DAVID R. HENDERSON, ROBERT M. MCNAB

AND TAMAS ROZSAS

Our exposition proceeds as follows. First, we illuminate why economic inequality was important for the operation of the centrally planned economies and how its real political purpose distorted its measurement and interpretation. Next, we identify several sources of inequality in the pretransition period, the effects of which researchers often overlooked or underestimated. Finally, we reach some conclusions and suggest courses for future research.

Market Forces and Socialism

The widely recognized inefficiency of the centrally planned economy was a fundamental reason for the high hidden inequality in socialism. One group or individual’s desires could be fulfilled only at the expense of others’ desires; thus, for central planning to work, central planners had to rank various people’s wants and to compare the importance of, say, one person’s desire for health care with another person’s desire for housing. In a centrally planned economy, the planners did not attempt to ensure that production occurred so that prices and quantities approximated what they would have been in a market equilibrium because socialist leaders denied the importance of market forces. Although socialist economist Oskar Lange (1936, 1937) made a case for “market socialism,” under which managers would be free to adjust prices to eliminate shortages and surpluses, and although many Western economists treated Lange’s views seriously, planners in the socialist economies did not. Their stated goal was to provide basic goods in “sufficient” quantities at low prices by directing production resources from luxury goods to the production of these basic goods. Pricing rested on a kind of cost-based calculation in which unprocessed raw materials were assigned almost no value. Because profit was regarded as a sin, and the distinction between the cost of capital and real profit was not understood or was ignored, the cost of capital was not included in the calculations.(1) Price controls and dictated production quantities were the means to achieve this goal.

Not surprisingly, people had to wait in lines and pay bribes to shopkeepers to obtain products that were common in the marked-based economies of the West. For certain basic commodities, however, the situation differed. Each country had its own set of basic goods that appeared to reflect some normative judgment of the people’s “needs.” For these products, dictated quantities were well above the demanded quantity even at the regulated price. Examples include white bread and milk in plastic bags in Hungary 2 and cornmeal and bottled milk in Romania.3 These measures resulted in some strange outcomes. Because bread was overproduced, for example, animals were fed on bread, not only on household plots (Shane 1994, 80), but often even in cooperatives getting their “supply” of unsold bread directly from the shops (Goldman 1987, 35). In Hungary, milk was packed in plastic bags and thus could not be sold the next day and had to be destroyed. These goods, however, were only a few of the regime’s selected favorites, considered to be essential not by the people, but by the government.

Many goods, including food, were distributed at the workplace, presumably to keep the workers motivated to come to work. That arrangement may explain why, during socialism’s collapse, when some employers quit paying the workers, the employees often still showed up for work. The food that was handed out then constituted their “wages.”

At the same time, many other products, considered to be basic in more developed countries, were not available even for a higher price. To estimate the supply and demand for bananas or oranges, for example, would be difficult. Oranges were sold only at Christmas and Easter in many of these countries; bananas appeared at Christmas only.4 Even in these limited periods, the prices of these fruits were regulated, and the resulting small amount supplied allowed the average citizen to buy no more than a few pounds. In contrast, some people bought a large number of bananas, such as the man in a Hungarian village who stated that he had made brandy from bananas.5 In addition, Hungarian military officers participating in live-firing missile exercises in the deserts of Kazakhstan frequently told stories about very cheap watermelons being available in huge quantities in the Caucasian region.6 This watermelon production was dictated to supply the whole country, but because the planners did not allocate enough trucks and gasoline to deliver the watermelons to the North, the watermelons were overabundant in a small area in the South.

In the mid-1970s, Hedrick Smith told similar stories:

Nevertheless, basic commodity industries were not the most inefficient segments of the socialist economy. The “heroes” of socialist economies were the military and the heavy-industry sectors. The central planners’ goal in these cases was to produce more in these industries no matter how much it cost the country. The planners initially used the heavy casualties of World War II to justify the forced development of heavy industry, but even as the prospect of conflict diminished over time, these industries continued to absorb significant quantities of resources. No one wanted products at the price the state paid for them, but members of top nomenklatura received them free of charge. These goods included huge Soviet cars that guzzled large amounts of gasoline, unbreakable “military” wristwatches, and hand-crafted luxury ornaments.

