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Remarks of Alan Greenspan, Chairman Board of Governors of the Federal Reserve System National Foreign Policy Conference U.S. State Department Washington, D.C. October 20, 1993 On November 9th, 1989, the Berlin Wall came down, symbolizing the end of an experiment in social policy that began more than four decades earlier with the division of the states of Western and Central Europe into market economies and those governed by state central planning At the end of World War II, as Winston Churchill put it, "From Stettin in the Baltic to Trieste in the Adriatic an iron curtain . descended across the Continent " The economies on the Soviet side of the "curtain" had been, in the prewar period, similar to the market-based economies on the western side Over four decades both types of economies developed with limited interaction across the dividing line It was as close to a controlled experiment in economic systems as could ever be implemented With the books now open on this experiment, we of course have learned much about how communist economics works, or, more exactly, does not But the biggest surprise is what this experiment is teaching us about how our own western economies and societies function. Or, perhaps more exactly, refreshing long dormant memories of the process Much of what we took for granted in our system and had grown to assume to be human nature was not nature at all, but culture The dismantling of the central planning function of a communist economy does not automatically establish a free market entrepreneurial system. There is a vast amount of capitalist culture and infrastructure underpinning market economies, which has evolved over generations- laws, conventions, behaviors, and a wide variety of business professions accounting, auditing, banking, and marketing - 2We are gaining significant new insights into how market systems work as the new leaders of the former communist states, with our help, struggle to convert centrally planned economies to ones based on free markets An understanding of how their systems worked, relative to ours, is crucial in managing the transition. Economists have had considerable experience in observing how market economies converted to centrally planned ones, but have virtually no exposure in the opposite direction. Ironically, in implementing the latter, we are being forced to understand fully the roots of our own system At the risk of being somewhat academic, I'd like to take some time to describe why countcies with centrally planned economies have not been able to match those with market-based ones in promoting the welfare of their citizens, and hence why the four-decade experiment in economic systems turned out in favor of capitalism. This explanation will help us to outline the problems that will have to be confronted in a successful transition of communist economies to capitalistic ones The most cogent way to understand why a centrally planned economic system, such as that which existed in the Soviet Union, has great difficulty in creating wealth and rising standards of living is to examine how the production and distribution of goods and services takes place in such an economy In theory, and to a large extent in practice, production and distribution are determined by specific instructions—often in the form of state orders—coming from the central planning agencies to the various different establishments, - 3indicating from whom, and in what quantities, they should receive their goods and services, and to whom they should distribute their final outputs. The machinery factory is given a quota to produce a certain number of machines to be shipped at a certain time to industries x, y and z At the same time, it is given authority to procure from the relevant steel works so many tons of hot rolled sheet or cold finished bars, certain electronic components from the electrical works, etc. Its employment and wages are predetermined. But, although wages are paid in cash, the actual ability to employ cash for purchases is often constrained by the second element frequently found in a centrally planned-economy, namely, rationing or its equivalent, standing in queues for limited quantities of goods. The consequences, as one might readily anticipate, are huge shortages of products that consumers desire, and are not produced in adequate supplies by the state orders, or huge surpluses of goods which, while produced, are not wanted by the populace I do not suspect that shoe stores ended up with an excess of left-footed shoes, but I am not fully convinced One might think that the planning authorities should be able to adjust to these distortions. They try But centrally planned economies face fundamental handicaps in making such adjustments. They do not have access to the immediate signals of price changes that so effectively clear markets in capitalist countries addition, individual enterprises have no incentive to respond to shortages or oversupply since their only obligation is to fulfil their part of the "plan," while In - 4economic planners are generally insulated from the demands of consumers by totalitarian political systems. Finally, to adjust means to move resources, people, equipment, and factories from producing one good to producing another This profoundly offends the underlying culture of a centrally planned economy, namely stability The ideal state of affairs for such an economy is one in which there is continuous production of the same type of goods, of the same quality, of the same design, obediently purchased in repetitive quantities, with cash wages backed by rationing coupons Innovation, new ideas, new products, and altered specifications cannot readily be accommodated in such an environment Irideed, the extent to which such changes occurred in the centrally planned edonomies of Eastern Europe seemed invariably to result from the overseers of the state orders endeavoring to replicate changes in western market economies. One would presume, however, that had no such market-based economies existed side-by-side with the centrally planned ones, that few changes from the old ways of doing things would have been implemented. That these economies were highly inefficient is best illustrated by the fact that energy consumed per unit of output was as much as five to seven times higher in Eastern Europe and the former Soviet Union than in the West. Moreover the exceptionally large amount of resources devoted to capital investment, without contributing to the productive capacity of these economies, suggests that these resources were largely wasted - 5In addition, such gaps in efficiency actually understate the gap in performance because they fail to take into account the impact of industrial activity on the environment. The market economies of the West have expended