Gorbachev's Blind Alley Jude Wanniski August 19, 1991

A month ago, I sent The New York Times an op-ed article arguing that the "hard liners" in the Soviet Union have been right to resist the economic reforms that have been urged upon Mikhail Gorbachev by the West! On August 2, the Times accepted the piece, in which I wrote that "Each of the planning efforts put forward require a chaotic leap into the unknown...They all require that the old system be demolished before a new system is built...The economy continues to disintegrate as more and more Soviet citizens observe the unofficial erosion of the ruble and simply stop working. Western political leaders are understandably concerned about a further collapse of the Soviet economy as another winter draws near."

The Times informed me last Friday they plan to run the piece sometime before September. The Soviet "hard liners," we now see, were less patient, and Gorbachev is out of a job. In the statement reported by Tass this morning on the coup d'etat, the "State Committee for the State of Emergency" quite correctly observed: "The policy of reforms launched at Mikhail S. Gorbachev's initiative and designed as a means to insure the country's dynamic development and the democratization of social life has entered for several reasons a blind alley."

Financial markets around the world reacted badly, with Germany's stock market naturally taking the biggest hit. The Soviet Union is seen to be a step closer to civil war. Russian President Boris Yeltsin calls for civil disobedience. So far, though, western reporters note the people of Moscow seem strangely composed. My guess is the people see this action by the security forces as being no worse than the path they were on. There's no reasonable alternative to a temporary revival of the command economy while the political leadership figures out what to do next. With winter now only several weeks off, the only mechanism available to the country's leaders is the central planning apparatus and the expertise of the Communist Party, such as it is.

The initial reaction in the West was that the coup represents a resurgence of the Communist dictatorship per se. Not quite. As the text of the emergency committee indicates, the ruling power elite reaffirms its commitment to "genuine democratic processes" as well as support for "private enterprise." My belief is that these are, at the moment, the genuine expressions of the political establishment in Moscow. The West simply has failed in counseling a realistic transition from one system to another. Gorbachev's fatal flaw was in betting all his chips on Harvard and the seductive idea of a "Grand Bargain" of Marshall Plan proportions. The Tass statement was emphatic on this point: "Only irresponsible people can bank on some aid from abroad. No handouts can solve our problems; our rescue is in our own hands." President Bush's embrace of Gorbachev at the London Economic Summit was ultimately meaningless, a photo opportunity at the end of a blind alley. What happens next? There is only one correct solution to the USSR's transition problem, as I have been insisting for two years; it is in the text of my NYT op-ed:

Perestroika's Problem

Mikhail Gorbachev continues to delay the USSR's movement to a market economy, not because of opposition from "hard liners," but because each of the planning efforts put forward require a chaotic leap into the unknown.

The central problem is this: More than 95% of the nation's wealth is held collectively, the land, the housing stock and the state enterprises. Less than 5% is held by individuals in the form of claims against the state — ruble deposits in state depositories. The debate in Moscow is not whether to transfer most of the collective wealth to private hands. That debate is over. It is how to manage the transfer, the privatization.

Everyone understands the transfer can't occur without creation of a banking system, the means by which commerce is arranged in a market economy. Neither banks nor other financial services, such as stock markets and insurance companies, exist in the Soviet Union. They've not been needed when a central apparatus has dictated the flow of resources within a framework of wage and price controls.

A banking system, though, cannot develop, either at a private curbstone level or through the network of state depositories spread across the USSR, without a convertible ruble. A marketplace cannot come into existence without a unit of account, a currency of known and predictable value in which contracts can be made and accounts kept.

Each of the reform plans put forth so far, including those recommended by Western economists, have a convertible ruble as an eventual target. But they all require that the old system be demolished before a new system is built. The inference is that somehow a headlong plunge into a "free market" will sort things out and the ruble will float to an unknown value that will then make it convertible.

Indeed, most Western economists seem to assume that if the Soviet government merely absents itself from economic life, a marketplace will arise as if by magic, by an "invisible hand." That is a gross error: what separates western capitalism from the law of the jungle is the visible hand of government in the marketplace. Government can either dictate prices, or it must provide a yardstick, a unit of account, by which individuals may set prices among themselves.

As it is, the ruble has specific meaning only within the old system, where its theoretical purchasing value is close to that of an American dollar. Outside the old system, the ruble has no value whatsoever as a unit of account and most recently traded in an Estonian auction at 77 rubles to one U.S. dollar. What value will the ruble have after a leap into the unknown?

In a country where most wealth is held by individuals, in the form of real property and financial assets tied to real property, inflation simply bails out debtors at the expense of creditors. Even in Eastern Europe there remains considerable wealth held by individuals in the form of real property. In the Soviet Union, individuals hold almost no real property or capital assets.

If the Soviet government were now to take the plunge, lifting wage and price controls and floating the ruble, almost the entire stock of capital held by Soviet citizens — their ruble deposits -- would vanish in the ensuing inflation. The state would hold close to 100% of the wealth, its debt to its people wiped out. How will the citizenry even make the down payments to acquire state assets in the privatization process?

More critically, what happens to the economic mechanisms necessary to the daily survival of the population in the time it takes between the demolition of the old command apparatus and the creation of a banking system around this worthless ruble? These are the questions the western critics of Gorbachev's delays have failed to answer.

Yet the economy continues to disintegrate as more and more Soviet citizens observe the unofficial erosion of the ruble and simply stop working. Western political leaders are understandably concerned about a further collapse of the Soviet economy as another winter draws near. President Gorbachev has now promised a convertible ruble by January and is racing to line up western support for a reserve fund of perhaps $8 billion in hard currencies, to support the ruble against speculators when convertibility is announced.

Critical details are still missing, though, most particularly the exchange rate at which the ruble will be made convertible. The answer lies in making the ruble worth more, not less, which the government can do by reaffirming the value of the ruble deposits held by Soviet citizens. This is a prerequisite to all other reforms. By shouldering this burden of debt itself, even guaranteeing it in gold instead of repudiating it, the state establishes the credibility of the ruble as a unit of account.

The effect on the Soviet economy would be immediate and dramatic. As soon as the Soviet state regains the confidence of the people in its currency, the economic mechanisms will work well enough to see the country through the privatization process to a market system, not to mention the coming winter.