Command Economy

• Why study command?– The command system creates initial conditions

for transition– Legacies from command critical for transition

• Path dependence

• Two types of legacies– Structural

• The result of past investments and other decisions• Enterprises, locational choices

– Institutional• Behavioral patterns• How to reverse past decisions

• Start with the analysis of command system

Command Economy

• Attempt to replace markets– The command principle strives to fully and

effectively replace the operation of market forces in the key industrial and developmental sectors of the economy, and render the remaining (peripheral) markets manipulable and subordinate to political direction.

• Two Basic Imperatives– Growth– Control

3 Key Purposes

1. maximum resource mobilization towards urgent and over-riding national objectives, e.g. rapid industrialization or the prosecution of war; • Used by many countries in wartime

2. radical transformation of the socio-economic system in a collectivist direction based on ideological tenets and power-political imperatives; and

3. not the least, as an answer to the disorganization of a market economy through price control, possibly occasioned by inflationary pressure arising from (1) and/or (2).

Basic Features of the STE• state-ownership of the means of production • centralized control by means of an administered

system of planning in physical terms.– The system replaces the market with a set of

directives from the center to the production units throughout the economy.

– These directives are commands, not suggestions. They are directives that have the force of law, and subordinates are responsible for fulfilling them, even if the plans are not feasible.

• The absence of markets implies loss of information about opportunity cost

• absence of private property, except for households

STE

• STE created by Stalin in 1928• Exported to Eastern Europe after

WW2• Imported by China after 1949• Yugoslavia mutates in mid-50’s

– Self-management

• North Korea, Vietnam, Cuba are underdeveloped examples of command economies

Basic Feature Continued, Implications• soft-budget constraints • chronic sellers market • emphasis on heavy industry • gigantomania • dynamic incentives problems • state control of investment • restrictions on entry, no exit

Socialist

Countriesa

Capitalist

Countriesb

Total ManufacturingAverage employment per firm 197 80

Percentage of those employedin firms with more than 500 workers 66 32

Textile IndustryAverage employment per firm 355 81Percentage of those employedin firms with more than 500 workers 75 17

Ferrous MetalsAverage employment per firm 2,542 350Percentage of those employedin firms with more than 500 workers 95 79

MachineryAverage employment per firm 253 82Percentage of those employedin firms with more than 500 workers 61 28

ChemicalsAverage employment per firm 325 104Percentage of those employedin firms with more than 500 workers 79 35

Food ProcessingAverage employment per firm 103 65

Percentage of those employedin firms with more than 500 workers 39 16

Source:Ehrlich (1985)aSample, including Czechoslovakia, GDR, Hungary, and Poland.bSample, including Austria, Belgium, France, Italy, Japan, and Sweden

0-100 100-500 500 and moreWest Germany 14.1 23.9 62France 22.5 24.9 52.6Italy 32.3 27.3 40.4

GDR 1 11.1 87.9Czechoslovakia 0.1 3.4 96.5Hungary 4.5 16.3 79.3Poland 1.4 18.2 80.4

source: OECD data for West Germany, France and Italy are for 1987, and for the other countries are for 1989.

Distribution of Employment by Size

Structural Differences

Agriculture Industry ServicesOECD (1991)

8 richest countries 5.5 29.8 64.78 middle countries 5.8 30.4 63.98 poorest countries 17.9 29.5 52.6

Centrally PlannedEconomies (1998)

GDR 10 44.1 45.9Czechoslovakia 11.6 46.8 41.6Hungary 17.5 36.1 46.4Poland 27.2 36.3 36.4

Ownership

• Not just commanding heights• In the Soviet Union, for example,

– the state and collective sectors accounted for some 88% of the value added in agriculture; controlled 98% of retail trade, and owned 75% of urban housing space

– The industrial sector was exclusively state owned.

• In 1985, for example, 91% of employment was in state enterprises, and another 6% was in kolkhozy.

– The extensive control of retail trade means that the smallest shops were state owned.

