Transition Economies:
Russia and China
40
40W-1
Two of the most profound economic events of the 1980s and 1990s were the collapse of communism in the Soviet
Union and the rapid emergence of the market system in China. Russia (which emerged from the breakup of the Soviet
Union) and China are perhaps the world’s most significant developing economies:Together they constitute 20 percent of
the world’s surface area and 23 percent of the world’s population. (Global Perspective 40W.1 compares salient facts about
China, Russia, and the United States.)
In this bonus web chapter, we examine the transition of Russia and China to market economies. But first we need to
understand the ideology, institutions, methods, and difficulties of central planning.
Ideology and Institutions
To understand the command economies of the Soviet
Union (prior to its collapse) and China (prior to its market
reforms), we must look back at the Marxian ideology
that gave rise to central planning. Russia and China each
has a unique history, but both nations established command
economies following communist revolutions based
on the ideas of Karl Marx. Those revolutions established
the Communist Party as the dominant force in the political
and economic life of both nations. The Russian
Revolution of 1917 produced a communist dictatorship
under Vladimir Lenin and, later, Joseph Stalin and others.
The Chinese Revolution of 1947 led to a communist
dictatorship under Mao Zedong. At the heart of the communist
ideology was belief in state (or communal) ownership
of capital and land.
The Communist Party in the Soviet Union and China
viewed itself as the representative of the proletariat (the
working class) and the peasantry. On the basis of MarxistLeninist
and Marxist-Maoist doctrines, the communists
envisioned their system as the inevitable successor to capitalism,
a system they believed was plagued by internal
contradictions resulting from the private ownership of
capital and land. To communists, the market system was
chaotic, unstable, and inequitable. Markets bred inflation,
unemployment, discrimination, and an unfair distribution
of income. In contrast, the communists viewed central
planning as a way to organize the economy’s resources rationally,
to meet basic human needs, to achieve macroeconomic
stability, to provide greater equality, and to end
exploitation of labor by capitalists.
Marxists believe in a labor theory of value, the idea
that the value of any good is determined solely by the
BONUSWEBCHAPTER
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G L O B A L P E R S P E C T I V E 40W.1
Selected Statistics: China, Russia, and the
United States
Comparisons of national data reveal large differences among China,
Russia, and the United States. (Latest comparable data.)
Source: World Bank, www.worldbank.org/; International Monetary Fund,
www.imf.org/; CIA World Fact Book, www.cia.gov/.
Square miles
(thousands)
Population
(millions)
Output per
capita
Share of labor
force in
agriculture (%)
Male life
expectancy
(years)
China
9561
1271.9
$890
74
69
Russia
17,075
144.8
$1750
14
59
United
States
9364
284.0
$34,870
3
74
40W-2 B O N U S W E B C H A P T E R 40WEB | Transition Economies: Russia and China
amount of labor required for its production. Because of
the capitalist institution of private property, Marxists argue,
capitalists own the machinery and equipment necessary
for production in an industrial society. Since the
working class owns no such capital goods, it is dependent
on capitalists for its employment and its livelihood.
Workers lack bargaining power because capitalists can
dismiss labor agitators and replace them from the large
“reserve army of the unemployed.” Capitalists exploit
workers by paying them a wage far below the value of
workers’ production. That is, capitalists can and will expropriate
the remaining value of workers’ labor as profit,
or what Marx termed surplus value. Although all value
comes from labor, in the capitalist system labor does not
receive all value. In the communist planned economic
system, the state as an agency of the working class extracts
surplus value and distributes it through subsidies
for public or quasi-public goods (for example, education,
transportation, health care, and housing).
The goal of communism was to overthrow capitalism
and to replace it with a classless society devoid of human
exploitation. The Communist Party
viewed itself as the vanguard of the
working class and peasantry, and its actions
were held to be in keeping with
the goals of those groups. In reality,
the Communist Party was a strong, oneparty
dictatorship that usually pursued the
interests of its party members.
State Ownership and
Central Planning
Two major features of the prereform and precollapse
economies of Russia and China were (1) state (government)
ownership of property resources and (2) central
planning.
State Ownership Under state ownership the Soviet
and Chinese governments owned all land, natural resources,
transportation facilities, communication networks,
and banking facilities and virtually all industry.
The government also owned most retail and wholesale
enterprises and most urban housing. Many farms were
state-owned; most farms, however, were government collective
farms, essentially cooperatives to which the state
assigned land.
Central Economic Planning Both nations had
“command” economies that relied on central economic
planning and were government-directed rather than
market-directed. Choices that are made through the market
in the United States and other market economies were
made by bureaucratic decisions in the Soviet Union and
China. Through a central 5-year or 7-year plan, the governments
attempted to coordinate all economic activities
as if they were parts of a large enterprise directed from
central headquarters.
Planning Goals and Techniques
Although central planning was far more complete in the
Soviet Union than in China, both nations relied on direction
from the central government. The following generalizations
describe the functioning of central planning
in both countries.
Industrialization (and Rural Development in
China) The main goals of the Soviet Union were rapid
industrialization, economic growth, and military strength.
40W.1
Labor
theory of
value
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It achieved those goals through extensive investment in
heavy industry (such as steel, chemicals, and machine
tools) and the allocation to the military of a large portion
of domestic output. Along with manufacturing, China
emphasized rural development, and small-scale industries
were scattered throughout the rural areas. But in both
countries the central planners pretty much neglected consumer
goods industries and the distribution and service
sectors.
Overcommitment of Resources In their efforts
to increase GDP, both the Soviet Union and China often
overcommitted their economies’ available resources. As a
result, not every planning target could be achieved. In
particular, the production of consumer goods often suffered,
since planning priorities emphasized heavy industry,
rural development, and the military.
Mobilization of Resources At first, both the Soviet
Union and China achieved some measure of industrialization
and economic growth through the mobilization of
labor, capital, and raw materials. In the early years of
planning there was substantial surplus labor in agriculture,
which the planners reallocated to industrial production.
Both China and the Soviet Union induced or coerced
a larger proportion of the population to enter the labor
force. They achieved economic growth mainly by
increasing inputs rather than by using fixed amounts of inputs
more productively. In the 1930s and again in the
years following the Second World War, that strategy produced
higher rates of economic growth than the rates
achieved by the United States and other industrialized
nations.
