The Czech Miracle

Why privatization went right in the Czech Republic


There are, at bottom, just two ways to bring economic rationality to a state which has seen none of it. One is to carefully analyze the situation, to call high-level conferences and consult with international experts, to measure each tentative step, to be cautious of doing the wrong thing—of going too far, of giving away too much. The other path is to decide that speed is the very essence of reform and that the great catastrophe lies not in doing the wrong thing but in doing nothing.

Most of Eastern Europe has chosen the cautious route. Alone among the former satellites of the Soviet Union, the Czech Republic has elected to go fast. Now as Hungary, Poland, and Russia struggle to emerge from the abyss of the planned economy, as Romania and Bulgaria and Ukraine bobble in a post-socialist/pre-capitalist never-never land, a thriving marketplace is flashing its sparkle in the Czech Republic, a modern experiment in radical capitalist transformation.

The Czech model was not how the Western experts had charted the East European reform era. Some did support macroeconomic "shock therapy," which has had notable successes in freeing prices and privatizing small enterprises, but the idea of turning state socialism into private enterprise in an instant—that they considered impossible. If the United Kingdom, with its commercial law, its investment bankers, its management consultants, its brokerage houses, and its stock exchanges took all of the 1980s to privatize 50 or 60 state-owned firms during the regime of the Iron Lady, then surely the task of privatizing the Czech Republic's 2,700 state-owned firms could not be done overnight.

In 1990, Czechoslovakia was the most socialized of any economy in the Warsaw Pact: 97 percent of productive assets were owned by the government. Hungary and Poland, at about 80 percent state owned, were teeming meccas of laissez faire by comparison. By March 1995, however, the assets of the Czech Republic, the two-thirds of Czechoslovakia which split from the Slovak Republic on January 1, 1993, were 80 percent owned by private persons or corporations—easily the highest ratio of any ex-communist European country. Poland, the test ground for early reforms including "shock therapy," is still unhappily stuck at 55 percent private, the same level as Hungary, a country with a 25-year head start on reform.

And the Czechs are not just privatizing like mad, they are "growing the economy." Czech living standards are increasing rapidly. Inflation—which had its pop when pent-up Crowns were unleashed in the early 1990s—is now under 8 percent a year; indeed, the currency has held its ground against the U.S. dollar since 1991. Exports are booming and the federal budget is in surplus. Unemployment is at 3.5 percent, a remarkable feat considering that layoffs from newly privatized firms are virtually ubiquitous. The expanding service sector is swallowing up thousands of "workers" from the "industrial" sector (such employees did not in fact engage in much productive work, nor did their factories demonstrate more than a semantic allegiance to industry). As Prime Minister Václav Klaus announced last summer, "We are the first Eastern bloc nation to emerge from major surgery and make it into the post-op recovery room."

Most phenomenal, however, is the electoral payoff of what the government still resists calling the "Czech Miracle." While reformers all across the formerly communist nation-states are in hurried retreat, as former apparatchiks turned populists steam back into power, the classical-liberal government headed by Prime Minister Klaus enjoys no serious political challenge from left or right. Prague is in full bloom and the Czechs are far too busy tending garden to launch the dirigiste backlash which swirls violently just beyond.

The Czech reforms were uniquely radical in transferring property from state ownership to private hands, and the society has responded with a flowering of initiative and entrepreneurship. And something more: civility. Politicians in the Czech Republic do not triumph by denouncing foreigners and Jews; the disagreements and arguments of this democratic land have not produced gridlock; frustration and hate do not cloud the cobbled byways of beautiful and historic Prague. And 56 percent (to 12 percent pessimists) of Czech citizens feel "generally optimistic" about their future.

Soon after the communist government in Prague collapsed in the "Velvet Revolution" of November 1989, a government was formed by the new prime minister, Václav Havel. One of the greatest of the dissident writers in Czechoslovakia, Havel earned his anti-communist stripes by doing hard time in a socialist reformatory. He commanded a powerful moral authority. Havel's economic ideas were, however, somewhat poetic; his principled opposition to the hardness of communism had made him squeamish vis à vis the harsh realities of a market economy.

