Nafziger Economic Development (4th ed)

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THE MILITARY-INDUSTRIAL COMPLEX

The unprecedented peacetime cost of military expenditures and the other costs of being a superpower made it difficult to maintain medical and social services and investment in civilian production. Russia’s military industry contributed twice the share of GDP as the United States in the late 1980s (Ellman and Kontorovich 1992:14; Economist, December 5, 1992, p. S10).

Afanasyev (1994:23) argues that the military-industrial complex continued to benefit from Russian political conflict after the end of the Cold War. In 1994, Yeltsin ceased funding conversion programs.

ENVIRONMENTAL DEGRADATION

Environmental disruption in the Soviet Union in the 1970s and 1980s was greater than in the United States; energy cost per unit of GNP was much lower in the United States than in the Soviet Union. Damage to the environment was a major cause of the fall in life expectancy (from about 70 in 1978–92 to 65 in 1994–2003, with 59 for males) and infant mortality rates rose in Russia in the 1970s, 1980s, and 1990s, a trend contrary to those in almost every other region of the world. Murray Feshbach and Alfred Friendly Jr. say that the Soviet Union died by ecocide through plunder of rich natural resources and systematic neglect and poisoning of the Soviet people. In 1986, the Chernobyl nuclear power explosion resulted in the exposure of 20 million people to excessive radiation. In Yerevan, Armenia, belching chemical works poisoned and deformed local children (Feshbach and Friendly 1991; Economist, April 25, 1992, pp. 99–100; Ellman 1993:1–42; Specter 1995:1, 6). Judith Shapiro (1995:149–178) explains Russia’s fall in life expectancy to increased poverty, which reduces strategies for coping with illnesses, and the deterioration of the medical and health-care system.

THE COLLAPSE OF TRADE AMONG COMMUNIST COUNTRIES

The political crises in Poland, 1980–81, and other Eastern European countries in the 1980s, and the effect of Eastern European crises and reforms on Soviet politics and trade made it more difficult for the Soviet Union to survive, let alone develop economically. Russia and Eastern Europe suffered supply disruptions from the collapse of centrally planned input–output links under the Council for Mutual Economic Assistance (COMECON) trading bloc. With COMECON’s trade patterns severed, Russia’s trade with Eastern Europe fell by more than 50 percent from 1989 to 1990. Analogously, Gosplan’s abolition reduced intrarepublic trade in the former Soviet Union from 1991 to 1992 by 46 percent (Economist, December 5, 1992, p. S10; Ellman and Kontorovich 1992:6, 18–19). Popov (1996:12) contends, however, that the collapse of inter-COMECON and interrepublican trade was not a result of the breakdown of the Soviet Union but the changes in relative prices, which made it impossible for fuel importing countries to finance their trade deficits with Russia. Popov (2001:32) argues that, by themselves, supply shocks triggered a 40 percent

decline in GDP: from reduced interrepublican trade (10 percent of GDP) and defense expenditures (10 percent of GDP), together with a Keynesian multiplier effect of 2.

INITIAL CONDITIONS, LIBERALIZATION, INSTITUTIONS, AND

DEMOCRATIZATION: A SUMMARY

Fjorentina Angjellari’s econometric analysis (2003) identifies initial conditions, institutional development, democratization, and liberalization as major variables explaining differences in real GDP growth among 25 transitional countries (5 growing and 20 declining) of the former Soviet Union and East-Central Europe in the 1990s. For Russia, the legacy of the Soviet period – initial conditions in 1991 – include distorted incentives and price signals, the party and state monopoly, inconsistencies under openness and decontrol, distorted information, enterprise monopolies, the lack of scarcity prices, the consumer sectors as buffers, soft budget constraints, the lack of market institutions, the neglect of services, the lack of technological progress, the burden of the military-industrial complex, and a degraded environment. Initial conditions are especially important in explaining Russia’s collapse of the immediate postSoviet period in the early 1990s. Slow progress in liberalization and marketization provides a significantly high explanatory power for regress during both the early and middle periods of the 1990s. Slow institutional development is especially important during the later period of the 1990s. Russia made little progress then in the development of markets, antitrust protection, demands for hard budget constraints, creative destruction of inefficient firms, alternatives to nomenklatura leadership, capacity to raise taxes, development of alternative institutions for health and welfare, institutions to foster technological innovation, development of accurate data sources, and a governmental agency to support environmental protection.

