metadata: authors: 0: author: Hillman, Arye L.
1: author: Schnytzer, Adi
count: Europe and Central Asia
docna: 0: docna: Creating the reform resistant dependent
            economy : the CMEA international trading relationship
docty: Policy Research Working Paper
subtopic: State Owned Enterprise Reform,Public Sector Administrative & Civil
            Service Reform,International Trade and Trade Rules,Trade and Services,Macroeconomic Management,Energy and Mining,Democratic Government,Economics and Finance of Public
            Institution Development,Public Sector Administrative and Civil
            Service Reform,De Facto Governments
teratopic: Environment,Macroeconomics and Economic Growth,International Economics and Trade
abstracts: cdata!: In this report the authors analyze the
            CMEA trading relationship using the standard concepts of 1)
            specialization in accord with comparative advantage, and 2)
            the incentives to resist trade liberalization because of
            rents accruing to industry specific factors of production
            (including job security that sustains hidden unemployment).
            These concepts permit a demonstration of how the CMEA system
            of international trade sustained a dependence relationship
            between the Eastern European economies and the Soviet Union
            that inhibited market oriented liberalization and
            adjustment. The authors focus on Poland and Hungary and in
            describing and analyzing the implications of CMEA trading
            relationship, they use conceptions and models that are well
            known from the theory of international trade and the theory
            of the firm. In conclusion, abolition of the CMEA trading
            system and a change to trade at world prices eliminates the
            terms of trade advantage of the Eastern European economies.
            The terms of trade loss and the writing down of the value of
            the CMEA capital stock are not independent or additive costs
            of the end of the CMEA system of international trade, but
            will have been linked via capitalization of the preferential
            terms of trade into the value of the CMEA transaction
            specific capital.
repnme: repnme: Creating the reform resistant dependent
            economy : the CMEA international trading relationship
display_title: Creating the reform resistant
            dependent economy : the CMEA international trading relationship
listing_relative_url: /research/1990/09/700181/creating-reform-resistant-dependent-economy-cmea-international-trading-relationship
topicv3: State Owned Enterprises m1326323 721,Trade m1326924 698,Trade in Services m1326928 780,Trade Balance m1327679 1136,Iron m1503514 2931
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Environment,Macroeconomics and Economic Growth,International Economics and Trade
no_of_pages: 33
model_extractions: **|Policy, Research, and External Affairs|**

# **Socialist Economies**

WPS 505 is

- - This paper a product of the Socialist Economies Reform Unit, Country Economics Department part of a larger effort in PRE to investigate how the legacy of the past institutional arrangements in the Eastern European economies affects restructuring and liberalization opportunities. Copies are available free from the World Bank, 1818 H Street NW, Washington DC 20433. Please contact CECSE staff, extension 37176 (28 pages with tables).

the socialist political monopoly ended in 1990, however, "market socialism" had yielded neither a westem-oriented nor a westem-type market economic system.

In analyzing the framework for intemational trade of the Eastern European socialist economies - the Council of Mutual Economic - Assistance (CMEA) Hillman and Schnytzer depart from the traditional focus on distortions in socialist intemational trade.

CMEA trade was intimately linked to the failure of reform to take hold in Poland, to the iack of progress under Hungarian market socialism, and to the other Eastern European economies' lack of interest in western-oriented reform. Once the dependence relation was established, the costs of disengaging from the CMEA were high, as Albania exemplified.

Instead they analyze the CMEA trading relationship using the standard concepts of (I) specialization in accord with comparative adva-vage, and (2) the incentives to resist trade liberalization (or any change) because of rents accruing to industry-specific factors of production (including job security that sustains hidden unemployment).

Eastern European economies benefited in the 1980s from preferential terms of trade that provided an implicit subsidy from the Soviet Union. But the Soviet Union also provided "hard" goods potentially saleable for hard currency (oil, natural gas, and raw materials) and took in exchange "soft" goods (machinery, equipment, etc.) that were not of sufficient quality to be marketable in the west (if at all) at prices that would recover costs. This trading pattem made the. capital of the Eastem European enterprise _transaction-specific:_ the capital could produce goods that were acceptable, _specifically,_ for CMEA _transactions_ only. The consequence was the very dependence and potential for opportunism in CMEA trade that in the West is avoided by intemalizing transactions within the firm. Reflecting the prior dependence relationship and enterprise incentives to resist westem orientation, the abolition of the CMEA trading system and the transition to world prices will impose a substantial terms-of-trade loss on the Eastern European economies, and the integration of CMEA and westem markets will undermine the value of domestic CMEA transactionspecific capital stock of the enterprises.

Hillman and Schnytzer describe how CMEA trade was negotiated, and demonstrate that the CMEA system of trade sustained a dependency relationship between the Eastem European economies and the Soviet Union that inhibited market-oriented liberalization and adjustment.

They focus particularly on Poland and Hungary, wherein during the 1970s and 1980s governments sought to introduce market-oriented reform. The Polish government designed several programs to "rationalize" domestic economic activity and in the early 1970s made a concerted effort to upgrade Polish industry using imported westem technology and capital. But the Polish ecoromy did not depart much from the centrally planned socialist system and remained firmly embedded in the CMEA.

in principle, central planning ended in Hungary in 1968, and the system of "market socialism" was introduced to encourage a decentralized domestic market cconomy and a western orientation in intemational trade. When The PRE Working Paper Serics disseminates the findings of work under way in the Bank's Policy, Rescarch, and Extemal AffairsComplex. Anobjectiveof the sCrics is to get thcsefindingsoutquickly, even if presentations areless than fullypolished. The findings, interpretations, and conclusions in these papers do not necessarily represent official Bank policy.

