Soviet Transition to a Market Economy

I wrote this paper my last year at Rice. This was for a course that was a history seminar, but it seemed more like an anthology course. Anyways, I had to pick some type of subject that dealt with Eastern Europe and political change (or something like that). So I chose to do a paper geared towards economics, but I'm not good at economics, in fact I suck at it, but nevertheless, I think it's a decent paper. It got me an A.

Russia’s transition to a market economy yielded no significant changes in the social organization of production. Naturally there was some doubt as to whether Russia was undergoing a transition to capitalism at all. The transformation of the Soviet Union into a modern, capitalistic Eastern Europe obviously did not occur overnight. This transition to a market economy is an ongoing process. This concept of transition economies surfaced in the early 1990s after the collapse of the Soviet Union. Approximately 25 communist or planned economies undertook the transformation from a centrally planned to a market-based economy, as well as the transition from single-party states to liberal democracies. Economic growth has a substantial impact on a nation’s economic performance. Naturally, economic growth is the primary objective in a nation’s economic policy (Deliktaş & Balcilar 7). Similar to post-Socialist Europe, other countries throughout history have undergone comparable patterns, often involving slow economic growth and currency inflation. Any change of government, whether the collapse of an old regime or a revolutionary movement – economic turmoil, if not recession, is almost always imminent. This paper discusses issues such as modes of production, national currencies, inflation, dollarization, and the transition to a market economy in Post-Socialist Eastern Europe.

Soviet Management Practices

In his entry in Post-Communist Economies, Simon Clarke writes about the management of holding companies in Russia. He argues that the “spontaneous development of the institutions and practices typical of a capitalist market economy” was not the result after the fall of the Soviet Union (Clarke 405). It is almost impossible to imagine a nation’s economy with a changing government to assimilate quickly. As a result, several critics doubted whether or not the former Soviet states were in a transition towards capitalism. However, there was a form of capitalism in Eastern Europe, dubbed “booty capitalism.” Booty capitalism is when banks and trading monopolies extract profits and nothing is reinvested back into production (Clarke 405). Thus the only winners in booty capitalism are big businesses, not the common worker or nation as a whole. Since these “new” businesses fail to reinvest in alternative methods of production, it is sometimes labeled “industrial feudalism” because it allows traditional Soviet practices to continue (Clarke 405). One of the many reasons why the Soviet system of labor failed was due to the fact there was little, if not any, incentive for management to intensify labor, lengthen the working day, economize the use of resources, or increase productivity. Clarke further reports that the management style can be characterized as “authoritarian paternalist.” The enterprise director, as he calls it, had absolute authority in a hierarchical formal structure (Clarke 407). To achieve the production tasks and goals, a chain of command involving chiefs, section chiefs, foremen, and sometimes ordinary workers enforced a system of punishments and rewards. Any internal conflicts were resolved off the record (that is, no official reports are made) or via transfers; any other larger conflicts were directed against the higher authorities (Clarke 407). This method of conflict resolution appears strikingly similar to that of a capitalist workplace. It seems that any minor incident usually concluded with a warning or informal meeting rather than dramatic measures.

Even the management structure in the new economy seemed to be a hybrid of Soviet and Capitalist practices. High levels of professionalism and loyalty of the senior managers was a repeated theme. These senior managers often possessed both technical and higher educations. The new managers generally were young and studied abroad for management training. Due to the resentment that often stems from appointing people from the outside to senior positions (because it inhibits promotions), senior managers are either appointed internally or from the holding company’s own staff (Clarke 412). This creates a better working environment for both the company and the common man – the company is happy because the worker is happy, and the worker is happy because of the possibility of a promotion through hard work is now available in a capitalist economy. Naturally this allows for a small, if not a substantial, growth in production and productivity. The ability to climb the proverbial “corporate ladder” is a great incentive for employees to work harder.