Democratization is important in affecting structural reform (liberalization) and institutional reform (Angjellari 2003). Freedom House (2003a) ranks Russia as “partly free,” noting the “powerful oligarchic interests and wide discrepancies in income that have an impact on the rule of law and equal political participation.” Earlier, Freedom House (2003b) indicated that “Russia has lost considerable ground in its protection of basic political rights and civil liberties over the last seven years, . . . experience[ing] an overall decline since 1997 in . . . electoral process; civil society; independent media; governance; and constitutional, legislative, and judicial frameworks.” Andrea Cornia and Vladimir Popov (2001:17) write of Russia as an “illiberal democracy” (see Chapter 4), whereas the Moscow-based journalist Masha Gessen (2003) characterizes the Russia of President Vladimir Putin (2000–) as a “managed democracy.” For William Smirnov, Deputy Head, the Institute of State and Law, Russian Academy of Sciences (2003), Russia, rather than being a “fullyfledged democracy,” is an “electrocracy,” in which

[t]he political and business elite isolated themselves from the unwanted part of society. Other stratums became isolated despite their will, mostly because of destitution. Small layers of the elite privatized not only most of the public property, but also

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huge chunks of state, justice and legal systems. Regional “czars” adopted own constitutions and decrees.

The lack of democratization and development of civil society hampered market and institutional reform, leaving Russia well behind such rapid reformers as Poland, Slovenia, and Hungary.

The Transition from Socialism to the Market in Poland

Poland’s transition from socialism to the market was more successful than Russia’s and may have been more successful than any country of the former Soviet Union and East-Central Europe. The Polish success underlines the importance of initial conditions and institutional development. Poland was the earliest transitional country to stop its slide in output, in 1992, and the first to attain pre-transition GDP, in 1996 (Figure 19-2).

Poland’s history under socialism, only since World War II, was shorter than that of Russia. Russia’s socialism was more centralized and totalitarian than Poland’s was. Indeed, Poland had sources of opposition to communism in the Roman Catholic Church, (and after 1980) the Solidarity labor union (led by Lech Walesa), and the intelligentsia.

Since 1970, according to Kazimierz Poznanski (1996:ix), Poland had a gradual disintegration of planning and a parallel reemergence of capitalist markets, changes that made the post-1989 reforms less momentous. Poland’s businesses faced fewer government restrictions and fewer demands by bureaucrats for bribes (Raiser 2001:232). Reforms under communism during the 1980s failed to increase productivity and contributed to a “cataclysmic” balance-of-payments crisis, but created market institutions that were further strengthened after 1989. When central planning ended in 1989, prices were decontrolled, a legal system was established to support the decentralized actions of private property owners, and a commercial code, company law, and a system of judicial enforcement of contracts from before World War II were reestablished (Sachs 1993:35–78).

Even if you exclude agriculture, which was never collectivized, in 1989 the private sector share of GDP was about 35 percent (Raiser 2001:232). By 1991, most of the private sector was indigenous new enterprises and expanded private entities rather than state-owned enterprises that were privatized (Poznanski 1996:240). In the first 30 months after mid-1991, the beginning of stabilization, 700,000 new businesses were started. At the end of 1993, half the employment and GDP was in the private sector (Sachs 1993:xii). By 1997, there were 10 legally registered enterprises per 100 persons, close to the Western average, but compared to less than 2 in Russia (Popov 2001:45).

Inflation in 1989, with generous wage indexation and credit expansion, was 638 percent. Deputy Prime Minister Leszek Balcerowicz undertook a plan of macroeconomic stabilization, with a tightening of credit, raising of the discount rate, cessation of cheap credit to industry, devaluation of the zloty, and liberalization of international

trade to provide competition to monopolies as prices were decontrolled (Sachs 1993:44–66).

