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The Soviet Roots

The roots of the virtual economy lay in the structure and institutions bequeathed to Russia by its Soviet predecessor. Some parts of the economy, notably the resource industries, were value-adding. But most of the vast manufacturing sector that Russia had inherited could not compete in a market setting. In fact, by the final years of the Soviet era, the manufacturing sector was in poor condition even on the terms of the planned economy.

map of Russia
By official Soviet standards, more than one-third of equipment in Russian industry was physically obsolete. Soviet planning practice, which emphasized output over costs, set physical, rather than economic, obsolescence as the criterion for removing a machine from the factory. As long as the machine could produce anything at all, it was kept in production. The result was very low replacement rates for capital equipment.

The location of industry in the Soviet economy was another problem. Not only did Soviet location policy ignore transportation costs but it also failed to take into account the costs associated with the cold Russian climate — in terms of energy use, health maintenance, and many other factors. By being placed in some of Russia’s coldest and most remote regions, the manufacturing enterprises were rendered even less competitive and less attractive for foreign investment.

Equally important as the structure of the Soviet economy and its lack of competitiveness was the fact that this reality was hidden. As the market transition began, past history and performance gave no information about which sectors, or enterprises, were value-adding and which were value-destroying. The culprit was distorted Soviet pricing.


Soviet Pricing and the “Circus Mirror” Effect

Soviet prices were not based on opportunity cost, or value; rather they were simply an accounting instrument to measure plan fulfillment. Although Soviet prices were set arbitrarily, they were not set randomly. They were determined by specific rules of the system, and this produced some systematic biases. First, the planners underpriced raw material inputs, especially energy. They based raw materials prices only on the operating costs of extraction, while ignoring rent. In so doing, they disregarded the opportunity cost of using the resources now rather than in the future.

Quote about GazpromSoviet prices were not based on opportunity cost, or value; rather they were simply an accounting instrument to measure plan fulfillment. Gazprom quote
The planners’ overriding goal was to increase today’s output. Scarcity pricing might have induced more conservation, but it would have militated against maximizing current production. This bias in raw materials prices fed into the system of industrial prices. Heavy consumers of energy were, in effect, subsidized. So, too, were heavy users of capital, thanks to the absence of interest charges. In short, costs of production were calculated on the basis of an incomplete enumeration of costs. This led to lower prices for inputs, especially resource inputs, than for final uses and thus an understatement of the share of gross output used in production and, hence, an overstatement of net output.

In addition to incomplete cost-based pricing, the Soviet system was explicitly biased toward certain users. The Soviet leadership assigned priority in the economy to heavy industry, especially defense industry, and it was important that it appear that these sectors were producing value. This nonscarcity–based pricing was like a distorting mirror at the carnival. It created the illusion that many enterprises were value producing when in fact they were value destroying.


The “Loot Chain”

A further factor contributing to the opaqueness of the Soviet economy and its post-Soviet successor was the way in which income from control of assets was passed down as payoffs through what Gregory Grossman (1998) referred to as the loot chain. In the USSR, wealth diverted from the official state economy into private hands was shared among networks of individuals in the form of payoffs, bribes, and other schemes. Over time an ever greater proportion of people’s incomes depended on the chain of corruption and side payments.

Quote about GazpromBasic ideas of a market economy, such as the relationship between individual effort and reward, became almost impossibly obscure. Gazprom quote
The virtual economy perpetuated the loot chain in post-Soviet Russia. The living standards of a huge number of people depended on the chain of production and distribution of goods and services in the virtual economy system. In the virtual economy, value redistribution, in contrast to looting pure and simple, occurred in a form that paralleled and was intertwined with actual productive economic activity. This made it especially difficult for agents to discern what their own value and the value of their assets would have been in a well-developed and transparent economy. Basic ideas of a market economy, such as the relationship between individual effort and reward, became almost impossibly obscure. One’s static position in the production process — for instance, membership in the work force of a particular enterprise — was more important for success than individual skills and abilities. The Soviet system separated “what you get” from “what you do.” The reality was that the effort-reward nexus was random. Instead of “from each according to his ability, to each according to his needs (or ability),” it was “to each according to some unknowable, random criterion.” The durability of the misperception depended on its opaqueness. There was no alternative, competing information about the real relationship. This meant that the loot chain was also a constraint on the future evolution of the economy. Individuals were dependent on the prevailing system at the same time that they could not know what an alternative system would offer. The uncertainty caused them to resist abandoning the prevailing system.


Impermissibility of True Reform

While there was no accurate information about the economic importance of the large Soviet manufacturing sector, its social and political importance was unavoidable. Many of the least competitive enterprises — the so-called dinosaurs of Soviet industry — were socially the most important. They employed millions of workers and provided for tens of millions of their family members. Entire cities depended on them. The sheer size of this sector — as shown by employment — operated to maintain its social and political importance, and the illusion of its economic performance. In a sense, then, the importance of the manufacturing sector in Russia was an illusion economically but continued to be a political and social reality.

This latter reality constrained serious market reform policies. Russia did not formally reject the policies themselves; instead, it continued with a pretense of market reform. Policymakers launched one measure after another in their attempt to transform Russia into a market economy. But very few of those measures were allowed to play themselves out to their full extent. The consequences of complete and proper implementation would have been politically intolerable. Thus, while the nation’s leadership proclaimed reform policies, enterprises and other agents continued to behave in ways that rendered the policies ineffective.

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