On the (Im)Possibility

of Market Socialism(1)

Michael Keren

The mid 1980s witnessed the collapse of the Soviet economy, followed by that of the Soviet empire, and of the economies of most other CMEA countries. France's last fling with socialism was rapidly aborted, and, at roughly the same time, many institutions of the labor economy in Israel, a socialist island in a capitalist sea, also foundered. The events of the 1970s had something to do with the strains which inflexible institutions could not withstand, and at least some of these institutions were very inflexible. Not all these events are related, but there may be more than mere coincidence here. It is this fundamental nexus which this paper explores. In particular, are socialism and inflexibility inter-linked? Have socialist economies been led by bureaucracies because this is their "natural" way of coordination? Is "Market Socialism" at all feasible? The fondest hopes of many have been pinned on this solution, which seems to promise both social justice and efficiency, or at least the avoidance of gross waste, as well as freedom from bureaucracy and decentralized entrepreneurship. Even though there seems to be no organized attempt at present to implement this possibly utopian ideal, it is sure to return to the agenda some time in the future.

The term socialism, as used above and throughout this paper, refers to an economic system in which all means of production, all productive organizations, are state owned. Hence the discussion here is not germane to the Israeli, possibly not even to the Yugoslav labor-managed, economy. The question is really whether such a large organization can be freed from its bureaucratic shackles, can it be coordinated by a freely functioning price mechanism? The linchpin in this story is the capital market, coupled with what Kornai2 has termed the "soft budget constraint" (SBC). The commitment to social ownership of capital is, in effect, a commitment to an exclusion. It excludes the private sector from the ownership of productive resources and, in effect, removes productive firms from the jurisdiction of the capital market. It puts the firm under the control of a public hierarchy, and the key question is whether this hierarchy can simulate the capital market. Section 1 below argues why this cannot be done. Section 2 shows that this impossibility leads to the SBC. Once this is the case, the firm is freed from the need to fight for its continued existence through the unceasing search for profits. There is, therefore, no force which makes it change whatever non-profit-maximizing policy it may have strayed on, and, as a result, it becomes less sensitive to market signals, its supply response to price changes and to changes in demand is less elastic (section 3). As a result the hierarchy finds it necessary to help the markets clear (section 4). One of the most damaging effects is not on the current operation of the economy, but on its accumulation of stocks, on its investment activity. This is a direct outcome of the distorted incentives and the SBC (section 5). The concluding remarks in section 5, tie the deformed structure of capital to the paths of possible reforms.

1. Can Hierarchy Simulate the Capital Market?

The introduction has already defined "socialism" for the purposes of this paper as an exclusion: it is a regime in which productive assets cannot be transferred to private hands. This, in effect, excludes them from being traded on the capital market. It is assumed that these productive assets are subdivided and organized in so-called enterprises. Even if these enterprises were legal firms which issued their own shares, these shares cannot be traded on any stock exchange, since the ownership of these firms is not to be traded, and the capital market services can, therefore, not be enlisted to aid the running of these firms.

The basic service the capital market supplies is the evaluation of each traded firm's net worth. This signals to its management and its owners how the market judges its future prospects. If this value declines relative to that of similar firms, this may be taken as an indication that the market considers the firm's policies inferior to those of its competitors. In severe situations, this may convey a recommendation to change the top management team of the firm, possibly through a takeover by an alternative team. In extreme cases, when the market believes that the expected present value of the firm's cash flow is negative or significantly below the breakup value of the firm, the capital market may apply direct sanctions by bankrupting the firm. This indicates that the firm should be dissolved and its assets freed to alternative uses. The capital market, as well as providing for the birth of firms, also provides for their death and for changes in their course in mid-life. It plays a Darwinian role of selection. As in Darwinian evolution, here too the role of chance is great, and the dependence on time is paramount. What succeeds today may be what failed yesterday, because yesterday was not ripe for the idea or because it was not properly packaged. Without a capital market the present structure may atrophy. But the capital market does not fulfill these roles in a socialist economy. Who can take upon himself this role in socialism? If socialism does not allow an external capital market to operate, can it create an internal one, inside the state hierarchy.

