Dwight R. Lee is an adjunct fellow at the Center for the Study of American Business at Washington University. He is also the Ramsey Professor of Economics at the University of Georgia. He is co-author, with Richard McKenzie, of Quicksilver Capital, reviewed on page 85.
Economists who return from a visit to the Soviet Union, as I recently have, are seldom bashful about suggesting remedies for the sick Soviet economy. Most of them observe that bureaucratic control is stifling Soviet economic activity, and they propose that the incentives and flexibility of private markets be substituted.
Correct though this advice is, it is easier to give than to take. No matter how much Soviet citizens and their leaders have become interested in economic reform, the move to a market economy will be difficult.
The fundamental problem facing Soviet reformers is the connection between market institutions and tolerance for economic freedom. Without market institutions, the Soviets will be hard pressed to allow economic freedom. Without tolerating economic freedom, they won’t be able to develop market institutions.
Some Superficial Problems
Most difficulties seen as hampering the transition to a Soviet market economy are overstated.
One perceived problem is the “ruble overhang.” Soviet consumers have amassed large holdings of unspent rubles because there are so few consumer goods. Although some rubles were confiscated recently in what was described as a currency reform, the fear remains that if Soviet consumers are allowed to spend all their money in free markets, explosive price rises will follow.
There is also the concern that the Soviet people have never lived in a market economy, and therefore won’t be able to respond correctly to the incentives of prices and profits. Workers aren’t accustomed to the disruptions of unemployment and job changes caused by shifting preferences and improving opportunities in market economies. After decades of depending on the state for subsidized housing, medical care, food, and almost everything else, Soviet consumers are supposedly unprepared to face the full-cost pricing and complex choices of the marketplace. Furthermore, Soviet citizens are seen as almost completely lacking in entrepreneurial spirit.
These concerns, though potentially troublesome in the very short run, are overstated as serious problems. Privatizing housing and other state-owned assets could soak up excess rubles, in addition to increasing the care given to what is now public property. Of course, temporary price increases are inevitable in a move from state subsidies to private markets, but market incentives would soon lead to dramatic reductions in the real costs of products to Soviet consumers by motivating significant increases in the quantity and quality of those products.
Also, there can be no doubt that people learn quickly to respond to the incentives, choices, and opportunities of the marketplace. South Koreans, Taiwanese, and Japanese, assumed by many to lack a market mentality, have demonstrated how quickly such a mentality can arise when given the opportunity. When workers find that they are rewarded for greater effort, they become more diligent. When consumers are faced with market prices and abundant alternatives, they quickly learn to make appropriate comparisons and sensible choices. And there is nothing like the potential for profit to stimulate entrepreneurial zeal.
The Fear of Freedom
Underlying all the problems associated with a transition from socialism to capitalism is a more fundamental issue that has been almost completely ignored. This concerns the interaction between market institutions and the tolerance for freedom that those institutions make possible.
Most Soviet citizens are eager for the economic improvements now recognized to depend on a market economy. Yet they continue to fear economic freedom, since in the absence of well-developed market institutions, such freedom can harm many innocent victims.
For example, one of Mikhail Gorbachev’s more important attempts at economic reform has been to allow cooperatives: private businesses largely limited to the service sector and permitted to set their own prices in response to market forces. Predictably, cooperatives have met with much poplar resistance, as they have been seen as acting without full accountability to the concerns of others. While cooperatives sell their products at market prices, they obtain many supplies at lower, controlled prices. This has led to resentment, public protests, and the destruction of cooperative property. The Kremlin has responded by increasing its controls on cooperatives.
In an economy dominated by state control, consumers grow accustomed to mandated allocations of goods to local shops. The idea of suppliers having the freedom to desert traditional consumers to make more profitable sales elsewhere is considered intolerable. Not surprisingly, a num-bet of Soviet republics have outlawed the shipment of goods beyond their borders by local enterprises.
While unemployment may never be welcome, in a market economy the freedom of firms to lay off employees is tolerated because workers can relocate to where their skills have the greatest value. Unemployment is far more frightening in the Soviet Union because Soviet citizens cannot read-fly move—government directives rather than market wages play the most important role in allocating labor.
But even though it has recently become easier for Soviet citizens to receive political permission to relocate, their ability to do so is still extremely limited by a chronic housing shortage. The typical Soviet family considers itself lucky to have an apartment of 500 square feet, and it isn’t uncommon for two families to share such an apartment. With long queues and political favoritism making it almost impossible for a family to obtain housing in another city, being laid off would be a genuine disaster for most Soviet workers. So in the absence of a free market in housing, there is little sympathy for the freedom of firms to lay off workers in response to changing market conditions. Yet such freedom is an essential feature of a market economy.
