM and 20 DM) and business quota of 60 DM per employee.

Under the German Currency Conversion Law on 27 June, private non-bank credit balances were converted at a rate of 10 RM to 1 DM, with half remaining in a frozen bank account. Although the money stock was very small in terms of national product, the adjustment in the price structure immediately led to sharp price increases, fuelled by the high velocity of money through the system. As a result, on 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.

Chile 1975

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

Background

Main article: Economic history of Chile

In September 1970, Salvador Allende, the UP candidate, was elected president of Chile. Over the next three years, a unique political and economic experience followed. The UP was a coalition of left and center-left parties dominated by the Socialist Party of Chile and the Communist Party of Chile, both of which sought to implement deep institutional, political, and economic reforms. The UP's program called for a democratic "Chilean road to [socialism]." When Allende took office in November 1970, his UP government faced a stagnant economy weakened by inflation, which hit a rate of 35 percent in 1970. Between 1967 and 1970, real GDP per capita had grown only 1.2 percent per annum, a rate significantly below the Latin American average.

The UP had a number of short-run economic objectives: initiating structural economic transformations, including a program of nationalization; increasing real wages; reducing inflation; spurring economic growth; increasing consumption, especially by poorer people; and reducing the economy's dependence on the rest of the world. The UP wanted to achieve their nationalization program through a combination of new legislation, requisitions, and stock purchases from small shareholders. The other goals—output and increased consumption, with rising salaries and declining inflation—were to be accomplished by a boost in aggregate demand, mainly generated by higher government expenditures, accompanied by strict price controls and measures to redistribute income.

The UP's macroeconomic program was based on several key assumptions, the most important being that the manufacturing sector had ample underutilized capacity. This provided the theoretical basis for the belief that large fiscal deficits were not necessarily inflationary. The lack of full utilization was, in turn, attributed to two fundamental factors: the monopolistic nature of the manufacturing industry and the structure of income distribution. Based on this diagnosis, it was thought that if income were redistributed toward the poorer groups through wage increases and if prices were properly controlled, demand and output would expand significantly.

During 1972, macroeconomic problems continued to mount. Inflation surpassed 200 percent, and the fiscal deficit surpassed 13 percent of GDP. Domestic credit to the public sector grew at almost 300 percent, and international reserves dipped below US$77 million. Real wages fell 25 percent in 1972. The underground economy grew as more and more activities moved out of the official economy. As a result, more and more sources of tax revenues disappeared. A vicious cycle began: repressed inflation encouraged the informal economy, thus reducing tax revenues and leading to higher deficits and even higher inflation. In 1972 two stabilization programs were implemented, both unsuccessfully.

During the first quarter of 1973, Chile's economic problems became extremely serious. Inflation reached an annual rate of more than 120 percent, industrial output declined by almost 6 percent, and foreign-exchange reserves held by the Central Bank were barely above US$40 million. The black market by then covered a widening range of transactions in foreign exchange. The fiscal deficit continued to climb as a result of spiralling expenditures and of rapidly disappearing sources of taxation. For that year, the fiscal deficit ended up exceeding 23% of GDP.

The depth of the economic crisis seriously affected the middle class, and relations between the UP government and the political opposition became increasingly confrontational. On September 11, 1973, the UP regime came to a sudden and shocking end with a violent military coup and President Allende's death.

When the military took over in September 1973, the country was divided politically, and the economy was a shambles. Inflation was galloping, and relative price distortions, stemming mainly from massive price controls, were endemic. In addition, black-market activities were rampant, real wages had dropped drastically, the economic prospects of the middle class had darkened, the external sector was facing a serious crisis, production and investment were falling steeply, and government finances were completely out of hand. After the military took over the government, there was a year and a half of benign neglect of the economy as the regime consolidated its power.

Economic reforms

The government welcomed foreign investment and eliminated protectionist trade barriers, forcing Chilean businesses to compete with imports on an equal footing, or else go out of business. The main copper company, Codelco, remained in government hands due the nationalization of copper completed by Salvador Allende, however, private companies were allowed to explore and develop new mines. Copper resources were, however, declared "inalienable" by the 1980 Constitution.

Results

In the short term, the reforms stabilised the economy. However, the reforms also set the stage for a debt crisis in 1982.

