Repressed Inflation in a Socialist Society
Inflation has been an major issue in Eastern Europe since World War II. Socialism generated a strong following because it was based on a zero inflation policy, enforced " through comprehensive price control, income policies, and subordination of the financial system to central planning." The new centrally planned economies underwent swift structural change and output growth, and maintained high investment ratios within the productive sector. Unfortunately, these mechanisms only repressed inflation, and proved that the market was more efficient at setting prices. Inflationary controls created rigid markets that resulted stunted technical progress and growth.
After episodes of hyperinflation in the 1940's much of the population was sensitive to changes in prices. The planners placed tight controls on prices and wages so that increases would coincide with one another. In the German Democratic Republic, prices were able to remain constant because of subsidization of certain products and "pricing authorities willingness to accept disequilibria in particular consumer markets." The actions taken by the pricing authorities simply masked problems of over subsidization and nonmarket allocations, which in the long run became harmful to the economy.
Furthermore, credit given to the consumer was limited and deposits were taken for cars and apartments. This practice relied on inflexible prices and constraint credit markets. Since consumer and commercial deposits were separated savings on the part of the consumer went to the government, and then was allocated for investment. The roundaboutness of the financial systems proved to be inefficient. The disequilibria in the credit market was the reason that inflation was repressed, and perpetuated the false notion that funds were being maximized by subsidizing firms for products.
The fixed prices caused disequilibria, but the "market" was forced into the planned equilibrium. One major result was queues, that led to shortages of goods forcing people to settle with less desired goods. Since the prices were fixed, producers had no incentive to redesign or create new products. Companies did not invest in research and development due to the fact the government subsidized all " market" activities. The government allotted investment funds to siphon toward the industrial sector, leaving the consumer sector underinvested and virtually growthless.
People had to consume those items that were provided by the state or turn to black markets. In which case these black markets developed in order to satisfy demand, and alleviated inflation pressures and equilibrate the economy. Yet, these markets worked against the central planning by allowing the inflated prices to penetrate the unsupervised markets, and drawing demand away from the consumer sector. The antagonistic relationship expunged money out of the central market, leaving less money to recirculate within the economy. Funds reached black markets, which in turn, took funds from the central market, and were not used towards subsidizing production. This drawing away of funds from the central market perpetuated a vicious cycle; that boiled down to increasing cost of production, but fixed consumer prices.
Furthermore, monetary policy was extremely conservative thereby separating commercial and household accounts. Unfortunately, "enterprises only have their deposit money... and [ were] prohibited from extending trade credit to each other," hence restricted corporations from investment. This separation also complicated the allocation process for the government to industrial firms causing more inefficiencies. This method did not allow firms to invest within their own companies, or invest in research; meaning production methods seldom changed, but costs to the firms were rising. Even though producers were subsidized, the fixed prices merely repressed inflation rather then the elimination of it.
The CPE rigid hierarchical government made the socialist economy inflexible. One major aspect is the planning itself , which does not in essence lend itself to change or adaptation once plans have been set. The validity of information gathered through set prices was questionable, because it did not reveal people's desires through a market mechanism. Repression of inflation only exacerbated the inefficiencies of the poorly planned centralized economy. Taking into account the inflexibility of the socialist economy and misinformation growth was only a short run phenomenon. The planners were ill prepared to sustain growth in the long run.
Second, the government prioritized resources towards the industrial sector, causing unbalanced growth which lead to disequilibrium in the system. This unevenness stunted the growth of the consumer sector. The shrinkage in the non-industrial sector made consumer goods scarce, and put pressure upwards on prices. The repression of inflation resulted in rigidity causing deadweight lose within the economy to rise, consequently inefficiencies and disequilibria hindered within the markets.
Meanwhile, in the industrial sector, emphasis was placed on higher production and larger investment. Problems resulted when demand fell and funds were not appropriated towards research and development of new technologies. The rapid expansion in the industrialized sector turned into slow contraction leading to overall retarded growth.
Repression of inflation can be seen through the example of socialist countries to have detrimental effects on growth. A major result was disequilbria in the market, which is illustrated through the planners willingness to ignore upward pressures on prices. Another problem that repressed inflation masked was the misallocation of funds within the consumer and industrial sectors. Funds were placed in the industrial sector, but were mostly used for production subsidization, rather then growth within the industry through research and development. Moreover, consumers were forced to black market operations, because the consumer market was inefficient in allocating scarce resources. Banking system perpetuated the inefficiencies by keeping commercial and personal accounts separate. Considering the above said factors, price authorities chose not to tend to the inefficiencies of the market by repressing inflation, which led to stunted technical progress and growth in long run.
Bornstein, Morris, Comparative Economic Systems: Models and Cases; Ricahrd D. Irwin Inc.: Homewood IL p.448
Bornstein, p. 485
Ray, Debraj, Development economics; Princeton University Press: Princeton, NJ, 1998 Chapter 5
Inflation was repressed, and perpetuated the false notion that funds were being maximized by subsidizing firms