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Reforming the Soviet Economy

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1991
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A joint international study examines the causes of the Soviet Union’s economic problems and argues for rapid and comprehensive reforms

Hugh Bredenkamp

By the end of the 1980s, it had become clear that the Union of Soviet Socialist Republics was bound for fundamental economic and political change. The Soviet leadership had attempted unsuccessfully to modify and thereby revive the traditional system. It now appeared ready to accept the demise of central planning and begin the transition to a conventional market economy.

Against this background, the leaders of the Group of Seven industrial nations (the G-7) and the President of the European Community, at their summit meeting in Houston in July 1990, asked the IMF, the World Bank, the Organization for Economic Co-operation and Development (OECD), and the newly established European Bank for Reconstruction and Development (EBRD) to prepare a study of the Soviet economy. The institutions were to make recommendations for reform of the Soviet economy and suggest criteria for effective Western assistance in the reform process. After five intensive months, including a number of visits to the Soviet Union, the summary and recommendations of the joint study were presented to the G-7 in December 1990 and published in January 1991; the detailed background papers appeared in three volumes in March (see box).

The official Soviet response to the study was generally positive. Nevertheless, the authorities have pressed ahead with a program of administrative measures that falls well short of the rapid and fundamental liberalization advocated by the four international institutions. The outlook for the near term is, on the whole, not encouraging.

Origins of the present crisis

The Soviet Union’s present economic difficulties are largely systemic. They reflect deep-seated problems with the system of central planning and the inherent limitations of the traditional resource-intensive strategy for growth (which relied on ever-increasing quantities of labor, capital, and raw materials to compensate for a relative neglect of technical and economic efficiency). These problems were brought to a head by poorly conceived attempts to improve the functioning of the existing system through piecemeal reforms.

After periods of relatively rapid growth in the 1930s and during reconstruction following World War II, Soviet growth had begun a secular decline by the 1970s. Labor participation rates approached their feasible limits; fuel and raw material reserves became less accessible and more costly to exploit; and the workforce appeared increasingly demoralized by the poor quality and meager supply of consumer products, sporadic and in some cases chronic shortages of specific goods, and the lack of incentives for hard work, creativity, and efficiency. The potential to offset these factors through technical progress was stifled by the system’s emphasis on meeting perennially ambitious output targets, which discouraged risk-taking and innovation on the part of enterprise managers.

In addition, the central command structure on which a planned economy relies so heavily to ensure consistency in production and expenditure decisions was effectively disabled by partial liberalization and decentralization in the late 1980s. The hope that, by approximating certain features of the conventional market system, the Soviet economy could emulate the generally superior performance of the Western economies proved to be a vain one. In a sense, the Soviet Union ended the 1980s with the worst of both worlds. Enterprises were left, by and large, to operate with neither the constraints and guidelines of the Plan nor the appropriate price signals and competitive discipline of the market.

The move toward reform

By the early 1980s, the Soviet leadership was becoming increasingly concerned at the prospect of economic stagnation, not least because of the threat this posed to the Soviet Union’s military prowess. As a result, when Mikhail Gorbachev came to power in 1985, he appeared convinced of the need for major reforms if the secular decline in economic growth were to be reversed.

In the event, the early Gorbachev initiatives, though they were presented as heralding a significant restructuring of the economy (perestroika), were more in the nature of traditional “campaigns,” intended to drive the existing system at a faster pace. They focused largely on the retooling and modernization of industry, requiring a higher rate of investment and a heightened emphasis on quality control. Various supporting measures—including the policy of glasnost or “openness,” and the ill-fated anti-alcohol campaign—were designed to make managers and bureaucrats more accountable and to enhance discipline in the workplace.

The results were unimpressive. Within a year, the retooling campaign ran into serious capacity constraints in the capital goods sector. Quality controls reduced factory shipments, and hence output, but failed to raise quality. Average growth in 1986-87 was lower than in the early 1980s. Meanwhile, glasnost served mainly to bring to the surface the disillusionment and unrelieved frustrations of the population, as living standards continued to decline. To make matters worse, the drop in world oil prices in 1986 forced the authorities to slash imports and divert output from domestic to convertible currency export markets.

First attempts at reform

In 1987, the first major attempts were made to reform the system. Though more ambitious than the preceding campaigns, these reforms were incomplete and failed to strengthen the role of market forces to any significant degree. Moreover, they proved to be deeply disruptive. The centerpiece of the new effort was the Law on State Enterprises, which took effect at the beginning of 1988 and replaced mandatory output targets with so-called state orders or procurement contracts, giving enterprises greater freedom to accumulate and use the proceeds from any remaining production. In practice, any prospects for the emergence of functioning wholesale markets were severely curtailed by the predominance of these state orders, which preempted most of industrial output in 1988 and 1989. The inflexible and distorted official price system was left essentially intact, as was the role of the state distribution agency (Gossnab) in allocating most material inputs. Outside the state sector, encouragement of private economic activity was limited to small numbers of joint ventures with foreign participation and a grudging acceptance of so-called cooperatives, which have since been subjected to sporadic campaigns of harassment.

