DRAFT
FOR STAFF USE ONLY
COMMENTS ON PAPERS PREPARED IN THE WORLD BANK
ABOUT SOCIALIST COUNTRIES
Janos Kornai
CPD Discussion Paper No. 1985-10
March 1985
CPD Discussion Papers report on work in progress and are circulated for
Bank staff use to stimulate discussion and comment. Th2 views and
interpretations are those of the authors.


Abstract
The first part of the paper analyzes some important common
characteristics of socialist economies: chronic shortages in the markets
for goods, labor and capital; the limited role of prices and the low price
responsiveness of economic units; weak financial discipline and the
accountability of State-owned firms; investment and import hunger and
forced exports; and the phenomenon of extensive forced growth. The paper
gives an assessment of how these characteristics of socialist economies are
reflected in the reports on these countries prepared by the World Bank.
The second part discusses some of the dilemmas which the reform process is
facing in socialist countries: the conflict between short-term macro-
adjustment and long-term institutional change, and the time-phasing of the
reform measures.


Table of Contents
I. Introduction ...................................... 1
II.          Common characteristics of socialist economies ..... 2
III. Three phases and three ideologies ................. 4
IV.          On the nature of the command economy .............. 7
IV  (a).  Shortage  economy  ..................................  7
IV (b). Weak price responsiveness
and soft budget constraint ..................... 11
IV (c). Expansion drive and investment hunger ............ 17
IV (d). The typical foreign trade performance ............ 22
IV  (e).  Forced  growth  ....................................  25
IV (f). About the underlying philosophy ................. 27
V.           The first reform dilemma:
macro adjustment versus institutional change ... 28
VI.          The second reform dilemma:  partial or overall,
one-stroke or successive reform ................ 31


I. Introduction
1.       The Country Policy Department of the World Bank 1- asked me to    2/
review the reports prepared by the World Bank about socialist countries.
I read 20 volumes which were written during the period 1979-1984. These
notes present my comments.
2.       My general impression was very favorable.   Most papers showed high
professional quality and great expertise. They approached the socialist
economies in an objective and impartial manner, with a willingness to help
the economic progress of these countries. Most of the studies were written
by economists who are not specialists in the field of socialist economic
systems. This may have drawbacks and I shall pursue the problem at a later
stage. It has, however, an advantage as well: the socialist systems have
been looked at with a fresh eye, without the influence of a priori estab-
lished theories and hypotheses. In short, I learned a great deal from
reading this very instructive and rich material.
1/ The author gratefully acknowledges the valuable suggestions given by
Luis de Azcarate, Basil Kavalsky, Parvez Hasan, Aziz Khan, Mark
Leiserson, Ed Lim, Kenneth Meyers and Martin Schrenk. The first draft
of the paper was presented to a seminar at the World Bank in June
1984; the author expresses his gratitude to the participants for many
interesting questicns and comments which were of help in the final
formulation of these notes. Of course, the views presented here are
those of the author and they should not be interpreted as reflecting
those of the World Bank.
The paper does not deal with Hungary. Nevertheless, the author, as a
Hungarian, received much inspiration from the debates on Hungarian
reform. Without implying any order of importance or completeness, the
following is a list of Hungarian economists whose work influenced my
thinking and the ideas expressed in this paper: L. Antal, T. Bauer,
Zs. Daniel, A. De ak, J. GAcs, J.M. Kovacs, M. Lack5, I. Merey, T. Nagy,
R. Nyers, G. Peter, M. Pulai, A.K. Soos and M. Tardos.
2/  In these notes, the following member countries of the World Bank are
regarded as centrally-planned socialist countries:   Afghanistan,
China*, the People's Republic of the Congo, Ethiopia*, Hungary, Lao
People's Democratic Republic, Nicaragua, Romania*, Viet Nam, the
People's Democratic Republic of Yemen* and Yugoslavia*.
All of these countries have at least two common attributes: (a) the
country is ruled by the Communist Party;   and (b) public ownership
plays the dominant role in the economy, or at least in industry,
foreign trade and banking.
The reports I read for the present notes covered the countries marked
with an asterisk in the list above.
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3.       Some further improvement is, of course, possible and I shall offer
a few suggestions with that end in view. I wish to draw the reader's
attention to a few limitations of the present review. I did not comment on
papers written about Hungary. I did not appraise the Bank's lending policy
in socialist countries. I reviewed only those chapters of the repcrts
which provided a description and analysis of the economies, their operation
and their performance. I regarded the reports as analytical studies and
tried to compare their findings with my own understanding and experience.
4.       I am aware that writing a report about a country under the
auspices of the World Bank inevitably involves certain "diplomatic" con-
siderations as it may affect the relationship between the Bank and the
government of the country. In many cases, the text of the report must be
agreed upon with government officials. Being a researcher and not a
diplomat, I applied my usual yardsticks. I looked at each report as if it
were written by an independent scholar. It is for the reader of the
pre'sent notes to decide what can and what cannot be accepted of my sugges-
tions, taking into account the requirements of "diplomacy".
5.       Finally, one more word of caution.   I do not pretend that I really
know the nature and characteristics of socialist systems adequately to be
able to offer well-demonstrated and irrefutable theorems. The study of
socialist economies is not yet a mature discipline. Most of us dealing
with the subject have only conjectures and hypotheses. The emphasis in my
comments is on the questions and not on the answers. I have suggested a
set of questions that the analyst should raise when exploring a socialist
economy. I have also briefy indicated my tentative answers, at least to
some of the questions. My answers must be treated with due caution and
tested one by one for each country. I do hope that, even if the analyst
does arrive at answers different from mine, my questions will have helped
him in future studies of socialist countries.
II. Common characteristics of socialist economies
6.       Let us begin with two quotations from a report about China.
"China's economic management is, by international
standards, extraordinarily centralized...." and "What
distinguishes these enterprise plans and targets from
those common in businesses in other countries is the
degree of external influence and the amount of detail
involved.... These factors have tended to allow
enterprises...very little independence."
7.       With what is the "international standard" to be compared?    What is
the "common business practice in other countries" which serves as a frame
of reference? If we compare China with the United States or West Germany,
the statement is true: China is very different as far as centralization of
firms' independence are concerned. But if we compare the Chinese State-
owned firm of the 1970s with that in the Soviet Union or East Germany,
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there is no striking difference. The degree of centralization or the
limitations on the autonomy of the enterprise is about "normal".
8.       Wlodzimierz Brus, the renowned Polish economist, in reviewing a
recent collection of articles by contemporary Chinese economists about the
problems of today's China, wrote that the reading of the bqok "has been the
source of a strange sensation...a feeling of 'deji vu". -     He felt that
China was confronted with the same set of problems which he and other
Polish economists faced in the Eastern European part of the world.
9.       It is my theoretical conviction that all socialist economies - or
at least the State-owned sector in all socialist economies - have some
common characteristics. There are significant differences between the
countries due to differences in historical background, size, culture,
geopolitical location, national policies, etc.    (There are also differences
between historical periods within each country to which I shall return
later.) Yet the differences can be much better understood if we make
comparisons with the common pattern, i.e., with a general model of
socialist economies. Accordingly, an import ant element of the suggested
set of questions is: what are the differences and similarities between the
particular country to be analyzed and the standard socialist pattkrn?
10.      There is very little of such comparison with other socialist coun-
tries in the reports I read. As a rule, the phenomena, which are possibly
different from what occur in non-socialist countries, but are quite
"normal" or "regular" in socialist countries, are not perceived by the
analy3t as differe2 from other phenomena which are really unique and
country specific. -    It is important to make clearer distinctions between
these two sets of facts.
11.      I do not suggest that meaningful comparisons between socialist and
non-socialist countries, relating their performances and analyzing their
similarities and differences, should not be ma e.    Such comparative
exercises can lead to important conclusions. -    However, the analyst must
be aware that he is comparing members of two different "families", or two
different "species", which have in many important aspects quite different
1/  Book review on G.C. Wang (ed.), "Economic Reform in the PRC", in the
Journal of Comparative Economics, 1984.
2/  For example, the investment drive in Yugoslavia is "normal", i.e., very
similar to the situation in other socialist countries (see nara-
graph IV (d)). At the same time, the institutional framework of con-
trol, property rights and management in a Yugoslav firm is unique.
This kind of distinction does not come out sharply in the reports on
Yugoslavia.
- A good example is the paper by Bela Balassa and Laura Tyson:
Adjustment to External Shocks in Socialist and Private Market
Economies, 1983.
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behavioral characteristics. The conduct that is "normal" in one species
may be "abnormal" in the other one, and vice versa.
III. Three phases and three ideologies
12.      Socialist systems typically go through three phases.   Phase 1 is
the heroic-enthusiastic period. It lasts for the years of revolution,
external and internal war and possibly a few years thereafter. This is the
time of swift nationalization, confiscation and radical redistribution of
private wealth and the rapid spread of revolutionary ideology. Moral
incentives play the predominant role. Phase 2 is the construction and con-
solidation of the bureaucratic-hierarchical command economy. Phase 3 is
when the reform processes evolve in the direction of a less centralized
market socialism. In theory, a Phase 4 could be conceived: a full-blown,
mature market socialism. Perhaps this will be feasible, but up to now
there has not been an existing socialist system which could be regarded as
the genuine representative of Phase 4.
13.      Some qualifications must be added.   The time sequence serves only
as a mental construction, a general model of the historical course of
events. Actual historical development in a country can be different. For
example, in the Soviet Union, Phase I was followed not by Phase 2, but for
a short interval (NEP) by a formation which bore resemblance to Phase 3.
It was only after the abolition of this temporary Phase 3 that Phase 2
appeared, i.e., the creation of the command economy in the Stalin epoch.