• But key factor is hierarchical control

Sample Hierarchy

ConsumerGoods

Defense

ChemicalPlant #3

Chemical Plant

#2

Chemical Plant

#1

Chemicals

Coke Plant #2

Coke Plant#1

Coke TrustRolling Mills

Steel Plant#2

Steel Plant#1

Steel Trust

FerrousMetals

CentralPlanning

Board

Old Gosplan (currently Duma)

Hierarchy

• Only vertical information flows– But there are informal horizontal flows

• Only at the top of the hierarchy can opportunity cost be assessed– Lower level agents cannot assess tradeoffs– Implies subordinate control crucial

• Bureaucracy must exercise full control and discretion– But subordinates have their own interests, which implies:

• Incentive problems• Need for monitoring systems (police, party, banks)• Corruption

• Fundamental issue: how to get agents to reveal information and follow orders

Soviet Growth Model• Mechanism for extensive growth• Paradoxical attitude towards time

– planners have a very low discount rate -- they are willing to sacrifice lots of current consumption for future consumption

– On the other hand, haste implies that they want to industrialize fast. So they cut corners, and ignore side effects and other costs.

• Diabetes example• Key point

– Haste sowed the seeds of the barriers to longer-term performance.

– In that sense, the rapid growth in output of the first couple of five year plans represent borrowing from future performance.

• Balloon payment• Key defect of the SGM is that output growth is

pursued without regard for the opportunity cost of that growth– E.g., environmental mess

Extensive vs Intensive Growth• Suppose that output is given by

• Then the growth rate of output is given by

– Thus growth occurs either thru growth of inputs (more K and/or more L) or technological change (growth in A)

– Extensive growth is the former, intensive growth is the latter

• Growth thru greater efficiency in use of inputs• Extensive growth is growth thru accumulation of inputs

Consumption Paths

• Whose utility is being maximized?– Households versus planners’ objectives– Planners willing to defer present

consumption versus future consumption– Planners combine haste with patience

• Their haste for fast growth with public’s patience for deferred consumption

– High rate of time preference on part of owners, cost paid for by public

Aral Sea

Soviet Growth Model (cont.)

• Growth implies maximize investment– How? Via control of consumption

• State is sole employer => monopsony

– Let be the subsistence level of consumption

– Then is aggregate consumption.– Let be aggregate consumption– Then investment is maximized, for given level

of K, by choosing L so that – What if ?

cLc

),( LKFY

cFL ˆ

LL *

Industrialization Strategy

• Heavy industry• Maximize investment• Collectivization

– Surplus labor argument• Transfer from rural to urban• State control over resources

– But peasant response

• Output growth versus welfare

USSR, Inc.

• Soviet economy as a single corporation• The corporation owns a large stock of

natural resources, – has no outside shareholders – (so that all "profits" can be retained for investment) – hires labor– Moreover, as a monopsonist in the labor

market, USSR Inc. can minimize the expenditure on labor.

• Transactions between enterprises are merely transfer prices between "divisions."

• The exceptions are purchase of labor and engagement in foreign trade.

Exceptions

• Labor is allocated partly by choice– State determines demand, but labor is

supplied• Though vagrancy is a crime – full employment

• Foreign Trade controlled by FTM– FTM trades with ROW

• Intermediary between producers and ROW

– Insulates domestic prices from world prices– Purchases (sells) goods at state prices and

sells (buys) at world prices

Haste

• Command system is good at mobilizing– achieving specific objectives– Extensive growth

• Growth through accumulation of inputs

• It is bad at assessing costs and tradeoffs– May be important for intensive growth

• Growth via greater efficiency

• Crucial Role of Resource Abundance– Delay in reaching BoP constraint

Growth Problems

• Over time growth rates decline in all STE’s– Despite continued growth in capital-worker

• Why?– Failure to transition to intensive growth

• Extensive growth trap

– Inability to substitute capital for labor– Innovation Problems

• The system worked best when the fruit was low-hanging– mobilization

Soviet Growth Rates Decline

Intensive vs Extensive Growth• Start with • Then the growth rate of output can be written

as:

• Intensive growth means high

• Extensive growth means accumulation– But notice that as capital accumulates,

increases– What happens to rate of return?