The Dilemma in Making the Transition to the Market
In the absence of a well-developed market economy, the fear the Soviets have of freedom is understandable. But this fear, and the reason for it, creates an agonizing dilemma for the Soviets as they attempt to make the transition from a socialist to a market economy. That dilemma can be stated simply: Tolerating freedom is difficult without market institutions, but developing market institutions is impossible without freedom.
The Soviet Union does not have the basic institutions required for the operation—and freedom—of a market economy, it lacks the type of banking system, legal structure, and commercial codes needed for the transactions and investment that are the lifeblood of the market. Neither does it have a stock market, which is essential for the rational allocation of capital formation that drives economic progress. These economic institutions, along with the political institutions of limited and stable government, are crucial to the social infrastructure that must be in place if improvements in the physical infrastructure are to be developed and utilized effectively.
If it were possible to impose market institutions by government fiat, then the Soviet government would be able to create an economy in which its citizens could begin benefiting immediately from a full measure of economic freedom. Unfortunately, market institutions cannot simply be decreed by political authorities. Market institutions have to emerge through a process of trial and error that requires time and freedom. The creation and operation of a market economy is a spontaneous and evolving process that can emerge only from freedom; it cannot be replicated by central direction.
Furthermore, while no economy can prosper without a well-developed system of market institutions, there is no one model of a market economy appropriate for every country. Markets are cultural artifacts, and the specific forms of market institutions suitable to one market economy are not suitable to other market economies. So while the Soviet Union can benefit from the general example of the prosperous market economies, even if Soviet authorities could choose a set of market institutions as they now exist in another country and impose them from above, the results would be disappointing.
The unavoidable conclusion is that the transition from a socialist to a market economy is going to be painful for the Soviet Union. The freedom that is necessary if markets are to develop is disruptive until that development is considerably advanced.
While this conclusion can hardly appeal to those most optimistic about Soviet economic reform, it should not be taken as a counsel of despair. Freedom is always disruptive, even when disciplined by a well-developed market. And even in the absence of market institutions, freedom is productive over the long run because market institutions emerge from the exercise of freedom.
Economic progress always takes time. No economy has gone from poverty to prosperity overnight. All market economies progressed only over significant periods of time, and all did so through a process that was neither smooth nor painless. But they did progress. Market economies have progressed far beyond that which can ever be possible under socialism.
After almost 75 years of rigid socialist control, it is now clear to all but the most ideologically blinded that prosperity in the Soviet Union—or in the independent republics that once formed the Soviet Union—an only be achieved by economic freedom and the market economies that will emerge from that freedom. The enormous talent and creativity of the Soviet people leave no doubt that, given freedom, they will quickly begin making the economic progress that has been denied them for far too long.
Some Important Lessons
The first lesson to be drawn is that the major industrialized countries should not attempt to assist the Soviet Union with financial aid. Indeed, foreign aid would more likely hinder rather than help the Soviet Union move to a free market. The benefits from making the transition far exceed the costs, but the benefits are a generation or more away while the costs are immediate and, for reasons already discussed, significant.
Mikhail Gorbachev and Boris Yeltsin, as with all politicians, are far more sensitive to immediate costs than to delayed benefits. By artificially propping up the flawed Soviet economy a little longer, such aid would let Soviet leaders continue to postpone granting the economic freedom required for genuine reform. Gorbachev has shown over six years of reluctance to start the painful process of moving to a market economy. He, or his successors, will start that process in earnest only when economic conditions deteriorate to the point where the temporary pain of freedom and reform is less than the permanent pain of the socialist status quo.
A second lesson is that, at a fundamental level, economic reform cannot be approached incrementally. The basic ingredient in reform is economic freedom, and the sooner the Soviet people are granted a full measure of that freedom the better. True, if a benevolently motivated government knew in advance exactly how particular freedoms would be used, then it might be possible for it gradually to permit more economic freedom in ways that allow for the benefits of freedom while minimizing the disruptions. But governments are seldom motivated by benevolence and never guided by omniscience. So freedom has to be granted quickly and completely.
This is not to deny that economic change will be gradual. No matter how immediately or completely economic freedom is granted, the evolution of market institutions and the expansion of economic prosperity will take considerable time. But to recognize that the progress of reform will be piecemeal is not to argue for gradualism on the part of government. The more clear and decisive the policy of economic freedom, the more difficult it will be for the apparatchiks, who continue to infest the huge Soviet bureaucracies and have a vested interest in the socialist status quo, to derail movement toward a market economy.
Another lesson is that the move to a market economy in the Soviet Union, or any other socialist country, is not primarily a task for government. There is little government can do to directly facilitate a transition from a socialistic to a market economy. Markets will arise as a result of the freedom that requires little more from government than getting out of the way of people attempting to better their conditions through productive activity. So even if the Soviet government could be depended upon to use foreign financial aid efficiently to promote the transition to a market-based economy, little, if any, financial aid would be required. The only financial infusions that can be depended upon to promote prosperity in the Soviet Union are private investments that will be forthcoming in significant amounts only when the Soviet government’s economic role is greatly reduced and, as a consequence, market institutions and arrangements have been allowed to develop.
