This is intended to be a brief supplemental to the lectures reading.
The discussion below also provides some historical background, but note that on the
exam you will be responsible for economics only and not history. Here are the important
concepts that I want you to concentrate on in particular:
1.
2.
3.
4.
Command economy and how it differs from market economy
Inefficiencies of command economy
Principle-agent problem
Reasons for the differential performance during the economic transition of
the 1990’s between Eastern European economies and the former republics of
the USSR
5. Privatization
6. Price liberalization
During the 1990’s we witnessed what can perhaps be called a turning point in the world
history: the collapse of the USSR and the entire eastern block and the transition of the
economies of the countries that comprised the bock from a command structured economy
and state ownership of resources to a market based, private economy. The process of this
transition was felt differently in all of these economies, but one striking trend was
observed: the economies that were within the USSR experienced more prolonged and
painful transition than their Eastern European counterparts (recall the handout illustrating
the so called transitional recession). Although it is difficult to explain this differential in
performance, some historical factors may be responsible for the outcome. I concentrated
on two of these in my lectures, and I assume I can hold you responsible for them when it
comes to the exam. These are: the duration of command economy structure and industry
composition.
But first I want to remind you of what we mean by command economies in the
context of USSR type economies. USSR throughout its entire existence was run by the
Communist party. Although the USSR held elections for the positions of Sovet
Deputatov (a legislative body of government similar to the US congress), the elections
were always with a single candidate, and in essence were nothing but an approval of the
selection of the candidates made completely internally within the Communist party, i.e.
the government. In fact the voter participation in these elections was strongly encouraged
to the point that it could be considered as mandatory. I can recall from my own memory
how members of the communist party that were volunteering their assistance to the
election process would knock on the doors and remind people to go and vote.
The lack of choice in the political arena was equally matched in the economy,
where the state owned all factories. Productive capital was the property of the state, and
state alone. The industries were comprised of many different firms but all of these firms
belonged to the state. Furthermore, industries were supervised through ministries, and
thus effectively all firms in an industry had the same upper management.
The principle of command economy is simple and yet extremely complex. It is
simple in the sense that all aspects of economy (production, distribution, allocation) are
owned by the state, we do not need to worry about the many private firms and how they
interact with each other. It is complex because the state has to plan for everything.
Consider a simple case, the students of GSU suddenly become health-conscious and start
dinking Minute Maid orange juice instead of Coca-Cola soft drinks, note that both
products are produced by the same company. It won’t take a long time for Coca-Cola to
recognize that the demand has changed as they will observe that bottles of Coca-Cola do
not disappear from the vending machines but orange juice is gone quickly. If Coca-Cola
wants to increase its profits then it will respond to this change in demand by increasing
the supply of orange juice and reducing the supply of soft drinks to our campus. The
longer Coca-Cola delays the adjustment the more potential profits it forgoes, hence there
is a strong incentive for them to react fast. Note that if Coca-Cola simply ignores
consumer behavior changes, another competitor will take advantage of this and start
supplying orange juice to our campus. Now, consider the same example but under a
command economy setting. The state owns the company that produces these drinks and
there is no competition to the state (recall that in the USSR there was no private sector
and the government was in charge of export/import sector, hence foreign competition in
consumer goods was completely under government control, i.e. the government decided
which foreign goods to purchase and put on the store shelves). The consumers change
their behavior, and a surplus in one product appears (soft drinks) and a shortage in
another (orange juice), what is the incentive for the state to respond quickly? Or more
precisely, the question is: What is the incentive for state bureaucrats to respond quickly?
Without strong monetary rewards and penalties that the market economy places on a
firm, bureaucrats in command economy firms behave in a much more inefficient manner.
The response to the change in consumer behavior may never come at all.
In the USSR the state was in control of everything when it came to the economy.
Not only did the state have to decide what to produce (i.e. how many units of various
goods had to be produced), but it also had to determine the production process. This
meant that the state had to decide where and how goods had to be produced, how goods
had to be transported to consumers/stores, how raw materials had to be transported to
businesses that use them. The state was also in charge of the allocation of output. The
state set all prices, including the wages thus effectively setting everyone’s standard of
living. This entire complex economic system was governed through a central planning
committee (GosPlan – Kommittet Gosudarstvennogo Plannirovanija). This organization
was centered in Moscow, but had representations in all regions of the country.
This structure was very similar across all countries of the USSR block. However,
the history of Eastern European countries (countries outside of the borders of the USSR)
and the USSR itself are not that similar.