Ironically, Václav Klaus, an economist who had not participated in the dissident movement, was inherited by Havel as finance minister, having been appointed by a gasping "reformist" communist government in 1989. By June 1990, Klaus had split from the Civic Forum, Havel's party, to form his own Civic Democratic Party, a party preaching a faster, more radical transition to capitalism. After the election of June 1992, Klaus replaced Havel, who was moved to the largely ceremonial position of president. Consistently, Czechs say that Havel, while a national hero, is simply "too soft" to make the hard decisions. Klaus is not.

Klaus's tough love won the policy debates early on, a fact Klaus credits to the one favor which Soviet domination had granted. When Russian tanks rolled through Wencelas Square, crushing the Prague Spring of 1968, they discredited the notion of "reform socialism" forever. When someone suggested a "third way"—neither capitalist nor communist—Klaus says the answer was smart and final: We tried that. When economic policies end up flattened with tank-track marks on their topside, you tend to remember the botch.

So the path was clear for quick action. Even before he became prime minister, Klaus and reform-minded liberals had enacted a commercial code (partly borrowed from Germany but tailored to domestic institutions), a restitution process, and a privatization law. The code set up a legal system so that contracts and property rights, the necessary legal pre-conditions of a market economy, could flourish. While establishing the most far-reaching restitution program in the Eastern bloc, the law set lightning-fast deadlines—those who wanted to file claims to "reprivatize" property expropriated by the communists after 1948 had less than a year, until September 30, 1991. The government did not want properties in limbo for years of wrangling over historic ownership rights. The initial privatization policy was intended for small-scale enterprises—restaurants, retail stores, printing shops, gas stations—to be sold by local governments. Since they were small potatoes, the move was relatively easy and uncontroversial: New owners would run things more efficiently, and it was not complicated to figure out who owned what when just a dab of physical assets were involved.

Restitution claims were opened up in November 1990 and moved about $4 billion in assets immediately into private hands. In all, some 100,000 physical properties, including farms, houses, and small businesses, were quickly restituted. Small-scale privatization auctions began January 26, 1991, and were essentially completed by the end of that year, when over 20,000 properties had been sold (25,584 by the end of 1993). The results were encouraging: Workers or others knowledgeable about a business were typically high bidders, and entrepreneurial talents were immediately unleashed. Managers who had adroitly pilfered state assets were turned into profit-minded capitalists in the stroke of a winning bid. Resources became efficiently utilized, and consumers gained a new importance.

The change was visible to the naked eye. As a visitor to Prague in July 1990, I was pained over the gaping hole in the consumer-service infrastructure. Restaurants were rarely open to tourists, even when personnel were on duty and tables empty, and shopping opportunities for convenience items were absolutely nil. The food was abominable; each meal seemed a weird experiment in nutritional efficiency (don't even ask about the communist-bloc yogurt). Just over a year later, in September 1991, I returned to a city bursting with bars and restaurants which catered to the tourist. The food was good—and cheap. By September 1992—the food increasingly delicious—I was complaining about rising prices and the annoying influx of Western fun seekers. Today the secret is out, and the streets of Prague are clogged with consumer demand.

Small-scale privatization was, however, only the beginning. The core of the Czech reform program, and what has driven its successes full throttle, is the tactical genius demonstrated by a Bolshevik troika of free-market economists in Prague. First there is Klaus, a relatively anonymous number cruncher who worked in the banking sector under the communists. And then there are two former professors at the Prague School of Economics who fell under the sway of the late Nobel-prize winning economist F.A. Hayek: Tomás Jezek, Hayek's Czech translator and the first minister of privatization (now a member of the Czech parliament), and Dusan Tríska, a flamboyant intellectual-turned-entrepreneur, who currently runs an electronic stock exchange more computerized than NASDAQ. From Hayek's work, they learned subtle lessons about information, property rights, and institutional transformation no other former communist country has taken to heart.

