Chapter 13 The Soviet Union: Reform and Collapse (Revised 2006) Background

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Chapter 13 The Soviet Union: Reform and Collapse (Revised 2006)
1. Background
Economic reforms have been attempted several times in the Soviet Union. Major reforms had been 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, 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 behaviors. As economic performance declined, these 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.
2. 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. The Soviet economic performance of the 1970s and early 1980s was not good, but it had certainly not been 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.

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.

Finally, some 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.
3. 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 restore discipline 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 anti-alcohol 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. 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, and so forth 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 is to lead 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 (now the WTO), 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 (now the European Union). And Gorbachev began to disengage the Soviet Union from Eastern Europe.

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 spending, 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 Super-ministries (gigantomania!).

4. 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, and so forth. 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 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 GDP. 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. 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.

5. Evaluation of the Provisions of Perestroika, 1985-1990
The first problem with Perestroika 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 caused production to decline. State-owned enterprises could not get 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. The state-owned enterprises that were required to pay the lower state price simply could not get the oil. State-owned enterprises could not obtain the resources needed for production for another reason. These resources 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 came because 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. The incomes of people in private and cooperative economic activity were more than double those of workers in the state sector. The rising incomes and falling production led to a problem: there was little to buy with the higher income.
A third problem from the provisions of perestroika was that the growth of investment in 1986, as proposed by Gorbachev, caused an 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 resources, this led to shortages, increased unfinished construction, and rising imports. The volume of construction that exceeded the planned time limit rose 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. This “investment cycle” caused instability.

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 “investment hunger” that is built into the system. In capitalist countries, investment demand would have been restrained by owners or by bankers. In the pre-reform socialist system, it might 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. As a result, there was greater regional inequality. This regional inequality contributed to the disintegration of the state after the failed coup of August, 1991.

The increased investment spending by the government 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 to complete 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 could not be 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 at 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 resources 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.
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 a very high 11% of GDP in 1989. (The budget 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.) Most of these deficits were 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 macroeconomic disequilibrium. The money created sat involuntarily in accounts in banks or in currency hoards --- this has been called the "monetary overhang". The inability of the political system to slow the money creation, reduce the budget deficits, and provide sufficient consumer goods surely contributed to the collapse of the Soviet economy.
Conclusion: Gorbachev dismantled the old system but failed to create a new one to replace it. The traditional forces restraining actions by enterprises were eliminated. Yet no new ones were created to replace them. The traditional communist system had had an internal logic; this was the reason it could persist for so long. To change part of the system, while trying to retain the rest, created chaos. (And responsibility for reform was placed on the central bureaucracy, whose powers would be reduced by the reforms and who would therefore act to subvert them.)
In 1989 and 1990, there was a shift in production and investment priorities toward the consumer sector. Curbs were imposed on exports. Interest rates were raised and state-owned apartments sold to tenants as a way of absorbing the excess savings. But this was too little, too late. The shortages became ever more severe. By this time, the debate had changed. The new debate involved how to create a market economy.
6. Results of Perestroika in Terms of Economic Performance
There was a slowdown in growth of real per capita GDP from 1985 to 1989. After 1990, Real GDP fell --- an estimated 2% in 1990 and another 13% in 1991. This would be considered a Depression. In the same vein, consumption per capita rose only at a 0.7% annual rate between 1985 and 1989, the slowest growth since World War II. After that, it fell.

Inflation (actual plus repressed) was very severe. Estimates are 10% inflation in 1988, 12-14% in 1989, 19% in 1990, and 100% in 1991. The combination of inflation with falling production is called stagflation. Money incomes rose rapidly (by 9.2% in 1988 and 12.9% in 1989), as was discussed above. Yet real incomes fell. According to one source, 88% of Soviet citizens would have been considered poor by Western standards in 1990.

Because of the repressed nature of the inflation (i.e., shortages), there was less working time. One source estimated that 30 million person years were spent in lines, about 25% of the waking time of every adult. Another study estimated that families spent an average of one hour and forty minutes per day shopping. By 1990, only 4% of the most important consumer goods were freely available in stores. Workers spending more time searching for goods and less time working is a further cause of the reduced production.

Because of the severe inflation, the domestic value of the ruble declined precipitously. Farmers responded to the reduced value of the ruble by reducing production. The share of grain production sold to the state fell to 30% in 1989, from the long-run average of 40%. The government had to respond by paying them in dollars or in goods (barter). The food shortages in the cities were therefore enhanced.
The social effects of the economic collapse became severe. Health deteriorated, with an especially high incidence of infectious diseases. (Life expectancy did rise in the late 1980s, but this was mainly due to the anti-alcohol campaign.) Crime rose 32% in 1989 and another 13% in 1990. Violent crime became commonplace in Russian cities. More than 400,000 people emigrated from the Soviet Union in 1990 alone. Finally, there was an increase in pollution. Some 16% of the Soviet Union as a whole (and more than half of the more densely populated areas) were considered "ecological disaster areas"! An environmental movement grew, leading to a large number of plant closures (about 1000 in 1989 alone) and thus further reducing production.

There was also a major balance of payments crisis (that is, large trade deficits) in late 1989 and throughout 1990. This was due to larger imports of grain and machinery and to lower revenues from exports as world oil prices fell. It was also caused by the government's decision to increase imports of consumer goods to reduce the shortages in retail markets. The trade deficits were financed in part by gold sales. But there was also a large increase in hard currency debt from Western governments.
7. The Debate in 1990
Beginning in 1985, there had been a major debate about policy. The debaters had coalesced into three groups: the conservatives who advocated a return to the traditional socialist system, the radicals, who advocated an end of the traditional system and the movement to a free market economy, and the moderates, who advocated a middle position. In this scheme, Gorbachev was a moderate; Boris Yeltsin was a radical.