In China, Phase 2 was not immediately succeeded by Phase 3, but the estab-
lishment of a command economy similar to the Soviet system was followed by
a partial return to Phase 1: the Cultural Revolution. It was only after
the end of this period that the transition to Phase 3 started. In general,
there can be cycles of decentralization and recentralization, movements
back and forth between the three phases.
14.      In other words, the terms "Phase 1, 2 and 3" refer more to a
logical order than to a temporal order. A possible interpretation of these
terms is to regard them as "ideal types" in the Weberian sense. They are
stylized archetypes or "panels" of which the actual complex system is com-
posed. China before the death of Mao could be regarded as a combination of
Phases 1 and 2, and contemporary China as a combination of Phases 2 and 3.
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15.      Behind the three archetypes, there are three ideologies. -/
examples for the first are different Maoist, radical and New Left ideolo-
gies. The second is represented by the official economic textbooks of the
command economy. The third is advocated in the writings of "market
socialists", starting with the classical paper by Oscar Lange in the 1930s,
and later on in the studies of Yugoslav, Hungarian, Pol sh, Czech, Soviet
and Chinese economists from the 1950s to the present. --
16.      As for the general pattern of socialist development, I offer four
observations:
(a)  The heroic-enthusiastic first phase is provi-
sional. It may last a few years, but cannot be
sustained for an extended period. It must give
way to Phase 2 or Phase 3 since strong material
incentives are indispensable. The most dramatic
examples are the transition of Cuba from Phase 1
to Phase 2, and the transition of China from
Phase 1 (or, more exactly, a particular combina-
tion of Phase 1 and Phase 2 under Mao's Cultural
Revolution) to Phase 3.
(b)  Phase 2, i.e., the bureaucratic-hierarchical
command economy, must be regarded as the most
common "classical" case of the socialist
economy. This formation is not provisional, but
is persistent. It is durable, characterized by
institutional inertia, and is resistant to
change. It is viable in its ability to coordi-
nate social and economic activities, to sustain
considerable growth and to ensure a substantial
increase of consumption for the population.
1/ Different classifications are used in the literature.     The author has
discussed three basic "coordination mechanisms" in one of his
studies: the bureaucracy, the market and "voluntary-ethical coordina-
tion" ("Bureaucracy and Market", Osteuropawirtschaft, 1984, No. 4,
pp. 306-319). Charles Lindblom distinguishes control and coordination
through the political system, through the market and through "persua-
sion" (C.E. Lindblom, Politics and Markets, New York, 1977). Con-
cerning ideologies, I have followed the classification of D.J. Solinger
(Three Visions of Chinese Socialism, Boulder, 1984, and "Marxism and
the Market in Socialist China", in V. Nee and D. Mozingo (eds.), State
and Society in Contemporary China, Ithaca, 1983).
2/ For an overview of the writings on market socialism, see A. Bergson,
"Market Socialism Revisited", Journal of Political Economy, 1967, and
A. Nove, The Economics of Feasible Socialism, London, 1983.
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(c) Phase 3 may or may not occur in all countries.
It has not yet been proven that all socialist
economies move from Phase 2 to Phase 3. Some of
them have already made these moves, some others
have not - although the ideas of reform may have
been put forward a long time ago.
(d)  Phase 3, having begun in a certain country, is
not guaranteed to be irreversible. The system
may fall back to Phase 2. To avoid misunder-
standing, let me reiterate that Phase 3 is not
inevitably prone to a return to Phase 2. I am
only saying that a reversal is possible. There
is no built-in institutional warranty assuring
irreversibility. On the contrary, the socialist
economy has a kind of "natural inclination"
towards a highly centralized bureaucratic
structure. During Phase 3, there is a constant
danger of reversal to Phase 2.
17.      I suggest to analysts of socialist economies to check very
carefully the four hypotheses listed above. Perhaps, in some countries,
the study of facts will support these conjectures. As mentioned in the
Introduction, I have stressed the questions to be raised and not my own
answers to the questions. It will be useful to clarify questions such as
the following: where could the country under examination be located in the
framework of Phases 1, 2 and 3? Can it be placed clearly in one of these
three "archetypes"? Or is it a combination of two or three of them? If
so, which type is predominant? Or is it a different structure which cannot
be fitted into the analytical framework outlined here?
18.      In addition to the questions concerning the system, there is also
the issue of ideologies. Which one is prevalent? Are there signs in the
literature of the country, in past and present disputes among economists
and politicians, that other ideologies exist? Even if the analyst does not
want to discuss the issues of ideologies and intellectual disputes in his
report, some insights can be very helpful in understanding what is going on
- and, even more importantly, what will be going on in the future - in the
economy under scrutiny.
19.      Several studies that I read gave interesting answers to some of
the questions raised in this section, but many others did not even touch
upon these issues. L'ct me give an example. I have never studied the
economy of People's Democratic Republic of Yemen. Reading a report pre-
pared by the World Bank on this country, I was unable even to guess if it
was in Phase 1, Phase 2 or Phase 3, or if it can be characterized by a
combination of the three phases, or if it was a different, unique forma-
tion. It would be very instructive to put the analysis of current economic
problems more in the historical and institutional context.
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IV. On the nature of the command economy
20.      This section focuses on Phase 2, i.e., the mature command econ-
omy. There are some common characteristics which prevail in all Phase 2
socialist systems. There are hundreds of books and thousands of articles
discussing such characteristics. I would have been'hopelessly ambitious to
survey the extensive literature. Instead, I arbitrarily selected only five
common characteristics which I considered to be significant in the context
of World Bank reports on socialist countries. -    Other researchers in the
field may put forward a different list of common characteristics, perhaps
no less relevant than mine.
21.      In the context of the common characteristics of Phase 2, my
comments have repeatedly referred to the borderline between Phase 2 and
Phase 3: where the classical command economy ends and where a serious
reform (and not only the illusion of a reform) begins. Some "litmus tests"
are offered in the hope that they can help determine whether the economy is
in Phase 2 or Phase 3.
IV (a). Shortage economy
22.      The bureaucratic-hierarchical commany economy is always a shortage
economy. There is chronic excess demand and, associated with it, shortage-
generated forced adjustment (forced substitution and forced saving, ration-
ing, queuing, etc.). Overall abolition of chronic shortages is an indis-
pensable element in a consisent set of reform measurer. The disappearance
of shortages is also an important litmus test, checking the depth of
reform. If stubborn shortages prevail in certain important segments of the
1/ I can present some of my ideas on socialist economies only in a
nutshell and inevitably this leads to extreme simplification. The five
issues briefly discussed in the present paper are analyzed in more
detail, together with other characteristics of socialist economies in
the following 3ooks of the author: Overcentralization, Oxford, 1959;
Rush versus Harmonious Growth, Amsterdam, 1972; Economics of Shortage,
Amsterdam, 1980; and Growth, Shortage and Efficiency, Oxford, 1982.
As introductions or summaries, the following articles are available:
"Resource-Constrained versus Demand-Constrai-ied Systems", Econometrica,
1979; "Adjustment to Price and Quantity Signals", Economie Appliqu6e,
1982; and "Some Properties of the Eastern European Growth Pattern",
World Development, 1981.
For partly overlapping, partly different viewpoints about the common
characteristics of the classical socialist command economy, see the
following books: W. Brus, The Economics and Politics of Socialism,
London, 1973; A. Nove, The Soviet Economic System, London, 1977;
P.R. Gregory and R.C. Stuart, Soviet Economic Structure and Perfor-
mance, New York, 1981; and P. Wiles, The Political Economy of
Communism, Oxford, 1962.
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economy, it is certain that the reform process has not penetrated into
these areas and that there is no competitive pressure on the producer.
23.      A shift from a seller's market to a buyer's market has a very
strong impact on the behavior of economic agents, both buyers and sellers.
A study prepared by the Bank by B. Byrd and G. Tidrick, Adjustment and
Reform in the Chongqing Clock and Watch Company (1983), has provided an
excellent description of such a change. The company participated in the
experimental introduction of decentralization reforms. It received more
autonomy, and the enforcement of centrally-prescribed obligatory output
targets became weaker. Some profit incentives were applied: for example,
a part of the profit could be retained in the firm and used for investment.
Despite the remarkable changes, the attitude of the firm did not alter too
much as long as the demand for the output of the firm at given State-fixed
prices persistently exceeded supply. The enterprise exhibited the usual
investment hunger and expansion drive (I shall return to this issue in
Section IV (d)) limited only by the availability of the resources needed.
The firm was more interested in the substantial increase of the quantity of
production than in the improvement of quality and in the fine adjustment of
supply to demand. But then suddenly the supply of the firm hit the demand
constraint. The central authorities were not willing to lower the price.
Under such circumstances, the former quick expansion exhausted the selling
possibilities: the firm jumped from the usual state of a seller's market
to the highly unusual state of a buyer's market. As a consequence, and as
would be expected, the attitude of the firm changed completely. The new
characteristics were that more attention was paid to the quality of output
and that the producer tried to adjust the composition of production to the
structure of demand. To outwit the rigidity of central price control,
perverse "disguised price decreases" appeared: e.g., first-grade watches
were sold for the price of second-gradel nes, or and improvement in quality
was hidden behind a second-grade face. -
24.      The case study on the Chinese clock and watch company represents
an exception in the large set of those prepared in the Bank on socialist
economies. In most of the other papers, brief references to shortages were
made here and there. For example, the otherwise highly illuminating 1981
report on China had a few words on hoarding on p. 148 (hoarding is a
typical side effect of chronic shortages and delayed or unreliable deliv-
eries). The follow-up report of 1983 contained several lines on shortages
on pp. 22-23 and pp. 65-66, but, reading through the extensive report, the
reader cannot obtain a clear picture. Was China in these years an excep-
tion to the rule? Was it or was it not a chronic shortage economy? As far
as I can judge, China was not an exception.
