29. Why Economic Reforms Fail
in Soviet-Type Systems(1)
[This paper identifies] the membership and motives of groups having strong incentives to keep the
STEs [Soviet-type economies] inefficient and prevent successful (i.e., market-oriented) reforms. We
show how those groups operate, and analyze their effects on the economic performance of their
countries. First the incentives for these groups to prevent decentralized management in the state sector
are spelled out. Then, their incentives to prevent the expansion of the more efficient private sector are
outlined. Third, having identified who benefits from the status quo and why, the paper discusses when
and how market-oriented reforms are aborted, limited, or reversed by those who stand to gain from the
Who Gains from the Status Quo and Why
Disincentives to Decentralized Management in the State Sector
Most analyses of Soviet-style systems focus excessively upon the distribution of power and neglect the distribution of wealth across the ruling stratum. By contrast, in an incentives-oriented analysis the distribution of wealth becomes the focus of attention. Power and privilege are viewed as means to acquiring wealth, and the desire to acquire wealth motivates the actions of the ruling stratum.
This shift of analytical emphasis does not mean that power and its distribution do not matter. On the contrary, the rulers of a STE may regard control over the working population as satisfying their need for power, either as an end in itself or as a means to attaining some long-run goal, such as the creation of "true communism." It is important, however, to realize that the means by which wealth is distributed is crucially important in determining the attitudes of elements in the ruling stratum toward decentralizing, market-oriented reforms. Without considering this issue, it is difficult to explain why economic reformsbadly needed by the rulers themselves to correct flagging economic performancedid not materialize or, if they did, why they failed or at best brought about very little improvement in economic circumstances.
At this point, Douglass North's explanatory framework for the structure and enforcement of property
rights, as well as their changes over time, should be brought into the picture. Applying what North(2)
calls a predatory theory of the state to the Soviet-type state, two, sometimes conflicting, objectives of
such a state are identified:
(1) to provide a set of public goods and services designed to lower transaction costs and increase the efficiency upon which the growth of wealth is predicated... and
(2) to specify the fundamental rules of the property rights structure, i.e., the ownership structure in factor and product markets, in a way that maximizes the rent(3) flowing to the ruler and the ruling stratum. The fact that this structure is extremely muddled in STEs is irrelevant, since such a muddle, i.e., the dominance of non-exclusively owned resources in the state sector, actually facilitates the expropriation of rent.
The following hypotheses now arise from these considerations:
(i) In STEs the fundamental conflict described by North, i.e., the conflict between efficient property rights designed to lower transaction costs and increase wealth and inefficient property rights designed to maximize rent to the ruling stratum, is strongly in evidence; and
(ii) in such states the nominal ruler will avoid offending powerful groups in the ruling stratum, i.e.,
the apparatchiks and economic bureaucrats, who benefit most from the institutional and
economic status quo.
In STEs the rulers agree to maintain a property rights structure favorable to those groups, regardless of the effect upon efficiency. In fact, modes of wealth distribution resulting from the STE structure of property rights differ so much from those in other pre-representative government states (i.e., traditional and "modern" autocracies), that institutional change leading to lower transaction costs and increased wealth is much more difficult to achieve. No STE, for example, has replicated the successful, efficiency-enhancing institutional changes of "authoritarian" South Korea or Taiwan.
In "old" autocracies the ruling stratum consists of either the traditional hierarchies or elites based on the military and the police. These appropriate to themselves a larger share of created wealth than they would obtain under a representative government. They get higher salaries and more "perks," while their status symbols (articles of conspicuous consumption or modern professional equipment) have a priority claim upon the state budget... [H]owever, the rulers of an STE preside over a ruling stratum consisting of these four pillars of the system: communist party apparatchiks, economic bureaucrats, the police, and the military. All may (and do) receive a larger share of the created wealth than is true in representative states. Their salaries may be relatively higher and their "perks" relatively more important in the STE shortage economy.(4) So far, the mode of wealth distribution appears to be the same as in "ordinary" autocracies.
