Shock Therapy vs. Gradualism: A Neoclassical Perspective

This paper considers the "shock therapy" vs. "gradualism" debate in the transition economics literature. It stresses the primacy of political economy considerations, which arise naturally when reforming policy makers do not have to lump-sum redistributive instruments. The paper summarizes the results of recent research by the author, which considers the implications of embedding an explicit model of policy formation into an otherwise standard, neoclassical model of structural adjustment. There are two principal findings. First, when adjustment cost: are very high, shock therapy will be politically infeasible, because it will not command majority support in a binary contest over the status quo. Second, in such cases, it is possible to construct a gradualist alternative which is politically feasible, which occurs because the pivotal group of voters (workers who begin in the declining sector) will perceive a net increase in the present value of their earnings vis-a-vis the status quo. Furthermore this gradualist alternative is dynamically consistent, in the sense that workers who choose to support reform at its inception will never wish to abandon it.