Russia began its experience with command economy in late 1917. 1917 was an
important year in the Russian history, it witnessed two revolutions, the removal of the
monarchy and the emergence of Bolsheviks as the dominant force. By the start of 1917
the Russian Empire was exhibiting signs of economic and political collapse largely due to
the relatively bad course of events on the front (recall that since 1914 Russia had been
engaged in WWI). In February of 1917 a revolution took place that formally removed the
monarchy in Russia. The February revolution was not lead by the Bolsheviks (majority
movement within the communist party, the word Bolshevik comes from the word
Bol’shenstvo, meaning majority, referring to the majority that sided with Lenin in the
split in the communist party), but rather represented a number of different political circles
and was largely supported by the capitalists. In February a new, Temporary government
under the leadership of Alexander Feodorovich Kerensky was introduced. This actually
appeared to be a promising period, as Kerensky tried to introduce fully functional
democracy in Russia and scheduled elections for the summer of that year. However,
Kerensky did not pull Russia out of the war and in fact ordered an offensive in the
summer to help the British and French allies.
It is difficult to say what exactly lead to the events of October, but the most
popular slogan of the Bolsheviks read “Peace, Bread”. The war was becoming
increasingly unpopular, and the failures of the summer battles made the already
dangerous situation at the front unsustainable. Furthermore, following the February
revolution, the Bolsheviks began to infiltrate the army and place political commissars
into the units (the term commissar emerged later in the early part of the civil war, so my
usage of this word here is not entirely correct). In October the army began to experience
massive desertions, but this time many of the deserters were organized by Bolshevik
commissars and instead of going home they marched into Sankt-Petersburg and even
Moscow. The revolution that took place on the 26th of October (November 7th of new
style) lead to the establishment of command economy in Russia. Immediately after its
establishment, the new republic found itself in the middle of a very bloody civil war that
lasted for four years (1918-1922). In December of 1922 the USSR was born. The USSR
encompassed the bulk of the territory of the Russian Empire. The events of the 1920’s
and 1930’s are somewhat important as it is then that the course of economic development
and shape of industries begins to form. The Western World spends most of the interwar
period in a sever economic slowdown and little economic integration of the USSR
economy into the world economy takes place over that period, furthermore, the USSR is
continuously under a threat of military conflict (this becomes especially obvious in the
1930’s), which creates the need to establish weapons production and heavy industry.
From its early start the USSR put an increasing emphasis on the establishment of heavy
industry, the slogan that Lenin used was: “Industrialization and Electrofication”.
It is worth mentioning here that Lenin also introduced the New Economic
Initiative, a plan that allowed existence of small private businesses. The idea behind this
step away from pure socialism and command economy was that small private businesses
will be able to meet consumer needs in a devastated by war economy. This initiative was
terminated later in the early period of Stalin’s rule. Along with the removal of the NEI
the last remnants of private business in agriculture are also removed in a gigantic and
bloody process of collectivization. The NEI is somewhat interesting as it gets revised
later by Mikhail Sergeevich Gorbachev in the later 1980’s although is never referred to
by its original name.
Throughout the 1930’s heavy industry rises rapidly in the USSR. Note that
Eastern European countries are not part of the block at this point and remain largely
market based economies, with functional market institutions. The entry of Eastern
European states takes place much later as a result of World War II. In 1939, the USSR
and Germany sign a non-aggression pack that also has a number of secret provisions
effectively dividing Europe into two spheres of influence, and that begins the process of
the loss of independence by the Eastern European states. Latvia, Lithuania and Estonia
along with Bessorabia (Moldova) and parts of Poland are annexed by the USSR in 193940. This introduces command economy in those countries, while most other Eastern
European states are either overrun or indirectly controlled by Germany. Following the
completion of the war, Poland, Czechoslovakia, Hungary, Romania, Bulgaria find
themselves under the USSR occupation and de facto belonging to the USSR block. Note
that these countries enter the block some 28 years after Ukraine, Belarus, Russia and the
other republics of the USSR had began their experience under command economy.
This is important because of two reasons. One, by the 1950’s the weapons
production was already established in the territory of the USSR, and little need exists for
establishing weapons manufacturing in Eastern European economies, thus emphasis is
placed on light industry. For instance, Poland ended up exporting clothing to the USSR.
The emphasis on industry remains throughout the block (see one of the slides in the
lecture notes that demonstrates industry contribution to GDP in selected eastern and
western economies), but the composition of the industry mix is not the same. Heavy
industry firms have one important characteristic, relatively large size in terms of
employment. Many of the heavy industry firms in the USSR employ in excess of 100,000
workers, and in many instances serve as the only employment center in an entire urban
area. These firms provide not only employment to their workers, but also many social
service provisions ranging from housing, healthcare to childcare. Light industry firms
tend to have smaller size and typically several firms are present in any given urban area,
thus decreasing the dependence of the area on each of the firms. Two, the length of time
the command economy regime was in existence. This has two effects, one the longer the
command economy is in existence the more difficult it will be to bring back the market
institutions, as the population’s experience with these institutions becomes forgotten, and
another is the very characteristic of command economy. Under command economy there
is a natural trend to have large size firms, as the government management of the economy
is simpler when there are fewer firms that require to be managed. These two reasons
implied that the USSR will have larger size firms than the Eastern European economies.
