IGOR GUARDIANCICH

University of WindsorDepartment of Pol it ical Science

45-354 Pol it ical Problems of Economic Development

The Rise and Fall of the Command Economy

1

Systemic Failure of the Command Economy

2

Reform is costly in both resources and emotional energy: only a major systemic failure was needed to justify it.

The communist system broke down due to inability to deliver material and social goods and services to which it was committed.

Two main goals of transitions from totalitarianism to democracy and from a command to a market economy: Higher living standards; Greater individual freedom.

Characteristics of the old system3

Soviet-type (Balcerowicz) and classical (economic) socialist systems (Kornai).

During revisionism deviations appeared: reforms towards a market economy (Hungary - Goulash socialism;

Poland – private family plots); variation in corporate governance, loosening the grip of the

central planner (Yugoslavia - workers’ self-government). 3 distinctive features (Lavigne):

single party controlling the economy, whether or not called communist;

collective or state ownership of the means of production; compulsory central planning as the main coordinating mechanism

with an increasing, but still subsidiary role for the market.

Single party controlling the economy4

Marxist two economic phases Socialism - economic scarcity still exists, but the party maximizes the

growth of output: no indication how the system should have worked, but job security, central

planning and the subordination of the individual to the collective were implicit. Communism - advances in technology abolish the concept of scarcity:

the Communist Party is deprived of its raisons d'être vanishes.

Marx never specifically suggest central planning: Marx’s anti-market writing and the failure of Lenin’s NEP (market-

oriented) empowered Stalin; only final demand and supply left to market allocation; job security at the expense of:

individualistic activity; private consumption.

The bureaucratic apparatus5

Nomenklatura CP controlled all the high-level appointments; rigid hierarchy in CP and in the economy:

at lowest levels SOEs and collective farms; CP above all authority and ruled in last resort.

Instead of rule of law, rule by law (CP could overrun legislation, government, parliament).

CP started economic reforms, decoupled form the National Planning Office. Economic administration

maximum of bureaucratic coordination, large number of sectoral and functional agencies (Planning Office, Office of Prices), implementing the plan and supplanting the market;

agencies for material and technical supplies (in Russia 1M employees) brought together suppliers and buyers, according to material balances.

Local government weak, SOEs were directly managed by federal ministries and central party

organs.

Collective ownership of the means of production6

Distinctive feature from Marxist perspective: income derived from private ownership unearned, labour-

income legitimate; private ownership of the means of production as institutional

basis for the free competitive market (seen as extremely inefficient mode of coordination).

Non-market (bureaucratic for Kornai) coordination mechanism chosen to replace the market: central planning in a complex economy inevitable (unfeasibility

of non-market and non-hierarchical coordination, e.g. cooperation of autonomous producers);

private ownership with central planning is impossible: gives rise to spontaneous, anarchic interactions in the economy.

Central planning7

Command-Rationing Mechanism (CRM) opposed to and replacing the (product) market in its coordinating and allocative functions: decision-makers were political authorities; plan was mandatory; implementing actors subject to sanctions; different time-spans:

yearly plan most important, 5-yearly plan of intentions.

Failure: available time was insufficient; crude methodology; biased data.

Cheating as built-in feature of the system

Content of CRM8

Material balances (developed under Stalinism): sources of supply (new production, imports, stocks) and uses of products

(intermediate outputs, investment, consumption, stocks, exports); balance achieved fortuitously through internal iterative adjustments and

only then through foreign trade; balance first drafted for material goods, then for machinery/equipment and

finally for manufactured consumption goods. unexpected users’ needs: balances had to be redrafted.

Coverage: most aspects of firms’ technical, industrial and financial behaviour; allocation of investment; fruits of centralised R&D.

The monobank verified that the transactions had taken place and at the official prices.

Main features of CRM9

Planned quantities: distribution and allocation of labour included.

Administered prices: informationally defective; principle of need instead of desert (equality but

inefficiency).Soft Budget Constraints (SBC):

ex post renegotiation of the funding for the firm; soft subsidies, credit, taxation, administrative prices.

