Economic Stabilization in Planned Economies: Toward an Analytical Framework

Thomas A. Wolf

doi:10.5089/9781451956696.024.A004

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Economic Stabilization in Planned Economies: Toward an Analytical Framework

Author: Mr. Thomas A. Wolf

Publication Date:: 01 Jan 1985

eISBN:: 9781451956696

Language:: English

Keywords:: SP; price level; excess supply; consumption goods; economic system; exchange rate; Trade balance; Demand for money; Wages

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THIS PAPER SEEKS to advance the development of an analytical framework for understanding and monitoring macroeconomic stabilization programs in planned economies. It builds on the comprehensive review of adjustment in planned economies by Allen (1982) and on other recent research. The paper does not elaborate a formal macroeconomic model of a planned economy. The intention, rather, is to highlight the key differences between planned and market economies in: (1) the sources of macroeconomic disequilibrium, (2) the transformation and propagation of such imbalances, and (3) the instruments available to the authorities for achieving internal and external balance.

Abstract

The term “planned economies” in this paper essentially refers to those European countries that are members of the Council for Mutual Economic Assistance (CMEA).¹ It is likely, however, that many, and possibly most, of the salient characteristics of the CMEA members’ economic systems are shared by other economies that might in general be regarded as “planned.” The paper argues that economic activity in all the planned economies considered here can be properly understood only in the specific historical and institutional context in which they have developed. Specifically, each of these economies has evolved to a greater or lesser degree over the past 25 years from a “classical” centrally planned economy (CPE). As a stylized model, the CPE continues to be appropriate in understanding perhaps the majority of the European CMEA countries. The stylized CPE is analyzed in some detail in Sections I through III.

All of the European members of the CMEA have experimented with economic reform over the past two decades or more. In very few cases, however, could such reforms be said to have been comprehensive, and in still fewer instances have such thoroughgoing reforms attained a more or less permanent character. At various times in the past 15 years modifications in the system of central planning were initiated in Poland, but more often than not these were relatively short-lived. Various changes have also been evident in Bulgaria, the German Democratic Republic, and Romania. Nevertheless, of all the CMEA countries, probably only Hungary can be said to have so comprehensively reformed its economic system as to be considered a “modified” planned economy (MPE). Because the functioning of the modified economic mechanisms is usually deeply influenced by the institutions, policies, and practices that developed earlier in the evolution of the CPE, the MPE as a stylized model is not considered until Section IV. Because various countries have initiated certain important changes in the system of central planning, some of the observations made in Section IV about the stylized MPE may well apply to several of the other planned economies. A summary of the study, its conclusions, and some suggestions for future research are presented in Section V.

I. Distinctive Features of the Centrally Planned Economy

The economic system of the CPE is characterized by:

state ownership of the means of production
detailed central plans (which may or may not be exactly met) for enterprise inputs and outputs and for foreign trade
financial plans that mirror the physical flows embodied in the quantitative plans
information flows and bargaining over plans and actual access to resources, which occur mainly in a bureaucratic (vertical) rather than a market (horizontal) setting
rigid prices set by the central authorities so as to facilitate quantitative planning and evaluation
plan fulfillment rather than profits as the main evaluative criterion for enterprises
a relatively free labor market, but wages that are (in principle) regulated closely from the center
a monolithic state banking system (“monobank”) with no fractional reserve banking
a dichotomized money supply in which household and enterprise money stocks are strictly separated.

Major policy goals in a CPE typically have included rapid economic growth fueled by high rates of industrial capital accumulation and growth in the industrial labor force, retail price stability, downward stickiness in money wages, job security, and severe limits on earnings differentials. Given the various systemic and policy factors in CPEs that imply relative rigidity of prices (including wages, interest rates, and both producers’ and retail commodity prices), it would be expected that the authorities’ short-run responses to demand- or supply-side disturbances would tend to stress quantity adjustments. Because of the priority on investment goods and the strong bargaining position of enterprises (relative to that of consumers) in dealing with the government, these quantity adjustments are likely, at least in the early stages, to impinge mainly on households and the balance of trade.

The Money Supply

An often-cited distinguishing characteristic of the CPE is the dichotomized money supply. One aspect of this separation is the form in which money is held. On the one hand, interenterprise payments are made almost exclusively on the basis of drafts drawn on deposits at the monobank. Net enterprise deposits may increase by virtue of net subsidies from the government, credits from the monobank, an increase in the trade balance denominated in domestic prices, and net sales to the household sector.² In the last case, currency is received that, except for enterprise currency holdings required for the payment of wages and salaries, must be exchanged at the monobank in return for an increase in enterprise deposits. On the other hand, households are permitted to hold financial assets only in the form of currency or savings deposits at branches of the monobank. These deposits normally bear only a low nominal rate of interest. Other interest-bearing financial assets are usually of negligible importance. House-hold financial transactions are carried out mainly in currency.

The money supply is further dichotomized in the sense that, although excessive liquidity among enterprises can spill over into excess household holdings of money, lending between the enterprise and household sectors is largely prohibited. There is no mechanism by which, say, an excess supply of money holdings in the household sector can be eliminated by lending directly or indirectly to enterprises.³ In a market economy, excess household money can be eliminated through some combination of a reduction in the labor supplied (thus lower incomes); increased expenditure on goods and services; and purchases of bonds (issued in part by enterprises). In the CPE, households are restricted either to reducing their incomes or increasing expenditure on goods and services.

Close bank monitoring of enterprise deposits in the classical CPE is usually thought to ensure that excess enterprise liquidity is kept to a minimum.⁴ It shall be seen later, however, that if enterprises face a “soft” budget constraint (the term is from Kor-nai (1979)), the consequences for macroeconomic disequilibrium may be similar to those encountered when enterprises initially have an excess supply of money. The conventional wisdom among many economists in the CPEs and among most Western analysts of these economies is that households in CPEs typically accumulate more money than they would if they were to be unconstrained in consumption. The presumption that households may have a chronic excess demand for consumption goods has been most significantly questioned by Portes, in a series of theoretical and empirical articles (Portes and Winter (1978, 1980) and Portes (1981)). Using various disequilibrium-estimation techniques, Portes and his collaborators reject the hypothesis of sustained excess demand in the market for consumption goods in four planned economies (Czechoslovakia, the German Democratic Republic, Hungary, and Poland) in the period 1955-75 and, indeed, claim to find evidence of excess supply regimes prevailing in several years (Portes and Winter (1980)). Until now, however, these results have met a rather skeptical audience among many analysts of planned economies.

Although the presumption of a chronic excess demand for consumer goods in CPEs remains debatable, it is noteworthy that Portes’s own work does detect several periods of excess demand alternating with some years of excess supply (as well as with many “equilibrium” periods). At a minimum the implication is that the common assumption made for market economies, that the money market tends to be in an unconstrained flow equilibrium, may not in general be appropriate for the CPEs. Thus a typical assumption in financial programming—that the ex post change in the money supply will be related systematically to changes in real income and the price level—cannot safely be made for the CPE.⁵

To say that households in the CPE may frequently be in disequilibrium does not necessarily mean, however, that the household demand for money is not a stable function in these economies. Portes (1983) argues that, if anything, the velocity of household money demand may be more stable in the CPEs than in the market economies because of the insignificant role played in the CPEs by interest-bearing financial assets as substitutes for money. But the probability, or at least the possibility, of frequent household disequilibrium does raise the question of how to specify correctly the household money demand function in a CPE.

Equation (1) relates the flow supply of household money (ΔM_h) to the household financial flows associated with incomes, net transfers, borrowing, and retail expenditures:

\begin{matrix} Δ M_{h} = W N + T + Δ D C_{h} - P_{c} Q_{c \cdot} & (\begin{matrix} 1 \end{matrix}) \end{matrix}

Here W is the average nominal wage rate, N represents the level of employment, T denotes net government transfers to households, ΔDC_h is the change in gross credit extended to households, P_c is the (composite) price of consumption goods, and Q_c is the quantity of goods actually purchased by households from the socialized enterprise sector.

Most academic literature about the determinants of household money holdings in the CPEs concentrates on the flow variables on the right-hand side of equation (1). In most analytical models, net budgetary transfers and bank credits to households are ignored for simplicity, and attention is focused on the relation between money wages and nominal consumption spending, or on the real wage relative to the growth of real consumption. In the most elaborate analytical macromodel of a CPE, Portes (1979) selects the real wage as one of the two main “instruments” that the authorities use to maintain external and internal balance.

Although it seems reasonable to regard net government transfers and monobank credits to households as instruments available to the macroeconomic authorities in a CPE, wages and consumption must be more realistically envisioned as intermediate targets. Aggregate money wages are a function of both the average money wage and the level of employment, and nominal consumption has both real and price components. Only the schedules of (official) prices and wage rates can really be considered as instruments under the direct control of the center.

Enterprise wage bill plans, planned average wage rates, or both are assigned directly by the center to enterprises in the CPE. Typically the wage bill is related to the planned growth in productivity and to the degree of plan fulfillment. But slippage may occur in a number of ways, including above-plan wage payments to piece-rate workers who overfulfill the plan, manipulation of performance or efficiency norms by enterprises to inflate bonuses, unplanned “upgrading” of individual job descriptions to justify higher wage rates, and bank accommodation of above-plan wage payments by enterprises that feverishly mobilize resources at the end of the plan period (referred to as “storming”) to meet production goals (Adam (1980)). Given differential wage rates across industries, short-run shifts in production priorities or shifts over the longer term in the mix between producers’ and consumption goods can also have an important effect on the average wage and on the growth of the real wage relative to real consumption opportunities (Kucharski (1983)).

The planners attempt to control enterprise employment through employment plans, the enterprise wage bill, and various efficiency norms, but endemic pressures of excess demand in the enterprise sector (more on this later) and the tendency to hoard labor may lead to aggregate employment growth that exceeds the plan. Adam (1980) argues that the planners’ inability to contain employment growth has historically been a more important source of excessive growth in wages than has the inability of the center to limit the average wage.

Retail prices in state stores and cooperatives typically are tightly controlled and held rigid for long periods in most CPEs. Prices on the collective farm markets for agricultural products and prices on some other markets are not centrally fixed, however, and within the socialized sector many price increases take place that are not reflected in official price statistics (for examples, see Winiecki (1982)). Many products typically will also be resold at higher prices on the black market. To the extent that retail prices are in general increasing more rapidly than the official retail price index, real consumption and real money balances may, of course, be growing at a slower rate than suggested by official statistics. At the same time, relatively rapid growth of real transactions in the unreported “second economy” would give a downward bias to official statistics on real consumption growth.

The output of consumer goods is nominally under the control of the central planners, but it is ultimately decided at the enterprise level. Enterprise decisions will, of course, be heavily influenced by the higher authorities, who determine the incentive rules regarding plan fulfillment, have the power to intervene directly to ensure that certain enterprises receive scarce inputs, and control real foreign trade flows. These rules and directives are the real “instruments” here; the quantity and assortment of consumer goods supplied are essentially targets.

In sum, the flow variables on the right-hand side of equation (1) in effect determine the “balance of money incomes and expenditures of the population” in CPEs. The authorities’ control over this balance, however, is at best indirect and incomplete and is based on manipulation of a number of instruments, ranging from wage rates and price schedules to performance norms, detailed wage bill plans, and direct supply interventions.

