Letting Go the Tiger's Tail

Reforming the Soviet economy is nearly impossible, but there is a way.


The Soviet elections in March have changed that country's political landscape. Coming at a time when it is increasingly apparent that the road to reform will be long and hard, the election results make it more likely that forward momentum will be maintained. It is correspondingly less likely that Gorbachev's perestroika will sputter to a halt without lasting change, as did repeated half-hearted reform efforts of the 1960s and '70s.

The election results carry three significant political implications. None has much to do with who will eventually hold a majority in the new Congress of People's Deputies or what powers, if any, that body will succeed in exercising.

First, the very facts that the election was held, votes were counted, results were announced, and defeated candidates admitted defeat indicate that the Soviet Union has taken the first steps toward constitutional government. All this has seriously eroded the ability of the party establishment to play by its own rules regardless of the law.

That is all the more remarkable because the elections were held under rules that seemed to offer the apparatchiki plenty of opportunities to outmaneuver the opposition. Nomination meetings were packed, rigged, or moved without prior notice. Preelection gatherings dominated by party regulars weeded out many reformist candidates. In many social organizations and territorial constituencies, all reformist opposition was eliminated before voters saw the ballot on election day.

Yet even where voters received a ballot with the name of just one candidate, that candidate often lost—courtesy of the Soviet system of negative voting. Voters cross off the names of candidates they want to vote against, rather than casting votes for those they support. To win, a candidate must get a majority of ballots cast. If a majority of voters cross off all listed candidates, new nominations must be made and a new election held. ("Eat your hearts out, Amerikanskis," commented one cartoonist.) At least three dozen major local and regional party leaders who ran unopposed or with only token opposition went down to defeat that way, including the party chief of Leningrad, a candidate member of the ruling Politburo.

Second, the elections laid to rest the myth of a silent majority of ordinary workers and citizens opposed to reform. That majority supposedly yearned for the good old days of political stability, when economic prospects, although minimal, were at least predictable. Western commentators and emigre cynics repeated this myth so often that even many dedicated Soviet reformers wondered if the people were ready for democracy.

Yes, rank-and-file workers do have complaints about perestroika, ranging from longer lines for vodka to decreased job security. But in March, did they express those complaints by voting for the apparatchiki and against the reformers? As the Russians say, vryad li. Hardly. Landslides in the 80-percent-and-up range for many reform candidates and against unopposed establishment figures effectively dispel the notion that reform is supported only by a thin layer of journalists and intellectuals.

Third, the elections established and legitimized Gorbachev's left opposition. (In the Soviet context, promarket views are "left," Communist orthodoxy is "right.") Gorbachev is no longer poised dangerously at the left end of the legitimate political spectrum, as he was as recently as the June 1988 party conference. At least some of the candidates elected in March to the Council of People's Deputies are genuine radicals who support multiparty politics, full private property rights for farmers, national independence for the Soviet Union's constituent ideas that remain anathema to Gorbachev himself. More numerous are delegates who, while accepting Gorbachev's moderate views of the appropriate scope of reform, would like to force its pace.

Gorbachev may or may not choose to ally himself with the left opposition when it comes to parliamentary tactics. But by lending an aura of moderation to proposals only recently seen as hair-raisingly radical, a legitimized left opposition increases his room to maneuver.

Despite a political boost from the elections, however, Soviet reformers still face some sobering economic realities. Hopes that perestroika would quickly revitalize the economy have by now been dispelled (and perhaps along with them, the fears of Western conservatives that reforms would give a quick boost to Soviet military power). Four major economic obstacles stand in the way of reform. They concern the country's capital structure, its organizational structure, the legal and cultural foundations of its embryonic private sector, and its fiscal and monetary mechanisms of macroeconomic balance.

THE CAPITAL STRUCTURE. Thirty years ago, when mathematical growth models were first becoming popular, American economists looked at the Soviet Union with envy. According to the models, multiplying a country's gross savings rate by an output-capital ratio gave you a projected percentage rate of growth. The Soviet economy had a gross savings rate on the order of 30 percent, compared with 10 percent or so for the United States. Consequently, if you drew growth curves for the two economies, no matter how low a base you started from for the Soviet Union, after a few decades the curves crossed and Soviet per capita GNP overtook that of the United States. Khrushchev evidently believed those growth models, if his bragging is to be taken as sincere, and a lot of smart economists at Harvard and MIT, who should have known better, believed them too.