I/ In socialist countries, we usually find the opposite phenomenon:
under chronic shortage, the firm may easily apply disguised price
increases. Second-grade products are sold for the price of first-grade
ones.
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25.      The 1980 and 1983 reports on Romania did not discuss the shortage
syndrome at all, although there was ample evidence that this was (and
probably still is) a rather fundamental issue in the country.    Yugoslavia
is a very special case in this respect: a peculiar combination of the
buyer's market segments and the seller's market segments. Unfortunately,
the otherwise very interesting reports did not offer a clear overview
concerning excess demand or supply. The 1983 report made remarkable
observations on shortage phenomena on the markets of investment resources
(pp. 46-47) and on the unsatisfied demand for foreign exchange (p. 69), but
did not connect these issues with the more general problem of overall macro
excess demand. Also, the difficulties in energy supply are, in my opinion,
related to the same overall question, but again this connection was not
recognized in the paper. Earlier reports on Yugoslavia did not discuss
this aspect at all. There was no discussion of the shortage issue in the
reports, on People's Democratic Republic of Yemen and Ethiopia.
26.      I found the neglect of the shortage problem to be one of the main
weaknesses in the reports.   Of course, the shortcoming is more serious if
the issue has not been studied at all.   And scattered hints to one or
another shortage phenomenon are not much better.   It should be recognized
that here we are facing an interdependent system of persistent imbal-
ances: unsatisfied demands and shortage-forced adjustments, which spill
over from one segment to the other. It can usually be found in seven
areas, the details of which follow.
27.      The first area is consumer goods for the household.    Grave short-
ages of larger groups of commodities, or partial shortages in the assort-
ment of supply, occur: e.g., certain types, models or colors are missing
and spare parts are not available, etc. It is typically a random, stochas-
tic phenomenon: one commodity is missing here today, another one at some
other place tomorrow. (This random character applies, of course, not only
to consumer goods, but to all other shortage events listed in the following
paragraphs.)
28.      The second area is services for the household.   One of the most
serious troubles in many socialist economies is housing shortage. In
addition, there are shortages in telephone services, repairs, hotels and
restaurants, the retail trade, public transport, health and education,
cultural services, etc.
29.      The third area is in the domain of private production activities
(e.g., in agricultural production on a farmer's small private lot), where
there is usually a shortage of certain producer's goods, e.g., fertilizers,
pesticides, machines, equipment spare parts, etc. Also, shortages prevail
in building materials for "do-it-yourself" private residential construc-
tion.
30.      The fourth area is in production:   shortages of material, energy,
semi-finished goods, parts, unpredictability of deliveries and too few
stocks on the side of the suppliers, with an assortment of goods not
adjusted to the rapid and flexible service of the buyer firm. (This is
complementary to hoarding of the same goods on the user's side:
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excessively large stocks of inputs.) The recurrent shortages cause bottle-
necks, improvised adjustments and ad hoc forced substitutions in the
production process. (Usually, an observer would recognize these facts and
would put them under the heading of "inefficiencies", but would never
connect them analytically to the more general problem of chronic shortage.)
31.      The fifth area is the shortage of manpower.   It usually starts
with excess demand for certain skilled categories. Later on, it grows
wider with the rapid expansion of industrial activities, absorbing open and
latent unemployment and underemployment. At the end of the extensive
growth process, the labor market shifts from a buyer's market to a seller's
market.
32.      The sixth area is the shortage of investment resources.    (This
will be discussed in more detail in a later section.)
33.      The seventh and last area is shortage of imported goods and,
associated with it, shortage of foreign currency and foreign credit. (This
will also be discussed later.)
34.      As spelled out before, all these shortages are linked together and
not only by spontaneous spillovers. In fact, policymakers have certain
freedom to reallocate shortages (i.e., the lack of goods) in the same
fashion as they are able to reallocate the availability of goods. The
waiting line for building materials of private households can easily be
shortened by lengthening the queue of enterprises for building material.
Food shortages can readily be eased or even eliminated by imports through
increasing the shortage of foreign exchange.
35.      Shortages and surpluses are not mutually exclusive.   On the con-
trary, they are closely associated. Since in a chronic seller's market the
producer-seller is not particularly interested in fine tuning his product,
it may happen rather frequently that he produces output which even the most
undiscriminating buyer is not willing to accept. However, it does not
matter as the producer can wait, since there eventually will be a buyer
willing to purchase. Another relationship between shortage and surplus
has been mentioned before: the tendency of hoarding. One more important
linkage is that bottlenecks in some inputs lead to underutilization of some
complementary inputs that are available at the time of the appearance of
the bottleneck. Excess demand and excess supply are therefore not mutually
exclusive on a more aggregate level.
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36.      Shortage -L/ is the basic form of imbalance in the Phase 2 type
socialist economy. Not to analyze the shortage syndrome in depth is
equivalent to going to a non-socialist Third World country and analyzing it
without the examination of unemployment-underemployment and open or
repressed inflation.
37.      I am aware that there are great difficulties in obtaining data.
Not only observers, but inside analysts as well experience similar prob-
lems. In many countries, important shortage indicators for a number of
fields, such as waiting time, length of queue, backlog of unfilled orders,
refusal of orders, ratios of forced substitution and so on, are either not
observed or not published. There are deep theoretical difficulties in
aggregating and/or synthesizing partial shortage indicators. Nevertheless,
it is not impossible to obtain some data. It is rather common in the
history of economic statistics that new demand for observation and measure-
ment sooner or later creates its own supply. I would be willing to be more
modest: even some "anecdotal evidence" is better than none. We could use
the following analogy. Consider two reports on the Great Depression of the
1930s. One contains hundreds of figures - but does not discuss unemploy-
ment. The other one cannot offer serious numerical tables on unemployment,
but at least gives some verbal description of the mass unemployment situa-
tion. I am sure that the second study will provide a much better under-
standing of the state of the economy of that period.
38.      I think that the reports wishing to give an overall analysis of
the economy should have a chapter or section on the "seller's market versus
buyer's market" situation of the economy. Such a section could cut across
the usual organization of the reports (internal versus external issues,
industry versus agriculture, short term versus long term, etc.) and may
offer important insights into the nature and performance of the economy.
IV (b). Weak price responsiveness and soft budget constraint
39.      In contrast to the neglect of the shortage question, the problem
of prices received a great deal of attention in most of the reports. There
were many valid observations about the distortions and arbitrariness of
relative prices, e.g., energy prices, interest rates, exchange rates and
1/  It is not my intention to enter into terminological disputes in the
present notes. Just for clearer understanding: the set of phenomena I
call "shortage" (or a subset of the same phenomena) is called by some
other economists "overall excess demand", or "repressed inflation" or
"persistent overheating", etc.   I also use as a synonym the term
"suction" in some of my works.
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other elements of the relative price system. 1- It is very important to
point out these type of shortcomings and the comments I make are not aimed
at refusing the legitimate criticism of existing price distortions. I wish
to complement the usual World Bank criticism ("wrong relative prices") with
another one, which I for one regard as equally or even more important:
does the economic agent respond to prices?
40.      Let me cite the approach widely applied by Western experts
(including the authors of many reports prepared in the World Bank) in the
analysis of socialist countries:   "the wishful theory of prices". When an
excessive demand for and an excessive waste of energy is perceived, the
conclusion is to "increase the price of energy". When it is seen that
there is an excess demand for investment resources and that there is
inefficiency in completion projects, the conclusion arrived at is "increase
the real rate of interest". Change the relative price of a product or of a
resource and one can expect the same result in a highly centralized bureau-
cratic-hierarchical command economy as one would get in a decentralized
price-sensitive market economy. This is wishful thinking: "get the prices
right" - perhaps that can be adequate advice in a system where profit
incentives and markets dominate the coordination of economic activities.
(Even there, this prescription is of course not sufficient to solve all
economic and social problems.) As for socialist countries, this kind of
advice is surely insufficient. The degree of price responsiveness is not
identical in all social systems, but is highly system specific. It depends
on the deeply imprinted behavior of economic agents that determines how
strong their response is going to be on the demand and supply side to
changes in relative prices. Focusing only on socialist countries, little
can be said as yet on which would be equally valid for all sectors in all -
countries and all the time. Therefore, I shall try to formulate some more
qualified observations.
41.      The household's purchasing power is strictly limited by its finan-
cial resources. Consumer credit is rather restricted and the repayment of
credit is rigorously enforced. Hence, the household has a "hard" budget
constraint. As a consequence, household demand for goods and services
exhibits the usual properties. Demand is an increasing function of income,
and a decreasing function of its own relative price. It is true that
demand formation in a chronic seller's market is somewhat different from
that in a chronic buyer's market. The buyer expects shortages and he
therefore will at least partially adjust himself in advance to expected
supply. There are important quantity signals which affect the buyer's
decision: the length of the queue to be joined, expected waiting time,
coupons and rations, selection criteria applied by rationing authorities,
I/  See, for example, the 1981 report on China, Vol. I, p. 124, and the
1983 report on China, pp. 23-24. Furthermore, see three studies on
Yugoslavia: Raising Productivity in Yugoslav Industry: Some Issues,
1981, p. 41; Employment Strategy and Manpower Policies for the 1980s,
1983, pp. iv and 96; and Adjustment Policies and Development Perspec-
tives, 1983, pp. 95-96.
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information about availability of substitutes, etc. Ultimately, however,
if the consumer price goes up, then it is rather likely - ceteris paribus -
that demand will go down.
42.      The same can be said about the behavior of private business within
a socialist economy: e.g., about private merchants, craftsmen, free-lance
professionals, owners of private restaurants, apartment landlords, private
farmers, etc. They also have a hard budget constraint, mostly not
separated or not quite separated from the household budget constraint of
the owner. If a private economic unit gets into financial troubles, the
socialist State will not bail it out but lets it down, and it will there-
fore suffer all the consequences of insolvency.
