Bonus Web Chapter

Transition Economies: Russia and China

Bonus web chapter Forty

Transition Economies:
Russia and China

CHAPTER OVERVIEW

Two of the most profound events of the past two decades are the collapse of communism in the Soviet Union and the rapid emergence of the market system in China. Russia and China are perhaps the world’s most significant developing economies: Together they constitute 20 percent of the world’s surface area and 23 percent of the world’s population.

In this final chapter, we first briefly look at Marxist (communist) ideology that gave rise to the command economies. Then we examine the institutions and techniques of central planning common to both the Soviet Union and prereform China.

Next, we discuss the coordination and incentive problems that central planning created. Finally, our attention turns to Russia and China’s transition to market economies.

WHAT’S NEW

Data on Russia and China have been updated. The discussion of the Russian economy has been revised in light of recent resurgence. The discussion on China reflects current problems the country is having with unemployment.

The two web-based questions have been replaced.

INSTRUCTIONAL OBJECTIVES

After completing this chapter, students should be able to

1. Summarize the Marxist ideology, especially the concept of the labor theory of value.

2. Identify two major institutional features of the former Soviet system and the prereform Chinese economy.

3. List seven characteristics of Soviet and Chinese central planning.

4. Describe the coordinating problem found in central planning.

5. Describe the difficult problem of incentives faced by central planners.

6. Explain the causes of the failure of the Soviet centrally planned economic system.

7. Describe the components necessary for the transition to a market system.

8. Identify the problems and accomplishments of Russian economic reform.

9. Compare market reform in China with the reform process in Russia and explain how it has differed.

10. Identify three institutions developed in China for the support and control of market activity.

11. Identify four problems that have slowed the transition process in China.

12. Define and identify terms and concepts listed at the end of the chapter.

COMMENTS AND TEACHING SUGGESTIONS

1. This chapter can be assigned near the beginning of the principles course, after students have been introduced to the operation of a capitalist market system. The contrast between central planning and a capitalist system seems to help students realize that the market system we often take for granted is something worth studying after all. In learning about the problems with a centrally planned system, students begin to appreciate the market forces and freedoms of a capitalist system. However, it is worth returning to this chapter after a thorough grounding in the microeconomics of the preceding chapters.

2. Current economic problems in the former Soviet republics and China are the focus of many news stories and offer an opportunity to discuss how our system deals with such problems, if they exist here. Or, if the problems don’t exist in the U.S., students can discuss why not. Another possible assignment would be to examine the published problems and have students design solutions for them. Ask students to identify specific types of problems relating to property rights, coordination of economic activity, and the presence or lack of economic incentives.

3. An article in the Los Angeles Times, April 18, 1998 “China’s New Tenants Won’t Buy Excuses” by Rone Tempest is an entertaining example of what can happen when foreign investors bring consumer rights, a sense of entitlement, and a more sophisticated view of property rights—along with their money.

4. Aboveaverage classes might be interested in discussing Oskar Lange’s ideas on the possibility of central planers duplicating market efficiencies with rational pricing methods. Market socialism is discussed in most texts on comparative economic systems.

STUDENT STUMBLING BLOCK

Students confuse Russia with the whole former Soviet Union. A map showing the size (stretching over 11 time zones) of Russia and its location relative to the fifteen former republics, which are now independent countries, is a good lesson in economic geography. A source of confusion related to this chapter is the common misperception that any government involvement in an industry is “socialism.” In learning about a centrally planned socialist system, students may be more aware of what the Soviet brand of socialism was like and less about the Chinese system.

LECTURE NOTES

I.Ideology and Institutions

1. History

1. The Russian Revolution of 1917 produced a dictatorship under Vladimir Lenin and later Joseph Stalin.
2. China’s communist revolution took place in 1947 under Mao Zedong.
3. Both nations viewed centrally planned socialism as a solution to the instability of what they believed were chaotic market systems.

B.Marxian ideology was the basis for the Communist Party’s power and economic system.