Perhaps the most serious policy error at this time, however, was the failure to control overall monetary conditions while relaxing administrative financial constraints at the enterprise level. Between 1985 and 1988, the state budget deficit soared from under 2½ percent to 11 percent of GDP. Government revenues from foreign trade were hit as oil prices fell; indirect tax receipts suffered under the anti-alcohol campaign and from the poor state of the economy in general; and subsidies rose as the authorities failed to pass on wholesale price increases—intended to stimulate production—to the consumer. Fiscal deficits were financed almost exclusively by credits from the central bank (Gosbank). Hence, broad money growth during 1987-90 (averaging 14-15 percent) was roughly twice the rate prevailing in the early 1980s. Meanwhile, the banking reform of 1988, which separated “commercial” and central banking activities, failed to give Gosbank the necessary independence to contain overall credit expansion. A modest squeeze on enterprise credit was insufficient to prevent a massive build-up in firms’ liquidity as transfers of profits to the budget declined under the new regime.

Flush with funds that they were now able to deploy as they wished, enterprises began to stockpile raw materials and other inputs, and to launch new investment projects. As shortages proliferated, many of these projects ground to a halt before completion, tying up valuable physical capital; and the incentive to hoard materials increased, aggravating the shortages still further. At the same time, firms began to grant annual wage increases of 8-10 percent, easily evading a poorly administered tax on “excess” wage growth. Given annual retail price increases that were typically held below 2 percent and broad stagnation in real output (GDP actually declined in 1990), the results were longer queues and empty shelves in the state stores, burgeoning black market activity, and deepening resentment and frustration among consumers.

This fundamental loss of control over the domestic economy was mirrored in the external trade sector. The state’s monopoly on foreign trading rights was substantially weakened in 1989 for all but a few strategic products, and exporters were for the first time permitted to retain some proportion of their foreign exchange earnings. The combination of trade liberalization and rapidly expanding domestic demand, coming on top of major adverse terms of trade shocks in 1986 and 1988, led inevitably to a deterioration in the external balance. Even the traditional (mostly oil-generated) trade surplus with the convertible currency area vanished in 1989.

Failure of perestroika

By 1990, the failure of perestroika was clear. Far from reviving the ailing Soviet economy, the partial relaxation of administrative controls coupled with a basic neglect of macroeconomic demand management had led only to increasing chaos. The authorities had shied away from the two steps that might have led to genuine restructuring and recovery: namely, price liberalization and tight financial policies. Shortages of materials and spare parts began to hit key sectors such as transportation, agriculture, and oil and gas (indeed, oil output began to fall in 1989). The breakdown in the retail distribution system provoked strikes in a number of sectors. A record grain harvest served mainly to expose the inadequacies of the storage and transportation facilities in the countryside, with the result that millions of tons of grain were left to rot in the fields. Conflicts over dwindling supplies of goods aggravated the mounting political tensions that had surfaced under glasnost between republics and among various ethnic groups. Meanwhile, environmental pressure groups prevailed upon local authorities to close down polluting plants that, in many cases, were monopoly producers of certain products, adding to the disruption of the economy.

The Economy of the USSR: Summary and Recommendations (57 pages) and A Study of the Soviet Economy (the background papers; 1,168 pages) are available from the World Bank Publications Department and IMF Publications Services, respectively. The three volumes of background papers provide a comprehensive overview of the Soviet economy’s structure, recent history, and wide-ranging problems. As well as presenting proposals for macroeconomic and systemic reform, of the sort described in this article, the study also discusses how reforms might be implemented in specific sectors. Separate chapters are included on energy, the environment, agriculture, manufacturing, transport, distribution, telecommunications, housing, and the metals and mining industries. There is also a discussion of the medium-term prospects for the Soviet economy under different reform scenarios.

On the external side, enterprises made uncoordinated and, in the aggregate, excessive commitments—through import orders and foreign borrowing—on increasingly scarce supplies of convertible currency. Foreign exchange reserves dropped sharply and arrears on payments to foreign suppliers amounting to more than $5 billion had accumulated toward the end of 1990.

The presidential guidelines

As the economic situation deteriorated, the reform debate in the Soviet Union became increasingly polarized. One side, whose views were represented most prominently in the Shatalin Report of August 1990, argued that the reforms had failed because they had not gone far enough and that an accelerated program of privatization and liberalization was required to stabilize the economy. Others, including the then Government under Prime Minister Ryzhkov, believed that stabilization required the initial reimposition of administrative control over inter-enterprise trade and steep increases in prices on basic consumer goods to reduce subsidies. This could be followed by a gradual, tightly controlled, liberalization of the economy.