Allocation by Directives The central planners directed
how inputs would be allocated among industries
and firms, thereby determining the composition of output.
The result was that planning directives, not a market
system, served as the allocative mechanism.
Government Price Setting Government, rather
than the forces of supply and demand, set the prices of
resources and products. Planners rarely changed the
prices of consumer goods and, as a matter of social policy,
set the prices of “necessities” such as housing and
food at low levels. Rents on housing in the Soviet Union,
for example, averaged only 3 percent of income and remained
at that level between 1928 and 1992. Government
also set the prices of resources and the prices of each
firm’s output. The prices were used primarily as accounting
devices to gauge a firm’s progress in meeting its
production goals. The emphasis of the various 5- or
7-year plans was on the quantity of output, not on its cost
or price.
Self-Sufficiency The Soviet Union and China each
viewed itself as a socialist nation surrounded by hostile
countries. Neither nation trusted the other. Each maintained
a strong military presence along their common
border and vied for influence among the developing
countries. Because of the hostility they perceived around
them, the central plan in each country stressed economic
self-sufficiency. Each country severely restricted trade
with western nations, and neither country encouraged
easy convertibility between their respective currencies
and those of other countries. The Soviet Union and China
traded mostly with other communist nations such as East
Germany, Poland, Hungary, Cuba, North Korea, and
Vietnam.
Passive Macroeconomic Policies The economies
of both the Soviet Union and prereform China were
quantity-directed systems in which money and prices
played only a limited role in resource allocation.
Monetary policy (changes in the money supply and interest
rates) and fiscal policy (changes in government
spending and taxes) were passive rather than active.
Unemployment—but not underemployment—was quite
low, partly the result of ambitious planning targets and
various admonitions and “educational” campaigns designed
to promote work. But low unemployment perhaps
had more to do with overstaffing (managers could
not fire redundant workers) and a lack of interest in
cost minimization (gross output was the overriding
objective). It also had to do with the massive, highly
labor-intensive public works projects that both nations
initiated in order to build infrastructure and glorify the
socialist state.
Both countries used direct government price setting
as the primary means of controlling the price level. By not
allowing prices to rise, they repressed inflationary pressures.
The controlled prices, however, created severe
shortages of consumer goods.
Problems with Central Planning
Central planning was fraught with serious problems that
contributed to the collapse of the Soviet economy and to
the market reforms in China.
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The Coordination Problem
As you know, the market system is a powerful organizing
force that coordinates millions of individual decisions by
consumers, resource suppliers, and businesses and, in so
doing, promotes the efficient use of scarce resources.
Substituting central planning as a coordinating mechanism
creates a significant coordination problem.
Example: Suppose that an enterprise in Moscow or
Beijing is to be set up producing shoes. The central planners
must establish a realistic annual production target, for
example, 1 million pairs of shoes. They then must make
available all the necessary inputs—labor, electric power,
leather, rubber, thread, nails, machinery, transportation—
for the production and delivery of those 1 million pairs of
shoes. When the product is a more complex one, such as
farm tractors, the planners’ coordination problem is greatly
compounded.
Because the outputs of many industries serve as inputs
to other industries, the failure of any single industry
to achieve its output target causes a chain reaction of
repercussions. For example, if iron mines, for want of machinery
or labor or transportation, do not supply the steel
industry with the required inputs of iron ore, the steel
mills will be unable to fulfill the input needs of the many
industries that depend on steel. Those steel-using industries
(such as automobile, tractor, and transportation) will
be unable to fulfill their planned production goals.
Eventually the chain reaction will spread to all firms that
use steel as an input.
The coordination problem becomes more difficult
as the economy grows. Early planning under Stalin in
the late 1930s and 1940s and under Mao in the 1950s
resembled the highly focused planning of capitalist nations
in coordinating resources to fight the Second
World War. The Communist Party established a few
key production goals and directed resources toward fulfilling
them regardless of the cost or their effect on consumer
welfare. But as time passed, the early “campaign
planning” in the Soviet Union and China gave rise to
increasing complexity. Products and production processes
grew more sophisticated, and the number of industries
that had to be planned for increased. Planning techniques
that had worked for the simpler economy proved
inadequate and inefficient as the economies grew.
Bottlenecks and production stoppages occurred with
regularity.
A lack of reliable success indicators adds to the coordination
problem under central planning. Market
economies have a single, trustworthy success indicator:
profit. Profit or loss measures each firm’s success or
failure. Profit depends on consumer demand, production
efficiency, and product quality. In contrast, the major
success indicator of the Soviet and prereform-China
economies was the achievement of a quantitative production
target assigned by the central planners. Production
costs, product quality, and product mix became secondary
considerations. Managers and workers often sacrificed
product quality, since they were being awarded
bonuses for meeting quantitative, not qualitative, targets.
If meeting production goals meant sloppy assembly work,
so be it.
It is difficult at best for planners to assign quantitative
production targets without unintentionally producing
distortions in output. If the production target for an enterprise
manufacturing nails is specified in terms of weight
(tons of nails), the producer will tend to produce only
large nails. But if its target is specified as a quantity (thousands
of nails), the producer will be motivated to produce
all small nails, and lots of them!
The Incentive Problem
In the capitalist system, profits and losses not only signal
success and failure but also act as incentives for firms
to increase or decrease production. If there is a shortage
of a given product, the price and profitability of that
product will rise, and producers will be motivated to
expand production. Conversely, if there is a surplus of a
product, prices and profits will fall, and producers will
be motivated to reduce output. Producers seek improved
product quality and production techniques because both
increase profitability. Workers seek to improve their job
skills and work harder in order to raise their incomes, as
higher pay can be translated into a higher standard of
living.
The reason such actions and adjustments do not occur
under central planning is that there is an incentive
problem. Central planners determined the output mix of
the Soviet Union and prereform China. When they misjudged
how many automobiles, shoes, shirts, and chickens
were wanted at the government-determined prices, persistent
shortages and surpluses of those products arose.