Produced by the PRE Dissemination Center
# Creating the Reform-Resistant Dependent Economy: The CMEA Intemational Trading Relationship

by Arye L. Hillman and Adi Schnytzer

# Table of Contents

<!-- Start of picture text --> I. Introduction 1<br>II. Determination of CMEA International Trade 4<br>Ill. Prior Perspectives on CMEA Trade 6<br>A. Irrationality 6<br>B. Empirical Studies 7<br>C. CMEA as a Customs Union 8<br>D. CMEA Terms-of-Trade 9<br>IV. Comparative Advar:tage and Sov;et Economic Rationality 10<br>V. Market Segmentation: Soft Goods and Quality 12<br>VI. Domestic Rerorm 13<br>A. Poland 14<br>B. Hungary 15<br>C. Albania 16<br>VIl. Transaction-Specific Capital and CMEA 17<br>Vil. Rents and Resistance to Reform 19<br>IX. Enterprise Opportunistic Behavior 20<br>X. Concluding Remarks 21<br>References 23<br><!-- End of picture text -->
# **Arye L. Hillman and Adi ISDnytzer**

# **I. INTRODUCTION**

Suldies of liberalization and adjustment in Eastern European socialist economies have been concerned with the framework for international trade that was provided by the Council of Mutual Economic Assistance (the CMEA'), and also the means whereby attempts were made to introduce market-oriented change into the economic systems of CMEA members. CMEA trade and domestic reform have for the most part been investigated as distinct phenomena. The one interconnection that was given some emphasis linked domestic resource allocation to discrepancies between domestic and world prices. This perceived link between the socialist economies' international trade and domestic economic activity stressed the distorted nature of domestic prices in the socialist economies, and pointed to the allocative inefficiency due to distortions that arose because of differences between domestic prices and world-market or appropriate shadow prices. Policy implications followed. Efficiency was proposed **to** require reforms that would permit market allocation in conjunction with unified exchange rates and price rationalization to be achieved by liberalization that would equalize domestic and world prices.<sup>2</sup> In this paper, we depart from this distortions-oriented focus on socialist international trade and domestic reform. The CMEA trading relationship is analyzed using the standard conceptions of

**-We** thank Csaba Csaki, David Tarr, Tamas Toth, and Erno Zalai for discussions on the topic of this paper. 'The CMEA, which provided the institutional framework for the international trade of the socialist economies, was founded in 1949. For a description of CMEA organizational principles and the pattern of international trade, see Schrenk (1990). Schrenk also considers scenarios for change.

'This has been the standard view, influenced by the 'distortions' and second-best literature of international economics. For perceptions of the reform process, see amongst others Adam (1989), Fallenbuchl (1986), Marer (1986), Marer and Van Veen (1987), Brada and Dobozi (1988), and Wolf (1988).
2 international trade theory of (i) specialization according to comparative advantage, and (ii) impediments to :iberalization that derive from incentives to resist change because of rents accruing to industry-specific factors of production. These conceptions permit a demonstration of how the CMEA system of international trade sustained a dependence relationship between the Eastern European economnies and the Soviet Union that inhibited market-oriented liberalization and adjustment.

As methodology for investigation of CMEA, we shall not assume a representative Eastern European economy, but rather draw upon the experiences of the CMEA economies. We shall in particular focus on Poland and Hungary, where during the period of the 1970s and 1980s there were expressed intentions and attempts at reform and westem-oriented change. Prior to the political and economic changes of 1989 and 1990, the Polish government expressed reform intentions in numerous programs that would "rationalize" domestic economic activity, and in the early 1970s a concerted effort was made to upgrade Polish industry using imported western technology and capital; however, contrary to intentions, the Polish economy did not depart substantially from the socialist centrally planned system and remained firmly embedded in CMEA. In Hungary, central planning in principle ceased in 1968 and under the system of "market socialism" that replaced central planning policies were introduced that sought to encourage the development of a decentralized domestic market economy and a western orientation in international trade. However, by the end of socialist political monopoly in 1990, Hungarian 'market socialism" had yielded neither a western-oriented nor a western-type market economic system. We shall show how CMEA trade was intimately linked tc the failure of reform to take ground in Poland, to the lack of progress under Hungarian "market socialism", and to the disinterest in western-oriented reform in other Eastern European economies, because of the cost of disengagmnent from CMEA and the effect on particular agents' incomes of disengagement. The costs of disengagement are exemplified by one experience of disengagement -Albania- that was the forced consequeilce of ideological dispute.
3 CMEA has been a topic of concern in another dimension,<sup>because of the subsidization of the</sup> Eastern European econoraies by the Soviet Union via the<sup>terms of trade for CMEA exchange.3</sup> The beneficiacies of these subsidies have been portrayed<sup>at the aggregate level as "countries", or as the</sup> dominant governing party that exercised political monopoly.<sup>The subsidies via the terms of trade enter</sup> into our framework at the level of individual incentives<sup>within the socialist enterprises. The terms of</sup> trade are linked to rents accruing to enterprises'<sup>CMEA capital, and thereby to incentives that bear</sup> upon the success of reform programs.

In describing and analyzing the implications of the CMEA<sup>trading relationship, we shall employ</sup> conceptions and models that are well-known from the<sup>theory of international trade and the theory of the</sup> firm. We have no reason to duplicate familiar formalizations.<sup>The framework of the Ricardo-Virier or</sup> specific-factors model of international trade establishes<sup>the presence of industry or enterprise-spFxific</sup> rents, values of which are influenced by the volume<sup>and terms of trade;4and the notion of transaction-</sup> specific capital in the theory of the western firm establishes<sup>why certain transactions are internal to the</sup> firm rather than conducted via the market.<sup>3</sup> We shall be obliged to explain how due to imperfect monitoring and imprecisely specified property rights<sup>rents arose at the enterprise level when</sup><sup>_de jure_</sup> residual claimancy resided with the state; and how rents<sup>were dissipated within the enterprise to yield</sup> gains when enterprises incurred financial losses.

