PERESTROIKA the Last Straw
Under the Soviet system, shortages and fixed prices were common. Inflation was relatively low and had been stable up to1986. Unemployment was low and the state usually ran a small deficit that it financed through private savings in the state banks. This relatively constant macroeconomic balance was destroyed by the newly-elected General Secretary Mikhail Gorbachev in four stages.
In the first, the traditional budget deficit of 2-3 % rose to about 6 % of GDP. Fiscal spending increased by about 1% for social sector, subsidies, and state investment. The cumulative rise of these elements created fiscal troubles. The government also collected less revenues from taxes on foreign trade, because of a fall in world oil prices. The budget deficit was kept secret from all but a few, so it was impossible for leaders to make the necessary changes until it was too late.
In the second stage (1989-90), nominal wages rose twice as fast as they previously had and enterprise taxes declined, while the budget deficit expanded. The cause of this was that the Law on State Enterprises had been passed, which gave the enterprises the freedom to raise wages and pass on the extra cost to the state.
The third stage resulted from a sharp fiscal increase in social spending of 25%. This occurred because, as was the case with the Law on State Enterprises, the Congress of the People's Republic had been given much leeway to act, but no requirement to act responsibly in its economic affairs. Wages continued to rise until the government failed.
In the final stage, state finances fell apart. The budget deficit soared to 20% of GDP and revenues began to collapse, as the republics refused to deliver taxes to the Union. Lines for rapidly disappearing goods were enormous, and prices tripled in 1991.
To make matters even worse, the USSR defaulted on its foreign loans. Beginning in 1986, it had been using foreign loans to help finance its budget deficits. Under Gorbachev, the Soviet foreign debt had increased from $14.2 billion in 1984 to $56.5 billion in 1991. At the same time, the central bank had run down the gold reserves and had printed more money to finance the budget deficit. The debt service ratio skyrocketed in 1990 and the USSR had a backlog of unpaid bills of $6 billion in 1991. It became increasingly difficult for them to get loans and the terms were shorter, while the interest charged was higher. At the same time, reserve currency hit an all time low of $100 million.
Several background factors contributed to the inability of reforms to work under communism. The principle one was the very nature of the beast of the Soviet primacy of politics over economics. The enterprises in the Soviet Union were inferior to their western counterparts in almost every aspect. The firms were subsidized, inefficient, and many incurred large losses. One of the major reasons for the failure of communist firms is found in their ownership structures.
Ownership rights to most assets are of two types: control rights and cash flow rights. Control rights include all rights on how to employ the asset, including the right to sell or lease the asset. Cash flow rights are the rights to earn benefits and pay costs that result from the particular use of the asset. An efficient ownership structure must align both control and cash flow rights to a single entity. The decision-maker must bear the full cost or benefit of his decisions for the ownership structure to be efficient.
In theory, the socialism is an economic system based on public ownership of productive assets. The "state" is supposed to allocate resources to maximize social welfare. In terms of ownership rights the state has control rights and holds cash flow rights on the behalf of the public. Because cash flow and control rights are held together, Marxists argued, the system was by definition efficient. Unfortunately, this was not the case, whatsoever. The "state" was in reality a collection of politicians not a single entity. In the former Soviet Union, control rights were held primarily by the politicians at all levels of government, and cash flow rights were held by the public in general. In essence, politicians made decisions as to the allocation of productive assets, and the public either benefited from efficient decisions or bore the costs of inefficient ones.
All of the power players, including enterprise managers, tried to maximize their power (and thus their control over resources) regardless of the economic effects. Correspondingly, superiors promoted those people who exhibited complete loyalty, whereas, any display of personal integrity was disapproved of, even if its aim was to achieve beneficial economic results. The ownership structure of the Soviet era was highly inefficient. The objectives of the politicians were far removed from the "public interest". Communist party officials persuaded vast and inefficient projects that tended to serve the politicians pockets or benefited his or her political supporters. For example, Khrushchev launched a Virgin Lands program designed to grow corn all over Siberia, and Brezhnev initiated the construction of the enormously expensive railroad through southern Siberia. Politicians did not care about the costs of these projects because they were borne by the public through lower standards of living.
The emphasis in the economy was also placed on production targets, rather than efficiency, profits, or competitiveness. As long as raw materials remained plentiful, there was no incentive to be sparing or efficient. When they began to run out, things rapidly deteriorated. Also, due to the very nature of socialism, commodities lacked value.
Prices were totally arbitrary and left to political whims. When the prices began to fluctuate, turmoil sat in. This reached a peak in 1990, as some prices were allowed to float freely, while others remained fixed. The "black" market also existed that undermined pricing. Under the socialist system there was no correlation between efficiency and profits, so when restrictions were lifted, managers sought to maximize their own gains, rather than those of the enterprise. This led to even further shortages and decreased output.
Ultimately, the inefficiency was staggering. Businesses and industries that had been protected and preserved under the communism were left to try to fend for themselves as managers selfishly acted in their own interests and prices skyrocketed. In addition, there was a complete breakdown of the political system and increasing awareness by the public that things were much worse there than in the West. Unsurprisingly, the whole political and economic system disintegrated by 1991, erasing the Soviet Union as a sovereign entity, dethroning Mikhail Gorbachev as its leader, and sending tremendous political and economic shock waves throughout the world.