Poland stabilized monetary policy and the zloty currency in 1989, achieving a convertibility that encouraged trade with Eastern Europe, the Soviet Union, and the West. Prices began to stabilize in 1990–91. Poland reduced the length of transition to world prices, so that the initial depression from changing trade patterns was shorter. Poland’s opening of the market to foreign trade, together with the slashing of subsidies, improved domestic efficiency (Sachs 1993).

The social safety net, which included price stabilization, unemployment benefits, job training, health care, and pension guarantees, contributed to greater mass support for reform than in Russia (Sachs 1993). Beginning in 1990, as discussed in Chapter 16, the United States and Western governments, as well as commercial banks, wrote down debt, whereas DCs created a stabilization fund to defend the zloty, allowing Poland a fresh start, despite its external economic crises of the 1980s.

Integration into the European Union in 2004 provided additional incentives and support for market and institutional reforms in Poland, as well as Hungary and the Czech Republic. In 2001, Poland’s GDP at PPP was 38 percent of the European Union 15 countries, Hungary’s was 51 percent, and Czech Republic 56 percent (Economist 2001). These recently acceding countries, together with the other seven – Slovenia, Slovakia, Estonia, Latvia, Lithuania, Malta, Cyprus – hope that their convergence within the EU will occur as rapidly as that of Greece (1981), Portugal, and Spain (1986).

The Transition to a Market Economy in China

Mao Zedong, a founding member of the Chinese Communist Party, led the guerrilla war against the Chinese Nationalist government from 1927 to victory in 1949. From 1949 to 1976, Mao, the Chair of the Communist Party, was the leader of the People’s Republic of China. Mao’s ideology stressed prices determined by the state, state or communal ownership of the means of production, international and regional trade and technological self-sufficiency, noneconomic (moral) incentives, “politics” (not economics) in command, egalitarianism, socializing the population toward selflessness, continuing revolution (opposing an encrusted bureaucracy), and development of a holistic communist person. From 1952 to 1966, pragmatists, primarily managers of state organizations and enterprises, bureaucrats, academics, managers, administrators, and party functionaries, vied with Maoists for control of economic decision making. But during the Cultural Revolution, from 1966 to 1976, the charismatic Mao and his allies won out, purging moderates from the Central Communist Party (for example, Deng Xiaoping) to workplace committees.

After Mao’s death in 1976, the Chinese, led by Deng, recognized that, despite the rapid industrial growth under Mao, imbalances remained from the Cultural Revolution, such as substantial waste in the midst of high investment, too little emphasis on consumer goods, the lack of wage incentives, insufficient technological innovation, too tight control on economic management, the taxing of enterprise profits and a full

cotton), that competed with exports from the U.S. Midwest and South, especially to Japan. These remarkable gains were achieved without increased farm inputs except for chemical fertilizer (Nafziger 1985:366–92: U.S. Department of Agriculture 1986; World Bank 1986a:104–106; U.S. Department of Agriculture 1988; Lichtenstein 1991:60–61).

The Brown University economist Louis Putterman (1993) shows that technical efficiency in Chinese agriculture fell between 1952 and 1978, but increased from 1978 to 1984, becoming the major source of growth. Decollectivization, the household responsibility system, the increased link of reward to output, and modest price decontrol during the reform period increased resource productivity. Work monitoring and incentives improved, agriculture was diversified, and families allocated more labor to highly remunerative noncrop (or even nonagricultural) activities.

