The Consequences of Central

Planning in Eastern Europe(1)

David Lipton and Jeffrey Sachs

Even with a consensus on the ultimate aims of reform, the tactical difficulties of creating a market economy are profound. Fundamental social, political, and economic changes must be carried out in the context of a deep and worsening economic crisis, inexperience in managing a market economy, fragile political institutions, the residual pressures of the communist power structure throughout society, the reemergence of historical enmities, and often very deep ethnic fissures. Moreover, the rapidly worsening economic crisis in the Soviet Union is producing an economic fallout in Council for Mutual Economic Assistance (CMEA) trade, and the risks of further instability in the Soviet Union hang like a pall over the region. Because the political and economic conditions in the various countries differ markedly, the prospects for success differ as well. The prospects appear to be brightest in the most westward countries: East Germany (where the process will occur as part of reunification), Poland, Czechoslovakia, Hungary, and Yugoslavia. In Bulgaria and Romania, the conditions are considerably less favorable, both economically and politically. And despite Gorbachev's strong orientation toward Western Europe, the Soviet Union remains a case by itself, where it is difficult to find a national consensus on almost any matter, including a return to Europe.

The Tyranny of Misleading Data

Western economists, accustomed to Western standards of analysis, sometimes take Eastern European data at face value. The data, however, can be misleading for several reasons.

First, under the communist regimes, data have simply been faked in some cases, and collected on a very inadequate conceptual base in other cases.(2) Real growth, for example, has been routinely overstated and inflation routinely understated in the data of Eastern Europe and the Soviet Union. Second, and most emphatically, in a shortage economy in which goods are not available at official prices measures of real living standards (such as the wage deflated by the price index) are likely to contain a serious upward bias. In a market economy, a fall in real wages usually means a drop in living standards. But in a shortage economy, a fall in real wages can simply mean the elimination of queues, and therefore a rise in living standards.

Third, almost all analysts of the socialist economies recognize the extreme bias toward heavy industry, much of which produces goods used by other heavy industry but without benefits either current or in the future for consumption. This output is given an important weight in the production and GNP accounts, but it is of little true economic value.

A Polish journalist recently put it well:

For the entire period of real socialism, investments were poured into a close production circle that offered no profit: coal was necessary to produce electricity; electricity was necessary to produce steel; and steel was necessary to mine coal. All that produced a statistical growth in national income, a growth which, as we now see, actually meant a decline in national wealth. Let us keep in mind that the prices for everything were taken out of thin air.(3)

It is bad enough that these data problems pose a serious barrier to analysis. What is worse is that the data can provoke unwarranted pressures on policy- makers. In the course of stabilization, for example, declines in measured real wages that will in fact vastly overstate the actual economic losses can nonetheless still generate strong political demands for government-mandated wage increases that could undermine the stabilization program itself.

With these data problems in mind, let us outline the main constraints on economic reform that face every government in the region.

The Stalinist Legacy

The countries in Eastern Europe have a socialist ownership structure. Industrial production is typically 90 percent or more state owned; the service sector is also heavily state owned, though an unknown level of activity takes place in the grey or black market. Agriculture is generally state owned and controlled, except in Poland, where farmers retained their private land after World War II, though under highly restrictive and repressive conditions.

The role of central planning as of 1990 differs considerably among countries. A summary statistic is the share of goods subject to central allocation by the central planning organs. By this measure, central planning remained in place until this year in Bulgaria, Czechoslovakia, East Germany, and Romania. Central allocation has been substantially phased out in Hungary and was progressively reduced in scope in Poland during the 1980s. In these latter economies, some portions of the economy, such as energy and trade with the Soviet Union, remained under central allocation until recently.

As Kornai has stressed, the shrinkage of the sphere of central planning in Hungary and Poland and the growing autonomy of enterprises did not mean the emergence of normal competitive market relations. Rather under the process of communist-led reform in Hungary and Poland, central planning was replaced in part by market-type controls but also by a burgeoning of ad hoc negotiations between the enterprise and the financial authorities. While in a nominal sense enterprises were guided by prices, interest rates, and tax rates, rather than material allocations, in practice the prices, interest rates, and taxes have all been the subject of continual negotiation.

