European Formative 2012/13 Jack Mauduit

Central planning failed because it was based on severe

aggregate supply constraints and soft budgets. Explain and
discuss.

Between the 1920s and the 1980s, many Eastern European and Northern Asian
economies were centrally planned. This meant that their economies were under
complete government control allowing for no free market and with targets and
policies set by a central authority. Prices were even set by government; there was no
invisible hand of Capitalism to find natural price equilibrium. In theory, a centrally
planned system has several merits; inefficiencies could be eliminated due to
coordination between industries, resources can be directed into investment leading
to rapid growth, the lowering of unemployment can be made possible, and business
cycles that had plagued the Western world in the 1920s to 1930s could be avoided.
However, in practice, this system had major issues, which eventually led to the
collapse of the former communist bloc countries. The waste and economic
inefficiency of the command system, along with problems that resulted from severe
aggregate supply constraints and soft budgets, which were supposed to embody
them, proved, in the end, terminal.

There were several factors that contributed toward the severe aggregate supply
constraints in the planned economies. To begin with, targets in the planning system,
as opposed to profits, resulted in a lack of incentive to respond to shortages in the
economy. Without profit, there is no pareto optimality as there is in a market
economy and therefore there is no incentive to render issues of shortages.
Furthermore, this lack of incentive led to a lack of innovation in planned systems.
The system offers no reward for quality and therefore products are made with the
lowest costs and are no further developed. Policy for import substitution also meant
that no new technology or innovative thinking was being gained from abroad. Prior
to the creation of the planned system, Schumpeter predicted Soviet planners would
lack entrepreneurship while Kornai found that out of fifty revolutionary innovations,
just four had come from Socialist backgrounds.
European Formative 2012/13 Jack Mauduit

Centrally planned systems displayed high levels of static inefficiency. The lack of a
price mechanism meant there was no good signaling device causing inefficient
resource allocation. The bureaucracy involved failed to lend hand to creating a
flexible economy. The planners used aggregated measures when setting targets that
failed to pay attention to detail. For example, the so called Big Nail problem
explains that if an industry is told to produce as many nails as possible, they would
produce lots of tiny nails, but if it is told to produce as greater weight of nails as
possible, it would produce several huge, useless, nails. This meant that producers
only cared about quantity and not quality. Bureaucrats also made market entry very
rigid leading to a lack of competition in markets. The Mises and Hayek Austrian
critique of socialism between 1920 and 1945 draws attention to the consequences
of eradicating the price mechanism. Where there is no market, there is no pricing
mechanism, without a pricing mechanism, there is no economic calculation
Socialism is the abolition of a rational economy. (Mises, 1920). Hayek follows Mises
statement by emphasizing that planners can never have the necessary knowledge to
plan an economy efficiently (1920).



This diagram shows a production possibility frontier with indifference curve SWF
representing the optimal position for society to be operating on the frontier. Society
European Formative 2012/13 Jack Mauduit
wants to be at point B, however, as Hayek mentioned in his critique, planners lack
knowledge from price mechanism signaling that is available in capitalist economies.
Although planned economies are capable of operating at full capacity, on the
frontier curve, there is no way however that central authority are able to know what
society needs and therefore are more likely to operate at A which is allocatively
inefficient.

These bureaucratic problems led to coordination problems throughout the system
leading to allocation errors. The lack of price mechanism led to shortages and
bottlenecks as it was too complex for planners to simulate, as predicted by Hayek at
the start of planning. Problems upstream also meant problems downstream were
inevitable due to inefficiencies in the organisation of the system.

Alongside aggregate supply constraints, soft budgets are also marked as a
fundamental flaw of centrally planned systems. Due to the defensive posture of
planned systems and insistence for self-sufficiency or autarky, the structure of the
economy was very dependant on certain high-priority sectors. These sectors were
offered soft budgets which effectively suggests that if they fail to meet targets, the
government would simply bail them out. This created a moral hazard. There were no
incentives for firms to be efficient or cut costs and workers lost productivity. Figures
of coal consumption per $1000 GDP emphasize the severity of the effect of these
soft budgets; for example, Poland used 1515 kg of Coal per $1,000 GDP whereas
France used just 502kg. Governments accumulated deficits, printed money and
borrowed against the future to finance their high-priority sectors that essentially
bankrupted the Soviet system.