In the long term, Chile has had higher GDP growth than its neighbouring countries.

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 decree tackled all aspects of the Bolivian economy and ended the hyper-inflation.

Background

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

Prelude to Decree 21060

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).

Post-Soviet states

The next important chapter in the history of shock therapy was the collapse of communism in Europe in 1989. This left many post-communist states in central and eastern Europe with centralised authoritarian economies that had to transition to decentralised, market-orientated capitalist economies.

Inspired by Bolivia's example, and advised by institutions like the International Monetary Fund and individuals like Jeffrey Sachs, many countries chose shock therapy to shake off the economic lethargy of the communist era and transition to the capitalist systems they wanted to be. These transitions provide an interesting and important view into shock therapy and its consequences, especially when contrasted with China, which began a gradualist transition (the opposite of the shock therapy approach) in 1978 under Deng Xiaoping.

Advocates of shock therapy view Poland as the success story of shock therapy in the post-Soviet states and point out that shock therapy was not applied appropriately in Russia, while critics point out that Poland's reforms were the most gradualist of all the countries and compare China's reforms with those of Russia and their vastly different effects.

Poland

Poland is viewed both as the success story of shock therapy by its supporters and as a vindication of its failures by its critics.

Background

After the failure of the Communist government in the elections of June 4, 1989, it became clear that the previous regime was no longer legitimate. The unofficial talks at Magdalenka and then the Polish Round Table talks of 1989 allowed for a peaceful transition of power to the democratically elected government.

The economic situation was that inflation was high, peaking at around 600%, and the majority of state-owned monopolies and holdings were largely ineffective and completely obsolete in terms of technology. Although there was practically no unemployment in Poland, wages were low and the shortage economy led to a lack of even the most basic foodstuffs in the shops. Unlike the other post-Soviet countries, however, Poland did have some experience with a capitalist economy, as there was still private property in agriculture and food was still sold in farmers' markets.

In September 1989 a commission of experts was formed under the presidency of Leszek Balcerowicz, Poland's leading economist, Minister of Finance and deputy Premier of Poland. Among the members of the commission were George Soros-backed Jeffrey Sachs, Stanisław Gomułka, Stefan Kawalec and Wojciech Misiąg. The commission prepared a plan of extensive reforms that were to enable fast transformation of Poland's economy from obsolete and ineffective central planning to capitalism, as adopted by the states of Western Europe and America.

Balcerowicz Plan

Main article: Balcerowicz Plan

On October 6 the program was presented on public television and in December the Sejm passed a packet of 11 acts, all of which were signed by the president on December 31, 1989. These were:

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

Privatization of companies was left until later.

Results

In the short term, the reforms smothered the building hyperinflation before it reached high levels, ended food shortages, restored goods on the shelves of shops and halved the absence of employees in the work place. However, the reforms also caused many state companies to close at once, leaving their workers unemployed, and government statistics show this change as unemployment rose from 0.3% in January 1990 (just after the reforms) to 6.5% by the end of that year, and a shrinking in the GDP for the next two consecutive years by 9.78% in the first and 7.02% (see main article).

In the long term, the reforms paved the way for economic recovery, with the GDP growing steadily to about 6-7% between 1995-7, falling to a low of 1.2% in 2001 before rising back up to the 6-7% region by 2007, often led by small service businesses, long suppressed by the Communist government. However, despite GDP indicating prosperity for Poland, the unemployment rate continued to rise steadily, peaking at 16.9% in July 1994 before steadily falling down to a low of 9.5% in August 1998 before rising once more to a high of 20.7% in February 2003, from which it had fallen until the year 2008. During the early years, the unemployment rate is thought to have been lower due to many of those claiming unemployment working in the grey (informal) economy, although this can account for no more than 5% of the unemployment rate. Poland also joined the European Union in March 2004, coinciding with the peak in unemployment, allowing its unemployed workforce to find jobs abroad in some EU states. Although this change must have had some impact on the unemployment level, there are no reliable statistics to indicate how large or significant this change was on the reduction of unemployment or how much worse the unemployment would have been without it.