Reform elsewhere has had a hierarchy: 1) establish macroeconomic stability (bring inflation under control and stabilize the exchange rate); 2) create, or patch up, commercial law; 3) deregulate prices; 4) liberalize markets by allowing new entry including imports; 5) privatize small-scale enterprises; 6) privatize large-scale enterprises. Country after country has worked from the same list; time after time they have stalled out before getting to step 6.

The Czech market reformers' list is just as comprehensive but prioritized differently. They have always seen the central reform, on which all other success hinges, as getting the vast bulk of capital out of the state's hands. The other reforms are merely a prelude to the central symphony of capitalism: private ownership of the means of production. Klaus considered a halfway market-socialist economy merely a higher circle of hell. His strategy rejected gradualism at two fundamental levels. Economically, only privatization of the great majority of productive assets could lead to the ultimate payoff—massive industrial restructuring. And politically, only the presentation of an aggressive, radical plan—a plan with a capitalist vision—could defeat the overwhelming reactionary forces of stasis and ugliness.

The Czech reformers believed that the approach preferred by Havel and most of the post-communist regimes in Eastern Europe was wrong in its economics—it eschewed radicalism in favor of perestroika—and in its politics—it offered paeans to democratic process but denounced strong political parties or platforms. This soft-pedaling of reform coupled with the romantic belief that democracy would, by itself, solve the problems of post-communist society, was absurd to the strident market liberals led by Klaus. They became democratic Bolsheviks, committed to creating a strong platform and a clear vision of bold, decisive public action. They saw the power vacuum created by the collapse of communism and argued that if a dynamic liberal agenda did not quickly fill it, reactionary sloganeering soon would.

The radical capitalist reforms in the Czech Republic reflect the belief that the key to success is a shift in the property-rights structure of society. As Klaus noted in a November 1993 speech at the Czech Economy Society in Prague: "The key task is looking for an owner who will perform post-privatization restructuring, not for a state bureaucrat who will restructure the firm before privatization."

The Czechs augured that without a radical shift to private property, reforms would be fruitless. How could one "reform" a vast auto plant if it were still owned by the state? Or bring balance to government expenditures if subsidies to bankrupt government companies continued? Or end subsidies if state ownership continued? Or restrain wages if the government employed most of the work force—a work force that now voted in non-rigged elections? Klaus saw quick privatization of state assets not as a luxury, but as the essence of reform. It would, he said, "minimize the period of pre-privatization agony, because no method exists to rationalise the behavior of firms waiting for privatization (without reintroducing central planning)." The parenthetical is hardly a throw away: It is the approach, to one degree or another, of rising political parties in every other country of the Eastern bloc.

Not only did reform without private property, and lots of it, make little economic sense, the Czech liberals believed that the only way to keep the reform flame on high was to overwhelm the public with so much opportunity that Czechs would not have time to quarrel over details. Dumping massive amounts of state property into private hands would not only achieve efficiency—production goes up as socialism goes down—but create a feeding frenzy on the corpse of the socialist state. This frantic cleansing process channeled society's political energy in a most productive way. Instead of decades-long maneuvers to position this or that interest group for the next well-considered round of privatization, the most calculating men and women snatched their opportunities to become vested in the property now (briefly) available. The social dynamic was goosed by a rush not to chaos and disorder—as in the first Bolshevik uprising—but by the self-affirming excitement of a race to stake their claims. The gold rush was on, and Czechoslovakians were given one brief shining moment to either become capitalists or to sit on the sidelines of history. Entrepreneurs overwhelmed the political fixers, and the Czech Miracle was born.