The monetary approach to the balance of payments reminds us, however, that all the price and quantity adjustments associated with the right-hand side of equation (1) also have their monetary counterparts. This correspondence can be seen by rearranging the standard monetary definition of the balance of payments so that the change in household money holdings is set equal to the sum of the change in the banking system’s net claims on (or change in net credit extended to) the government and enterprise sectors (ΔNDC_g and ΔNDC_e, respectively),⁶ the change in gross claims on (change in gross credit extended to) households (ΔDC_h), and the change in the banking system’s holdings of net international reserves (ΔR):

\begin{matrix} Δ M_{h} = Δ N D C_{g} + Δ N D C_{e} + Δ D C_{h} + Δ R . & (2) \end{matrix}

The complexity of instruments and targets implicit in equation (1) seems to disappear here, since the problem of controlling changes in household liquidity appears to be only a matter of establishing a ceiling on the domestic banking system’s net accumulation of claims. In effect, net household hoarding (ΔM_h—ΔDC_h) is equal to the combined dishoarding of government and enterprises plus the net accumulation of claims on the rest of the world. This identity conceals, however, a somewhat more complicated reality, as will be shown in Section II.

The Foreign Trade Sector

In the CPE there is in effect a state monopoly of foreign trade. The planners’ direct controls over trade are buttressed by exchange control. The official exchange rate typically has little economic function in the classical CPE because real trade flows are usually administratively determined independently of domestic prices. Even if domestic relative prices, which often do not correspond to real scarcities, were to affect foreign trade decisions, a change in the exchange rate would still have little effect because in the classical CPE there is no direct link between the exchange rate and domestic prices. (Tne exchange rate therefore has no influence on domestic real balances, the real wage, or relative prices, all of which serve as potential means by which changes in the exchange rate may affect internal and external balance in a market economy.)

Although employee bonuses in the state-owned foreign trade organizations may be at least partially based on these organizations’ “profits,” the profits (losses) of the foreign trade organizations are essentially taxed away (subsidized) by the financial authorities by a process called price equalization. The net price-equalization tax (subsidy) in a CPE may be substantial because of significant distortions between the structures of domestic and foreign relative prices. As shown in Wolf (1980a), the difference between the trade balance denominated in foreign currency prices converted at the official exchange rate (that is, the so-called valuta balance) and the trade balance denominated in actually prevailing domestic prices is accounted for by the net profits of the foreign trade organizations:

\begin{matrix} B_{T}^{'} = B_{T} + F, & (3) \end{matrix}

where B’_T and B_T are the valuta and the domestic price trade balances, respectively, and Fis the net profit of the foreign trade organizations from foreign trade.

The official exchange rate in the CPE may, of course, have some small effect on real trade flows. Zakharov and Shagalov (1982) in effect suggest that in the Soviet Union, for example, the foreign trade organizations take an interest in the prices that enter into their valuta turnover. It has also been suggested that foreign trade organizations are evaluated in part on their foreign trade profits. That the interests of the foreign trade organizations in their valuta prices have only negligible, if any, effect on Soviet real trade flows, however, is suggested by evidence in Wolf (1982a) that Soviet real exports to the West during 1970-78 were actually reduced, other things being equal, as export prices in valuta increased. As will be discussed at some length in Section IV, whether changes in the exchange rate can play an adjustment role in planned economies depends on the broader context of price formation and enterprise decision making in such economies.

If there are no net capital flows with the rest of the world other than those accommodating a trade imbalance, B’_T in equation (3) will also equal the change in net international reserves of the CPE, denominated in valuta (ΔR in equation (2)). As with a market economy, a change in net international reserves need not imply net hoarding or dishoarding in either the enterprise or household sectors (see Wolf (1978)). For example, a loss of reserves could be just equal to government subsidization of losses by foreign trade organizations in foreign trade. In terms of equation (3), in this case $B_{T}^{'} = F, w i t h F < 0.$ Put still differently, in this case enterprise plus household hoarding would be zero, and the decline in reserves would be equivalent to net government dishoarding.

Special care should be exercised in calculating the ratio of a CPE’s trade balance or external debt to its national product, and in making implicit comparisons with such ratios calculated for market economies. One problem is that the concept of net material product (or NMP) used by most CPEs will typically yield a lower figure for national product, and therefore a higher calculated normalized trade surplus (deficit) or normalized debt, than would calculations of gross national product (GNP) according to the United Nations’ System of National Accounts (SNA) methodology (for exploration of this issue, see Marer (1982)). Furthermore, some CPEs account for foreign trade according to the so-called Soviet methodology, which departs from the standard SNA approach and which under certain circumstances could bias the calculation of GNP from the SNA standpoint (see Wolf (1982b) for details).

II. Sources and Symptoms of Disequilibrium

Further development of an analytical framework for better understanding macroeconomic adjustment in planned economies will depend in part on clearly distinguishing between the sources and symptoms of disequilibrium. Drawing these distinctions should also assist in the later identification of possible indicators of disequilibrium at different stages of the adjustment process.

Supply-Side Disturbances

By way of illustrating the complexity of the adjustment problem faced by authorities in a CPE in the event of an exogenous disturbance, consider the case in which the authorities have worked out with the enterprises physical and financial plans that establish, among other goals, a planned growth in household liquidity. By equation (2), the planned increase in net household liquidity (ΔM_h-ΔDC_h) will be equal to the combined planned change in net credit extended to the government and enterprise sectors plus the planned increase in net international reserves (ΔNDC_g+ ΔNDC_e+ΔR).

Now consider an adverse supply shock that reduces the domestic supply of an important intermediate good. Assume that this input is widely used in the production of both producer and consumer goods. A brief taxonomy of the basic options facing the authorities will be instructive. One way of classifying these options is to ask whether enterprises will be subject to what Kornai (1979) has called “hard” or “soft” budget constraints. A “hard” constraint in this case means that the authorities will not accommodate increased above-plan demands by enterprises for credit or subsidies. If the constraint is “soft,” and Kornai argues that this is typical of planned economies, such accommodation will be forthcoming.

The taxonomy of policy options can be best envisaged by defining equations (1) and (2) for both actual and planned values of each variable, subtracting the latter from the former and indicating the difference with a prime, and finally setting equal the right-hand sides of the resultant equations and simplifying:

\begin{matrix} Δ N D C_{g}^{'} + Δ N D C_{e}^{'} = {(W N)}^{'} + T^{'} - {(P_{c} Q_{c})}^{'} - Δ R^{'} . & (4) \end{matrix}

Here a primed value for a variable greater (less) than zero reflects an actual value above (below) that in the plan. For simplicity, it is assumed for the time being that interenterprise credits are either prohibited or not possible because all enterprises are constrained to maintain deposits at a bare minimum.⁷ Given this assumption, the “hard” budget constraint means that equation (4) is equal to zero. Enterprises in effect are forced to manipulate the prices and quantities under their control so as not to exceed their planned levels of borrowing and subsidies and to maintain their planned level of deposits at the monobank. In this case household liquidity will also not expand by more than the planned amount. In essence four possibilities exist, but all four responses could be partially pursued in combination.

First, the planned output of consumer goods could be produced $(Q_{c}^{'} = 0),$ with the full output effect of the reduced inputs falling on investment. Second, output of consumption goods could bear the full amount of the cutback $(Q_{c}^{'} < 0),$ , but a buildup in household liquidity and decline in enterprise deposits could be avoided if producers of consumer goods cut back their wage bills by the full value of the shortfall in production; that is, (WN)’ = (P_cQc)’. This cutback would involve a reduction in average wages, employment, or both. Third, these same producers could instead be permitted to increase prices of their actual output by an amount necessary to maintain their revenues at the planned level despite the fall in real deliveries of consumer goods; that is, $P_{c}^{'} Q_{c} = - P_{c}^{p} Q_{c}^{'},$ where the superscript p refers to the planned level. Fourth, enterprises could draw down inventories of consumption goods below planned levels to attain the planned revenue target.

Three basic possibilities exist in the case of the “soft” budget constraint. The first two involve permitting enterprises to expand imports of intermediates or finished goods (or both) above—or to reduce exports of these products below—planned levels. In terms of equation (4), this involves above-plan deterioration in the valuta trade balance (ΔR’ < 0) that is just offset by some combination of above-plan government subsidies or bank credits to enterprises; that is, $Δ N D C_{g}^{'} + Δ N D C_{e}^{'} > 0.$ The net result is no change from the planned increase in the household money supply. Only in the third case does an above-plan increase in household liquidity occur: here the entire output decline takes place in consumer goods $(Q_{c}^{'} < 0) .$ Money wages and employment are maintained at the planned level, prices remain fixed, and households accumulate a greater than planned amount of money. Enterprises are able to replenish their deposits, which are below planned amounts because of reduced revenue from the sale of consumer goods, by increasing their borrowing from the monobank or by receiving higher subsidies from the government; that is, $Δ N D C_{g}^{'} + Δ N D C_{e}^{'} > 0.$

Heretofore it has been assumed that enterprise deposits at the monobank will be maintained at their planned level regardless of the particular pattern of adjustment to the supply disturbance. There is the possibility, however, that the velocity of enterprise deposits may increase, as can easily be seen by rearranging equation (4):

\begin{matrix} (Δ N D C_{g}^{'} + Δ D C_{e}^{'}) - Δ M_{e}^{'} = {(W N)}^{'} + T^{'} - {(P_{c} Q_{c})}^{'} - Δ R^{'} . & (4 a) \end{matrix}

Here $Δ D C_{e}^{'} a n d Δ M_{e}^{'}$ refer to above-plan changes in monobank credits to enterprises and in enterprise deposits, respectively.

Suppose that in response to the supply disturbance it is determined that resources will be diverted from output of consumption goods without accompanying increases in retail prices or wage reductions (or both) that are designed to prevent the accumulation of excess household liquidity. Rather than being financed by above-plan bank credits, as earlier, enterprises as a group might be able to finance the diversion by reducing their gross deposits; that is, $Δ N D C_{g}^{'} + Δ D C_{e}^{'} = 0, a n d Δ M_{e}^{'} = {(P_{c} Q_{c})}^{'} < 0.$ This alternative could be accomplished through a general economizing on enterprise deposits or by means of increased interenterprise credits that could be extended by firms happening to have excess liquidity to those faced with cutbacks in domestic sales of consumption goods. Clearly, then, above-plan gross credit extension by the banking system is not a necessary precondition for an above-plan increase in household saving, a deterioration of the trade balance, or both.

Several observations would appear to be in order. First, the distribution of adjustment among the different right-hand-side variables in equation (4) will depend on a complex of economic and institutional factors as well as on policy considerations. For example, whether actual wages deviate from those planned will depend on the degree of slack inherent in the system of wage regulation, the scope for changing levels of employment, and policy judgments made by both the center and enterprises with respect to the average wage and to job security. Whether net government transfers to households can be permitted to differ from planned levels is again a policy judgment, and one with significant distributional implications. The scope for deviations from the planned value of sales of consumption goods is a function of the precise system for the setting of retail prices, judgments about the extent of disequilibrium existing in this market and its political consequences, and the substitutability between the production of investment and consumer goods of the particular intermediate input in question. The latitude for above-plan deterioration in the CPE’s international reserve position will be determined by, among other things, the substitutability of foreign and domestic sources of the intermediate input and, possibly, by the availability of foreign credits.

Second, a policy of holding to planned net credit ceilings in the face of adverse supply shocks may well be incompatible with historic policies in CPEs regarding the priority of investment, downward stickiness in money wages, job security, and maintenance of retail price stability. In the event of such shocks, the accommodation of above-plan subsidies or credits to enterprises may not reflect a lack of toughmindedness on the part of the financial authorities in their individual negotiations with enterprises, but rather a sober recognition of the political reality that certain socioeconomic policies have to be accommodated.

