4 The Collapse of the Soviet System

Buttressed by theoretical models as well as a theory of history, let me give a broad outline of what I think is going on. We are witnessing the disintegration of a closed system as embodied by the Soviet Union. The disintegration affects all aspects of the system, notably an ideology, a system of government, an economic system and a territorial empire. When the system was intact, all these elements were integrated; now that the system is falling apart, the various elements are decaying in various ways and at various speeds but events in one area tend to reinforce developments in the others.

The decay started a long time ago, with the death of Stalin to be precise. A totalitarian regime needs a totalitarian at the top. Stalin fulfilled that role with gusto. Under him the system attained its maximum extension, in both ideological and territorial coverage. There was hardly an aspect of existence that escaped its influence. Even genetics obeyed the Marxist doctrine. Not every science could be subjugated with equal success, but at least the scientists could be tamed and their contact with youth restricted by confining them in the Institutes of the Academy and preventing them from teaching at universities. Terror played a large part in making the system work but the cover of ideology successfully concealed the underlying coercion and fear.

It is a testimony to Stalin's genius that the system survived him by some thirty-five years. There was a brief moment of hope when Khruschev revealed some of the truth about Stalin in his speech before the twentieth Congress but, eventually, the hierarchy reasserted itself. This was the period when dogma was preserved by administrative methods, without any belief in its validity. As long as there had been a live totalitarian at the helm, the system enjoyed some maneuverability: the party line could be changed at the whim of the dictator and the previous one excised. Now that flexibility was lost and the system became as rigid as our theoretical model prescribes. At the same time a subtle process of decay set in. Every enterprise and institution sought to improve its own position. Since none of them had any autonomy, they had to barter whatever powers they had for the resources they needed for their own survival. Gradually an elaborate system of institutional bargaining replaced the central planning and central control that had prevailed while the system had been in totalitarian hands. Moreover, an informal system of economic relationships evolved which supplemented and filled the gaps left by the formal system. The inadequacy of the system became increasingly evident and the pressure for reform mounted.

Now comes a point that needs to be emphasized: reform accelerates the process of disintegration. It introduces or legitimizes alternatives at a time when the system depends on the lack of alternatives for its survival. Alternatives raise questions; they undermine authority; they not only reveal discrepancies in the existing arrangements but reinforce them by diverting resources to more economic uses. A command economy cannot avoid a misallocation of resources: introduce a modicum of choice and the shortages are bound to become more pronounced. Moreover, the profits that can be earned by diverting resources from the command economy are much greater than what can be earned from productive activity; it is therefore not at all certain that overall production will benefit.

The fact remains that in every communist country, with the notable exception of the Soviet Union itself, there has been an initial improvement when economic reform was introduced. The reason is that a command economy is so wasteful that any change is initially for the better. Only later does the damage done to the rigid structure of the centrally planned economy begin to outweigh the initial benefits obtained.

The Chinese reformers concluded, after a study tour of Hungary and Yugoslavia in 1986 which was sponsored by my foundations, that reform enjoys an initial ‘golden period’ during which an improvement in the allocation of existing resources gives people a definite sense of progress. Only later, when existing resources have been redeployed and new investments are necessary does the reform process run into insuperable difficulties. At that point, political reforms are needed to make further economic reforms possible.

As this theory implies, the communist system suffers from a fatal flaw which cannot be remedied by reform: investments are hopelessly inefficient because capital has no value. It is understandable why this should be so: communism was meant as an antidote to capitalism which had alienated the worker from the means of production. Communism claimed to protect the interests of the worker; therefore, the interests of capital could receive no representation. All property was taken over by the State and the State was an embodiment of the collective interest, as defined by the party. Thus the party was in charge of the allocation of capital; but its allegiance was with the workers: therefore it could not even recognize that capital also needs to be protected. This was the fatal flaw. Capital is a scarce resource, just like labor or land, and it needs to be allocated among competing uses. This is a basic principle of economics which was ignored by the system of central planning as it evolved under Stalin.

The theoretical model of a closed society calls for distortions that would be inconceivable in an open society. What better demonstration could one ask for? Economic activity under the Soviet system is simply not economic; it is better understood as the expression of some kind of quasi-religious dogma. Perhaps the best analogy is with the pyramid-building of the pharaohs. This interpretation explains why the portion of resources devoted to investment is maximized, while the economic benefit derived from them remains at a minimum. It would also explain why investment takes the form of monumental projects. We may view the gigantic hydroelectric dams, the steel plants, the marble halls of the Moscow subway, the skyscrapers of Stalinist architecture, as so many pyramids built by a modern pharaoh. Hydroelectric plants do produce energy and steel plants turn out steel, but if the steel and energy are used simply to produce more dams and steel plants the effect on the economy is not very different from that of the construction of pyramids.