Currency and Inflation

One of the major problems that former Soviet states faced was hyperinflation. After the Soviet Union broke up, ten out of the fifteen former states of the Soviet Union were hit by hyperinflation. Prior to 1993, hyperinflation has appeared a total of eighteen times in recorded world history (Åslund 49). Åslund believes hyperinflation can be attributed for the preliminary failure of the market economic reform in twelve members of the Commonwealth of the Independent States (CIS). Åslund offers evidence for his theory – three Baltic nations, Estonia, Latvia, and Lithuania, broke out of the persistence of the common currency area in the CIS in 1992 and escaped hyperinflation, along with Kyrgyzstan, the first CIS member to establish its own national currency in May 1993 (Åslund 49). Albeit Kyrgyzstan is not an economic powerhouse, the ability to prevent hyperinflation is one step toward building a solid economy. Åslund also believes that even factors such as the years of communism, geography, and the degree of economic distortions are not as important of a factor for a post-communist transition compared to membership in the ruble zone. He blames the IMF for the preservation of the ruble zone, deeming it the “worst single mistake in the post-communist transition in terms of cost” (Åslund 50).

Nevertheless, in the end the preservation of the ruble zone stabilized. According to scholars John Odling-Smee and Gonzalo Pastor, there were three policy options open for the alternative currency regimes: “a cooperative ruble area arrangement in which all participating central banks would have a say in credit and monetary policy for the ruble area; national currencies; and a Russia-dominated ruble area in which the CBR (Bank of Russia) would be solely responsible for monetary and exchange rate issues” (quoted in Åslund 50). Obviously the Russia-dominated ruble area was politically impossible, and people would question if the Soviet Union truly had broken up. By the end of 1991, all of the fifteen Soviet republics had set up their own central banks and began issuing money, independently of the other banks, including the Soviet Gosbank (Åslund 50).

Currently all of these former Soviet states have their own independent national currencies. The introduction of these national currencies helped financially stabilize each nation. The three aforementioned Baltic countries that created their national currencies first were also the first economies to stabilize (Åslund 50). Even though the national currencies were successful in stabilizing their own economies, it did lead to some problems. The fifteen banks were competing with one another in issuing credits. The more credits one bank or country issued, the bank or country received a larger share of the total GDP. The smaller republics could not issue as much money and therefore obtained a smaller share of the common GDP (Åslund 50-51). This clearly is a handicap to the smaller or poorer nations. That is one reason why the Baltic nations insisted on a national currency and introducing it as early as possible. It was believed to be impossible to control monetary production by more than one central bank in one currency zone through a cooperative agreement (Åslund 51). Through false reporting and the illegality of electronic payments, the Soviet republics did not trust each other and felt that mutual cheating was the only logical approach. It was obvious that a cooperative monetary system in one ruble zone was impossible to implement, and by breaking up the ruble zone, separate national currencies emerged to be the best alternative (Åslund 51).

Ukraine: Trouble with Transitioning

Besides Russia, Ukraine was by far the most important republic economically in the Soviet Union. In addition to producing four times the amount of the next-ranking Soviet state, its fertile black soil accounted for more than one-fourth of Soviet agricultural output (CIA World Factbook). Ukraine’s varied heavy industry supplied unique equipment, such as large diameter pipes, and raw materials to other regions of industrial and mining locations in the former Soviet Union. Because of Ukraine’s dependency on the importation of energy, notably natural gas, it imports approximately 85 percent of its annual energy requirements. Relying on foreign imports of energy, especially from other Soviet states can only lead to disaster with the dissolution of the USSR.

Robert S. Kravchuk writes, “The former Soviet Republic of Ukraine has suffered the worst of what economic transition has to offer” (Kravchuk 45). His evidence includes the country’s decreasing economic production in output, employment, productivity, and investment. During the two year period of 1991-1993, Ukraine’s inflation record was the worst of any former Soviet state with average monthly price increases of 33 percent in the beginning of 1992 to mid-1994 (Kravchuk 45-46). Kravchuk even labels Ukraine as an “economic basket case” due to its ridiculously fluctuating economy and continuous inflation. According to the definition of hyperinflation – a general monthly price increase in excess of 50 percent, Ukraine has been guilty of hyperinflation seven times during this period, six of them in the second half of 1993 (Kravchuk 46). These price inflations were accompanied by rapid growth and production of the money supply. The period of the greatest monetary expansion occurred between 1992 and 1994, around the same time as the highest price inflation. Monetary stabilization was achieved around mid-1996, approximately the same time as the introduction of Ukraine’s permanent currency, the Hryvna (Kravchuk 46).

