Getting to Market

March 1, 1991 Topic: Economics Tags: PostmodernismSociology

Getting to Market

Mini Teaser: Over the past century, economists and other intellectuals have produced an enormous amount of literature on how to convert capitalist market economies into socialist centrally planned ones.

by Author(s): Charles Wolf, Jr.

All these methods would result in the creation of a resale market for equities and mutual fund shares.  Contrary to some of the debate on this issue, none of the methods requires that state enterprises be carefully evaluated before privatization is accomplished.  Choosing among the alternative methods does require assessment of their respective advantages (for example, simplicity, comprehensibility, and speed), as well as their disadvantages (for example, distributional unfairness and inequity).

In any event, whichever method or methods of privatization are selected--and experimentation with several is advisable because none is clearly preferable to the others--their success remains linked to the other elements of the transformation package.  Unless rewards are linked to asset ownership, and unless such rewards can be accumulated legally, incentives to innovate and to increase productivity will be impaired.  Effective supply responses to price and wage deregulation depend on the incentives provided by private ownership and accumulation.  Moreover, private ownership is essential for market forces to provide an effective "stick," as well as "carrot."  If ownership is in the hands of the state, the discipline imposed by market competition will be attenuated, if not eliminated.  When state enterprises are confronted by losses, they typically evade or ignore the threat of bankruptcy that private enterprises would face if confronted by similar losses.

It has sometimes been argued--by Gorbachev, Li Peng, and others both inside and outside the reforming command economies--that privatization is neither necessary nor effective.  The argument is that a "culture of envy" has become strongly pervasive and ingrained, especially in the Soviet Union.  Since privatization leads to wide gaps between rich and poor, it is said, privatization won't be tolerated, and won't be effective if it is imposed.

This "culture of envy" may be attributable to the long-standing, widespread experience in communist societies that sharp disparities in income and living standards are associated with political favoritism and corruption, rather than with private ownership, innovation, and productivity.  Such resentment is not unknown in market economies.  Nevertheless, in moving from command to market economies, private ownership plays a crucial role by providing the incentive structure required for markets to function efficiently.  Avoiding socially unacceptable disparities in income distribution is a responsibility of public expenditure and tax policies, within the context of private ownership and market competition.

The fifth element--establishment of a social security system as a "safety net"--is also essential for the transformation process to succeed.  Without it, the process may create fear of widespread unemployment, social stress, and political instability, thereby seriously impeding the transition.

In most command economies, social protection--against illness, disability, age, and unemployment--has principally been the responsibility of state enterprises.  As privatization proceeds, these responsibilities are likely to become one of the principal functions of government, financed by taxation and by payments levied on the insured.  In the initial stage of transformation, taxation will probably have to bear most of the burden, although, for reasons to be discussed later, the real incremental burden imposed on the economy by the social safety net is likely to be less than is usually assumed.

The final element--currency convertibility--is essential to complete the transformation process by linking internal markets and their prices, wages, productivities, and technologies to those of international markets.  This linkage provides the opportunity for comparative costs and comparative advantage to operate for the benefit of the transforming national economy. With a convertible currency, the transforming economy can determine those goods and services it can produce at relatively low cost compared to the costs of other countries, and those it produces at relatively high cost.  In response to convertibility, exports of the relatively low-cost goods will expand, as will imports of the relatively high-cost ones.

If the other elements of the package--especially monetary and fiscal discipline and market-determined prices--are effectively implemented, currency convertibility with a floating exchange rate can be embarked upon and sustained with minimal hard currency reserves, contrary to a frequent argument about the need for large reserves as a precondition for convertibility.  Poland's establishment of a convertible zloty at the beginning of 1990 was accomplished notwithstanding the country's net foreign exchange indebtedness of over $50 billion.  Although Poland received a foreign exchange stabilization loan of over $1 billion from the United States, none of it was drawn upon in the ensuing year.  Instead, with its convertible currency system, Poland accumulated hard currency foreign exchange holdings of over $2 billion in 1990.

The interactions and mutually supporting relationships among the six elements of the transformation process are summarized in Figure 1.  The lines indicate the contribution by one element to the effectiveness of another to which the arrowhead points.  (For example, monetary and fiscal reform contribute to the effectiveness of price and wage deregulation.)