LK

Two Explanations of Slowdown• TFP growth declines due to increased complexity

of the economy– Difficulty with diffusing innovation

• Low elasticity of substitution– K/L increase due to high savings rate and limits to

growth in labor force– If substitution is difficult output growth is reduced

• Note that this is organizational, not technological– No entry, limited exit– Input-output conservatism in planning

• Extensive growth and natural resources– Energy was underpriced and over-utilized– when prices are liberalized many industries are

producing negative value added

Price System

• Prices unrelated to social costs– Socially necessary costs

• Average not marginal• Non-existent charges for rent and capital• Raw materials underpriced• Costs of production were thus calculated based on an

incomplete enumeration of costs.

• Prices biased based on user• Circus mirror effect• Does it matter?

– USSR, Inc., => transfer pricing– But illusion about sources of value

• Implications for transition

Price System (cont.,)

• Why have prices in a planned economy?– an accounting device– Monitoring of plan performance– Related question, why have money?

• Active and passive money• Soft-budget constraint (Kornai)

– If budget constraints are not binding a resource constraint must eventually be reached

• Implies that shortage is an equilibrium phenomenon in STE’s

• Leads to sellers’ markets

SBC

• Dynamic Commitment problem– Subsidy available ex post not ex ante– Effort costly for manager, bonus for fulfillment is

B

– Effort is sufficiently costly so• If effort is low, Y = 0 with no bailout, Y – R with bailout

– If low effort manager must be bailed out because low output is bad for planner

– Manager knows this so he supplies low effort

SBC

Chronic Sellers’ Market

• Primary cause => the emphasis on growth at all costs

• Taut plans => uncover hidden reserves• Soft-budget constraints

– Plan fulfillment imperative– Excess demand for labor

• Shortage and priority– Personality dominates

• Lack of quality

Dynamic Incentives Problems• Planning from the achieved level

• Enterprise exploits hidden information– Agents must be induced to reveal information

• Simple 2-person game– Enterprise director can tell the truth or lie– Planner can issue a feasible or a taut plan

1)1(ˆ tt YY

Preferences • Director’s preferences:

• Planners’ preferences:

• Illustrative payoff matrix

• Equilibrium: both lie

Bonus Function

• To get director to reveal information planner implements a bonus function

• But why pay to overfulfill?– Need for extra resources to meet

shortages– Increase effort

Canonical Bonus FunctionB

q

More on the Bonus Function• Solves static problem• Assume that effort is required to

produce more output– Moral hazard

• But that this differs depending on productivity– Hidden information (adverse selection)– Then preferences depend on the nature

of the enterprise

Canonical Bonus Function

B q( )

B

qq

B 0

B B0

U H

U L

q 1

Canonical Bonus Function

• Generates separation• If no bonus for overfulfillment, then

pooling• Sets up the dynamic incentives problem

– Fulfillment today risks fulfillment tomorrow

• Consequences– Need for a safety factor– Ratchet effect– Taxing high performance

Dynamic Problem

– Let be utility for fulfilling the plan for the high productivity enterprise

– Current gain from overfulfilling is:

– Loss from revealing information is

– Then director must compare

Dynamic Problem

• LHS is the current gain from revealing (CG)

• RHS is the present value of future losses (DFL)– Depends on the time horizon of the agent

• Whenever DFL > CG the director will conceal true capacity– Ratchet effect => fear of a higher future

target lowers current performance– Predictability, Shchekino

Shchekino Experiment

• Planning experiment– Planners commit not to change targets

for 5 years– Enterprise can keep costs savings– Labor productivity rose so fast, 52% in

first year, planners reneged• Changed plan targets 7 times in 10 years• Another plant 17 times in 5 years

• Inability of planners to commit

Ratchet Effect

• More severe the greater is – Time horizon– Utility loss

• And the smaller is – The discount rate

• Leads to reduced incentives to perform and innovate– Alexeev and weightlifting records– Slow diffusion of innovations

Result

• Who said this?