Third, if a stance appropriate to a “hard” budget constraint is to be followed in such circumstances, several difficult decisions must be made by the enterprises, in close collaboration with the authorities, about the distribution of adjustments among cutbacks in real investment and consumption spending, lowered money wage rates, employment reductions, and price increases. Given the complexity and time involved in making such decisions within classical central planning and a hierarchical bargaining process, a tendency to avoid the problem (at least temporarily) by accommodating the subsidy and credit demands of enterprises and permitting the development of imbalances in the consumer and foreign trade sectors is understandable. One might therefore expect market economies to reach a new general equilibrium following a supply shock much more quickly than would CPEs, but whether this is the case is an empirical question.

The Investment Cycle

It is demand-side rather than supply-side disturbances, however, that are probably most qualitatively different in their effects in market and planned economies. It is noteworthy that, whereas Western analysts of CPEs have tended to examine the implications of and instruments for eliminating disequilibrium in the market for consumption goods (see the next section), many contemporary economists in the CPEs have focused on the sources and perpetuation of disequilibrium within the enterprise sector. In particular, there is now an abundant literature on so-called investment cycles in CPEs, and many economists in CPEs believe that such cycles are the primary cause of changing degrees of imbalance in the consumer and foreign trade sectors.

Giving a major role to investment in seeking to explain macro-economic fluctuations in CPEs is certainly consistent with the historical priority that planners have attributed to investment in these economies. It is not obvious, however, why there should be investment “cycles” in a planned economy. But just as it is important when studying, say, the causes of inflation in market economies to understand why the authorities may feel compelled to increase the money supply at excessive rates, so it is critical to an understanding of macroeconomic fluctuations in CPEs to attempt to comprehend why and how excess demand pressures may originate in those economies. There are several theories regarding investment cycles in CPEs;⁸ the discussion of them must be brief and, therefore, rather eclectic.

Consider a planned economy with two composite goods—an investment good (I) and a consumption good (C). The production possibilities frontier for this economy is drawn in Figure 1, with operation on the frontier assuming both full employment of resources and their most efficient utilization. Imagine that this economy, a price taker, faces external terms of trade equal to q*. Were it to trade so as to equalize the domestic rate of product transformation and the terms of trade, it would produce at point P*. With production at P*, the real wage in terms of the consumption good would be equal to OW* on the C-axis.

Using the simple consumption function drawn in the lower part of the diagram, where the demand for consumption goods (C^d) is assumed to be a positive function of both the real wage (w) and real household money balances (M_h/P), one can find the amount of the consumption good demanded at each real wage. Thus at real wage 0W*, 0E₄ of the consumption good is demanded. The balance of domestic production of this good (E₄E₅) would be exported at terms of trade q * for imports of the investment good, with the domestic consumption mix of the two goods (0E₄ and 0I₄) indicated by point C*. In this case consumers are in equilibrium, and trade is balanced in foreign currency prices.

Imagine that in reality the planners pursue an import-substitution policy that causes production to take place on or within the production frontier to the northwest of P*. Now consider two types of plausible investment cycles.

Overfull Employment Planning

The first might be associated with the phenomenon of “overfull employment planning”—the perceived tendency of planners in many CPEs, particularly in the 1950s, consciously to set overly taut plans with the belief that, although all sectoral plans would not be fulfilled, aggregate output would thus be maximized, and plans in the priority sectors might even be fulfilled or overfulfilled (see Hunter (1961) and Holzman (1953)).

Assume that in the five-year plan the planners target an annual production-consumption combination of (P₀, C*).⁹ Observe that at the real wage corresponding to P₀, OW*, consumers demand 0E₄ of the consumption good, and consumers would be in equilibrium at C*. Assume that actual output in the first planning period takes place at P₁ with the full output shortfall affecting the consumption good. The planners are still intent to fulfill the investment plan, however, so that R₁ P₁ of the consumption good is exported for of C₁ R₁ of the I-good, leaving excess demand for the C-good equal to C₁ C*. The alternative to disequilibrium in the household sector in this case would be to maintain consumption at the planned level by exporting only S₁P₁ of the C-good and by incurring a trade deficit of P₁P₀.

Assume for simplicity of exposition a stationary economy, and consider that production in the second year of the plan also takes place at P₁. If balanced foreign trade were achieved in the first period at the expense of consumer disequilibrium, consumer demand in the second period would presumably be even greater than the amount indicated at the real wage 0W₁ as households attempt to unload part of their excess money holdings. Thus the function C^d(w, M_h/P) would shift to the right, and the new desired consumption point would be to the right of C* in the upper part of Figure 1. In effect, excess consumer demand would now be greater than C₁C*. At the same time, if the supply of labor were positively related to actual consumption in a period of excess consumer demand, the production point would shift inside the frontier, reinforcing the situation of disequilibrium (see the discussion of household disequilibrium in the next section).

At some point the planners might be moved to reduce investment spending so as to eliminate all or most of the excess demand for consumption goods. They might do so by allowing investment to decline to 0I_i (or even further) in order to eliminate the household-liquidity overhang. This decline in investment could be (but historically has seldom been) accompanied by some combination of wage reductions and price increases that would lower the real wage and would cause a shift in the household budget line, which in turn would move consumption demand to the left. Although the authorities might scale down investment enough in the following periods so as to eliminate effectively the household disequilibrium, it is difficult to imagine them significantly overshooting in this respect, given the clear priority attributed to investment goods. Yet it is precisely this type of overshooting that must occur, at least in the context of an explanation of disequilibrium based on an investment cycle, to produce the periods of “excess supply” empirically identified by Portes and Winter (1980). Once essential balance (or a tolerable imbalance) is re-established in the household and foreign sectors, the authorities might be willing to re-embark on a strategy of overfull employment.

Most close observers of planned economies view the phenomenon of overfull employment planning as a historical curiosity symptomatic of the earliest years of central planning and the rapid drive toward industrialization in these countries. Whereas many economists studying CPEs might now dismiss the relevance of overfull employment planning as such, they find little if any evidence for the disappearance of investment cycles. The more contemporary explanations of investment cycles are not inconsistent with the overly taut planning approach. Indeed, it is likely that the same basic forces said to determine contemporary investment booms in CPEs were at work even in the earlier periods of central planning. Advocates of the investment-cycle approach argue that it is precisely the lack of fundamental change in these systems over the past two decades that explains the persistence of investment cycles in CPEs.

Excess Enterprise Demand

The newer approaches emphasize the continued importance of rapid economic growth as a goal of the planners, and the continuing implicit preference of the planners for investment goods. At the same time, the planners may now be more sensitive to the problems created by excessive liquidity in the household sector and more reluctant than before (with some notable exceptions) to overheat the domestic economy. It is argued that enterprises clearly recognize the preferences of the leadership, as well as its intention to formulate less taut plans. Because they perceive, however, that output growth in general and plan overfulfillment in particular continue to be the main de facto criteria for evaluating enterprises, managers and their supervisory ministries will behave in effect as output maximizers. They will hoard labor and other inputs and will seek to expand output, not through product or process innovations that might slow or temporarily halt production, but by relatively low-risk, new investment projects. The enterprises are seen as having an excess demand for investment goods (and intermediates) that is accommodated financially by the authorities to some extent (the “soft” budget constraint), but that is never satiated because there are limits (essentially, the imbalance that is tolerable in the household and foreign trade sectors) to this accommodation. In this view, the source of this excess enterprise demand for investment is not an excess supply of enterprise liquidity but the implicit criterion of output maximization.¹⁰

There is an insidious aspect to the investment cycle under these conditions because the enterprises, recognizing the reluctance of the planners to overheat the economy but having in mind above all their own interests, may consciously understate the full cost (to be spread over several years) of individual investment projects. The object is to get each of the projects approved and the necessary sums appropriated for their commencement. The assumption is that once the projects are approved the authorities will find it increasingly difficult to stop annual appropriations before they are completed (see Bauer (1978) and Winiecki (1982)).

Imagine a five-year plan being negotiated between the center and the enterprises whereby annual output is set at P₁ in Figure 1. At the real wage OWi corresponding to P₁ consumers will be in equilibrium at C₂, which is the planned consumption point. Planned trade is also balanced at C₂.

The plan might be essentially met in the first period, but proponents of the investment cycle argue that by the second period the excessive nature of the investment needs of enterprises must emerge. Rather than being content with investment of 0I₂, enterprises press the authorities to accommodate investment of 0I₄. The authorities have in essence three choices (or a combination of them). One is to combine the refusal to extend above-plan credits or subsidies to the enterprises with a prohibition against wage reduction or price increases on consumer goods. If it is assumed for the time being that enterprises have no initial excess liquidity, this policy in effect keeps them from diverting resources from consumption into investment or from applying for above-plan import licenses. In equation (4), $Δ N D C_{g}^{'} + Δ N D C_{e}^{'} = 0,$ and the economy remains at C₂.

A second policy would be to refuse new credits or subsidies but to permit enterprises to finance the diversion of resources by means of wage reductions and price increases; that is, (WN)’ < 0 and P’_c> 0. The real wage would decline, but in Figure 1 observe that it must fall to OW₂ to induce enough of a decline in consumption demand to put households in equilibrium at C₁. Finally, the authorities could simply permit the budget constraint to be “soft” and finance some combination of increased imports (ΔR’<0) and diversion of resources from consumption (Q’_c< 0) while adhering to the wage plan and fixed retail prices. Extreme versions of this third case would be consumption at C₁ with balanced trade but with excess household demand of C₁C₃ for the consumption good, or consumption at C₃ (thus no household disequilibrium) with the entire disequilibrium falling on foreign trade (a deficit equal to P₁P₃). Bauer (1978) and others (see Hewett (1983) for recent evidence with respect to Hungary) have found considerable evidence of what Bauer calls the “consumption or foreign trade symmetry” with respect to CPE investment cycles of the type suggested by this third case.

As the effects of disequilibrium discussed earlier multiply in later plan periods, one would expect the accommodation of this investment demand to be reduced. The stock of unfinished construction would presumably peak, and, as investment is cut back, both the household and external disequilibrium could be diminished. But, although the “accommodated” excess demand for investment will have been lessened, the proponents of the cycle theories suggest that the underlying excess demand will persist. For Kornai (1982b), such investment cycles merely represent fluctuations in what must be considered a normal state of “chronic shortage.”

As noted, not all analysts would agree with this particular depiction of the investment cycle. Some, such as Goldman and Kouba (1969), would also stress the constraining nature of the trade balance, which, for countries relatively poorly endowed in raw materials, causes imports of materials to “lead” the fluctuations in investment. A recent study of growth cycles in the German Democratic Republic by Boot (1984) suggests that energy and raw material shortages can be an important factor leading to a slowdown in investment.

Some observers even doubt the existence of investment cycles in CPEs, or in any event that such cycles are any more explainable by economic than political factors. This is the position of Wiles (1982), who collected annual investment growth figures for all the European CMEA members, as well as Mongolia, for the period 1950-80. A tabulation by this writer of peak investment growth years for each of these countries for each five-year-plan period beginning in 1961 shows, however, that investment growth peaked in the second and third years of the plan 32 percent and 21 percent of the time, respectively. This is suggestive of frequent investment cycles of the type outlined above, although such evidence is certainly less than definitive.¹¹

That investment often gets out of control in most CPEs is disputed by few. The main disagreement concerns the causes of these booms and the degree to which they may exhibit “regular” or cyclical features. Investment spurts would appear to be attributable to both policy and systemic factors. Past policies of overfull employment planning and a legacy of priority given to rapid industrialization undoubtedly have helped create a psychology of output maximization on the part of enterprise managers and their immediate ministerial supervisors. At the same time, despite introduction of at least nominal “capital charges” in enterprise profit calculations in many CPEs in the past 20 years, investment in these economies is typically still not evaluated by a consistent set of standards. As suggested by Tyson (1983), successful investment reforms depend on a combination of an effective capital price-rationing standard and the enforcement of “hard” budget constraints, or financial discipline, at the enterprise level.