CMEA trade was confidential, because of bilateral strategic<sup>bargaining in the determination of</sup> prices and quantities. The manner in which prices and<sup>quantities were established provides a guide to</sup> identification of the appropriate model of CMEA trade.<sup>We shall accordingly begin with a description</sup> of how CMEA trade was determined. This is followed by a<sup>consideration of the evidence on the past</sup> 5For evidence on subsidization, see Marrese and Vanous (1983a, 1983b); on the prior claims<sup>that CMEA exchange</sup> was disadvantageous to the Eastern European economies, see the interchange<sup>between Menderson (1959) and</sup> Holzman (1962). Definitively with repect to Hungary, January 1991 marks the end of deviation between<sup>CMEA</sup> terms of trade and world prices. 'See Jones (1971), Mayer (1974). 'See Williamson (1983, 1985).
4 role of comparative advantage and national specializaiion in socialist international trade. Contrary to perceptions of irrationality in CMEA trade, a role for specialization can be identified. The transaction-specificity of enterprises' factors of production associated with the pattern of CMEA specialization is shown to nave provided the basis for the creation of reform-resistant dependent economies in Eastern Europe.

There is some perhaps some little irony in the ma,nner whereby the dependency relation was established and sustained. Whereas in the west transaction-specific capital underlies the incentive to avoid market transactions, in the case of CMEA, international trade was based on exchange associated with such capital, creating the very dependence and potential for opportunism that internalization of transactions within Lhe western firm seeks to avoid.

# IH. DETERMINATION OF CMEA INTERNATIONAL TRADE

An analysis of the consequences of the CMEA trading relationship requires an understanding of how CMFA trade was conducted.6 Although in principle CMEA was a multilateral trade and payments arrangement, CMEA exchange took the form of bilaterally negotiated trade. Trade was planned to be bilaterally balanced with "payment" via a clearing system, in distinction to the decentralized multilateral market exchange in convertible currencies of western international trade. The determination of CMEA trade began with negotiations regarding "harmonization" of five-year plans (5YPs) of the individual CMEA economies: Hungary was a special case, in that after 1968 no central plan was binding on enterprises. Such little harmonization as there was in practice, took place two or three years prior to the first year of the upcoming SYP. The structure, volume, and balance of trade for basic commodity groups was determined via an iterative bargaining process during this harmonization 6For prior discussions and interpretations of the evidence on CMEA prices include Hewett (1974) and Van Brabant (1987). Toth (1988) and Zalai (1988) provide the sources for the account in this section.
**_5_**

stage.

Socialist international trade was therefore not directed at satisfying contemporaneous 'needs" that could not be met by the domestic plan. InternatV.nal trade commitments were contemporaneous with the plan.

The sequencing of bilateral negotiations allowed the Soviet Union a preeminent position: each Eastern European country undertook negotiations with the Soviet Union before entering into negotiations with other CMEA trading partners, and the Soviet Union was the dominant trading partner for each country.

Until 1976, the prices at which CMEA trade took place were based on the average of world price-s over the previous five years. Prices, once computed, remained fixed throughout the 5YP period. Subsequen **t** o 1976, prices were based on a moving average of past prices. However, since the moving average was calculated for five years, this represented no change compared with the earlier procedure. Price determination rules for raw materials were directly established with reference to world markets. For example, for oil, the price of a particular grade from Rotterdam was that prevailing at Rotterdam, plus half the cost of transportation from that port to the importing CMEA country. Price determination of manufactured goods entailed the prospective buyer presenting the seller with a price quotation from a western supplier who could offer a similar product. Negotiations at the ....nisterial level then determined price adjustments warranted by quality differences between the western and CMEA good.

The prices thus determined were however but starting points or "guidelines" for more detailed negotiations that took place in the course of annual foreign trade planning, at which stage negotiations resulted in further amendments. Thus, in the final outcome, with the exception of fuels and raw materials, there was often little systematic relationship between the pricing guidelines established in the initial negotiations and the prices at which CMEA exchange took place.

The quantities of goods to be traded were negotiated on the basis of the disaggragated output
6 tar,ets of the negotiating countries 5YP's, prior to each country's commencement of its domestic annual planning. Different teams of negotiators attended to the physical flow of diffeient commodity groups. The "importance" of a commodity determined the level of seniority of the foreign trade ministry officials who undertook the negotiations. Outcomes of negotiations were collated on a daily basis to ensure approximate adherence to the SYP targets and a planned bilateral zero net balance of trade between the negotiating countries. No adjustments were made for quality differences.

At least for Hungary, the one-year protocols in general represented between 80 and 90 percent fulfillment of the 5YP trading precommitments. The lack of perfect correspondence in general reflected the diversion of prenegotiated exports from a CMEA trading partner to hard currency markets. The Soviet Union as supplier of fuels and minerals confronted ready alternative hard-currency markets for its predesignated CMEA exports, and was principally responsible for deviations from the prespecified trading commitments. It was usually evident by the third year of the plan if prenegotiated cYP international-trade quantities were not to be honored. The transferable ruble, which was the CMEA unit of account, was transferable neither over time nor between countries. Hence, there were limitations on the recourse by trading partners in seeking compensation for failure to comply with prenegotiated supply commitments.

# m. PRIOR **PERSPECTIVES ON CMEA TRADE**

## A. Irrationality

In prior perceptions of CMEA trade, there has been an emphasis on irrationality in the system of exchange. A typical western international economics textbook rendition of CMEA trade would stress the distortions and inefficiencies due to absence of a market mechanism, and would sut,gest that international trade under central planning resulted in a neglect of comparati; e advantage. For example, Caves and Jones (1985) propose that "..it is surprising if East-West trade achieves any rationality in
7 relation to the basic forces of comparative advantage." Wilfred Ethier (1988, p. 539) observes: "..in centrally planned economics domestic relative prices do not reflect opportunity costs and do not guide the actions of foreign trade organizations."

