On the eve of the Fiftieth Anniversary of the Communist Revolution, the Russians have embarked on yet another economic revolution. With hardly a word about ideological purity, Premier Alexei Kosygin has announced that by 1968 profits, sales and rate of return on investment will replace fulfillment of quotas as the main standards of success for every Soviet firm. Moreover, Soviet managers will have to pay interest or capital charges for the capital they use. Profits will be divided up in a form of profit-sharing, and some enterprises will even have to pay rent. The economic reforms are matched in their significance, according to one Russian economist, A. Birman, only by the transition to N.E.P. in 1921 and the launching of the Five Year Plans in 1929-32. Clearly what the Soviets are currently attempting amounts to a repudiation of formerly sacred doctrines.

Why have the Russians picked this juncture to make such basic structural changes? It is not an impetuous action. The call for reform originated with Professor Evsei Liberman in September 1962.[i] This was followed by more than three to four years of active debate and about two years of actual experimentation. During this period the majority of Russian economists came to acknowledge that there was a need for a drastic overhaul. They were obviously shocked when they saw their rate of economic growth fall badly during their Seven Year Plan from 1959 to '65. Most observers came to realize that a long-run upturn in the growth rate would depend on the resolution of some basic underlying problems. What was needed was improvement of day-to-day operating procedures as well as reform of the process by which longer-run changes were made. All of this would require a more productive use of the country's capital and the stimulation of innovation.

By the early 1960s, the Soviet economy had become a very complicated mechanism and was in serious danger of self-strangulation. The central planners were finding it harder and harder to make efficient decisions without help from factory managers. There were simply too many eventualities for Moscow to be able to plan for them. Yet the central planners continued to insist on detailed control over day-to-day operations. The factory managers were given little authority to deviate from quantitative plans, frequently drawn up a year or more in advance. Moreover, plant managers were often led to produce completely inappropriate items by a misdirected incentive system. The system contained no mechanism for responding to error. Often there was more concern about the bureaucrats than about the factory's customers. It was true that these methods had brought growth in the past, but increasingly output was unrelated to needs.

Growth and change had been obtained in the past largely by pressure and prodding. Because managers and planners were almost always submerged in their daily operating problems and had very short-term goals, the government had to launch campaign after campaign to shake the economy out of its deeply furrowed ruts. This was the only way to move industry to Siberia or force the growth of the chemical industry or the use of natural gas. While such campaigns often accomplished their stated purpose, Soviet observers began to point out that they also involved considerable waste. Invariably all other activities would be halted in order to devote exclusive efforts to the campaign goal. Occasionally a second campaign would then be necessary to right the balance.

The Russians also discovered that their capital productivity had fallen badly. Capital was less productive because of the inefficient operating methods just described. The problem was intensified because capital was treated as a free good. There was no interest or repayment. Consequently, factory managers would try whenever possible to hoard capital, especially raw materials, for their productive needs. In this way they could insulate themselves from the transportation tie-ups and supply bottlenecks that were a hallmark of centralized planning. But in addition to input accumulations, many factories and stores have begun recently to find themselves with stocks of their output which have accumulated unexpectedly because of unsuitability or poor quality.

Partially as an effect and partially as a cause of all these factors, little innovation arose from within the factory itself. When the priorities were high enough, as on military and space projects, there could be impressive innovation. But lesser projects produced none of the instant innovation which seemed to characterize Western industry. When innovation came it was often too costly and too late. For instance, Russian officials now admit that during the five years required to work out the production problems of the Ural 4 computer and the Zaporozhets automobile, both had been made obsolete by production advances in the West.[ii]

What the Russians needed was some system that would provide them with self- generated flexibility and growth. Only with such a reform could they hope to improve their rate of economic growth, compete more effectively in foreign markets, improve the supply of consumer goods and ameliorate their inventory problem. It would not suffice just to know when to introduce new products; there also had to be some way of knowing when to drop old ones.

For a time many economists thought that the computer would solve all these problems. It was expected that advances in planning and computing technology would eventually make it possible to determine centrally all production, price investment and consumption decisions. The various unknowns would be thrown in and the necessary answers would come parading out in neat formation. Soon, however, even some of the computer specialists came to realize the impracticality of relying on the computer alone.[iii] There were simply too many unknowns for everything to be determined centrally.

Looking around, the Russians saw that in the Western countries, and even in a country like Jugoslavia, the market economy handled day-to-day transactions with a maximum of efficiency and a minimum of regulation. The Russians also saw that the problems of learning and responding were solved when the market economy was combined with something like the American system of competitive enterprise. Whatever shortcomings it may have, business enterprise in the United States responds to "feedback." In such a system, failure to so respond can lead to financial loss for some identifiable group or person. Consequently, managers have a great incentive to respond. The Russians realized that if their problems were to be solved, they would need similar responsive effort and flexibility in their economy.