Structurally, there are two key elements to the Czech economic reforms. The first is the logic of the "mass privatization." This was an idea hatched by Dusan Tríska, who had seen the plan suggested in a Polish policy paper in 1989 and knew about a giveaway of the government's power company to citizens in British Columbia in the 1970s. Adult citizens would bid for companies with voucher coupons, with each entitled to buy one booklet of 1,000 "points" for a nominal sum. The idea was appealing because simply transferring assets to private citizens is equitable and democratic. It also had a very practical aspect to recommend it: Assets could be privatized with minimal payment. That's a fairly important feature when you are dealing with 15 million near-penniless survivors of communism. So on philosophical grounds—"you deserve a break today"—as well as pragmatic ones—"no cash? no problem!"—turning over state enterprises to the citizens, one man, one share, seemed the right thing to do.

But a second structural aspect has been equally important. It is the creation of succeeding "waves" of large-scale privatization, a formalized sequencing of abrupt deadlines by which project proposals have to be submitted to the Privatization Ministry. This seemingly bureaucratic constraint—calling for private firms or individuals to create great mountains of paperwork for government to administer—was an economic brainstorm. What it did was motivate a massive unveiling of the information as to what, exactly, constituted the Czech capital base. Not only what land, equipment, inventories, and productive capacity already existed, but what could—if reasonably deployed—exist in the future.

The information that the Czechs needed to privatize 3,000 large state enterprises was vast. The central authorities had little actual knowledge of the stock of social capital; the communists may have laid claim to most everything, but they were terribly sloppy bookkeepers. Just finding out what state enterprises consisted of—their physical equipment and inventories, their land and bank accounts, their liabilities, their accounts receivable—was a mess. The national financials, in other words, made Bill Clinton's foreign policy look orderly.

Just one complicating factor, for instance, were loans from one firm to another. Since the state never let any company go bankrupt, managers had incentives to borrow to the max. Who would lend? Other firms, of course—who could register paper assets (interest-earning bonds) while going to still another firm for needed working capital. If push came to shove, the government would rush in and offer subsidies to mitigate financial losses. It was a financial shell game, and, because firms never suffered for defaulting or being defaulted upon, no one entity really knew which loans were operative at any one time.

Against this lack of information, the secret weapon in the Czech Republic's remarkable transformation is what Klaus adviser Tríska calls "the highly flexible concept of a privatization project." Instead of bureaucrats going over the books and deciding what state assets to unload and how, the process is bottom-up. The public petitions the government to privatize a particular property. In effect, private citizens compete to present the best "privatization project" to the state. The advantage is obvious, according to the deputy secretary of the Privatization Ministry, Roman Ceska, who told me in September 1993: "We suffered from the Hayekian information problem."

This is the classic situation in any modern economy. As brilliantly posited by the late Austrian cum English economist F.A. Hayek, the problem is that (even in the best of circumstances) the essential bits of data upon which economies actually run are dispersed throughout society. The pertinent facts concerning demand and supply are known only to individual people who will only reveal such information when it is in their interest to do so. This is not the sort of governmental problem that can be fixed by further research. The data are nowhere available. Information about how, exactly, to achieve efficiencies are hidden deep within the recesses of the human imagination, only to be unlocked by the magnetic force of self-interest.

The Czech reforms have been explicitly designed to tap into this informational gold mine. Rather than dictating the terms of large-scale privatization in a world of darkness, the government has accepted proposals from private persons (not restricted to citizens—everyone, even foreign corporations, could play). The rules of the game were established by the privatization authorities and the deadlines were brutally short. But the projects were all designed by the private sector.

An example is provided by the privatization of the Hotel Pariz. A beautiful old inn built in 1903-07 and standing less than one mile from Wencelas Square in Prague, the building spans six stories and features 100 rooms, one café, one restaurant, and two banquet rooms. It has a secretarial center and will soon house a health club.

Antonín Brandejs is the general manager (and part owner). A Czech in his early 50s, Brandejs left his country during the political turmoil of 1968, living as a global nomad in Germany, France, Canada, and the Middle East. With the collapse of communism, he returned and sought to reclaim the business his family had owned since his grandfather purchased the hotel in 1923. It had been expropriated by the communists in 1948.