# B. **Empirical** Studies

These textbook observations of CMEA trade as lacking economic rau-)nality reflect a theme that recurs quite generally in the literature. Yet empirical investigations of the international trade of the dominant country in the CMEA - the Soviet Union - have provided hin.s of regard for comparative advantage. Rosefielde (1971, 1974) found that the pattern of Soviet trade during the years 1955-1968 was consistent with the predictions of the Heckscher-Ohlin Theorem. If Soviet trade did reflect comparative advantage, this could not have been the consequence of a decentralized competitive allocative market mechanism. It was Rosefielde's view that his empirical findings reflected rational economic calculation, if not in accord with principles of market valuation. He speculated: 'Whatever special ideological forces may be at work in determining the composition of Soviet trade with the socialist bloc, they are seemingly subordinate to the dictates of pure theory.. .Several possibilities can be entertained ranging from perfect planning to the semi-divine intervention of Stalin's not too invisible hand. Attention is focused here on the least implausible of a wide variety of implausible explanations.. .that the Soviet results are the outcome of comparative advantage, labor value, accounting price calculations".

There is further empirical evidence suggesting that CMEA trade may have been "rational". In a study encompassing the decade 1963-1973, Joseph Pelzman (1980) observed the presence of sustained systematic relationships in trade patterns. Soviet exports to Eastern Europe were, for most product groups, determined by Eastern European CMEA demaads for intermediate inputs to facilitate industrialization programs, whereas Soviet CMEA imports for the most part reflected supply capabilities in Eastern Europe. Pelzman also investigated the scope of intra-industry trade between 1958 and 1973 (Pelzman, 1978), shedding light on the extent to which such trade responded to economies of scale. Two sectors, machinery and equipment and chemicals, exhibited significant and growing levels of
8

# intra-industry trade during this period. Pelzman's interpretaticn of the data was that:

In the early stages of their development (late 1940s and 1950s), the East European economies were dependent on the Soviet Union to purchase the machinery output of their new heavy industries in exchange for basic raw materials. In the early and mid 1960s the Soviet Union recognized that this composition of trade and specialization entailed a sizable loss to itself. As a partial corrective measure the Soviet Union initiated a move to restrict the exchange of raw materials for East European machinery unless the East Europeans were willing to supply the Soviet Union with semi-manufactures, consumer goods and food stuffs. Tn.; Soviet move, while gradual, is illustrated in the growth of intra-industry trade in the machinery and equipment sector.

There is here "rationality" expressed in the Soviet quest to establish a systematic basis for the direcdtion of CMEA trade. Pelzman viewed his empirical results as further proof of Soviet intentions to base CMEA trade on specialization and comparative advantage, vHii the Soviet Union as supplier of raw materials and energy and as importer of East European machinery and engineering equipment.

The pattern of trade observed by Pe:tzman continued throughout the 1980s. Table 1 shc,ws the systematic elements in the trading relationship between the Soviet Union and the six Eastern European CMEA countries. Soviet exports were principally fuels, mineral raw materials and metals, in return for which the Eastern European economies provided manufactured goods.

# C. **CMEA** as a Customs Union

If there are systematic elements of "rationality" associated with CMEA exchange, can CMEA be described as a customs union or free-trade area in the western sense of such trading organizations? There have been suggestions that the customs-union model is appropriate.<sup>7</sup> Customs-union theory portrays economies with a common external trade policy. Prices for CMEA exchange were however the outcomes of bilateral negotiations in the manner which we have d^-cribed, and although formal CMEA pricing rules provided a starting point for bilateral bargaining, trade flows and prices for 7 Thus, for example, Pelzman (1977) motivated his empirical investigations of CMEA trade creation and trade diversion with the proposal that CMEA could be regarded as a customs union because its annual bilateral negotiations could be considered a proxy for the accepted cotnmon external tariff. The view of CMEA as a customs union has been developed by Holzman (1974, 1976, 1985) and Bergson (1980).
9 different commodities weie nregotiated separateiy. Given the ex-ante balanced-trade constraint, actual prices also deviated fronr. the initial price offers at which bilateral bargaining was initiated. **Hence** different prices could prevail for the same goods in different bilateral CMEA exchanges.!

Nor does sustoms-union theory encvmpass the strategic asymmetries associated with **CMEA** trade. The theory assumes voluntary market exchange, but voluntariness did not apply **without** reservation to CMEA trade. CMEA obligations imposed upon the Eastern European economies the requirement of a mandatory minimum volume of trade with the Soviet Union.

The CMEA did have the one attribute of a customs union that it constituted a market-segmenting discriminatory trading arrangement, with terms of trade that differed from world prices.

# D. **CMEA Term-uf-Trade**

Studies initiated by Marrese and Vanous (1983a, 1983b) reveal that via the CMEA **term of trade the** Soviet Union subsidized the Eastern European economies.9 The subsidies derived from the Soviet Union's selling fuel anid non-food raw materials in exchange for manufactured goods at relative prices more favorable to CMEA countries than prevailing world-marke **t** erms of trade.

7be Marrese-Vanous calculations have been subject to qualifications anc. reservations (Brada, 1985, 1988; Holzman, 1985; Desai, 1986), and have been supplemented by other estimates. Poznanski (1988) has downgraded the Marrese-Vanous estimate of the Soviet transfer over the period 1972-1984 and finds evidence of periodic shifts in the direction of transfer; while Marrese and Wittenberg (1989) have updated the computation of the implicit terms-of-trade subsidy for Hungary.