But as long as the managers who oversaw the production
of those goods were rewarded for meeting their assigned
production goals, they had no incentive to adjust production
in response to the shortages and surpluses. And there
were no fluctuations in prices and profitability to signal
that more or less of certain products was desired. Thus,
many products were unavailable or in short supply, while
other products were overproduced and sat for months or
years in warehouses.
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Q U I C K R E V I E W 40W.1
• Marxian ideology is based on the labor theory of value
and views capitalism as a system that expropriates surplus
value from workers.
• The main features of the former Soviet economy and
the prereform Chinese economy were state ownership of
property resources and central economic planning.
• Central plans in the Soviet Union and China were
characterized by (a) an emphasis on rapid industrialization,
rural development (in China), and military power; (b) resource
overcommitment; (c) growth through the use of increasing
inputs rather than through greater efficiency;
(d) resource allocation by government directive rather than
by market; (e) government determination of price; (f) an
emphasis on economic self-sufficiency; and (g) passive
monetary and fiscal policies.
• Two major problems of central planning are (a) the difficulty
of coordinating inputs and outputs and (b) the problem
of fostering incentives, including those that prompt
technological advance.
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The centrally planned system also lacked entrepreneurship.
In market systems, the large potential monetary
rewards to innovators serve as a stimulus to technological
advancement. Moreover, firms that improve their products
or production processes realize a profit, while those
that do not eventually suffer a loss. Central planning does
not trigger the profit motive, nor does it reward innovation
and enterprise.
The route for getting ahead in the centrally planned
economies of the Soviet Union and China was through
participation in the political hierarchy of the Communist
Party. Moving up the hierarchy meant better housing,
better access to health care, and the right to shop in
special stores. Meeting production targets and maneuvering
through the minefields of party politics were
measures of success in “business.” But a definition of
success based solely on political savvy is not conducive
to technological advance, which is often disruptive to
existing products, production methods, and organizational
structures.
Indeed, in both the Soviet Union and prereform
China, managers and workers often resisted innovation.
Since enterprises were essentially government-owned monopolies,
no private gain accrued to managers or workers
for improving product quality or developing more efficient
production techniques. Managers and workers actually
resisted government-imposed innovations, because
higher and sometimes unrealistic production targets usually
accompanied innovations.
The lack of competition also discouraged innovation.
There were no new start-up firms driven by the profit
motive to introduce better products, superior managerial
techniques, or more efficient production methods.
Similarly, the goal of economic self-sufficiency isolated
Soviet and Chinese enterprises from the threat of competition
from imported goods. Enterprises went on producing
the same products with the same techniques, even as
both the products and the techniques grew increasingly
obsolete.
Finally, workers lacked motivation to work hard
because there were so few material incentives. Because
of the low priority assigned to consumer goods in
the production plans, only a limited array of inferior
products and services was available to consumers.
While hard work might result in promotions and
bonuses, the increase in money income did not translate
into a proportionate increase in real income. Why work
hard for more income if there is nothing to buy? As a
Soviet worker once lamented to a western journalist:
“The government pretends to pay us and we pretend to
work.”
Collapse of the Soviet Economy
The problems of central planning contributed to market
reform in China, but led to the collapse of the
Soviet economy. We will consider Russia first and then
China.
In 1991 the Soviet Union broke into several newly
independent states, the largest of which is the Russian
Federation (Russia). The immediate reason for the collapse
was political: a clumsy, failed attempt of old-line
communists to take control of the government. (The
failed coup led to the ascendancy of Boris Yeltsin in
Russia and to independence for the former republics of
the Soviet Union.) But a number of economic problems,
some stemming directly from the failures of central
planning, contributed to the collapse of the Soviet
Union.
Declining Growth
Soviet economic growth in the 1950s and 1960s (at least
as measured by highly questionable Soviet statistics) was
quite impressive: The economy grew at roughly a 5 to
6 percent annual rate. But economic growth fell to 2 to
3 percent annually in the 1970s and to less than 2 percent
in the mid-1980s. In the last year or two before the system
broke down, real output was falling sharply.
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Poor Product Quality
Further evidence of failure was the poor quality of Soviet
goods. In such vital manufacturing sectors as computers
and machine tools, Soviet technology lagged some 7 to
12 years behind that of the United States, Japan, and
Germany.
Technology lagged even more in consumer goods,
which were of notoriously poor quality and limited choice.
Durable goods such as automobiles, large household appliances,
and consumer electronics were primitive by U.S.
standards. Also, widespread shortages of basic goods, interminable
shopping lines, black markets, and corruption
in product distribution characterized the consumer sector.
Lack of Consumer Goods
Not only were consumer goods of poor quality, but they
were also in short supply. In the early decades of Soviet
communism, the government established a “social contract”
with its citizens to the effect that, by enduring the
sacrifices associated with rapid industrialization and
growth, consumers would be rewarded with abundance in
the future. The failure of the system to meet such expectations
contributed to frustration and to deteriorating
morale among consumers and workers. The rewards for
past sacrifices never materialized.
Large Military Burden
Large Soviet military expenditures of 15 to 20 percent of
domestic output, compared to 6 percent in the United
States, absorbed great quantities of resources that otherwise
would have been available for the development and
production of consumer and capital goods. The government’s
policy during the Cold War era was to channel superior
management and the best scientists and engineers
to defense and space research, a policy that adversely affected
technological progress and the quality (and thus
the productivity) of capital goods in the civilian sector.
Agricultural Drag
By the standards of market economies, agriculture in the
Soviet Union was a monument to inefficiency and a drag
on economic growth. This sector used about 30 percent
of the nation’s labor force and roughly 25 percent of its
annual investment. Output per worker was only 10 to 25
percent of the U.S. level. The low productivity of Soviet
agriculture was attributable to many factors: relative
scarcity of good land, erratic weather patterns and growing
seasons, serious errors in planning and administration,
and, perhaps most important, the lack of an effective
incentive system.
Formerly a major exporter of grain and other agricultural
products, the Soviet Union became one of the
world’s largest importers of farm goods. The reliance on
imports seriously drained the foreign currency reserves
that the leadership might have used to import capital
goods and technology from the West.
The Russian Transition
to a Market System
The former Soviet republics, particularly Russia, have
committed themselves to making the transition to a market
economy. The Russian economy has experienced dramatic
reform since 1992, when Boris Yeltsin succeeded
Mikhail Gorbachev as Russia’s president. Reforms are
slowly continuing under Vladimir Putin, who succeeded
Yeltsin in 2000.