• Yuri Andropov, General Secretary, CPUSSR– Top officials know the problem, can’t solve

it

Lack of Observability

• Inflated reports – simulation – is commonplace

• Difficulty of monitoring• Occasional audits show this:

Enron, Global Crossing, Stock options• Similar problems occur in corporations• Directors and managers engage in simulation

– simulation of performance to achieve bonuses– Simulate earnings to benefit from options– Incomplete information necessary but not sufficient

• it is also necessary that rewards be skewed toward the present,

– especially if those costs can be shifted on to others in the future.

• Much harder to keep simulations hidden in markets– Need to hide losses, but Soviet pricing does not

reveal losses

Vasily Alexeev

Date of First Adoption versus Diffusion (proportion of output produced in 1982)

Structure of Command Economy• Imperative is microbalance• Planning by material balances

– Feasibility, not optimality– Iterative process of vertical information flows

• Basic idea– Sources = uses, good by good– For good j we have:

– Where does come from?• The input requests from other enterprises• Where does this come from?jX

Material Balances, cont.• Planners start with a target for sector j:• Enterprise calculates its input needs

assuming fixed coefficients:

• So multiply to get needs:

• Now planner adds. E.g. for sector 1 (such an equation for each sector of course):

0jX

Schematic

Chemical Plant #3Chemical Plant #2Chemical Plant #1

Chemicals

Steel Plant #3Steel Plant #2Steel Plant j

Steel

CPB

0jX

Material Balances, cont.

• Put the sum back into the material balance:

– No reason to assume it equals zero.– So adjust output targets:

– Now we have a new set of input needs for each enterprise. For j we have:

– And we just repeat the whole process, again, and again…

Material Balances, cont.

• Process continues till all the Dj’s are zero• Notice how simple are the operations• If the process goes on long enough a feasible plan

result– But the number of iterations could be very large– In practice only one or two iterations

• So plan as implemented is infeasible– Some plans taut, others slack

• Note emphasis on intermediate goods– But optimal plans look at final goods

• Central control and subordinate responsibility– Micro-balance is the imperative

• Process assumes truthful revelation

Incentives versus Complexity• Mises, Hayek thought central planning

problem was too complex to solve• Lange and Lerner suggested market

solutions– Set Q such that MC = P– But this ignores incentives problems– Why would managers follow the rules? – Private information (about actions or

conditions) is valuable• Agents must be induced to reveal this

Command Problems• Detailed planning and the corresponding

directives are often late, are insufficiently detailed, may lack the requisite information, hence often cannot be effectively coordinated– Owing to their rigidity they are peculiarly

vulnerable to uncertainty• Planning in a command economy must be

largely in physical terms due to the crucial importance of balance. – The bottom line of the planning process must be

available physical units of required inputs, in appropriate assortment, quantity and timing, necessitating physical targets for production and input utilization.

• Success indicator problem

Success Indicator Problem

• Bonuses are non-synthetic• One linear price schedule produces

imbalances– No secondary market– Planners cannot know tradeoffs at each enterprise

• Pollution permits

• Emphasize priority– Quality problems shifted to users– Because micro-balance is priority– Teaching versus research?

• Bonus for retention

Command

• Command is good for well-defined measurable tasks– Build the Atom Bomb

• Don’t worry about cost = $25.7 billion at current prices

• Command is bad at assessing tradeoffs– No prices to measure opportunity cost– Physical indicators lead to success indicator

bias– Teaching is harder to measure than research

Shortage

• SBC, fixed prices, output fixation => shortage– In production, to avoid wasted resources; full

utilization to achieve growth– In consumption, because planners do not want

to divert output– Of course, flexible prices could eliminate

shortage, but command means dominance over market• Market allocation weakens central control

• Implication: Generalized shortage

ShortageP S

D

Q

P

Q

Excess Demand

*P

The Big Nail

Problems with Linear Pricing

quality

SW

B

A P

P

quantity

enterprise 1

enterprise 2

Mormon Comparison

• Many similarities– Sense of encirclement– Holistic vision of utopia

• Virtuous haste– Totalitarian leadership (without terror)– Primacy of collective over individual– Hostility to speculation, private initiative– Insulation and isolation

• Need for autarky to conserve foreign exchange

• Like the Soviet economy, economy was collectivist, mobilizational, centrally planned, largely command-managed, and often redistributional in regard to factors, products, and the economic surplus.