Regardless of the precise magnitude, there is a consensus that the Soviet Union subsidized The non-uniformity of prices is also evidenced by the long-term contracts for fuel supplies signed by the Soviet Union and both the **GDR** and Czechoslovakia outside the framework of the normal CMEA arrangement, and the aid provided to Poland by the Soviet Union in the wake of the Solidarity crisis. 9Marrese and Vanous (1983) estimate the value of the subsidy between 1960 and 1980 to have been $87.2 billion. **$75.5** billion of the transfer was estimated to have taken place during 1971-1980.
10 Eastern Europe via preferential CMEA terms of trade. An analysik of CMEA trade that professes to be general would incorporate and explain the subsidies provided via the terms of trade.

Marrese and Vanous suggest national-security objectives as the motive for the Soviet subsidies; this view would have the Soviet Union providing preferential terms of trade as compensation to **the** East European countr,oSs for their contribution to Soviet national security. The compensation is proposed to have been "covert", in that it was known to the CMEA governments, but not to the population **at** large. The East European population was "worse off due to its association with the Soviet Union", but not "the East European government that shared the preferences of the Soviet government to a greater extent than its East European population". The population was worse off, _inter alia,_ because of an imposed economic system and development strategy. But the preferential CMEA terms of trade rewarded the loyal pk.rties of Eastern Europe.

We shall present an alternative explanation of whom the preferential terms of trade rewarded. But we require as background an account **of** .he historical role of comparative advantage in CMEA trade.

# **IV. COMPARATIVE** ADVANTAGE **AND SOVIET ECONOMIC RATIONALITY**

The Stalinist model of economic development associated economic progress with parallel industrialization along balanced growth paths.'" Little role was assigned to the classical notion of comparative advantage. Consistently with the Stalinist model, CMEA was not regarded as a ^ustoms union, but precisely as a "council for mutual economic assistwnce", the function of which was to coordinate and provide mutual assistance in achieving the objective of balanced industrialization." In the post-Stalinist period, the model changed. Comparative advantage gained acceptance as

**'°See** Schnytzer (1982). "On the CMEA in its formative years, see Kaser (1967).
a guiding principle, implying a need for specialization and reliance on international exchange. The Soviet Union sought at various times since the second half of the Krushchev era to establish a supra-national CMEA planning body that would guide member countries into specific patterns of specialization in domestic production, but this was successfully resisted by the Eastern Europeans.

The initial Soviet failure was in Romania, although Hungary and Poland also rejected Krushchev's proposals for supra-national planning. In 1957, the CMEA was in its first wave of Soviet-directed specialization in engineering. Romania was producing a type of truck not allotted to it. As a consequence, the Soviet Union threatened to ce)ase all steel deliveries to Romania - not merely the intermediate inputs necessary for production of the truck. The next and by far the most famous conflict over comparative advantage and production specialization concerned the Galati steel mill. In late 1960, the Soviets agreed to assist the Romanians with the steel project by providing machinery and equipment valued at $500 million at contemporary prices, to be delivered between 1961 and 1968. However, a policy decision to foster international socialist specialization was made at the 22nd CPSU Congress in October 1961. Romanian comparative advantage was perceived not to be in steel, and the Romanians were pressured by both the Soviets and the East Germans to abandon the steel project. The Romanians refused, thereby giving rise to a conflict between adherence to the principles of the Stalinist development strategy and international socialist specialization according to perceived comparative advantage. Romania's chief planner, Gaston-Marin justified Romania's position as consistent with orthodox socialist principles of development, declaring at the November-December 1961 plenum of the central committee: "Our Party has always resolutely opposed and has always combatted from a Marxist-Leninist standpoint those erroneous "theories" which while defending the keeping of proportions between branches of the national economy and the priority development of a heavy industry on the scale of the whole socialist camp rather than within the framework of the individual socialist country, in fact deny the necessity of creating the technical and material base of socialism and present in a distorted manner the principles of specialization and cooperation within the framework of the socialist international division of labor." By November 1962, Romania was placing orders for steel machinery in the West. What had begun as
12 an economic dispute took on political dimensions,<sup>initiating the Romanian "independent line".'2</sup> However, although the Soviets failed directlv<sup>to dictate a pattern of CMEA comparative</sup> advantage and international specialization, specialization<sup>did nevertheless evolve. Tendencies towards</sup> specialization that entered CMEA exchange<sup>were subject to the influence of two characteristic features</sup> of central planning, static technology and the<sup>absence of quality competition.</sup>

# V. MARKET SEGMENTATION: SOFT GOODS<sup>AND QUALITY</sup>

In the traditional, centralized classic Soviet model,<sup>growth was based on planning in terms of</sup> physical output targets. In this scheme, prices had<sup>a control rather than allocative function. In the quest</sup> to ensure plan fulfillment, enterprise managers<sup>were offered bonuses tied exclusively to the physical</sup> quantities produced. Thus, for the manager, there<sup>was no incentive to be concerned with output-mix</sup> or quality. Incentive schemes designed by planners<sup>did seek to substitute for quality competition in a</sup> western market economy. However, little success<sup>was achieved in establishing and maintaining quality</sup> standards.'<sup>3</sup> The quality differentials segmented<sup>CMEA and western-CMEA markets. Within CMEA,</sup> low quality goods were purchased by domestic<sup>consumers for want of an alternative, and were supplied</sup> to foreign consumers via CMEA trade. For these<sup>low quality or "soft" goods the unit cost of production</sup> exceeded the price obtainable on the world market,<sup>if at all western consumers could be induced to forgo</sup> the higher quality western substitute. In direct competition<sup>with western goods, cost differences could</sup> not compensate for the inferior CMEA quality. Market<sup>segmentation became instrumental in permitting</sup> the soft goods to survive.

'<sup>2</sup> For further discussion, see Wiles (1968).