Privatization
To encourage entrepreneurship, Russia has privatized
(transferred to private owners) much government
property—housing, factories, machinery, and equipment.
Many new firms have been created, with more than twothirds
of the former state-owned enterprises now privatized.
Ninety percent of the nation’s small companies are
now privately owned, as are 80 percent of the service
sector companies.
The privatization process involved two phases. In the
first phase, the government gave vouchers, each with a
designated monetary value, to 40 million Russian citizens.
Recipients could then pool their vouchers to purchase enterprises.
The second phase, which began in 1994, permitted
investors to purchase state enterprises for cash.
This development, which enabled foreign investors to
buy Russian enterprises, attracted much-needed direct investment
from abroad. It also enabled a handful of business
groups led by so-called oligarchs to gain control over
the production assets in several sectors of the Russian
economy. In 1995 a “loans-for-shares” program enabled
these groups to strengthen their grip on the economy.
Under this plan, the oligarchs loaned the financially
strapped Russian government money in exchange for ownership
shares and management rights in the remaining
major state industries, such as natural gas, oil, nickel, and
electricity. Most of Russian enterprise is now in private
hands.
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Land reform has progressed more slowly. Although
Boris Yeltsin decreed in 1996 that Russian peasants could
buy and sell land, it will take many years to develop a
functional market for farmland. Farmers, who have
worked for decades on collective farms, fear the uncertainties
and problems that might accompany privatization
and free markets.
Price Reform
Russia recognized the need do away with governmentcontrolled
prices. The problem was that prices in the
Soviet economy bore no relationship to the economic
value of either products or resources. As we noted earlier,
the Soviet government fixed both input and output prices
and in many instances did not change those prices for
many years. Because input prices had little, if any,
relationship to the relative scarcities of resources, it was
impossible for firms to minimize their true production
costs.
Example: High prices of energy have prompted firms
in market economies to greatly reduce energy use per unit
of output. But the government underpriced energy in the
former Soviet Union. Consequently, its industries used
two or three times as much energy per unit of output as
did those in leading industrial countries.
Not only was energy priced far below its true price,
but so too were many basic consumer goods. The Soviet
rationale for setting low prices was to ensure that everyone
could afford such goods. As Figure 40W.1 shows,
that pricing policy helps explain the chronic product
shortages and long lines that had frustrated Soviet consumers.
The perfectly inelastic supply curve S1 reflects
the fixed output of, say, shoes called for by the central
plan. The demand curve D1 slopes downward, as it would
in a market economy. In view of S1, the equilibrium price
would be Pa. But in an effort to make shoes accessible to
those with lower incomes, the government fixed the
price at Pf.
The result was that not everyone who wanted shoes
at Pf could obtain them. Because the quantity demanded
Qf at Pf was greater than the quantity supplied Qa, a shortage
of shoes occurred. Similar shortages in other markets
explain the long lines of consumers and the empty shelves
the rest of the world saw in television news clips. It also
explains the black markets in which goods were sold at
much higher prices than those fixed by the central
planners.
The task, then, was to eliminate these price controls. In
January 1992, the government decontrolled about 90 percent
of all prices. As a result, prices immediately surged.
The decontrol of prices, however, had several positive
effects. As Figure 40W.1 shows, the decontrol at first
raised prices rapidly, as from Pf to Pa in this example.
There simply was no mechanism for firms to increase the
amount of output supplied in response to the price increases.
But with privatization, the higher prices signaled
profit opportunities to enterprises and thus triggered a
positive supply response. The relevant supply curve then
took on its more familiar upward slope as in S2, and equilibrium
output increased from Qa to Qe. Equilibrium price
moved downward from Pa to Pe. More generally, prices
began to reflect more closely the marginal cost to the
Russian economy of producing goods and helped direct
resources to where they were best suited to meet consumer
wants.
Promotion of Competition
As we have seen, the industrial sector of the former
Soviet Union consisted of large state-owned single-firm
“industries” that produced about 30 to 40 percent of
total industrial output. When several enterprises
produced a certain product, the planning process
Pa
0 QfQeQa
Price
Quantity
S1
S2
D1Shortage
Pe
Pf
F I G U R E 40W.1
The effects of centrally planned prices. Central planners in the
Soviet Union established below-equilibrium prices such as Pf on many basic
consumer goods to allow low-income persons to buy them. But at
such low prices, quantity demanded (here Qf) exceeded quantity supplied
(set by planners at Qa).The resulting shortage meant that many consumers
could not obtain the goods they wanted.The elimination of government
price setting initially increased price from Pf to Pa. But with privatization
in Russia, the higher price stimulated greater output along
supply curve S2. Price therefore settled at Pe while output jumped from
Qa to Qe.
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coordinated their actions to create a cartel. In short,
most production took place under monopoly or nearmonopoly
conditions.
Russian reformers realize that an efficient market
economy requires the dismantling of these public
monopolies and the creation of antitrust laws to sustain
competition. But only limited “demonopolization” has
accompanied privatization so far. In many industries,
private monopolies have simply replaced public monopolies.
Joint ventures between Russia and foreign companies
are one avenue for increasing competition, and Russian
legislation has made it easier for foreign firms to invest directly
in Russia. A future avenue might be government
antitrust actions to break firms into competing entities.
(Key Question 5)
Making the Ruble Fully Convertible
The Soviet economy had been isolated from the world
economy for 75 years. A key step in the transition to a
market economy was to open the economy to international
trade and finance. Russia has had modest success
in this endeavor; for example, it has made the ruble a
fully convertible currency. This means that the ruble is
acceptable in exchange for other currencies. But because
of hyperinflation in Russia and a series of political
and economic crises, the ruble plunged in value from
90 rubles ϭ $1 in 1992 to 5800 rubles ϭ $1 in 1997.
The free fall of the ruble was detrimental to Russia’s
world trade, since no one wanted to buy or hold rubles.
The trade that did occur usually involved dollars or
simply barter.