The first question to settle is whether the role of the capital market can be fulfilled by independent boards, or whether it should, or would, devolve into the hands of the state hierarchy. It is the latter path that has not functioned well in the Soviet-type economies, and therefore it might seem that more individual supervision provided by separate boards may be preferable. Consider an arrangement in which a board of directors is appointed to oversee management and operations of each socialist firm, and to ensure that each firm maximizes profits. This may seem to be a good solution, but it only shifts the need for control one step higher; someone must oversee the performance of these boards. Even if the remuneration of the boards' members is linked to the profits of their enterprises, the problem remains the same. These boards are not traded in the market, and no independent evaluation of their work is automatically available. The hierarchy will therefore have to oversee the boards, instead of the enterprises. Even when they function properly serious questions arise about the boards' independence. Any profits which the enterprise makes would of course be paid into the treasury's accounts (except for that part used to pay the boards' members). But over the course of operation almost any firm's profit might become negative, in which case the national treasury would have to subsidize the firm. It is likely to use this opportunity to obtain some voice on the policy of the enterprise, at the least to have its own appointees on its board.

For permanently loss-making enterprises, it may even demand full control over the board. Clearly, the public boards cannot remain independent from those in control of the public purse, and eventually the whole public sector is likely to come under the control of some public hierarchy even if it did not start this way, either because the control of independent boards did not fulfill expectations, or because of usurpation by the treasury, finance ministry, or some other master of the purse. This public hierarchy is referred to below as the managing hierarchy or, in brief, as the planner.

Can the planner simulate the capital market? We might suppose that the superior in charge of an enterprise or its board of directors could be told to maximize enterprise profits, to change its management or CEO (chief executive officer) whenever he thought that the firm strayed from the profit maximizing path, and, under extreme conditions, to dissolve the firm when there was no hope for its profitable operation. The superior is likely to have one great advantage over the actors playing in the financial market: he should have much better inside information on the activities of his subordinates. This advantage is however outweighed by the disadvantages of opportunism.

Each bureaucrat has to consider his own and his colleagues' personal files: advancement in a hierarchy is based on past and expected services, on the way the bureaucrat has served the organization, (i.e. his superiors) in the past and is likely to serve in the future. Since his main task is to make decisions and see them through, i.e., coordinate their implementation with insiders and outsiders, his contribution to the organization is judged, at least partly, by the quality of the projects he has approved and guided throughout his career. Any reorganization decision affects these files. If he was also responsible for starting the firm and now decides the firm should be shut down, he raises a question mark about his wisdom in launching it in the first place. If his predecessor is the initiator, then an internal fight may erupt in the hierarchy, a fight that is likely to center around personalities rather than the economics of the situation.

Opportunistic behavior arises from the absence of competition. In a capital market, it is not one individual who decides the fate of firms but an interplay of many groups, each with its own assessment and its own resources, which it is ready to imperil so as to make a substantial gain (or avert a loss) if its gamble should succeed. The weighted opinion of the market determines the fate of the firm, where the weights are asset weights. In the hierarchy the bureaucrat is alone, without competing opinion. It is true that he can consult others, but neither he nor the others are putting their own money at risk.