'<sup>3</sup> As a recent example, a Central Institute of Quality<sup>Control was established in the Soviet Union in 1987. An</sup> enterprise's output was required to pass inspection<sup>by the Institute before counting towards plan fulfillment.</sup> Products that did not meet requisite standards were<sup>not delivered to the planned user, and for purposes of plan</sup> fulfillment such output was regarded as never having been<sup>produced. However, in the first quarter of 1987, in</sup> the machine-building sector, the quality controls impeded the delivery of goods<sup>to the exten</sup><sup>**t**hat, by the end of</sup> the year, the screening function of the Institute had<sup>in effect been eliminated.</sup>
13 There were some limited quantities of western imports<sup>available: during the 1980s Hungary and</sup> Poland permitted the import of higher-quality western<sup>consumer goods. But the western goods did not</sup> threaten the local soft-good producers. High import<sup>prices relative to domestic wages, in conjunction</sup> with tariffs, foreign-exchange cor.trols, and other<sup>protectionist means, limited access to the western</sup> commodities. In the CMIEA beyond Hungary and Poland,<sup>only soft consumer goods were available.</sup> Capital and intermediate goods were also "soft". There<sup>was demand for these goods in a central-</sup> planning context (except in Hungary) in each CMEA<sup>country. Since membership in CMEA - and hence</sup> trading at some minimal level - was mandatory,<sup>in the early years at least the soft intermediate goods</sup> were traded partly to ensure bilate:al trade balances.<sup>The Soviet Union was a ready purchaser of soft</sup> capital and intermediate goods because at the given world<sup>prices of western substitutes there was no</sup> domestic demand for high-quality inputs - or for those<sup>priority sectors where better quality may have</sup> been sought at world prices, imports were subject to<sup>western embargoes. Once soft intermediate and</sup> capital goods became embedded in the production process,<sup>demand was generated for spare parts, again</sup> soft. Industrial workers were also trained in the use of equipment<sup>in "soft" goods sectors.</sup> The CMEA economies thi. became precommitted<sup>to production of and international trade</sup> amongst themselves in soft goods. The soft-goods economies<sup>of the CMEA could persist because of</sup> market segmentation that avoided direct confrontation between<sup>"soft" and "hard" goods.</sup>

# VI. DOMESTIC REFORM

Persisting inefficiencies and the technological advance of<sup>the west brought to the fore in the</sup> 1960s the recognition of the need for reform of the planned<sup>socialist economy.'4Reforms were proposed</sup> that would maintain socialism, but would replace central<sup>planning with market allocation. Only Hungary</sup> '<sup>4</sup> The implications of high concentration of industry associated<sup>with planned centralized development were on the</sup> other hand excluded from the East European reform<sup>discussions of the 1960s. On considerations concerning</sup> market structure and reformn of socialist industry, see<sup>Hillman (1990a).</sup>
14 proceeded beyond proposals. The Hungarian New Economic Mechanism of 1968 eliminated central planning and introduced "market socialism".

Outside of Hungary and Poland, market-oriented reform was opposed by CMEA governments in the two decadc-s preceding the revolutions of 1989. Czechoslovakia and East Germany in particular took the position, consistent with Marxist-Leninist ideology, that it was possible to improve the efficiency of the centrally planned economy and to resolve the quality problem without recourse to markets. These two countries were the producers of the most sought-after soft goods in the CMEA.

The interconnection between domestic reform and CMEA trade is demonstrated by a brief review of the circumstances in the two countries - Poland and Hungary - where reform was intended, and the consequences in another, Albania, of disengagement from CMEA.

# A. Poland

In the decade of the seventies the Polish leader Edvard Gierek set out to implement a modernization program, based on borrowing in the West to import technologically sophisticated capital equipment for Polish industry. Polish industry did not absorb the western technology and capital goods. Empirical evidence distinguishing western from CMEA capital indicates no systematic relation between infusion of western capital and technology, and productivity improvement in Polish industry; in some industries the marginal product of western capital was negative, whereas the marginal product of CMEA capital was positive in all industries.'' The attempted modernization left Poland with domestic industry that remained oriented towards CMEA soft-good production and western debt obligations that could not be honored. The recovery program of the subsequent Jaruzelski regime emphasized a redirection of foreign trade to within CMEA.

A conventional view is that the Polish reform attempts failed because foreign trade remained "See Terrell (1990).
15 over-centralized, and because in the absence of domestic prices that reflected opportunity cost, it was impossible to determine comparative advantage, and thus impossible to penetrate western markets. This conventional distortions-oriented view downplays the role of individual incentives. The incentives confronting the managers of state enterprises were to resist disengagement from CMEA.

# B. **Hungary**

The most concerted efforts in Eastern Europe at introducing a market-oriented economic system with western orientation in international trade took place in Hungary. Yet, although in principle based on decentralized markets, the Hungarian economy continued in the two decades subsequent to 1968 to be dominated by large state enterprises that required subsidies for continued viability, and ties persisted between the enterprises and the state bureaucracies that had been responsible for the planning of the operations of the enterprises under central planning. The essential characteristic of a market economy, a capital market, did not develop. As in Poland, the enterprises did not absorb western capital and technology to the extent that opportunities were present,'<sup>6</sup> and the economy remained committed to a production pattern based predominantly on soft goods.'<sup>7</sup> The persistence of prominent CMEA trade throughout the 1980s is demonstrated in Table 2. Table 3 compares the industrial composition of Hungarian exports to the Soviet Union and the OECD. No significant change took place in the commodity composition of industrial exports between 1971-1975 and 1986. Whereas almost half of industrial exports to the Soviet Union comprised mr"'hines and vehicles, the share of these goods in Hungarian exports to the OECD remained around 10 percent.