On January 1, 1998, Russia recalibrated its currency
by removing three zeros. For example, a 10,000-ruble
bill became a 10-ruble bill. That conversion immediately
altered the exchange rate from $1 ϭ 6000 rubles to $1 ϭ 6
rubles. After the Russian government defaulted on several
large international loans in 1998, the ruble fell from
$1 ϭ 6 rubles to $1 ϭ 23 rubles in a matter of days. Since
1998 the dollar-ruble exchange rate has declined to about
$1 ϭ 31 rubles.
Price-Level Stabilization
The transition to free markets brought with it hyperinflation.
In response to the decontrol of prices in January
1992, prices tripled and quadrupled almost overnight.
Russian households had stored huge amounts of currency
and deposits at savings banks during years of waiting for
scarce consumer goods to become more abundant, and
this so-called ruble overhang helped fuel inflation once
prices were decontrolled and privatization began to deliver
consumer goods to the marketplace.
But the most important source of inflation was the
large government deficits financed by increases in the
money supply. The deficits in turn had many roots.
Privatization of state enterprises caused the government
to lose the net revenues (revenues minus costs, or what we
call profit) brought in by those firms. The uncertainties
inherent in the transition led to general disorder and
widespread tax evasion. To ease losses suffered by enterprises
during the transition, the government extended
massive subsidy credits, financed by printing new money,
to both industry and agriculture. Finally, the government
increased pensions and welfare benefits by printing yet
more money.
Russia’s economic reforms, however, did create an independent
central bank, and its anti-inflationary monetary
policy brought about a significant decline in the rate
of inflation. As shown in column 3 in Table 40W.1, inflation
declined from 1735 percent in 1992 to 15 percent in
1997. But the printing of money to pay international loans
and the collapse of the ruble in 1998 caused rapidly rising
prices of imported goods (in rubles) as well as domestic
goods. Inflation jumped to 28 percent in 1998 and 86 percent
in 1999, before settling back to 21 percent in 2000
and 2001 and 16 percent in 2002. (Key Question 6)
Other Major Problems
Along with the successes and difficulties we have
noted, the Russian transition to the market economy
T A B L E 40W.1
Real GDP Growth and Inflation in Russia, 1992–2002
(2) (3)
(1) Growth of Real Rate of
Year GDP, Percent Inflation, Percent
1992 Ϫ19 1735
1993 Ϫ11 875
1994 Ϫ13 308
1995 Ϫ6 197
1996 Ϫ2 48
1997 ϩ2 15
1998 Ϫ3 28
1999 ϩ5 86
2000 ϩ8 21
2001 ϩ6 21
2002 ϩ5 16
Source: International Monetary Fund, www.imf.org/.
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B O N U S W E B C H A P T E R 40WEB | Transition Economies: Russia and China 40W-9
encountered other significant problems, particularly in its
early years.
Declining Output: 1992–1996 Real output and
living standards declined during the first 5 years of
the Russian transition to capitalism. Column 2 of Table
40W.1 documents that real GDP declined in each year
between 1992 and 1996, with the worst year being
1992, when real GDP fell by 19 percent. Declines of the
magnitudes shown in the table resemble those associated
with the Great Depression in the United States in the
1930s.
The causes of the output declines between 1992 and
1996 include (1) rapid inflation, which created an uncertain
environment for borrowing and investing; (2) the unraveling
of Russia’s international trade relationships with
the former communist-bloc nations of eastern Europe;
(3) bankruptcy and the closing of many former stateowned
enterprises that could not survive in a market environment;
and (4) the massive reallocation of resources
required by the reforms and by a substantial reduction in
government spending on the military.
Because real output equals real income, declining real
output meant declines in Russian living standards.
Farmers, government employees, and pensioners were hit
hard, and many workers had to accept deep cuts in real
wages in order to keep their jobs. Some workers were
owed large amounts of “back pay” because of the inability
of their employers to pay wages. At least 30,000 scientists
left Russia to work in other nations.
Inequality, Corruption, and Social Costs Economic
inequality increased in Russia in the 1990s. Many
people became impoverished while a wealthy class of “new
Russians” emerged. Many of the newly enriched citizens
gained their wealth through entrepreneurship. Others
prospered as executives, managers, and scientists in the
newly privatized industries. Still others, however, enriched
themselves via corruption and illegal activities. The major
disruptions, swift changes, and lack of regulatory oversight
that accompanied the transition created many opportunities
for corruption and organized crime to expand
and flourish.
Considerable friction between gainers and losers, the
growth of organized crime, and “crony capitalism” triggered
public doubts as to the desirability of a market economy.
In particular, most observers now view the loans-forshares
program as a “great grab” of state assets by a handful
of Russian oligarchs. Social services also declined during
this period. Medical and educational services deteriorated
and school enrollments declined. Alcoholism, historically
high in Russia, increased sharply and the life expectancy
of Russian men declined from 65 to 59 between 1988 and
2002.
Weakness of Government Another transition
problem was the weakness of government in enforcing its
laws, including the collection of taxes owed by enterprises
and political subdivisions. Widespread tax evasion
led to declining tax revenues, enlarged budget deficits,
and financial instability. Declining tax revenues further
weakened the central government’s ability to enforce tax
laws, so a kind of vicious circle occurred. Moreover, the
reduced revenues crippled the central government’s ability
to perform other basic functions such as maintaining
law and order, providing regulatory oversight of banks
and security markets, and providing a social safety net for
its citizens.
Recent Revival
Despite these seemingly overwhelming problems, Russia
largely “muddled through” the first decade of its transition
to capitalism and democracy. The market reforms
are now largely irreversible and the severest economic
dislocations have ended. Political instability has been significantly
reduced under Vladimir Putin, and the Russian
economy has recently experienced strong economic
growth. Partly because of rising oil production and high
oil prices, real output in Russia increased by 5 percent in
1999, 8 percent in 2000, 6 percent in 2001, and 5 percent
in 2002. If these growth rates continue, Russia’s real GDP
will double within 12 years! Along with economic growth
has come declining unemployment. Russia’s unemployment
rate fell from 13 percent in 1999 to about 8 percent
in 2002.
The strong recent growth of income and a crackdown
on tax cheaters has greatly increased tax revenues.