In October 1990, the Supreme Soviet approved President Gorbachev’s proposal, entitled “Guidelines for the Stabilization of the Economy and Transition to a Market Economy.” Despite a clear statement that “there is no alternative to shifting to the market,” the presidential guidelines were couched in general terms and appeared to steer closer to the gradualist path for reform.

The presidential plan outlined four stages in the reform process. The first phase would focus on the stabilization of the economy and the beginning of commercialization and privatization of state enterprises. The second phase would emphasize the gradual liberalization of prices and the introduction of a social safety net. In the third phase, structural reforms covering, for example, the labor compensation system and the housing market, would be implemented, and financial policies would be eased as inflationary pressure subsided. The final phase would include the establishment of foreign exchange convertibility of the ruble for enterprises. No precise timetable was set, but the presidential guidelines expressed the hope that the four stages could be completed in 1½-2 years.

Stabilization was to be achieved by a combination of measures. Administrative price adjustments would, in effect, validate part of the repressed inflation, as well as reduce some of the worst relative price distortions (including the very low domestic price of energy). In addition, a limited proportion of retail and wholesale prices would be liberalized in the first year. Sales of state assets (physical or financial), a shift in the structure of production away from investment and defense toward consumer goods, and an increase in interest rates on bank deposits could absorb whatever remained of the “monetary overhang” (the accumulated stock of excess liquidity in the economy, which was estimated in the joint study to have reached 25 percent of GDP by 1990). A reduction in the state budget deficit to 2½-3 percent of GDP, the statutory elimination of monetary financing of the deficit (except in extremis), and the use of conventional instruments of monetary control would then prevent the re-emergence of inflationary pressures.

Further liberalization of prices would depend on the success in stabilizing the financial situation and supply conditions. It was expected that price controls on all but a narrow range of consumer goods would be lifted by the end of 1992. The prospective role and instruments of incomes policy were set out only in general terms, but appeared to include limited indexation and the continuation of some revised form of tax on “excessive” wage increases.

The proposals on commercialization and privatization in the presidential guidelines were particularly vague, as was the discussion of competition policy. The importance of financial accountability for enterprises was stressed, for example, but no criteria were given for the selection and evaluation of enterprise managers prior to privatization. The potential role for increased exposure to foreign competition in the restructuring process was ignored, and the impression was given that further trade liberalization would proceed relatively slowly.

More fundamentally, the presidential guidelines failed to confront one of the major risks of a gradualist approach to reform: namely, that the chaos in production and distribution could continue to spread, making the ultimate transition more difficult and possibly even discrediting the goal of a market economy altogether. Some would argue that this danger was already apparent in the Soviet Union by the end of 1990.

The joint study’s recommendations

In part with these concerns in mind, the joint study by the IMF, the World Bank, the OECD, and the EBRD put great emphasis on the mutual inseparability of price liberalization, enterprise reform, and macroeconomic stabilization. No one of these could stand on its own, and only this combination of policies could ensure the speedy restoration of equilibrium in product markets.

Thus, the study proposed early and comprehensive decontrol of prices with few exceptions. These included, for example, most public utilities since they were likely to remain communally owned monopolies, and housing rents. Various options were suggested for the protection of vulnerable social groups at reasonable cost, in ways that would not hinder the reforms.

Since exposure to world market prices would help to establish quickly a rational set of domestic relative prices, it was proposed that licensing and other quantitative restrictions on foreign trade be lifted early on. Where the scale of price adjustment might be excessively disruptive (e.g., in the case of petroleum prices), a simple set of border taxes should be installed to absorb part of the initial shock. These taxes would need to be phased out according to a pre-announced timetable within, say, three years.

The efficient determination of market prices requires that enterprises operate on commercial principles under hard budget constraints. Ultimately, this would be best assured by the removal of almost all enterprises from state ownership and control. This is not practical in the short run, however, and the study therefore proposed a mixed approach. Small-scale enterprises—particularly in the transport and distribution sectors, where assets may be relatively easy to value—should be auctioned off as quickly as possible. Larger enterprises could first be converted to joint stock companies, shares which might be held initially by state holding companies. In time, as industries were rationalized and restructured, and as relative prices stabilized, these enterprises too could be privatized. During the transition, enterprise managers would be given performance-related incentives and total independence in day-to-day operations.

“... little could be achieved in the way of reform until formal agreement had been reached on such issues as the ownership of state assets and the sharing of fiscal revenues and expenditure responsibilities.”

