January 14, 1990
"Soviets' Catch-22: Economic Reform Could Spur Spiraling Inflation"
San Jose Mercury News
By Timothy Taylor
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THE Soviet Union has booby-trapped its own economy. Practically everyone agrees that it needs a dose of free-market reform. But if the Soviets allow freer markets and flexible prices, their economy may well rocket into triple-digit, Latin American-style inflation.

Even by Soviet standards, the current shortages of consumer goods are severe. Boots are in short supply because so much salt is used to thaw the snow that boots last only a year or two. In some cities, soap is rationed to one bar per person every three months. There are shortages of meat, coal, knives and forks, cigarettes, sugar, notebooks and much else. A survey of 1,200 consumer goods conducted last August by the Soviet government found that only 200 were generally available.

Shortages of basic consumer goods like these do not result from a lack of technology; instead, they occur because central planners rigidly control prices and supplies. The very visible hand of government central planners prevents entrepreneurs from starting businesses, discourages middlemen and retailers from finding products and delivering them, and stops consumers from signaling what they are willing to pay.

Even Friedrich Engels, a co-author and close friend of Karl Marx, wrote over a century ago that without markets and competition for consumer items, "what guarantee do we have that the necessary quantity and not more of each product will be produced, that we shall not go hungry in regard to corn and meat while we are choked in beet sugar and drowned in potato spirit, that we shall not lack trousers to cover our nakedness while buttons flood us in millions?"

But in the current Soviet economy, it appears all too possible that rising prices could surge into a riptide of inflation. Such an inflation would prevent prices from providing appropriate economic signals to Soviet producers and consumers, and could make market-oriented economic reform ineffective or even harmful.

The primary threat of inflation comes from the "monetary overhang," the money that Soviet citizens would like to spend but can't, because there has been so little to buy. Although this amount is (obviously) hard to estimate, Soviet consumers may be sitting on $1 trillion of buying power that they are eager to spend. Some of this inflationary money came out of the woodwork last week, ck? when VCRs were auctioned to some Soviet citizens for $6,000 apiece.

A second inflationary threat comes from the enormous Soviet budget deficit, which official Soviet estimates (probably optimistic) are putting at 12 percent of GNP. By comparison, the U.S. budget deficit is now about 3 percent of GNP; even the monster deficits of the early 1980s were only 5 or 6 percent of GNP. In the United States, budget deficits are financed mainly by borrowing from U.S. and foreign savers. But the Soviet deficit is financed largely by printing money, which adds to the inflationary pressure of money floating around in the economy, longing to be spent on something.

This threat of explosive inflation is looming over all attempts to encourage freer markets in the Soviet Union. Rapid inflation, especially in a country long accustomed to price control, could detonate violence. That's why Mikhail Gorbachev said last fall: "I know only one thing. That after two weeks of such a market, people would be on the streets and it will smash any government."

How the Soviets should attempt to avoid having inflation blow up their budding markets was a hot topic at the annual meetings of the American Economic Association, held a couple of weeks ago in Atlanta.

One proposal was to begin by reducing Soviet food and housing subsidies. Gur Ofer of Hebrew University pointed out that since these subsidies are roughly as large as the Soviet budget deficit, reducing them would cut the budget deficit, sop up some of the monetary overhang, and the higher prices would provide an incentive for farmers and builders to expand production.

Poland, where the annual inflation rate is about 600 percent, is now trying to eliminate its own government subsidies for these very reasons. Ending subsidies will surely cause economic pain in the short run, perhaps extreme pain, but the hope is that it will allow prices in Poland to serve a useful economic function in a year or two.

But Gorbachev may have less breathing space than the current Polish government. Poland is still riding an adrenalin high from electing a non-Communist government, and for the moment, Poles seem prepared to make some sacrifices and give the new government a chance. By all accounts, angry Soviet consumers are not in the same tolerant mood.

A second possibility is that the Soviet budget deficits could be attacked through higher taxes. Ronald McKinnon of Stanford University pointed out that the Soviet system has traditionally raised revenue by rigging prices; the state sets wages and prices in such a way that state enterprises make profits, which the government then spends on something else.