How did the Ukrainian government benefit from inflation and not collapse in the face of adversity? Kravchuk suggests John Maynard Keynes’ theory that governments in general raise their revenues by purposefully inflating their currencies. Keynes wrote that a nation’s ability to “live for a long time… by printing paper money” and “live by this means when it can live by no other” (Kravchuk 54). This tactic essentially deceives the public as to the basic value of its monetary assets. The exclusive right for a government to issue new money is called seigniorage. The depreciation of existing money balances since the newly issued money is termed the inflation tax. The actual change in monetary holdings, or real balances, is equal to the sum of seigniorage and the inflation tax (Kravchuk 54). The combination of seigniorage and the “new” inflation tax help deceive, or cover up, the government’s weakening currency. Domestically, this is a brilliant way to mislead the public; internationally, the national currency becomes more worthless. Ukraine’s inflation began to dwindle around 1995-1996, mainly due to the implementation of fiscal reform backed by an IMF-sponsored program (Kravchuk 55). Luckily for the Ukrainians, their period of deception was relatively brief. Continuous years of purposefully inflating currency can only lead to a larger predicament for the government to patch up in later years.

Ukraine’s most significant success in the economic realm in its first half decade was the Currency Reform of September 1996 (Kravchuk 61). The aforementioned hryvna was announced on August 24, 1996 by then President Kuchma. Because it coincided with the fifth anniversary of Ukraine’s independence, the announcement was anticipated with much regale. One of the most important reasons why the previously used karbovantsi needed replacing by the hryvna was the inflation. The simplest of transactions could involve millions of karbovantsi (Kravchuk 61). This new currency obviously saved time in bookkeeping since the large amounts of karbovantsi needed allowed the record-keeping to be free of fewer errors. The introduction of the new currency also had to come at a time of relative price and monetary stability, to ensure not to disadvantage anyone in the reform. During the summer months of 1996, monthly inflation rates were a measly 0.1 percent, an ideal time for the currency conversion of 100,000 karbovantsi to 1 hryvna (Kravchuk 62). This basically eliminated five digits from prices.

The Ukrainian government should be applauded in their conversion efforts; approximately 95.5 percent of circulated cash was converted between September 2 and 16 (Kravchuk 62). The new currency also proved strong from its inception – the Ukrainian Interbank Currency Exchange reported that the hryvna started trading at 1.76 to the dollar, holding through October and slowly rising to 1.82 per dollar in November and 1.88 in December. Even the Russian currency exchanged at 3,000 rubles per hryvna and 1.18 to the Deutsch Mark (Kravchuk 63). It is extremely impressive that the Ukrainian currency proved to be significantly stronger than the Russian ruble. The elimination of dollarization and currency inflation via a new, stronger currency greatly assisted the Ukrainian economy. A stronger currency allows a nation to open its trading doors to other countries that may have been skeptical about the worth of their products and currency inflation, thus promoting economic growth through exports.

Dollarization and Poland

In addition to the issues of national currencies and stabilizing economies, dollarization can sometimes help control inflation. Dollarization is the use of any economically stable foreign currency as a country’s unofficial national currency. The United States dollar is often the most popular currency used, hence the term dollarization (Bien 68). Havrylyshyn and Beddies continue to define their definition of dollarization as to mean “the holding by residents of a significant but still partial share of their assets in the form of any foreign currency denominated asset” (Havrylyshyn & Beddies 330-31).

Visible forms of dollarization, that is, forms that can be measured, are cash dollarization, deposit/asset dollarization, and liability dollarization (Havrylyshyn & Beddies 331). Why does dollarization occur? Currency inflation is usually the primary reason; when the use of domestic currency for purchases and transactions is too high due to the lack of confidence in the local currency, it motivates the public to adopt a more reliable currency. Even more than a decade after these former Soviet states gained independence, the amount of dollarization is relatively high and even rising in some countries. Expectantly dollarization is lowest in the Baltics at 27 percent with the average rate of dollarization approximately 35 percent among the former Soviet states, and as high as 52 percent in Belarus (Havrylyshyn & Beddies 337). Regardless of Havrylyshyn and Beddies arguing that dollarization does have benefits, it is difficult to ignore the fact that the countries with the lower dollarization rates are the ones that have lower inflation rates and more stable economies, like the Baltic states.