Nevertheless, the most important products in the “‘heroes’ of socialism” category were products of the defense industry and the “services” of secret-police organizations. These industries expanded their control over a major part of resources, thereby becoming politically influential, especially in the former Soviet Union, which was not so much an economy as a glorified arsenal. By continuing to draw resources away from other uses, this military-industrial complex slowed the development and democratization of the former Soviet republics during the transition.

The Need for Economic Indices

According to the logic of central planning, measuring production in money terms would be “unsocialist” when the government set both prices and quantities. As a consequence of this logic, socialist statistical agencies did not use the United Nations System of National Accounts (UNSNA) during most of the socialist regime. They used instead a material-product system based on production quantities rather than on values expressed in money terms (Campos 2001; Estrin, Urga, and Lazarova 2001). Remarkably, though, they began to use the UNSNA right before the transition. Why they did so is an important question.

Signs of an impending economic crisis were already visible during the 1960s. At the macroeconomic level, the Soviet economy was beginning its slow decent into stagnation. Thomas Hammond, a researcher who visited Moscow in 1966, described the following: “An exhibition boasting of Russia’s agricultural achievements seemed a bit ironic, because the food situation that year was the worst the country had seen in a long time. Indeed, the crop failure was so serious that Russia was forced to buy wheat from the United States” (1966, 319).

At the microeconomic level, rationing and shortages continued long after World War II. A basic rule of thumb was: “If you see something for sale that you want, buy it, because tomorrow there probably won’t be any” (Hammond 1966, 320). Hammond also cited his conversation with a Russian professor who mentioned food riots in Novocherkassk in 1962. Another common saying was, “If you see something for sale that you do not need, buy it anyway. You can trade it with others for what you need.”7 Signs of a serious economic crisis were also visible during the 1970s and 1980s. Indeed, in the 1970s, shortages were so widespread under socialism that New York Times correspondent Hedrick Smith, who won the Pulitzer Prize for his coverage from Moscow, titled one chapter of his classic book The Russians (1976) “Consumers: The Art of Queuing.” In the midst of various stories about queuing for basic consumer items, Smith wrote, “The accepted norm is that the Soviet woman daily spends two hours in line, seven days a week” (1976, 83).

Technological development was slow under socialism, and the fast technological change in the West in the 1970s and 1980s left the socialist economies farther and farther behind. General Secretary Mikhail Gorbachev recognized this widening gap. “Over the last few years,” he stated at a conference in November 1989, “the gap between the USSR and the developed countries in the assimilation of new, high, and in the first place information technologies, based upon the broad use of the latest achievements in science, has steadily increased.”8 Many socialist countries, especially the Soviet Union and Romania, experienced serious shortages of almost everything during the 1980s.

These problems, however, could not be reflected in socialist statistics. These statistics registered steadily increasing production quantities. Recording fulfillments and overfulfillments of plans was the ideal method to show development where in actuality none was occurring. Using this method of accounting, however, did not solve the true underlying problems. The inefficiencies of these socialist economies caused the planners to look for resources elsewhere. “Exporting revolution” did not help because central planning destroyed the economy in all of the countries newly subscribing to the collectivist ideology. The only way to sustain the regime for additional decades was to borrow from Western banks, governments, and international financial institutions. Because these lenders required economic indices in the form accepted by the rest of the world, socialist countries first began to employ both the old materialproduct system and the UNSNA, then finally abandoned the material-product system altogether even before the end of communist rule.

Statistics in Socialism

Switching to a new system of aggregating numbers from the same sources did little to change the deceptive nature of socialist statistics. Filer and Hanousek (2002, 234) warn us about the consequences of the differences between Western and socialist accounting standards and the danger of seemingly identical meanings of totally different variables. Campos argues that socialist statistical offices, originally set up to measure quantities, “were poorly equipped to deal with issues such as price changes and unemployment” (2001, 667). He also observes that fulfilling plan targets, the main incentive of socialist statisticians, led to overreporting the results.