43.      The situation is qui7 te different with the State-owned and
centrally-controlled firm .  /  If the firm gets into financial troubles,
the State is willing to bail it out: it will receive subsidies, tax
exemptions, soft credits and rescheduling of due payments. The adminis-
trative price will be adjusted to the overrun of costs, or other means of
covering the losses will be applied. It is built deeply into the expecta-
tions of the leadership of the firm that the State will help out the firm
in case of insolvency or other great financial difficulties. Under such
circumstances, even if there were some profit incentives (e.g., bonus for
the managers linked to profits, profit sharing for employees, profit reten-
tion for internal welfare expenditures and investment, etc.), profitability
still would not be a matter of life-and-death. The enterprise can survive
long-lasting or ever-persistent large deficits. There is no automatic
penalty because of losses. The correlation between present a-ad expected
future profitability on the one hand and the growth of the firm on the
other hand is weak or non-existent. I call this set of conditions the
"soft budget constraint".  The firm has financial accounting.   It has a
balance sheet, as do all other enterprises in the modern business world,
but the budget constraint is "expendable", depending on the success of
lobbying and bargaining with different State authorities and on the
paternalistic attitude of the State vis-a-vis the State-owned firm.
44.      And now we can return to price responsiveness. Conventional
demand and supply theory postulates the existence of a hard budget con-
straint. Demand is-finite, constrained, because the budget is constrained.
This simple relationship does not hold if the budget constraint is
softened. The softer the budget constraint, the closer comes the slope of
the demand curve to a vertical position, i.e., to the perfect insensitivity
to prices. The firm can be unresponsive to relative price changes, as well
I/ The status of a cooperative firm (with collective ownership and more or
less autonomy of the elected management) is typically somewhere between
the status of the State-owned centrally-controlled firm and the private
economic unit. There is a large variance of situations according to
the degree of dependence on governmental authorities. In the present
short notes, I cannot elaborate on the specific problems of the coop-
erative sector.
305/Kornai/JKornai/ARKhan/sep/03/06/85


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as to expected income from the sale of its output, if any deficit arising
from this unresponsiveness and from the consequent inefficiency is sure to
be almost automatically compensated for by subsidies, tax exemptions, soft
credits and so on. If the firm as well as the medium and higher level
officials of the economic administration are motivated to increase produc-
tion and to speed up growth, then under a soft budget regime run-away
demand for production inputs in general (and for investment resources in
particular) will be generated. Here is one of the most important roots of
chronic shortage in socialist economies.
45.      Some qualifications must be added to avoid possible misunder-
standing. First, the stringency of a budget constraint is not a binary
variable: either soft or hard, It has a scale and intermediate positions
are possible. External assistance is usually not granted automatically as
some effort is needed to obtain it. The firm's managers must resort to
pressure groups, lobbies or to personal connections. Some hidden corrup-
tion in the form of reciprocal favors may occur. Thus, softening of the
budget constraint is not without costs. Therefore, even if it is softened,
the budget constraint has at least some influence on the behavior of the
firm.
46.      Secondly, the stringency of the budget constraint is an ex ante
behavioral variable, a component of the firm's expectations. It is deter-
mined by the collective experience of many years. It cannot be altered
from one day to the other, e.g., introducing new legal regulations, bank-
ruptcy laws, incentive schemes or credit criteria. It will to a large
extent depend on long-term experience with the enforcement of such changes.
The managers and also other employees of the firm must witness for a number
of years that profitability is "dead serious" and that price and profit
signals cannot be neglected since such neglect leads to harsh reprisals in
the career of the manager, in the job security of the employees and in all
prospects of the whole enterprise.
47.      Thirdly, the budget constraint, as it appears in standard micro
theory, is a static concept. In real life, the issue is a dynamic one.
Assistance fills up the gap between flow of expenditures and flow of sales-
generated revenues of the firm.
48.      Fourthly is the fact that usually a seller's market prevails
results in a particular asymmetry of price responsiveness. It is usually
somewhat stronger on the supply side and somewhat weaker on the detrand
side. The firm, in its capacity of a seller, may give preference to more
profitable products. (The firm prefers more profitable production to a
less profitable one since, even with a soft budget constraint, it is
unpleasant to apply for State support and bail out.) And since the seller
is stronger than the buyer, he can force the latter to adjust his demand to
given supply.  (With arbitrary pricing, relative profitability does not
reflect relative scarcities.) At the same time, the firm in its capacity
of a buyer will be more insensitive to costs. It is not a consistent cost
minimizer: it buys and uses the inputs it has, and it will be glad to get
the needed material, to have semi-finished goods delivered and to have the
305/Kornai/JKornai/ARKhan/sep/03/06/85


-15-
needed services at hand. It will not be particularly selective concerning
the costs of different input combinations.
49.      There is no synthetic measurement of the stringency of the budget
constraint. It can be observed and measured only indirectly with an appro-
priate set of indicators. Here are a few examples: frequency of bank-
ruptcy cases and different procedures following insolvency; the "rules of
the game" concerning exit and merger; the fiscal redistribution of taxes
and subsidies amongst the firms (who gains and who loses with the redis-
tribution); and the business practice of the banking systems (what are the
real - and not the publicized - criteria of credit rationing). Again, as
in the case of the shortage syndrome, the softness of the budget constraint
is an observable and measurable fact of life - but the difficulties of
observation and measurement can be rather great.
50.      Here again is an important litmus test, one concerning the border-
line between Phases 2, 3 and 4, i.e., the transition from the classical
command economy to market socialism. Even with more flexible and more
realistic prices and some profit incentives, we may be far away from a
genuine market socialism if the budget constraint is relatively soft :And
the response to price signals relatively weak. The hardening of the budget
constraint and the strengthening of price responsiveness are among the most
reliable indicators concerning the consistency and "seriousness" of the
reform.
51.      Most of the reports prepared   n the World Bank did not raise the
issue of the soft budget constraint. -    In many studies, the secondary
(legitimate, but secondary) question, "get the prices right", is completely
separated from the primary question, which is does the agent respond to the
price because the whole social framework compels him to respond? Or is
such compulsion missing?
52.      A word of caution is in order here.   I consider price responsive-
ness the primary issue and the correction of the distorted price structure
the secondary issue. These adjectives refer only to a logical order of
causality and not to the temporal order of practical measures. It does not
imply that a reform process defer the improvement of relative prices until
the budget constraint becomes hard. What is meant by this is that the
hardening of the budget constraint is a precondition of the strong effect
of prices. Both the hardening of the budget constraint and the improvement
*1/ Evidently, I do not complain that the authors of the reports did not
use my terminology of "soft budget constraint". This is only a
metaphor, which may help explain a complex social phenomenon.    It is
easy to find synonyms, or other ways of expression. One could speak
about financial discipline and strict accountability, intolerance
against persistent loss making, the punishment by the market for finan-
cial failure, etc. My criticism is that these issues did not get
sufficient attention.
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-16-
of the price system are greatly needed and it is desirable to go ahead with
both simultaneously.
53.      I am glad to recognize that in the last few years there has been a
growing interest in these issues. A good example is the already quoted
paper by Byrd and Tidrick about a Chinese clock and watch factory. The
authors have tried to examine thoroughly the consequences of a soft budget
constraint and the attempts to "harden" it. There is a very stimulating
paper on Yugoslavia by P.T. Knight entitled Financial Discipline and
Structural Adjustment (1983). The paper is exemplary in finding convincing
quantitative in dicators:  number of loss-making economic units, the size of
losses, the relative frequencies of bankruptcy procedures and administra-
tive "rehabilitation" processes. A particularly interesting finding is the
role of interfirm credits as "softeners" of the budget constraint. To put
it in very simple terms, the budget constraint is really not binding when
the firm simply does not pay the bills and the legal system tolerates the
acceleration of mutual forced indebtedness. A later follow-up note by
Chandra Pant (1984) presented the latest news in this respect. It showed
that there are efforts in the direction of hardening the budget constraint,
but the enforcement of appropriate legal resolutions seems to be not
sufficiently rigorous.
54.      In contrast to the growing interest focused on the stringency of
the budget constraint, much less attention is paid to price responsive-
ness. I could not find a single report which examined this issue at
length. This, in my opinion, is mainly the fault of economists working
within the socialist economies.   It is our duty to study the problem in
much more detail. It is a very difficult research task; there are
unresolved theoretical and statistical problems. For example, energy
elasticities decreased, although not to a sufficient degree, in some
socialist countries since the first energy crisis in 1973. What are the
causal factors? Did the decrease occur because administrative constraints
(energy import quotas, energy quotas allotted to productive enterprises,
etc.) became tighter? Or because firms responded to an increase of energy
prices by decreasing their demand for energy? Probably both factors played
a role, but we need some kind of theoretical and statistical separation to
understand causality. The same applies more generally to the demand for
imported goods. There are administrative quantity restrictions and there
are, at least in some countries, changes in the exchange rate. What is the
effect of the first and of the second cause on the demand for imports?
Much more research is needed to answer these questions. But, given the
level of our ignorance at the present moment, even a somewhat vaguely
expressed awareness of the issue is better than complete neglect.
55.      Here, a short digression to monetary policy will be in order.    A
repeated suggestion to socialist countries is this: apply a tight monetary
policy if you want to restrict runaway total demand. The advice concerning
monetary macro policy is based on tacit assumptions concerning the behavior
of the micro units. If total money supply is restricted, the micro units
will spend less and ultimately will restrict the purchase and the use of
real goods and services. In my opinion (shared by some other researchers
305/Kornai/JKornai/ARKhan/sep/03/06/85


-17-
of socialist economies), L/ the tacit assumptions underlying the usual
macro advice are wrong: the transmission mechanism between total money
supply, together with the response of micro units to a change in monetary
policies, work rather differently from the underlying tacit assumptions.