Disequilibrium in the Market for Consumption Goods

As suggested in Section I, changes in household liquidity will reflect specific policies and actions by both the authorities and the enterprises (with respect to average wages, employment, retail prices, the real output of consumption goods) as well as the decisions of households. Furthermore, personal money holdings will be directly influenced by net transfers received from the government and by the change in household credit made available by the banking system.

The change in liquidity desired by households when they are unconstrained in consumption might be postulated by the following simple equation:

\begin{matrix} \begin{matrix} {\begin{matrix} Δ M_{h}^{*} \end{matrix}}_{t} = λ \end{matrix} [{(M_{h}^{d})}_{t} - {(M_{h})}_{t - 1}], & (5) \end{matrix}

where ${\begin{matrix} Δ M_{h}^{*} \end{matrix}}_{t}$ is the notional flow demand for money in period t, ${(M_{h}^{d})}_{t}$ is the stock demand for money at the end of the same period if consumers are unconstrained in consumption, (M_h)_t-1 is the supply of household money at the end of the preceding period, and λ is an adjustment parameter where 0 ≔ λ ≔ 1.

There is very little agreement about the form or the stability of the stock demand for money function in the CPE. Ofer and Pick-ersgill (1980) list several plausible factors motivating household saving in planned economies, including the possibility, in an economy of frequent micro- and macro-level disequilibrium, that the accumulation of household liquidity may be positively related to the perceived uncertainty of the availability of consumer goods, because households “must have liquid assets to take advantage of unexpected opportunities” (p. 127). In a disequilibrium setting, it could be argued that household demand for money will be a function of actual consumption expenditure rather than of income, although this formulation is questioned by some.¹² In attempting to raise the household demand for liquidity, the authorities may manipulate retail prices (and possibly supplies of consumption goods, if actual consumption is an argument of the money-demand function), raise interest rates on savings deposits (a practice historically eschewed in most CPEs), or announce future increases in the production of consumer durables that require cash payment.

Excess demand in the market for consumption goods, $C_{t}^{e}$ may be defined as the difference, in period t, between aggregate household demand for consumer goods, $C_{t}^{d}$ , and their aggregate supply, where the latter is defined as actual output of consumption goods (defined here to include net imports), $C_{t}^{o}$ minus the planned increase in enterprise inventories of these goods, $Δ I N V_{t}^{p} :$ ¹³

\begin{matrix} C_{t}^{e} = C_{t}^{d} - (C_{t}^{d} - Δ I N V_{t}^{p}) . & (6) \end{matrix}

Actual consumption (C_t) is equal, on the one hand, to the current output of consumption goods less the actual change in inventories (ΔINV_t) and, on the other hand, to the difference between aggregate demand for consumption goods and the excess of the flow supply of household money (equation (1)) over the notional flow demand for money (equation (5)):¹⁴

\begin{matrix} C_{t} = (C_{t}^{o} - Δ I N V_{t}) = C_{t}^{d} - [{(Δ M_{h})}_{t} - ({Δ M_{h}^{*})}_{t}] . & (7) \end{matrix}

Solving equation (7) for C°_t, substituting into equation (6), and simplifying yields

C_{t}^{e} \begin{matrix} = [{(Δ M_{h})}_{t} - ({Δ M_{h}^{*})}_{t}] - Δ I N V_{t}^{'}, & (6 a) \end{matrix}

where ΔINV’_t is the difference between the actual and planned change in inventories of consumption goods.

Ignoring for the moment the possibility of micro-level disequilibrium, observe that actual consumption will take place on the effective supply curve where there is aggregate excess demand. If enterprises were instructed to respond to excess demand by reducing inventories below planned levels, actual consumption would exceed the “supply” $(C_{t}^{o} - Δ I N V_{t}^{p})$ as defined by equation (6). When there is excess supply, however, consumption will not occur off the demand curve. This suggests that to estimate excess demand from estimated demand and supply functions based on fitted values for actual consumption (see Portes and Winter (1980) for such estimates) might bias the empirical results away from findings of positive excess demand. Expressing excess demand for consumption goods in terms of equations (6) and (6a) suggests, therefore, that empirical work in this area should probably take inventory behavior more explicitly into account.

As noted earlier, the conventional wisdom that the CPEs are subject for long periods to “repressed inflation,” or to “involuntary saving” on the part of households, is not accepted by everyone. Portes (1983, p. 152), for instance, suggests that “many phenomena usually attributed to monetary disequilibrium, such as shortages and the ‘second economy’ …, are in good part due to distorted relative prices and deficiencies of the distributive network.” Indeed, whereas the basic distinction between micro-economic and macroeconomic disequilibrium may be clear, the interaction between them and the variety of possible adjustments to both states have heretofore received inadequate attention in the literature on CPEs.¹⁵

The complexity shrouding this issue may be illustrated by using the two-commodity diagram in Figure 2. Consider two consumption goods, A and B. Assume that planned production of the two goods is at P on the production possibilities frontier of the socialized sector, and that actual output is equal to planned output. For simplicity of exposition it is also assumed that initial inventories of both goods are equal to zero and that no accumulation of inventories is planned. Foreign trade in the two goods is also ruled out by assumption. The relative retail price of the two products sold at state retail outlets is set by the authorities at q. The line from the origin, 0H_q, is the income-consumption path corresponding to this relative price. With production assumed to be fixed at P and the relative price to be fixed at q, households will have excess demand for the A-good and there will be an excess of the 5-good for each case of macroeconomic equilibrium or disequilibrium considered below.

Household budget lines q₀, q₁ and q₂ represent respectively states of zero, positive, and negative macro-level excess demand in the consumption-goods market. Thus with budget line q₀, excess demand for the A -good of C₀ R₀ is exactly offset, at relative price q, by unplanned inventory accumulation of the B -good of R₀ P. With budget line q_u excess demand for the A -good of C₁R₁ exceeds, at the same relative price, unplanned inventory accumulation of the B-good of R₁P. The tighter household budget indicated by q₂, however, results in unplanned inventory accumulation of of the B -good of R₂P, which exceeds the value of excess demand for the A-good, C₂R₂. Observe that in each of these cases, in which consumption takes place inside the budget constraint, there is an unplanned buildup in inventories as well as an “excessive” accumulation of household liquidity, yet the macro-level situation in each case is fundamentally different.

In general, however, the response of households in each case will not be limited to the “excessive” or “involuntary” saving suggested in Figure 2. At least several other responses are possible and, in many instances, likely. If households are in a position to choose among these responses, it may be said that the amount of money they end up accumulating will represent their “effective” flow demand for money (see Barro and Grossman (1976)). In the event of quantity constraints in consumption, this effective flow demand (or flow supply) will in general exceed the notional flow demand for money.

Virtually all of the Western literature on disequilibrium has heretofore stressed the possibility that households, faced with the prospect of involuntary saving, will opt instead for increased leisure; will devote a greater share of their nominal working time to searching out consumption opportunities, particularly with respect to the A -good; or both.¹⁶ This possibility is usually assumed to cause a decline in employment, which induces a shifting of the production point within the production frontier (or alternatively, a collapse of the frontier). A multiplier process ensues, characterized by declining output (including that of consumer goods) and further reductions in employment. Aggregate wages presumably fall too, and the economy moves toward a constrained equilibrium at a lower level of income and employment. Whether this process should be modeled in terms of declining supplies of labor (with an attendant lower wage bill), or simply lower levels of labor effort (which might not involve a decline in employee money incomes), or some combination of the two, is not at all clear (see Kemme and Winiecki (1984)).

A second possibility, emphasized by Kornai (1979, 1980) and other East European economists, is “forced substitution” of the B-good for the A-good at the existing relative price. At each of the consumption points corresponding to maximum involuntary household hoarding (R₀, R₁ and R₂, respectively), consumers are of course in a state of micro-level disequilibrium, in that the rate of commodity substitution in consumption is not equal to the existing relative price. Households might consider themselves better off in consuming more of the unconstrained product and moving to the right from those respective points along line segment R₂P.¹⁷ Indeed, one could imagine them moving to the right even as far as their budget constraints or production permitted (that is, to P when $C_{t}^{e} \geq 0, a n d t o R_{2}^{'} w h e n C_{t}^{e} < 0.$ ) According to equation (6a), however, this movement would have no impact on the state of excess demand at the macro level because the reduction in involuntary saving would be exactly offset by the decline in unplanned inventory accumulation.

A third alternative is for households to engage in various “second-economy” activities designed to expand consumption in the aggregate and to eliminate the micro-level disequilibrium. One possibility is the production of additional units of the A -good outside the socialized sector. For simplicity of exposition, however, the ensuing discussion will be confined to the retrading by consumers or shop clerks of some portion of the A -good produced by the state sector (0A₀) on the black market at a price higher than that set by the authorities.¹⁸ This phenomenon cannot really be adequately analyzed in Figure 2, however, because the existence of the black market presupposes different initial consumption possibilities or different relative marginal utilities, or both, among individuals between the two goods and between these goods and money. It is clear, however, that if a black market is tolerated by the authorities the price of the A-good will be bid up, and the average price at which this product is actually consumed will be higher than the state-administered price. The effective relative price of the B-good will fall, and the actual price level will rise.

In the figure, the (average) relative price line in each case will become flatter. Arbitrage of the A-good, outside the socialized sector, will increase household incomes as well as household final expenditure on the A -good. If either income or expenditure is an argument of the money demand function, black market activities may increase the quantity of money demanded (that is, $Δ M_{h t}^{*}$ may be greater than otherwise).¹⁹ In this event the relative price line will actually pivot inward at the point of intersection of the original price line and the B-axis. For example, in the case of zero excess demand the new price line might be q’₀.

The demand for consumption goods will now be subject to both expenditure and substitution effects. Aggregate consumption demand should rise because of the increase in money income. At the same time, the lower relative price of the B-good should stimulate increased demand for this product. Increased consumption of the B-good would, of course, simultaneously reduce excessive money accumulation by households and unplanned inventory accumulation by enterprises. By equation (6a), however, the increase in $Δ M_{h}^{*}$ in the initial case of zero excess demand would result in $C_{t}^{e} < 0$ (that is, excess supply on the consumption-goods market). It is possible, although by no means certain, that black market activities could eliminate the involuntary money accumulation by households. In that event, the flow supply of money and unplanned inventory accumulation of the B-good would be reduced from the initial values by, say, R₀ R’₀ for the initial case of zero excess demand in Figure 2, but at the same time the flow demand for money in terms of the B -good would be increased by R’₀P The net result would be $Δ M_{h t} = Δ M_{h t}^{*}$ , but $Δ {I N V}_{t}^{’}$ equal to R’₀P, or excess supply.

The foregoing analysis is only suggestive and is by no means definitive. There is a need for more extensive formal modeling of the choices that households make in such situations among increased saving, increased leisure, “forced substitution” of one product for another, and engaging in black market and other second-economy activities as either sellers-producers or buyers.²⁰ What this cursory look does suggest, however, is the difficulty of distinguishing empirically between micro- and macro-level disequilibrium. Furthermore, even if one could satisfactorily measure ex post the extent of excess demand in the consumption-goods market as a whole, a finding that there was overall zero or negative excess demand in a given period, combined with essential stability of the official retail price index, would not necessarily mean that conditions of positive or zero excess demand had not initially prevailed and been alleviated by some combination of a decline in labor supplied to the socialized sector and various second-economy activities. To ignore these “spillover” effects in econometric estimation could conceivably lead the empirical researcher to the conclusion that excess demand pressures had not existed in the first place. Moreover, this analysis suggests that, even if there were initially zero aggregate excess demand for consumption goods, the existence of micro-level disequilibrium might cause spillover effects involving macroeconomic variables such as the aggregate quantity of labor supplied, aggregate saving, and the de facto price level.

