Shock therapy is the belief that the best way to fix a broken economy is to implement radical changes and introduce new market oriented policies, in one fell swoop whatever the short term cost. Shock therapy is associated with the economist Jeffrey Sachs who advocated free market reforms for Eastern European countries like Poland and Russia in the early 1990s. (Sachs actually disliked term ‘shock therapy’ arguing it was coined by media and makes it sound more painful that it needed to be)
Shock therapy is different to a more gradual approach which seeks to make incremental changes and transition.
Shock therapy generally refers to policies used for making a transition from a Command (state controlled) economy to a mixed economy. However, shock therapy might also refer to
- Policies to reduce inflation quickly.
- Policies to reduce budget deficit.
- Policies to restore competitiveness and reduce current account deficits.
Shock Therapy policies involves
- Price liberalisation – ending price controls
- Ending government subsidies
- Privatisation. Selling state owned industries to the private sector. It is hoped that under private control, firms will have more incentives to be efficient and cut costs.
- Tightening of fiscal policy – higher tax rates, lower government spending to reduce budget deficit and control inflation.
Benefits of Shock Therapy
- It is considered a quicker method to overcome economic inefficiency and deal with wasted resources.
- With firm leadership, people know what to expect and make efforts to deal with the new situation. For example, if you want to control inflation, it is important to change expectations. Sticking to strict anti-inflationary policies, will help bring down inflation expectations and make it easier to achieve.
- Stretching out economic reform, can prolong the old difficulties.
- Jeffrey Sachs, a key supporter of shock therapy, argued it was harder to make the leap to a market economy in two stages. Privatisation, price liberalisation and control of inflation are complementary policies.
Successes of shock therapy
Some point to successes of shock therapy approaches, such as:
- Bolivia in 1985. In particular, Bolivia were successful in bringing a period of hyperinflation under control.
- Germany in 1948, when price controls were eliminated; this helped to end hyperinflation and improved confidence in the currency.
- Poland in 1990s. Poland’s free market reforms enabled inflation to be brought under control. After initial difficulties, economic growth was impressive during the 1990s, but unemployment rose sharply as state owned industries closed. Unemployment rose from 0.4% in 1989 to peak at 16.9% in July 1994.
Criticism of shock therapy
- It can lead to a significant increase in inequality because those on low incomes may not be able to afford the new prices and may lose their job
- It often causes a rapid rise in unemployment, which can cause a significant problems of social unrest and inequality.
- Some economies may not be ready for a sudden shift. For example, the Russian privatisation programme of the 1990s enabled the wealth of the country to be owned by a few oligarchs. The economy lacked sufficient infrastructure and legal system for a free market economy.
- Bolivia’s shock therapy policies reduced inflation, but also led to an even higher rate of unemployment – reaching 21% in 1986. Bolivia’s second wave of market reform in the 1990s was also criticised, such as the failure of water privatisation.
- China is often cited as an example of an economy which has benefited from a steady and gradual transition from command to free market economy. The process of market liberalisation has been stretched out over 30 years, and has enabled very high rates of economic growth – without any of the short term pain of recession and high unemployment.
Shock therapy and austerity
Some see deep austerity policies as a different type of ‘shock therapy’. For example, the Baltic states like Estonia, Latvia and Lithuania – embarked on strict deficit reduction policies in the aftermath of the 2008 recession. This was relatively successful from the point of reducing the budget and current account deficits. But, it is controversial because it led to very high rates of unemployment. Also, although the economies later posted high growth rates, this masked the fact GDP fell significantly during the period of shock therapy. (see: Lessons from Estonia and Latvia)