The struggle for the Pariz began in January 1991 when, under the newly enacted restitution law, Brandejs's family began the process of making a claim. They were entitled to the physical property minus the value of any improvements. But how you measure the value of such improvements is just the pesky sort of complication that has hammered every restitution program in Eastern Europe. An enormous amount of money had been spent in recent years on renovating the hotel, but much of the money was either wasted (for instance, some rooms in the luxury hotel were left without bathrooms and had to be re-renovated) or pilfered (through insider dealing, with suppliers giving kickbacks to hotel management).

In a capitalist economy such historical accounting numbers are irrelevant in private transactions: Why do I, a buyer, care if you poured money down a rathole?—I won't pay you a penny more for it. But when the state is restituting only part of an asset, the division of spoils requires some estimate of how much the government's part is worth. Not only did the process use book values to represent the portion they would not restitute, state managers strategically drove up book values with crazy expenditures (made with state funds) in the last days of socialism. This in a deliberate attempt, says Brandejs, to make it more difficult for people such as him to regain lost assets.

Brandejs finally gave up on restitution. It would take years, he felt, to assert his claim—and there emerged a much faster way to do just that: He submitted a privatization proposal to the Ministry of Privatization in January 1992. It wasn't easy. The state managers who controlled the hotel played all kinds of games with the books; no one could make heads nor tails of the operating numbers. Why the subterfuge? The hotel's managers themselves had submitted two privatization proposals, one "basic," another "competing." (The second bid brought in an Asian partner to finance still more renovations and offered to pay off Brandejs's restitution claim to the tune of $250,000.) Brandejs's proposal emphasized his restitution rights but also put up cash—nearly $3.5 million to the state. In addition, his company offered to assume all hotel debts.

The competitive process was grueling and lawyer intensive. Brandejs spent precious dollars preparing his bid, presenting his case at hearings before both the Ministry of Privatization and the Ministry of Trade. The managers withheld information as fiercely as Brandejs sought it; both parties politicked heavily. In the end, however, Brandejs won, getting approvals from both ministries and the national government, a three-stage obstacle course designed to provide checks and balances to limit corruption.

It took less than six months for Brandejs's proposal to receive final approval in July 1992. While Brandejs himself believes the process was grueling and drawn out, it worked like lightning compared to the alternative. Although he had begun his restitution claim a year earlier, what U.S. court could manage such a complex matter so adroitly in such a flash? And the criteria that gave Brandejs's family the winning edge flowed from legitimate principles of law: His family did have a moral claim to restitution and his proposal, which stressed that the business would be run as a family operation in a long and proud tradition, was found as the superior productive use of the assets. The judicious outcome considered both equity and efficiency as positive social goods, the perfect signal to send a society in transition to a market economy.

The Hotel Pariz today exudes the tender loving care of grandpa Brandejs's own, having been renovated from January 6 to March 31, 1993. Antonín is very proud of this speedy renovation, considering that under socialist management the hotel was closed nearly seven years before reopening in 1987—when managers discovered the missing bathrooms, leading to another two years of closure. Antonín works long hours and is a whirl of managerial energy. His brother manages the kitchen; his cousin's husband is an assistant manager. The hotel's staff of 130 has been kept on. But under the new management—and new work rules—some have decided to leave. Overall employment is up slightly, to 135, due to increased business. The occupancy rate in October 1994 was 86 percent—superb.

The two managers who ran the hotel for the state are long gone, but both are prosperous. One serves as a consultant to the many new private hotels springing up to service Prague's booming tourist sector. The other opened a new restaurant. When I asked Brandejs where a civil servant would get the money to do that, he smiled: "You don't have to ask," he said.