The central-government budget swung from a deficit of
4.2 percent of GDP in 1998 to a surplus of about 3 percent
of GDP in 2002. The improved budget situation
has also made it easier for the Russian government to
police illegal activity and exert regulatory oversight on
business and banking activity. The Russian goal of
achieving a “normal” market-based economy definitely
is closer than it was just a few years ago. Russia has survived
a turbulent transition decade and may now be on
its way to sustained prosperity. But even optimists agree
that it may take several decades for Russia to create a
vibrant market economy on the order of the western
European nations.
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Q U I C K R E V I E W 40W.2
• The former Soviet economy collapsed under the pressure
of declining economic growth, poor product quality,
a lack of consumer goods, a large military burden, and
agricultural inefficiency.
• Russia has committed itself to becoming a capitalistic
market economy. Ingredients in its transition from central
planning to markets include (a) creating private property
and property rights, (b) removing domestic price controls,
(c) promoting competition, (d) opening the economy to international
trade and finance, and (e) ending inflation.
• The early years of Russia’s transition to a market economy
were accompanied by declining living standards,
increasing income inequality, and social costs such as corruption,
organized crime, rising alcoholism, and reduced
life expectancy.
• Although Russia still faces difficult economic times, it
has made substantial progress in its move from communism
to capitalism. Its GDP grew by an average of 6 percent
annually between 1999 and 2002.
40W-10 B O N U S W E B C H A P T E R 40WEB | Transition Economies: Russia and China
Market Reforms in China
China has taken a different path in its transition to a
market economy. In 1992 Russia pursued a rapid and
radical transformation to private property and free markets
called “shock therapy” to achieve “irreversibility” of
its reforms. China’s market reforms began far earlier—
in 1978—in a piecemeal, experimental, and gradual manner.
In 1992 Russia concluded that its political apparatus,
the Communist Party in particular, was an obstacle
to economic reform and that political reform (democratization)
must precede it. China, in contrast, has sought
economic reform under the strong direction of its
Communist Party. China’s view is that the upsetting of
the political system would generate endless debate, competition
for power, and ultimate stagnation and failure
for its economic reforms. Unlike Russia, China feels that
communist dictatorship and a market economy are compatible.
China has preserved many of its state-owned enterprises
while simultaneously encouraging the creation
of competing private enterprises.
Although China’s GDP per capita is only $890 compared
to Russia’s $1750, China has instituted its market
reforms without suffering the economic depression that
confronted Russia. In fact, China has achieved a 9 percent
annual growth of real output over the past two decades (as
compared to typical growth rates of 2 to 5 percent for
most advanced economies).
Market reforms in China began in 1978 under the
leadership of Deng Xiaoping, the successor to Mao
Zedong. Deng did not share Mao’s utopian vision of an
eventual communist economy in which people would work
for the glory of the community and monetary incentives
would play only a minor role. Instead, Deng recognized
that the profit incentives of a market economy could raise
China’s living standard. But he also realized that only a
gradual transition to such an economy could preserve
the Communist Party’s political control over China.
Many Chinese critics of Deng derisively called him “a
capitalist roader,” implying that he was setting China on
the road toward capitalism. As it turned out, those critics
were right.
Agricultural and Rural Reform
Market reform in China began in agriculture in 1978, at
which time nearly 70 percent of the Chinese labor force
was rural. The key elements of the 1978 to 1984 reforms
were the leasing of land to individual farmers (“decollectivization”)
and the establishment of a two-track price system.
For the first time, individual farmers were allowed to
lease government-owned land (for 15-year periods).
Under the two-track price system, farmers had to sell a
prescribed amount of farm output to the government at a
set price but could sell any surplus in markets at marketdetermined
prices. Farmers were eventually allowed to sell
increasing portions of their output at market-determined
prices rather than at lower government-determined prices.
In 1978 farmers sold only 8 percent of their commodities
in competitive markets, but by 1990 that share had risen
to 80 percent.
Decollectivization and price reform significantly
strengthened production incentives and swiftly moved
the Chinese economy toward market-based agriculture.
Responding to the profit motive, farmers boosted their
productivity by substituting tools for labor, shifting crops
toward more valuable commodities, and farming previously
untilled land. Agricultural output in China rose
dramatically throughout the 1980s. Equally important,
the increased productivity in agriculture freed up labor
resources to a growing number of privately owned rural
manufacturing firms called township and village
enterprises.
Reform of Urban Industries
The success of reforms in agriculture prompted the central
government to extend reforms to the state-owned
enterprises (SOEs) in urban areas. These enterprises
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B O N U S W E B C H A P T E R 40WEB | Transition Economies: Russia and China 40W-11
were granted more authority to determine the quantity
and variety of their outputs, to make their own employment
decisions, and to retain much of their net revenues.
(Previously, they had to send the bulk of their net revenues
to the central government.) The government also
extended the two-track system of prices to nonagricultural
products. The SOEs were allowed to buy increasing
portions of their inputs at market prices rather than
at government-set prices and sell increasing portions of
their outputs at market prices instead of having to sell
most of it to the government at fixed prices. The share
of output sold at market prices rather than at governmentset
prices went up from 12 percent in 1980 to 66 percent
in 1987.
Furthermore, the Chinese government encouraged
the formation of nonstate enterprises called urban
collectives—enterprises owned jointly by managers and
their workforces. Like town and village enterprises, these
nonstate firms were not subject to the directives of the
central plan, so they were far more capable than the SOEs
of gauging and meeting consumer wants. The urban collectives
experienced explosive growth of output and employment,
some of it at the expense of the SOEs.
Moreover, the competition among these nonstate enterprises
and the SOEs spurred innovation and greater productivity
in many of the SOEs.
Special Economic Zones
In 1980 China created special economic zones (SEZs)
that were open to foreign investment, private ownership,
and international trade. Located in coastal regions,
these special zones attracted increasing amounts of foreign
capital (particularly from Hong Kong). They also
increased Chinese exports significantly. As the successes
of the SEZs became apparent, China increased their
number and scope. The SEZs in China’s southern
provinces, in particular, became booming enclaves of
“near-capitalism.” The success of the SEZs relative to
other regions in China eventually eroded support for
central planning.