The long term results of shock therapy point to both a rise and a fall in living standards. Ownership of consumables (cars, TVs, VCRs, washing machines, refrigerators, personal computers, and the like) boomed, as did consumption of fruit and vegetables, meat and fish. However, the huge economic adjustment Poland underwent created massive anxiety. This anxiety was added to by crime. In 1989 and 1990, the crime rate in Poland rose substantially. The increase was attributed to several factors: social stresses from the uncertainties of the transition period, the institutional inadequacy of the Ministry of Internal Affairs to deal with social unrest without wielding unlimited authority and widespread scepticism that prevented public cooperation with police investigations. Morale in the police force dropped with large budget cuts and low prestige associated with the job. Only by 1992 were the police finally reformed and rehabilitated, although strict budgets meant that their effectiveness remained constrained. Although crime is now comparable to the rest of Europe, Polish citizens are still most afraid of crime in the EU (alongside Greece). Anxiety was also added by poor safety on the roads, as Poland's underdeveloped road system could not cope with the volumes of traffic generated by both foreign trade and increased car ownership.

Finally, corruption was widespread in Poland. After series of major corruption scandals including most prominently Rywin affair, Transparency International rated Poland as the most corrupt state in 2003 of the then 25 EU members. Since 2006 situation improved very rapidly and by 2011 Poland's Corruption Perceptions Index places it as only 10th most corrupt of 27 EU states, or 8th most corrupt of 12 new EU member states.

Applications

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

New Zealand

The economic reforms of New Zealand's 1984 Labour government, collectively known as Rogernomics (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.

Ex-USSR

Since the USSR's collapse, the post-Soviet states faced many problems. Poverty in the region had increased more than tenfold. The economic crisis that struck all post-Soviet countries in the 1990s was twice as intense as the Great Depression in the countries of Western Europe and the United States in the 1930s.

However, it has not been established whether these adverse outcomes were due to the general collapse of the Soviet economy (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 that 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.

Theory

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

Hyperinflation

Main article: Hyperinflation

Jeffrey Sachs first proposed shock therapy when he noticed that most periods of hyperinflation had been ended in a decisive stroke, often in a day. Therefore, it's important to look at the theoretical basis for hyperinflation to understand why Sachs noticed shock therapy proved so successful in fighting it.

There are two main models used to explain hyperinflation, the confidence model and the monetary model. Hyperinflations see a rapid increase in the money supply and the velocity of money. Either one, or both of these together, is the root cause of hyperinflation and in both models, one follows from the other.

In the confidence model, some event, or series of events, such as defeats in battle, or a run on stocks of the specie that back a currency, removes the belief that the authority issuing the money will remain solvent—whether a bank or a government. Because people do not want to hold notes that may become valueless, they want to spend them in preference to holding notes that will lose value. Sellers, realizing that there is a higher risk for the currency, demand a greater and greater premium over the original value. War is one commonly cited cause of crisis of confidence, particularly losing in a war, as occurred during Napoleonic Vienna, and capital flight, sometimes because of "contagion" is another. In this view, the increase in the circulating medium is the result of the government attempting to buy time without coming to terms with the root cause of the lack of confidence itself. A crisis of confidence is particularly damaging to a fiat currency (i.e. most modern currencies), a currency whose value is unrelated to any physical quantity, as fiat money is typically backed by future tax revenues and its (typically exclusive) acceptability to the government for payment of taxes and charges.

In the monetary model, hyperinflation is a positive feedback cycle of rapid monetary expansion. It has the same cause as all other inflation: money-issuing bodies, central or otherwise, produce currency to pay spiralling costs, often from lax fiscal policy, or the mounting costs of warfare. When businesspeople perceive that the issuer is committed to a policy of rapid currency expansion, they mark up prices to cover the expected decay in the currency's value. The issuer must then accelerate its expansion to cover these prices, which pushes the currency value down even faster than before. According to this model the issuer cannot "win" and the only solution is to abruptly stop expanding the currency. Unfortunately, the end of expansion can cause a severe financial shock to those using the currency as expectations are suddenly adjusted. This policy, combined with reductions of pensions, wages, and government outlays, formed part of the Washington consensus of the 1990s.

Ending hyperinflation depends on which model is the main cause. In the confidence model, the method of ending hyperinflation is to change the backing of the currency — often by issuing a completely new one. Also, if possible, any action that restores confidence in the government can help end the hyperinflation (e.g. the psychological effect of food in the shops after shortages in most hyperinflations, the election of a new government both capable of and dedicated to tackling the problem). In the monetary model, the issuer of the currency must stop expanding the currency.

