traditional centrally planned economies main features of the soviet model of centrally planned...

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TRADITIONAL CENTRALLY PLANNED ECONOMIES

The Economic Transformation of the Soviet Union, 1913-1945

edited by Robert William Davies, Mark Harrison, S. G. Wheatcroft

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Objectives of Typical CPEs

Rapid growth

planners typically target very rapid growth, much higher than capitalist countries

Industrialization

not all sectors promoted equally

emphasis on heavy industry (political issues)

Centralization of decision making and control

Full employment

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Main features of the soviet model of centrally planned economy:

The dominant position of the state sector in the whole economy.

Non market allocation of economic resources.

Independence from the World markets (sometimes autarky)

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Key Elements

Social (state) ownership seen as a primary means to

achieve rapid growth

maintain centralized control

CPEs are command economies centralized, bureaucratic management of

economy non market allocation of economic resources

detailed physical planning

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Planning – Information flows

CPO

Ministry 1 Ministry 2 Ministry M

Enterprise 1 Enterprise 2 Enterprise N1 Enterprise 1 Enterprise 1 Enterprise NM

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CPEs are pressure economies high rate of forced saving

taut planning of

outputs

inputs

inventories

CPEs are priority economies planning based on priorities reflecting

political criteria

socialist ideology

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CPEs rely on extensive development growth and industrialization through massive

increases in resources

the alternative is intensive development -- growth through productivity increasing innovation

CPEs are closed economies foreign trade suppressed

used only as a safety valve to complete domestic plans

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CPEs are shortage economies shortages are chronic

not just occurring temporarily

shortages are general applying in all spheres of the economy

shortages are intensive severely affecting economic actors and decision

making in general

does not preclude surpluses

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Planning – Incentives; Long-term

In the long-term, what matters is innovation by existing firms, the exit of very bad firms, and the formation of lots of new ones.

But why should firms innovate when they face no effective competition and have a guaranteed market for their output?

Hence firms came to have an innovation plan, with targets for innovations.

The result was that often, quite small changes would be presented to look like an ‘innovation’, and serious innovation was still quite sluggish.

Poor links between research institutes and enterprises also didn’t help the situation. Research institutes had incentives to invent things, but why should enterprise then use the results?

Overall, system good at copying, poor at real innovation.

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• physical planning

– balancing of equations in physical units

• sequential

– successive approximation rather than

simultaneous solution of equations

• requires vertical channels of information

and control

Material Balance Planning

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Central planning – some theory

Running the economy through a massive administrative structure, and much vertical flow of information – up and down the planning hierarchy. This already implies an economy that is predominantly state owned, since except under war-time conditions, private firms would not want to be involved in this process.

These vertical flows replace the typical horizontal flows of price and quantity information in a decentralised, market-type economy.

Hence need Central Planning Office (CPO) at the top, then sectoral and/or regional structures, then down to the individual production units – firms and farms (also organisations like schools, research centres, etc.).

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Operating a central planning system

To make a central planning system work there are some key choices to be made:

For what period should we construct the plan?

How much of the economy should it cover? (scope of plan)

In how much detail should we construct it?

What scope, if any, should remain for market-type mechanisms?

What information flows are needed to formulate and implement a plan?

What incentives/rewards/penalties are needed at different levels to make the system function? (incl. defining the plan targets)

What are the implications of our planning model for other features of the economic structure?

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Planning

Period – usually one year (for an operational production plan), or five years (for a medium-term investment plan).

Scope – in former socialist countries, almost the entire economy; in war-time UK, focus on aircraft production.

Detail – could be a few key commodities and a limited number of major firms (as in China), or hundreds (or even thousands) of economic balances, as in former Soviet Union.

Market mechanism – need to use to some extent for labour market and the markets for consumer goods (see later), also in foreign trade with western countries (see later)

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Planning – Information flows

CPO

Ministry 1 Ministry 2 Ministry M

Enterprise 1 Enterprise 2 Enterprise N1 Enterprise 1 Enterprise 1 Enterprise NM

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Planning – Information flows (2)

Figure on previous slide shows simplest organisation chart for a centrally planned economy, with three levels – usually there would be more than this.

