Economics 110 The Soviet Union: Reform and Collapse
Background
Economic reforms have been attempted several times in the Soviet Union. Major reforms were attempted in 1965 and again in 1982. These reforms attempted what has been called "the perfection of control": attempts to improve the existing system without changing it fundamentally! They were initiated in response to the recognition of inadequate economic performance, were typically poorly designed, and faced considerable opposition from within the bureaucracy. These reforms were of two kinds. One kind involved the improvement of central planning. For example, the administrative bureaucracy was streamlined, new mathematical methods were introduced along with greater computerization, and the number of plan indicators and amount of detail was reduced. The second kind of reform involved decentralization, an expansion of the autonomy of enterprises, and new, more complex, incentive schemes. With their new autonomy, and with other elements of the system unchanged, enterprises engaged in increasingly dysfunctional behavior. As economic performance declined, the reforms were abandoned! As a result, there were no fundamental differences between the system existing in May, 1985 (when Gorbachev took power) and the system created by Stalin in the late 1920s and early 1930s!
The Causes of Perestroika
While it was obvious in 1985 that the economic system was performing inadequately, it must be stressed that the system was NOT NEAR COLLAPSE! As we noted earlier in the section on economic performance, the Soviet economic performance of the 1970s and early 1980s was not good, but it was certainly not disastrous! The traditional system could have gone on for a long time without substantial reform! Why then was perestroika (restructuring) begun specifically in 1985?
Some people believe that the high economic growth rates in the West were responsible for perestroika. One argument that had been used by the Party to make the economic system acceptable to the citizens involved "the superiority of socialism". As long as socialist countries grew faster than capitalist countries, this argument was persuasive. But in the late 1970s and early 1980s, Western capitalist countries were performing much better than socialist countries. This undermined the legitimacy of the government! The party leaders must have found the rapid growth of Japan, South Korea, and Taiwan particularly hard to take!
Other people believe that the American proposal for a Strategic Defense Initiative (SDI) was responsible for perestroika. This was the proposal to place a system in space capable of shooting down Soviet missiles. It shifted the military competition between the United States and the Soviet Union to the area of high technology. This was an area in which the Soviet Union was particularly backward in the relation to the United States, and in which it had been stagnating for many years. The idea that the Soviet Union was a military equal of the United States was now threatened!
Still other people believe that the Soviet defeat in Afghanistan was responsible for perestroika, in that it undermined support for the party and caused many people to question the Marxist-Leninist ideology that they had taken for granted.
It was noted by many in the Soviet Union that central planning is totally inappropriate in the new technological environment, with its emphasis on flexible manufacturing, on complex relationships between enterprises, and on innovation occurring as part of the process of production. Central planning is also more feasible when labor and natural resources are plentiful, as they were in the 1950s and 1960s. But it is a wasteful system once labor and natural resources become scarce.
The Beginning of Perestroika
The beginning of perestroika involved "restoring discipline". Gorbachev believed, as had the two party leaders before him, that the system of reward and punishment had become inadequate to bring forth sufficient production. The earliest policies to come from this idea had come in the early 1980s, before Gorbachev. They involved prosecution of corrupt officials and managers. They also involved the police rounding up people on the streets and in movie theaters during working hours! The first Gorbachev policy in this regard was the "anti-alcohol campaign", a major attempt to reduce the drinking of alcohol by closing liquor stores and reducing hours of sale, by raising the prices significantly, and by increasing penalties for being drunk on the job. Production of alcoholic beverages in state factories was reduced by 50% during 1985 to 1987. The result, as might be expected, was a large increase in illegal production of alcoholic beverages! (This led to extreme shortages of sugar in state stores.) Since the government had relied on taxation of alcohol as a major source of revenue, this policy led to a drastic reduction in tax revenues, contributing greatly to budget deficits. The campaign was ended in 1988!
Another early policy of Gorbachev involved a considerable change in the leadership, both of the Party and of the ministries and enterprises. This was undertaken because of the widespread corruption of officials during the administration of Brezhnev. As part of his "war on the Party leadership", Gorbachev initiated Glasnost ( a policy of greater openness in the operation of the political system). He removed the party from much of its role in the economy, thereby removing the essential monitoring feature of the socialist system. Freed from party domination, factories, cities, etc. could act as they pleased! He also removed the official state ideology of Marxism-Leninism (as a means of undermining the traditional party leaders). This, made possible the revival of nationalism, which subsequently led to the disintegration of the state!