Consequently a superior in a hierarchy has both motive and opportunity to act opportunistically [which] leads to rules, and the larger the organization, the weaker the supervision and the tighter the rules. It is this that turns large hierarchies into bureaucracies, and very large hierarchies into heavy bureaucracies. For particularly weighty decisions (and a reorganization especially the dissolution of an enterprise is such a decision) the procedures become very complex and usually require committees with quasi legal procedures. These procedures are costly in both time and organizational resources, and as in other judicial procedures, favor the "accused", i.e., those who stand to lose from the decision. And then the staff of the firm have their say as well. For them any forced change of firm policy, even more so a dissolution of the firm, involves some hardship, some learning of new skills, some investment in new specific human capital. The final decision of the hierarchy must therefore be perceived as fair, i.e., it cannot be made except under the due process. But this takes time and a lot of administrative energies. Hence, radical changes of policies and of leading personnel, and even more so bankruptcies, are likely to be very rare affairs at the best of times. More likely they will not take place at all. And if they do, the real cause may not be economics, but politics. In any case, a large hierarchy is incapable of carrying out the tasks of the capital market: it cannot bankrupt firms, except under very rare circumstances, and it will have difficulty changing the management on economic grounds. This leads directly to the soft budget constraint, as is argued in the next section.

2. The Soft Budget Constraint

Section 1 has argued that the planner in a socialist economy, lacking an external capital market, will find it very difficult to dissolve firms or even to effect radical changes of management, hence of policy. If in fact ailing enterprises cannot easily be weeded out, they must be allowed to continue their existence and must therefore be supported financially. This is the origin of the SBC. In a market economy composed of independently owned firms, special efforts are required to avoid insolvency when the cash flow is negative and liquid resources have been exhausted. An independent firm may be bankrupted by the very disinclination of credit suppliers to roll it over in times of financial need. When the same situation confronts a publicly owned firm, the decision to close down, to cease operations, requires a special effort. As long as this decision is not taken, the firm continues to exist and may continue operations without any change of course. In other words, the financial support of the firm continues to be provided by the parent institution in spite of the drain on its resources. The connection is not restricted to socialist economies: in the case of any larger organization, the winding up of operations of any of its parts, be it a plant or a division, is subject to an internal decision of the firm. Likewise in the case of the socialist enterprise, a positive decision on bankruptcy is required by its superiors, and this, as was argued in the previous section, is not likely to be forthcoming. Instead, an automatic supply of funds may come from the banking organizations: these have to supply all needed liquidity, because they have no right to bankrupt a firm by starving it of cash. The more complex forms of support (subsidies or price changes, cheap credits, stock purchases, etc.) require conscious organizational policy. In the Soviet case some of it is built-in: the rule that prices should equal average costs makes it possible for the pricing authorities to raise prices when costs exceed receipts.

The most important aspect of the SBC is the incentive effect; the enterprise itself, its management and its workers, are aware of the existence of the soft budget constraint, and it is this awareness that molds their behavior. An organization certain that it cannot fail just because it is not covering its costs behaves differently from one that has to concentrate first and foremost on keeping financially afloat. It is the incentive effect of the soft budget constraint, namely the reduction in elasticity, which is the subject of the next section.

3. The Soft Budget Constraint and the Firm's Response Elasticity

The effect of the SBC on a firm's incentives and behavior depends upon its perception of the likelihood that sanctions which are ordinarily the task of the capital market will be exercised against it.

Suppose first that the firm's management believes that its standing in the bureaucracy depends only on its profitability, or that its existence may be endangered if it slips into the red. In this case it would follow a rule of thumb that aimed at maximizing profits, provided that enough consumption on the job can be taken by the staff, i.e., that the level of effort exerted by the personnel not be excessive. The only capital market service that the firm is missing is the advice on policy and management provided by its valuation relative to that of competing firms. In other words, we have no outside opinion on the efficacy of the policy rules used by the firm. If, however, the firm's staff adopts the more natural belief that the firm is subject to a SBC and that it cannot founder, incentives are very strongly affected. The remuneration of the personnel now depends on those who soften the budget, i.e., on the whims of the hierarchical superiors: they will have to provide some other desiderata of the superior, which is not likely to be profits. The various groups of employees are now likely to collude together to divide among themselves some consumption on the job. The firm ceases to aim at profit as a maximand.