II

What is so radical about the Reform? First of all, the old system of planning and incentives has been scrapped. No longer will factories be assigned quantitative output targets. The first experiments were conducted in May 1964. Bolshevichka, a Moscow factory making men's clothes, and Maiak, a Gorki manufacturer of women's dresses, became the first enterprises to be evaluated on something other than quantity of production. To stimulate production of items better suited to the customer's needs, the payment of premiums was made dependent on the fulfillment of delivery and profit plans. In January 1965, some heavy-industrial firms in the Ukraine were also permitted to experiment. The scheme grew rapidly and by the end of the year over 400 consumer-goods manufacturers and 3,000 retail stores had been converted to the new system.

In September 1965, Premier Kosygin himself announced that the reorganization would gradually be extended to the whole economy. He ordered the adoption of a slightly revised set of gauges which in addition to profits included rate of return on capital, interest, capital charges and rent. Market research and advertising were also to be more used. To say the least, such economic forms are highly unorthodox by Soviet standards. None the less, as of January 1966, Soviet managers in 43 major factories were to be judged on the fulfillment of sales or profits targets and the rate of return on capital (profits as a percent of capital). These factory managers will have to deduct interest at a rate of .5 to 2 percent on any bank loans they may have. No longer will sums of capital be allocated to them as a gift from the budget for capital already borrowed. These capital charges are to average 6 percent of the enterprise's fixed and working capital. The interest charge and capital charge are to be supplemented by a rent charge, to vary so that firms and mines more favorably located than others will not earn undue profits. All of these charges must be deducted from profits before premiums can be paid or the rate of return calculated. By January 1967, almost one-third of all the country's industrial workers will have been switched to the new incentive system, with the rest of the factories scheduled to be converted by 1968.

Wherever possible, economic standards and charges will be set several years in advance. In this way it is expected that the managers will seek to do their best without fear that their targets will be jacked up the moment they show signs of improved operation. This should free them for more experimentation. Logically they should be more willing to risk the introduction of new processes and products if they know they will not be criticized for making lower profits during periods of innovation and will not have their increased profits taken away from them as soon as they work out the kinks.

Enterprises whose products are already in abundant supply or whose inputs are in short supply will be judged by how well they fulfill their profit plan. It is hoped that this will cause them to produce as efficiently as possible. Firms whose output is in short supply will have to fulfill sales targets. This will insure that such goods will continue to be produced. A sale will not be counted, however, until payment for delivery has been deposited in the bank to the seller's account. Better quality may be stimulated in this way because the buyer will not release his funds until he is satisfied that he has received what he asked for.

In a further effort to increase flexibility, Soviet authorities are introducing new supply procedures. Wherever possible, enterprises are authorized to work out their own purchase and sale agreements without the interference of ministerial authorities. This will ultimately mean the increased use of salesmen, trade fairs, marketing research and advertising. If stocks of merchandise are made readily available in local warehouses, managers should have less reason to hoard supplies in their own private warehouses. Ultimately, it is thought, this could lead to the end of centralized allocations for all but the highest priority goods.

The rate of return is to be used in conjunction with either profits or sales as the second criterion of success. Rate of return is now defined as profit in relation to capital, as Liberman had suggested. Previously when rate of return (rentabelnost) was discussed, it referred to profit as a percent of cost.

With the new criteria the manager has a strong incentive to cut back on his capital stock. Anything the manager does to reduce the denominator in the profit-to-capital ratio will presumably lead to a more efficient use of capital and a reduction of inventories. But by reducing his capital, the rate of return is further improved because interest and capital deductions will be lower, and therefore profit (the numerator) will be higher. If this curbs the squandering of capital, then capital productivity will be increased and an important goal of the reform will have been achieved.

The net profit that remains after the deduction of interest, capital charge and rent determines not only the rate of return but also the amount that is available for the discretionary use of the factory manager. The manager is entitled to put a specified portion of net profit into three funds-the Incentive Fund, the Cultural and Housing Fund and the Development Fund, all three of them designed to promote the firm's productivity.

Since the size of these funds depends on the enterprise's profitability, they are expected to stimulate the workers' interest in holding down costs more than in the past when extra pay and bonuses ("premiums") depended on the quantities produced. In the new system, fulfillment of targets remains an important factor in calculating the amounts that can be put into the fund, but over-fulfillment is rewarded at a lower rate. This is the reverse of former procedures. According to Liberman, this will stimulate plant directors to seek higher targets in the beginning and not hold back on their efforts.