After 1984, agricultural growth decelerated so much that Minister of Agriculture He Kang indicated in 1989 that the “situation in agricultural production is grim” (Lichtenstein 1991:61). First, most rural areas had already captured onetime gains from household accountability. Second, in the late 1980s, the government reduced its massive subsidies, which had increased sixfold and expanded the expenditures of state revenues on agriculture from 5 percent in 1978 to 20 percent in 1984, straining government finances. This reduction in subsidies decreased the procurement price the state paid farmers. Third, in the mid-1980s, many farmers awoke to profitable opportunities in rural (township and village) enterprises, both in industry and trade. In 1984, reforms had allowed interprovincial trade, private ownership of capital, access to urban markets, hiring of wage labor, and subcontracting, all of which gave greater scope to private and collective nonstate rural enterprises. As employment and sown hectares in crops declined in the 1980s, farmers experienced diseconomies of small-scale production. Fourth, farmers, based on previous volatility and an uncertain future, feared a reversal in land tenure system, becoming reluctant to invest in agriculture and undertake innovation. Fifth, the rural banking infrastructure was underdeveloped. Government lending by the Agricultural Bank of China, under the control of local party officials, was politicized so that few loans were available at market interest rates for flourishing households. Sixth, since in the 1970s government had distributed rights to communal land in fragmented plots on the basis of household size rather than farm management ability, few highly-productive farmers had the opportunity to expand (Hardt and Kaufman 1991:ix–xiv; Lichtenstein 1991:60–64; Putterman 1993; Fewsmith 1994:153–154).

Aggregate data showed that agricultural productivity grew rapidly in the 1990s. However, Carter, Chen, and Chu (2003:53–71), using farm household surveys, show that China’s farm 1990s’ gains were exaggerated due to “data aggregation biases and [lack of] reliability of China’s national agricultural production statistics.”

The Organization for Economic Cooperation and Development (2002:59) indicates that, “with the exception of grains, the production, distribution, and marketing of crops and livestock products are free from significant government intervention.” Trade liberalization, from China’s accession to the WTO, is likely to increase pressure for further domestic agricultural policy reform.

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China had a 1998 population density of 10.2 persons per hectare of arable land, less than Japan and Korea, but about twice that of the European Union and about seven times that of the United States. China’s agricultural comparative advantage is in “labour-intensive crops such as fruits and vegetables and a disadvantage in . . . landextensive crops such as grains and oilseeds” (OECD 2002:62).

In 2003, 61 percent of China lived in rural areas, in part a legacy of the Maoist era when migration to urban areas was discouraged. However, agriculture’s share in China’s exports has been falling steadily since 1980, and agriculture’s share in imports has increased. Globalization and structural shifts with economic growth are accelerating the migration of surplus farm labor to urban areas, where China has a comparative advantage. A major effect of liberalization is internal adjustment costs as farmers face competition from other regions (OECD 2002:60–63).

TOWNSHIP AND VILLAGE ENTERPRISES (TVEs)

In the 1980s, TVEs, organized as cooperatives, produced 60–70 percent of rural output. TVEs enjoyed cheap production factors, primarily cheap labor (with no lifetime employment guarantees as in SOEs), but also startup capital from the collective accumulation, banks, and credit cooperation, and free (sometimes almost unlimited) land. Their cheap products catered to the market, giving TVEs advantage over other sectors. The private sector had not yet been accepted ideologically and politically, and SOEs had not yet been reformed. Moreover, TVE ownership by the community meant that business and government functions overlapped, and TVEs did not bear any burden imposed by government. TVEs were flexible, eventually undertaking contracts or leasing arrangements with other entities; organized as joint-stock cooperatives, limited liability companies, shareholding companies, conglomerates, foreign joint ventures, or conglomerates; or, in a few instances, even being privatized. TVE production helped correct price distortions, and pushed reform forward (Lin, Cai, and Li 2003), outstripping state-owned enterprises in productivity (Jefferson 1999:168). In 1996, collective-owned enterprises –TVEs, the primary form, and urban – comprised 39 percent of industrial output, a growing share since 1985 (Jefferson and Rawski 1999b:27). TVEs behaved similarly to labor-managed enterprise (see Chapter 18), sharing surpluses with workers (Pitt and Putterman 1999:211).

