Shock Therapy

Definition and policy package

Shock therapy denotes a package of radical economic reforms based on the principles of laissez-faire and the free market. The Russian article summarizes it as rapid and comprehensive price liberalization, strict control of the money supply, broad privatization of state enterprises, abandonment of most subsidies, and reduction of the state apparatus in the economic sphere with tighter control of state spending. English-language accounts describe a simultaneous prescription of liberalizing all prices, privatization, trade liberalization, and tight monetary and fiscal policies, listing the ending of price controls, the stopping of subsidies, the sale of state-owned industries, and higher tax rates with lowered government spending. Its supporters declared that these reforms were intended to restore the economy and pull it out of crisis.

Name and lineage

Jeffrey Sachs is widely credited with the term, but Sachs himself says he never picked it, does not much like it, and that it "was something that was overlaid by journalism and public discussion." His ideas came from studying historic periods of monetary and economic crisis and noting that a decisive stroke could end monetary chaos, often in a day. Naomi Klein, by contrast, popularized the phrase with her 2007 book, arguing that neoliberal free-market policies rose to global prominence through a strategy of "shock therapy" accompanied by political and social shocks such as military coups, state-sponsored terror, sudden unemployment and exploitation of labour.

Cases

In West Germany, currency reform took effect on 20 June 1948 with the Deutsche Mark replacing the Reichsmark. On 27 June private non-bank credit balances were converted at 10 RM to 1 DM with half frozen, and on 4 October the military governments wiped out 70% of remaining frozen balances (an effective 10 to 0.65 ratio), dispossessing many small savers. The same day Ludwig Erhard announced, despite Allied reservations, that rationing would be considerably relaxed and price controls abolished. In the short term the reforms helped end hyperinflation and shops refilled with goods, but the price liberalization, which excluded rents and essential goods, still caused inflation and a general strike, and a turn to a social market economy followed. Here too redistribution ran from the bottom up, favouring those who held non-monetary assets, and by late 1948 the German transition followed a dual-track pattern with a planned core and a market-coordinated periphery.

In Chile in 1975 the government welcomed foreign investment and eliminated protectionist trade barriers, forcing Chilean businesses to compete with imports. The main copper company Codelco stayed in state hands because of Allende's nationalization of copper, while private companies could explore and develop new mines. In the short term the reforms stabilized the economy; in the long term Chile had higher GDP growth than its neighbours alongside a noticeable increase in income inequality.

In Bolivia, galloping hyperinflation began after political instability, in the term of Hernán Siles Zuazo. On 6 August 1985 Víctor Paz Estenssoro was elected, and on 29 August, three weeks after his election, Decree 21060, the architect of which was Planning Minister Gonzalo Sánchez de Lozada, was passed. It allowed the peso to float, ended price controls and eliminated subsidies to the public sector, laid off two-thirds of employees of the state oil and tin companies and froze the pay of the remaining public-sector workers, liberalised import tariffs with a uniform 20% tariff, and stopped payment of foreign debt under an IMF-negotiated deal. De Lozada explained the reasoning with the image of a very sick patient who must be operated on before dying, adding that "inflation is like a tiger and you have only one shot." Sachs, then economic adviser to the Bolivian government, took part in the plan, and inflation fell from over 20,000% in 1985 to 15% in 1989.

Application in the former Soviet bloc and its outcomes

After the collapse of the USSR in 1991, shock therapy was adopted and sustained by Poland, the Czech Republic, Slovakia, Latvia, Lithuania and Estonia, and was also adopted but eventually aborted by Russia, Albania, North Macedonia, Bulgaria and Kyrgyzstan. Nearly all post-Soviet states suffered deep and prolonged recessions, with poverty increasing more than tenfold. In Russia, Yegor Gaidar began implementing the programme in January 1992 by deregulating prices, removing legal barriers to private trade, cutting subsidies to state industries and allowing imports; the immediate result was hyperinflation and the near bankruptcy of much of Russian industry, while Gaidar and other reformers insisted a painful transition was necessary and dubbed themselves an "economic kamikaze team" on a suicide mission to break the old Soviet system. The Russian article dates the Russian episode as 1992 to 1998 and treats it as not following the classical shock-therapy scenario, because one of its main conditions, a sharp reduction of inflation, failed: average annual inflation in 1991 was 301.5%, and double digits (21.5%) were reached only in 1996. Market reforms also bore fruit earlier than often assumed: the goods shortage was to some extent overcome in early 1992 through imports, inflation fell to 83% for 1998, and GDP showed its first growth in 1997.

Shock therapy devalued the modest wealth individuals had accumulated under socialism and amounted to a regressive redistribution of wealth in favour of elites who held non-monetary assets. Contrary to proponents' expectations, Russia's rapid transition to the market increased corruption rather than alleviating it. The cost to human life was profound: Russia suffered the worst peacetime increase in mortality experienced by any industrialized country, and where roughly 2% of Russia's population lived in poverty (under $4 a day) in 1987-1988, by 1993-1995 it was 50%. A significant body of scholarship cited by Kristen Ghodsee and Mitchell A. Orenstein holds that rapid privatization produced poorer health outcomes in former Eastern Bloc countries, and the World Health Organization itself stated that "IMF economic reform programs are associated with significantly worsened tuberculosis incidence, prevalence, and mortality rates in post-communist Eastern European and former Soviet countries."

There is debate whether adverse outcomes were due to the general collapse of the Soviet economy, which began before 1989, to the policies subsequently implemented, or a combination. Sachs resigned as advisor, stating he felt his advice was unheeded and his recommendations not actually put into practice, and criticized the US and IMF for not providing large-scale financial aid to Russia. Some accounts may over-weight the advice of international financial institutions and under-weight the domestic politics of the countries making the decisions: before the break-up of the USSR the Soviet government was committed to a gradualist approach to reforming state ownership, and it was only by 1992, after dissolution, that the new Russian government's fear of a communist return led it to adopt rapid mass voucher privatization, more radical than anything considered in 1990, hoping to create a capitalist class supporting Yeltsin. In Poland, where this political motive was absent, privatizations were much less rushed, reckless and inequitable, and Poland saw a much lower increase in inequality and more growth. Another factor in the collapse was that the break-up of the Soviet Union greatly hindered trade between areas previously part of the same economic zone.

Assessment and distinctions

Shock therapy has been controversial: proponents argued it helped end economic crises, stabilized economies and paved the way for growth, while critics including Joseph Stiglitz believed it deepened crises unnecessarily and created unnecessary social suffering. Economic liberalism rose to prominence after the 1960s and liberal shock therapy became increasingly used as a response to economic crises, for example by the IMF in the 1997 Asian financial crisis. German historian Philipp Ther asserted that the imposition of shock therapy had little to do with future economic growth in Europe, and prominent proponent Jeffrey Sachs has stated he believes shock therapy should be accompanied by debt forgiveness.

Shock therapy is contrasted with gradualism. A gradualist approach builds institutions and buffers first and marketizes step by step, whereas shock therapy injects all prescriptions simultaneously. Such a prescription is also called the "big bang" approach. Critics of the Russian implementation argue that maximum liberalization of economic activity, arbitrary distribution of state property, and financial stabilization through a hard restriction of aggregate demand produced a poor quasi-market system. Academician A. D. Nekipelov described features including unprecedented naturalization of economic activity, a sustained interest rate exceeding returns in the real sector, a chronic fiscal crisis, and an orientation toward financial-trade speculation and stripping of previously created wealth. "Illusion therapy," by contrast, is a separate concept denoting shock economic policies imposed in a way that society does not feel the shock; the English-language source documents its first experience in Iran's subsidy reform project.