Extreme monopolization.Council for Mutual Economic Assistance (CMEA).

The economic inevitability of failure 10

‘One may anticipate the nature of the future socialist society. There will be hundreds and thousands of

factories in operation. Very few of these will be producing wares ready for use; in the majority of cases what will be manufactured will

be unfinished goods and production goods.’(Ludwig von Mises, 1920)

Faulty ideologyPerverse incentivesDefective information

Faulty ideology11

Marx-Leninist ideology systematically fails: central planning as deliberate decision to sacrifice efficiency

in the allocation of resources for rapid economic growth; scarcity not an ideologically acceptable description of the

relationship between inputs and outputs; production decisions made upon internal accounting

procedures, regardless of profitability at world market prices.Inefficiency exacerbated through:

no notion of opportunity costs in resource allocation; rejection of the idea of human capital.

Tangible failures: 2/3 of output had a comparative disadvantage at world prices;

1/5 of output produced negative value added.

Perverse incentives (I)12

Workers against achieving efficiency Static (current performance):

wages were (too) equalized; workers not promoted if worked hard, not sacked if

worked effortlessly Dynamic (future innovativeness):

no upgrading of skills, due to grim advancement opportunities.

Taylorist environment in State-Owned Enterprises.

Incentive to work was minimal: ‘We pretend to work, you pretend to pay us!’

Perverse incentives (II)13

Managers faced a worse situation: Centrally planned quotas to be reached (physical targets):

sanctions (even death for sabotage); SOEs do anything to meet them; profit targets irrelevant, SBC, resources treated as infinite; widespread hoarding of workers and stockpiling of goods.

Ratchet effect (if quota is exceeded, the target is updated): no incentive to work at full capacity; managerial abilities:

bargaining with authorities, bribing, getting subsidies, reducing plan targets; no incentive to innovate:

if it fails, quota is not met, if succeeds targets are raised.

Creation of a sellers’ market, unresponsive to consumer demands. Low quality and long waiting times.

Information distortion14

Theoretical problems, Socialist calculation debate: identification of consumer preferences for a correct

production mix is feasible only when the economy is still very simple;

free market prices indispensable for rational calculation.Practical problems:

availability of adequate economic data for central planning: insufficient quality of information, data available to the central

planners were all systematically subverted. informational capacity of the center (to process data and

arrive at rational decisions on the allocation of resources): as complexity grows, the sheer quantity of data becomes

unmanageable (Romania 10M indicators).

Characteristics before the collapse15

Low labor productivity, because of labor hoarding: cost overruns bore few penalties, compared to not meeting the plan’s

targets, hoarding of any kind of inputs was generalized.Use of physical gross indicators of performance, implied

persistent problems of goods’ quality and product mix: sellers were not responsible directly to buyers, so the quality was low.

Quantitative production norms and the ratchet effect made managers suspicious of any technological advances.

Uncertainty about inconsistent plans led to the: duplication of capacity within branches and firms, to build spare parts.

Horizontal relations between managers: to counterbalance the inefficiencies of centralization; a secondary market (semi-legal or illegal) for inputs and goods arose.

Manifestations of the collapse16

Economic slowdown: no passage from extensive to intensive growth; low substitutability between capital and labor, ROI fell to zero; world’s biggest, most inflexible rust-belt.

Widening technological gap with the West. Rising per capita consumption:

concentration on provision of capital as opposed to consumer goods implied: higher imports from the West; low investment in ‘non-productive’ sectors (education, health); emergence of grey and black markets.

Premature welfare syndrome and declining health standards. Tariffs, protectionism, state monopoly in foreign trade:

no profits from free trade; borrowing from the West for their exports; trade balance in deficit – inflation, budget deficits.

The Transformational Recessions17

From a seller’s to a buyer’s market: repressed inflation turns gradually into moderate open inflation; excess real aggregate demand ceases to exist (no monetary overhang).