In addition to this problem, the production allocation also contributed to the later
problem in the USSR. The emphasis on heavy industry and weapons manufacturing
reduced the amount of resources available to consumer goods production. As a result the
consumers suffered due to lower quantity and quality of available consumer goods. For
instance, most households in the USSR did not own color TV in the mid 1980’s.
Furthermore, the production process in heavy industry started to become increasingly
outdated sometime in the 1970’s and was certainly outdated by the time of privatization
reforms.
In addition to the above problems, the command economy suffers from several
types of inefficiency just due to the very setup. Some of these have already been
mentioned above in the context of the soft drink/orange juice example. Another one that
needs to be mentioned is the principle-agent problem that can lead to loss of efficiency.
The USSR government took pride in saying that the USSR had zero unemployment rate,
in fact it was illegal not to supply your labor in the socialistic process, and the state was
required to provide you with employment. This, on the surface seemingly noble notion of
putting the responsibility of providing workers with employment on the shoulders of the
state removed any incentives for hard work. Workers were aware that little punishment
existed for inefficient performance as employment was virtually guaranteed by the state.
If we assume that every worker was only 80% efficient in their work, this would imply
that the country operated with an effective unemployment of 20%. The principle –agent
problem is defined as the problem of a conflict of interest between the principle who
hires the agent to perform work on the behalf of the principle. Note that all workers in the
USSR in a way collectively act as the principle, as everyone benefits from better
performance of the economy in theory at least, but when they work as agents little
incentives exist to perform fully efficiently (in a way this employment problem in the
USSR can be defined as the Free Rider problem but for the exam sake we will ignore
this, as we talked about the Principle-Agent problem on the example of corporations
(shareholder/manager) and the analogy here is not that far from the one discussed in
class).
By the early to mid 1980’s the signs of economic problems become apparent
throughout the block. In 1985 Mikhail Sergeevich Gorbachev is appointed to the position
of leadership in the USSR as General’ny Secretar’ (Secretary General of the Communist
Party, and hence the ruler of the USSR). Shortly after he begins the process of reforms.
The reforms take two major directions: introduction of basic freedoms (freedom of
speech for example was beginning to be introduced) and economic reforms that take form
similar to the NEI of the 20’s, i.e. small private businesses are allowed to emerge. These
reforms fail to produce a turnaround in the economy and by the late 1980’s economic
problems are visible to every resident of the USSR, as shortages began to appear across
almost all consumer goods translating into lines in the stores.
The economic downturn was not the full extend of the problems facing the USSR
block, the political disintegration, ethnic tensions, demand for political and economic
freedoms threatened to tear the block apart, and in 1989 the rapid process of
disintegration of the block began. Perhaps the most memorable single event in the
disintegration process was the opening of the Berlin Wall that took place on November
9th 1989. This started the process of integration of the DDR into the West Germany. This
process quickly spread across the region and in less than one year the block lost most of
its members. Almost everywhere in Eastern Europe the process of political change was
peaceful, although one exception, Romania, stands out. In December of 1989, the
government of Ceausescu attempted to hold on to power in light of protests, after failing,
the leadership attempted to leave the country, an attempt that ended in the capture and the
execution of both Ceausescu and his wife. During all this time the USSR remained a state
ruled by the Communist party, but also experienced some conflicts exploding in some of
its regions, although largely ethnically driven these conflicts further underlined the
weaknesses of the regime.
In August of 1991, a military coup took place in the USSR. The coup was lead by
many members of the Politbureau, the government of the USSR, and the coup was aimed
at overthrowing Gorbachev and stopping the process of reforms in the country. Later that
year (December 8th) the future of the USSR was decided by the heads of Belorus, Russia,
and Ukraine. The USSR went into history on January 1st of 1992. On the ruins of the
USSR a loose economic entity – the Commonwealth of Independent States (the CIS) was
established. It is important to note that by this time the economies of Eastern European
countries had already gone through about one year of economic reforms, and naturally
some of their experience could act as an example to the new government of Russia that
was facing the economic reforms of transition.
The economic reforms of transition are very complex, can be split into several
important categories:
Privatization.