There are several costly consequences of dollarization. It leads to the lower demand of domestic money because of reduced credibility in the local currency, forgone tax revenue through underground economic activity, and a facilitation of crime and corruption. Accounting for macroeconomic instability, dollarization can also lead to high inflation and depreciating exchange rates (Havrylyshyn & Beddies 330). Despite these negative aspects of dollarization, it does have an upside. Most studies initially believed that dollarization was harmful, but now indicate that it is not as damaging as previously thought and actually has a beneficial dimension in promoting the growth of financial market developments (Havrylyshyn & Beddies 329). This growth of financial market developments is made possible through better portfolio diversification, which can then reduce or even reverse capital flight. Since dollarization occurs as a free choice by rational economic agents, it can be used as an inflation-beating strategy (Havrylyshyn & Beddies 330).

The use of a foreign nation’s currency is not a new trend. Its classic form appeared during the hyperinflation period in Germany after World War I, peaking in 1923 (Bien 68). Dollarization comes in both direct and indirect forms. In the direct form, the foreign currency is mixed in with the domestic currency and performs the same functions, including circulation and payment. The indirect form is limited to a measure of value: the prices of products, services, and loans, but the regulation of obligations are still based off the “exchange rate of the national currency on the day of liquidation of the obligation” (Bien 69). Poland has utilized dollarization for several years prior to 1991, but after the fall of the Soviet Bloc dollarization was closely managed and limited by legal regulations. Initially it did not have a significant influence on the circulation of the local currency, but is now displacing the Polish currency in areas of economic and private life (Bien 69-70).

The legality behind dollarization began in Poland during the 1950s, but was especially favored in between 1980 and 1982 because of the general consensus of the weakening Polish zloty, and thus began stocking up foreign currencies (Bien 70). It is interesting to note that dollarization is often characterized by consumers using foreign money to purchase goods on the black market or in times of hyperinflation (the case of Germany between the World Wars). Poland actually used dollarization as a part of its economic reform – exporters were given the right to purge a portion of revenues earned in foreign currencies in the form of foreign exchange allowances. This included using these so-called allowances to pay for imported and capital goods, as well as transferring a portion of the allowances to their partners (Bien 70). In addition to these uses, exporters were allowed to cover major losses in exporting with their earnings from selling a portion of the foreign exchange allowance at rates above the official rate to other enterprises (Bien 72). Not only were large exporters “rewarded” with dollarization, private importation increased in Poland. Travel bureaus offered destinations to attractive markets and bazaars worldwide, and with the reduction or removal of taxes on goods in the domestic market, coupled with the introduction of a unified tax of 15 percent on imported products, thousands of people desired to go into the private importation business while utilizing foreign currencies (Bien 72-73).

However, as a result there was an increase in demand for foreign currencies and continuing dollarization in Poland, leading to a speedy increase in inflation. In the fourth quarter of 1986 the dollar was worth 790-950 zl, and a year later it climbed to 1,350 zl (Bien 71, 73). At the end of 1988, the Polish government announced a quick “return to normalcy” of the country’s economy. One tactic was to turn the dollar into a common commodity that could be easily acquired by anyone with the amount of cash in domestic money at a price created through supply and demand. In turn this maneuver would place more confidence in the local currency and turn it into “real” money, and at the same time converting the dollar into an everyday commodity (Bien 73). The government banked on combining the official and black market rates in order to substantially reduce the exchange rate. In order to do this, the black market was made legal, and several money exchanging businesses opened to buy and sell foreign currencies, both from the private sector and foreigners (Bien 73). Yet this plan backfired – the market reacted with a sharp increase in the rate of the dollar, peaking at 12,000 zl in October 1989 and dollarization greatly increased due to the rise of inflation (Bien 74).

The impact of dollarization is evident – although it may lead to a small beneficial role in the economy, for the most part it makes countries more dependent on the foreign currency. As shown with Poland, Dollarization can lead to higher rates of inflation and exchange rates, as well as black market economies that do not account towards the country’s economic welfare. A nation must either have confidence in its currency or the ability to control dollarization if it desires a smooth transition into a strong, if not at least successful, market economy.

Macroeconomic Performance: GDP & TFP

Economic growth has a substantial impact on a nation’s economic performance. Even with the fairly successful transition of the Ukrainian economy, currently some of the former Soviet republics are still experiencing economic regression and contraction. These regions have experience a substantial drop in GDP growth since 1990, and in some cases the transition economies barely recovered to pre-transition GDP levels as recently as five years ago.

