Shock therapy (economics)

From Academic Kids

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. Prominent economist Jeffrey Sachs was the foremost proponent of shock therapy for several emerging economies.

According to Professor Sachs, shock therapy traces its roots from the economic liberalization programme undertaken by post-war West Germany in the late 1940s. During 1947 and 1948, price controls and government support were withdrawn over a very short period - this had the effect of kickstarting the German economy. Germany had previously had a highly authoritarian and economic interventionist government and seemingly overnight threw off these restrictions and became a developed market economy. These free-market reforms became the basis of neoliberal economic theory.

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 too release all price controls, 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 radical changes to the structure and incentives within economies.

Some people consider the effects to be primarily negative, such as short-term unemployment rates ranging from 20-40%, increased crime rates and increased social tensions between the poor and the rich. Others judge that the effects have been positive, or that the theory was inadequately applied.

What is not in doubt is that sudden changes to economic structure and incentives require changes to behaviour, 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.

An interesting case study in the use of shock therapy is Poland. When democracy came to the eastern European nation, the government took Sachs' advice and immediately withdrew regulations, price controls and subsidies to state-owned industries. Though the immediate effect was negative, things eventually got better. Though many were out of work, producers that still had jobs worked harder and made more. Today, although Poland is still a relatively poor country, it is growing very quickly. But it is debateable how much of this benefit is getting to ordinary people.

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