Today, long after the growth curves should have crossed, they are as far apart as ever. We now have a clearer idea of what the Soviet Union has bought with all the blood, sweat, and tears entailed by its 30 percent gross savings rate. To oversimplify only slightly, it has bought an economy capable of turning out industrial inputs on an unsurpassed scale—more steel, more coal, more ton-miles of rail transportation, more tractors, more combines, more concrete than anyone else. But it has failed grotesquely to build a capacity for converting those inputs into outputs capable of satisfying human wants.

As reforms proceed, a substantial part of the Soviet capital stock, which does not meet world standards, will simply have to be abandoned. Profit incentives, freer wholesale trade, and greater access to Western technology may eventually make it possible to replace it with something better. But no shortcuts will make it possible to produce high-tech steels in the hulking blast furnaces of Magnitogorsk or bring in a good wheat harvest with obsolete and defect-ridden Soviet combines.

What is true of fixed capital is true to a substantial degree of human capital, as well. It is not that Soviet managers and workers lack training and education—many of them are very well trained and educated. The problem instead is that their skills have been developed to complement the existing stock of fixed capital and existing administrative institutions. Those skills cannot always be transferred to a new environment. Workers and managers will need to be retrained or replaced with a new generation of personnel better adapted to the more technology-oriented, market-oriented Soviet economy of the future.

THE ORGANIZATIONAL STRUCTURE. A market economy is not a uniform plasma of individuals interacting atomistically in response to market forces. Instead, the units that interact in the marketplace come in many sizes and shapes, ranging from tiny independent contractors to huge corporations with hundreds of thousands of employees. The distribution of units by size, purpose, and organizational form is far from random. It is, instead, the outcome of a long process of evolution in which economic organisms better adapted to their environment have displaced those less well adapted.

What, for example, is the optimal size, shape, and scope of a firm that produces automobiles? When we think of an auto maker, what comes to mind is an assembly plant where an engine is bolted to a chassis, a body is welded on, tires are mounted, and a finished car rolls out the door. But assembly is only part of a total production process that extends from coal and iron mines to the showroom floor. What tasks should come under ownership of the firm that does the assembly? What tasks should be assigned to independent contractors? What tasks should go to firms with an intermediate degree of independence, such as franchises or "captive" suppliers with dedicated facilities?

The answers were not obvious to the entrepreneurs who built the American auto industry. They experimented with every imaginable alternative. Henry Ford once tried to build an auto works integrated from the smelting of iron ore to the finished car. That was too much integration. It was an organizational nightmare that had to be abandoned. Meanwhile, the early General Motors was going to an opposite extreme. It didn't even make the bodies for its cars, buying them instead from Fisher Body, then a separate company. That was too little integration—GM eventually bought out Fisher and made it a subsidiary. At the retail end of the auto market, should an auto maker own a chain of factory outlets, or should it sell its cars indiscriminately to any retailer, as Cheerios are sold? Both have been tried, with the franchised dealer, substantially controlled but independently owned, as the most popular solution.

Economists who study such things maintain that for maximum efficiency, an economy must adapt its organizational structures to the tasks at hand, taking into account a multitude of variables. The organizational structure of the Soviet economy, however, has evolved to suit the needs of central planning, not those of the market. Even if we stipulate, charitably, that it is well adapted to its environment, there is no reason to think that the same structures will work well in a market context, any more than a fish, thrown up on the beach, can breath with its gills or use its beautifully streamlined fins to crawl back into the water.

Consider, for example, the tendency of Soviet firms to integrate backward even at the cost of producing on an uneconomical small scale. A Soviet manufacturing firm may have a shop where bolts of a certain hard-to-obtain size are machined by hand. A Soviet construction firm may have its own sawmill processing poorly suited timber from local forests. Such undertakings make sense in a system where a vital rule of self-preservation is to avoid putting yourself in a position where someone else's failure to fulfill a part of the plan jeopardizes your ability to fulfill your part.