In fact, the newly implemented economic indices had no real meaning in centrally planned economies anyway. Where all prices and production quantities are regulated, calculating gross domestic product (GDP) values from Five-Year Plans would have been just as good, and just as meaningless, as measuring them using sophisticated statistical methods. Once the key numbers for the next period were established by the planners, it was easier to derive false data to support these numbers than to measure productivity and output accurately; accurate measurements would only have shown the fallacy of the planning process. Because statistical offices did not have the power to question whether the plans made sense, providing the “right” input for calculating aggregate indices was safer than providing the real input.

In sum, pretransition statistical data cannot be used to describe the real economic and social conditions of the socialist era. Therefore, researchers must turn to other sources to reconstruct the real past. Unfortunately, scarcely any useful independent data sources existed for these countries because they were different even from many developing countries that have insufficient statistical capabilities. Whereas in many developing countries a weak but willing state often welcomes independent researchers from developed countries, in socialist countries the state is strong enough to prevent most, if not all, independent research.

In light of the foregoing deficiencies of official data for the centrally planned economies, the reported experience of various individuals and generalizations from typical examples are the only possible avenues for reaching the truth. In the next section, we rely mainly on such sources to describe the causes and true degrees of inequality during the socialist era.

Hidden Inequalities and Income Transfers in Socialism

The total price of any good equals the monetary component and the nonmonetary component. An important part of the nonmonetary component is the time taken to get the good. When price controls keep prices lower than they otherwise would be, the drop in the monetary component is offset by an increase in the nonmonetary component because effective maximum-price controls cause shortages, so people spend more time waiting in line. (Sometimes, also, they pay bribes to shopkeepers and other sellers, thereby increasing the monetary component in an unmeasured way.) In every political system, the politically powerful have an advantage. Under the comprehensive price controls of World War II in the United States, for example, gasoline was rationed, but congressmen and high government officials were given “A” ration stickers that allowed them all the gasoline they wanted at an artificially low price; at the same time, average citizens often could not drive from one city to another because of the small amount of gasoline allowed them. Airplane and railway tickets also were rationed. The famous television newsman David Brinkley, for example, tells how as a young man during the war he broke off a romance because he could not travel to the city where his lady friend lived. Brinkley writes, “The new gasoline ration was too small to allow me to drive. Airplane and railroad tickets required a priority” (1995, 46).

Under socialism in a one-party state, the rationing system facilitated even more extreme privileges. Because no legal political forces existed outside the Communist Party, political power had few effective limits. Although all Soviet bloc countries had some kind of legislative body, it was subordinated to the Communist Party through the legislators’ party membership. As a result, real decisions were made by party leaders, who took no direct responsibility for these decisions. This system led to a plethora of privileges, including privileged access to goods and services, for top state officials and party members at all levels. Moreover, these privileges often included lower prices as well as privileged access.

Because members of the nomenklatura had power over the disposition of various scarce resources, they frequently used their connections to provide favors to each other at the expense of the rest of society. In addition, this group not only used these resources but also overused them or gave them away, owing to the lack of oversight and the concentration of power in the Communist Party elite. The only price they had to pay for these privileges was their loyalty to the regime, which was more important to the regime than actual party membership. In short, competition by personal characteristics replaced more impersonal market competition.

The Real Value of Privileges

Although the extensive system of privileges obviously had a substantial effect on income inequalities in the socialist era, it did not appear in pretransition measures of income inequality. As one discontented Soviet put it, “Everything is maskirovannoye —masked” (qtd. in Smith 1976, 41). Leonid Brezhnev, general secretary of the Soviet Communist Party and president of the USSR, for example, had Rolls Royce, Mercedes, Cadillac, Lincoln Continental, Monte Carlo, Matra, and Lancia Beta automobiles (Goldman 1983, 104, as cited in Lebergott 1993, 29). Of course, the value of these high-quality vehicles never showed up in Brezhnev’s reported income.