Ertuğrul Deliktaş and Mehmet Balcilar estimate efficiency measures for twenty-five Baltic and Eastern European countries, including former Soviet republics utilizing stochastic frontier analysis (SFA)[1] and data envelopment analysis as a confirmatory study to determine if the transition to a market-based economy increased in total factor productivity (TFP)[2], economic efficiency, and technical progress (Deliktaş & Balcilar 6). The mean annual efficiency level for the 25 transition economies is 0.548, and the yearly rate of growth in technical efficiency is 1.8 percent between 1991 and 2000. However, the mean annual technical change in those economies is -4.3 percent; there is zero technological progress, which actually equates to technological regress (Deliktaş & Balcilar 6). Some of these nations are having difficulties, leading to taking a step back rather than a step forward in their transition to a market economy.

As previously mentioned, economic growth is the primary objective in a nation’s economic policy. The absence of economic growth can become a barrier in curbing a nation’s long-term poverty (Deliktaş & Balcilar 7). Table 1 (attached) from Deliktaş’ and Balcilar’s study shows the annual mean GDP growth rate of these transition economies between 1990 and 2000 (Deliktaş & Balcilar 8). According to Table 1, only seven nations, including Poland and the Czech Republic experienced positive growth rates during the time period.

There are three major factors that economists use in determining the economic performance of a nation. The first focuses on growth in real per capita GDP, also known as real per capita income. It is a first hand indicator that is associated with the standard of living. The other two factors are the disparities in the distribution of income among poor countries and the average productivity performance of workers, such as output per person employed or per hour worked, along with “multifactor productivity measures based on the concept of total factor productivity (TFP) and its components…”(Deliktaş & Balcilar 7).

Slow and regressing GDP rates obviously have a considerable effect on a nation’s GDP per capita levels. Poland is probably one of the best success stories, if not the best, of all the transitioning economies. The 2004 estimate of GDP per capita for Poland was $12,000 (CIA World Factbook). Table 1 indicates that Poland experienced a 4.6 percent average annual GDP growth in 1990-2000. Compare this to Tajikistan’s growth of -10.4 percent. In the same year, the estimated GDP per capita was just a measly $1,100 (CIA World Factbook). The relationship to GDP growth and GDP per capita for these two countries is not a coincidence. The direct proportion of higher GDP growth and GDP per capita reveal a better quality of life for workers. The quicker and smoother assimilation to a market economy can ultimately benefit not only the government, but all of its citizens as well. After all, the government’s ultimate goal is to help as many of its citizens as possible through its reforms and laws.

Conclusion

In summation, there exist numerous barriers for the transformation from a socialist to a capitalist market economy. Incentives such as promotions, the restructuring of management, and utilizing a punishment and reward system can lead to more productive workers. Emulating a capitalist workplace through both internal management of businesses and methods of conflict resolution can achieve better economic production. Eliminating hyperinflation and currency inflation through the use of either a new domestic currency or establishing noncompetitive central banks can help stabilize a transitioning economy. Separate national currencies are the best alternative because of the false reports of “cheating” banks in the failed ruble zone. Unlike the Ukrainian government, avoiding seigniorage and economic dependence with other Soviet states is a key move in obtaining an economy without holes in resources and exports. Strict regulation of dollarization can help prevent the otherwise negative consequences of high inflation rates, loss of confidence in the domestic currency, and black markets. Economic growth is by far the primary objective for any nation, especially since it is linked directly to the standard of living and poverty of a country. The transition to a market economy can be extremely difficult, but as we have seen through Poland and Ukraine, it is possible to be successful.

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[1] The econometric methods (SFA) can be classified as (1) those that assume all deviations from the frontier are due to inefficiencies, and (2) those that allow some variation around the frontier due to factors that cannot be controlled by the firm. In the first method, a deterministic frontier is prescribed, while a scholastic frontier is prescribed in the second. Econometric methods allow flexible functional forms for the frontier and impose some restriction on the statistical properties of efficiency terms (Balcilar and Cokgezen 2001, quoted Deliktaş & Balcilar 12).

[2] Productivity and economic growth are important because they determine the real standard of living that a country can achieve for its citizens. There is a simple link between a nation’s productivity growth and standard of living. TFP growth is simply the sum of efficiency and technical changes. These two changes constitute the TFP change index (Balcilar and Cokgezen 2001, quoted Deliktaş & Balcilar 12).