Mormon comparison, cont.

• More similarities– Property owned by church– Capital formation

• Via tithes, mostly in kind

– Prices as accounting devices, economy demonetized

– Frequent reforms– Cooperative forms of organization

• Key differences– Voluntary, not coercion– Building on virgin soil

Seeds of Transformation

• End of isolation– Immigration of gentile tradesman

• Like the second economy of USSR

– Railroads lower transportation costs• Raises cost of autarky

• Hostile US legislation• Trade leads to corruption and sub-

rosa privatization

Second Economy

• Informal economy arises to meet challenges of command

– Precisely because command economy cannot achieve balance, and as terror dissipates

• 2nd economy defined as “all production and exchange activity that meets at least one of two criteria:

1. being directly for private gain; 2. being in some significant respect in knowing

contravention of existing law.” See Grossman, 1977, p. 25.

• These market-mediated activities are at times supportive, helping to achieve tolerable micro-balance in the increasingly complex economy,

– but they often are in violation of planned implementation and regime values.

Second Economy

• Brezhnev on second economy– You don't know life. No one lives on wages

alone. I remember in my youth we earned money by unloading railroad freight cars. So, what did we do? Three crates or bags unloaded and one for ourselves. That is how everybody lives in [our] country.

– Blat markets

• 2nd economy activity necessarily introduces discretion– Potential for diversion

Second Economy

• Virtually every area of economic life is touched upon, and often entangled with, ‘second economy’ activities– legal private activity naturally opens a loophole for

illegal trading and entrepreneurship, generally below the purview of the authorities.

• Dual contradictory roles of 2nd economy:– First, it addresses a number of the problems of

coordination and balance endemic to the command mechanism

– But, second, it mocks the pretense of social direction and control, subverts its egalitarian impulse, accentuating differences in access and income, and gives lie to the pretense of a ‘new’ ideologically correct (‘Soviet’) man

Evaluation and Size• 2nd economy completes the cancerous

development of agent autonomy– Generates undesirable (system perspective)

redistribution of incomes, • although recipients, including many high placed

officials, find it very desirable.• Size

– Estimates based on the surveys of Soviet emigrants relate to the second half of 1970’s and range approximately between 10% and 30% of incomes of urban households.

– An alternative set of estimates based on the Soviet-era official family budget survey data puts the second economy at around 23% of household income (Kim, 2003).

– Could be as large as 12% of GDP in 1979• But double counting

Legacies

• Two types– Structural legacies– Institutional legacies

• Financial underdevelopment• Absence of rule of law

– Khruschev: ”Who’s the Boss: we or the law? We are masters over the law, not the law over us — so we have to change the law; we have to see to it that it is possible to execute these speculators.”

• FTM

Structural legacies

• Industrial structure– Industry bias

• Industry intentional, agriculture unintentional

• Under-provision of services

• Hypermilitarization• Industrial concentration

– Gigantomania– Absence of small enterprises

Distribution of Capital Stocks

Structure by Labor Force

Indicators of Raw Materials and Energy Consumption, 1988

Enterprise Size in US and Russia

0

5

10

15

20

25

30

35

50 to 99 100 to 249 250 to 999 1000 to 9999 GT 10,000

Per

cen

t

Russia US

Hypermilitarization and Climate• Size estimates difficult

– Pricing distorts measurement– Cost shifting

• Defense burden unsustainable– Locational burden– Interaction with climate problems

• Soviet Union got colder in 20th century!• Too many people in the wrong places

– Big problem for market economy

Location in RussiaPopulation of Siberia and Far East in 1989: 37 mln (25% of RF total) Manufacturing employment: 1.8 mln (16% of RF total)

