Institutional Determinants of Labor Reallocation in Transition

Studying the transition means analyzing the interactions between institutions and structural change, a process we still know very little about. In this paper we show that the transition process has been very different in the countries of the Former Soviet Union (FSU) and those of Central and Eastern Europe (CEE) in terms of reallocation of labor from the old to the new sector, the extent of real wage decline and responsiveness of employment to output changes. We sift through the theoretical and empirical literature to find an explanation for these diverging adjustment trajectories and conclude that the difference can be explained in part by different policy models. The CEE countries adopted social policies that upheld wages at the bottom of the distribution and hence forced the unproductive old sector to restructure or collapse. The FSU countries allowed wages to free fall and hence did not force the hand of the old sector. Why these two models were adopted is the subject for political-economy research, however we speculate that it has to do with the relative appeal of joining the EU.