Shock Therapy: How it Works in Economics, Examples

What Is Shock Therapy?

In economics, shock therapy theorizes that sudden, dramatic changes in national economic policy can turn a state-controlled economy into a free-market economy. Shock therapy is intended to cure economic maladies—such as hyperinflation, shortages, and other effects of market controls—to jump-start economic production, reduce unemployment, and improve living standards.

However, shock therapy can entail a rocky transition while prices increase from their state-controlled levels and people in formerly state-owned companies lose their jobs, creating civil unrest that may lead to forced changes in a country's political leadership.

Key Takeaways

  • Shock therapy is an economic theory that says that sudden, dramatic changes in national economic policy can turn a state-controlled economy into a free-market economy.
  • Shock therapy is intended to boost economic production, increase the rate of employment, and improve living conditions.
  • Economic policies in favor of shock therapy include ending price controls and government subsidies.
  • Shock therapy can have a negative impact on the economy, causing unemployment to increase and civil unrest.

How Shock Therapy Works

The term "shock therapy" refers to the concept of figuratively shocking, or shaking up, the economy, with sudden and dramatic economic policies that affect prices and employment. Characteristics of shock therapy include the ending of price controls, the privatization of publicly-owned entities, and trade liberalization.

The opposite of shock therapy, gradualism, indicates a slow and steady transition from a controlled economy to an open economy. An open economy is generally considered to be a more responsible and effective strategy for improving an economy.

In general, policies that support shock therapy will involve:

  • Ending price controls
  • Stopping government subsidies
  • Moving state-owned industries to the private sector
  • Tighter fiscal policies, such as higher tax rates and lowered government spending

Shock therapy could also include policies to reduce inflation and budget deficits, or policies that reduce current account deficits and restore competitiveness.

Examples of Shock Therapy

Economist Jeffrey Sachs is widely associated with shock therapy. He developed a plan of shock therapy for post-communist Poland in 1990, for post-communist Russia in 1992, and several other countries, including Bolivia and Chile. Bolivia, in particular, in 1985, had success as a result of shock therapy in ending a period of hyperinflation.

Poland also initially seemed to benefit from shock therapy as inflation was controlled, but it saw a sharp rise in unemployment that peaked at 16.9%. Sachs did not like the term shock therapy, which he said was coined by the media and made the reform process sound more painful than it was.

In Russia, neoliberal shock therapy did not produce favorable outcomes. Shock therapy was applied swiftly and on a large scale, as opposed to how it was applied in other nations. Almost all of Russia's industries were undervalued and sold to private individuals and companies, with most acquired by a few Russian oligarchs.

With limited government intervention, most industries disappeared. The Russian currency declined, causing high inflation and the erosion of most citizens' savings. Unemployment increased drastically, and government subsidies were removed, further pushing Russian families into poverty.

Like the name of the concept implies, shock therapy can effectively cure certain economic maladies by jolting the economy, but it can also backfire, causing unemployment and civil unrest.

Advantages and Disadvantages of Shock Therapy

Some support shock therapy for its purported benefits, which include:

  • A more efficient method to solve economic imbalances
  • Setting clear expectations for consumers

On the other hand, those who oppose shock therapy see many cons to its use, such as:

  • Creating a swift and sufficient income inequality
  • Rise in unemployment
  • Economic overwhelm