1.Marx’s labor theory of value holds that all value was determined by the amount of labor time required for its production. However, capitalists owned the means of production and had power over the workers whom they employed.

2.Workers were exploited by the capitalists, who bought the labor for a low wage and got fulltime service from each worker. The value of workers’ production exceeded their wages, and this led to the capitalist earning what Marx called “surplus value.”

3.Communism’s function was to overthrow the capitalist control of the means of production so that the worker had control and would no longer be exploited. The Party viewed itself as the vanguard of the working class, but in practice it was a strong dictatorship.

C.There were two major institutional characteristics of the previous economies of Russia and China.

1.There was state ownership of all property, transportation and communication facilities, banking institutions, virtually all industry including retail and wholesale enterprises, and most urban housing structures.

2.There was central economic planning, which meant that the economy was directed by the central government rather than by decentralized market mechanisms.

II.Central planning and its problems

A.Planning goals and techniques.

1.Industrialization and military strength had the highest priority in terms of resource allocation in the Soviet Union. In China emphasis was placed on developing small-scale industries scattered throughout the rural areas. Both countries neglected consumer goods industries.

2.Resources were overcommitted and planners committed more resources than were available, so there were persistent shortages.

3.Resources were initially mobilized to achieve rapid economic growth and this was successful through the 1950s. Both China and the Soviet Union induced or coerced a larger proportion of the population into the labor force.

4.Allocation of inputs was done by directive.

5.The government fixed prices of virtually all inputs and outputs, but prices did not reflect the relative scarcity of a given resource or product.

6.The Soviet Union and China aimed at selfsufficiency and avoided trade with Western countries if possible.

7.Macroeconomic policies were passive, meaning that money and prices accommodated output plans but did not play a role in influencing their outcome.

1. Problems of central planning were serious.

1. The coordination problem was massive; outputs of some industries are inputs in others, so problems in any single sector would immediately be felt in many. There was no price mechanism to provide incentives to eliminate bottlenecks, as is true in a market economy. Planners had to coordinate inputs and outputs for thousands of production enterprises. Bottlenecks were common, with roots dating to the early 1960s or before.

2.The incentive problem.

a.In a market system, profits and losses signal success and failure and provide incentives to increase or decrease production. In central planning managers are rewarded for meeting assigned goals and have no incentive to respond to product shortages or surpluses.

b. The centrally planned system also lacked entrepreneurship. Without profit there is no reward for innovation or enterprise.

c.In centrally planned systems business is essentially a government-owned monopoly with no reward for improving product quality or developing more efficient production techniques.

d. Workers lack motivation because there are few material incentives.

III.The Collapse of the Soviet Economy: The Soviet Union ceased to exist in November of 1991 and became 15 separate nations.

A.After rapid economic growth through the 1950s and 1960s (5 to 6 percent reported per year, compared to 3 percent in the U.S.), the rate fell to 2 to 3 percent in the 1970s, and by late 1980s the Soviet GDP was actually declining.

B.The quality of goods was below international standards, the selection of consumer goods was extremely limited, and technology was primitive by world standards. Shortages of basic goods were common, leading to long lines, black markets, and corruption in product distribution.

C.The lack of an ability to fulfill consumer needs contributed to the fall of communism.

D.There was a huge military burden: 15 to 20 percent of GDP was devoted to military as compared with 6 to 7 percent of a much larger GDP in the U.S.

E.The agricultural sector experienced great inefficiency and consumed 25 percent of annual investment. It employed 30 percent of the labor force while still not producing enough for the population to feed itself. Output per farm worker was 10-25% that of U.S. farm workers.

IV.The Russian Transition to a Market System.

A.Privatization

1.Since 1992 more than two-thirds of former state-owned enterprises have been privatized, including 90% of small companies and 80% of service sector companies.

2.In the first phase government gave vouchers to 40 million Russian citizens, which could be pooled and used to purchase enterprises.