Thus it can be seen that a given net unplanned accumulation or decumulation of enterprise inventories of consumption goods may in general be associated with zero, positive, or negative excess demand on the consumption-goods market. This ambiguity also makes it more difficult to make simple inferences from above-plan domestic credit creation concerning the existence of generalized excess demand in the economy. Recall from equation (4) that the sum of above-plan net credit extended to the government and enterprises by the domestic banking system $(Δ N D C_{g}^{'} + Δ N D C_{e}^{'})$ is equal to the unplanned increase in net household liquidity $[{(W N)}^{'} + T^{'} - {(P_{c} Q_{c})}^{'}]$ minus the above-plan increase in net international reserves (ΔR’). Now consider the case of zero macro-level excess demand on the consumption-goods market combined with micro-level disequilibrium (budget line q₀ in Figure 2). Assume that, after the black market activities discussed earlier take place, enterprises are left with unplanned inventory accumulation of the B-good. In equation (4), sales revenue from the sale of consumer goods is below plan (that is, (P_cQ_c)’ <0), and, provided that the wage bill has not fallen commensurately, enterprises will require some combination of above-plan net credits or government subsidies $(t h a t i s, Δ N D C_{g}^{'} + Δ N D C_{e}^{'} > 0)$ to maintain their planned liquidity.

Above-plan credits, then, are not associated here with an above-plan balance of payments deficit, with excessive enterprise demand for investment and associated inputs (the investment cycle), or with accommodation of enterprise demands in the event of an adverse supply disturbance. In this case, above-plan credits arise from the accommodation of the liquidity needs of enterprises that are associated with a planning “error”—an “incorrect” output mix of consumption goods given existing consumer preferences and the administered relative price. Whether the planners or the enterprises or both are responsible for the error is of course an open question. This error will be reflected, in the national accounts, in above-plan growth in investment (an unplanned increase in inventories) at the expense of consumption; but observe that the cause of the “excessive” investment in this case is the lack of enterprise adjustments to micro-level disequilibrium within the consumption-goods sector rather than excessive aggregate demand.

III. Internal and External Balance

The foregoing discussion of the sources and symptoms of disequilibrium suggests that the relation between internal and external balance is fundamentally the same in market and planned economies. Unlike the (stylized) market economy, however, the classical planned economy lacks a mechanism by which the myriad price and quantity adjustments necessary to move the economy to a new general equilibrium can be made relatively swiftly and efficiently. Because of the complexity of attempting to manage the enterprise sector from the center, and because the main socioeconomic goals of CPEs historically have biased policies away from adjustments of wages, employment, and consumer prices, one might expect that the authorities would place a greater burden of short- and medium-term adjustment on the consumption-goods and foreign trade sectors.

Attempts by Western economists to model more or less formally the macroeconomic balance problems of CPEs have tended to focus on balance in the consumption-goods market (Brada (1982)), in the foreign trade sector (Wolf (1980a)), or in these two sectors together (Portes (1979)). The last of these models represents the most ambitious attempt to date to analyze the trade-off of internal-external balance and warrants some discussion.

Portes’s approach is strongly influenced by the macroeconomics of disequilibrium and quantity rationing associated with the work of Barro and Grossman (1971, 1976). Unlike most other applications of disequilibrium economics and econometric techniques to the CPEs, however, Portes in his study refrains from assuming that households will be typically quantity-constrained in consumption.²¹ Excess demand for consumption goods therefore becomes just one of several possible disequilibrium regimes in Portes’s model. Household demand for consumption goods and household supply of labor functions therefore differ depending on the type of disequilibrium (or equilibrium) regime that happens to prevail.

Household demand for consumer goods is assumed to be a positive function of the real wage and real household money balances and, in the event of an excess supply of labor, of the quantity of labor actually supplied. Household supply of labor is assumed to be a function of the real wage (with the partial derivative permitted to be positive, negative, or zero), a negative function of real household money balances, and, in the event of an excess demand for consumer goods, a positive function of the quantity of consumption goods supplied. Thus the negative feedback or spillover effect of excess demand in the consumer goods sector on output in general, a fundamental characteristic of the disequilibrium models, is incorporated here. In general, of course, the partial derivatives with respect to each argument in all these equations are different depending on which disequilibrium or equilibrium regime is assumed to hold.

The gross output of the economy is assumed to be a positive function of, among other things, an imported intermediate good, and for simplicity this intermediate good is assumed to be the only import. Exports to pay for these imports are made from final output. The CPE is assumed to be a “small country” in world trade. Government spending and enterprise investment are in effect lumped together as the “flow of goods purchased by government.”

Portes focuses on the planners’ problem of maximizing a utility function (with real consumption and government purchases as arguments), subject to the attainment of balance in the markets for consumption goods and labor and of some target for the balance of trade. According to Portes, the planners’ policy instruments are the real wage, real exports, and government spending. He focuses on the first two in his detailed analysis of internal and external balance, however, on the grounds of both analytical tractability and the assertion that government expenditure (including investment) is of higher priority and is relatively inflexible (compared with consumption spending) in the CPE. In real wage and real exports space, Portes derives quite complex internal (CC) and external (BB) balance curves representing the locus of combinations of real wages and real exports necessary to maintain balance (he notes that “equilibrium” would probably be a misnomer here) in the consumption-goods and foreign trade sectors. The interpretation of these curves is significantly more complex than in the Mundell-Swan type of diagrams of external-internal balance for market economies because the possibility of sustained disequilibrium in the consumption market means that shifts in the CC curve can affect the shape of the external balance curve.

Portes’s internal-external balance model yields several valuable insights regarding the macroeconomic processes of the CPE. Problems with the model reside largely in its relative neglect of the household demand for money, the sources of disequilibrium, and the choice of instruments that the planners allegedly use to maintain an acceptable degree of imbalance in the economy.

As noted, one of these instruments is the level of real exports. Technically speaking, real exports are not an instrument, although the assumption that planners have direct control over these flows makes them a policy instrument. The main problem with choosing real exports as an instrument is that they have not been the primary mechanism of foreign trade adjustment in most real world planned economies in recent years.

Real imports have borne the burden of adjustment in these economies, for two reasons. First, it is probably easier for the authorities to decree that real imports be reduced than to induce or direct that domestic enterprises increase the quantity of ex-portables to be supplied abroad, particularly in the context of domestic macroeconomic policies that continue to accommodate internal excess demand pressures. Second, whereas most CPEs appear at first glance to satisfy the requirements of Portes’s stylized small country assumption, in reality their foreign trade positions are somewhat more complex. In trade with other CPEs, undertaken largely on the basis of bilateral negotiations, these economies are typically not price takers. In exports to the convertible currency area (exports outside the CMEA), CPEs frequently have market access problems and have encountered increased de facto quantitative restrictions in recent years. Consequently the expansion of real exports, without significant further deterioration in their terms of trade, has been very difficult for most of the planned economies.

It would also appear that Portes’s choice of real exports rather than real imports as a policy instrument was strongly influenced by his assumption that, whereas output in his model clearly depends on the level of (intermediate) imports, changes in output tend to drive foreign trade decisions (not vice versa), and therefore the authorities would not use imports as a balancing item. Although this approach has some appeal as a description of the authorities’ view of foreign trade in the past (exports as a “necessary evil” to pay for imports), it would seem less apt today and appears to be contradicted by the actual experience of some planned economies.²²

The other main policy instrument in the Portes model is the real wage. As discussed, however, the real wage is less a policy instrument than an intermediate target. On the one hand, the average nominal wage is determined by enterprises that may have considerable leeway in practice in manipulating wages within the framework of a complex system of wage regulation. On the other hand, by decreeing changes in turnover taxes the authorities may directly manipulate retail prices, but in practice this manipulation is only done after careful and usually lengthy weighing of the income-distributional consequences of changes in nominal and relative prices. (Clearly, many of the distributional aspects of stabilization programs in market-oriented developing countries, as discussed by Johnson and Salop (1980), apply as well to planned economies; indeed, policymakers in the latter have tended to show great concern about the distributional implications of virtually every economic policy.)

It might be contended, however, that the authorities have greater control over the average money wage than suggested above. Undoubtedly the extent of control varies among CPEs and over time for a given planned economy. Furthermore, one could choose to see the designation of the real wage as a policy “instrument” not in the narrow sense but as a proximate instrument in the way that the money supply (rather than, say, open market operations per se) is seen as the instrument of monetary policy in a developed market economy.

Even if one were to accept, for the sake of argument, that the real wage is a policy instrument in a CPE, there still are problems in making the real wage one of the cornerstones of a framework of internal-external balance. This difficulty resides in the historical experience that the real wage does not appear to have been used in an active way as a short- and medium-term balancing tool in CPEs, particularly for instances of excess demand for consumption goods. Only recently (and mainly in MPEs) have authorities actively used increases in administered retail prices as a balancing instrument. Instances of using reductions in the average money wage to eliminate pressures of excess household demand would be even more difficult to detect. This is not to deny, however, that in a growth context a slowing of the rate of growth of nominal wages might not have been undertaken to reduce the increase and even the level of excess demand pressures.

Aside from directly reducing the demand for consumption goods, a reduction in the real wage in Portes’s model also may lead (if the partial derivative has a negative sign) to an increased quantity of labor supplied, with a corresponding positive impact on output and the quantity of consumer goods supplied. Although this effect would tend to reinforce the power of the real wage as a stabilization instrument, it would probably be of rather negligible importance in the short term and possibly even in the long run.²³

Several of the planned economies that have recently pursued more active wage and price policies have in practice combined consumer price increases with roughly offsetting increases in money wage rates. Although the roughly proportional increases in wages and prices had little effect on the real wage, the price increases alone reduced the real value of money balances and other wealth holdings.²⁴ In Portes’s own model, such a reduction in real balances leads to both a fall in household demand for consumption goods and an increase in labor supplied, as households presumably seek to rebuild their real wealth. The burden such a policy places on those with relatively large wealth holdings may make it even more attractive from the standpoint of policymakers who must worry about distributional consequences.²⁵ Such a policy has enabled the authorities simultaneously to achieve some diminution in excess demand, possibly to reduce some distortions in the relative price structure, and to avoid some of the negative political consequences of a decline in the real wage. As a practical matter, then, real money balances rather than the real wage might be seen by authorities in CPEs as an important intermediate target of their wage and price policies.

Finally, Portes’s model tends to ignore changes in real output of consumption goods as an important means to alleviate excess demand in that market. Output of consumer goods is no more of an instrument than is the real wage, but clearly it is a target that can be strongly influenced by the planners. In Portes’s model a diversion of output from “government” to consumers would involve a shift in his CC (or internal balance) curve. He does not rule out such a shift, but by relegating this policy instrument to third-variable, or “shift,” status Portes leaves the impression that such a policy response is less likely than either a change in real exports or in the real wage. The impression is further created that investment will tend to be as planned and that developments in the investment sector may not be a major source of disequilibrium. Indeed, rather than viewing the relation between governmental planners and the enterprises as a potentially significant source of disequilibrium, Portes, as noted earlier, lumps the two together and portrays disequilibrium as emerging from the interaction between “socialist central planners” and households “in the process of plan construction and implementation” (Portes (1979, p. 326)).

This implied dominance in Portes’s model of price (the real wage) over quantity adjustments, in societies that historically have made retail price rigidity and downward stickiness in money wages virtually an article of faith, seems a bit incongruous to many students of the “classical” planned economies. Portes and his collaborators have, however, focused in more recent empirical work on the supply of consumption goods as an important equilibrating variable to be manipulated by planners in the CPE (Portes and others (1983)).