Transformation of the real structure of the economy: prices and foreign trade free, relative prices adjust, suppressed demand

emerges; Schumpeterian transformation of production, under mobility constraints.

Disruption in coordination: bureaucratic coordination not immediately substituted; market coordination needs regulation and state initiatives.

Financial discipline and the enforcement of efficiency: HBC introduced (bankruptcy and restructuring); privatization raises unemployment, reduces demand, contributing to recession.

Backwardness of the financial sector: SOEs continued to receive subsidies, POEs no immediate credit access.

The rise in inflation18

Monetary overhang Socialist system had strict control over money supply:

demand and supply at official prices; official prices too low:

money supply exceeds demand, which was reflected by parallel market prices. Severe loss of confidence for money as a vehicle for savings:

parallel market price explosions; flight from monetary savings prior to liberalization.

Delays in stabilization due to political turmoil Policy makers perceived high inflation as beneficial to the economy

(seigniorage); looser policies might have avoided large output declines early on, but at the cost

of large recessions later on and delayed recovery. Lack of political consensus was the cause for protracted inflation:

strong reformers with large consensus and weak opposition were needed; rent seekers captured the political process after the break down of political

institutions and created inflation.

Inflation and hyperinflation19

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000CZ 1,4 9,7 52,0 11,1 20,8 9,9 9,6 8,9 8,4 10,6 2,1 4,0HU 17,0 28,9 35,0 23,0 22,5 18,8 28,2 23,6 18,3 14,3 10,0 9,8

PL 251,1

585,8 70,3 43,0 35,3 32,2 27,8 19,9 14,9 11,8 7,3 10,1

SK 2,3 10,8 61,2 10,0 23,2 13,4 9,9 5,8 6,1 6,7 10,6 12,0

SI 1.285

551,6

115,0

207,3 32,9 21,0 13,5 9,9 8,4 8,0 6,2 8,9

BG 6,4 26,3 333,5 82,0 73,0 96,3 62,0 123,

01.08

2 22,2 0,7 9,9

RO 1,1 5,1 170,2

210,4

256,1

136,7 32,3 38,8 154,

8 59,1 45,8 45,7

EE 6,1 23,1 210,5

1.076 89,8 47,7 29,0 23,1 11,2 8,1 3,3 4,0

LV 4,7 10,5 172,2

951,2

109,2 35,9 35,9 25,0 17,6 8,4 4,7 2,6

LT 2,1 8,4 224,7

1.020

410,4 72,1 39,6 24,6 8,9 5,1 0,8 1,0

RU 2,0 5,6 92,7 1.526

875,0

311,4

197,7 47,8 14,7 27,8 85,7 20,8

UKR 2,2 4,2 91,0 1.210

4.734

891,0

377,0 80,0 15,9 10,6 22,7 28,2

The output collapse20

Sharp changes in relative prices: price and trade liberalization; changes in taxes,

subsidies, terms of international trade, borders) in an environment of severe resource mobility constraints.

Elimination of the excessive real aggregate demand to establish a buyer’s market.

The collapse of captive markets within CMEA.

The collapse of the arms industry and of state financed investment in housing, energy, agriculture and infrastructure.

Output collapse: the stylized facts21

GDP falls were huge, although the statistics probably overestimate them (PL 7-12%; CEE 15-25%; RU 25-35%; FSU 30-40%).

Gross industrial output fell more (CEE 40-50%; FSU 50-60), but some contained negative VA at new prices.

Investment expenditures fell more than GDP; so consumption and standards of living fell less.

Recoveries were L-curves, instead of J-curves (Poland). Deep structural changes during recovery:

from arms, government services, heavy industry, energy to financial services, trade, IT, consumer goods.

Deep changes in the sectoral composition of GDP: from manufacturing to services (due to large contractions and productivity

gains and relative price declines).