Managers, engineers and the like will get all their bonuses from the incentive fund, but for the blue-collar workers there will also be some payments from the old wage fund, so that the worker is not penalized if his performance is good but the enterprise fails to be profitable for reasons beyond his control. The size of the bonuses varies from industry to industry and differs according to the situation of the enterprise, but there is a formula that puts a limit on the amount of profits that can be spent this way, in order to be sure that wages do not increase faster than productivity.

The Development Fund is a particularly important one, designed to encourage innovation and investment by the firm itself. The share of profits that can be put into this fund is related to the size of the capital of the enterprise; yearly amortization charges are added to it and also proceeds from the sale of old or surplus capital equipment. Ultimately as much as one-fifth of all the capital investments made in the Soviet Union may come out of the Development Funds of individual enterprises. Liberman sees a connection between this kind of decentralization of investment and the direct incentive payments to workers and managers, because the Development Fund, by increasing the importance of self-financing for each enterprise, gives managers much more control than they had in the past. Moreover, the use of bonuses from the other funds and cultural and housing benefits are also to a considerable extent under their control.

III

No one among Soviet officials pretends that implementation of the Reform will be easy. As Kosygin recently remarked to the Supreme Soviet, there are two immediate problems: poor pricing and bureaucratic resistance. Existing Soviet prices do not adequately reflect the true value of the product. Wholesale prices have not been thoroughly revised since 1955. Supply-and- demand relationships among different commodities have changed markedly since then. By producing those items which have unduly high prices, factory managers will be able to make unintended profits on an undesired assortment of goods. This could easily provoke the reintroduction of detailed controls.

Kosygin also mentioned that there has been resistance to the Reform by those who fear it will undermine their own positions. "A certain conservatism and lack of initiative," he asserted, "are sometimes displayed in trying to solve a number of matters connected with the operation of the economic reforms." There has been foot-dragging by the ministries of the industries affected. Kosygin declared: "The ministries should not demand an excessive amount of reference notes and information of various kinds from the enterprises." To the extent that ministerial intervention limits a firm's ability to deal through direct contracts, it eliminates the possibility of feedback.

Of course it is not just the bureaucrats who oppose the change. Like their counterparts all over the world, many Soviet managers fear the effects of competition and are reluctant to abandon the relatively tranquil climate of fixed markets and stable production quotas in which they have operated. Finally, like the workers in the movie "The Man in the White Suit," there are many Soviet workers who recognize that increased efficiency will mean layoffs and unemployment.

With such opposition there is a possibility that some or all of the Reform may be suspended. After all, Soviet economic history is filled with the scraps of brilliantly conceived experiments. A real danger exists that the slow pace of the Reform could create such chaos that the entire program might be discredited. Possibly the Reform should have been introduced throughout the economy simultaneously to prevent the distortions that result from piecemeal change. Yet this too could cause trouble.

Some East European cynics liken the Russian dilemma to the problem supposedly faced by Czech traffic authorities. In order to ease Prague's traffic jams, they recommended that all of Prague's traffic be shifted to the left side of the road, as in England. After some reflection the city fathers decided that this would be too much of a change to make at one time. Instead, they ordered that only the taxis and trucks should move on the left. During the transitional period the automobiles-like the bulk of Soviet industry-would continue to move as they had originally.

Some Soviet officials feel that the new interest rate and capital charge will hold back the introduction of new capital. This indicates a misunderstanding of the function of capital charges. A charge for capital should not frustrate investment if the proposed equipment is productive enough to make possible repayment of the capital charge. If it is not productive enough, then the investment should not be made in the first place. It was just because of the absence of such a restraint that capital has been consumed so wastefully in the past. However, just in case the managers do hold back too much on investment, senior officials have the power to exempt new capital from the capital charge until the new equipment is operating at full capacity.

To the surprise of some, the Reform is also creating problems where it was thought none existed. The introduction of economic guides like interest and rent has created a schizophrenic split between Russia's domestic and foreign-trade interests. With their new economic methods, the Russians have begun to reëvaluate their production possibilities. They have discovered that they have not engaged in the most productive kind of foreign trade. Now that they are beginning to recognize the impact of rent and interest, they find that they have seriously underestimated the substantial costs of the capital and land resources involved in expanding the production of their raw materials. As a result they have complained publicly and repeatedly that they have been subsidizing their East European allies with such items as oil, iron ore and coal. Naturally this comes as a shock to the East Europeans who have long complained about Soviet overpricing of raw materials.[iv]

As part of their drive for more effective foreign trade, the Russians may move to free plant managers from some of the controls of the Ministry of Foreign Trade. Such changes have already been made in Hungary and Poland where some firms are authorized to deal directly with their foreign counterparts. Now they respond not to command, but to the world market. To the extent that Russian firms become more competitive in the world market, they should also become more efficient as domestic producers.