To examine briefly some basic implications of the particular systemic and policy characteristics of CPEs for stabilization programs, equation (2) may be rewritten in a more conventional form:

\begin{matrix} Δ R = Δ M - Δ D . & (8) \end{matrix}

This “monetary” identity of the balance of payments indicates that for any economy the change in net international reserves equals the ex post change in the domestic money supply minus the increase in domestic credit (ΔD) extended by the banking system.

In the simplest models of stabilization programs it is typically assumed that in the market economy the change in money balances will equal the flow demand (ΔM = ΔM*); that the latter is a stable function of the excess stock demand for money (see equation (5)); and that the stock demand for money is a stable function of such variables as real income, the price level, interest rates, and (possibly) the expected rate of inflation. Given projections for these variables, which of course are actually not independent of the stabilization policies followed by the government, one can estimate the increase in money holdings that will take place in a given period. Having in this way “exogenously” determined ΔM, and with a targeted floor for the change in net international reserves ΔR, it would remain for one only to solve for the required ceiling on domestic credit (ΔD).²⁶

Equation (2) for the CPE may also be rearranged in the same form as equation (8):

\begin{matrix} Δ R = Δ M_{h} - Δ D^{"} . & (9) \end{matrix}

Here ΔR and ΔM_h are as defined earlier, and ΔD” refers to the change in net domestic credit extended to government and enterprises (ΔNDC_g + ΔNDC_e) plus the change in gross credit extended to households (ΔDC_h). Using equation (7), substituting for ΔM_k in equation (9) yields

\begin{matrix} Δ R = Δ M_{h}^{*} + (C^{d} - C) - Δ D^{"}, & (9 a) \end{matrix}

where, as before, ΔM*_h is the flow household demand for money, C^d is the aggregate demand for consumption goods, and C represents actual consumption.

Whereas actual consumption may be fairly accurately measured, at least for retail sales in the socialized sector, both the demand for money and the demand for consumption goods can only be estimated. Whether ΔM*_h and C^d are stable functions of some set of macroeconomic variables in CPEs remains to be seen. Portes and Winter (1978, 1980) have estimated such functions for four planned economies, using both equilibrium and disequilibrium models. It is not clear, however, that they have estimated identified demand functions. Moreover, a major implication of their results, that chronic excess demand is not a feature of consumption-goods markets in these economies, has, as noted, been given a quite skeptical reception among many other close observers of planned economies. Clearly further modeling and econometric work is necessary in this area.

The main implication of equation (9a) is that credit ceilings alone may not be an adequate means to achieve both internal and external balance in a CPE. This inadequacy is partly because the household money demand and consumption functions may not be easily estimated. Even if this difficulty of estimation were not a problem, there is no assurance that the market for consumption goods will be in unconstrained equilibrium.²⁷ By the same token, merely setting a floor on the balance of payments would not ensure equilibrium in the market for consumption goods.

As noted in Section I, such monetary identities also present a disarmingly simple picture of macroeconomic adjustment. In the foreign trade sector, for example, authorities are forced to make numerous decisions about the relative importance of various importables and the relative salability of and domestic demand for exportables. The foreign trade system is usually not designed to permit trade flows to respond to changes in relative prices, and domestic price levels tend also to be insulated from foreign prices. Where, however, foreign trade organizations are given the incentive to respond to changes in valuta foreign trade prices induced by exchange rate changes, there could be scope for the exchange rate to be effective in stabilization programs in CPEs. Equation (1) also reminds us of the complex wage, price, employment, tax, transfer, and output decisions that must be made to achieve some targeted change in the household money supply. In the stylized market economy with stable money demand, the imposition of a credit ceiling will in theory also set in motion a multitude of such decisions, but within an essentially decentralized framework. Given the microeconomic complexity implicit in the task of macroeconomic adjustment, one wonders whether the stabilization programs initiated by virtually all CPEs in recent years will actually provide a new impetus to economic reform.

IV. The Modified Planned Economy

An MPE may be characterized by the following changes in the classical system. First, detailed plans regarding enterprise inputs and outputs are no longer developed in close consultation with the central authorities. Whereas detailed central planning may still characterize many infrastructural activities (energy, transport, and the like), enterprises in the rest of industry (and possibly in agriculture, too) are encouraged to develop their own plans and even to move away from plan fulfillment as the major evaluative criterion. Indeed, a second important characteristic of the MPE is that enterprise profitability is meant to supplant plan fulfillment in this function. The pre-eminence of profitability as a maximand is significantly tempered, however, by the recognition on the part of enterprise managers that the firm’s workers and local and higher authorities remain important “constituents.” Higher profits may therefore have to be balanced against the need to ensure satisfactory increases in average wages and job security and the need to retain the confidence of the branch ministry and local authorities that the firm’s investment plans and activities are consonant with the broader goals of the leadership.

A third feature of the MPE, and one that is integrally related to the first two, is the encouragement given to significantly increased horizontal bargaining among enterprises and to the market as an allocator of resources. Thus the “comprehensive” nature of the reforms characterizing the MPE is evident in the recognition by the reformers that the profitability criterion, increased enterprise initiative, and increased scope for market forces are inextricably related. In practice, however, this emphasis on market relationships and horizontal bargaining is weakened by the heavy residue of mutually supportive hierarchical relationships and by the unwillingness of the government and the party to give up their ability to determine the main directions of the economy.

Fourth, the system of wage regulation is modified so as to give the enterprises much greater leeway in determining the distribution and growth of wages among their employees. Instead of the enterprise’s wage bill being assigned from the center as a function of planned increases in employment, labor productivity, and plan overfulfillment (the “direct” system)—or possibly as a function of the increase over the previous year in the degree of fulfillment of a particular evaluative indicator (the “mixed” system)—the enterprise now determines its own wage bill, average wage, or both. This determination, of course, is subject to various centrally determined parameters, including tax rates related to the size or increase of the wage bill (the “indirect” system). A similar degree of decentralization also applies to the determination of bonuses for workers and managers. Although central regulation of wages remains, it is now more parametric in character.²⁸

The reduced scope for governmental price controls is an important fifth characteristic of the MPE, and an obvious corollary to the intention to expand the allocative role of the market. Greater price flexibility is permitted for a number of producer and consumer goods, although enterprises typically are limited in the frequency and the amount by which they can change even the “flexible” prices. These restrictions (imposed in part to limit speculation in general and to restrain, in particular, price increases by the domestic monopolies inherited from the CPE), as well as maintenance of fixed prices on many other goods, mean that serious price distortions will persist.

The intention to reduce and, indeed, virtually to eliminate price distortions gradually, however, also leads to a sixth key feature of the MPE—encouragement of more direct, export-oriented linkages between domestic production enterprises and foreign markets, and the development of organic linkages between domestic and foreign currency prices for a wide range of products.

Seventh, bank credits and enterprise self-financing are meant to become much more important in the financing of investment in the MPE. Moreover, banks are instructed to use the interest rate as a much more significant credit-rationing device than in the classical planned economy. Finally, there may be some movement toward ending the dichotomy of the enterprise and household money markets.

There are other distinctive features of the MPE, such as increased “privatization” of economic activity (particularly in the handicraft and service sectors), but these will not be considered here. Rather, the intention is to consider briefly the effect that the major systemic modifications noted above may have on the attainment of internal and external macroeconomic balance in the planned economy.

A significant difference between the CPE and the MPE is the greater scope for and variety of sources of price changes in the latter. The planner’s interest in stability of producers’ and retail prices for planning and control purposes is significantly reduced in the MPE with the general elimination of detailed central planning. At the same time, as mentioned, the market is permitted a much larger role for price determination as part of the general design to encourage more decentralized decision making and more efficient allocation of resources.

In the MPE prices may now change as the result of administered modifications of prices designed to reflect increased producers’ costs or to ameliorate some of the more egregious cases of consumers’ excess demand for fixed-price goods. In the case of products with “flexible” prices, these may change without direct intervention because of changing domestic cost conditions, shifts in domestic demand, a modification of the official exchange rate, or changes in world market prices.

Through the indirect, parametric system of wage regulation, the authorities can still strongly affect movements in wages. The authorities are not always able to predict the reactions of enterprises to changes in the “levers” of wage regulation, however, and it would seem erroneous to attribute to the authorities complete control over nominal wages (Adam (1980) and Marrese (1981a)). Nevertheless, their influence is considerable, and it can now be executed more generally and simply through changes in such parameters as permissible maximum increases in the average wage and the progressive rates of taxation levied on enterprises’ wage bills.

This presumed greater flexibility for the authorities with respect to wage regulation and a lessened reluctance frequently to change administered prices and the exchange rate may make the real wage a more malleable intermediate target for the MPE planner than for his CPE counterpart. Although the real wage thus becomes in principle more malleable, it may also become less controllable and more variable, particularly as a result of permitted unadministered price changes.

An important problem for the MPE planner in wage regulation, as well as in other areas of the economy, is the trade-off between efficiency on the one hand and price stability and equity on the other. One of the purposes of the less direct form of wage regulation is to encourage enterprises to use labor in the most productive way. Labor is viewed as a scarce resource, and wage and bonus differentials are used as an incentive device. Aggressive firms may have an interest in a rapid expansion of the average wage, widening worker income differentials, and possibly letting off certain workers. Each of these policies may be resisted by authorities concerned with relative price stability and particularly sensitive to unemployment and issues of income distribution.

Reduced governmental intervention, heightened enterprise autonomy, and increased emphasis on financial discipline within the “real” sector of the MPE raise at least the possibility that the monetary authorities of the MPE can pursue a more independent and active monetary policy than in the CPE. This may be seen by setting equal equations (1) and (2) and rearranging terms:

\begin{matrix} Δ N D C_{g} + Δ D C_{e} + Δ R = W N - P_{c} Q_{c} + T + Δ D_{e} . & (10) \end{matrix}

In the classical CPE, decisions by the planners and enterprises relating to the “real” and fiscal variables on the right-hand side of equation (10) will frequently drive “accommodating” adjustments of the banking system’s asset accounts on the left-hand side of the equation. In the MPE, however, enterprises are granted greater autonomy over the right-hand-side variables (wages, employment, prices, and output) and may be subjected to greater financial discipline. Money holdings of enterprises will therefore also be determined to a greater extent by the enterprises themselves. If the monetary officials of the MPE were given the authority and instruments to set effective upper limits on changes in the banking system’s assets, these changes, reflected on the left-hand side of equation (10), might then drive the fiscal and real adjustments of government and enterprises that appear on the right-hand side of the equation.

As noted earlier, the fairly strict dichotomy between the two types of money in the CPE may be relaxed somewhat in the MPE. Heretofore, however, such relaxation has been minor. Enterprise money and household money are still created in essentially the same way as in the CPE, and households are in effect still kept from lending to enterprises directly or through intermediaries. Granting the banking system a more direct intermediation function and permitting its borrowing and lending rates to be determined by the market might, in an MPE, help to ease the problem of frequent (if not chronic) excess demand in the consumption-goods market. Without essential freedom of both interest rates and the prices of consumer goods, however, it is difficult to see how household consumption and savings preferences and enterprise profitability calculations could in effect be brought together so as to yield equilibrium in both the consumption- and investment-goods markets.²⁹

Given the policy goals inherited from the CPE, it is not difficult to understand why the basic dichotomy of the money supply is maintained. Providing for intermediation between households and enterprises through the banking system, at market-clearing interest rates, would significantly lessen the authorities’ control over the basic “proportions” of the economy. Furthermore, the development of a private capital market would effectively widen income differentials, as “unearned income” from the ownership of financial assets assumed greater importance. Moreover, allowing the banking system to relend accumulating household deposits to enterprises might only fuel pressures of excess demand in the economy if market-clearing prices and interest rates were not also in general permitted.