3.The second phase, which began in 1994, allowed state enterprises to be purchased for cash, which enabled foreign investors to buy Russian enterprises, providing much needed direct investment from abroad.

1. In 1995 wealthy lenders were given shares in many companies in exchange for loans.

5. Land reform has progressed more slowly. It will take many years to develop a functional market for farmland.

B.Price Reform

1.Prices in the former Soviet system bore no relationship to the economic value of either products or resources.

2.Because input prices did not measure the relative scarcity of resources, it was impossible for a firm to minimize real production costs.

3.Prices of many consumer items were fixed at artificially low levels and shortages existed for many of these goods. (See Figure 40W-1)

4.In January 1992, the government decontrolled about 90% of all prices including the Russian currency. Domestic prices surged and the international value of the Russian ruble sank.

5.The decontrolled prices began to more closely reflect the marginal cost of producing goods, which helped reallocate resources to best suit consumer wants.

C.Promotion of competition.

1.The former Soviet Union consisted of large state-owned enterprises—monopolies that produced 30 to 40 percent of total industrial output.

2.Russian reformers realized an efficient market economy requires competition, but only limited change has occurred.

3.Joint ventures between Russia and foreign companies are one possible way to increase competition and recent legislation has opened the door for firms to invest directly in Russia.

D.Joining the world economy by making the ruble convertible.

1.The Soviet economy was largely isolated from the world economy for over 75 years; joining required making the ruble a convertible currency.

2.The plunging value of the ruble has been detrimental to Russia’s world trade. The international value of the ruble has been more stable since its crash in 1998. It traded at about 30 rubles to $1 in October 2003.

E.Price level stabilization. (See Table 40W-1.)

1.The transition to free markets brought hyperinflation.

2.“Ruble overhang”—or hoarding of rubles—existed as Russian households had huge amounts of currency and bank deposits waiting for consumer goods to be more abundant.

3.Large government deficits were financed by increases in the money supply.

a.Privatization of state enterprises caused the government to lose profits.

b.The uncertainty of transition led to general disorder and widespread tax evasion.

c.The government extended massive subsidy credits to both industry and agriculture.

d.Pensions and welfare spending was increased by printing more money.

4.Russia’s economic reforms included the creation of an independent central bank that implemented antiinflationary monetary policy, reducing inflation from 1,735 percent in 1992 to 15 percent in 1997.

F.Other major problems of the transition.

1.Real output began its fall in the 1980s but the decline accelerated during the reforms (1992-1996, Table 40W-1); the magnitude resembles that associated with the Great Depression in the United States. Causes of the declined include

a.Rapid inflation, which caused an uncertain environment.

b.Unraveling trade relationships with former Soviet Bloc trading partners.

c.Bankruptcy and closing of many former state-owned enterprises.

d.Massive reallocation of resources including major cuts in military spending.

2.Because real output equals real income, the Russian living standard has declined dramatically; at least 30,000 scientists have left Russian to work elsewhere.

3.Economic inequality has increased during the transition. While some new wealth has been created through entrepreneurship, others have enriched themselves via corruption and illegal activities.

4.The major disruptions, swift changes, and lack of regulatory oversight created major opportunities for organized crime.

5.Greater economic freedom has brought greater economic insecurity; medical and educational services have declined, alcohol abuse has increased.

6.A remaining concern about the transition to markets in Russia is the weakness of government in law enforcement, particularly the collection of taxes.

G.Recent Revival

1.Aided by rising oil prices and production, and greater political stability, Russia’s real GDP has increased by at least 5 percent per year since 1999. The unemployment rate fell from 13 percent in 1999 to about 8 percent in 2002.

2.Recent income growth and stronger enforcement of tax collection has increased tax revenues, helping to turn the government’s 1998 budget deficit into a surplus in 2002.

3.The most severe economic dislocations seem to have ended, but the transition to a fully functioning market economy will require additional time.

V.Market Reforms in China

A.China has taken a different path to market reform than Russia. The reforms began earlier, were more gradual, and allowed the old systems to function along with the new.