Although the tendency toward self-sufficiency means some goods are produced on too small a scale, an opposite tendency toward giantism means that other goods are produced in one or two monster plants, where a market economy would have many competing facilities. The monsters make a certain administrative sense in the context of central planning. But if you suddenly tell Soviet firms that they are free to buy inputs wherever they want at prices negotiated with their suppliers, they may find that there is only one supplier with which to negotiate. What was an administrative convenience under a planned system becomes an unworkable monopoly when market relations are introduced.

In short, if it is to create a functioning market economy, the process of perestroika will have to include a restructuring of organizational forms as well as of physical and human capital. Cutting the existing organizational units free to sink or swim in a market environment is likely to make matters temporarily worse until old units are broken up, new alliances formed, new forms of contractual relations worked out, and so on.

LEGAL AND CULTURAL FOUNDATIONS. Converting the existing state-owned economy to market principles won't be easy, but an alternative has been suggested. That is to let a new, market-based system of private and cooperative small businesses grow up like furry little mammals darting between the legs of the dinosaurs. Gorbachev's reforms have featured some important initiatives in this area. Thousands of private taxis have hit the streets, and hundreds of cooperatives now supply consumers with everything from restaurant meals to artificial limbs. But even as the individual and cooperative sector has grown, it has become evident that serious legal and cultural weaknesses limit the role the private sector can be expected to play in the near future.

One problem is widespread resentment of the substantial incomes earned by successful cooperative entrepreneurs. Repeatedly, in letters to the press, in questions on phone-in TV shows, and elsewhere, variations on the following theme crop up: "The law permitting cooperatives was enacted so that they could supply the market with urgently needed goods and services. Instead, they have taken advantage of the law to enrich themselves."

Such comments reveal cultural attitudes far from conducive to the growth of a market economy. Supplying the market with goods and making a profit are seen as mutually antagonistic rather than complementary. The idea that the opportunity to get rich is a necessary incentive for obtaining a dependable supply of goods is not widely accepted. Soviet consumers seem to want cooperatives to come up with better potatoes than the state stores but not to charge higher prices for doing so.

What is more, there is a tendency to react to the high prices and incomes of the first wave of cooperatives by placing restrictions on prices, profits, and entry. The idea never seems to occur that relaxing restrictions and encouraging entry would increase the supply of goods, place prices and profits under increased competitive pressures, and make it possible for more people to share in the prosperity.

But public hostility is only the start of problems faced by individual and cooperative enterprises in the Soviet Union. The legislation that permits such enterprises to exist does not give them the right to participate on an equal footing with state enterprises in markets for capital equipment and material inputs. How, then, is a cooperative restaurant to buy a stove, an individual tailor to buy cloth, or a private plumber to buy copper pipe? One alternative is to buy them at retail, which puts the cooperatives in direct competition for scarce goods with ordinary consumers and heightens public hostility. The other is to buy them "on the left" at the wholesale level, which almost invariably entails bribes. That drives up the cost of doing business and further damages the coops' public reputation.

Finally, there is a growing problem with victimization of individual and cooperative enterprises by organized crime. Cooperative restaurants that don't pay protection money get their windows broken. Mafias that control public markets force farmers and craft workers to pay heavy fees for stall space that is supposed to be free on a first-come, first-served basis. Less sophisticated criminals resort to simple armed robbery. Of course, extortion, racketeering, and violent crime are far from unknown in Western market economies. Soviet entrepreneurs' lack of legal protection, however, renders their problems more serious.

Just a short time ago, almost every private business venture was itself a crime. The police are at best slow to make the switch to a new role as defenders of private enterprise; at worst, they have allegedly conspired with the criminals victimizing the private sector. The court system, too, is ill equipped to help. In a system where many forms of private property were until recently illegal, theft is not always even technically a crime. When hostile police and court systems are considered together with public resentment toward profitmaking in general, cooperatives and private service workers end up being cast in the role of villains, while the extortionists who prey on them are seen in the role of Robin Hoods.