Cumulative GDP growth (1990=100)22

The disappearance of full employment23

Sharp changes in relative prices over a short period of time triggered supply-side shocks – new supply functions altogether; demand-side shocks – due to different elasticities to prices,

but also changes in tastes, real incomes and real wealth.Asymmetric adjustment to new equilibria:

demand and prices instantly; supply gradually.

Presence of rigidities in resource mobility, labor with skills incompatible with a market economy: 10% became unemployed; 10% retired early – ‘great abnormal pensioner booms’; 10% entered the informal grey or black economy.

Unemployment rates24

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000CZ 0,7 4,1 2,6 4,3 4,3 4,0 3,9 4,8 6,5 8,7 8,8HU 1,4 8,2 9,3 11,9 10,7 10,2 9,9 8,7 7,8 7,0 6,4PL 6,5 12,2 14,3 16,4 16,0 14,9 13,2 10,9 10,2 13,4 16,1SK 1,2 9,5 10,4 14,4 13,6 13,1 11,3 11,8 12,5 16,2 18,6SI na 7,3 8,3 9,1 9,1 7,2 6,9 7,1 7,4 7,4 6,4BG 1,6 10,5 15,0 16,3 18,6 13,7 13,0 14,5 16,0 17,0 16,4RO na na na na na na na na na 7,1 7,3EE 0,6 1,5 3,7 6,6 7,6 9,7 10,0 9,6 9,8 12,2 13,6LV 0,5 0,6 3,9 8,7 16,7 18,1 20,5 15,4 14,3 14,5 14,6LT na 0,3 1,3 4,4 3,8 17,5 16,4 14,1 13,2 14,6 16,4RU na na 5,3 6,0 7,7 9,2 9,3 10,8 11,9 12,9 10,7UKR 0,0 0,0 0,2 0,3 0,3 0,3 1,3 2,3 3,7 4,3 11,6

Informal economy: Household electricity approach

25

1989 1990 1991 1992 1993 1994 1995CZ 21.7 24.3 31.7 31.8 27.1 24.5 21.8HU 24.6 25.6 31.1 33.2 33.6 31.4 29.6PL 22.9 31.6 32.5 31.7 31.1 27.9 23.9SK 21.7 24.3 32.0 32.0 34.1 32.0 28.4SI 26.7 26.8 27.4 31.2 28.4 25.0 22.7BG 23.3 28.9 33.7 34.1 34.0 35.9 34.0RO 17.3 24.4 36.9 39.0 37.5 34.2 28.3EE 16.9 22.0 32.0 37.4 38.4 38.1 35.8LV 17.3 19.4 22.6 41.7 45.5 43.1 43.7LT 17.0 21.0 31.7 47.4 52.2 47.6 46.0RU na na na 37.8 36.0 39.1 39.2UKR na na 28.1 37.4 47.0 54.6 52.8

Great abnormal pensioner booms26

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 %CZ na na na 2,521 2,519 2,523 2,498 2,507 2,545 2,537 0.6

HU 2,587

2,668

2,795

2,868

2,948

3,010

3,059

3,104

3,139

3,184 23.1

PL 5,598

6,154

6,505

6,703

6,873

7,036

7,172

7,313

7,466

7,524 34.4

SK na na na na 1,386

1,387

1,393

1,402

1,415

1,435 3.5

SI na 419 449 458 458 460 463 468 472 476 13.6

BG 2,273 2,347

2,443

2,440

2,424

2,409

2,381

2,392

2,387

2,381 4.8

RO 2,570 3,018 3,201 3,253 3,439 3,600 3,740 3,875 4,020 4,181 62.7EE 361 374 383 387 376 375 375 374 375 378 4.7LV 610 648 661 665 663 666 662 664 660 653 7.0LT 879 909 891 897 907 898 930 990 1,076 na 22.4

RU 32,848

34,044

35,273

36,100

36,623

37,083

37,827

38,184

38,410

38,381 16.8

UKR na 13,100

13,600

14,200

14,500

14,500

14,488

14,487

14,535

14,520 10.8