B.Market reform began in agriculture in 1978. The key elements were the leasing of land to individual farmers and the establishment of a two-track price system (lower prices for government orders and market prices for the surplus). Responding to the profit motive, individual farmers increased their productivity and agricultural output soared.

C.The success of reforms in agriculture led the central government to extend the reforms to state-owned enterprises (SOEs) in urban areas.

1.The two-track price system was again employed, gradually increasing the portion of inputs and outputs that could be sold at market prices.

2.The government also encouraged the formation of urban collectives—enterprises owned jointly by managers and their workforces. The urban collectives experienced explosive growth, some at the expense of the SOEs. However, the competition spurred productivity advance and innovation in many of the SOEs.

D.In 1980 China created special economic zones (SEZs) open to foreign investment, private ownership, and international trade.

E.Reforms in China also included building institutions to facilitate the market system and its macroeconomic control.

1.A central bank, a stock market, and currency exchange facilities were established.

2.China replaced the system of “profit transfers” from state enterprises to the central government with an enterprise tax system.

F.Transformation of the SOEs.

1.In the 1990s the market reforms continued as the Communist Party operatives running the SOEs were replaced with professional business managers.

2.In a competitive environment many SOEs found that they were producing the wrong goods, in the wrong amounts, using the wrong combinations of inputs. In short they were inefficient, in both production techniques and in allocation of resources. Some will be allowed to fail, others will issue stock with the government holding a controlling interest.

VI.Outcomes and Prospects

A.China’s economic growth rate in the past two decades is among the highest on record for any country during any period of world history. (See Table 40W-2.)

B.The growth of per capita income in China has resulted from increased use of capital, improved technology, and shifts of labor away from lower-productivity toward higher-productivity uses.

C. Rapid expansion of international trade from $5 billion in 1978 to $266 billion in 2002 took place.

D.China still faces some significant economic problems in its transition to the market system.

1.Outright ownership of farmland is still prohibited and this inhibits investment in farm equipment and capital improvements on the land.

2.The financial and monetary control systems in China are still weak and inadequate. Many unprofitable SOEs owe colossal sums of money on loans made by banks.

3.Unemployment is a problem in China, with an estimated 10 percent unemployment rate in 2002. The problem is especially acute in the interior regions of the country.

4.China still has much work to do to fully integrate its economy into the world’s system of international finance and trade.

5.There is great regional unevenness in China’s economic development.

1. Conclusion

1. China’s gradual path has been more successful so far, but questions remain about future prospects.
2. Once Russia stabilizes, it may be in a stronger position than China because it has become more democratic.

VIII.LAST WORD: Police Smash Down Smirnov’s Doors

1. In November 2000, masked police smashed through the doors of one of Russia’s leading vodka makers while factory workers threw bottles at the police.
2. Reports said the police were enforcing a court decision naming a new director of the company, but its head, Boris Smirnov, said that the court’s decision was illegal.
3. The conflict arose with a claim by one of the leading industrial banking groups, Alfa-Eco, that it had obtained 50% of Smirnov shares. Smirnov claimed that these shares were false.
4. Related disputes also continue.

1. Smirnov Vodka is fighting a court battle in the U.S. with UDV North American Co.’s Smirnoff Vodka, the world’s leading brand, over the use of the name. UDV says it acquired the name in 1934 when its predecessor Heublein bought the name from Russian émigré Rudolf Kunett who bought it originally from a Smirnov founder.
2. Another dispute in Russia in August 2000, was over control of Moscow’s Kristall distillery, which makes Stolichnaya and other brands of vodka. Two men who both claimed to be the manager occupied the executive offices with their private security guards. A court decided the dispute in September 2000.
3. Because privatizations are often questioned, workers seized a paper mill in Russia to protest foreign ownership and a worker was shot by police. In another case, rival factions fought for control of a chemical plant in Yekaterinburg.

ANSWERS TO END-OF-CHAPTER QUESTIONS