That is why there is so much room for putting existing resources to better use. Redirecting existing resources is relatively easy, but when it comes to investment decisions, much more profound changes are needed. Capital must be treated as a scarce and valuable resource. A price must be put on capital and the rate of interest used as a guide in its allocation. This means, in effect, that the party must be removed from its role of the guardian of capital. Any reform attempt is bound to run into implacable opposition at this point. The resulting compromise cannot produce an efficient allocation of resources. It is on this issue that every reform is bound to come to grief: only a change that goes beyond reform and qualifies as a transformation of the system can hope to be effective.

This line of argument is well supported by the historical evidence. Both in Hungary and in Yugoslavia, and later in China, reform initially produced positive results. Its greatest success was in agriculture, where decentralization and the introduction of incentives led to higher output within a relatively short period of time. This gave the reform movement credibility on which it could draw later. The allocation of capital was not much of an issue, particularly in China, where practically no machinery is employed in agriculture. People just worked harder because they were allowed to enjoy the fruits of their labor. Outside agriculture, reform consisted mainly of introducing a more realistic price structure and a more flexible plan, giving enterprises a greater degree of autonomy. In China, for instance, the plan called for the production of four items: bicycles, watches, sewing machines, and radios. Greater availability of these products gave people a sense of progress and helped maintain the momentum of reform.

Reform was a gradual process, directed from above. The difficulties also arose gradually and they had to do with the weakening of the center and the imperfect autonomy of the decision-making units. It is difficult to trace the process in general terms because reform followed a somewhat different path in each country; it was intricately interwoven with political developments and it took many twists and turns. I am not well qualified to provide a historical account because I was not paying any particular attention until the last few years. But that may be an advantage because it allows me to concentrate on the salient features.

Although the enterprises were given increasing latitude, they were not converted into truly autonomous units. They remained responsible to the state, or more exactly to the party that was in charge of the state. Managements were members of the nomenklatura and their appointment, as well as their removal, depended on the party apparatus. Direct commands from the ministry may have been replaced by indirect rules couched in monetary terms but the lines of command remained the same. As a result, what was proclaimed as a market-oriented system was not really dependent on the market but remained oriented towards the sources of power.

There is always a divergence between the system as designed and as it really functions. When market-oriented reforms are introduced, the gap does not disappear; it merely changes its shape. Direct command are replaced by rules couched in monetary terms, but, in practice, the supposedly fixed market rules are subject to administrative adjustment.

Enterprises operate under what Janos Kornai called ‘soft budgetary constraints’: there are no real penalties for breaking monetary rules. Being members of the party/state hierarchy, managers find it more rewarding to try and change the rules in their favor than to play by the rules as given. This leads to the emergence of a small group of successful entrepreneurs, the so-called ‘red barons,’ whose success depends on their ability to manipulate the system. One only needs to look at Hungary today to see how complex such a system can become: almost every large enterprise has a special set of taxes and subsidies that apply to it. Ostensibly, these are associated with trading within the COMECON; be that as it may, they affect the fortunes of the companies concerned more profoundly than any other factor.

In a quasi-market system, enterprises are not allowed to fail. Reformers may clamor for the introduction of bankruptcy procedures, but bankruptcy would generate unemployment, and unemployment would be an admission of the failure of the system. The political center, as long as it retains any power at all, resists bankruptcies, especially among the non-economic pyramids of heavy industry.

Hungary has, by now, established quite a sophisticated two- tier monetary system, in which the central bank is supposed to exercise monetary control through commercial banks. Hungary is a member of the International Monetary Fund and its agreement with the IMF calls for strict limits on the amount ' of money in circulation and credit outstanding. But the limits cannot be enforced: enterprises simply do not pay each other. Suppliers have to stand in line to be paid when the debtor company receives money on its own account. Since the suppliers' debtors are also standing in line, the phenomenon has spread throughout the economy, until it now affects some 60 percent of all enterprises and the non-existent credit outstanding equals seven weeks of national production. No wonder that monetary controls are ineffective! All this would change if companies were forced into bankruptcy: creditors standing in line would lose money so that they would be much more reluctant to supply goods on credit. But it was only in December 1989, when Hungary was on the verge of passing from reform to transformation, that the decision to put fifty- one companies into bankruptcy has been taken - and, of course, it has not been executed.