Location in CanadaPopulation: 85 000. (0.34% of Canadian total) Manufacturing employment: 295…people (0.017% of Canadian total)

TPC in Canada, USA, and Russia

Duluth, population = 86,000

0

5

10

15

20

25

2 -2 -6

-10

-14

-18

-22

-26

-30

-34

-38

Mean: -11.7Coldest decile: <-22.1

Duluth January Daily Temperatures, 1994-2002

Omsk, population = 1.2 million

Omsk January Daily Temperatures, 1994-2002

0

5

10

15

20

25

2 -2 -6 -10 -14 -18 -22 -26 -30 -34 -38

Mean: -16.8Coldest decile: <-27.2

Perm, population = 1.008 million

Perm January Daily Temperatures, 1994-2002

0

5

10

15

20

25

2 -2 -6

-10

-14

-18

-22

-26

-30

-34

-38

Mean: -12.5Coldest decile: <-22.7

Finally, use the

10

How Cold is Cold?Cold Thresholds in Siberia

Effects on Stan dard Soviet M achin er yT em p.(°C )

A lloyed steel com po nen ts (ball b earing s, etc.) shatter ; s aw fram es andci rc u lar s aws stop work; a l l com pres sors stop w ork ; stan dard steels andstructures ru ptur e on mass scale

-35 to –40

T restle cranes fa il; s om e tractor shoes break-30 to –35

M inim um tem per atu re fo r use o f an y stan dard equ ipm en t-30

U nallo yed steels b reak ; car-engine space, fue l tank s, and o il tank s m ust beins u la ted; frost- resis tant rubber requ ired; non- frost resistant convey or be ltsand standard pneum atic hos es break ; som e cranes fa il

-25 to –30

Standard c ompress ors w ith in ternal c om bus tion engines cease to operate ;standard ex cavator h iltbeam s break; destruction of som e tow er c ranecom ponents, dredging buc kets, and bulldoz er b lades

-20

H igh -carb on steels b reak; c ar batter ies m ust be heated; first cr itica lthres hold for s tandard equipm ent

-15

D estruc tion o f som e standard m eta l dredge com ponents-10

Internal com bustion engines require pre-start engine heaters-6

Source: Dogay ev , cited in Mote.

Internal vs External Inefficiency• Internal inefficiency

– Lack of high-powered incentives– Input combinations and X-inefficiency

• External inefficiency– Lack of market pricing

• allocative

• Dynamic inefficiency– Lack of innovation

Legacy of Never-ending Reform• Waves of reform• Why a treadmill?

– Rejection of alien organisms

• Pitfalls of partial reform– Cooperatives – Supply diversion

• Timber and boxcars

Example

• Efficient rationing of timber• Plan price = P, excess demand in

housing– Cooperatives bid for timber

• x units of timber diverted to housing from boxcars

Supply Diversion• Notice that P* is the shadow price of timber

– With freedom to sell, timber sector sells qm to the housing (cooperative) sector, cutting back deliveries to the boxcar sector

– Shadow value of timber is now much higher in boxcars

• Consumer surplus falls by A in boxcars and rises by C in housing; note A >> C

• Producer surplus in boxcars falls by B = 2C

• Notice that the problem arises because the boxcar industry cannot compete for timber, and the capital in that sector cannot flow to housing. – The moral of this story is that as the state loses

control over the state sector, diversions make things worse.

– But China will be different!

Achievements

• Full employment– By law => no unemployment insurance– Soft budget constraint

• Free health care– Good at infections, bad at modern diseases

• Low income inequality– Gini Coefficient

• Ratio of the area between the Lorenz curve and OB, and the whole area OAB.