resources to minimize the adverse impact of industrial activity on the environment and thereby lowered their net output No such resource allocation was made in the Soviet bloc, and the cumulative effect of this neglect is appalling In sharp contrast to the quasi-permanence of centrally planned economies, capitalist market economies are driven by what Professor Joseph Schumpeter, a number of decades ago, called "creative destruction " By this he meant ttie continuous obsolescence and abandonment of goods and services, replaced by newer ways of doing things, newer products, and novel engineering and architectural insights The result has been an economy of continuous retirement of factories and equipment and a reshuffling of workers to new and different activities. Indeed, what is not fully understood about the American economy is the extent to which it "churns" as new activities and new jobs continuously displace older ones Indeed, it is nothing short of startling to realize that in the United States approximately 400,000 workers a week lose their jobs matched normally by a slightly higher figure of newly created job openings Such job turnover is facilitated by the extraordinarily large number of new small businesses that come into existence every week and month, offset by a comparable number of establishments that fail, down-size through mergers, or are otherwise abandoned Market economies in that sense are continuously renewing -6themselves. Innovation, risk taking, and competition are the driving forces that propel standards of living progressively higher What drives this innovative process, as I indicated earlier, is a whole infrastructure of market institutions. Until the Berlin Wall was breached, and the need to develop market economies out of the rubble of central planning became apparent, little thought had been given to this critical institutional infrastructure by the economics profession It is certainly apparent from the recent experiences in Russia, and elsewhere in Eastern Europe, that the mere elimination of central planning does not in itself automatically create a market economy Nonetheless, you do get something akin to it in that black markets replicate much of what seemingly goes on in a market economy But there are really quite fundamental differences. Black markets, by definition, are not supported by the rule of law There are no property rights in such a market, that is, in the formal sense, the right to own and dispose of property protected by the enforcement power of the state There is no law of contracts or bankruptcy, or judicial review and determination again enforced by the state, the essential ingredients of a market economy A formal legal structure, which defines and protects property rights and trade through the laws of contract and bankruptcy, must preexist before a viable sophisticated market economy can emerge from the remnants of a centrally planned one Even now many potential investors in these newly emerging economies fear that a signed contract, which has the force of law and is backed - 7by police powers in the West, is nothing more than an autograph in some economies of the East In addition to a legal structure, a functioning market economy also requires a number of business professions, professions that have no purpose and, hence, no existence in a centrally planned system I speak of accountants, auditors, and marketing specialists, all those professions whose activities are an integral part of the mechanism of production and distribution in a market economy, functions which are accomplished by state orders, rationing, and queuing in a centrally planned economy. The effects of accounting, for example, or lack thereof in the old Soviet Union, is really quite instructive. A machine or a facility in the old Soviet Union was generally continued in operation until it literally broke down Thus, it is not very much of a surprise to see on collective farms tractors that look as though they hark back to the 1920s. What accounting in a market economy does, if perhaps in a somewhat crude form, is to estimate economic depreciation of an existing facility such that, when the net book value of a facility approaches zero, its capability of adding value to the production process also approaches zero This is a signal that such equipment should be replaced with a newer version What constitutes the state of economic depreciation, itself, is of course continually changing. Obsolescence is a relative term But no matter what principle of accounting is applied in a market economy, one rarely, if ever, finds 50-year-old facilities still functioning But such facilities were widespread in the - 8old Soviet Union. The sophisticated auditing procedures that have evolved over the years fine tune our accounting procedures to improve the basis of decision making that in a market economy replaces central planning The profession of marketing endeavors to ascertain the multitude of choices that consumers and business make on a day-by-day basis and which, as a consequence, contribute to a system of price signals that drive production and distribution in a market economy In a centrally planned economy this function is crudely accomplished, if at all, by the political hierarchy who substitute their judgments of what goods are valuable for those of their fellow citizens It is, thus, no accident that in-defense and military activities the shortfall in the performance of centrally planned economies was far less than in civilian activities, relative to their counterparts in market systems. Finally, the most important difference between market and centrally planned systems, is the role played by banking and finance In a centrally planned system, banking and finance play a decidedly minor role. Since the production and distribution of goods and services is essentially driven by state orders and rationing, finance is little more than record keeping. While there are pro-forma payment transfers among state-owned enterprises, few if any actions are fundamentally driven by them Payment arrears, or even defaults, are largely irrelevant in the sense that they are essentially transactions among enterprises owned by the same entity, that is, the state. There are no credit standards, no interest rate risk, no market value changes, that - 9is, none of the key financial signals that determine who gets credit, and who does not, and hence who produces what, and sells to whom, in a market economy As a consequence, the central planning systems of the old Soviet Union and their Eastern European satellites usually consisted of a single bank and a savings bank system, the main purpose of which was to hold the savings deposits of the populace There were of necessity more sophisticated institutions to finance international trade and payments. Nonetheless, the domestic financial