Shock therapy as an artificial economic shock

A shock in economics is defined as an unexpected or unpredictable event that affects an economy, either positively or negatively. Recessions are often modelled as negative economic shocks in which the current state of the economy is untenable and the economy tries to restore itself to a new equilibrium position. In the short-run, as the economy adjusts to the shock but before it reaches the new equilibrium, the shock often causes productivity to fall, unemployment rise, and closure of firms that are now non-viable in the new environment. The new environment enables new kinds of businesses and people must learn new skills and exploit new opportunities to achieve long-run equilibrium.

Shock therapy can be largely understood by thinking of it as an artificial shock imposed by government policies. Neoclassical theory provides a very useful tool in trying to describe an artificial shock theoretically, in that neoclassical theory provides an idealised view of an economy based on certain assumptions, most of which are made true through market institutions (often but not necessarily provided by the government), law, culture or historical practise, and is very useful in explaining most situations (especially in modern Westernised economies). Even when some of the assumptions required for neoclassical theory are not in place resulting in an imperfect market and the results of neoclassical theory becoming distorted or failing, comparing the result with neoclassical theory can prove useful. Other, slightly different formulations of economic thought strive to describe shocks, the most important of which is neoliberalism.

Neoclassical shocks

In neoclassical theory, large negative shocks cause unemployment in the short run, and the larger the shock, the larger the unemployment. As a result, large shocks can lead to grave social problems, political unrest and, in the worst cases revolution. However, the market is already adjusting itself to return to the new equilibrium, causing job creation and opportunities. If there is no interference to prevent the markets adjusting to the new equilibrium, the markets immediately correct themselves with new firms and full employment, providing workers can acquire the new skills to exploit these new jobs, or are able to move to areas where they can find new employment.

In response to a shock created by bad government policies, sudden market liberalisation can allow the free markets to reach the equilibrium that the bad government policies prevented them reaching. If the response originates in the markets or other external factors, government intervention slows the free market's path to optimal recovery and liberalisation of the economy speed recovery. However, if the shock is large—causing social and political conditions that destroy or prevent the recovery (e.g., revolution)—government intervention to slow the recovery using gradualist policies and spreading the pain is justifiable.

Imperfect market shocks

The most important type of nearly neoclassical shock is due to market failure and imperfect markets. Sudden free market liberalisation in the absence of free market institutions (as was the case in post-Communist states) or in which a Western-style economy is unnecessarily liberalised (e.g. cutting police budgets, removing regulation) are both examples of imperfect market shocks.

The nature of the imperfect market shock depends on what assumption of the perfect market is voided. The most important assumption for all markets is the idea of property rights. The free market doesn't just depend on the exchange of commodities, but on the rights to use them in particular ways for particular amounts of time. Markets are institutions that organize the exchange of control of commodities, where the nature of the control is defined by the property rights attached to the commodities. Property rights are the most important because they can have the most dramatic effect on the results, and are thought to be behind the most important causes of market failure.

Another important assumption is perfect competition, which has many smaller assumptions tied to it. These include perfect information, no barriers to entry and many competitors. Again, there are different imperfect markets depending on what assumption is relaxed.

Many competitors assumes that there is more than one firm producing any commodity. In the event of large-scale privatisation of a state-owned company as part of shock therapy, privatising such a company without waiting for a competitor creates a monopoly where the company can use its pre-eminent position to create barriers to entry, control prices and maintain its monopoly. Also, in post-authoritarian systems with fragile legal and democratic systems, such pre-eminent companies can also influence the government and the legal system to help maintain its monopoly.

Perfect information assumes that prices and product quality is known to all consumers and producers. The idea of imperfect information (most commonly called information asymmetry) has many ramifications for markets. The most important one concerning shock therapy is international trade and financial liberalisation. Because international banks possess better information about other international firms than they do about local firms in a country (and local banks possess better information about other local firms), liberalisation of trade and finance never leads to an even playing field for local firms if international investment is high. Hernando de Soto Polar also notes that in conjunction with imperfect property rights, local firms may not be able to access foreign capital when borrowing against their own capital, which may have imperfect property rights (his so-called dead capital), while local lenders know more about the conditions under which something is owned and can be borrowed against.