The problems of urban cooperatives and individual service workers are shared, to some degree, by the private agricultural sector, on which Gorbachev is pinning hopes for a solution to food shortages. The same resentment toward success has manifested itself in the countryside in the form of burned barns and poisoned cows. Also, farmers working the land under new long-term lease agreements face problems similar to their urban counterparts when it comes to equal access to supplies and legal remedies for the criminal and administrative abuses to which they are subject.

MACROECONOMIC PROBLEMS. Soviet reform faces serious macroeconomic obstacles, as well, in the form of inflationary pressures that will very likely become more acute as time goes on. An economy's capital stock, organizational structure, and legal and cultural institutions place limits on the total supply of goods and services. Given limits on aggregate supply, if overall demand is not similarly limited, inflationary pressure will result as people bid up the prices of limited goods and services.

Western economies have used a variety of tools for managing aggregate demand, ranging from the classical gold standard to Keynesian monetary policy, to monetarist central banking by rules. None of them can boast of having found the perfect formula for steady, inflation-free growth. But the Soviet economy faces the even more serious difficulty that macroeconomic institutions for control of aggregate demand can hardly be said to exist at all.

The problem begins on the fiscal side with the fact that there is no sharp distinction between what we think of as government expenditure (expenditures for defense, civil service salaries, pensions, and the like) and the current and capital expenditures of state-owned industry. So industry cost overruns—whether due to overstaffing of enterprises, the slow pace of capital construction, or whatever cause—add to the state budget deficit. The resulting deficit, Soviet economists have now conceded, is far larger as a percentage of GNP than that of the U.S. government.

Turning to the monetary side of things, in the U.S. economy, the separation of monetary from fiscal policy has made it possible for growing budget deficits in the 1980s to coincide with moderating inflationary pressure. The Treasury finances its deficit by selling securities in a way that has no automatic impact on the money stock. The Federal Reserve is able to manipulate bank reserves and deposits independently of what the Treasury does.

In the Soviet Union, however, there is no separation of fiscal and monetary policy. Budget deficits are not financed by sales of securities to the public (except to a trivial degree through the sale of some savings bonds). Instead, they are automatically monetized. As a result, signs of inflationary pressure are everywhere evident.

In the past, prices were rigidly controlled so that inflationary pressure could manifest itself only in repressed forms—growing queues and shortages in the markets for consumer goods and accumulation of idle currency and savings account balances by the public. Those traditional forms of repressed inflation have grown more acute in the past year or two. Savings deposits have soared, and even such ordinary consumer goods as laundry detergent and razor blades are now rationed or unavailable.

But at the same time, reforms have begun to loosen the central authorities' grip on prices, so inflation is also taking a more open form. For example, to encourage innovation, makers of consumer goods have been allowed to set their own prices for newly introduced styles and models. However, many firms have taken advantage of this pricing freedom by charging higher prices for "new" products that differ from the old ones only in trivial ways. Completely uncontrolled prices in the cooperative sector have soared to even higher levels, fueling the popular perception of coops as unprincipled profiteers.

The inability of Soviet macroeconomic policy to control aggregate demand puts reformers in a quandary. From a microeconomic point of view, flexible prices based on supply and demand are an absolute necessity if there is to be any hope of increasing efficiency and the rate of innovation in state industry. Yet so long as aggregate demand is out of control, giving enterprises the freedom to set their own prices means that those prices will be flexible mainly upward. The experience of neighboring Poland is hardly encouraging in this regard. There, attempted economic reforms have led to rapid open inflation, reportedly over 60 percent in 1988. The inflation has led to political protests, strikes, and a general erosion of living standards. Reform-minded Soviet economists rightly fear that inflation could undermine the popular support that economic reform still enjoys.

Given the daunting economic realities facing Soviet reform, it is easy to spin out pessimistic scenarios. Gorbachev's perestroika could simply peter out, returning the country to the stagnation of the Brezhnev era. The threats that reform poses to the power and privileges of the party elite could spark a conservative coup with Stalinist, anti-Semitic, and Russian-chauvinist overtones. Or efforts to force reform with inadequate macroeconomic discipline could lead to runaway inflation—the South American disease.