Referring to the effect of subsidies on essential items and to the quality of vacation homes for the top party brass, Milanovic argues that these privileges would not have altered measured income inequality to a great extent. He claims that others exaggerated the value of these privileges: “Elite privileges were exaggerated both by [the] indigenous population, because of the secrecy in which privileges were held, and by overly credulous Western analysts. In effect [as] anybody who has visited vacation homes previously kept strictly off-limits for all but the top Party brass can testify, their level of comfort and service is below that of an average Holiday Inn” (1996, 200). However, in dismissing the value of a vacation home by comparing it unfavorably to a Holiday Inn, Milanovic is, wittingly or not, implicitly appealing to Western standards. Although few middle-class Americans will regard a Holiday Inn as a luxury hotel, Americans are not the relevant group here; eastern Europeans are. In the mid- 1970s, living space per person in the Soviet Union was approximately only 120 square feet (W. S. Smith 1973, 405, as cited in Pejovich 1979, 55). Every room at a Holiday Inn has its own bathroom, whereas in the early 1970s approximately half of all Soviet housing lacked running water or plumbing, and much of the other half shared bathroom facilities with other families (Pejovich 1979, 55–56). For almost anyone in the eastern European socialist countries, a Holiday Inn would have been the height of luxury. To “translate” Milanovic’s statement for Western ears, it would need to read something like this: “In effect, as anybody who has visited vacation homes previously kept strictly off-limits for all but the top Party brass can testify, their level of comfort and service is below that of an average Hyatt.” In other words, access to a vacation home of high quality by socialist standards for a couple weeks each year free of charge constituted a substantial perquisite for those with political connections, and it would have been widely envied by those without it.

Milanovic might have made the following more telling and accurate criticism of the idea that vacation homes increased the inequality of incomes. Not just the politically connected had access to such vacation homes. Rather, even those not so connected could get such access if they did what the authorities wanted them to do: refrained from criticizing communism, refused to support many of the victims of communism, showed up at work, and so forth. In other words, access to vacation homes, like so many other perquisites under communism, was a means of creating loyalty to the regime and cementing workers into the system.

The nomenklatura, especially those at the top, had access not only to goods but also to state resources. Thus, in Romania, “During the past decade tens of thousands of workers slaved to satisfy Ceaucescu and his wife, Elena, by creating gold-leaf walls, crystal chandeliers, marble columns, intricate parquets, handwoven carpets. Their reward: breadlines and winters without heat. With more than a thousand rooms the palace is one of the largest buildings in the world” (Szulc 1991, 5).

Another set of privileges that researchers tend to underestimate includes the special treatment in health care, education, and housing, as well as exceptions to rules about foreign travel, customs, and the possession of foreign currency. Consider just one of these special treatments—the ability to travel abroad. One way for Westerners to understand its importance is to imagine that our own government has a generally enforced stricture on travel abroad, but that it relaxes this stricture for the small percentage of the population that is politically connected. So, for example, if we live in New York, we would be prohibited from traveling to Montreal, Toronto, London, Paris, Tokyo, or any other place outside of the United States. Most of us would regard this one stricture as equivalent to a huge drop in our real income and would therefore regard permission to travel to these (now exotic) cities as a substantial benefit. Under socialism, all of the other rules—for example, on health care, housing, and education—also exacerbated income inequality.

Corruption

An unmeasured but pervasive practice, corruption, may also have significantly influenced income inequality in the pretransition period. Corruption, as measured by surveys and other subjective methods, appeared to rise early in the transition process, especially with respect to the privatization process (Goorha 2000; World Bank 2000a). This upsurge should not have been surprising. One important form of corruption in a socialist system is being paid illegally for something that someone else values. To be corrupt in this sense, therefore, one must produce something of value. Even if the corrupt person is diverting resources that are not his to others who value them, the diversion is productive. Being productive is a skill that differs greatly from the ability to fill out paperwork or to produce items that meet some central planner’s goal. Therefore, when socialism ended, the people best situated to take advantage of the newfound economic freedom were those who were corrupt—that is, those who had been productive previously. They had formed the de facto entrepreneurial class, the risk takers, and had they operated in a free society their whole lives, many of them never would have been corrupt because they would have been able to carry out their entrepreneurial activities openly and legally.