So Czech privatization has largely overcome the Hayekian knowledge problem by encouraging competition among the very people most likely to have the relevant information. As Roman Ceska, the former deputy minister of privatization and current minister of the National Property Fund, puts it: "This is the only way to get information into the process. It was an open competition to submit a proposal. Everybody was invited—the municipalities, the companies, the consultants—and were giving us their ideas. This created a flow of information to the Ministry of Privatization. The only problem is that we were deluged with so many project proposals"—over five proposals for each of the Czech Republic's nearly 2,700 large state enterprises.

Under laws passed in February 1991, the newly formed Ministry for Privatization compiled a list of large-scale firms to be privatized. Managers of each firm—for instance, the Hotel Pariz's former state managers—were required to submit a "basic" proposal, including key legal and financial information, as to how to privatize the assets. Excepting only infrastructure industries such as the railways, hospitals, and utility companies, every Czech firm—even behemoths like the Kladno factory with 20,000 workers—was fair game for privatization. On November 1, 1991, the ministry published the names of more than 1,000 firms eligible for privatization and invited competing proposals from the public as to how each firm should be privatized. The deadline for submitting such proposals was January 18, 1992. (When an enterprise had no proposals, the ministry would create its own proposal, usually dumping the company's shares into voucher privatization.) The process ignited a flurry of political and financial activity and about 15,000 proposals.

This was a magnificent database for rationally—and quickly—divesting the state of its (potentially) productive assets. Insiders who submitted basic proposals had incentives to draw up coherent privatization plans because their proposals were subject to outside competition. In the end, insiders saw about half their proposals accepted—a much higher rate than that enjoyed by outsiders. The key to their success was two-fold: They provided relatively reliable information, and they relied heavily on voucher privatization. Competing privatization proposals tended to rely much more on direct sales to new manager/owners. Ministry officials, conscious that a surprising number of citizens were purchasing voucher coupon books, wanted to reward the general public as much as possible.

In selecting among rival proposals, the Ministry of Privatization was able to award property rights not in a perfect manner, but in at least a plausible way, one that avoided rampant confusion and chaos. Moreover, it realigned political interests: The instant the process began in earnest, thousands of prospective entrepreneurs (those submitting privatization proposals, each including some benefit to the authors) began to push hard for privatization. Since state managers were intimately involved in this competitive process, it removed them from the ranks of another competitive process: obstruction. In every other post-communist country, these apparatchiks form the core of opposition to reform: Why help privatize what you (as a state manager) can pilfer? The Czech answer: If you don't help us privatize, someone else will.

Privatization projects included various means for transferring state assets to private owners: direct sales, tender offers, restitution, auctions, and voucher coupons. All told, about half of the book value of large-scale privatization was distributed via vouchers—$10 billion. Beginning October 1, 1991, Czechoslovakian citizens over the age of 18 were invited to purchase their 1,000-point booklet to use in the voucher privatization auction. These coupons were officially registered for 1,000 Czech Crowns ($35, about one week's wages) at over 650 outlets across the country.

In original surveys, only some 2 million participants were anticipated, and Western consultants and bankers pooh-poohed the idea in great spasms of laughter. The spectacle of hapless financial illiterates understanding market investments was just too funny. When Klaus, as finance minister, explained precisely what he planned to do with voucher privatization to a group of industrialists and financial experts in Vienna, Austria in 1990, the corporate bigwigs thought he was insane, reports Albert Zlabinger, an academic economist in Vienna who set up the meeting.

Yet some 8.54 million citizens—71 percent of eligible purchasers—bought and registered voucher coupons. Enthusiasm was spurred by the spontaneous emergence of investment privatization funds (IPFs), some of which guaranteed 20,000 Crowns for those willing to turn over their 1,000-Crown investments. In the Czech Republic alone, 186 separate companies established 264 IPFs in the first wave (and another 353 funds in the second wave). They entered a competitive fray to represent investor interests and advertised heavily, thus increasing demand for coupons. Some 72 percent of all the coupon points were entrusted to such funds in the first wave of privatization.