In the STE, however, another mode of wealth distribution exists that maximizes the rent of two particular segments of the ruling stratum: party apparatchiks and members of the economic bureaucracy. This mode, unknown in other systems, enables these groups to benefit from their protracted interference in the process of wealth creation itself. There are two interconnected ways in which this is done.
The first is through the principle of nomenklatura, i.e., the right of the communist party apparatus,
from the central party committee down to the enterprise committee, to "recommend" and "approve"
appointments for all managerial positions in the economic (and public) administration and all
managerial positions in enterprises. These appointments are made primarily on the basis of loyalty
rather than managerial competence, and apparatchiks usually appoint themselves and their friends in
the party to those well-paid jobs. Nomenklatura has adverse effects for at least two reasons:
(i) it signifies a severe limitation on the pool of talent from which managers are drawn; and
(ii) given the well-known negative selection process under totalitarianism, the pool of
nomenklatura-included talents is not only smaller but also of lower competence relative to any
other pool in the society with similar occupational, age, sex, and other characteristics.(5)
Bureaucrats and apparatchiks learned long ago that their wealth does not depend primarily upon ideology or upon creating social wealth but upon the rents they extract through their control of the wealth creation process. Thus, loyalty to superiors is important in struggles between various coteries within the ruling stratum who position themselves to extract more benefits from the inefficient economic system. Power or ideology considerations alone, i.e., the attempts of any one group to set an ideologically different course for the party, rarely dominate.
A major mode of rent extraction involves the system of side payments or kickbacks from managers of (primarily industrial) enterprises. In a shortage economy, these kickbacks are mostly of a non-pecuniary nature. Enterprise managers offer to those who appointed them, and to other superiors and colleagues who may advance their careers, a variety of goods and services, and have the opportunity to benefit in the same way. More often than not these side payments involve goods in short supply which have a high black market price. These goods are, however, sold to favored people at list prices or even at reduced prices because of allegedly "lower" quality. (Actual lower quality goods do, indeed, reach the market en masse, but kickback-related goods are carefully selected for high quality!) These offers may include delegating workers from auxiliary factory divisions to build country houses at sharply reduced prices, to build one-of-a-kind furniture for the apartment of a superior on the same basis, etc. The relative unimportance of efficiency allows managers to absorb, without being held accountable, the costs of these kickback activities. Leakage of wealth thus takes place not only through the losses incurred and gains foregone by incompetent managers but also because of the time and effort spent on rent-seeking activities.
Both types of rent extraction exist because of the muddled structure of STE property rights. Since the means of production are in theory, but not in fact, socialized, since workers are "the hegemonic class" in a socialist society and the communist party is "the leading force of the working class," and appointment through the nomenklatura, or any other decision process for that matter, can be justified. It does not matter whether or not STE property rights were originally devised to achieve a socialist purpose or to maximize rents for the ruling stratum. What matters is that muddled property rights allowing protracted interference in wealth creation serve the latter purpose very well.
Under the nomenklatura system personnel shifts from the ranks of apparatchiks to those of the economic bureaucracy are by far the most frequent. The reverse flow also occurs, however, since young economic bureaucrats perceive that their professional career is advanced by a spell in the party apparatus. On the other hand, such interaction with the party and the nomenklatura is much less common for the police and the military.
The different methods of rent maximization used by groups in the ruling stratum are of primary importance for the prospects of reform in the Soviet system. All segments of the ruling stratum prefer the status quo to the alternative of representative government. But two segments onlyparty apparatchiks and economic bureaucratshave, in addition, a strong incentive to maintain the undemocratic, centralized institutional status quo in the economic sphere. To see why this is so, consider that decentralization assumes, as a first step, the substitution of parameters for commands. Since parameters (in contrast to plan targets), such as the interest rate, need not be input- or output-specific, intermediate levels of economic bureaucracy become superfluous. A look at Figure 1 shows clearly that the liquidation of the intermediate levels of economic bureaucracy (the dashed-line rectangular area) makes redundant not only the bureaucrats employed in industrial ministries and unions, but also reduces the pool of well-paid jobs to which apparatchiks may be appointed through the nomenklatura. It is only to be expected that such changes will be strongly resisted by the powerful groups most strongly affected.