In less advanced reform economies, institutional bargaining is all-important because there is no price put on capital and no penalty for its inefficient use. As a consequence, the demand for capital is practically unlimited and the allocation of capital, which is in theory the function of the central planning agency, is in practice determined by pulling strings within the bureaucracy. Even so, there is never enough to go around. Two outstanding facts about the Soviet Union: the average time of construction of an industrial plant is around eleven years, and inventories amount to almost a full year's production. No investment can be economic in these circumstances, in the sense of producing returns that would allow paying a realistic rate of interest. In other reform economies the situation is not half as bad as in the Soviet Union, but the problem of capital allocation remains the root cause of chronic macroeconomic imbalance.

China is a particularly clear-cut case. Prior to the recent setback, reform had made considerable headway; production was soaring, but investment demand was growing even faster. Every province wanted its own bicycle factory and every department along the Yangtse River its own container port. As a result, inflationary pressures became unsustainable. The reform faction of Zhao Ziyang pressed for changes in the management of enterprises but lost out and political repression followed.

Inflation is the bane of reform. The system prides itself on stability. Yet, as soon as any kind of market mechanism is introduced, a rise in prices becomes unavoidable on account of the pent-up demand. At first it is gratefully accepted because a supply of goods at higher prices is much preferable to no supply at all. In the case of basic commodities, prices remain controlled but the amount the State has to spend on subsidies goes up. This increases the amount of money in circulation, so the pressure of demand on the rest of the economy increases; in so far as it cannot be satisfied, an overhang of unspent money accumulates. The urge to invest also becomes more pressing. When prices are stable, there is no penalty on investing unwisely; when prices rise, there is a positive inducement because real interest rates turn negative. When wages are also allowed to rise, all hell breaks loose. And it is very hard to prevent that from happening because, as the center weakens, enterprises become increasingly preoccupied with keeping their workers happy. When the workers start to organize, the pressure becomes irresistible.

I call the transformation of latent into manifest inflation the Polish disease, because it is in Poland that it has reached its apogee. But it has occurred in Yugoslavia, the land of self management, much earlier and the process can also be observed, in various stages of development, in Hungary, China - and the Soviet Union. In Poland it reached fruition in 1989, when the political power center was paralyzed and the enterprises had to fend for themselves as best they could. `Real' wages rose some 30 percent but, of course, they were not real because production did not rise at all; in fact, it fell by about 8 percent. The difference was taken up by the so-called inflation tax, i.e. the depreciation in the value of money while it is in the hands of the population. It took an ever rising inflation rate, reaching 1,000 percent near the end, to square the circle. The enterprises subordinated all their other obligations to paying their workers: they stopped investing, they stopped paying taxes, they even stopped paying their suppliers. At the same time, nobody wanted to hold zlotys and, when a free market in dollars was legalized, zlotys became practically value- less in dollar terms. With the total value of money in circulation rapidly shrinking, the state had to print more and more to finance the budget deficit. That is why inflation span out of control.

Once it is recognised that reform is a process of disintegration, it can be seen that the course of reform bears a remarkable similarity to the boom/bust pattern one can discern in stock markets. It starts off relatively slowly. At first it satisfies some of the aspirations attached to it and is reinforced thereby. But when results begin to diverge significantly from expectations, the divergence also serves to reinforce the process: the shortcomings of the system become more apparent, its ability to resist change erodes while the desire for change gains momentum. Political and economic changes mutually reinforce each other. As the economic influence of the decision-making center is weakened, its political authority is also undermined. It is bound to resist - after all, the primary instinct of every bureaucracy is to preserve itself - but its resistance will engender further attacks until the political objectives come to overshadow the economic ones, and destroying the center of power becomes the primary goal. At that point reform is superseded by revolution.

There is another factor that tends to play an important part in the process: foreign debt. Reforming regimes often try to alleviate the problem of scarcities by borrowing from the West. Unfortunately, they waste the borrowed assets just as they waste their own because they do not have a proper system of capital allocation. Both Poland and Hungary borrowed heavily in the 1970s; but the investment plans were ill-conceived and inefficiently executed so that the projects not only failed to pay for themselves but left the countries heavily encumbered by hard currency debt. Cause and effect are hard to disentangle in a reflexive process but there can be no doubt that in each case a reform regime sought to justify itself by creating the illusion of progress. There is a positive correlation between economic reform, foreign debt and subsequent economic decline. This can be seen by comparing Poland, Hungary and Yugoslavia on the one hand with Czechoslovakia and East Germany on the other. Romania is a special case, because it had a live totalitarian despot in charge who was willing and able to inflict incredible hardship on the population in order to repay the foreign debt.