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It follows that the role of the state is very different in the planned and market economies. In the prereform era, state controls supplanted much of the institutional infrastructure of a market economy, overriding contract law with administrative practice. Thus, elimination of state control involves rebuilding the rule of law and the capacity to enforce a framework of rules of the game. It involves rebuilding a capacity to manage the macro economy by means of monetary and financial policies, to establish independent financial institutions, and to provide public goods and a social safety net. Restructuring of government will involve building local governments with the capacity to provide local public goods and agencies at all levels that will provide more public services and less regulation.

Structural Change, Investment, and Growth

Initial reform policies—liberalization, stabilization, and privatization—have set some of the Eastern European transition economies well on the road to integration with Europe. But successful implementation of each of these policies assumes the existence of supporting institutions and minimum levels of governmental administrative capacity. Where such infrastructure is lacking—notably in the republics of the former Soviet Union—the desired policy results have been more difficult to achieve.

The second stage of economic reform involves a still more difficult process, the reallocation of labor, capital, and management from subsidized state sectors to expanding export and consumer-oriented sectors. Eastern Europe has had considerable success in mobilizing domestic saving and attracting foreign investment, while Russia and the Commonwealth of Independent States continue to suffer capital flight.

Initial Conditions and State Dependence

The task of restructuring production is hampered by initial conditions. The Soviet Union shared with Eastern Europe a bureaucratic power structure controlled by a communist party and oriented toward the maintenance of political power. Yet the legacy of the Soviet system serves as a more serious impediment to restructuring in Russia than in Poland, Hungary, Czechoslovakia, or even Estonia.

The classical Soviet system was a highly centralized bureaucratic hierarchy that produced distorted incentives, biased information, and high levels of lobbying. Its structure protected bureaucratic monopolies and allowed party leaders to pursue political objectives at the expense of economic performance. Ericson (1991) depicts a system that lacked rudimentary incentive-compatibility or market-based flexibility. This system had the following characteristics:

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