With enterprises in the MPE expected and free to respond within limits to market forces, foreign trade with the convertible currency area will no longer be under the firm control of the authorities.³⁰ In theory there is now no way the planners can force enterprises to export (import) certain bundles of goods to (from) convertible currency markets. Clearly, however, both exports and imports may be limited by the authorities by means of specific quantitative restrictions or, in the case of imports, by exchange controls. To the extent that such quantitative restrictions are eschewed, the authorities of the MPE are then effectively limited to the same mix of subsidies and taxes that governments of market economies may use to influence foreign trade.

One aim of economic reform in MPEs may be to eliminate or at least to minimize quantitative controls on convertible currency trade. Persistence of direct price controls and attendant distortions between domestic and foreign currency prices of tradables, however, will provide innumerable opportunities for arbitrage that could yield a net resource loss for the economy (Holzman (1966) and Wolf (1980b)). As long as price controls are pervasive, it is difficult to see how quantitative controls—whether on trade, on payments, or on both—can be eliminated. Continued expansion of the scope for flexible pricing of tradables, however, would reduce the need for such controls.

Assuming that the authorities permit relatively free trade (for enterprises), the official exchange rate now assumes more than just the accounting function it tends to have in the CPE. With some domestic prices now being “linked” through the exchange rate to foreign currency prices of tradables, changes in foreign currency prices or in the exchange rate itself can now affect the domestic price level. This gives the exchange rate a potential effect on the real wage and on real wealth that was not possible in the “classical” planned economy. By the same token, changes in the exchange rate may affect domestic relative prices, inducing potential substitution effects in both production and consumption not witnessed in the CPE (see Wolf (1978) for more detail). In general, the exchange rate becomes a potentially significant instrument for macroeconomic stabilization in the MPE, and in theory its use would somewhat relieve the stabilization burden placed on credit and fiscal policies, just as in a market economy.

Although the addition of another instrument to the authorities’ portfolio may at first sight be welcomed, an exchange rate that directly links many domestic and foreign prices, in an economy in which planners and managers retain many of the habits developed in the CPE and in which significant price controls persist, could introduce elements of complexity. The foreign trade sector now becomes a much more significant source of uncertainty for the authorities. Given the quasi-market nature of the economy, enterprises’ responses to changes in world market prices or in the exchange rate will not be fully predictable. The exchange rate, unless revalued in line with the world inflation rate, now also becomes a direct transmission vehicle for imported inflation. Furthermore, given the domestic price distortions and continued price equalization on some tradables, under certain conditions changes in the exchange rate and external terms of trade could have undesired effects on the trade balance denominated in foreign currency.³¹

It is therefore not surprising that, although organic linkage between domestic and world market prices is often cited as a hallmark of the MPE, such linkage may be exceptional or only indirect. Despite the popular impression, the linkage between foreign and domestic prices was rather indirect in Hungary under both the “prime cost” system of the 1970s and (although to a lesser degree) the initial stage of the “competitive” price system introduced in 1980. Reasons for this tenuous linkage included the authorities’ fear of imported inflation and their interest in maintaining certain distortions in the structure of domestic relative prices. The effect of official exchange rate changes on the domestic price level and the structure of domestic relative prices, the main channels by which changes in the exchange rate may affect the trade balance in the short and medium run, was therefore muted. Recent changes in the “competitive” price system in Hungary, however, provide for improved linkage of foreign and domestic prices.

Even when a significant linkage of tradable prices is achieved, the sensitivity of enterprises to price changes is still open to question. Among the reasons cited for relative price insensitivity (and therefore, for low trade elasticities) are enterprise incentive systems that encourage only monotonically increasing profits (Tardos (1980)); the sanctity of individual job security and the unwillingness of authorities to allow firms to go bankrupt (the “soft” budget constraint of Kornai (1980)); obligatory deliveries to CPE trade partners under long-term, bilaterally negotiated trade protocols; and informal pressures on enterprises from the authorities regarding the provision of adequate supplies of various products to domestic markets at artificially low prices (Kornai (1982a)). In sum, the extent of effective price linkage and constraints on enterprise price sensitivity will be critical determinants of the response of the trade balance to changes in the real exchange rate.

The supply of and demand for foreign exchange in the MPE will be directly affected by conditions in the market for producers’ goods and, to some extent, by conditions in the market for consumption goods. These demands and supplies will also be affected in general by the exchange rate. Reformers in MPEs typically have argued that the exchange rate should be a uniform one (applying to both commercial and noncommercial transactions), and that it should essentially be a “marginal” rate based on estimates of the full real costs of import substitutes and exportables (see Trzeciakowski (1978)). In practice, however, a lower exchange rate that is closer to the average domestic cost of earning foreign exchange has been selected by the authorities. There are several reasons for this choice, including the habitual aversion to marginalism inherited from the CPE context, the desire to avoid domestic inflation, and the reluctance to reward intramarginal firms with abnormally high profits on foreign trade. Selection of the below-marginal rate means that, in the absence of government intervention, a trade deficit in foreign currency terms is virtually certain.³² The existence of significant price distortions also reduces the value of the exchange rate as an equilibrating device, as noted earlier. Despite the intentions of many reformers, therefore, significant government intervention in trade persists in MPEs, although it is now typified by production or export subsidies for high-cost exportables and various subsidies and quantitative restrictions on the import side.

Because of possibly limited enterprise sensitivity to price changes, the income and real balance effects of a devaluation may dominate the substitution effects induced by the change in relative prices. Whereas the rising price level may reduce excess domestic demand pressure, relatively low substitutability in both consumption and production among exportables, importables, and nontradables may mean a somewhat delayed expansion of exports. In this way MPEs may be similar to many developing countries (Crockett (1981)), although the difficulty that enterprises have in letting go workers in MPEs suggests that their slackened demand might be reflected in increases in (or reduced depletion of) inventories, rather than in rising unemployment.

The usual perception is that excess demand on the market for consumption goods will be less endemic in the MPE than in the classical planned economy (see, for example, Adam (1980)). This may be so, but it may be due less to systemic differences than to the policy choice to give consumption a higher priority in such economies. Nevertheless, the possibly more malleable system of wage regulation and the variety of mechanisms for price flexibility in the MPE do give the authorities a somewhat greater potential for making short- and medium-term price adjustments to correct perceived imbalances in the household sector. Relatively “automatic” price increases for flexibly priced goods will also tend to reduce pressures of excess demand. Direct intervention with respect to the supply of consumption goods is less probable in the MPE than in the CPE, although it is by no means unknown.³³

Although in principle the profit criterion has greater importance in the MPE than in the CPE, many economists argue that the problem of the “soft” budget constraint has not been eliminated. In practice, it is argued, enterprise managers perceive that profit maximizaton is not expected of them, and that they still exist in an economy of chronic shortage. They continue to devote significant time to vertical bargaining with the higher authorities to obtain special subsidies and tax relief, which permit their enterprises to remain “profitable” while at the same time allowing them to acquire the additional resources (Kornai (1980) and Hare (1982)). Some argue that the “excess enterprise demand” theory of investment cycles (see the second subsection under “The Investment Cycle” in Section II) is equally applicable to MPEs, in which the habitual behavior learned under classical planning dominates and where the higher authorities are not strong enough to impose “hard” budget constraints on the enterprises (see Bauer (1978), Kornai (1982b), and Winiecki (1982)).

Emergent disequilibria in the MPE will in general be reflected in greater short-run price and wage flexibility than in the classical planned economy. Given the likely persistence of significant price distortions (combined with greater enterprise autonomy than in the CPE), however, the possibilities of “perverse” enterprise responses (from the standpoint of the national economy as a whole) may be heightened. Economic authorities and even some reformers in the MPE may underestimate the motivation and ability of managers operating in a more decentralized environment to use the system efficiently to their own advantage. Hence the importance of “correct” financial parameters, while frequently espoused, may not always be fully appreciated.

The instruments by which the authorities will attempt to move the MPE back toward internal and external balance will differ in nature from those used in the CPE. Parametric approaches are now possible, but, given the less direct nature and possibly ambiguous effects of such approaches in the quasi-market environment of the MPE, the authorities may be tempted (at least temporarily) to revert to the more direct and interventionist, quantity-oriented instruments characterizing the CPE.

Formal modeling of internal-external balance in the MPE is challenging if not intractable: in an MPE one can assume increased profit orientation (but not necessarily a tendency toward profit maximization); some (but by no means complete) price flexibility; effectively joint wage regulation by the center and the enterprises; and so on. The dilemma in modeling is that the institutional reality of the MPE may be too complex to model effectively; but if one abstracts from these institutional complexities, the resultant analytical model will tend to look very much like that of a standard market economy with some price distortions (and the like) and therefore will not be very insightful regarding the reality of the MPE.

V. Summary and Conclusions

This paper has sought to contribute to the analytical framework within which macroeconomic disequilibrium and stabilization programs in planned economies might be better understood. Two types of stylized planned economies have been considered: a “classical” centrally planned economy (CPE), in which the basic institutions and practices of central planning are initially established; and a “modified” planned economy (MPE), which has evolved out of the CPE. Rather than elaborate formal macro-economic models of these economies, the discussion has concentrated on analyzing the relatively distinctive ways in which macro-economic disequilibrium may be generated, transformed, and finally brought under control in the context of classical and modified central planning.

The classical planned economy discussed here is a stylized version of the economic system of all the European members of the CMEA in the 1950s and probably is an appropriate characterization, in fundamental outline, of the majority of these economies today. The basic macroeconomic relations distinctive to the CPE were analyzed in some detail in Sections I and II. Most pertinent, for analytical purposes, are the following characteristics of the CPE’s macroeconomy.

First, foreign trade and the balance of payments are controlled by the planners through a system of direct controls. Second, liquidity holdings of households and enterprises are fairly rigidly segregated and dichotomized, in that there is virtually no lending or financial intermediation between the two sectors. Third, whereas enterprise liquidity can be directly controlled by the authorities, changes in household money balances are determined by wage rates, employment levels, the quantity of consumption goods supplied by the enterprises, administered retail prices, net budgetary transfers to households, and new credits made available by the banking system. Central control over average wages, employment, and the quantity of consumption goods is at best indirect and incomplete.

Fourth, long-standing socioeconomic policies of the CPE, as well as the nature of the centralized planning system, bias policymakers toward quantity rather than price adjustments to dis-equilibrating supply-side or demand-side disturbances, at least in the short and medium run. These shorter-run quantity adjustments are likely to be focused on the consumption-goods market and to be reflected, under propitious foreign credit conditions, in a deterioration of the balance of payments. Adjustment is focused on these sectors in part because the priorities of the planners and the relative bargaining strength of the enterprises and their immediate supervisory organs lead the higher authorities to “accommodate” the buffering of investment spending from the disturbance. Moreover, policies ensuring the downward inflexibility of the money wage, job security, and retail price stability—combined with the center’s difficulty in rapidly making the necessary changes in wages, employment, and prices—place the burden of adjustment on the supply of consumption goods.

Fifth, it is believed by many that the main source of demand-side disturbances in contemporary CPEs (and MPEs) is not excessive wage growth per se but investment cycles that develop from a fundamental excess demand on the part of enterprises for investment and current inputs in an environment of perceived chronic shortage.