The Hungarian success at decentralizing enterprise decision making was unique in CMEA. However, there was a tendency to exaggerate the degree of success. The rhetoric of market socialism See in particular Dezsenyi-Gueullette (1983). '<sup>7</sup> There is substantia **l** iterature on the Hungarian reforms and obstacles to change. See Bauer (1983, 1988)), Tardos (1983), Gacs (1986), Inotai (1986), Komai (1985, 1986, 1988), Marer (1986), Brada anu Dobozi (1988).
16 gave the impression of substantive progress with market-oriented reforms, while association with western institutions suggested a western market orientation. Yet twenty years after the abolition of central planning there had been but limited progress made in achieving a market economy with functioning labor and capital markets that had an allocative roles. Hungarian industry remained highly concentrated, and highly protected fronm import competition from western "hard goods".'<sup>8</sup> Like Poland before it, Hungary had by the end of the 1980s accumulated a substantial foreign debt (but unlike Poland, had never defaulted). And as in Poland, Hungarian industry had also proved unsuccessful in adopting western technology that was in principle available. Hungary remained a 'soft goods" economy yet to confront the adjustment problems associated with disengagement from CMEA.9

# C. Albania

Whereas Poland and Hungary, despite intentions otherwise, failed to disengage from CMEA, one case reveals the cost of disengagement. In 1961, the first year of the Albanian Third Five-Year Plan, the Soviet Union severed all economic relations with Albania and imposed a boycott. The Chinese government announced that it would replace Soviet aid to Albania. However, Albania was tied to the CMEA system, and Soviet and East European construction plants, machinery, and spare parts were in place. The Third 5YP was a disaster. It was not until 1966 that the relatively simple Albaniaa economy, facing no foreign debt difficulties and with the willing assistance of China, recovered from the disruption of disengagement from the CMEA. Yet Albania had been part of the CMEA for little more than a decade.' "See Gacs (1989), Oblath (1989). "'See for example Hillman (1990b), Newbery (1990). "For a detailed account of the Albanian experience, see Schnytzer (1982).
17

# **VII. TRANSACTION-SPECIFIC APITAL AND CMEA**

The disincentive to disengage from CMEA finds its expression in rents associated with industry- **specific factors of production.2 '** Insofar as state enterprises were not privately owned, private claims to **industry-specific capital** could not underlie protectionist interests in the manner that such interests arise in **western market** economies.' Residual claimancy to the returns from investments in the state-owned **enterprises did not however** reside exclusively with the state. Via the reward structure and discretionary expenditures, enterprise management was a residual claimant, as have been workers via rent sharing and job security that dissipated rents in hidden unemployment. In instances in Hungary and Poland where control of the enterprise came to be in the hands of enterprise councils, _de facto_ private residual claimancy to the returns from industry-specific capital was more directly establishede Because of CMEA/non-CMEA market segmentation, industry-specific capital in CMEA economies was also transaction-specific. The conception of transaction-specifi **c** apital in the theory of the western firm explains why transactions are internalized within a non-market organization (the firm) rather than undertaken via market activity. Transaction-specific capital introduces scope for "opportunistic behavior", since from the buyer's perspective, ex-ante agreements are not optimal ex-post. A **seller who has made the** investment in transaction-specific capital is confronted with an incentive of **the party with whom he** is transacting in the sale of output derived from the investment to exploit an ex-post monopsonj position to decrease the price at which exchange takes place. Internalizing the transaction within the institutional setting of a firm avoids such opportunistic behavior.

The soft/hard goods distinction that segmented CMEA and western markets placed the Eastern 2"Residual claimants to the returns to factors of production specific to an import-competing industry gain from protection of **the** output produced by the industry, and owners of specific factors elsewhere in the economy lose, whether in other import-competing industries or in the export sector. The stance of intersectorally mobile factors on protection depends upon consumption preferences. See Jones (1975) for elaboration. **20n** protectionism in the westem market economies, see Hillman (1989).

'On residual claimancy in Hungary, see Hillman (1990b), Newbe.-y (1990), Hare (1990); on Poland see Grosfeld (1990), Schaffer (1990).
18 European CMEA economies in analogous circumstances with respect to their international trade. Via bilaterally negotiated CMEA international trade, the Soviet Union supplied the Eastem European economies with hard good.s that could not be secured via the export of soft goods in the broader western international market. Si.ch exchange tied the Eastern European economies to CMEA: only the Soviet Union was willing to (deliver oil and other natural resources in exchange for Eastern European soft goods.<sup>24</sup> The trans?,ction-specifi **c** apital derived from the post-Stalin introduction of comparative advantage as a principle governing CMEA trade. In the scheme of CMEA specializzation, the Eastern European economies were assigned production of manufactures which because of lack of technological advance became soft goods that were suitable for trade only within the CMEA. Elements of dependence are in general associated with specialization according to comparative advantage.> In the case of the CMEA, transaction-specific capital and technology created dependence that in substantial degrees constrained the Eastern European economies to trade with the S:; .-.et Union, or among themselves.

The CMEA institutional trading arrangement facilitated bargaining to determine exchange among non-market planned economies (with the post-1968 exception of market-socialist Hungary). CMEA trade was a non-market activity for all participants (including Hungary), just as are internal transactions of the western firm. CMEA internalization of transactions therefore did not eliminate, but rather was based on, strategic bargaining which allowed for realizations of opportunistic behavior.

