Barriers to the creation of new firms are a critical obstacle to sustained growth in the transition countries of Eastern Europe and the former Soviet Union, according to a new report by the World Bank entitled "Transition: The First Ten Years."

In Bulgaria and Romania protection of state enterprises and farm collectives through the banking sector led to sharp increase in bad debts to the banking sector. These bad debts prevented the expansion of bank credit to new, small and politically less connected enterprises. Eventually they triggered banking and macroeconomic crises in both countries, the report says.

Reducing barriers to entry—a strategy of "encouragement"—must therefore be accompanied by a hardening of budget constraints on old and new firms—a strategy of "discipline"—without tilting the playing field toward either kind of enterprise. "Encouragement and discipline should go hand in hand," says Pradeep Mitra, co-director of the report team. "Allowing resources to be sucked into old enterprises does not leave adequate economic space for new firms. At the same time, not having a vibrant emerging private sector limits the options available to those in old enterprises and makes it more difficult to downsize."

The failure of so many countries to adopt economic reforms that support discipline and encouragement is because people who benefited from early reforms like liberalization and privatization because they controlled state assets or enjoyed close ties with the old political elite tend to oppose subsequent reforms that erode their initial gains. Such reforms would include further trade liberalization, measures to facilitate entry of new domestic and foreign competitors, and legislation to protect minority shareholders and creditors. If their initial gains are a large fraction of the economy, as is the case in natural resource and energy-rich countries, the early winners may capture the state, preventing further reforms and forcing the economy into a trap of a low level reform equilibrium.

Understanding how such reform traps arise and how to break out of them is an important issue addressed by the report. A key message in the report that emerges for a reformist team that comes to power with a mandate for change is to redistribute gains from the early stages of reform.