The "activity" or "passivity" of money is conditional on the stringency of
the micro budget constraints. Conventional demand management works with
the household; lower wage and less consumer credit - perhaps after some
adjustment of saving - will lower consumer expenditure. One does not get a
similarly mechanical response from the State-owned and centrally-controlled
firm operating with a rather soft budget constraint. Even after tightening
the total quota for credits, the firm may go ahead with procurement and
actual use of resources. It still may be indifferent to the danger of
insolyency as long as it can be more or less sure that somebody else (the
Bank or the State) will pay the bill, or as with many Yugoslav firms, it
simply does not pay some bills at all.      I It will not feel scared by a cut
in total bank credit. It simply will not believe in the persistency of
such a tightening.
56.      Institutional changes altering micro behavior and changes of
monetary macro policy must be simultaneous in order to get the expected
results from the latter. Space limitation of the present paper does not
allow for further elaboration. Here, I can given only a few hints on this
rather complicated problem, which surely deserves further serious research.
In any case, perhaps these few words may serve as a warning: routine macro
advice must not be applied without thorough reconsideration of the micro
foundations of macro policy.
-IV (c). Expansion drive and investment hunger
57.      A very characteristic property of the standard "classical" beh v-
ioral pattern is the insatiable hunger for expansion and investment. -    It
can be observed in government agencies, political institutions in charge of
economic affairs, non-profit organizations and, last but not least, in
State-owned firms.  Investment hunger is shown persistently at all levels
of the bureaucratic hierarchy, from the shop-floor manager to the director
of the large company, to the government cabinet minister.
1/  See W. Brus, Ogoline problemy funkcjonowania gospodarki soc-
jalistycznej, Warsaw, 1961, and G. Grossman, "Gold and the Sword:
Money in the Soviet Commany Economy", in H. Rossovsky (ed.), Indus-
trialization in Two Systems, New York, 1966.
2/  This is an arbitrary creation of money by credits forced upon the
creditors.
3/  The papers Raising Productivity in Yugoslav Industry:   Some Issues,
1981, and Yugoslavia: Employment Strategy and Manpower Policies for
the 1980s, 1983, use the term "investment mania".
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58.      Different explanations were offered in the literature.   Some
authors have put the emphasis on the ambitious growth objectives of the top
leadership. They wanted to speed up development, to close the gap as soon
as possible between the highly developed capitalist countries and the
socialist economies. They wanted rapid growth for the sake of strength-
ening the overall power of the country, its defense capacity and ultimately
to ensure a high standard of living.   Because the top leadership had these
growth objectives, they have forced "output maximization" and/or "growth
maximization" upon the lower levels of the hierarchy down to the firm by
means of tight output and investment plans and managerial bonuses linked to
the fulfillment of the plan.
59.      In my opinion, it is true that the leadership of socialist
countries gives a very high preference to growth objectives, but this is
only the half of the story explaining investment drive. There is a
voluntary propensity to invest at a high rate at all levels of the
hierarchy. This prevails even in the periods in which for some reasons
(e.g., because of external disequilibria) the top leadership would be in
favor of less investment.
60.      In many socialist countries, a recurrent alternating of "stop-go"
policies can be observed. Acceleration of investment and other economic
activities is followed by deceleration, or sometimes by absolute contrac-
tion. In other words, we see irregular or - in soT countries and in some
extended periods - regular cyclical fluctuations. -    Some economists point
to the restrictive phase of the cycle and conclude that the mere existence
of such restrictions disproves that investment hunger is persistently
insatiable. I think that this line of reasoning implies an error in logic,
confusing the role of the allocator and of the claimant for investment
resources.
61.      Let us consider a medium-level authority, say, the minister of
light industry. He has a double role. He is the allocator of investment
resources over the subsector of light industry. (I am using here and in
the forthcoming discussion the term "allocation of investment resources" in
1/  The most important work in the field is the book in Hungarian on
investment cycles by T. Bauer: TervgazdasAg, beruhAzAs, ciklusok
(Planned Economy, Investment, Cycles), Budapest, 1981, which elaborates
a general theory of cycles based on the experience of several socialist
countries. There are many other interesting studies that are available
in English: T. Bauer, "Investment Cycles in Planned Economies", Acta
Oeconomica 1978; A.K. Soos, "Causes of Investment Fluctuations",
Eastern-European Economics; M. Lacko, "Cumulating and Easing of
Tensions", Acta Oeconomica 1980; 0. Kyn, W. Schrettl and J. Slama,
"Growth Cycles in Centrally Planned Economies: An Empirical Test", in
0. Kyn and W. Schrettl (eds.), On the Stability of Contemporary
Economic Systems, G6ttingen, 1979;   and M. Maresse, "The Bureaucratic
Response to Economic Fluctuation: An Econometric Investigation of
Hungarian Investment Policies", Journal of Policy Modeling, 1981.
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the following sense. This is a collective term which includes the bureau-
cratic allocation of investment quotas, permits the start of concrete
investment projects, the rationing of investment credits and subsidies, the
licensing imports of investment goods, etc.) At the same time, the
minister is a claimant for investment resources from the central planning
authorities and ultimately from the government and central political
bodies. In this second role, he is competing with his fellow ministers of
heavy industry, agriculture, transport, etc. Given this double role, his
mentality will be Janus-faced. Downward looking he will be restrictive,
trying to resist the excessive claims of his subordinates.    In the decel-
erating phase of the investment cylce, he may be more restrictive than
usual. Upward looking, however, he will be demanding, urging the superior
decisionmaker to give more resources to his sector. Reference is made
always to the upward-looking face when talking about the insatiable invest-
ment hunger. This hunger never ceases and during restrictive phases it
becomes even stronger.
62.      The term "insatiable" should not be taken literally.    The sub-
ordinate must submit a reasonable figure as his claim for the investment
quota, otherwise his superiors will not take him seriously. There is some
voluntary restraint for the sake of a "reasonable image" and a better
maneuvering in the battle for resources. But this does not hinder the
creation of claims which to a very large extent exceed in total the avail-
able physical resources. The total claim is not infinite in the strict
mathematical sense, but sufficiently large and "run away" to be considered
insatiable or nearly so.
63.      A conclusion for the analyst who wants to understand the nature of
a socialist country is that it is not sufficient to look at ex post
investment data such as investment expenditures, new capital formation,
etc. What is going on ex ante must be studied and this should be done in
several stages. The last stage is the investment plan, which can be com-
pared with fulfillment. The plan, however, is already an outcome of a
compromise between planners, allocators and claimants. We have to trace
the sequence of events and also consider what happened during the planning
and project-approving processes and what was the relationship between
claims on the one side and the estimates concerning available resources on
the other side. This is where the tension of the investment sphere
begins: the limitless (or almost limitless) claims for resources.
64.      The decisionmaker in his role as a claimant does not respond to
the interest rate. This is evident in the case of the hierarchical levels
above the firm. Also, the firm does not really respond to interest rates
when deciding on investment resource claims. There is systemic bias in ex
ante estimates of investment costs. A more modest proposal has a better
chance of acceptance. It is reasonable, therefore, to underestimate costs
and to overestimate returns. At a later stage, it is hard to stop the
execution of the original investment decision.
65.      As for causal explanation, there are three mutually interrelated
causes:
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(i)    the softness of the budget constraint.   If the
decision was wrong and the increment of output
due to the investment project does not pay off
the costs, the deficit will be covered. The
State acts as a general insurance company. The
main area where the softness of the budget
constraint appears is not so much in current
expenditures than in the sphere of investment;
(ii)   the impersonality and anonymity of the decision
process. According to the given legal regula-
tion, someone must have signed the document
which gave the starting signal to the project.
But the individual who signed this piece of
paper surely consulted his superior and perhaps
the superior again consulted his own superior,
as well as many others, and thus the decision
when reached is usually based on a certain
consensus. This consensus base brings collec-
tive wisdom into the decision - but it under-
mines personal repsonsibility. In case of
failure, all members of the consenting group
are interested in covering up the deficit,
i.e., by softening the budget constraint; and
(iii). chronic shortage.   This is a vicious circle as
investment hunger contributes to total demand
and exceeds physically available resources. At
the same time, chronic shortage strengthens the
confidence of the investor. He will surely
find buyers for the additional output which has
been produced with the newly created capital.
In a market economy, investment is highly
dependent on optimistic or pessimistic expecta-
tions concerning future sales prospects. In a
chronic shortage economy, such anxiety does not
exist.
66.      An important litmus test of the transition from Phase 2 to
Phases 3 and 4 (from "classical" to reformed market socialism) is the
analysis of the investment hunger phenomenon.   If there is no voluntary
restraint on the claimant's side, the reform did not go far enough.
67.      It is remai able that Yugoslavia, one of the leading countries in
the reform process, does not stand this particular test.    Invest nt hunger
is not less intensive here than in any other socialist country.-      At
least causes (i' and (ii) still prevail in Yugoslavia;    as for cause (iii),
1/  All World Bank papers dealing with Yugoslavia fully recognize this fact
and provide many examples and data to suport the observation.
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Yugoslavia is not a clear-cut case, but a peculiar mixture of a seller's
market and a buyer's market.
68.      It is not a litmus test to check the opposite side, the allo-
cators' behavior. Phase 2 socialism, i.e., a highly centralized command
economy, is able to apply very effectively a restrictive macro policy by
cutting dramatically investment quotas, by stopping or by slowing down
investment projects in progress, by prohibitini,new starts, by denying
licenses for importing investment goods, etc. -    The more centralized the
economy, the easier to ensure the implementation of drastic restrictive
macro policies.