Similar resistance appears at the enterprise level. For example, strengthening enterprises' budget constraints by holding them financially accountable for the effects of management decisions will be resisted, since the costs of kickback-related activities would begin to affect the enterprises' balance sheets as well as rewards and penalties for managers and workers. The effects would also be felt by every actual and potential receiver of kickbacks who would spread resistance even wider. Financial accountability could, in fact, affect the whole system of dependence based on loyalty. Conflict resulting from a divergence between the requirements of loyalty and those of financially sound performance is an everyday occurrence in modified STEs, like Poland and Hungary, where financial indicators matter to some extent. That conflict's outcome, however, is predetermined in favor of loyalty because of the operation of the nomenklatura. Simply put, managers caught between whether to follow the "suggestions" of their superiors or pursue other, more financially appropriate goals for their firm choose the former and ask for subsidies afterwards. Otherwise they might lose their jobs. That is why even in Hungary, the most reformed STE, the budget constraint continues to be "soft," to use Janos Kornai's well-known phrase.(6)
Predictably, apparatchiks and economic bureaucrats would most strongly resist attempts to replace nomenklatura by selections based on merit. As a result, nomenklatura has never been abolished for managerial posts in the economic sphere, the sphere where efficiency gains are most important for the rulers. While it is true that apparatchik and bureaucratic resistance is found throughout the STE, its intensity differs among sectors of the economy. Since the best paying managerial jobs under the nomenklatura (i.e., those enjoying best opportunities for kickbacks) are in industry, it is in industry that reform faces the strongest resistance and, correspondingly, the highest probability of failure. The economic history of STEs shows some partly successful reforms of state agriculture, a sector in which opportunities for rent extraction are less frequent and the benefits smaller. To date, no reforms of state industry, based on general parameters, accountability, or merit, have been successful.
The wealth-maximizing interests of apparatchiks and bureaucrats in maintaining the inefficient economic status quo is in sharp contrast with that of the current ruling groups in the Soviet-type states. On the other hand, while a "small but powerful group at the top," to employ Thalheim's phrase, does not necessarily need central planning in its system of rule and wealth-maximization, those upon whom it depends for maintaining that rulethose who control the STEdraw considerable benefits from the existing economic arrangements.
Before proceeding with the argument, the term "control of economic activity" by the economic bureaucracy and party apparatus requires some further definition. In an STE, this function has little in common with guidance toward efficient achievement of desired economic outcomes, at least those desired by the public or even by the ruler. Rather, the goal most often is to maximize rent for the ruling stratum. Control is process-oriented, rather than outcome-oriented, and is based on detailed prescriptions of how, when, and with what means to produce what outputs. The obedience of subordinates is all-important, since this gives superiors a sense of control and of an ability to protect their rents. Ironically, control of the process does not confer control of the outcome because the consequences of following such detailed prescriptions are far from the expected ones: part of output exists only on paper; products are shoddy and obsolescent; deliveries are late; efficiency indicators miss plan targets and the managers are obviously unable to do anything to correct the situation. Another irony is that this style of control may impede realization of the ruler's own objectives, yet the ruler is also powerless because the apparatchiks and economic bureaucrats are essential for his (their) political control of the whole system. Controlling economic activity means simply that the apparatchiks and economic bureaucrats are able to issue commands ("suggestions" at the very least) affecting process or product. These commands are superficially in form, but not in substance, obeyed by enterprises.
The ruler-ruling stratum relationship clearly is crucial to understanding reform failure in the Soviet system. The juxtaposition of these two groups in this article should not be confused, however, with the oft-encountered "good czar, bad officials" approach to Russian politics. The rulers (or "ruling group") is actually representative of all the ruling stratum and reflects all the moral, intellectual and professional consequences of decades of system-specific negative selection. Thus, the czar is not any better than his officials. Nonetheless a great difference exists between the rulers and other groups in the ruling stratum. The ruler, alone within the ruling stratum, is interested not only in seeing reports that commands are fulfilled, but also, and more importantly, in seeing that the commands were actually fulfilled! No other group bears that ultimate responsibility. He will be blamed for any failure of the system by competing groups within the ruling stratum, and his interest in real performance makes the ruler more sensitive to falling efficiency and consequently more ready to reform the economy than is the average representative of the ruling stratum.