– Wealth v income, and access to goods

Lorenz Curve

Earnings Distribution, Full-time workers

US Income of Top Decile

Social Uncertainty

• Command economy minimizes income shocks– Full employment, socialized medicine

• Social insurance is high– Underemployment vs unemployment

• Risk taking is low• Institutions to cope with uncertainty

in modern economy are absent

Life Expectancy at Birth, Russia, 1958–59, 1961–62,1963–64, 1965–2002

An Alternative Factor

• Decline of Oil prices– When rents exploded, so did commitments

• Rents = market value of revenues less natural costs of extraction

• Including subsidies to Eastern Europe

– When rents declined hard to cut commitments• Resource abundance is addictive• increase in energy investment between 1981 and

1985 absorbed nearly 90 pct of increment allocated to industry

• Production maintained by borrowing from future

– Tightened the resource constraint

An Alternative FactorRussian Oil & Gas Rents 1970-2005

$0

$50

$100

$150

$200

$250

$300

1970 1975 1980 1985 1990 1995 2000 2005

Real (2005)USD blns/yr

OIL

GAS

Rents and GDP

70

80

90

100

110

120

130

140

150

160

1970 1975 1980 1985 1990 1995 2000 2005

Russian GDP in 1990 PPP (1970=100)

$0

$50

$100

$150

$200

$250

$300

$350

Oil and Gas Rent (2005 dollars)

Rents, Addiction

• Resource rents postponed day of reckoning– "In sum, the Soviet economic system became what it is in

part thanks to the country's rich resource base, which permitted the planners largely to ignore the day-to-day discipline of the balance of payments and therefore also the imperatives of the market place and the pains of real economic cost. On this basis an elaborate and rigid institutional edifice sprang up. This economic system thrived for two human generations and achieved marked successes by its own criteria. But inevitably it hardened and came to be supported and protected by powerful vested interests [Grossman, 1983: 202].

• addiction to rents postponed fundamental reforms, made the system more fragile

• The lesson is that resource abundance, misapplied, can be addictive

Addiction• Addiction leads to short-time horizon

– This leads to an inability to implement reforms.• Three characteristics

– tolerance - the need for an increasing amount of the substance to obtain the same effect

– withdrawal - severe unpleasant effects when the addict ceases to use the substance craving –

– "willingness to sacrifice all (to the point of self-destructiveness)" in order to obtain and use the substance.

• In Soviet case tolerance arose because windfall was used for many new activities – defense, East European subsidies and other international

adventures– interests created that depend on rents, makes withdrawal

painful– where is the methadone for an addicted Soviet economy?

Defense Addiction

• Marshal Akhromeev on addiction• Why it was necessary to produce so many

weapons? Akhromeev answered: – "Because at a great cost of many sacrifices we

created first-class factories, no worse than the American ones. Would you order them to stop work and begin producing cooking pots?"

– Shakhnazarov described the "military-industrial mentality" as a "cancerous growth" that had metastasized to every sphere of Soviet life

• This is an example of addiction. The investment in factories created interests that were very costly to reverse.

Aspects of Collapse

• Macroeconomic– Budget crisis, inflationary finance

• Shortages, stolen hours, more queues• Weaker state lower tax collection

• Microeconomic – Misallocation of resources– Lack of property rights– Pseudo privatization

Two Views on Collapse• Essentialists

– Essentialists hold that the Soviet system collapsed because it was essentially abnormal

– The nature of the Soviet system made its eventual collapse inevitable and even predictable

• Of course, few made this prediction before the system collapsed. Autopsies are easier on dead bodies.

• Voluntarists– Soviet economy was murdered, or its death was

decisively hastened, by voluntary acts of policy, though the consequences may have been unintended.

• “We tend to confer the mantle of inevitability on accomplished facts, and arguing that what happened did not have to happen is likely to be dismissed as inventing excuses for the losing side. But the collapse of the Soviet system was the unintended result of a small number of disastrous decisions by a few individuals”

Was Demise Inevitable?

