The mid 1980s witnessed the collapse of the Soviet economy, .. and of the economies of most other CMEA countries. France's last fling with socialism was rapidly aborted, and, … many institutions of the labor economy in Israel, a socialist island in a capitalist sea, also foundered. …. institutions were very inflexible. .. this paper explores. In particular, are socialism and inflexibility inter-linked? Have socialist economies been led by bureaucracies because this is their "natural" way of coordination? Is "Market Socialism" at all feasible? The fondest hopes of many have been pinned on this solution, which seems to promise both social justice and efficiency, or at least the avoidance of gross waste, as well as freedom from bureaucracy and decentralized entrepreneurship. Even though there seems to be no organized attempt at present to implement this possibly utopian ideal, it is sure to return to the agenda some time in the future.
The term socialism, … refers to an economic system in which all means of production, …, are state owned. …. The question is really whether such a large organization can be freed from its bureaucratic shackles, can it be coordinated by a freely functioning price mechanism? ….. It puts the firm under the control of a public hierarchy, and the key question is whether this hierarchy can simulate the capital market. …
1. Can Hierarchy Simulate the Capital Market?
"socialism" … is a regime in which productive assets cannot be transferred to private hands. This, in effect, excludes them from being traded on the capital market. It is assumed that these productive assets are subdivided and organized in so-called enterprises. Even if these enterprises were legal firms which issued their own shares, these shares cannot be traded on any stock exchange, since the ownership of these firms is not to be traded, and the capital market services can, therefore, not be enlisted to aid the running of these firms.
The basic service the capital market supplies is the evaluation of each traded firm's net worth. This signals to its management and its owners how the market judges its future prospects. If this value declines relative to that of similar firms, this may be taken as an indication that the market considers the firm's policies inferior to those of its competitors. In severe situations, this may convey a recommendation to change the top management team of the firm, possibly through a takeover by an alternative team. In extreme cases, when the market believes that the expected present value of the firm's cash flow is negative or significantly below the breakup value of the firm, the capital market may apply direct sanctions by bankrupting the firm. This indicates that the firm should be dissolved and its assets freed to alternative uses. The capital market, …plays a Darwinian role of selection. As in Darwinian evolution, here too the role of chance is great, and the dependence on time is paramount. … But the capital market does not fulfill these roles in a socialist economy. Who can take upon himself this role in socialism? If socialism does not allow an external capital market to operate, can it create an internal one, inside the state hierarchy.
The first question … is whether the role of the capital market can be fulfilled by independent boards, or whether … would, devolve into the hands of the state hierarchy… Consider an arrangement in which a board of directors is appointed to oversee management and operations of each socialist firm, and to ensure that each firm maximizes profits… it only shifts the need for control one step higher; someone must oversee the performance of these boards. … These boards are not traded in the market, and no independent evaluation of their work is automatically available. The hierarchy will therefore have to oversee the boards, ….. Even when they function properly serious questions arise about the boards' independence. …
Clearly, the public boards cannot remain independent from those in control of the public purse, and eventually the whole public sector is likely to come under the control of some public hierarchy …. This public hierarchy is referred to below as the managing hierarchy or, in brief, as the planner.
Can the planner simulate the capital market? We might suppose that the superior in charge of an enterprise … could be told to maximize enterprise profits, …The superior is likely to have one great advantage over the actors playing in the financial market: he should have much better inside information on the activities of his subordinates. This advantage is however outweighed by the disadvantages of opportunism.
… advancement in a hierarchy is based …. on the way the bureaucrat has served the organization, (i.e. his superiors) in the past and is likely to serve in the future. Since his main task is to make decisions and … coordinate their implementation … his contribution to the organization is judged… by the quality of the projects he has approved and guided throughout his career. …. If he was … responsible for starting the firm and now decides the firm should be shut down, he raises a question mark about his wisdom in launching it in the first place. ..
Opportunistic behavior arises from the absence of competition. In a capital market, it is not one individual who decides the fate of firms but an interplay of many groups, each with its own assessment and its own resources… The weighted opinion of the market determines the fate of the firm, where the weights are asset weights. In the hierarchy the bureaucrat is alone, without competing opinion. It is true that he can consult others, but neither he nor the others are putting their own money at risk.