As a result, if rulers try to change the economic system significantly, they may face a revolt by functionaries who have the strongest incentives to maintain the status quo, placing their political dominance in jeopardy. Thus, rulers face both the rent-maximizing and the transaction cost constraints stressed by North. In periods of declining performance, the ruler feels the transaction cost constraint. Inefficient property rights do not generate the increased wealth needed, for example, to sustain the superpower status of the Soviet Union, or to avert consumer dissatisfaction in all Soviet-type states. On the other hand, if the ruler attempts a significant revision of the existing property rights structure, he risks loss of support from important members of the ruling stratum who will turn to competitors for political power. It is, moreover, a special feature of STEs that even if competitive constraints on the ruler diminish and reforms begin, their implementation is in the hands of party apparatchiks and economic bureaucrats. Reforms, if not aborted or weakened from the start, may then be sabotaged, distorted or finally reversed.
Clearly and unequivocally it is the apparatchiks and bureaucrats of STEs who gain most from
maintaining the institutional status quo, and they are the groups which resist change most strongly.
Given the key positions of these groups in the STE system, we may predict a very high probability of
failure of decentralizing, market-oriented, efficiency-increasing reforms.
Disincentives to Expanding the Private Sector
Expanding the role of the private sector in an STE usually has the same objectives as decentralizing, market-oriented, efficiency-enhancing reforms in the state sector. Theoretically, private sector expansion could serve as a substitute for state sector reforms, and could provide the means to circumvent strong resistance to market-oriented change in the state sector. In actuality, attempts to reform the state sector have complemented simultaneous private sector expansion. Changes in policy toward the private sector have been numerous, however, since often the private sector has had to contend with various forced concentration drives in the state sector. In the course of these drives, large state enterprises often gobbled up small state and private enterprises alike.(7)
Analysts invariably cite ideology as the cause for the limited role of the private sector (except in agriculture) in Soviet type economies. The same ideological argument comes to the fore in two other circumstances: (i) when Western experts and journalists seek the sources of vilification campaigns and other obstacles to change that follow each official policy shift favoring the private sector, and (ii) when rulers must explain the unsatisfactory results of pro-private sector policy changes. In the latter case, the rulers usually produce some type of circular memorandum aimed at the economic bureaucracy or party committees and lecturing them on the need to overcome the "old-style," "dogmatic" approach with respect to the role of the private sector under socialism. These memoranda are usually ineffectual.
An ideological explanation for the failure to harness private enterprise to improve performance in a persistently disequilibrated and structurally distorted STE fails for two reasons. First, ideological fervor has generally subsided, although admittedly to differing degrees, since the imposition of the STE system. This subsidence has occurred in all spheres of the society and suggests that ideology is not a good explanation for unabated hostility towards the private sector. Second, and more important, any ideological reservations have had to be overcome first and foremost at the top. When a policy to promote the private sector is announced, it is actually the ruler who has to "eat the toad", i.e., to confess directly or indirectly, that the state sector cannot do what the private sector is expected to do. Even policy changes announcing the most limited expansion of the private sector amounts to precisely such a confession. It would seem, then, that few lower level bureaucrats or party apparatchiks, whose position depends not on performance but on loyalty, will dare to sabotage the latest twist of the party line and remain ideologically hostile to privatization.
On the other hand, the ancient principle of cui prodest suggests that there must be strong disincentives for certain groups to follow the rulers' privatization lines. The two avenues of rent distribution, i.e., nomenklatura and kickbacks, operate simultaneously in a STE. However, in interactions between segments of the ruling stratum and the private sector, both are conspicuously absent, or extremely rare. There are no well-paid posts to be filled by nomenklatura appointment in small private enterprises, nor is there a "soft" budget constraint, so permissive to a variety of rent-maximizing kickbacks even under reform. A shift of activity from the state to the private sector reduces, therefore, the possibilities for party apparatchiks and economic bureaucrats to extract rent. Hostility towards the private sector is, therefore, based not on ideology or even actual rent losses, but on gains foregone when expansion of the state sector is curbed in favor of the private sector.