• Productivity growth slowed, but never turned negative– The odds on overtaking fell– Reforms upset performance

• Reforms made the system more fragile– Monitoring costs rose and deterring

corruption became more costly• Erosion of belief in system

– So small shocks could lead to collapse

Weakening of Central Control• Critical difficulty for central planning

– Brezhnev Communism = Stalinism without terror

– Raises the prices of information and action• Loss or resources at center

• Agents have two options– Fulfill the plan, F– Don’t fulfill the plan, NF– Payoffs depend on whether observed or not– Let be the probability of being observed

Stalinist Incentives

• Let be the payoff to NF if unobserved• Suppose that and• Then the expected payoffs are

• Planners want– Two instruments, detection and punishment – We can plot this

Stalin v Brezhnev

• Stalinist system set punishment = - infinity– Lowers cost of detection

• Brezhnev system– Cheating is optimal for larger range of

• Problem is more severe with greater complexity– Glasnost makes it even worse – Explosion of Second Economy– Loss of central revenue

Multiple Equilibria

• The same system can have two equilibria– High output– Low output

• Consider the producer’s decision to supply effort– Depends on gains and penalties– And whether this is observed

Producer’s Choice of EffortProducer works hard, if

Gain from working hard > cost of working hard

If work is hard and monitoring is strict, then

Gain reward for working hard, avoid penalty for not working hard, spend

effort working hard

Work hard if reward gained + penalty avoided > cost of effort

If work is hard and monitoring is lax, then

Don’t work hard

No rewards gained, low effort supplied

Dictator’s Choice

• Dictator wants to deter stealing– Two key parameters:

• Cost of incentives provided• Costs of monitoring

• Over time these parameters shift– Complexity raises monitoring costs– Weakening center (decline in oil revenue)

raises costs of providing incentives• High output is no longer an

equilibrium

Dictator’s Decision

Dictator Monitors if

Effort is high, and if Effort is low and if

Cost of monitoring < value of output stolen +

future output lost

Else, don’t monitor Costs of monitoring < output stolen + future output loss

Else, don’t monitor

Parameter Shift

• Evolution of the system led to parameter shift– Complexity raises monitoring costs– Information flow weakens central authority– Value of incentives decreases as their cost rises– Second economy grows

• High output is no longer the equilibrium• Reforms weaken the structure

– Do not lower monitoring costs – Reforms make defection easier

• Cooperatives• Law on state enterprise

Bank Run

• Why the sudden collapse?• As center weakens officials defect• Race to cash in on assets• Solnick on the collapse• Key to bank run

– Illiquidity– Sudden loss of trust

Solnick• “...the image of a "disintegrating" state...is...seriously

incomplete. Soviet institutions did not simply atrophy or dissolve but were actively pulled apart by officials at all levels seeking to extract assets that were in any way fungible. Where organizational assets were more specific to their particular use by the state, as in the case of draft boards, for example, hierarchical structures proved more resilient. Where organizational assets were chiefly cash and buildings, hierarchical breakdown was almost total. At both ends of the spectrum, the catalysts of state collapse were the agents of the state itself. Once the bank run was on, these officials were not merely stealing resources from the state, they were stealing the state itself."

Shock to Loyalty

• Income of an official is• Probability of detection

– Strength in numbers

• Expected value of defection• Critical value of loyalty

Critical Loyalty Value

n* 1 n

2Kny

w)1( w

K

Add Theft

• Race to cash in– Each defecting agent steals

• Not enough to steal, illiquidity• Official income is now

• Output falls faster– Critical value reached sooner– Agents know nothing will be left if

The Bank Run Case

n* n' 1 n

2Kny

w)1(

w

K

2)1(1 nnKy w)1(

w

Conclusion

• Was the collapse a disaster?• Implications for transition

– Political and economic collapse• Is this more difficult than just economic

reform?

– Macroeconomic imbalance– Window of opportunity– Agenda for reform?

• No blueprints

Midterm One Results

0

2

4

6

8

10

12

14

40 43 46 49 52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 100

79.58462Mean1.471695Standard Error

82Median89Mode

12.40072Standard Deviation153.7779Variance1.166432Kurtosis-1.13572Skew ness

57Range40Minimum97Maximum

5173Sum65Count

3.01466Confidence Level(0.950000)