Clearly, the most important aspect of these reforms is privatization. Privatization
refers to the transition of ownership of productive capital (factories, farms…) from state
ownership to private ownership. Since all factories in the USSR belonged to the state,
privatization was an essential step that had to be undertaken in order for market economy
to be introduced. On the surface, privatization appears to be a simple procedure, as state
assets can simply be auctioned off to the highest private bidders, but that is only on the
surface. Remember that the USSR had no financial markets or private banks, hence how
individuals will be able to raise significant capital to finance those purchases? When one
purchases a stock in a US company, how does one determine what stock to buy? In the
US we have a number of various sources of information on financial situation of listed
companies, but in the USSR because all companies belonged to the state there was never
any need for that information, and hence no such sources of information were available.
This has a significant implication and that is that those people who happen to be in
position of having that information, these can be the managers of the companies, these
people have an advantage over everyone else, as they may know the true value of the
business. Furthermore, in the USSR prices were fixed by the state and varied
significantly from world prices, one notorious example was the cost of energy products
like oil, fuel, natural gas, all of which were priced drastically under the world prices. This
may mean that even profitable enterprises may become non-profitable as the prices are
allowed to adjust to world levels. But the distribution of information is not the only
problem that is present in the process of privatization.
How should the state assets be allocated? During the course of the existence of the
USSR all citizens of the country effectively paid for the formation of these factories, now
these assets are to be sold, but shouldn’t all citizens of the country be compensated during
this process? In Russia, the compensation, or more precisely the distribution scheme was
done through vouchers, which were distributed to the population, and then could be used
as payment in the auctions of state enterprises.
In addition to the above concerns, privatization has yet another important set of
requirements, i.e. the establishment of market friendly institutions. The USSR economy
did not need to be concerned with property rights, taxes on income and capital gains,
corporate law, and etc. So, now, all of these had to be addressed. This meant that the
country had to undergo legal reform and change its educational system to produce
lawyers and accountants that would maintain the new system. This process can take
several year, and itself requires political stability so that the continuity of these newly
established institutions is maintained.
Another important reform is price liberalization, this refers to the removal of
government controls over prices. Recall that housing, energy products, food all had prices
significantly below world levels, any removal of government restrictions on the mobility
of these prices would result in increases in these, something that would adversely effect
the standards of living of the population, and hence will not be politically popular.
Different Eastern European economies attempted to address differently these
reforms. Poland implemented what is known as shock therapy, a process where all of the
reforms are introduced almost simultaneously and ideally at full speed. Poland began its
reform process on January 1st of 1991. The shock therapy turned out to be a success in
Poland, and the next year the Polish economy posted positive growth in the GDP, posting
one of the best, if not the best performance in all transitional economies by experiencing
the transitional recession for only about two years. Hungary proceeded differently
through the transition by spreading the reforms over a longer time period and doing them
gradually, this approach reduces the immediate pressure on the economy, but also seemed
to have prolonged the course of the transitional recession, at least in Hungary it lasted for
about three years. It is worth noting that Hungary had some elements of private economy
even under the command economy regime.
Although at first the Russian government under Gaidar was interested in
implementing the Polish model in Russia, but the reforms ended up being spread over a
period of several years. Recall the slides we discussed in class and also the tables with
growth rates for various Eastern European economies during the period of transitional
recession.
Privatization process was particularly difficult in Russia, and elsewhere in the
territories of the former USSR, and hence it was spread out over a longer period of time.
The key reasons for the difficulty lied in the industrial composition (heavy industry, large
employment centers, obsolete production process). It is relatively easy to privatize a
profitable small business, as there will be many investors willing to purchase it, but
finding investors for a large factory that produces low quality output using inefficient
production methods is a much more difficult task. But this meant that profitable
enterprises will be privatized and with their privatization the government will stop
receiving their profits as revenue, while inefficient, non-profitable enterprises will remain
under government control. Note that privatizing these large industrial enterprises would
certainly mean a huge rise in unemployment, while maintaining them under government
control although may have insured those jobs temporarily also meant that government
expenditures will not decrease, while privatization of profitable firms reduced the stream
of revenues to the government. Furthermore, new owners of recently privatized firms did
not have to follow the USSR laws of guaranteed employment, and hence were likely to
fire some workers to improve the efficiency of their factories even further, which meant
an increase in unemployment.
By now the CIS includes all but the three former Baltic Republics of the USSR. It
acts as a trade zone, and a zone of economic cooperation. In Eastern Europe, outsides of
the boundaries of the former USSR, the transition for the most part is over. In May of
2004, ten countries, all former members of the Command economy block, entered the
European Union, a sign that economic recovery in the region is producing positive
results. In 2007, Romania and Bulgaria are scheduled to join the EU. In Russia, the
current economic growth expected to be above 7%, a robust performance, also largely
lead by price changes in the oil and natural gas markets. At the same time political issues
remain in many of the parts of the former USSR. Recent wave of peaceful revolutions
suggests that the political and economic reforms are still underway.