The story does not end here. A bureaucrat, or even an apparatchik who can indirectly influence each decision, may extract rent by taking a bribe for a concession to set up a private industrial firm, or to open a restaurant or a repair shop. But this way of extracting benefits violates private sector property rights, where resources are clearly exclusive, and is consequently much more dangerous. In plain words, taking bribes is a criminal act. By contrast, in a STE rent extraction from the state sector is either fully legitimized, i.e., through the nomenklatura and the rationing of goods at the center's order, or, as with system-specific kickbacks, belongs to the "grey area" between the improper and the criminal. Therefore, since negative selection assures that moral scruples are rare among ruling stratum rent-takers in a STE, something akin to a political earthquake, like the "Solidarity" period in Poland, is needed to threaten all who predatorially extract rent from a STE system. Otherwise, only a few luckless individuals whose punishment was decided upon by higher-ups will be the show pieces in trumpeted, but deceptive, anti-corruption campaigns.
It should be stressed that only so-called "secondary" corruptionthat not legitimized within the ruling
stratumis the type usually punished in an unreformed STE. Such secondary corruption arises from
conflicts between the utility function of the ruler and that of his agents. This is readily understandable
in light of North's property rights approach. The inability of the ruler to constrain his agents perfectly
would result in the diffusion of some of the ruler's monopoly rent and would, therefore, call down
sanctions on the head of the offenders. Barzel(8) and Cheung(9) note the ruler's problem is rendered more
difficult, and the rent diffusion is greater, when the measurement of output is more difficult and more
costly. Since in STEs this measurement is most difficult in industry, one would expect diffusion is
greatest precisely in that sector; Winiecki(10) has confirmed this. Diffusion is so great in fact that it
trickles down to some of the ruled as well, through widespread falsification of performance reports by
enterprises. Nomenklatura-covered managers and, to a smaller extent, but in larger numbers, all
employees of affected enterprises may all benefit from these falsifications.(11)
When and How Reforms Fail: The Strategies and Tactics of "Counterreformation"
Because decentralizing market-type reforms of the state sector and expansions of the private sector adversely affect rent extraction possibilities, the apparatchiks and bureaucrats who benefit from the existing STE arrangements embrace what may be termed a multifaceted "counter-reformation" course. To understand how reforms may thus be reversed or aborted one must consider again the relations between the rulers (or ruling group) and key elements in the ruling stratum, especially the apparatchiks and economic bureaucrats.
In analyzing those relationships and the "counter-reformation," however, it is necessary to consider the ability of the members of large groups to act in concert. Olson(12) stresses that large groups are not always able to act as if guided by their collective interest, yet for STEs this generally valid point does not apply so fully to actions by the apparatchiks and economic bureaucrats. A large difference exists between, on the one hand, a large, perhaps opposition, group struggling to bring organized pressure on a government or a ruling party to effect certain outcomes and, on the other hand, a large group that consists for all practical purposes of the government and/or its ruling political party. "Counter-reformers" in STEs, indeed, usually are in the party and often coalesce around members of the ruling group itself. There are always one or few top party figures who think that cracking the whip, tightening discipline and increasing control are enough to solve the problem of falling efficiency. The hostile group's capability to act collectively is much greater in such situations for the simple reason that theirs is a very unusual, often majority, interest faction with access to mechanisms of political and economic control. If such a group sets itself to thwarting reforms outlined by the rulers and their advisers, the organizational and descriptive capacity of the "counter-reformers" may turn out to be markedly greater than that of politically powerful elements who are outside the mainstream of economic control.
Even if they do not act collectively but only individually, the "counter-reformers" unusual position in the party and the bureaucracy will help them throw sand into the machinery of reforms... For example, they can twist and distort decentralizing reforms pertaining to all state enterprises in a given industry or region, or they may forbid establishment of private enterprises in a given industry or region. These actions symbolize an Olsonian "free rider" situation in reverse: everyone outside the informally organized group of "counter-reformers" brings his valuable individual contribution to the common cause of resisting reform.