For any particular good (or, more usually, product group – such as TVs or household furniture), the planners need to construct a material balance.

They do so by collecting information on sources of supply – from domestic producers (and possibly imports); and expected demand from domestic firms (intermediate demand) and final users (government, households, investment, exports).

Note that the information flows to construct this material balance are mostly vertical, and mostly to do with physical volumes of outputs and inputs – little to do with costs and prices.

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Planning – Information flows (3)

If a given material balance doesn’t balance at some point in the process of formulating their plan, the planners have three ways to deal with it:

They can ignore it, and in effect rely on firms to manage (using reserves, stocks, or whatever);

They can instruct producers to produce more with the given inputs; or require some users to use less of the product per unit of their own output (firms); or ration supplies to households; or

They can undertake a comprehensive recalculation of the whole set of material balances – but this is very complicated and time consuming, so no time to do this many times. Thus a significant change in the steel balance will upset the coal balance, a change in output of vodka will upset the sugar balance, etc.

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Planning – Incentives

Eventually, the method of material balances yields an operational plan for the coming year.

Firms (and farms) know what output they should be producing, and to whom they should deliver it;

Firms also know what inputs will be delivered to them, and how many workers they can employ;

Retail outlets (shops) know what products will be supplied to them for sale in the coming year.

The whole plan is generally based on fixed, state-determined prices, typically set for quite long periods (supposedly based on some measure of costs).

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Planning – Incentives (2)

So how does this planning system work, what incentives does it offer the various agents in the system to cooperate in supplying information, and then to strive to fulfil the resulting plan?

Related to this, we also need to consider some serious informational problems with the model.

We review these issues in stages:

Static, short-run operation of the system;

Medium-term operation – investment;

Long-run operation – innovation and change

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Planning – Incentives (3); Short-run

Firms were usually rewarded for plan fulfilment, generally

with reference to their output target, xp.

Thus a firm’s bonus might take the simple form:

B = α + β.(x – xp)

In this case, the firm loses out if it under-fulfils the plan, but receives more and more bonus the more it produces.

An alternative would set B = 0 if x < xp, which implies a big

penalty for under-fulfilment, while over-fulfilment is rewarded.

Sometimes, both over-fulfilment and under-fulfilment might be penalised, with the highest reward for exact achievement of the plan.

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Clearly, firms can do better if their initial plan is not too

demanding, i.e. if xp is low. Thus firms have an incentive to try to get low plan targets.

But if they then over-fulfil by a lot, the central planners will know that the firm was underestimating its capacity – and next year’s plan will probably be a lot higher.

Hence it makes sense for firms to set modest targets that they over-fulfil by a little.

To counter this sort of behaviour, the central planners commonly adopt a simple rule of thumb, planning from the achieved level – this simply means that next year’s plan target is some percentage above this year’s actual output. This is sometimes called the ratchet principle of planning.

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What does the output target, xp, actually mean? Note that in practice, xp will normally include several different products, measured in value terms, or in physical units. E.g. 10mn roubles worth of machinery; 155,000 tons of furniture.

The firm might find it easier to produce some products rather than others, hence it has an incentive to choose the product mix that meets the plan target most easily.

With a target expressed as a value, the firm will prefer to produce the items that give the highest revenue per unit of ‘effort’ – this may not be equivalent to the most profitable mix unless the firm is rewarded for making profits.

With a plan target expressed as tons of furniture, might be easier to go for a small number of heavy items (as was the case in Soviet Union).

Firm needn’t care whether specific goods demanded or not.

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Planning – Incentives; Medium-term

Turning to investment, note that all firms will be keen to invest, in this system – because expansion is good for annual bonuses (mostly paid to managers), and penalties for a bad project are low or zero (soft budget constraints).

Hence task for planners is to keep investment down, make sure not too many projects get started in a given period.

The five-year plans were basically massive lists of investment projects, often only quite loosely co-ordinated.

Most investment financed from tax revenues, mostly coming from above-plan profits of enterprises – especially in FSU, above-plan profits were often taxed at 100%, not a great way to give firms incentives to improve efficiency.

Investment went to sectors where the planners expected or wanted to see growth – and it was too bad for the lagging sectors when they got it wrong.