THE INDIVIDUAL ECONOMY

Reform also included small entrepreneurial activity, what the Chinese call the individual economy. One precursor of these individual enterprises was the cooperatively run enterprises, such as TVEs, which required far less capital per worker than state-owned enterprises. After 1976, another trigger to urban reform was dealing with the urban unemployment caused by the return to cities of youths “sent down” to learn from peasants in the countryside during the Cultural Revolution. These youths could not be absorbed in state enterprises, already overstocked with underemployed workers. Therefore, especially after 1984, the state allowed these youths to set themselves up in businesses as individuals or as members of urban collective enterprises. They opened small restaurants, set up repair shops and other retail outlets, or became pedicab

operators, increasing substantially the convenience of urban life (Lippit 1987:201– 19). The income was often higher, though the prestige and security were lower, than state-sector jobs. Furthermore, farmers coming to the city to sell their produce expanded the quantity and improved the quality of urban services, especially after 1984 (Perkins 1986:39–61). Overall, China’s privately self-employed in cities and towns (primarily in services, commerce, handicrafts, and catering) grew from 150,000 in 1978 to roughly 5–10 million in 1988, increasing industrial output and soaking up underemployed labor (Ignatius 1988:10). In 1996, individual-owned firms accounted for more than 80 percent of the eight million enterprises in China, but less than 16 percent of industrial output (Jefferson and Rawski 1999b:23–27).16

INDUSTRIAL REFORMS

Mao’s emphasis on self-reliance gave license to provincial protectionism. As provinces became more self-sufficient, their demand for other provinces’ surpluses decreased, compelling potential surplus provinces to divert additional resources to self-reliance. After 1979, one of the post-Maoist leadership’s major contributions to growth was the substantial gain to specialization from attacks on regional protectionism (Lyons 1987:237, 278).

Earlier in this chapter, we discussed determinants of the performance of public enterprises in LDCs. State-owned enterprises rather than private firms are the keys to China’s urban reforms. After reforms were first introduced in the late 1970s, urban reforms entailed built-in contradictions, as market forces threatened the power and expertise of bureaucrats, who were trained to run a Soviet-style command system. Indeed, initially SOE reform in China was more about effective state control than about profitability or privatization. Moreover, SOEs did not increase efficiency when reforms were first introduced.

Early problems with reform. The reform instituted a management responsibility system, in which an enterprise manager’s task was to be carefully defined and performance was to determine managers’ and workers’ pay. Reforms were to give enterprise management considerable autonomy to choose suppliers, hire and fire labor, set prices, raise capital, and contract with foreigners. Management was supposed to have responsibility for the success or failure of the enterprise. The initiative and decisions were to be centered in producing units rather than in government administration. Under this system, taxes on enterprise bonuses at more than a certain level replaced the profits and losses the state absorbed. But, as of the mid-1980s, only a fraction of managers of industrial enterprises opted for the responsibility system.

Economists identify several problems with China’s industrial reform. Rewarding producers with higher pay for higher productivity requires an increase in consumer goods, especially food. And with reduced investment, growth must rely on technical

16Individual-owned enterprises, by Chinese definition, employ no more than seven workers. The figure here defines the individual economy more broadly, including firms with eight or more employed, a minority of the total.

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innovation and increased efficiency. Although the early reform period emphasized worker authority in selecting managers, this selection was deemphasized when it increasingly conflicted with the professionalization and responsibility of managers (Lippit 1987:209–216; Lichtenstein 1991:48).

Moreover, in China’s central planning system, the planning commission and the People’s Bank made most decisions, a power that could not be taken away at one stroke. The planning commission set targets on an annual basis for the amount of output required in each industry and the inputs that would be required to achieve that output. The planners conveyed these targets to the planning commissions and eventually to individual enterprises, which recommended changes based on local conditions. However, in practice, large SOEs were managed in the first 10 years after Mao very much like they were during the Maoist period. Industrial reforms did not have much effect on this sector. Initially, when the reform decentralized decision making, it merely replaced central restrictions with local and regional restrictions (Perkins 1986:52–53; Hardt and Kaufman 1991:xiii).