The preceding considerations suggest that (1) aborting reforms costs less effort by the interested parties than reversing reforms later, and (2) reversing less consistent reforms (with inconsistency deliberately built into the systemic modifications) costs less effort than reversing more consistent reforms.
Although the counter-reformers are very effective in adjusting their obstructive actions to different circumstances, they probably cannot always implement their first-best (i.e., completely reform-suppressing) solutions and may try to abort reforms, at least in part.
Aborting reforms neither means that no changes whatsoever are introduced nor that all changes are repudiated. It means, rather, that the reforms actually introduced do not threaten the property rights structure in the state sector through which apparatchiks and economic bureaucrats maximize their rent. Abortive reforms also do not alter either the institutions or the procedures of central planning. Examples of such abortive or sham reforms abounded in the 1980s in such STEs as Bulgaria, Czechoslovakia, and the German Democratic Republic. The 1980s Soviet reforms likewise belong to the category of abortive reforms.
The second-best solution for the apparatchiks/bureaucrats is to introduce internally inconsistent quasi-reforms, which modify the system so inconsistently that they are doomed to fail. To the category of quasi-reforms belong the Polish reforms of 1956-1958 and 1973, and most of the East European reforms of the 1960s. Quasi-reforms may increase the effort apparatchiks and economic bureaucrats must expend in controlling economic activity, but that increase is only temporary, since reversal of the quasi-reforms is assured because of problems created by the inevitable reform and system contradictions. In any case, the structure of property rights remains intact.
With inconsistencies often obvious from the start, beneficiaries of the traditional STE model need only to wait until the first problems appear to begin their campaign for reform reversal. Usually they do not need to wait for long, since STEs always enter reform periods in a state of larger or smaller disequilibrium, and reforms can thus be blamed for the persistence of disequilibrium even if no other reform-related adverse consequences have appeared. Actually, major adverse consequences will, in any event, likely arise because of quasi-reform and system inconsistencies. To be sure, small efficiency gains may be registered, but they are temporary and disappear over time under the impact of the process of reform reversals.
...Counter-reform measures designed to maintain an unchanged degree of control over economic activities can be supplemented or reinforced by other measures. These may include expressions of various policy preferences or ad hoc regulations that contravene the thrust of reforms and, if implemented, reduce the ability of enterprises to react to profitable opportunities. These measures also raise costs, reduce quality, increase obsolescence of outputs, and otherwise make firms less efficient. Ironically, counter-reformers use the adverse results arising from their interference as evidence of the failure of the reforms themselves during the next campaign for reversal.
Propaganda against reforms supplements these other measures. It often includes two types of
arguments: "reforms increase inflation," although reforms usually only bring hidden inflation into the
open; and "reforms increase inequality," although reforms usually, at least at the beginning, reward
more efficient smaller enterprises and reduce existing, unjustified wage and salary differentials favoring
employees of large enterprises. Also, isolated critical anecdotes by individuals or by employees in large
enterprises are often overblown in the press and mass media, strengthening the campaign against
reforms by conferring upon it a quasi-legitimacy.
Despite the pessimistic analyses offered in this article, one should not conclude that economic reforms in STEs will inevitably fail. ...[U]nder certain conditions of long-term economic decline, such as apparently affected all East European STEs in the 1980s, political changes may positively affect the chances for the success of economic changes.
Winiecki(13) suggests two scenarios which could lead to real economic reform. The first involves the breakdown of consensus within the ruling stratum and the defeat of those interested not only in maintaining political power but also in maintaining the existing structure of property rights in the economic sphere, i.e., the party apparatchiks and economic bureaucracy. The other scenario assumes a gradual self-limitation by the communist party as the economic decline drags on and as the costs of maintaining the existing system increase as a result of falling absolute wealth and the augmented efforts needed to control economic and non-economic activities. Since the decline of STEs is multifaceted, combining falling living standards, rapidly increasing pollution, and increasing mortality, many hard questions will be asked within the ruling groups and the ruling strata. Accordingly, the probability of the occurrence of one of these scenarios may increase. Either scenario would enhance the prospects of successful economic and political reform in STEs as they approach the last decade of the 20th century.
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