In this context, the eventual re-establishment of internal and external balance by the CPE authorities, once disequilibrium has developed, will inevitably require downward quantity adjustments in the market for producer goods, possibly combined with wage and price adjustments in the household sector designed to reduce the real wage, the real money balances of households, or both. The extent to which derivative excess demand on the market for consumption goods is characteristic of the CPE, and the degree to which adjustment to excess demand when it does occur is made by quantity versus price adjustments, remains a subject of dispute among analysts of the classical planned economies. As discussed in Section III, the possibility that excess household liquidity may arise quite frequently in the classical planned economy suggests that policies for economic stabilization may have to proceed on a somewhat different basis for the CPE. Specifically, a ceiling on net domestic credit creation cannot necessarily be relied upon to generate simultaneously some minimum improvement in the balance of payments and unconstrained equilibrium in the household sector. Because of the general absence of direct linkage between foreign currency prices and domestic prices, as well as the predominance of the quantity plan in foreign trade, the official exchange rate will usually not play an important stabilization role in the CPE.

The MPE is examined somewhat more briefly in Section IV. The MPE is a stylized version of an economy that has experienced reform of many of the basic institutions of the classical planned economy. Among the most important distinguishing characteristics of the MPE are: (1) the elimination of detailed central planning in most sectors of the economy, (2) a general upgrading of profitability as an evaluative criterion for enterprises, (3) an expanded scope for market forces and increased price flexibility, (4) the establishment of many direct links between foreign markets and domestic prices, and (5) the change from direct to more parametric forms of wage regulation. Many institutions of the CPE are left intact, however, and many of the patterns of enterprise behavior developed under years of classical central planning survive in the MPE. It is argued here that macroeconomic problems and stabilization programs in MPEs can satisfactorily be understood and monitored only if the specific policy and systemic antecedents of these economies in the classical planned economy are clearly understood.

Given the new linkage to foreign trade prices in the MPE, the exchange rate now takes on a potentially significant function that is absent in the CPE. In practice, however, patterns of informal intervention and continued subsidization from the center, together with the maintenance of price controls on a wide range of products, may reduce the effectiveness of the exchange rate as a stabilization instrument and, in some cases, may even lead to devaluation having adverse effects on the trade balance.

The expanded role for price flexibility and the shift to more indirect forms of wage regulation would seem to enhance the ability of authorities in the MPE to respond rapidly to disturbances with changes in the real wage. Because of the increased scope for enterprise-initiated price changes and sometimes unpredictable enterprise responses to changes in the parameters of wage regulation, however, the real wage as an intermediate target could conceivably become even more difficult to fine-tune in the MPE than in the classical planned economy.

The basic dichotomy of the money supply may not be eliminated in the MPE; nor, according to many analysts, is the endemic excess demand thought to be so characteristic of the enterprise sector in the CPEs. Investment cycles and at least periods of induced excess demand on the consumption-goods market may therefore continue to be problems in the MPE, although possibly on a reduced scale.

Few of the assertions made in this paper have yet been backed up with rigorous empirical evidence. There are clearly a number of areas in which more intensive research—of an institutional, analytical, and empirical nature—needs to be done. Several of the more important areas will be briefly mentioned.

Clearly a stabilization program for a CPE or an MPE can only ensure equilibrium on the consumption-goods market if the growth target for the household money supply is set realistically. Such targeting requires a much better understanding than we have now of the money stock demand function and the flow adjustment function for households in the planned economies. Related to this issue are the need to examine more rigorously the variety of responses by households to excessive accumulation of liquidity and the need to develop improved methods for effectively distinguishing between macro-level and micro-level disequilibrium in the consumption-goods market. These issues are discussed in Section II (under “Disequilibrium in the Market for Consumption Goods”). Despite considerable empirical work in recent years, the debate over the existence of chronic excess demand in the market for consumer goods continues unabated.

Another area of debate is the source of inflationary disturbances in the classical planned economies and the MPEs. As discussed in Section II (under “The Investment Cycle”), economists in the planned economies themselves have increasingly been stressing so-called investment cycles as an explanation for periodic disequilibrium. These theories have not as yet been subjected to rigorous empirical testing (with the exception of the econometric study by Marrese (1981b)). As with attempts to measure disequilibrium in the household sector, part of the problem in this area arises from the lack of adequate data, but there is also a need for more rigorous conceptualization of the processes by which imbalances are actually generated.

Inadequate wage regulation per se is sometimes cited as an important source of excess demand pressure in the market for consumption goods. Although there is a rapidly growing literature on the wage regulation process in several planned economies, it is difficult to assess with any precision the effect that moving to more parametric systems of wage control may have on the authorities’ ability to control and to manipulate wages. This is an area that requires a great deal more analytical work to supplement the often quite detailed descriptive studies now available.

It would also be useful to refine our understanding of the various indicators of disequilibrium in both classical planned economies and MPEs (see Allen (1982) for a list of such indicators) and to explore the potential for quantification of such indicators with a view to their possible incorporation in more formal models of the stabilization process.

The role of exchange rates in MPEs has received some attention in recent years, but most of the literature is either mainly descriptive or overly stylized. There is clearly a need for additional analytical work that would explore the diversity of exchange rate systems among the planned economies and the effects on macro-economic stabilization and structural adjustment that exchange rate policy may have in the different systems. There now exists a history of more or less “active” exchange rate policies in Hungary (and to some extent in Poland) in the 1970s and early 1980s that might provide the basis for empirical work in this area.

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Mr. Wolf, economist in the Developing Country Studies Division of the Research Department, is a graduate of Amherst College, Columbia University, and New York University. An earlier version of this paper was written in 1983-84 while he was Associate Professor of Economics at The Ohio State University and a consultant to the Research Department of the Fund.

Those countries are Bulgaria, Czechoslovakia, the German Democratic Republic, Hungary, Poland, Romania, and the Union of Soviet Socialist Republics.

So-called enterprise reserve funds are considered here, for simplicity, as a form of enterprise “deposit.”

Credits from the monobank to enterprises need not be limited by the value of household savings deposits. Rather, the latter are more a function of the former. Moreover, because the interest rate on savings deposits tends to be quite nominal, the increase in deposits does not necessarily imply the elimination of excess household liquidity.

This control over enterprise liquidity would appear to be less stringent in MPEs. See Section IV.

Of course, this assumption may be unwarranted for many market economies as well.

The change in net domestic assets, as conventionally defined, would equal ΔNDC_g plus (ΔDC_e+ΔDC_h), where ΔDC_e denotes the change in gross credit to enterprises.

For simplicity, actual net transfers to households are also assumed to be equal to their planned value.

Important discussions of the investment process and cycles in planned economies include Bauer (1978), Goldman and Kouba (1969), Kornai (1982b), Tyson (1983), and Winiecki (1982).

Chung (1976) illustrates overfull employment planning by an (imagined) outward shift in the production possibilities frontier.

For significantly more detailed presentations of such views, see Bauer (1978) and Kornai (1982b).

Wiles’s (1982) figures on investment growth were used for this tabulation. Kemme and Winiecki (1984) also note that changes in net material product (NMP) in the CPEs are statistically more highly correlated with concurrent than with lagged values of investment. This correlation raises questions of the efficiency of investment spending in these economies.

¹²See, for example, Kemme and Winiecki (1984). Muellbauer and Portes (1978) suggest that the demand for money function is quite different in a disequilibrium setting.

To define excess demand as the difference between notional consumption and either actual output of consumption goods or actual output minus the actual change in inventories would mean, respectively, that either any increase (decrease) in inventories, whether planned or not, would be considered as an increase in excess supply (demand), or that excess supply would be impossible because output less inventory accumulation could never be greater than notional consumption.

This expression is consistent with the observation of Portes and Winter (1980) that, in the event of disequilibrium on one or more markets for consumer goods, aggregate actual consumption will always be less than either aggregate demand or aggregate supply unless either all of such markets are in conditions of excess demand or all show excess supply.

Some preliminary work in this direction may be found, however, in Howard (1979), Portes and Winter (1980), and Kohn (1981).

See, for example, Barro and Grossman (1976), Howard (1976), Portes (1979), and Brada (1982).

Howard (1979) has shown that, with prices and income held constant, a decrease in the ration of a good in excess demand will lead to an increase in quantity demanded of “unconstrained” substitutes, including other commodities, leisure, and money.

For a useful classification of second-economy markets in a CPE, see Kat-senelinboigen (1977).

Hartwig (1983) emphasizes the effect that black market activities could have on the household demand for money. Laski (1982) suggests that the demand for money is influenced as well by the perceived probability of households’ being able to purchase scarce goods in the future at official outlets at administered prices, and by consumers’ rates of time preference.

The most ambitious attempt to date to deal with disequilibrium in consumption-goods markets in a choice-theoretic framework is Howard (1979). Black market activities per se, however, are not included in Howard’s model.

For examples of models in which excess household demand for consumer goods is essentially assumed, see Howard (1976) and Brada (1982).

See, for example, the discussion of the Hungarian experience in Hewett (1983).

Also see Holzman (1980) for criticisms of Portes’s choice of policy instruments. In an empirical study of the Soviet Union, Howard (1976) found that the labor supply response to assumed excess demand for consumption goods was minor relative to the measured spillover effects in the collective farm market and the buildup in household liquidity.

Equiproportionate increases in the average money wage and the retail price level need not reduce real household money balances. Much depends on what happens to net government transfers and credit extensions to households. In the simplest case, if wages, the price level, net transfers, and new credits all increase by the same proportion, real household money balances will decrease if the percentage increase in the above variables is greater than the rate of growth of nominal household money in the previous period.

This focus on real balances, rather than on the real wage, as the intermediate target is noted by Brada (1982).

The real world is of course more complex than the simple monetary model would suggest. Several of the assumed “exogenous” variables are indeed endogenous, and some behavioral relationships that are typically assumed may be at least seemingly contradictory.

In the event that credit ceilings are based on reliable estimates of money demand, it is possible that the balance of payments target, and therefore the targeted increase in household liquidity, might still be exceeded because of diversion of resources from the consumption-goods market to the foreign sector.

See Adam (1980). Marrese (1981a) discusses in some detail the Hungarian system of wage regulation in the 1970s.

Tardos (1984) gives an insightful discussion 6f the obstacles to fuller integration of markets in the Hungarian context.

To the extent that a high percentage of trade with other planned economies continues to be undertaken according to bilateral trade agreements, however, this portion of the MPE’s foreign trade may be said to still fall more or less under the control of the central authorities.

Wolf (1978), for example, shows in a two-good model that a devaluation designed to improve the trade balance in convertible currency could, if the domestic price of the exportable were linked to the exchange rate but the domestic price of the importable were fixed, have a positive effect on the domestic currency balance of trade (B₁,) but actually could cause a deterioration in the balance in foreign currency. Also see Wolf (1980b).

Marer (1981) and Böhm (1983) discuss the Hungarian and Polish cases, respectively.

Kornai (1982a) emphasizes the continuing importance of “quantity signals” given by the authorities to enterprises in the MPE.

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IMF Staff papers: Volume 32 No. 1

Author: International Monetary Fund. Research Dept.

Volume/Issue:: Volume 1985: Issue 001

Publisher:: International Monetary Fund

ISBN:: 9781451956696

ISSN:: 1020-7635

Pages:: 195

DOI:: https://doi.org/10.5089/9781451956696.024

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The “Investment Cycle” in Planned Economies

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Disequilibrium on the Consumption-Goods Market in Planned Economies

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Abstract

I. Distinctive Features of the Centrally Planned Economy

The Money Supply

The Foreign Trade Sector

II. Sources and Symptoms of Disequilibrium

Supply-Side Disturbances

The Investment Cycle

Overfull Employment Planning

Excess Enterprise Demand

Disequilibrium in the Market for Consumption Goods

III. Internal and External Balance

IV. The Modified Planned Economy

V. Summary and Conclusions

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