In general, corruption has been found to influence income inequality. Thus, some researchers have concluded that income inequality must have increased in the transition period with the precipitous declines in reported economic growth and tax progressivity and with the concentration of former state-owned assets in the hands of the few (Gupta, Davoodi, and Alonso-Terme 1998).9

However, even though corruption during the transition to private ownership surely must have increased personal wealth for those who were corrupt, the increase in measured inequality cannot spring from this corruption because the increases in personal wealth were not counted as income in the surveys in transition countries. Corruption in public administration, health care, education, or law enforcement, in contrast, directly affected income inequality in both the pretransition and the transition periods. We emphasize that this kind of corruption probably was much more prevalent in the socialist era. Measuring it, however, is much more difficult than measuring the corruption in privatization or in business practices during the transition period. Both Goorha (2000) and the World Bank study (2000a) cited earlier identify the origins of today’s corruption in pretransition practices. These sources cite, as the cra dle of today’s practices, the formation of the nomenklatura through the influence of Communist parties that appointed individuals to key positions. Among the origins of corruption, the World Bank study also mentions the culture of state intervention, together with the rapid devaluation of the salaries of bureaucrats during the early years of transition. Still, neither study considers whether corruption might have been greater when the legislature and the judicial branch were inseparable from the executive branch of the government, and the Communist Party controlled all of them as well as the researchers’ access to data. Basic economic theory—in this case, the idea that when people can more easily get away with something that benefits them personally, they will do so more often—implies that corruption must have been greater under communism. Corruption in privatization was only one aspect of corruption, a relatively easy aspect to measure in a new era when conducting independent surveys had become possible. Focusing on corruption related to privatization might have caused researchers to assume that little corruption existed in the past. In fact, corruption and privatization had no connection during the socialist era for one main reason: that era, by definition, had no privatization.

We need not rely only on basic economic theory, however; we can also look at the evidence. Shortages and artificially low official prices, the existence of privileges and black markets, and the uncontrolled power of bureaucrats helped corruption to thrive in an era of lies and nationalized plunder. People without connections had to pay unofficial service fees for nearly everything. Those who paid the fees were typically already in the lower part of the income scale. Those who received the fees were typically already in the upper part of the income scale. Therefore, because such fees were unmeasured, the degree of income inequality was understated. This system of bribery became so prevalent during the socialist era that few people in the socialist countries regarded it as corruption.

Health Care

Informal payments in the health-care sector also received attention in the transition period as serious impediments to health-care reform (Lewis 2000). The research shows that in the former Soviet republics, informal payments were made in more than 60 percent of transactions; in Armenia, the frequency of informal payments was 91 percent. Informal payments are also reported in most eastern European countries. Although these payments were undoubtedly frequent during the transition, recent reports ignore what happened before the transition: in socialist countries, most people regularly paid for health care. Referring to such payments as gratuities rather than bribes was simply a way of rationalizing and justifying a practice. Moreover, the health care was low quality and often dangerous. Smith, for example, tells of a conversation he had with an East German gynecologist who had practiced for three years in Leningrad. She stated: “Hospitals are overcrowded. Now they are building them with smaller rooms, say six to a room, but the ones I saw had many beds. Not a very pleasant atmosphere. The food is poor. Most families bring food to their relatives in hospitals and they give gifts to the saniturki, nurses’ aides, so that bed linens will be changed regularly and things will be kept cleaner” (qtd. in H. Smith 1976, 96).

In contrast, no payment was required from the well connected, who were already in the higher-income ranks, because they could do favors for the doctors and nurses at the expense of the state. In addition, well-connected people did not wait in lines, but the average citizen could not even make an advance appointment. Special hospitals for the privileged had better equipment, more trained personnel, and better collateral services. In the Soviet Union, for example, the nomenklatura could get zero-price care at the Kremlin Clinic, which was not a single clinic but a system of clinics and hospitals. Other nomenklatura could go to sanitariums and clinics along the Baltic Coast and the Black Sea, run by the “Fourth Administration” of the Ministry of Health. Other prestigious organizations, such as the Academy of Sciences and the Bolshoi Ballet and Opera Company, had special clinics and hospitals whose quality was much above average (H. Smith 1976, 43). Because these institutions were also part of the state-provided “free” health-care system, the user fee was either very small or zero.