State enterprises, whether in Eastern Europe or elsewhere, almost inevitably create financial problems in two main areas of decision making: wages (where they are prone to pay excessive wages out of the income stream that would otherwise accrue to the Treasury) and investment (where the manager has a craving for investment spending, because he stands to gain from control over a larger firm, but bears little or no cost if the investments fail). Even in Western Europe the state sector has run into repeated financial difficulties, and in Latin America the state sector has contributed significantly to the genesis of the debt crisis. But the situation in Eastern Europe is even more grave, since the state sector is not disciplined by being part of a larger market economy. To the extent that state enterprises have been decontrolled, but without introducing real market competition at the same time, the result has been a worsening of financial indiscipline of the firm and, eventually, of the macroeconomy. The state enterprise system does not rely on capital markets to allocate credit. Investment spending is typically negotiated between enterprises, the relevant government ministries, and the central planning commission. Once approved, investments are paid for by various reserve funds set aside by an enterprise, centrally allocated investment funds from the national budget, and loans from the central bank. None of these funding sources requires an adequate assessment of investment prospects.

The countries of Eastern Europe differ in the extent to which the private sector has been permitted to operate. It has been highly restricted in Bulgaria, Czechoslovakia, Romania, and Yugoslavia. A very small private service sector survived the socialization process in East Germany. A somewhat larger private sector has been allowed to operate under the reforms in Hungary and Poland. But even in these last cases, the private firms have been heavily restricted by administrative barriers, punitive tax laws, shortages of inputs, and unavailability of foreign exchange and credit, the allocation of which has been almost entirely directed to the state sector.

All the countries suffer from heavily distorted relative prices. Energy and household necessities (mainly food and rent) are heavily subsidized. The exchange rate is overvalued, in the sense that foreign exchange is rationed at the official price (both for current and capital transactions), so that the black market exchange rate is heavily depreciated relative to the official rate. Therefore, while import prices measured at the official exchange rate are cheap, most imported goods are severely rationed in supply (or simply not available), so that the effective price facing end users is extremely high.

On a sectoral level, the industrial structure in every country is strongly skewed toward heavy industry and capital goods and away from light industry, services, and consumer goods. This emphasis mainly reflects two factors: first, the obsessive growth orientation of the Stalinist model and, second, trade patterns instituted by the Soviet Union, which has induced the Eastern European countries to develop large industries to process Soviet raw materials and then re-export them to the Soviet Union in semifinished or finished form.

In Poland, for example, in 1987 the industrial and construction sectors produced 52 percent of GDP, compared with just 29 percent to 38 percent in Greece, Portugal, and Spain. By contrast, the growth of the service sector in Poland has been severely stunted by the focus on industry. In the same year the service sector in Poland employed 35 percent of the labor force, far less than in Greece, Spain, or Portugal (see Table I).

The organization of industry is designed to facilitate top-down planning, rather than market competition, with a heavy orientation toward large firms integrated both horizontally and vertically. There is a virtual absence of small to medium-sized firms, with employment between 50 and 100, the kind of firm that plays such a vital role in growth in the Western industrialized economies. Part of this centralization results from large-scale production units, and part from the tendency to group separate factories in a particular sector together in a small number of enterprises. The anti-competitive nature of the industrial structure is often exacerbated by the presence of enterprise associations that tie together firms at the industry level and act as cartels.

Consider again the case of Poland. The average state enterprise in Polish industry (excluding the so-called cooperative sector, which represents 13 percent of employment in the state sector) has 1,132 employees, typically in multi-plant operations. The average number of employees per plant (again excluding the cooperative sector) is 378 (see Table 2), compared with about 80 workers per plant in a sample of Western economies. The 115 largest enterprises, each with more than 5,000 employees, account for more than one fifth of industrial employment and production. At the other end of the spectrum, only 982 enterprises in all of socialized industry in Poland have fewer than 100 employees. In Korea, where small and medium-sized enterprises have provided much of the impetus for growth and economic development, 33 percent of the labor force is employed in establishments with fewer than 100 workers. This contrasts with only 10 percent in the Polish state sector.

The socialist economies also lack adequate procedures for the entry and exit of enterprises. Enterprises are typically "founded" by ministries or local authorities, which at the same time arrange for the funding to begin operations. Absent such sponsorship, there is little chance that state enterprise activity can spring up to meet even the most obvious economic needs. On the side of exit, bankruptcy and liquidation of state enterprise activity has been virtually unknown. In fact, the absence of markets and meaningful relative prices in the economy means that it is difficult, if not impossible, to distinguish between enterprises that should and should not survive.

All countries of Eastern Europe suffer from chronic excess demand, though to varying degrees. The extent of shortages at official prices has been very high in Bulgaria, Poland, and Romania, and less severe in Czechoslovakia, Hungary, and Yugoslavia. In the former countries, the supply of basic consumer goods (such as food) has been erratic and often formally rationed. Active black markets exist in which goods are available at a multiple of the official price. In Czechoslovakia, Hungary, and Yugoslavia, markets for basic consumer goods have generally cleared (though quality is often low and variety is limited), while shortages remain acute for housing, telephones, automobiles, and other types of consumer durables.