But when the central planners loosen their grip on prices, it becomes clear that many businesses are actually losing money, and the resources available to the government decline. According to McKinnon, the freer prices that have already been allowed are one cause of the increased Soviet budget deficit.

Explicit taxes would also help create appropriate economic incentives. Under the current Soviet system, the state seizes profits and subsidizes losses. If the state were to tax only a portion of profits and close down money-losing operations, efficiency would appear much more attractive.

A third choice for reducing the threat of inflation is to let imports sop up some of the monetary overhang; let Soviet consumers spend their excess savings on imported blue jeans and wine and cheese and televisions.

The difficulty with this idea is that those who export to the Soviet Union must be willing to take rubles as payment, and the value of rubles on world markets is low, uncertain and sinking. As long as the Soviet economy is unreformed, unproductive and running huge deficits, the value of the ruble isn't likely to improve much.

To persuade exporters to sell in the USSR, the Soviet government must devise a way of making rubles worth something to foreigners, probably by guaranteeing that rubles can be traded for a preset amount of dollars or marks or yen or gold. But if the ruble turns out to be worth less than hoped, making good on the guarantee could be very costly.

A fourth possibility is to reduce the value of the monetary overhang by introducing a parallel currency. One method discussed in Atlanta by Herb Levine of the University of Pennsylvania is have 10 percent, then 20 percent, then 30 percent, and eventually all wages paid in "new rubles." New rubles could be spent in well-stocked, free-market stores, and the government would offer to trade, say, one new ruble for every ten old ones. In effect, the Soviet government would simply decree that savings aren't worth much.

Soviet consumers with old rubles would have to spend them as best they could, trade them at the government rate, or whatever the market will bear. But again, government must fear the reaction of Soviet citizens to such a plan.

A fifth option is for the Soviet government to sop up some of the monetary overhang and finance some of its budget deficit by selling long-term bonds. To avoid having the same problem of monetary overhang when the bonds are paid off in the future, the bonds might be paid off with, say, a car or a television or a VCR. Such bonds could buy a few years for economic reforms to have a chance, although if the reforms do not succeed, it might be quite costly to pay them off.

None of these reforms needs to be swallowed whole, all or nothing. One of the few advantages of reforming a truly messed up economy is that even partial and imperfect reform will still be a major improvement.

A limited set of market-oriented reforms was proposed by Deputy Prime Minister Leonid Abalkin last November. But that same month, because of fear of rising inflation, the Soviet government imposed tighter price controls and production quotas. When the government acted on the Abalkin report in late December, it decided that the Soviet economy should cure its economic problems with tight central planning through 1992, before attempting serious market reforms.

Of course, it seems unlikely, to say the very least, that the cure for Soviet economic ills will be found in three more years of central planning. But without some attack on the monetary overhang and the Soviet budget deficit, phasing out price controls and central planning might easily ignite a firestorm of inflation and public unrest.

Economists often refer to a centrally planned economy as a "command" economy, because it responds to commands rather than prices. The great irony of the debate over Soviet economic reform is that the ultimate command economy is apparently unable to move for fear of political backlash. As Herb Levine noted, "Capitalist systems privatize pain; communist systems politicize pain."

The danger is that while the Soviets hesitate on economic reform, the Soviet economy is decaying. The further out of shape the Soviet economy gets, the more pain will be needed to shape it up.

Perhaps it is not surprising that the most discouraging view of Soviet economic reform that I heard at the economics meetings came from Genadii Zateev of Gosplan, the Soviet economic planning ministry. Of the push for economic reform, he said, "The old economic system was condemned, but the new one was not created."

Of the current state of affairs, he said, "The Soviet economy is looking like a kingdom of curved mirrors." Of prospects for genuine economic reform, he concluded, "Even the most radical Soviet Communist leaders, like Gorbachev, have no potential to pursue real market reforms.... When market reforms will happen, only God knows."

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