Imperfect market failure in Russia

Prominent economist Joseph Stiglitz ties all these ideas together to explain the reason why shock therapy failed in Russia.

Through the idea of property rights, Stiglitz uses the idea of Adam Smith's invisible hand to explain that, in the presence of severe corruption, a lack of institutionalized law and order and artificially depressed exchange rates, the free market created by shock therapy in Russia created a race to the bottom to asset strip the country and remove the capital abroad, rather than the mutually beneficial race to control the market in commodities that would otherwise happen. Competition meant that if the nominal owner of the capital didn't asset strip the capital first, someone else would.

Likewise, with the previously large Soviet nationalised industries being privatised quickly created a situation where major markets operated in a monopoly owned by a few individuals (the Russian oligarchs) who had links with the government of Boris Yeltsin.

Neoliberal shocks

Main article: neoliberalism

Neoliberal theory broadly follows neoclassical theory with some exceptions. While neoclassical theory uses the conditions of perfect markets to describe the conditions under which it works, neoliberal theory rejects those in favour of ideas based largely on the work of Milton Friedman and broadly argues that perfect markets occur naturally provided that economic and political freedoms are present and maintained. The applicability of neoliberalism, in contrast to neoclassical theory, is increased by improved freedom, and neoliberal shocks can fail only if:

• property rights are violated
• people are not free enough to maintain perfect competition

As a result, it is implicit in neoliberalism that gradualism can never work as the markets are not free enough for neoliberalism to function, and shock therapy is the only possible path to economic reform and prosperity. The neoliberal explanation for the failure of any application of shock therapy is limited to issues of corruption in the government or legal systems, and a too slow pace of reform, which can lead to the neoliberal shock becoming an imperfect market shock (as outlined above).

Neoliberals viewed the free price system of free markets as a system which exchanged information very efficiently about the state of the economy as prices fluctuated to supply and demand, an idea that developed into the efficient-market hypothesis. In this view, even if perfect information does not exist for any individual, on the whole, the market must contain broadly perfect information about the commodities being traded as each transaction carries information about the parties involved. Also, neoliberals believe that government regulation and unnecessary bureaucracy are the chief barriers to entry in a market, tying perfect competition to market freedom once more, and emphasise that governments actively involved in the economy provide dominant monopolies with a means to use their market power into political power, which they can use to maintain their monopoly. However, monopolies can still corrupt law and order in a neoliberal system to maintain their status, which explains the focus on anti-corruption measures that neoliberal theorists maintain.

The neoliberal reliance on freedom also supposes another important neoliberal belief, which comes from the work of Friedman and has been absorbed into idea of rational expectations, which supposes that the freer the economy, the healthier it is. As a result, a country needing to apply shock therapy must be doing so because it allowed the government to unnecessarily interfere in the operation of the free market.

Miscellaneous other shocks

Neoclassical models of the economy tend not to incorporate the idea of feedback. Feedback is important as it can cause economies that are doing well or badly to undergo positive feedback, making downturns worse and recoveries into bubbles that then burst into recessions. In the presence of positive feedback, shocks become amplified, becoming much more serious than they are. As a result, shock therapy is never the answer to economic recovery, and there is often wisdom to initial government intervention to break the vicious cycle.

Illusionary shock

Illusion Therapy refers to the imposition of shock economic policies on economy in a way that the society doesn't feel the shock or assumes that the dramatic change in policies is not as shocking or radical as it is in the real world. The situation of "Illusion" can be created using a wide range of sociopolitical tools and techniques including information blackout on national statistics, imposing repeated false news shocks before the final shock (to decrease the social sensitivity or to habituate the people to the future shock), spreading misinformation, rewarding the society with interim exogenous rents and promoting them as the benefits of the shock, etc. Illusion Therapy is used to soften or elude the potential social backlash during the shock. The first experience of illusion therapy has been documented after the implementation of Iran's subsidy reform project.

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
• Balcerowicz Plan
• Russia under Yeltsin and the History of post-Soviet Russia
• Reaganomics
• Rogernomics

Other

• The Shock Doctrine
• Constitutional economics
• Political economy
• fiat money

External links

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