The colluding parties will have an unwritten agreement among them on conditions of work. Changes in hierarchical routines, in work assignments, or in their authority become substantial operations once the maintenance of bureaucratic peace becomes a paramount target of the firm. The adaptation of the mix of outputs, even more so of the mix of inputs, are more complex and difficult to engineer in the bureaucratic environment than in the economics textbooks. When the mix of outputs is changed, labor and machines have to be shifted around and implicit contracts have to be recontracted. When labor is moved, old habits are broken and friendships disrupted. All of this makes for disutility to veteran workers. In particular, a decrease in labor inputs causes frictions and exertion on the part of management; an increase in labor inputs requires new investments in specific human capital, in training the new recruits. These efforts will not easily be taken if their expected effect, some gain in profits, is only of secondary importance. In other words, the firm's price elasticity of both demand and supply declines. The price change required to bring supply and demand into balance increases. The use of prices to clear the market leads to very wide price volatility.

The effect of the lower price elasticity on the hierarchy are discussed in the next section.

4. Low Response Elasticity and Centralized Allocation

The replacement of the market by administrative allocation can be blamed directly on the lowered price elasticity of the enterprises. The higher price volatility, which is now required for market clearing, is unpopular for two reasons. The first one is political: price volatility or frequent price changes make the planning of purchases more complex and are, therefore, disliked by most consumers. Furthermore, price volatility also means that maintaining a balanced budget for all enterprises is more laborious and the work of the bureaucracy in its support of the SBC becomes more complex. Firms' profits become highly variable, but not in a manner which provides information on the relative efficiency of the various enterprises. When the profits of a firm turn negative, subsidies have to be provided if the firm is not to be bankrupted; when they become too positive, it may be thought necessary to siphon them off. The relative superiority of market allocation over administrative allocation declines, and the temptation to use quantitative targets and limits rather than prices as market clearing tools becomes irresistible.

Hungarian experience can be seen in this light: prices were allowed a fairly free rein after 1968. By 1972, some firms became very unprofitable, mainly large low-flexibility firms, whose continued existence was never in doubt. The hierarchy felt compelled to stop the "excessive" freedom of prices, and control market imbalances by direct though informal signals to the firms. These consisted of both informal messages to the firms, suggesting certain output levels for deficit products, and the general rule of "responsibility to supply", i.e., an informal understanding that firms who were customary suppliers of certain commodities were responsible for providing their customary clients with their reasonable needs. There was, in effect, renewed, though invisible, target fixing. Enterprises colluded with their superiors and obeyed these targets, which were not sanctioned by any written law.

5. Conclusion: What Remains of Market Socialism?

The aims of market socialism are many, but those that interest us here can be put in two groups, decentralization and equality. The former requires a debureaucratized economy, with enterprises free from central coercion, free to take their own initiatives. Equality requires the exclusion of private ownership of productive assets, which may lead to inequality in both assets and incomes, hence of consumption, and a difference in power the aspect that interested Marx most. The message of this paper is that these two are in conflict: the exclusion of private property excludes the services of the capital market, and the hierarchy cannot function as its proxy. Instead, it softens the firm's budget constraint. The enterprises are aware that their budget constraint is soft, that they do not stand to gain much by higher profits nor lose much when profits slip. They become dependent on the hierarchy, reduce their sensitivity to price changes and make the control of costs a secondary objective. Their superiors are forced into using prices to balance budgets rather than markets, and use quantity targets as means of balancing the market.

This has an obvious and deleterious effect on current operations, on costs and on quality. Equally pernicious is the effect on the dynamics of the firm. Investments are channeled into projects that may help production target fulfillment, with little consideration for costs. There is no interest in new cost saving processes, and new products are introduced only if the superiors press the enterprise into producing them. Old physical capital is not discarded, because it can be maintained at high cost of maintenance workers at non-storming time and may be of use at storming time. Human capital is poorly invested: engineers have no cost consciousness, no quality consciousness, but are concerned with keeping the processes working at whatever the cost.

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