In 1990, Prime Minister Rhyzkov announced a large rise in prices of many basic items, especially food. The result was widespread protest, causing the government to back down; the price increases were not implemented. This event followed the militant strike of the coal miners in 1989 and the assertion of sovereignty by some of the republics, including Russia. This hostile public reaction and the worsening economic situation induced Gorbachev to shift toward the radicals. He formed a group of 13 people, known as the Shatalin Working Group, to create a strategy for shifting to a market economy over a period of 500 days. In the strategy created by this group, there were to be three stages. In Stage One (the first 100 days), the Soviet Union was to be reconstituted as a confederation. Power would flow from the republics; coordination would occur through an Inter-republican Economic Council. There would be free trade and a common external tariff. Some state and party assets were to be sold. Government expenditures were to be cut in order to balance the budget. Defense was to be cut 10%, the KGB (similar to the American CIA) was to be cut 20%, and government investment was to be cut 15%. No government would be able to finance budget deficits through the creation of money; only borrowing from the public would be allowed. Enterprises in construction, automobiles, services, trade, light industry, and food processing were to be privatized, although most enterprises would still be filling state orders. This privatization would absorb some of the excess savings (the "monetary overhang") held by the population. Small enterprises would be sold immediately to the public. Large enterprises would be shifted to holding companies; sale from there to individuals would take place over several years. There was also to be a massive land reform, with the establishment of 150,000 to 180,000 small farms with freedom over production decisions. Prices would still be frozen. In Stage Two (100 to 250 days), there would be steps toward the liberalization of prices. The economy would be opened to foreign trade and to foreign investment. Imports would be a force for increasing competition. Most importing and exporting would be done by the enterprises, not the government. There would be a beginning of ruble convertibility. The exchange rate would be determined in foreign exchange markets, with 10 to 15 banks participating. It was thought then that the exchange rate would be 5 to 8 rubles per dollar. Because of the austerity measures, some enterprises would fail; unemployment would rise. Incomes would be raised to keep up with inflation as the prices were liberalized. Finally, in Stage Three (Day 250 to 500), 30% to 40% of industry and at least 60% of retail, food, and service enterprises would be privatized. Three-fourths of industry would operate without subsidies. Most retail prices would be determined by supply and demand. The economy would be basically a market economy.
Gorbachev was ambivalent about this strategy. The terrible economic situation gave "ammunition" to those conservatives who opposed Gorbachev and who wanted to return to the traditional system. Fearing them, Gorbachev "shifted gears", and acted to limit reform. His program, known as "The Main Directions", showed a desire to slow the timetable of the Shatalin Plan. Gorbachev specifically rejected the quick shift toward privatization and liberalizing prices. Most production still came from state-owned companies at the time of the coup in August 1991. One part of the Shatalin Plan that Gorbachev did accept was the recreation of the Soviet Union as a confederation. The signing of the agreement to implement this confederation motivated the coup attempt of August, 1991. The failure of the coup attempt eliminated the conservatives as a factor in the debate. It also removed Gorbachev from any significant power. By 1992, the debate was dominated by the "radicals"! However, at the end of 1992, the demotion of Boris Yeltsin's main economic adviser (Yegor Gaidar) indicated that there has been a shift back in the direction of the moderates.
8. Problems Facing the Reformers
Implementing reform proposals is very difficult for several reasons. First, increases in prices, even accompanied by increases in incomes, are very unpopular with a population long accustomed to stable prices. Given the large "monetary overhang", prices rose greatly once there was some liberalization. Inflation in 1992 was around 2,500%. This is “hyperinflation”. Rising unemployment is also likely to be unacceptable to the population. This makes it hard to end the soft-budget constraint.

Second, there were very few enterprises in the former Soviet Union. For more than 1/3 of products, one enterprise accounted for between 70% and 100% of production in the entire Soviet Union. Freed from external controls, this would create a major potential for use of monopoly power. Thus, simultaneously opening to increased foreign trade and creating an aggressive anti-trust policy were essential.

Third, there are the problems of inter-republican relations. Should there be one currency for the new republics with one central bank, or will each republic have its own currency? (As of now, the three Baltic countries and the Ukraine have their own currencies.) Also, in inter-republican trade, Russia has a dominant position in oil, coal, natural gas, and iron ore. This created a potential for exploitation of other regions by Russia.

Fourth, there are the problems of the international economic relations. The ruble needed to be made convertible in order to open international trade and investment. This required a fund of hard currencies, most of which had to come from the West. It would be hard for Russia to enter the world economy until the quality of its export products improves significantly. As of 2006, oil is still Russia’s main export product. In addition, repaying the $70 billion international debt presented problems.

Finally, there are the political aspects. Some argue that reforms should proceed more gradually. Some argue for immediate reform --- so-called "shock therapy". As we shall see, Russia opted for shock therapy whereas China opted for more gradual reforms. How fast the reform process should be completed is one of the major debates still going on in all of the former communist countries.
Beginning in 1992, Russia started to process of shifting to a market, capitalist economy. The debate period was over. It was time to act. There were major questions to be answered about the speed of the reforms (as we just saw, Russia opted for shock therapy), the timing of the reforms (which reform should precede the others), and the manner by which each reform should be carried-out. In the next chapter, we will begin to examine the decisions that Russia made. We will consider the reasons for those decisions. And we will evaluate the results of those decisions.

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