Actual bidding for shares began on May 18, 1992, three weeks before the elections which would catapult Klaus's Civic Democratic Party to power and place the economist in the strategic position of prime minister. Indeed, political opponents argued then (and now) that the mass privatization scheme was pandering to popular sentiment. A most splendid compliment, given the violent populism which has elsewhere sprung up in opposition to capitalist reforms.

The voucher auction was conducted in five rounds in the first wave of large-scale privatization, six in the second. On the first pass, each company's stock value was set at the same price (three shares for 100 points). If a firm's stock shares were oversubscribed, the price on the next round was raised; if undersold, then the price reduced. On the next round, bids were again registered, and adjustments similarly made. Whenever excess demand was less than 25 percent, shares were allocated to bidders on a pro-rata basis (with individuals favored over funds) and the issue taken off the board. This iterative procedure continued until the final round. At that point, unsold shares were deposited in the National Property Fund, and oversubscribed issues were awarded on a pro-rata basis. The bidding in the first wave was concluded December 20, 1992.

The book value of the 1,491 Czechoslovakian companies scheduled for voucher privatization had been about 299 billion Crowns ($11 billion), although initial market valuations turned out to be roughly half that. Hence, the state was endowing each participating citizen with a stake in the new society, albeit something less than 40 acres and a mule—about $700 per voucher player (in the first wave) at November 1994 market prices.

And the physical process of transferring the assets went sensationally well. The daunting task of evaluating firm values was handled smoothly and efficiently—by fund managers. These experts compete to be agents for investors for a modest percentage commission. The lack of sophistication of Czech citizen-investors turned out to be a non-issue: Despite the prevailing skepticism and the virtually ubiquitous condemnation of mass privatization by Western policy analysts, the market institutions needed to make a non-traumatic transformation arose instantly in the newly privatized world. The mere existence of private assets spontaneously created—as if by an "invisible hand"—the means needed to manage capital shares.

Western experts had warned that giving away stock shares to citizens was doomed to failure because of the "dispersion" issue. Where stock ownership is so widely distributed that no one party has an incentive to monitor the value of firms or the performance of managers, financial chaos reigns. Investment does not go where it is best utilized, and company managers tend to goof off. The classic example, of course, was state socialism itself: Although everyone "owned" state enterprises, such nominal ownership placed no effective constraint on managerial behavior; hence the state managers looted the enterprises they ran.

Yet the Czechs again relied on a bottoms-up strategy: Simply hand off equity ownership to individuals and allow markets to find a solution. Poland, on the advice of the World Bank, employed precisely the reverse strategy. There the state has searched for responsible new owners by attempting to place large state enterprises into 10 or so investment portfolios, to be managed by professional stock experts. The plan required agreement on how the funds would be structured as well as how assets would be allocated between them. The plan has been debated for four years.

Conversely, the Czechs simply let the market decide ownership structure. What spontaneously emerged was a competitive mutual-fund market. Hundreds of competing investment portfolios were created, with about 12 large funds accounting for half of total investment points. The competition keeps fund managers focused, and the funds' scrutiny keeps the privatized firms' management honest and efficient.

Restructuring companies that have been run for the benefit of state managers, often in conspiracy with feather-bedding employees, is a brutal task. Firm insiders will continue to depreciate the capital base unless confronted by well-informed and highly motivated monitors. To monitor managerial performance on the stockholders' behalf, Czech mutual-fund managers have climbed onto corporate boards, becoming intimately involved in managerial decision making. Each fund is, really, an army of takeover artists: It sets its agents upon state enterprises with the assignment to take the assets back for productive use.

Stanislav Ryska is a socialist manager who is happy to be a takeover target of capitalism. Director of development for Tonak, a Czech manufacturer of hats since 1799, Ryska was perpetually frustrated by the internal contradictions of socialism. Despite excellent export opportunities for its products, the state enterprise was at the mercy of another state firm, Centrotex, which had been given a monopoly over textile exports. For reasons known only to the bureaucrats themselves, increasing Tonak's exports was considered uninteresting. Freed of these shackles, Tonak's exports are booming—indeed, total Czech exports to the European community shot up 116 percent from 1989 to 1992—and Ryska's salary is up 300 percent.