The bargaining process advantaged the Soviet Union as first mover in bilateral negotiations, and also via the hard/soft structure of the commodity pattern trade that gave the Soviet Union the option of directing to the world market "hard" goods which had been precommitted to CMEA export. Since their industry-specific capital was transactions-specific to CMEA exchange, the East European economies

> 24Transaction-spec **i** nvestment was also associated with imports. For example, Hungary invested in pipelinesfic within the Soviet Union to supply imports of Soviet natural gas. 'See Arad and Hillman (1979), Cheng (1987).
19

# lacked the same flexibility in redirecting exports to hard-currency<sup>markets,</sup>

# VmI. RENTS AND RESISTANCE TO REFORM

Under the CMEA system of international trade, exports<sup>were in principle precommitted to</sup> ensure the planned bilateral trade balance, and hence<sup>marketing and other selling efforts as would be</sup> associated with exports to the West were not required<sup>to ensure sustained CMEA sales. Nor was the</sup> "soft-good' output in any event appropriate for western<sup>markets. Enterprises as exporters consequently</sup> had no incentive to seek disengagement from the<sup>CMEA soft-goods economy. Reforms that might</sup> entail a reorientation of international trade towards western<sup>markets could only erode the rents associated</sup> with residual claimancy within the enterprise to CMEA<sup>transaction-specifi</sup><sup>**c**apital.</sup> An enterprise exporting to the CMEA, as part of the<sup>traded goods sector, also potentially</sup> confronted import competition. However, imports<sup>in the planned economy are by their nature</sup> non-competitive with domestic output. Thus in Hungary,<sup>after the abandonment of central planning in</sup> 1968, the enterprises maintained a preference for "planned" CMEA<sup>imports - that is, implicit protection</sup> via CMEA imports that were planned in advance as non-competitive<sup>with their own output. Government</sup> will have exhibited the same preference, insofar as CMEA<sup>trade was a sciurce of employment stability.'</sup> Since Hungary was a "market" rL er than planned economy,<sup>domestic enterprises potentially</sup> confronted competition from western imports. Viability<sup>of the soft-goods enterprises required that</sup> market segmentation with respect to the west be sustained,<sup>via regulation of international trade. There</sup> was no assurance that a tariff could compensate for<sup>soft/hard good quality differences. Exchange</sup> controls and quantitative restrictions were thus required to<sup>preempt import competition.7,</sup> Notwithstanding socialism, the incentives regarding self-interested<sup>stances on protectionism were</sup> 2 See Hillman (1990a). 27See **Gacs** (1989), Oblath (1989).
**20**

thus sinilar to those in western market economies.' Just as each western enterpr.ie has an interest in protection for its own output, but would favor free trade for other sectors, so each individual CMEA enterprise would have benefitted from the dismemberment of the CMEA system that protected other enterprises in the economy. As consumers of final output and purchasers of intermediate inputs, the management and the workers of the enterprise would thereby escape the soft goods economy. But because of the rents associated with de facto residual claimancy to CMEA transaction specific capital, it was in the interest of enterprise managers and workers to resist broad-based disengagement from CMEA.

# IX. ENTERPRISE OPPORTUNISTIC BEHAVIOR

Within the decentralized decision-making system of Hungarian market socialism, the resistance to change associated with the CMEA trading relationship was compounded by the role of the state as centralized international trade negotiator on behalf of the enterprise as decentralized supplier. The state would precommit in CMEA trade negotiations to supply the enterprise's output. The state's commitment introduced the possibility of opportunistic behavior by the enterprise,' which could threaten to withhold the prenegotiated supply of soft goods. The enterprise could request subsidies to ensure supply for export of the goods that the state had undertaken to provide to CMEA trading partners. There was therefore a direct link between CMEA trade and the 'soft" budget constraint (see Kornai, 1985) that has been perceived to confront enterprises under -iarket socialism.

Whatever their claim to shares of profits, enterprise managers had full claim to subsidies which were convertible to discretionary expenditures within the enterprise. To ensure the need for subsidies that would be forthcoming via the soft budget, the enterprise had an interest in dissipating all potential 2'See Baldwin (1982,1984),Hillman (1982,1989), Hillman and Ursprung (1988). 2<sup>3</sup> See Schaffer (1989) for a formalization.
21 profits in discretionary outlays and activities that revealed increased costs of production.

# X. CONCLUDING REMARKS

Domestic reforms in socialist economies have been associated with resolution of inefficiencies that derive from distorted domestic economies, and CMEA trade has been associated with irrational trading patterns or with customs-union conceptions. We have sought to direct the focus on CMEA trade away from distortions and efficiency concerns to a framework that acknowledges CMEA specialization via assigned comparative advantage. This framework encompasses behavioral implications of residual claimancy to rents (albeit dissipated) that accrue to transaction-specifi **c** apital and which underlie the resistance to disengagement from CMEA. Via the enterprises' CMEA transaction-specific capital, the CMEA system of trade sustained an incentive structure that gave rise to reform-resistant dependent economies in Eastern Europe.

The transaction-specifity of capital segmented CMEA and western markets, .and thereby facilitated differential CMEA terms of trade that subsidized the Eastern European economies at the expense of the major CMEA economy; yet the Soviet Union via its monopsony position in CMEA hard/soft goods exchange could have applied its bargaining power to improve its terms of trade. The preferential terms of trade were however consistent with the furthering of the dependency relationship. For the terms of trade were a determinant of the value of rents accruing to the socialist enterprises' CMEA transaction-specific capital. The preferential terms of trade increased the returns to the CMEA transaction-specifi **c** apital of the Eastern European soft-good enterprises. Incentives for the enterprises to orient themselves away from CMEA exchange towards western markets were therefore diminished. Via the enhanced returns to CMEA transaction-specific capital, the preferential CMEA terms of trade were thus a component of a domestic incentive structure inhibiting enterprise orientation towards the west and fostering intra-CMEA trade dependence.
22 Abolition of the CMEA trading system and a change to trade at world prices eliminates the terms of trade advantage of the Eastern European economies. Also, the end of segmentation between CMEA and western markets decreases the value of the domestic CMEA transaction-specifi **c** apital stock. The terms of trade loss and the writing down of the value of the CMEA capital stock are not independent or additive costs of the end of the CMEA system of international trade, but will have been linked via capitalization of the preferential terms of trade into the value of the CMEA transaction-specific capital.