Soft budget constraints in the economy led to both shortages and repressed
inflation. Soft budgets meant that companies bid for as much input as they can
regardless of need simply because the government is paying for it and they can sell
whatever they produce with no risk. Demand for inputs became insatiable as it did
for investment also. The unconstrained nature of the socialist market, compared to
that of a capitalist one, created the incentive to hoard, leading to shortages. Inflation
European Formative 2012/13 Jack Mauduit
was high as a result of the excess demand, however, it would have no effect on
shortages due to the still enforced soft budget constraints. This enterprise sphere
showed how prices and money had no influence on limiting demand, only vertical
and horizontal shortages caused by allocation to suppliers effectively curtailed
demand.

Another issue caused by the runaway spending was a huge monetary overhang. The
soft budget constraints combined with hard budget constraints consumers faced led
to repeated shortages causing repressed inflation as the central planners refuse to
increase prices meaning that consumers are forced into saving as there is nothing
else to spend their money on. This creates a monetary overhang and is referred to as
a consequence of the consumer sphere highlighting that repressed inflation is
inevitable as a result of the economic policy enforced in socialist systems.

Leibenstein in 1966 introduced the concept of X-inefficiency to the socialist world.
The lack of competition in markets caused by rigidities domestically and
internationally meant there was a lack of pressure on management and workers
leading to lower productivity. For example, while the socialist East Germany
produced 2699 tons of brown coal per worker, the capitalist West Germany
produced 5905 tons, stressing the wasteful nature of centrally planned systems.
Economist Holzman in 1976 labeled this hidden unemployment they pretend to
pay us and we pretend to work. X-inefficiency is shown on the production possibility
frontier diagram shown previously by point C. This is inside the frontier showing that
the economy is not only allocatively inefficient, it is also failing to operate at full
capacity as a result of a lack of competition and low productivity.

Despite the many failures highlighted regarding aggregate supply constraints and
soft budgets, the socialist system did have some successes. Soviet nations displayed
rapid, if distorted and inefficient, industrialisation as a product of directing resources
into these high-priority areas. It is also argued that the centrally planned structure
was fundamental in finding victory for socialist nations in World War II. Centrally
planned systems also introduced the concept of mass education that has
European Formative 2012/13 Jack Mauduit
revolutionized countries around the world. Furthermore, although technological
progress was a weak feature of these economies due to lack of competition,
incentive and import substitution, some areas excelled in technological progress as a
result of targeted investment. At the time, the race to space was a very important
political milestone for the USSR and hence investment was pumped into the space
programme. In 1957, Sputnik saw Russia send the first Earth satellite into space and
in 1961 sent the first man into space, both huge technological achievements.

These successes are however insignificant I when looking at the big picture.
Shortages are an inevitable consequence of a system with a lack of incentive and a
corrupt and inefficient government. The soft budget constraints of enterprises
aggravate the shortages and lead to inflation in the economy albeit repressed. Soviet
policy is to blame for the repressed inflation rather than being endemic to the
system. These two major failures of the centrally planned system contributed largely
to the downfall of the Soviet Union in the late 1980s.

By the mid 1980s, the USSR economy was in crisis and politicians were becoming
restive as a result of unprecedented stagnation. The paramount reason for such
decline is the inefficiency of central planning as an allocative mechanism for
advanced societies. As a system, planning has an inherent bias towards producing
quantity rather than quality. Quality is not easy to measure or enforce. Economist
Lavigne in 1999 summarized by saying that the socialist model was very wasteful in
human and material resources, failed to achieve modernization and left all the
countries lagging behind the developed market economies.