In sum, the process of transforming command, non-market economies to market ones is both better understood and more tractable than might be inferred from much of the public debate.  Transformation is a systems process encompassing the interactive and mutually supporting elements described above.  The debate which disputes this systems view argues that one or another of the six elements is not essential, or is of higher priority than other elements, or should precede the others.

For example, as noted earlier, Gorbachev, Li Peng, and some of their "conservative" advisers contend that private ownership of productive assets, including land, is not essential because its incentive effects can be obtained through leases administered by the state.  In opposition to this view is the position of American banker Leif Olsen, Soviet economist Nikolai Shmelev, and others, who assert that private ownership in general and privatization of state enterprises in particular are the most fundamental ingredients of economic restructuring.  Along the same line, Canadian economist Reuven Brenner argues that reform of the legal system, to assure and protect property rights, is the essential precondition for any further reform efforts.

Another stance, associated with economists Gregory Grossman, Igor Birman, and Judy Shelton, emphasizes the primacy of monetary and fiscal reform and, in the Soviet case, substantial reduction of the existing monetary stock--the so-called "ruble overhang"--as an indispensable precondition for preventing the rampant inflation that would otherwise follow price deregulation and other reform measures.

Indeed, I have previously advanced some of these views myself.  In earlier writings on the Soviet Union, I suggested that price and wage deregulation, combined with the mandatory conversion of large ruble holdings into long-term, non-tradable bonds to reduce the "ruble overhang," were necessary and sufficient measures for moving the Soviet economy toward marketization.  And in subsequent work in China, I focused on the central importance of currency convertibility in achieving marketization.  Now, it seems clear to me that trying to transform a command system into a market system without the synergy provided by all of these elements is like trying to swim with only one arm and leg.  To attempt the transformation process on a piecemeal and gradual basis would be--to use another simile--like trying to shift a country's driving practices from the left side of the road to the right side in stages.  The risk of serious accident is manifestly greater than if the change is accomplished all at once.

Some Recent Experience

Among the command economies that have attempted to transform themselves into market economies, Poland's efforts have been the most far-reaching.  Yet these changes have been incomplete.  On the positive side, Poland's budget deficit has been reduced from approximately 8 percent to about 1 percent of GNP.  Monetary discipline has been encouraged by separating the central bank from the treasury.  Ninety percent of all prices have been decontrolled and convertibility of the zloty has been maintained at a stable rate since January 1990, with exports increasing, hard currency imports declining, and a resulting trade surplus of over $2 billion.

Though these are significant accomplishments, they are not sufficient.  To date, the Poles have only partially privatized, have deferred the breaking up of state monopolies, and have delayed the wage reform necessary to create proper incentives for labor and management.  Hence, supply responses and sectoral resource reallocations have been inhibited, and output, employment, and inflation have suffered.  Still, if one were grading the various country efforts, Poland would receive a strong B.

By contrast, Gorbachev's faltering attempts to move toward a market economy and to combine the now-defunct Ryzhkov and Shatalin plans would barely rate a D.  Thus far, controls remain on the prices of essential consumer goods and basic commodities like oil, gas, lumber, steel, and other key goods and services, such as transportation and communications.  Although their "established" or official prices have been raised, the levels and parities among them are still determined by central planners.  Gorbachev's recent edict, making fifty and one hundred ruble bills worthless, is a meager and ineffectual effort to reduce the money supply at the same time as other measures continue to add to it.  Budgetary spending is supposed to be curtailed, yet subsidies for many enterprises have been maintained.  State enterprises are supposed to resort increasingly to "self-financing" to meet their financial needs.  In fact, credit extensions are still available to them if stringencies arise, especially if the enterprises can argue that financing is needed to fulfill state contracts.  Although Gorbachev has said state enterprises will be privatized, no timetable or operational plan for doing so has been established.  And to the extent that convertibility of the ruble is mentioned at all, the intention is that it will be done "gradually," without any indication of when or how this will be accomplished.  Even these limited measures have been set back as a result of recent increased reliance on KGB and military authority in running the economy.

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