At the enterprise level, excess demand is manifested in chronic shortages of basic inputs at official prices. There are informal supply networks through which state enterprises cope in part with the chronic supply shortages. In Hungary and Poland, where small-scale private firms have been allowed to operate, the private sector firms are generally cut out from these informal supply networks, and therefore face extreme shortages and the need to bribe individuals in state-owned enterprises to obtain even a haphazard supply of inputs.

Another coping mechanism of all enterprises has been an autarkic production strategy in which the firm eschews specialization, at great cost to efficiency, in order to produce all the necessary components for the production process. It is more or less the opposite of Japan's just-in-time (kanban) production organization, in which large firms rely on small, highly specialized firms to provide inputs on a carefully timed, highly reliable basis. In Eastern Europe, there are almost no small independent firms servicing large enterprises. All work is done in-house.(4)

The origins of excess demand lie deep within the system and include: the planners' drive toward rapid growth through heavy investment; the soft budget constraint of enterprises engaged in constant negotiation with the financial authorities; the planners' fear of unemployment; and the communist regime's lack of legitimacy to impose strong austerity measures with public support and its unwillingness or inability to do so by brute force.

Political Context

The collapse of communist one-party rule was the sine qua non for an effective transition to a market economy. If one proposition has been tested by history, it is that the communist parties of Eastern Europe would not lead a process of radical reform sufficiently deep to create a real market economy. There were too many barriers: the ideology of state ownership; the power structure of the party, based heavily on state enterprise managers and bureaucrats loath to allow real competition to the state enterprises; the communist leaderships' lack of legitimacy among the public, making it impossible to impose the short-run costs of deep economic restructuring; and the low regard in the West for the communist governments, making it impossible for them to mobilize the international financial support vital for the economic transition.

Thus, the emergence of noncommunist rule has been a fundamental watershed for real reform in Eastern Europe. But, at the same time, the emergence of noncommunist governments in the region not only does not erase all existing political difficulties, but actually introduces new ones. The economic strategy must take cognizance of the new political context, which, in our view, argues overwhelmingly for a very rapid, straightforward, and sharp program of economic reform.

The first point is the Latin American lesson of the 1980s, that a fragile democratic opening combined with a deep economic crisis is a fertile brew for populist politics. Only decisive actions by a reformist government can keep these populist pressures in check. In most countries, stabilization by itself will require a sharp cutback in budget subsidies and a rise in unemployment. The restructuring of industry will also impose costs on particular groups. The urgent need to address the deteriorating infrastructure (including the environment) may also require a reduction in current consumption.(5)

These conditions will produce ample opportunities for politicians who promise illusory low-cost paths to reform. In the short-term, populist pressures will lead to opposition to cuts in subsidies and to calls for "reactivation" of the economy through wage increases and demand expansion. In the longer run populists politicians will find support among workers in declining industries who will press for protection, subsidies and other steps to halt the necessary industrial restructuring. The risks are compounded because both electorates and government officials will be highly inexperienced in the process of real economic reform.

Governments in the region may also be stymied by the likely reintroduction of prewar electoral rules based on proportional representation. Voting bases on proportional representation tends to produce weak multiparty coalition governments that have a particularly difficult time in reducing an inherited government deficit. The prewar history of the region amply demonstrates this proposition.

Another profound political difficulty relates to the bureaucracy. The new governments of Eastern Europe are inheriting bureaucracies created and appointed by the communist party. The structure and personnel in these bureaucracies will change only gradually over time. There are tens, if not hundreds, of thousands of officials whose professional experience lies in a lifetime of bureaucratic planning of economic life, whose links are to party-appointed managers of state enterprises.

The bureaucracy provides an extraordinarily important practical argument for radical free market policies, even in circumstances where "market failures" exists and pure theory might suggest more nuanced policies. It is naive to think of the existing bureaucracy as equipped, professionally or temperamentally, to implement sophisticated policies based on Western-style theories of the "second-best." The bureaucracy cannot be relied upon for efficiency in regulating monopoly prices, promoting infant industries, or implementing industrial policy.

Other deep political fissures are likely to reopen, after decades of dormancy. The prewar rural-urban economic battles in the region are already revving up in Poland, and will likely do so soon in Hungary. The nationalist and ethnic battles, within countries and between countries, are also reawakening at an alarming rate. One can mention the recent nationalist violence in Yugoslavia, between Serbs and Albanians; in Romania, between ethnic Hungarians and Romanians in Transylvania; in Bulgaria, against the Turkish minority. Even many Slovak leaders are agitating for a break with the Czechs, or at least for national autonomy within a Czecho-Slovak federation with a weak central government.