The most precious thing provided by a market economy is not an abundance of material wealth, but freedom. Those of us with the good fortune to spend our lives in market-based economies have difficulty appreciating our freedom because it is always difficult to appreciate advantages one has never had to do without. Few people who benefit from markets and freedom recognize how precious their freedom is, and fewer still are aware of how crucially their freedom depends upon the institutions of the marketplace. For this reason, it is difficult for people in market economies to understand the ambivalence toward freedom felt by those in socialist countries, such as the Soviet Union, and the severity of the problems faced in their attempt to move to a market economy.
There can be no doubt that the citizens of the Soviet Union desperately desire the freedoms that so many of us take for granted, as do the citizens of all repressive socialist regimes. Many Soviets have taken tremendous risks and made enormous sacrifices to escape the tyranny of their motherland and reach the freedom and opportunity of countries with established market economies.
Yet, at the same time, there is widespread reluctance by the Soviet people to accept significant increases in economic freedom within their own country. This cannot be understood unless one recognizes that the freedom so many of us take for granted is a freedom that is difficult to tolerate in the absence of market institutions. Lacking the institutions of the marketplace, it is impossible for the Soviets to immediately begin realizing the benefits from freedom available to those who live in market economies.
Unfortunately, acquiring the market institutions needed to discipline the exercise of freedom, thereby making it easy to tolerate, requires the exercise of freedom. The Soviets are understandably reluctant to allow freedom without workable markets, but the institutions required for workable markets can emerge only when freedom is allowed.
Overcoming this dilemma is not impossible, but neither is it easy. Making the transition to a market economy is going to be a disruptive and painful process for the Soviet Union. And there is little that can be done by other governments to facilitate the transition. Only when the Soviet government allows freedom, and the economic disruption that will initially go with it, can the process of moving toward a market economy begin in earnest in the Soviet Union. 
1. It should be acknowledged, however, that attitudes formed during several generations of socialism can be a barrier to a transition to a market economy. For example, James Buchanan argues, for reasons consistent with the thesis developed here, that the attitudes of Soviet citizens are such that they have a difficult time accepting much behavior that is standard in market economies. See James M. Buchanan, “Tacit Presuppositions of Political Economy: Implications for Societies in Transition,” working paper. (Fairfax, Va.: Center for the Study of Public Choice, George Mason University, 1991.).
4. Even if it were possible for Soviet political authorities to impose workable market institutions, it would be naive to expect them to do so. Those with the greatest authority are those who have succeeded under the existing political and economic institutions. The changes occurring in the Soviet Union are not the result of an enlightened leadership dedicated to doing what is in the best long-run interest of Soviet citizens. Rather the changes are being forced on a leadership interested primarily in maintaining its power and perks by international economic forces that are relegating centrally planned economies to the ghettos of the global economy. See chapter 7 of Richard B. McKenzie and Dwight R. Lee, Quicksilver Capital: How the Rapid Movement of Wealth Has Changed the World (New York: Free Press, 1991). Also see, Gary M. Anderson and Peter J. Boettke, “Perestroika and Public Choice: The Economics of Autocratic Succession in a Rent-Seeking Society,” working paper (Northridge, Calif.: Department of Economics, California State University, 1990).
5. For a useful discussion of the evolutionary process by which social institutions, such as those of the market, are created and reformed, see Karen i. Vaughn, “Can Democratic Society Reform itself: The Limits of Constructive Change,” in For a Free Society in the Coming Decade: The N. Gotto Essay Prize Competition Winning Essays, Mont Pelerin Society, 1982 General Meeting, Berlin. Although Vaughn’s concern is with democracies, her discussion highlights important aspects of reform that apply to non-democratic societies.
6. In July 1991, at the G-7 conference in London, the seven major industrialized nations decided against giving the Soviet Union direct financial assistance. But the door was left open for consideration of future Soviet requests for financial aid. In the aftermath of the attempted coup, the pressure in the industrialized countries to give government aid to the Soviet Union has intensified.
7. And as Nobel prize winning economist Friedrich Hayek has informed us, “If we knew how freedom would be used, the case for it would largely disappear. We shall never get the benefits of freedom, never obtain those unforeseeable new developments for Which it provides the opportunity, if it is not also granted where the uses made of it by some do not seem desirable . . . . It is because we do not know how individuals will use their freedom that it is so important.” See F. A. Hayek, The Constitution of Liberty (Chicago: The University of Chicago Press, 1960), p. 31.
8. In arguing against a “big bang” approach to Soviet economic reform, Padma Desai points out that “Even a ‘big bang’ policy of simultaneous and instant policy announcements will necessarily encounter reality, and the rate of effective implementation on different components of the package will diverge, yielding piecemeal reform.” (emphasis in original) See Desai, op. cit., p. 182.