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Planning – Incentives; Medium-term

For much of the Soviet period, planners had a theory of growth that led them to give priority to heavy industry (production of means of production – not a bad idea in early stages of development, not so sensible later on).

They also gave high priority to production of military equipment, etc.

Most consumer good sectors had rather low priority, hence were technologically under-developed, often experienced shortage conditions.

Not surprisingly, best managers and best rewards were to be found in heavy industry and defence.

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Planning – Incentives; Long-term

Entry and exit of firms

Innovation and change in existing firms

Cost-reducing innovation

Product innovation

Seeking new markets, designing new products

Improving product quality – problems of supply chains and sales networks

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Planning – Information

Already discussed in connection with material balances, and where we saw that plan targets were often expressed in terms of aggregated information.

The aggregation problem is even more serious, as much plan information is aggregated and then disaggregated as it passes up and down the planning hierarchy – essential to make plans understandable, but also a source of errors.

If we tried to plan using fully detailed information, there would simply be too many balances to manage, probably several million.

So how does the market system work? It is fully decentralised, based on horizontal information flows. Each agent only needs to know about the prices that affect its own business, not about the entire economy. No one has the full picture, no one needs to.

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Trade and foreign investment under

central planning

Outline:

Trade with socialist partners, Comecon;

Trade with western partners;

Restrictions on trade – conventional trade barriers, controls on high-technology trade;

Foreign investment and technology transfer;

Exchange rates, deficits and indebtedness

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Trade with socialist partners, Comecon

Trade mostly determined as part of the regular planning process, normally annual bilateral deals between each pair of countries.

Trade conducted in the ‘transferable rouble’. Prices based on western world market prices,

though lagged and smoothed to remove fluctuations.

Not much attention to comparative advantage, so trade probably not very efficient either in volume, direction or commodity mix.

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Comecon

Comecon was the usual name given to the CMEA – Council for Mutual Economic Assistance, based in Moscow.

Essentially an Eastern version of the EEC (now the EU), but included countries not in Europe like Mongolia and Cuba.

Trade among socialist countries was planned through Comecon, and the Comecon bank handled payment and financing aspects of this trade.

Comecon also tried to promote production specialisation among the socialist countries.

Mostly not very efficient, nor very flexible.

Probably also, too much influenced by the biggest country, the Soviet Union.

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Trade with western partners

This part of the socialist countries’ trade could not be planned like the Comecon trade.

For exports, the countries usually had to take the world market prices as given, and could only export what the market demanded at these prices.

For imports, the socialist countries could choose the quantities (volumes), but they had to pay whatever prices the market conditions imposed.

Hence western trade for the socialist bloc was an aspect of their economic life subject to substantial risks. It was not something they could control.

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Restrictions on trade

There were some tariffs on trade among the socialist countries, but mostly the trade was determined through the plan – with the implication that any trade not in the plan was not allowed.

Trade flows not much influenced by price-type signals or by cost factors. So how did anyone know what trade was profitable, what wasn’t? (mostly they didn’t, though some countries did start to produce measures of export efficiency).

With western trade, a mix of tariffs and quotas, also most countries used multiple exchange rates.

Some trade preferences for developing countries, usually implemented through annual trade deals that could be included in the planning process (e.g. trade between Soviet Union and India)

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Restrictions on trade (2)

There were some controls over exports of advanced technology from western countries to the socialist bloc.

Controls administered by a NATO sub-committee, CoCom – the Coordinating Committee for Multilateral Export Controls (some controls lasted until 1994).

Basic aim: to stop the socialist bloc acquiring advanced military technology, electronic equipment (incl. computers), etc.

Such embargoes can simply stimulate domestic production of the banned exports, or encourage theft of technology.

However, there is no doubt that these controls did slow down the development of certain key technologies in the socialist bloc.

Indirectly, they made the arms race relatively more expensive for the Soviet bloc, possibly advancing the time when the system collapsed, especially as the system was bad at internal innovation.

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Foreign investment and technology transfer

Before 1989, very little FDI in the socialist countries, mostly due to the highly restrictive conditions under which it was allowed.