69.      As for World Bank reports, most of them have clearly recognized
the tendency of excessive investment drive,      This will surely help in
understanding the importance of the issue. What is mostly missing in my
opinion is a deeper analysis of the causes of the investment-hanger phenom-
enon. Quite a few studies also apply in this context of what I referred to
above as the wishful theory of prices. If there is excess demand for
investment resources, the cause must be the incorrect 3 nterest rate (too
low or, in real termls, even negative interest rate). -    And if this is the
diagnosis, the therapy clearly follows to get the interest right. My
comment carries on from Section IV (b). First, create price and interest
responsiveness. Only if t is is safely assured, can an interest rate
policy become effective. -
70.      An offshoot of the wishful theory of prices is the suggestion
to apply cost-benefit analysis based on rational shadow prices as an
1/  See, for example, China: Socialist Economic Development, Vol. I, 1981,
p. 18, or the 1981 Country Program Paper for a vivid description of
such dramatic investment cuts. Similar Romanian experiences are
described in Romania: Economic Memorandum, 1984.
2/ A few examples:    China: Socialist Economic Development, Vol. I, 1981,
p. 161; Office Memorandum on Ethiopia, April 13, 1983, p. 7; Country
Program Paper on Romania, 1980, p. 3;   People's Democratic Republic of
Yemen: Economic Memorandum, 1982, pp. 2-3, 20; and Yugoslavia:
Adjustment Policies and Development Perspectives, 1983, pp. 46-47.
3/  This is the repeated reasoning for the case of Yugoslavia.    See Raising
Productivity in the Yugoslav Industry: Some Issues, 1981, pp. iii and
41; Yugoslavia: Employment Strategy and Manpower Policies for the
1980s, 1983, p. 96;   and Yugoslavia: Adjustment Policies and Develop-
ment Perspectives, 1983, pp. 95-96. See, furthermore, China: Recent
Economic Trends and Policy Developments, 1983, p. 33.
4/  The word "first" in the former sentence refers to a causal-logical
order: price responsiveness is the precondition of an effective
interest rate policy. It does not imply any suggestion concerning the
temporal order of measures. I shall return to this later in Section V.
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instrument of project selection. 1/ The proposal assumes tacitly that the
planner is an unbiased "homo rationalis", considering nothing else but what
follows from the impartial numbers of the cost-benefit calculation. In my
experience, people at all levels of a bureaucratic decision process are
normal human beings: they have good intentions and do a good job. At the
same time, they want to please their superiors; they may succumb to pres-
sures and to lobbying, and may be influenced by personal loyalities vis-a-
vis their "own" sector, branch, region, etc. Depending on the preference
of the boss, it is all too easy to prepare a tailor-made calculation which
either supports approval or supports refusal.   Similar wishful thinking is
behind the suggestion to make investment decisionmaking less "politicized"
and more efficiency oriented. This is not a change which can be achieved
by preaching the reasonableness of such a shift. If a decision is not a
business-like one, favoring or hurting the financial interest of a well-
defined group of individuals, it will inevitably be a part of a "political"
(or, more precisely, a politico-bureaucratic) decision process.
71.      Many papers put all the emphasis on the governmental macro policy
in the controL of investment and did not dig more deeply to the micro roots
of the problem. The problem has already been discussed in Section IV (b)
and will readdressed in Section V.
IV (d). The typical foreign trade performance
72.      The performance of socialist economies in foreign trade can be
understood only if it is placed in the context of the behavioral regulari-
ties of the system. As with the previous section, what follows will be far
from complete. I have presented only a few observations, which are closely
related to the issues discussed in other parts of the paper and will focus
on Phase 2, the classical command economy.
73.      The decisionmakers controlling foreign trade activities are not
"profit maximizers": they are either the officials at the higher or medium
level of the bureaucratic hierarchy, or the managers in the firm. The
responsiveness to prices, costs and exchange rates is weak or nil. The
gain or loss from foreign trade is not clearly calculated; it is impos-
sible to make such a calculation with arbitrary prices.
74.      The first driving force of foreign trade is "import hunger".    The
producer enterprises, government agencies in charge of ensuring the supply
1/  See China: Socialist Economic Development, Vol. I. 1981, p. 16;
China: Recent Economic Trends and Policy Developments, 1983,
p. viii; Romania: Economic Memorandum, 1984, p. 71; and
Yugoslavia: Adjustment Policies and Development Perspectives, 1983,
p  64.
2/  See China: Socialist Economic Development, Vol. I, 1981, p. 161;    and
Yugoslavia: Adjustment Policies and Development Perspectives, 1983,
p. 64.
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of goods to domestic firms, non-profit institutions and households are
eager to obtain imports. They do not have any strong economic motivation
to think about the cost. This is a phenomena parallel with investment
hunger. As a claimant, each firm and each agency would like to get as
large an import quota and licenses as possible. Furthermore, there is an
insatiable appetite at all lower and medium levels of decisionmaking for
high quality modern machinery and equipment, which is a phenomenon not only
parallel, but practically associated with investment hunger. In the case
of acute and intensive shortages, the claims for more imports filling the
gaps of domestic supply become more aggressive.
75.      Turning attention to the export side:   apart from exceptional
situatiuns, the producer firm enjoys the easy conditions of the domestic
seller's market. It therefore has no endogenous motivation to search for
export markets in the convertible currency area, which would demand impec-
cable quality, delivNry exactly on time, etc. If the firm must export, it
is still more convenient to supply another shortage economy: a less selec-
tive buyer.
76.      Of course, the top leadership in charge of national balances is
perfectly aware that imports must be ultimately compensated for by exports.
But only the top leadership feels that as an endogenous compulsion. For a
transmission mechanism, they rely on administrative command methods.
Against spontaneous import hunger, prohibitions are used in highly dis-
aggregated quotas and licenses. Instruments of export promotion are
mandatory export targets, which are often very detailedinstructions as to
what to produce for which market, and bonuses for fulfillment or over-
fulfillment of the plan. The central organs put pressure on the medium and
lower levels of the bureaucracy and finally on the firms to export by all
means and at any cost. It is a drive for a maximum quantity of proceeds in
convertible currency, irrespective of the true domestic costs. If the
quality of the goods and the terms of delivery are not sufficiently attrac-
tive in the eyes of the foreign buyer, a lower selling price can achieve
the deal. Nobody is directly financially hurt if an export transaction
leads to a deficit since, in that case, the softness of the firm's budget
constraint also helps.
77.      There is a peculiar combination of hard and soft budget con-
straints. The balance of payments for a long while was a rather soft
constraint, easily expandable by increasing foreign debt. Then, after
economic and political shocks, it suddenly became very hard. This hard-
ness, however, is felt only by the top leaders and it is not automatically
"transmitted" to the producers and consumers through any w2ll-functioning
market mechanism. There is a deep contradiction: the convertible currency
constraint is hard at the national level, but at the same time the budget
constraint of the firm in domestic currency is soft, mellowed through an
enormous variety of tax exemptions, subsidies, etc. Under such circum-
stances, the firm, driven by endogenous motivation, does not participate
voluntarily in the improvement of the foreign trade situation. Neverthe-
less, the balance of trade and the current account can be improved, but
only with energetic administrative measures, drastic import cuts and forced
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export achievements, accompanied by great losses, inefficiencies and
sacrifices.
78.      This is, of course, a very crude picture, neglecting many details,
exceptions and national differences. Let us now consider the approach in
the World Bank papers. They present accurate and well elaborated analyses
of the foreign trade and the balance of payments situation of the country
under scrutiny. These sections of the reports offer important, interesting
and valuable information and they serve as a data source for further inves-
tigations and comparative studies.
79.      As for the normative aspects, the general advice contained in
quite a few papers is surely correct: a more outward-looking, export-
oriented policy would be useful. Less emphasis should be laid on import
substitution and more on export promotion - this is a convincing recom-
mendation. And yet the question remains as to why these countries do not
pursue such a policy. Is it because they have not received similar advice
before, or is it because there are endogenous forces, behavioral regulari-
ties at work which act against these desirable trends? I am inclined to
believe the second hypothesis.
80.      A deeper positive analysis of the system, preceding the normative
recommendations, was missing in most papers - as in the case of the issues
discussed in the earlier sections. Most of the socialist countries,
especially the smaller ones, have not been aiming at self-sufficiency or
autarky in the last two decades; they are not inward looking at either the
national or the CMEA level. Their desire is to make good use of the
possibilities offered by foreign trade. In spite of recognizing the
desirability of outward-looking policies, they keep falling back to the
symptoms just described. Under the circumstances of a command economy, it
is much easier to give instructions for import substitution than to
penetrate into new markets with exports. An economic system cannot have a
"multiple personality", exhibiting one character for the domestic purpose
and another character which is quite different for the external purpose:
inside, exploiting the easy terms of a seller's market; outside, working
hard to sell on a buyer's market; inside, enjoying full security of the
survival of the firm and of all existing jobs; outside, behaving as an
actor used to tough competition; inside, being careless with costs; and,
outside, responding sensitively to profits and losses. In short, there is
no therapy for shortcomings in foreign trade without curing the domestic
troubles of the economic system.
81.      The wishful theory of prices appears here in the form of allusions
concerning exchange rage policies. The criticism of an arbitrary exchange
rate (or, even worse, a whole set of arbitary rates for different purposes)
is legitimate and useful. This criticism must not, however, lead to the
simplistic conclusion that, even if nothing else has changed, a correction
of the exchange rate will produce the desired and expected effects. The
primary question is again the responsiveness to the price signal. If the
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responsiveness is weak, then the impact of exchange rate policies, com ared
to the influence of administrative regulation, will be weak as well. -
82.      It is precisely this aspect which offers one more litmus test of
the transition from Phase 2 to Phase 3 and Phase 4. Has exchange rate
become an effective signal? Is the export or import price - through the
intermediation of the exchange rate - an effective signal for the domestic
producer and consumer? Are there transparent a7d self-controlled linkages
between domestic and export or import prices? 2     Or are there still
administrative barriers which, at the first instance, insulate the domestic
market from the foreign market and then allow connections only under
bureaucratic regulation through mandatory targets, quotas, licenses,
rationing and fixed prices?