The new wind of reform also appears to have affected Soviet foreign aid. Now that capital and interest rates are coming into their own, the Russians have adopted a more commercial attitude in their economic relations with the less developed countries. There is more emphasis on economic feasibility and on how much Russia will receive in return for its aid. Some economists have called for an increased emphasis on loans which will lead to greater Soviet and East European exploitation of the raw materials of the developing countries. (Of course the word exploitation is not used in Soviet self-analysis; that appears only when Western countries are involved.) As part of this trend, the Russians apparently intend to charge more for their loans. In August 1966, they provided Brazil with a loan at 4 percent interest, much more than the traditional Russian rate of 2.5 percent.

IV

Two big questions remain: Will the Reform increase overall administrative efficiency, and will it stimulate the productive innovations so much desired? Undoubtedly there will be improvements on both counts, but will they be enough?

Liberman and the other proponents of the Reform are convinced that decentralization is a necessary step in the right direction. If anything, they feel the Reform will make central planning more effective. They dispute those who worry that the use of direct contracts, wholesalers, market research, advertising and profits will mean the end of central planning or the excessive diversion of natural resources from heavy to light industry. On the contrary, the reformers insist that freeing the planners from having to deal with so many small details will make it possible for the planning organizations to concentrate their efforts on issues of more importance. No longer will the authorities in Moscow have to worry about such things as whether or not a factory in Novgorod is sending the right size screws to the right factory in Minsk on time. Instead the planners can devote their attention to long-term goals and major investment needs. Where necessary, heavy industry can be protected by use of price adjustments and government subsidies.

By dividing up responsibilities in this way, the planners also hope to make more effective use of computing equipment. Once the central planners are freed of the minutiae of individual plant problems, they should be free to use their computers to project alternative solutions to long-range problems. The reformers also hope that the individual firm will be able to use its own computers to improve its operational efficiency through the use of operations research techniques. However, the Russians will have to face the uncertainty of whether the Reform will be basic enough to make it possible for the risk-taking manager to coexist with the computer. In the United States, the computer and the methods which it makes possible such as input-output and linear programming are like any other business tools. Their main function is to provide additional information for the ultimate decision-maker. But in private competitive enterprise, the manager generally decides to accept or reject the findings of such devices in light of his own independent judgment.

Because all industry in the U.S.S.R. is state-owned, the computer is often viewed in a different light there. State managers must always stand ready to make a public accounting of their actions. Therefore they in turn want someone or something to provide them with authority to act. If there is written authorization to do something, then the person is free to act because he knows that he will be able to point the finger at someone or something else. In such an environment, the use of the computer is considered particularly desirable since it can provide justification or authorization for managerial action.

But there is the danger that the solutions offered by the computer will be viewed not as possibilities but as binding solutions. Just because the answer is from the impersonal computer and just because it is in writing, the manager opens himself up to criticism if he takes another course of action. It will be interesting to see if the Reform will make Soviet managers independent enough so they will feel free to use the computer instead of being used by it. If not, it will be found that one form of inflexibility has been substituted for another.

Successful use of the computer is dependent upon the solution of yet another problem. If the computer is to be of value, the information it has processed must be rapidly transmitted to the responsible decision-maker. At present this cannot be done because almost all communications in the U.S.S.R. are written. Since it cannot be used as proof of authorization, a telephone call is seldom if ever used to issue orders or to convey information. This explains the mountains of written work involved in even the simplest transactions. If there is to be efficiency and flexibility, the Russians will have to develop a speedier and more reliable communications system and they will have to free themselves from their over- dependence on the authoritative written word.

Administrative efficiency, in the final analysis, is dependent on more than the availability of hardware; there must also be well-trained managers. Heretofore the Soviets have used production engineers who have been trained to produce in large quantities and to secure unavailable components. Will it be possible to revise the whole concept of managerial administration so that two generations of quantity-oriented production specialists can be converted into quality-conscious innovators? As the Minister of Education has acknowledged, such a change can hardly take place overnight. In recognition of the urgent need to develop a new breed of manager, open admiration is now expressed for such managerial hatcheries as the Harvard Business School.[v] In fact, a Russian exchange student is now enrolled in Cambridge learning the technique of teaching American business administration.