Development of Supporting Institutions
The reforms in China also included the building of institutions
to strengthen the market system and its macroeconomic
control. For example, the Chinese government
established the Bank of China as the central bank
and gave it the power to regulate the banking system
and control the money supply to avoid inflation.
The government replaced the system of “net revenue
transfers” from state enterprises to the central government
with an enterprise tax system. It established a socalled
swap market in which Chinese enterprises could
trade foreign currency as needed to conduct international
business. Finally, it developed a stock market for
the exchange of the shares of newly created stockholderowned
corporations.
Transformation of the SOEs
In the 1990s Chinese reformers turned to making stateowned
enterprises more “corporatelike.” The idea was to
replace Communist Party operatives with professional
managers who would be independent of the central government.
The government also redirected the goals of
such enterprises away from social objectives (providing
employment, housing, health care, and day care) and toward
economic objectives (producing high-quality goods
for which there was a demand). This partial “corporatization”
of state enterprises, however, exposed the inefficiencies
of the SOEs. In the competitive marketplace,
many SOEs found that they were producing the wrong
goods, in the wrong amounts, using the wrong combinations
of inputs. In short, thousands of SOEs proved to be
inefficient and unprofitable.
After Deng’s death in the mid-1990s, leadership of
China passed to Jiang Zemin. In 1997 Jiang and the
Communist Party called for consolidation of the major
SOEs into 1000 large enterprises that over time will issue
stock and become shareholder-owned corporations. The
purpose is to make the firms’ managers responsive to their
shareholders. The government, however, will hold the
controlling share of stock ownership in these 1000 corporations.
All the other 300,000 state-owned enterprises
will be sold to private individuals (or groups) or, if they
have no value, will be allowed to go bankrupt.
In 2002 Jiang Zemin relinquished considerable power
to Hu Jintao, who is expected to continue Jiang’s gradualist
approach to reform.
Outcomes and Prospects
Economic reform in China has achieved impressive
results, but it is still incomplete in terms of a modern
market economy.
Positive Outcomes of Reform
China’s economic growth rate in the past two decades is
among the highest recorded for any country during any
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40W-12 B O N U S W E B C H A P T E R 40WEB | Transition Economies: Russia and China
period of world history; it has averaged nearly 9 percent
annually since the beginning of reforms in 1978. That
means that real output and real income have quadrupled
in less than two decades. About 40 percent of this growth
has resulted from increases in capital goods. Expanded
output and income have boosted domestic saving and investment,
and the expansion in capital goods has further
increased productivity, output, and income. The rising
income has attracted more direct foreign investment.
Such investment was about $50 billion in 2002. (China’s
growth rates for recent years are shown in column 2,
Table 40W.2.)
A rapid expansion of China’s international trade has
accompanied the expansion of real output. Chinese exports
rose from $5 billion in 1978 to $266 billion in 2002.
These exports have provided the foreign currency needed
to import consumer goods and capital goods. Imports of
capital goods from industrially advanced countries have
brought with them highly advanced technology that is
embodied in, for example, factory design, industrial
machinery, office equipment, and telecommunications
systems.
During the period of reform, China’s real GDP and
real income have grown much more rapidly than China’s
population. Per capita income has increased at a high annual
rate of 8 percent since 1980. This is noteworthy because
China’s population has expanded by 14 million a
year (despite a policy which encourages one child per
family). Per capita income in China is now $890 annually
based on exchange rates. But since the prices of many
basic items in China are still low and are not totally captured
in exchange rates, Chinese per capita purchasing
power is estimated to be equivalent to $4260 of income in
the United States.
The growth of per capita income in China has resulted
from increased use of capital, improved technology,
and shifts of labor away from lower-productivity toward
higher-productivity uses. One such shift of employment
has been from agriculture toward rural and urban manufacturing.
Another shift has been from state-owned enterprises
toward private firms. Both shifts have raised the
productivity of Chinese workers.
Problems
China still faces some significant problems in its transition
to the market system, however.
Incomplete Property Rights Since the initial
surges in the 1980s, productivity growth in agriculture
has stagnated. A possible reason may be that property
rights are incomplete. The Communist Party has opposed
privatization of farmland, fearing a reversion to the
wealthy landlord system it fought to abolish. Instead, the
government policy has been to lease land for 15-year
periods. But without ownership rights, many farmers are
reluctant to invest in farm equipment and capital
improvements on the land. The return on such investment
depends on the assurance of having land to farm.
Thus, further capital investment in Chinese agriculture
may depend on the right to buy and sell land.
Macroeconomic Difficulties At times, investment
booms in China have resulted in too much spending relative
to production capacity. The result has been some
periods of 15 to 25 percent annual rates of inflation. (See
column 3 in Table 40W.2 for recent Chinese inflation
rates.) China has successfully confronted the inflation
problem by giving its central bank more power so that,
when appropriate, the bank can raise interest rates to
damp down investment spending. This greater monetary
control, along with slowing economic growth, reduced
inflation significantly. In fact, in 1998, 1999, and 2002
China experienced mild deflation.
Nevertheless, the overall financial system in China
remains weak and inadequate. Many unprofitable SOEs
owe colossal sums of money on loans made by the Chinese
state-owned banks (an estimate is nearly $100 billion).
Because most of these loans are not collectible, the
government may need to bail out the banks to keep them
T A B L E 40W.2
Real GDP Growth and Inflation in China, 1991–2002
(2) (3)
(1) Growth of Real Rate of
Year GDP, Percent Inflation, Percent
1991 9 3
1992 14 6
1993 14 15
1994 13 24
1995 11 17
1996 10 8
1997 9 3
1998 8 Ϫ1
1999 7 Ϫ1
2000 8 1
2001 7 1
2002 8 Ϫ1
Source: International Monetary Fund, www.imf.org/.
mcc19359_ch40w_40w01-40w16 09/27/2003 16:46PM Page 40W-12
Q U I C K R E V I E W 40W.3
• Market reform began earlier in China (1978) than in
Russia (1992) and was based on gradualism rather than on
“shock therapy.”
• The key elements of China’s economic reform
are decollectivization of agriculture, establishment of
township and village enterprises, price reform, establishment
of privately owned urban enterprises, creation of
special economic zones, development of support and control
institutions, and corporatization of state-owned
enterprises.