IV (e). Forced growth
83.      The standard growth pattern of Phase 2 is characterized by a
certain set of priorities. It is not completely consistent and invariable
over time. Nevertheless, there are clearly recognizable features.
(i)    The main growth objective is The maximization
of the medium-term growth rate of output (and
not the long-term growth rate of consumption).
This is a disputed issue; other economists
suggest that other objectives are revealed in
the choice of high-level planners (e.g., maxi-
mization of net capital formation or invest-
ment).
(ii)   Priority is given to the so-called "productive"
sphere over the "non-productive" sectors. To
the latter belongs housing, services, commerce,
health, education and infrastructure.
1/  Yugoslavia is a special intermediate case, different from the socialist
countries which are clearly in Phase 2. It would be wrong to suppose
that the socialist sector here is completely unresponsive to price
signals. It is questionable, however, as to how strong the response of
the Yugoslav enterprise is to price, exchange rate and similar other
signals. Without convincing studies clarifying this question, one
cannot accept (or reject) unhesitatingly the following straightforward
proposition: a more active exchange rate policy is the most important
issue. (See Yugoslavia: Adjustment Policies and Development Perspec-
tives, 1983, p. 96.)
2/  The linkage between domestic prices on the one hand and export and/or
import prices on the other hand is a very important problem, closely
related to other issues discussed in the paper. I cannot, however,
elaborate on it here.
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(iii)  Manufacturing (most importantly, heavy indus-
try) is given priority over all other sectors.
(iv)   There is a strong bias in favor of the large
(and often the gigantic) enterprise, as opposed
to medium or smaller units, even in areas where
the medium or small size would certainly be
more efficient.
84.      This is not an exhaustive list.   Two or three more tendencies
could be added. The most common name for this particular growth pattern is
"forced growth". I called it "rush" in one of my lectures. For che sake
of rapid expansive growth, requirements for balanced and harmonious growth
are stubbornly disregarded.
85.      From time to time, there are corrections.    Some of them are intro-
duced after a careful evaluation of the results as a consequence of a
"self-criticism" of policymakers and planners. Sometimes, catastrophes or
public protests induce change. The corrections are usually only marginal
and provisional. Ultimately, inertia and rigidity prevail. Intertemporal
averages over longer periods show that proportions of different sectors,
once established, change only extremely slowly.
86.      A litmus test of the seriousness of reforms is the examination of
the following questions: are they significant and, more importantly, are
they long-lasting and permanent readjustments in favor of formerly
neglected sectors, such as housing, infrastructure, health and so on? Is
production better adjusted to needs, as expressed either through economic
signals (high demand prices, the black market, the semi-legal second
economy, abnormally long waiting queues, etc.), or through "voice", -
i.e., complaints, proposals and protests?
87.      There were a few interesting hints in differe7t World Bank reports
to the peculiarities of the "forced growth" pattern. -     A more thorough
analysis would certainly help both positive understanding and policy forma-
tion. This is a field where comparative research can be very instructive,
contrasting the growth pattern of the country under examination with the
pattern of other socialist countries and non-socialist economies as well.
The Bank has a long and highly respected tradition in this area, which
could be well utilized here.
1/  Albert Hirschman's term in Exit, Voice and Loyalty, Cambridge,
Massachusetts, 1970.
2/  See, for example, Romania: Economic Memorandum, 1984, p. iii;     and
People's Democratic Republic of Yemen: Economic Memorandum, 1982,
pp. 2-3.
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IV (f). About the underlying philosophy
88.      Sections IV (a) to IV (e) discussed five common characteristics of
the classicial command economy. As mentioned earlier, I do not claim that
these and only these features are important; a few more could be added.
To each proposition put forward in the present paper belongs a new set of
questions searching for deeper explanation. I deliberately omitted impor-
tant issues, such as the analysis of the political system and the role of
non-private (state or collective) ownership, which to some extent explain
the phenomena discussed here. I think that a serious analysis of these
issues would lead us far beyond the scope of economics into the realm of
other disciplines such as history, sociology and political science.
89.      Even if we remain within the limited scope of the present paper,
there is an underlying philosophy in the discussion of the common charac-
teristics of socialist economies. I assume that certain cohesion exists
amongst the most important attributes of a specific socio-economic system.
They are, in a historical perspective, not only correlated in the
statistical sense, but there is also a causal interaction among them.
90.      It is widely disputed whether we can find a set of primary
explanatory factors distinguishable from a secondary set, which is more or
less a consequence of the first one. For example, can the objectives and
priorities of the policymakers be derived from the socio-political charac-
teristics of the system, such as ownership, political structure, institu-
tions and so on? Or does the main direction of causality run the other way
round: the conscious efforts to achieve certain objectives lead to the
creation of an appropriate institutional mechanism? I am inclined to base
my research on the first hypothesis, but the problem deserves further
investigation. In any case, there is mutual causation and interaction.
This proposition goes back to the ideas exposed in Section II: all
socialist countries exhibit some important common properties.    In other
words, they belong to the same "species" of social systems. -     This is
what makes any deeper reform so difficult. No single element can be
removed arbitrarily without changing the rest. Or, in a somewhat narrower
formulation, there are many (not all) elements which cannot be altered.
without alterations in many other elements.
91.      And here we have arrived at the topics of the next two sections,
which will discuss some problems of reform. As indicated in the Introduc-
tion, the emphasis will be on the formulation of the questions and not on
the detailed elaboration of the answers. I want to assist the outside
analyst of a socialist economy to recognize the dilemmas he is likely to
face.
1/  The proposition that all socialist countries belong to the same
"species" does not exclude the possibility that many of their attri-
butes to some extent may appear in other "species" as well. For
example, we may find many symptoms of the soft budget constraint
syndrome or of investment hunger in developing mixed economies.
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V. The first reform dilemma: macro adjustment versus institutional change
92.      There have been various serious imbalances in the socialist
economies in recent years (partly in common with many non-socialist coun-
tries and partly more system specific). Internal shortages, chronic excess
demand, repressed or open inflation have appeared in all of them, as well
as unemployment in some of them. There were external imbalances as well:
trade deficit, balance of payments deficit and excessive foreign debt. Not
all socialist countries are tormented by these imbalances to the same
extent, but in some of them the situation has become or is on the way to
becoming rather critical.
93.      What kind of measures should be taken in response to the imbal-
ances? The answer of the reformers is to introduce much more decentraliza-
tion, more reliance on market forces, more competition, liberalization and
deregulation. Some reformers make light-headed promises in the zeal of
obtaining more popular support, raising hopes for fast and painless
results. The majority of reformers is, rightly, more cautious. They
maintain that the reforms will produce some visible improvements in the
near future, but many of the beneficial results will show up only after a
longer lag, when the new mechanism has been consolidated and the behavior
of the economic actors has been adjusted to the new rules of the game.
94.      We can witness a very different response to the imbalances as
well. This is the reaction of the conservative-orthodox advocates of the
Phase 2 socialism, or of some "conditional" reformers who are not against
changes, but want to postpone them after the macro difficulties and imbal-
ances are put in order. Many officials do not even think about the
dilemmas of reform, but act according to a Pavlovian "conditioned reflex":
solve a macro imbalance by centralized activist State intervention. A few
examples are:
(a) drastic cutback of investment by administrative
rule; (This was discussed in more detail in
Section IV (c), and the references to World Bank
papers can be found on p. 21 in the footnote to
paragraph 68.)
(b)  administrative restrictions of imports. This can
be 4one formally by applying tighter quotas and
granting less import licenses. Or it can be done
informally by placing more pressure on the
importer, requesting that he "voluntarily" give
up his import intentions. Also, import substitu-
tion can be relatively easily enforced by central
command;
(c)  commands to producer firms and to the foreign
trade companies to increase exports, even if the
profitability and efficiency of the additional
transactions become much lower; (This topic and
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the import issue have already been discussed in
more detail in Section IV (d).)
(d)  running down the inventories of the producers and
of the commercial sectors. This temporarily
results in import substitutions and/or domestic
production, but increases the probability of
shortages, bottlenecks and the spillover effects
of such disturbances, causing further shortages
and bottlenecks at some other points; and
(e)  the enforcement of austerity programs by drastic
increases of some centrally-fixed consumer prices
and only partially compensated for by nominal
income increases, thus ultimately causing an
acceleration in inflation.
95.      The more energetic the central intervention (and, as a precon-
dition, the tougher and more disciplined the bureaucratic hierarchy), the
faster and more spectacular the results. The fact that there are serious
difficulties and imbalances has an ambiguous effect on the reform process.
On the one hand, it strengthens the position of the reformers in disputes.
They can argue that one cannot go further with the present mechanism and
that far-reaching modifications are needed. If everything were fine, who
would be interested in changing the old rules and old institutions? On the
other hand (and this aspect is tne more decisive one), serious imbalances
create an unfavorable economic environment for reform. Let us go over the
same sequence of issues again:
(a)  Liberalization of market forces would immediately
reveal a great many.structural disproportions.
It is true that the price adjustments can ensure
short-term equilibrium on the market, but later
on the price and profit signals should be
followed by the adjustment of capacities. The
composition of supply which dominated demand on
the chronic seller's market should finally come
closer to the composition of demand. Structural
adjustment, however, requires rather large sums
of investment - and this at a time when invest-
ment has been cut because of macro imbalances.
(b)  A strong competition between imported and
domestically produced goods is very much needed
to wake up the inert producers used to the
relaxed condition of a seller's market. In small
countries, in many sectors or subsectors, no
parallel domestic production of the imported
goods can be afforded because this would lead to
the abandonment of economies of scale. Hence,
imports must serve as the real or the potential
competitor. But, again, it is not easy to demand
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full import liberalization when the country is
suffering from deficits in external balances.