Another major problem was fragmented administrative control, numerous overlapping authorities for project approval, and multiple levels of controls at different levels of government, what the Chinese call too many mothers-in-law. In 1983, the Qingdao Forging Machinery Plant, a state enterprise, was responsible to the national Ministry of the Machine Industry, the city materials board, and the county for material supplies, to the municipal machine industry office for plant production, to the county planning agency for output value, to relevant county agencies for supplies from the plant, to two separate county agencies for personnel, and to the county committee for party matters, which was immersed in implementing policies (Guangliang 1987:303–304).

Thus, planning was not integrated or coherent, and enterprises were not treated consistently concerning targets. Investment decisions were bureaucratized and politicized. Moreover, administrative agencies lacked enough information about enterprises and commodities to make good decisions. Despite the management responsibility system, in practice management was still centralized and rigid, with firm managers having limited control over performance. Enterprise managers had few incentives, because the state gave managers production plans and designated product recipients, so there was little room for initiative or innovation (Barnett and Clough 1986:54–57; Lee 1986:45–71; Lippit 1987:215–216; Riskin 1987:352–353; Tidrick and Chen 1987; Lichtenstein 1991:73).

One redeeming feature was that plans were not as rigid in practice as in theory; otherwise the Chinese economy would have ground to a halt. Although bargaining and trading made the system more flexible, these arrangements required the enterprise manager to spend much of his or her time negotiating special deals with the planning bureaucracy and other managers. The system placed a premium on “back door” deals, rather than organizing labor and other inputs to use more efficiently. The manager whose only skill was saving money was of little use in achieving success, because he or she could always borrow money cheaply from the People’s Bank or take funds from the enterprise’s net income.

The key to getting enterprise managers to respond to market signals was for them to pay more attention to making profits rather than simply expanding output. Managers concentrated on profits when they were able to keep a larger and more predictable portion of them and use them for bonuses for them and their workers, rather than turning profits over to the state budget (Perkins 1986:54).

Profits can only guide enterprise behavior efficiently if they are determined by prices reflecting true relative economic scarcity. When prices were set incorrectly, as in China, even in the years immediately after the 1979 reforms, they gave the wrong signal, spurring enterprises to produce too little of what was short and too much of what was in surplus. For example, wrong market signals meant that enterprise managers tried to purchase vast imports in excess of the foreign exchange available. Managers who accumulated more foreign exchange and other inputs could then more easily meet success targets.

For the market to have meaning, enterprises must be able to buy productive inputs and sell products on the market. But prices usually did not show where resources could best be put to use, thus providing false signals to enterprises. In many instances, enterprises were still not allowed to retain profits for capital; indeed, much capital was still allocated administratively rather than by interest payment. Moreover, in 1980, more than 100 industrial products were subject to compulsory planning.

For some time after 1979, prices were arbitrary and distorted and changed only incrementally throughout the system. Setting multiple prices by regions did not correspond to the cost of distances traveled. Distorted prices meant that profits were not linked to supply and demand. Enterprises were spurred to produce overpriced goods regardless of the market. Scarce goods that were priced cheaply become even scarcer. Furthermore, the Chinese, like the Russians, restricted entry and exit of firms, lacking the benefit of creative destruction.

For increasing market forces to result in higher levels of efficiency, enterprises must compete with each other rather than have monopoly control of particular markets. To be sure, enterprises had more freedom buying and selling, and collective enterprises sometimes competed with state enterprises. Yet as long as central planners allocated key inputs administratively, competition was limited, at least for intermediate products.

Additionally, the Chinese authorities took time to establish a labor market, thus thwarting smooth labor adjustments to changes in demand. Traditionally, workers hired by state enterprises had an “iron rice bowl,” meaning that they could not be fired. During the Cultural Revolution, wages were effectively frozen and bonuses frowned on, so material incentives for improved performance were lacking. Moreover, because China lacked adequate safety nets, management was reluctant to fire labor, and substituted employment for productivity objectives. Management promulgating a system of freer hiring and firing threatened the morale and solidarity workers felt with the “iron rice bowl.” Moreover, during the Maoist period, workers became increasingly disaffected so that the Chinese authorities had to compensate by becoming more repressive to maintain labor discipline. But during economic reform, managers were subject to substantial pressure from workers, so that managers’