Gorbachev also tried to reverse the inward-orientation of the Soviet Union toward the rest of the world. In part, he did this because he believed that the Soviet Union would need an infusion of Western capital in order to modernize. In 1986, the Soviet Union requested observer status in the GATT, the first step in becoming a member (this was finally granted in 1990). In 1989, it negotiated an agreement to remove obstacles to selling Soviet products in the European Community. And Gorbachev began to disengage the Soviet Union from Eastern Europe. Eventually, Comecon was disbanded!
The other early Gorbachev reforms, like those of previous reforms, were attempts to improve the traditional system. They included a large increase in state investment, especially in machine building (most of which was military related), a major renovation and re-equipping of old factories, a stated goal of introducing so many new products that 60% of all products would be new in just five years, the creation of a new bureaucratic agency to evaluate the quality of products, and the merging of Ministries into Superministries.
The 1987 Law on State Enterprise
According to this law, which went into effect in 1988, enterprises and local authorities were to have more decision-making authority over production and input mix, the structure of wages and bonuses, the amount of investment, etc. Detailed annual plans were to be eliminated! The number of centrally distributed products was reduced from 13,000 to 618!
Second, ministries were to have only indirect means to influence enterprises, such as changes in taxes, in interest rates, or in prices. Third, enterprises were expected to be financially self-sufficient, meaning that costs plus capital needs were to be financed from sales revenues. If an enterprise could not become self-sufficient, provisions were made to allow bankruptcy for the first time. Fourth, enterprises gained the right to export and import on their own. At first, this right was granted to only 70 manufacturing enterprises; by January, 1991, this number had risen to 26,000! However, the Foreign Trade Organizations still controlled about 60% of all foreign trade at the end of the 1980s and about 90% of all foreign exchange was still under state control. Those enterprises that earned foreign exchange were able to keep only a small portion of it and were strictly controlled as to the ways they could spend their foreign exchange. Fifth, foreign exchange auctions were begun in 1989. These were to be the first steps in making the ruble convertible. Sixth, the enterprise director was to be elected by the workers for a 5 year term in multi-candidate elections. Not only was the enterprise director no longer to be appointed by the party, but, as noted above, the party lost all of its monitoring role inside the enterprise. Seventh. the cooperative sector was to be greatly expanded, in effect legalizing the second economy. By 1990, there were over 245,000 cooperatives, employing about 6.1 million people and producing about 7% of the GNP. They were allowed originally in 29 types of services. And private economic activity was legalized. But, Gorbachev was not at all comfortable with this shift toward capitalism! As a result, employed workers were to undertake private activity only in their off hours. And private activity was discouraged by high fees and by licensing requirements. Finally. prices were to be revised by 1991. Only a few products were to have centrally set prices. Trade between enterprises was to be done at prices negotiated between them. On April 2, 1991, prices of consumer goods were raised by 60% to 70% on average (despite increases in wages, individual purchasing power was estimated to have fallen 15% to 20%). But prices of many consumer goods and on many products traded between enterprises were still centrally controlled!
One must conclude that these reforms did not represent a shift to capitalism! But they were an attempt to decentralize and place a greater emphasis on markets while maintaining the basis of the traditional system!
Evaluation of the Provisions of Perestroika, 1985-1990
The first problem was that prices were freed for some products, but were still fixed for most of the "important" products sold between state enterprises. This meant that prices were distorted! Distorted prices led to an inability to obtain needed resources by state enterprises. This caused production to decline! First, state enterprises could not get the needed resources because they were not allowed to pay the higher prices. For example, oil refineries could sell oil to cooperatives who could sell it to consumers at three times the state price; state enterprises who were required to pay the lower state price simply could not get the oil! Second, state enterprises could not obtain the resources needed for production because these were stolen from the state enterprises and resold at the higher market prices, often by enterprise directors! Theft from state enterprises rose 1/3 from 1989 to 1990 and another 39% from the first quarter of 1990 to the first quarter of 1991! This problem was especially severe in the construction industry. In a country where economic ties between enterprises had been closely regulated by the plan, this breakdown was much more devastating to production than it would have been in the market economies of the West where companies would have had many years of experience in finding alternative sources of supply!
A second problem was that the provisions of perestroika led to rapidly rising incomes. First, because enterprise directors were elected by the workers (a practice ended in 1990) and because they were freed from outside controls, workers' wages rose considerably! Wages rose 8% in 1988, 9.4% in 1989, and 12.3% in 1990! Enterprise directors knew that increasing wages was the best way to assure a happy work force --- one that would re-elect them. And with no private owners, as in a capitalist system, and no party control, as in the pre-reform socialist system, there was no one to restrain this practice! Second, agricultural incomes grew due to the higher procurement prices paid by the state and to the higher incomes from sales from the private plots. And third, there was a major shift into private and cooperative economic activity as it became legal to do so. Their incomes were more than double those of workers in the state sector!