(c)  The effects of more enterprise initiative, less
bureaucratic restrictions and the stimulating
impact of the shift towards a domestic buyer's
market will show with the better quality, more
reliable delivery, more innovation, finer adjust-
ment to demand and, as a final consequence, in
more successful exports - but in some cases only
after some delay. The trouble is that more
exports to markets paying in convertible currency
are needed right now.
(d)  The shift in the allocation of macro output (more
to pay the external deficit, less for domestic
investment and consumption) is inevitably accom-
panied by some inflation. Inflation, however,
weakens the reliability of price signals and
undermines financial discipline in the sensitive
"educational" transition period, when the actors
just start to learn responsiveness to prices.
(e)  Austerity programs are perhaps inevitable.   The
well-trained economist, who has no prejudices
against reform, understands that the cut into the
standard of living today is the fault of the
prereform Phase 2 system, aggravated by the
deterioration of external conditions (and by the
poor response to the deterioration). But the man
on the street will not follow this true but com-
plicated reasoning. Many people think in terms
of synchronized causality: if there is a reform
currently underway and if the standard of living
is falling, the fall, therefore, is caused by the
reform. Populist opponents of reform extensively
use such arguments.
96.      Perhaps there does exist a narrow strait between the Scylla of an
economic crisis caused by macro imbalances and the Charybdis of the defeat
of the reform. Caution, wisdom and good luck. can help find the narrow
strait. In any case, the outside analyst and advisor must consider very
carefully his position before intervening in the process when searching for
a solution. There are no readily available rules of thumb equally applic-
able everywhere and at all times. The same advice, which may be acceptable
and can be implemented in a non-socialist Asian, African or Latin American
developing country, can cause more harm than good in the delicate transi-
tion period from Phases 2 to 3 to 4 in a socialist country.
97.      Reading the World Bank reports, I got the impres ion of a somewhat
ambivalent or, if I may say so, schizophrenic attitude. - As works of
micro economists trained in the tradition of Adam Smith, the papers
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reflected an approval of the reform ideas: more decentralization, deregu-
lation, liberalization and more reliance on market forces. As works of
macro economists and perhaps also of bankers, the same writings approved
the drastic macro measures, which are strongly connected with centraliza-
tion (or perhaps recentralization).
98.      There is a genuine conflict between different ultimate values.   I
do not think that this conflict can be resolved (or evaded) in a perfectly
value-free and ideologically neutral "technocratic" manner. The Introduc-
tion underlined that it is not my job to evaluate the World Bank's actual
policy vis-a-vis socialist economies. As a researcher - and also as a
citizen of a socialist country - I am unambiguously on the side of the
reform process, because only this can bring these economies closer to a
long-term solution. Drastic central interventions may cure acute troubles,
but may only postpone the treatment of chronic problems.
VI. The second reform dilemma:
partial or overall, one-stroke or successive reform
99.      A focal point of disputes is the speed and the scope of reform. In
each country where reform is under discusison, a large variety of views is
expressed, from the very cautious to the middle of the road to the radical.
100.     Digressing slightly, I have a few words about experiments.   I
share the scepticism of those who do not trust laboratory experiments in
this area, e.g., the introduction of a new planning and incentive scheme
for some selected enterprises, while the rest of the firms work under
unchanged conditions.  The result cannot be conclusive.   If it is a
success, it may be because experiemental firms received "green light",
preferential treatment. If it is a failure, perhaps it was because they
were operating in an alien environment. Any suggestion of such laboratory
experiments should be treated with suspicion: they will only serve to
defer genuine changes.
101.     The whole reform process is an experimentation in vivo.   No one
can be sure of the outcome.   Nothing is final as repeated revisions are
required. The latecomers are fortunate enough in that they can make use of
the positive and negative experiences of the pioneers: the Yugoslav and
the Hungarian economies. The cost of experimentation was or is still being
paid by the population of these two countries - the lessons are available
free of charge for the others. That is a much more reliable source of
information than the artificial in vitro experiments.
102.     Turning back to the original issue of speed and scope, I would not
search for a simple summary answer. I suggest the introduction of classi-
fication and the subdivision of the issues into three classes.
1/ See, for example, the papers on Romania and the earlier reports on
China.
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103.     The first problem of the first class is ownership.   In the classi-
cal Phase 2, several forms of ownership exist side by side; in the reform
process, many more appear. The dominant sector in Phase 2 (or at least the
dominant sector in the production of non-agricultural goods and services)
is the sector of State-owned and centrally-controlled firms. An outstand-
ing component of reform is the increasing contribution of other, non State-
owned units to the total output.   I am using a collective term with a
negative definition (non State-owned) as I wish to put a large variety of
forms under this heading:
(a)  activity based on private ownership, which is the
main source of family income. For example,
private craftsmen, merchants, freelance profes-
sionals, private farmers belong to this category.
It may or may not be associated with the employ-
ment of non-family members;
(b)  activity based on private ownership, but only as
a secondary source of family income. The first
source remains employment in a State-owned firm,
governmental agency or any other form of ,on-
private ownership such as forms (c), (d) and (e)
below. Examples of these forms are work on the
private household plot which complements collec-
tive or cooperative agriculture, repair or con-
struction activity aq a second job in in a "do-
it-yourself" fashion for self-consumption, free-
lance professional service as a supplementary
activity, etc.;
(c)  activities based on.different variants of
cooperative ownership;
(d)  activities based in different forms of collective
ownership, excluding the central governmental
ownership. The owner could be a local community,
a non-profit institution (e.g., a university), an
association, etc. This category and the classi-
cal case of centrally-controlled state ownership
are distinguished by the locus of discretionary
power: whether it is the center or some lower-
level organization which appoints or fires the
manager and checks the operation of the economic
unit;
(e)  labor-managed firm, as practised in Yugoslavia.
(The official Yugoslav terminology prefers to
call it "social sector.) It is relatd to forms
(c) and (d), but is not identical with them; and
(f) combinations of non-private and private owner-
ship. There are many feasible arrangements. An
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example is the different tenancy and rental
contracts between units based on non-private
ownership and an individual or a group of indi-
viduals partly using privately owned assets.
Nowadays, the vast majority of Chinese agri-
culture belongs to this category. Such combined
forms also can be applied in manufacturing, in
the retail trade, in service, -_tc.
104.     In most countries, the contribution to forms (a) - (f) to total
output can increase only gradually. The shift may accelerate or decelerate
in different periods, but it must certainly be a consecutive process. This
is a genuine experimentation in vivo taking place in a wide variety of
forms. A historical natural selection is needed: let the viable forms
survive and the unviable ones cease. It is better to apply neither arti-
ficial support, nor artificial suppression, but let the different forms
compete with each other. It will then resolve itself to a point where the
social and political limits of a peaceful coexistence are naturally estab-
lished between public and private ownership.
105.     In the second class, the State-owned sector proper, there is one
change which can be introduced relatively easily, without too many precon-
ditions. Surprisingly, perhaps, this is the simple abolition of mandatory
short-term output targets and input quotas for the firm. There is no need
to be overly cautious - the compulsory indicators can be abolished at one
stroke. To reassure those who are in favor of maintaining a strong central
control, one might point out that the short-term output targets and input
quotas are effective but rather crude, instruments for that purpose. The
center can get rid of them and still keep tight control by relying on
other, usually less crude instruments: fiscal and monetary policy, price
and wage control, redistributive measures and formal and informal regu-
latory interventions.
106.     Drastic abolition can be accomplished even in the case of a firm
that has not yet become a genuinely market-oriented unit, subject to com-
petition and strong profit incentives and for whom the price and wage
structures are still distorted, budget constraints still soft and so on.
This is not to say that, under such circumstances, allocation efficiency
will improve very much. But once the most unnecessary bureaucratic
restrictions are removed, there will be quite significant improvement in
firms' initiative and in their adjustment to demand. Their decisions will
be based more on consensus and not only on rigid discipline. These are
gains without any corresponding real loss. The Yugoslav and Hungarian
cases present ample evidence that, after the abolition of short-term
central instruction, the economy does not collapse; on the contrary, it
will run somewhat more smoothly.
107.     The third group of measures centers around a deeper reform of the
State-owned sector, deeper than the simple termination of short-term
commands. How can an enterprise be transformed into a truly market-oriented
economic unit, but at the same time maintain State ownership? This seems
to be an extremely complex problem. There is ho part of the whole institu-
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tional and organizational framework and no aspect of economic policy
unaffected by such a deep change. It is unreal to hope for a one-stroke
solution.
108.     There is, however, a collection of measures which inevitably must
be linked together as a "minimum package". Here are a few components of
the package.   Sections IV (a) - IV (f) have already provided some arguments
as to why these measures must be linked together:
(a)  autonomy and full responsibility of the firm;
(b)  hard budget constraint:   radical abolition of
subsidies, uniform tax rules with only a very few
exceptions, appropriate legal procedures for
bankruptcy and takeover and strict enforcement of
the law in case of persistent deficit;
(c)  deregulation of prices (perhaps a few exceptions
can be granted temporarily);
(d)  the determination of correct interest rates and
exchange rates;
(e)  import liberalization;   domestic and import
competitive pressure on the producers;
(f)  significant profit retention in the profitable
firm; and
(g)  establishment of appropriate financial institu-
tions for efficient voluntary reallocation of
savings accumulated by profitable firms.
109.     This is not an exhaustive list;   a few more items may be added and
some others already included in the package could be reformulated. My list
serves more as an illustration of the idea of a "minimum package" than as a
concrete proposition. This is all the more so as the compilation of such a
package must depend on the specific momentary situation of the country in
which the ccllection of measures will be applied. In each country, very
careful selection of what should belong to the "minimum package" and what
can be left for later successive steps would be needed.
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