Another form of discrimination was to prescribe different medicines for privileged and nonprivileged people with the same health problems. In more difficult cases, differences in methods and available equipment were also evident. For the privileged elite, even an expensive operation in a Western hospital would have been available at government expense, whereas the citizen without connections would be subject to inferior treatment and conditions.

All of these factors made the actual income distribution more unequal than official data imply. Two caveats should be added to the preceding analysis, though, both of which were important in the Soviet Union. First, those who received medical care at the most prestigious clinics did not always receive better care. In an ironic twist of poetic justice, the same system of privilege that gave the nomenklatura access to such clinics gave the prestige medical jobs to the politically well connected. Though better connected, they were not necessarily better as health-care professionals.10 Second, access to health care, as to food at the workplace, was often widely distributed as a way of cementing loyalty to and reducing criticism of the socialist regime.11

Pretransition inequality in education is another important factor that most researchers have overlooked or underestimated. Mickelwright observed during the transition in Slovakia and Bulgaria an increase in the ratio of household education expenditures per child in the top decile of per capita income to expenditures per child in the bottom decile (1999, 365, fig. 7). Relying for the most part on this observation, he argues that access to education became more restricted for low-income families during the transition, but this conclusion does not follow from his data. The increasing difference in education expenditures is consistent with a much more plausible explanation: the elite presently spend more on education to obtain a higher-quality education for their children, whereas under socialism the elite could get a better education for their children without spending more because the government provided better schools for children of the elite.

A recent World Bank study (2000b) of the challenges that transition countries face in the field of education also focuses on problems that arose during the transition, depicting education in the communist era as ideal. The study reports enrollment rates in tertiary education for the transition period from 1989 to 1997.12

As shown in figure 1, enrollment rates in tertiary education have increased in most transition countries, even in some of the otherwise weakly performing former Soviet republics. Far from showing increasing inequality, this evidence shows the opposite. The opportunities to study became more evenly distributed in a freer society than in the communist past, when all efforts were concentrated on building a static society with emphasis on basic education and barriers to higher education.

The communists’ motive for emphasizing basic education was not philanthropic. Rather, the main purposes were to build loyalty to the regime and to maintain the social hierarchy. Hence, they set quotas for the number of workers’ children admitted to higher education, and these privileged positions were assigned to those who were loyal to the regime. Even places in good high schools were assigned to those with solid political connections. Many people joined the Young Communists, for example, not out of conviction, but out of a desire to get into a good school. With total control of the economy, Communist Party leaders assigned people even to the most menial jobs. As one Hungarian government official asked, “Who will get the hoe if everybody studies?” Although most of the early leaders of the socialist countries were not highly educated, the ruling elite soon realized that privileged access to education was an important factor in maintaining their power. The barriers built into the educational system served this purpose effectively.

Education had to be “free” for the sake of socialist rhetoric, however. As a result, “free” higher education, available for everybody in theory, benefited the elite even more than a higher education with high tuition fees. Communist decorations, parents’ party membership, and references from the secretary of the local section of communist youth organizations all played a part in the entry process into higher education. This process facilitated selection in favor of the groups already privileged, with already higher incomes. Even Mickelwright, despite his claim that access to education became more restricted for lower-income people during the transition, notes that these biased selection methods under communism created privileges for the elite:

Two important distinctions must be made, though, between the West and the socialist countries. First, in Western countries, unlike in the socialist countries, parents or students have to pay more for better education. Second, in the West, those who earn higher incomes are typically more productive than those who earn lower incomes; in the East, by contrast, those with higher incomes were typically well connected politically....

David R. Henderson is an associate professor of economics at the Naval Postgraduate School in Monterey, California, and research fellow with the Hoover Institution, Stanford University; Robert M. McNab is an assistant professor of economics in the Defense Resources Management Institute at the Naval Postgraduate School in Monterey, California; and Tamas Rozsas is leading councilor in the Ministry of Economy and Transport, Department of Information Technologies and Statistics, Budapest, Hungary.