structures were primitive. Indeed, non-cash monetary instruments, important means of payment in most market economies, barely existed Clearance of payments, which in market economies are either instantaneous or. at most, take several days, takes weeks or months. The basic reason, of course, is that it didn't matter. Few decisions in the centrally planned economies were affected by the lack of a developed financial system The evident primitiveness of the financial system and its irrelevancy in a centrally planned economy creates a truly important insight into how crucial in the production and distribution of goods and services are the sophisticated financial institutions and instruments in the West. To repeat, the presumption that if you eliminate the infrastructure of central planning and free prices, wages, capital movements, etc market will automatically develop overnight is dubious that a free Scrapping the central planning system is obviously a necessary condition of the evolving of a market system. But unless there are rudimentary institutions that can be rapidly converted - 10 to effective market-based structures that can facilitate production and distribution, the transition will be significantly stretched out. Even more deep-seated than the specific market institutions, the law of contracts, bankruptcy law, property rights, the disciplines of accounting, auditing, and marketing, are the attitudes of people: in the most profound sense, the culture How do people deal with one another? What is the implicit premise of the exchange of goods and services in various different types of economic systems? How do education and ideology interrelate? We have learned more about these inculcated differences as the old centrally planned economies break down and, accordingly, how much of our culture is developed and not solely the consequences of human nature In a market economy, youngsters learn the workings of free trade and exchange very early. What are the appropriate attitudes among individuals in, for example, an exchange of money for goods at the grocer or the drugstore? Presumptively there is a status of equality that exists between the purveyor of goods and the purchaser in a market economy. There is in most instances due respect, mutually accorded The customers rely on their suppliers livelihoods rest on their customers Sellers' In a centrally planned economy, by distinction, the job of the purveyor of goods does not depend on the sanction of the consumer And, indeed, for those of us who have been exposed to waiters and clerks in restaurants and retail establishments in the old Soviet Union, this behavior pattern is strikingly obvious -11 The differing attitudes and views are carried from generation to generation through family value and education systems Hence, the process of full transition will obviously be slow. It will be especially difficult for economic reasons as well. "Creative destruction" in an advanced market economy is gradual There are rarely huge discontinuities. But the centrally planned economies are frozen in time They reflect an earlier age. I suspect that the output of Czechoslovakia in say 1988, could have been competitive in the western markets of say 1958, but not later. But rebuilding a modern competitive market economy from a 1958 base is a disruptive, expensive, and time-consuming task Another difficult aspect of adjustment in Eastern Europe and the former Soviet Union will be overcoming distortions in the location of economic activity. Marxist ideology has always presumed competition to be destructive and, hence, the centrally planned economies of the Soviet bloc organized their production through state monopolies overestimate economies of scale Moreover, Soviet planners tended to As a result, the production of most products was highly concentrated geographically, often in huge "one-industry" towns Soviet planners also tried to promote economic development in the many nonRussian regions in order to offset centrifugal forces ever-present in Moscow's multi-ethnic empire. Whole industries were distributed across the Soviet bloc with little regard to transportation costs or the other factors that determine industrial location in market economies - 12 Because of these policies, the regional economies of the former Soviet bloc are inter-dependent to an abnormal degree. This, in turn, has meant that the disruptions to inter-regional trade that have, inevitability, accompanied the break-up of the Soviet economic system have been very costly Given the difficulties of the transition, one almost would like to move the populations of these countries to a vacation hotel for a few years while the old system is torn down and rebuilt from scratch. Reformers, of course, have no such luxury The adjustments as we can readily observe are slow and socially wrenching But there is no alternative Fortunately, the peoples of the former Soviet Union and those of Central Europe appear to understand this The percent who would truly like to resurrect the old regimes is small Up to this point I have spoken exclusively about the economic benefits of a market system But there is an important link between economic and political systems. It is no accident that real democracy developed in the part of Europe that had a market-oriented economic system In fact, this is merely one example of a general rule. The fact that virtually all real democracies have liberal, capitalist economic systems suggests that such an economic system may well be a necessary, although clearly not a sufficient, condition for the development of democracy When too much economic power is concentrated in the hands of the government, the governers' self interests tend to dominate the interests of its citizens - 13 We should remember the most important task of Eastern Europe and the former Soviet Union today is not economic reconstruction, it is the establishment of democratic political systems that respect and protect individual rights Market-oriented economic systems should be promoted as much because they are the economic system that is most compatible with democracy, as because of its unquestioned economic superiority If successful, the changes taking place in Eastern Europe and the former Soviet Union today will benefit the West in many ways The full integration of the peoples and natural resources of the former Soviet bloc into the global market-based trading system creates opportunities for investment and global economic growth that are truly awesome. Most importantly, the spread of liberal democracy to this region will, in the long run, make our world safer Eastern Europe and the former Soviet Union's transition to democratic market economies will doubtless be both difficult and slow, but the rewards are patently worth waiting for
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