Most foreign investment took the form of so called joint ventures (a foreign firm and a local firm usually formed a new company, a subsidiary of both, to manage an agreed project).

During the 1980s, the more liberal socialist countries (e.g. Poland and Hungary) tried to encourage more FDI, but their efforts were mostly not a big success.

A few western hotels and fast-food outlets were established, and there was some early cooperation in car production.

There was very little investment by firms in socialist countries outside their home country – mostly this was not allowed.

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FDI and TT (2)

As for technology transfer, this occurred through licensing agreements, the import of western capital equipment, and to an extent through technology theft.

But in areas that had top-level priority, the socialist system could achieve big successes, e.g. Soviet space programme.

Limited movement of people and skills (an important vehicle for technology transfer among western countries).

Few people from the socialist countries worked in western universities and research institutes, and the countries have been slow to modernise their own universities and research facilities.

Spending on new technology and R&D in the former socialist countries still very low – they still rely heavily on imports of technology rather than developing it locally.

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Exchange rates, deficits and indebtedness

Normally, we think of countries as having a single exchange rate and a single balance of trade/balance of payments.

For the socialist countries this was not the case, as they effectively operated with two separate accounts – one for hard (or convertible) currencies (usually expressed in US dollars), one for socialist trade (in transferable roubles).

Hence each country had two key exchange rates – that with the US dollar, and that with the transferable rouble.

But in practice, the countries also operated so called multiple exchange rates, i.e. different exchange rates for different product groups.

The result was an extremely inefficient, non-transparent foreign trading system (cf. Uzbekistan, even today in 2006).

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Deficits and indebtedness

Until the 1970s, the socialist countries mostly maintained both their hard currency accounts, and their transferable rouble accounts, roughly in balance.

World oil price rises in 1973 (Yom Kippur War) and 1979 (Iranian Revolution), led by a strengthened OPEC.

Soviet Union continued to supply its allies with cheap oil, and most socialist countries acted as if oil prices rises would be ‘temporary’.

Western banking systems suddenly awash with cash to invest, so willing to lend to lots of countries where not much lending in the past, including the socialist countries.

Result – some socialist countries started to accumulate hard currency debt (e.g. Hungary), some remained more cautious (e.g. CSFR).

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Deficits and indebtedness (2)

Some countries accumulated debt as a result of internal political conflict + poor economic management (e.g. Poland).

Countries that continued to treat energy as very ‘cheap’ developed economic structures that made their energy use very inefficient – most of the former Soviet Union still uses 2 – 3 times as much energy per unit of GDP as in the UK! This later became a source of problems for the transition.

By the late 1980s, Poland was already in default, other countries like Hungary had worryingly high levels of external debt. Not a good ‘initial condition’ for transition.

Romania, in contrast, had had high external debt, but the ruling group half starved the population and severely restricted most imports in order to pay off most debt by the late 1980s.

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Deficits and indebtedness (3)

By the time that the Soviet Union disintegrated in 1991, it had accumulated external debts of the order of $80 billion (exact amount is still debated).

Russia then inherited all the external debts and assets of the former Soviet Union.

Low oil price in early 1990s + poor export performance of Russia left the country struggling to service the debt.

Hence need for some rescheduling, partial debt relief, and external assistance.

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Central planning – its successes

Mobilised resources and achieved high rates of investment (a necessary, but not sufficient condition for growth).

Generated fast growth, largely by replicating known technology – so called extensive growth.

Shifted resources from low productivity agriculture into higher productivity industry.

Lack of open unemployment.

Low but equal level of wealth (equal sharing of poverty).

Socialistic welfare state.

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Central planning – where it went wrong

Rapid growth rates in early years turned out not to be sustainable. System good at replication, poor at serious innovation. Generated widespread micro-imbalances, inefficient shortages and

surpluses. The centrally planned economy was a supply-constrained economy; Non elastic character of the economy. Non innovative character of the economy. Lack of the financial discipline. Irrational allocation of resources.

Encouraged inefficient micro-level behaviour: Politicized economic decisions. Informal network of contacts. Almost no entry and exit of firms Too many plan targets for each firm, so managers not sure which

should have priority.

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