Consequently a superior in a hierarchy has both motive and opportunity to act opportunistically … It is this that turns large hierarchies into bureaucracies, and very large hierarchies into heavy bureaucracies. For particularly weighty decisions … the procedures become very complex and usually require committees with quasi legal procedures. … The final decision of the hierarchy must … be perceived as fair, i.e., it cannot be made except under the due process. But this takes time and a lot of administrative energies. Hence, radical changes of policies and of leading personnel, and even more so bankruptcies, are likely to be very rare affairs at the best of times. More likely they will not take place at all. And if they do, the real cause may not be economics, but politics. In any case, a large hierarchy is incapable of carrying out the tasks of the capital market: …This leads directly to the soft budget constraint, as is argued in the next section.
2. The Soft Budget Constraint
…If in fact ailing enterprises cannot easily be weeded out, they must be allowed to continue their existence and must therefore be supported financially. This is the origin of the SBC. … The connection is not restricted to socialist economies: in the case of any larger organization, the winding up of operations of any of its parts, be it a plant or a division, is subject to an internal decision of the firm. Likewise in the case of the socialist enterprise, a positive decision on bankruptcy is required by its superiors, and this, … is not likely to be forthcoming. Instead, an automatic supply of funds may come from the banking organizations: …
The most important aspect of the SBC is the incentive effect; the enterprise itself, its management and its workers, are aware of the existence of the soft budget constraint, and it is this awareness that molds their behavior. An organization certain that it cannot fail just because it is not covering its costs behaves differently from one that has to concentrate first and foremost on keeping financially afloat. ..
3. The Soft Budget Constraint and the Firm's Response Elasticity
Suppose first that the firm's management believes that its standing in the bureaucracy depends only on its profitability… it would follow a rule … that aimed at maximizing profits, provided that … the level of effort exerted by the personnel not be excessive. The only capital market service that the firm is missing is the advice on policy and management provided by its valuation relative to that of competing firms. In other words, we have no outside opinion on the efficacy of the policy rules used by the firm. If, however, the firm's staff adopts the more natural belief that the firm is subject to a SBC …, incentives are very strongly affected. The remuneration of the personnel now depends … on the whims of the hierarchical superiors… which is not likely to be profits. …
4. Low Response Elasticity and Centralized Allocation
The replacement of the market by administrative allocation can be blamed directly on the lowered price elasticity of the enterprises. The higher price volatility, which is now required for market clearing, is unpopular for two reasons. The first one is political: price volatility or frequent price changes make the planning of purchases more complex and are, therefore, disliked by most consumers. Furthermore, price volatility also means that maintaining a balanced budget for all enterprises is more laborious and the work of the bureaucracy in its support of the SBC becomes more complex. Firms' profits become highly variable, but not in a manner which provides information on the relative efficiency of the various enterprises. …
Hungarian experience can be seen in this light: prices were allowed a fairly free rein after 1968. By 1972, some firms became very unprofitable, mainly large low-flexibility firms, whose continued existence was never in doubt. The hierarchy felt compelled to stop the "excessive" freedom of prices, and control market imbalances by direct though informal signals to the firms. ….There was, in effect, renewed, though invisible, target fixing. Enterprises colluded with their superiors and obeyed these targets, which were not sanctioned by any written law.
5. Conclusion: What Remains of Market Socialism?
The aims of market socialism are many, but those that interest us here can be put in two groups, decentralization and equality. The former requires a debureaucratized economy, with enterprises free from central coercion, free to take their own initiatives. Equality requires the exclusion of private ownership of productive assets, … The message of this paper is that these two are in conflict: the exclusion of private property excludes the services of the capital market, and the hierarchy cannot function as its proxy. Instead, it softens the firm's budget constraint….
There is no interest in new cost saving processes, and new products are introduced only if the superiors press the enterprise into producing them. Old physical capital is not discarded, because it can be maintained at high cost of maintenance workers at non-storming time and may be of use at storming time. Human capital is poorly invested: engineers have no cost consciousness, no quality consciousness, but are concerned with keeping the processes working at whatever the cost