For a Western observer of Soviet affairs, the challenge is to come up with a credible optimistic scenario—one that leads, eventually, to a prosperous, free, and democratic Soviet Union. Here is what one might look like:

Begin with the political prerequisites of economic reform. Gorbachev, or someone substantially like him, must remain in power for some time to come. A conservative like Yegor Ligachev could lead the country only into stagnation—Upper Volta with rockets, as Vitalii Korotich, liberal editor of Ogonyok, calls that variant. A populist like Boris Yeltsin would most likely lead the country into inflationary chaos—Argentina with rockets.

But it is not enough simply for Gorbachev to remain in power. It is also necessary that he and the rest of the Soviet leadership be progressively radicalized, led to choose bolder options, less constrained by ideological taboos and the interest-group politics of the old elite.

The outcome of the March elections bodes well in this regard. The elections seem to leave Gorbachev in control of a centrist, reformist bloc flanked on the right by a weakened conservative faction and on the left by a greatly emboldened radical faction. For the moment, Gorbachev has room to maneuver on the left without being beholden to anyone.

Assuming, then, the proper correlation of political forces, what concrete economic policies might increase the chances of a successful transition to a more market-oriented and efficient system? A sine qua non is to find a way to control inflationary pressures. A three-part program, each part of which already has backers among Soviet reformers, might do the job:

• Untangle the government's budget from that of industry by aggressively pushing the concept of self-financing for all enterprises. This must include a willingness to risk bankruptcy for hopelessly uneconomic enterprises.

• With the budgets decoupled, attack the remaining government budget deficit with radical cuts in defense expenditures and continued shrinkage of the bloated administrative apparatus.

• Develop innovative ways to absorb the excess purchasing power of the population. The overhang of purchasing power is far too great to handle with such palliatives as increased imports of consumer goods and further growth of the cooperative sector, although those measures could play a subsidiary role. A more radical approach would be to sell state-owned property to the public: allow tenants to buy their state-owned apartments, sell shares in industrial enterprises to their workers, and allow collective farmers actually to purchase farmland, not just lease it.

If inflationary pressures can be brought under control, the sputtering economic reform of state industry can be put back on track. Most importantly, reform must include thoroughgoing restructuring of the price system. Subsidies must be ended and both wholesale and retail prices set free to respond to supply and demand. But price reform can only be accomplished in an environment where aggregate supply and demand are balanced.

Meanwhile, although there will be no quick fix, a serious long-term attack should be made on impediments to the individual and cooperative sector, both farm and nonfarm. In part, doing so will require concrete steps to regularize the legal status of that sector and provide adequate police protection. But perhaps even more important, it will require clear moral leadership at the highest level. Although no Soviet leader on the foreseeable horizon can be expected to endorse capitalism as such, it must at least be established that a humane socialism cannot be built on the principle of leveling to the lowest common denominator and blind envy toward the success of one's neighbor.

Finally, the success of economic reform will depend on recognizing that the material payoff will not be rapid. In terms of gross national product, there is every reason to think that the Soviet economy will and should shrink before it begins to grow again. To some extent, the impact of a shrinking GNP can be cushioned by shifting resources from the military to the civilian sector and by paying more attention to the quality of consumer goods than to their quantity. But prospects for an across-the-board rise in living standards belong to the long term.

In the meantime, what can the Soviet leadership offer in return for the popular support it needs? The answer is simple: peace, freedom, truth, democracy, national and cultural autonomy, and most important of all, self-respect. Cynics both in the Soviet Union and the West have said that those things are valued only by a few intellectuals, that the narod—the people—have no use for them or even fear them. The March election indicates otherwise.

Despite the fact that Gorbachev has "only" given people a more open press, an end to jamming of foreign radio services, a bit of truth about Soviet history, and a chance to express themselves at the polls—only those things, and not a sausage in every bowl of borscht—the people did not vote against reform. The message they sent was to get on with it. Even if the road ahead runs downhill for a while, they see turning back to the past as no solution.

Edwin G. Dolan teaches economics at Gettysburg College in Pennsylvania and is the author of a leading economics textbook.