Assuming that managerial practices can be improved, will this also stimulate the flow of innovation? Theoretically, the Russian manager should be able to operate as efficiently and be as inventive as his counterpart in the large American corporation. The Reform, with its emphasis on sales, profit and rate of return, is much the same incentive system that is used by such large American corporations as DuPont and General Electric. Similarly, these American corporations permit decentralized investment within certain limits, just as will now be the case in the U.S.S.R. Consequently, like their American counterparts, the new Soviet enterprises should now be able to promote numerous important innovations and move the inventions from their laboratories to the production floor.

Innovation in the United States, however, does not originate solely in the larger corporations. In fact, there are many who argue that much of the American leadership in innovation comes not from the larger corporation, but from the small private enterprise. Despite the growth of large corporate research laboratories, a large proportion of the basic discoveries in the United States continue to come from small firms, which sometimes succeed so well that they turn into large corporations themselves- like Polaroid, Itek or Xerox. It is hard to see how the Russians even with the Reform will be able to avail themselves of this particular kind of innovation.

The phenomenon of the small and creative entrepreneur is possible only where there is private ownership of capital. The man with the idea must be able to solicit financial support for his project from a wide variety of financial sources. It is not enough to have inventors with ideas that are advanced for their day; there must also be a wide variety of financiers around to support them. The more sources of capital there are, the more likely it is that an investor will be found who can appreciate the worth of a particular investment. When the state controls all the society's capital, the sources of capital are sharply reduced. Normally there will be no more than one decision-maker and no court of appeal. If the state's capital controller happens to lack the vision to appreciate a particular invention, no matter how brilliant the discovery may be, it will not move past the idea stage. Innovation also requires a willingness to take a risk and lose. The stewardship of the state's funds, however, generates extreme conservatism, hardly a desirable environment for promoting innovation.

In partial recognition of the handicap associated with state control of capital, the Reform does permit some decentralized investment by the enterprise in the hope that inventors will be able to seek out alternative capital support. Yet even if the single government veto over capital is abolished, there may be a need for something more. To be successful, the Reform must touch off a competitive spark among the country's managers. Whatever its limitations, the phenomenon of competition in the West plays a basic role in stimulating the search for new and better processes and products. While the Soviets are trying to emulate this spirit, it is questionable whether they will be successful in generating it at the enterprise level. There have been some very dynamic nationalized enterprises like Volkswagen. But such firms have made their mark in competitive coexistence with private enterprises. So far it has been very difficult to ignite that inventive spark when all the enterprises in a country are owned by the state.

Radical as the Reform is, it does not herald the advent of capitalism. As the Chinese have been quick to note, however, the use of such tools of the marketplace as profit, interest and rent certainly is not a reaffirmation of Marxism. What is in progress seems to be a determined effort to improve the effectiveness of a form of state capitalism. The dynamic operation of a massive and complex industrial system dictates the use of certain universal techniques. The Russians do not have too much choice; it is like trying to go up the down escalator. As their economy becomes more complicated, it becomes harder and harder to move forward at a rapid rate. Without the Reform, their economy may well be carried backward. With the Reform, they hope it will be able to move forward-at the very least, hold its own.

[i] Many Westerners have come to refer to all that has followed as Libermanism. The Russians themselves make no such personal identification. As will become apparent, however, the Reform being introduced is a close copy of Liberman's original proposal. For a discussion of the earlier debates see Leon Smolinski, "What Next in Soviet Planning?" Foreign Affairs, July 1964, and Marshall I. Goldman, "Economic Controversy in the Soviet Union," Foreign Affairs, April 1963. Reportedly, Liberman's earlier articles also sparked the first attempts at reform in Czechoslovakia.

[ii] E. Rakovskii, "Tekhnicheskii Progress i Faktor Vremeni," Planovoe Khoziaistvo, July 1966, p. 16.

[iii] Izvestiia, December 4, 1964, p. 5; Komsomolskaia Pravda, April 24, 1966.

[iv] For example, see I. Dudinskii, "Toplivno-Syrevaia Problema Stran SEV i Puti ee Resheniia," Voprosy Ekonomiki, April 1966, p. 85; L. Zevin, "Vzaimnaia Vygoda Ekonomicheskogo Sotrudnichestva Sotsialisticheskikh i Razvivaiushchikhsia Stran," Voprosy Ekonomiki, February 1965, p. 73.

[v] Ekonomicheskaia Gazeta, No. 43, October 26, 1963, p. 7; No. 12, March 1966, p. 7.

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