Managers are not supposed to take so kindly to the brutal efficiency-enforcers of financial markets. But good managers, of course, prosper more than ever; the cries of anguish come from those who lose their access to fluffy jobs, ill-gotten perks, and socialized slush funds. Ryska, who now works closely with mutual-fund managers representing Tonak shareholders, is the pillar of corporate diligence, constantly on the alert for new export possibilities. Once suppressed by a system that rewarded mediocrity on the job and subservience off it, the entrepreneurial manager is today on the rise.

Competing privatization proposals for Tonak were submitted by the firm's managers. The winning proposal included a sale of 2 percent of the company's assets to a group of employees, with 78 percent of stock equity to go into voucher privatization. (Twenty percent of ownership shares were given to the National Property Fund, which pays restitution claims to people who cannot recover physical assets—for instance, those thrown in jail by the communists.) Emphasizing voucher privatization was a common ploy by managers who thought dispersed ownership would help keep them solidly in charge. But after the dust settled on five rounds of voucher bidding, 45 percent of Tonak's shares were owned by three mutual funds, with 24 funds accounting for 58 percent. Just 20 percent of shares are owned by individuals—fairly typical. Of the five members of the executive committee of the board of directors, three represent investment funds (Harvard Capital & Consulting, the largest fund, Srejber Investing-Mutual Fund, and the Czech Savings Bank).

The new owners cut employment at Tonak from 2,050 to 1,750, mainly by attrition. About the same time, the firm's eastern export market collapsed: It shipped 30 percent of its output to Russia in 1989, but only 3 percent in 1993. Yet sales overall surged, and real output per worker—in just the first year of privatization—increased 20 percent.

The way in which it happened demonstrates the complexity of the economic system. The company's main product is furry hats made from rabbits. In fact, Tonak produces more traditional rabbit fur hats for Orthodox Jews than any other supplier in the world. Prior to privatization it had largely exported components to be assembled elsewhere. Since privatization it has been exporting finished product—with enormous marketing success. It has also found a ready market for its hats in…Australia, of all places.

Tonak has also rationalized its manufacturing, buying new Swiss machinery to monitor the quality of its skins and getting more final product out of each animal. Under state ownership, the factory used only 34 percent of each rabbit pelt. Now, it plans to squeeze 75 percent out by the year 2000. Part of this efficiency push is motivated by a desire to economize on the firm's waste-disposal fees. Labor practices are likewise adjusted; about 30 percent of employee compensation now depends on the number and quality of hats produced.

Each of these steps represents a step toward economic rationality, and it is the sum of millions of such tiny productivity gains that will stitch together the Czech Republic's coming prosperity. Each requires a modicum of imagination and an abundance of fortitude—there is always and everywhere resistance. Under state socialism, Ryska had to battle his managers, other managers, and Tonak's workers with each little push toward a more efficient world. Worse than enemies were his lack of friends: Who will join the battle for social prosperity when all it brings is trouble?

But Stanislav has found some new friends. They are called stockholders and they—or their paid agents—conspire with him regularly. "Mutual funds played a very positive role in reforming management," he says today. They supply a pressure for efficiency—a vacuum under socialist management. And while this new tension satisfies profit-hungry shareholders, it also serves the larger social interest. The new regime forces firms to be consumer friendly, to reward industrious employees, and to invest in productive assets and technology (no matter whose petty fiefdom is challenged). This ruthless drive to economic rationality is what will finally yield the fruits of material prosperity in an advanced market economy, and it is today what fuels the striking optimism uniquely observed in the Czech Republic's recovery from communism.

Contributing Editor Thomas W. Hazlett teaches economics and public policy at the University of California, Davis. He has been a faculty member of the Foundation for Teaching Economics Seminars at the Prague School of Economics and is a senior fellow of the Liberal Institute of the Czech Republic.