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The Rise and Fall of the Command Economy

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  1. The Rise and Fall of the Command Economy IGOR GUARDIANCICH University of Windsor Department of Political Science 45-354 Political Problems of Economic Development

  2. Systemic Failure of the Command Economy • 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.

  3. Characteristics of the old system • 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.

  4. Single party controlling the economy • 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.

  5. The bureaucratic apparatus • 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.

  6. Collective ownership of the means of production • 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.

  7. Central planning • Command-Rationing Mechanism (CRM) opposed to and replacing the (product) market in its coordinating and allocativefunctions: • 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

  8. Content of CRM • 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.

  9. Main features of CRM • Planned quantities: • distribution and allocation of labour included. • Administered prices: • informationallydefective; • 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).

  10. The economic inevitability of failure ‘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 ideology Perverse incentives Defective information

  11. Faulty ideology • 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.

  12. Perverse incentives (I) • 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!’

  13. Perverse incentives (II) • 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.

  14. Information distortion • 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).

  15. Characteristics before the collapse • 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.

  16. Manifestations of the collapse • 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.

  17. The Transformational Recessions • 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.

  18. The rise in inflation • 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.

  19. Inflation and hyperinflation

  20. The output collapse • 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.

  21. Output collapse: the stylized facts • GDP falls were huge, although the statistics probably overestimate them (PL 7-12%; CEE15-25%; RU 25-35%; FSU30-40%). • 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 sectoralcomposition of GDP: • from manufacturing to services (due to large contractions and productivity gains and relative price declines).

  22. Cumulative GDP growth (1990=100)

  23. The disappearance of full employment • 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.

  24. Unemployment rates

  25. Informal economy: Household electricity approach

  26. Great abnormal pensioner booms