The study concluded that the target for the 1991 state budget deficit proposed in the presidential guidelines, if accompanied by significant interest rate increases, was broadly in line with the requirements of short-run stabilization. It was considered, however, that a substantial effort would be needed to lower the deficit to this level (2½ 3 percent of GDP). Appropriate measures would include sharp cuts in price subsidies and in lower priority expenditures, such as personnel and administration, subsidies to loss-making enterprises, and defense outlays (which, even at the probably understated level of 7 percent of GDP, absorb a higher share of resources than in most countries). Ad valorem indirect taxes should be introduced as a matter of urgency to ensure that wholesale price increases are automatically passed through to the retail level, thereby protecting the budget. Further comprehensive tax reforms and expenditure restructuring would be needed in the medium term.

Until financial markets were functioning effectively, it was thought advisable to “overdetermine” monetary control—by retaining quantitative credit ceilings, setting interest rates at a level that would give a positive real return on financial assets, and imposing reserve requirements on banks. Credit ceilings would be phased out over time. The study did not preclude the use of a monetary reform at the outset, but warned against the risk of loss of public confidence in the currency (and even in the reform process itself).

The study also identified the need for reforms in a number of other areas, including a substantial overhaul of the legal system to produce well-defined property rights, enforceable contracts, and bankruptcy procedures, and a social benefit system to cope with transitional unemployment. At the same time, the government should begin to withdraw from direct intervention in the wage-setting process. Finally, the study proposed various measures to promote a progressive deepening of the nascent foreign exchange market in the Soviet Union, with a view to unifying the exchange rate at a realistic level and achieving current account convertibility within one or two years.

Western assistance

The sheer size of the Soviet Union gives Western assistance at most a supporting role in the reform process; ultimate success will depend on the efforts and determination of the Soviet people themselves to transform their economic system. The study concluded that—once the commitment had been made to implement a broad-based liberalization of prices, sound financial policies, and enterprise reform—financial assistance from the West could help to ease the transition and improve the conditions for longer-term growth. Without such a commitment, additional financial resources would be largely wasted. This is a view shared by many in the Soviet Union.

Food aid, however, could be granted as an immediate priority. In offering this proposal, the study nevertheless made clear that the biggest single contribution to the alleviation of food and other shortages would come from early implementation of fundamental economic reforms.

Various types of technical assistance could help prepare the ground for such reforms. Western expertise and experience, including from the private sector, could be applied in the design of policies, the establishment of new institutions, and the development of an appropriate legal framework. Assistance could also be given in banking, auditing and accounting, and marketing. To be effective, Western involvement would need to be closely coordinated, primarily by the Soviet Union itself.

Widespread project assistance would begin only once reform was underway (though prior action might be justified in the cases of energy and the environment). The initial focus should be on developing those parts of the infrastructure that could elicit a rapid supply response: for example, in agriculture, food processing, retailing, and transportation and storage. Gradually, additional support from foreign direct investment could be expected. In addition to important legal and institutional changes, however, this would probably require further infrastructural investment, for example, in the modernization and expansion of the currently inadequate telecommunications system.

There might also be a case for balance of payments assistance to permit additional imports of capital goods, as well as to cushion the long-suffering Soviet consumer from some of the costs of the transition. The needs under this heading would depend largely on conditions (for example, regarding energy output and export prices) prevailing at the time.

Recent developments

In the months since the conclusions of the joint study were published, two of the major concerns expressed at that time have continued to shape the process of reform in the Soviet Union. The first relates to the division of authority and responsibility between the union-level and republican governments. The study suggested that little could be achieved in the way of reform until formal agreement had been reached on such issues as the ownership of state assets and the sharing of fiscal revenues and expenditure responsibilities. In the event, the constitutional deadlock seemed no closer to a resolution in the early part of 1991 than it had during 1990, and the process of reform was largely paralyzed as a result.

A second, related, concern was that unless the authorities made a quick and irreversible break with the past, particularly on price controls, the momentum for reform could collapse at an early stage. A cautious, administrative approach would be most likely to stall in the face of bureaucratic and political inertia, while shortages and economic chaos continued to spread. This danger loomed large in early 1991. While the new government under Mr. Pavlov continued to advocate both the objectives and, by and large, the methods set out in the presidential guidelines, signs of progress were few and far between. Indeed, the ill-conceived attempt at partial monetary reform in January, which appeared to have all the costs and almost none of the benefits of a genuine monetary reform, was probably counterproductive. So too was the granting of wide-ranging powers to state investigators to interfere in Western as well as Soviet businesses, with a view to controlling the exploitation of the government’s own distorted price system. The disarray in retail and wholesale trade is unlikely to be resolved by the announcement in April of substantial administered increases in retail prices, with only partial liberalization. Markets continue to be largely incapacitated by ceilings and other forms of state controls on prices.

Against this background, the immediate prospects for the Soviet economy do not seem particularly bright. Nor is there the consoling prospect, which radical reform would bring, of strong and sustained growth in the future. The ultimate recovery will be quicker in coming the sooner the major constitutional issues are settled and the authorities embark on a comprehensive liberalization of the economy.

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