All Commentary
Friday, November 1, 1991

Polands Flawed Reform Plan

Professor Cleveland teaches finance at Birmingham-Southern College, Birmingham, Alabama.

Poland’s economy recently has undergone some radical changes. Price restrictions have been lifted, its borders have been opened to foreign goods, and interest rates and exchange rates have been allowed to fluctuate. These are encouraging moves toward a free market system.

The results, however, have been mixed. Small businesses have opened in record numbers and many shortages have been eliminated, but unemployment has risen and productivity has fallen. Why hasn’t Poland’s economy responded in a more positive fashion?

The problem is that wages remain regulated. Increased unemployment and lagging productivity are the natural result.

In a market where product prices move freely and businesses are free to compete for customers, it is important to produce a quality product while remaining price competitive. However, if the government controls the wages a firm may pay, it becomes very difficult to do this. Since employers no longer can compensate employees for exemplary performance, workers lose the incentive to put forth maximum effort. Instead each employee tends to discharge his duties at a minimal level of acceptable performance.

Controls on wage rates, therefore, mean that more labor hours will be needed to produce a given product. This raises production costs, hindering the firm’s ability to remain price competitive.

The quality of the firm’s product also suffers. Not only is the employer unable to reward employees on the basis of productivity, he is unable to reward those who are careful not to make mistakes in the production process. Therefore, where wages are restricted, a firm won~ be able to compete with firms whose wages aren’t restricted.

In places such as Poland, where wages are controlled while other prices are free to fluctuate and markets are relatively open, firms cannot produce goods of sufficient quality at low enough prices to compete with outside firms that don’t have to abide by such artificial restrictions. Productivity falls and unemployment rises.

There is an additional result from Poland’s peculiar mix of free market changes with continued socialist policies: the tremendous growth of small retail businesses. I saw this firsthand when I visited Warsaw recently.

Within walking distance from my hotel, there were people on a major street selling all types of goods right out of the trunks of their cars. It was amazing to see the wide variety of products. Across the street was a flea market made up of small, wood-framed booths that housed other emerging retail establishments. It was obvious that these vendors had made something of a successful stride forward by procuring a fixed establishment for their operations. Beyond this stage were the business enterprises that were opening in many of the storefronts in the downtown area. The availability of produce that can be bought from these retailers is nothing short of miraculous.

However, the success of these enterprises is not without peril. In particular, there is some question as to how much they will be able to grow. The reason is once again the wage-rate restrictions. If a retailer is to hire an employee, he must pay the regulated wage. Therefore, it will be very difficult for these potential employers to expand their operations. Will they hire more employees than they can personally supervise? The evidence is against it. An employer can’t afford to hire a supervisor who must be paid a regulated wage. Therefore, firms will grow only to a limited size.

This poses another problem for the Polish people. If business expansion is limited, the country’s ability to compete in large-scale production with other countries will be hampered. Poland won’t be able to gain from economies of scale. This, in turn, will limit the increase in the standard of living that the Polish people can expect from the changes they have made thus far.

Poland’s future remains uncertain. Already there are special interest groups, such as the nation’s farmers, who want to close the borders to foreign products. This would begin to wipe out the gains that already have been made.

Poland’s reform plan is flawed. However, the flaw is not the result of its new free market policies. Rather, the flaw is due to the residual socialist policies that remain in force.