• Since the beginning of market reform in 1978,
China’s real output and per capita income have grown
at average annual rates of 9 percent and 8 percent,
respectively.
• China’s economy faces remaining problems of incomplete
property rights, underdevelopment of financial institutions,
lack of full integration with the world economy,
and great unevenness in regional development.
B O N U S W E B C H A P T E R 40WEB | Transition Economies: Russia and China 40W-13
in operation. If China (through its central bank) simply
prints additional money to accomplish this bailout, renewed
inflation undoubtedly will result.
Unemployment is also a problem. Even though the
transition from an agriculture-dominated economy to a
more urban, industrial economy has been gradual, considerable
displacement of labor has occurred. Western
economists estimated that the unemployment rate in
China was about 10 percent in 2002. In particular, there
is substantial unemployment and underemployment in
the interior regions of China.
Integration into the Global Economy China
still has much work to do to integrate its economy fully
into the world’s system of international finance and trade.
As a condition of joining the World Trade Organization
in 2001, China agreed to reduce its high tariffs on imports
and remove restrictions on foreign ownership. In
addition, it agreed to change its poor record of protecting
intellectual property rights such as copyrights, trademarks,
and patents. Unauthorized copying of computer
software, movie videos, and compact discs has been a
major source of trade friction between China and the
United States.
The increase in imports to China that will result from
the lower tariffs will probably cause greater unemployment,
because many workers will have to shift from highly
inefficient industries to more efficient ones.
Geographically Uneven Development Finally,
China’s economic development varies substantially from
region to region. This fact became even more apparent
after the former British colony of Hong Kong became
part of China. Hong Kong is a wealthy capitalist economy
with per capita income of about $24,000. The standard
of living is also relatively high in China’s southern
provinces and coastal cities, although not nearly as high
as it is in Hong Kong. In fact, people living in these
special economic zones have been the major beneficiaries
of China’s rapid growth. In contrast, the majority of
people living elsewhere in China have very low incomes.
Despite its tremendous growth since 1978, China remains
a relatively low-income developing country. (Key
Question 8)
Conclusion
Clearly, Russia and China have taken different paths in
their transition to market systems. It may seem that
China’s path of dictatorship and gradualism is superior
economically (political realities aside) to Russia’s path of
democracy and swift transformation to capitalism. While
Russia suffered years of declining output and income,
China experienced very high rates of economic growth.
But we must not be too hasty in reaching this conclusion.
The disorder arising from Russia’s abrupt transition to
democracy and capitalism may be behind it, placing Russia
in a stronger position than China to succeed in the future.
The Communist Party’s dictatorship in China may or
may not last. History suggests that economic freedom often
creates demands for political freedom: free speech,
freedom of peaceful assembly, freedom to organize political
parties, free elections, and so on. Are China’s
communist leaders willing and able to design a gradual
path toward political freedom? Or is China’s period of
disorder still to come? We have no answers for these
questions. Time will tell.
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L A S T W O R D Police Smash Down Smirnov’s Doors
Russia Has Privatized Most of Its Former State-Owned
Companies. But as Revealed in the Following Article,
Privatization Has Not Always Been a Smooth and Easy
Process.
MOSCOW (AP)—A squad of masked police smashed through
the doors of one of Russia’s leading vodka makers Saturday
while workers inside threw
bottles of vodka at them in a
dispute over control of the
company.The actions in central
Moscow were the latest
in a series of tense and often
violent confrontations over
some of the country’s most
prominent businesses, and
the second this year involving
makers of renowned
vodkas.
News reports said the
officers were enforcing a recent
court decision supporting
the naming of Sergei
Yuzefov as general director of
the company. Smirnov head
Boris Smirnov said on Russia’s
NTV television that the court
decision was illegal. “I will
appeal to the constitutional
commission,” he said.
Television footage showed officers gathered outside the
doors of the Czarist-era building, apparently discussing strategy
for entry. Then one yelled “it’s burning, it’s burning!” As police
tore at the doors, a burst of flame appeared and a case of vodka
was thrown from inside. Other officers smashed open windows
with rods, then crawled through. Inside, employees lay face
down on the floor as police surged through the halls.
The conflict stems from this summer’s claim by Alfa-Eco,
part of one of Russia’s largest industrial and banking groups,
that it had obtained 50 percent of the shares in Smirnov. The
other 50 percent are reportedly held by Boris Smirnov, who
has refused to recognize Alfa-Eco’s claim, saying that he has
never seen supporting documents.“It is an absolutely unprecedented
case. It is a result of falsification of documents by a company
Alfa-Eco that is known for its dirty deeds,” Mikhail Grishin,
a security officer for Boris Smirnov, told Associated Press
Television News. “This was a true bandit seizure of the building,”
said Smirnov’s lawyer Viktor Shubar.
Late Saturday, police continued to guard the building. The
dispute comes as Smirnov fights a court battle in the United
States with the distilling giant UDV North America over the
latter’s use of the name “Smirnoff” for its vodka, which is the
best-selling vodka brand in
the world. UDV says it acquired
the Smirnoff name in
1934 when its predecessor
company Heublein bought
it from Russian émigré
Rudolf Kunett. Kunett it says,
had bought the brand from
an impoverished Vladimir
Smirnoff, one of founder
Pyotr Arsenyevitch Smirnov’s
five children who had left
Russia before the Bolshevik
Revolution and had Gallicized
his name.
In August, a dispute
over control of Moscow’s
Kristall distillery, which owns
Stolichnaya and other noted
brands, resulted in a twomonth
standoff in which men
with competing claims to being
manager occupied the company’s executive offices and manufacturing
facilities, each backed by private security squads.
A court finally ruled on the dispute in late September and
the winner,Alexander Romanov, said he considered the dispute
resolved.
In the chaotic and often questionable privatizations that
followed the collapse of the Soviet Union, disputes over companies
have broken out frequently.Workers seized a paper mill
last year to protest foreign ownership of the plant, and troops
shot one worker when they raided the plant to end the occupation.
In September, rival factions brawled for control of a
chemical plant in Yekaterinburg.
Source: Jim Heintz, “Cops Smash Smirnov’s Doors Down,” Associated Press, Nov. 4,
2000. Reprinted by permission of the Associated Press.
40W-14
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