A third problem from the provisions of perestroika was that the growth of investment in 1986, as proposed by Gorbachev, caused another investment cycle. Investment grew 8.4% in 1986, 5.6% in 1987, and 6.2% in 1988 as a result of Gorbachev's proposal to renovate and re-equip old factories. Combined with the difficulty in getting needed inputs, it led to shortages, increased unfinished construction, and rising imports. The volume of construction that exceeded the planned time limit exploded, rising by almost 800% between 1987 and 1990! The long delays made some projects technologically obsolete before their completion! Finally there had to be a retrenchment, with investment rising only 0.9% in 1989 and 3.9% in 1990.
The decentralization of investment decisions to the enterprises (in 1989, about half of total investment was financed by enterprises from internally generated funds) also led to a large number of project starts. This is a natural result of the expansion drive that is built into the system. In capitalist countries, investment demand would be restrained by owners or by bankers. In the pre-reform socialist system, it may have been restrained by party leaders in the firm or by planners. Now there was no one to restrain the desire of enterprise directors to expand! Decentralizing investment decisions to the enterprises also made it difficult for the state to redistribute investment to the poorer regions, enhancing the regional inequality. The regional inequality surely contributed to the disintegration of the state after the failed coup of August, 1991!
The increased investment spending went mainly into a few areas --- especially machine tools. Consumer goods production and agriculture were neglected. Railroads also were neglected. Increased rail shipments were handled by making trains longer and heavier, rather than modernizing and building new tracks. The result was a severe problem of maintenance as the railroad stock was pushed beyond its capacity. The backlog of delayed track repairs became so long that it would takes 66 years at the existing rates of repair! Railroad accidents also increased. As a result of railroad problems, inputs did not arrive at factories, which then had to shut down. Producers of inputs also had to shut down because their warehouses were overflowing with goods that had not been shipped. Food products that were in short supply in cities were piled up in factories or on the farms. Petroleum refineries had to shut-down while agriculture was experiencing a shortage of fuel at harvest time!
Fourth, while agricultural production increased a respectable 2% annual rate from 1986 to 1990, there were still problems in food production resulting from the provisions of perestroika. Prices charged for farm machinery and other inputs rose more than farm productivity did, raising the costs of production. The rising costs forced the state to raise procurement prices paid to the farms. For political reasons, it was not possible for the state to raise the prices of food products sold to consumers. Thus, the higher procurement prices meant an increase in food subsidies! In addition, the problems of the collective and state farms were not addressed by perestroika. The main problem was the lack of adequate food processing, storage, and marketing infrastructure. The reforms of perestroika did nothing about this. The food problems of today results from this lack of attention to investment in the agricultural sector and to the macroeconomic disequilibrium (see the discussion below)!
A fifth problem emerged as a result of regional decentralization. With incomes and spending rising, production stagnating, and prices of many goods basically fixed, only one result could occur --- severe shortages of many key goods! In this situation of severe shortages, many of the republics and cities, now freed from party control, refused to sell goods to other areas. National autarky was replaced by republic and city autarky! Since the Soviet Union had extreme regional specialization (in some cases, all of the production of a good came in a single area), republic and city autarky exacerbated the problem of declining production!
Sixth, despite the promises of the reform proposals, in reality there was an inability to end the soft-budget constraint. The increase in wages paid combined with fixed state prices made many enterprises unprofitable. Although bankruptcy was now allowed, virtually no bankruptcies occurred. The argument that the system generated full-employment was one of its legitimating features! Large-scale unemployment was unthinkable! So the enterprises were bailed-out by subsidies from the state as before, contributing to government budget deficits. This, plus the increase in food subsidies and in investment spending noted above, caused the budget deficits to reach 11% of GNP in 1989! (The deficits were also caused by spending resulting from the Chernobyl disaster and Armenian earthquake as well as decreased revenues resulting from the anti-alcohol campaign, the falling world prices for oil exports, and the decline in enterprise profits paid to the state.) Some of these deficits were financed by borrowing from the public and some from external loans. But most of it was financed by money creation. From a typical average of 2.2 billion rubles per year, money creation grew to 12 billion rubles in 1988, 18 billion in 1989, and 27 billion in 1990! In effect, money was being created to pay for the rise in incomes described above! But production of goods and services was stagnating! The result was a macroeconomic disequilibrium! The money created sat involuntarily in accounts in banks or in currency hoards --- this has been called the "ruble overhang"! The inability of the political system to slow the money creation, reduce the budget deficits, and provide sufficient consumer goods surely precipitated the collapse of the Soviet economy!