Growth of the Second Economy in the Soviet Union

Why did the ‘second economy’ grow to such a significant extent in the Soviet Union and what were its consequences for the functioning of the planned economy and the welfare of its citizens?

“You don’t know life. No one lives on wages alone. I remember in my youth we earned money by unloading railroad freight cars. So, what did we do? Three crates or bags unloaded and one for ourselves. That is how everybody lives in [our] country.” Brezhnev (1988) [1] 

According to Russia’s former president, Vladimir Putin, the collapse of the Soviet economy in 1991 was “the greatest geopolitical catastrophe” of the 20TH Century (BBC News 2005). Despite the initial apparent success of the Marxist doctrine, the USSR (Union of Soviet Socialist Republics) eventually disintegrated due to various reasons: a repressive and controlling regime, an economy based on central administrative planning and state ownership, information problems, limited incentive schemes and restricted supply of consumer goods. An underground economy, referred to as the second or shadow economy, emerged in the Soviet Union in response to inefficient production and excess demand and, as illustrated by Brezhnev [2] ‘s anecdote, it became rooted in the economic system and accepted within Soviet reality.

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Grossmann (1977) [3] defines the second economy as “compris[ing] all production and exchange activity that fulfils at least one of the two following tests: (a) being directly for private gain; and (b) being in some significant respect in knowing contravention of existing law.” O’ Hearn (1980) argues that “the fact that it is outside the planning structure, or [its] extra-plan” character must be included in the definition in order to comprehend that parallel market economies were neither built into the planning process nor officially sanctioned by Soviet structures.

This essay aims to analyse why the second economy became such a large part of the economic system in the Soviet Union and what the effects were in terms of economic and societal performance.

The Soviet Union had an administrative command economy based on central planning. Five-year plans were designed to set production targets and allocate resources in order to respond to the country’s economic needs (Gregory and Stuart 1998). It comprised complicated bureaucratic procedures that operated within a hierarchical organisation where information and orders circulated from one decision-making body to another. A system based on bargaining and planning to fulfil economic needs whilst maximising utility within a given set of constraints is theoretically possible. In practice however, there were significant differences between planning and managing that resulted in the second economy growing to such an extent as to being able to respond to the system’s shortages and failures. According to Professor Grossman’s estimates, in the late 1970s, private income from extra plan activities was between 28 and 33 percent of total household income (Grossman 1987). Treml (1995) estimated that the second economy employed between 10 and 12 percent of the total labour force. It is important to notice that these figures are based only on approximations due to the veil of secrecy and contradictory information that surrounded second economy activities in the USSR (O’ Hearn 1980).

The central planning system failed due to inconsistencies within the plans (Sampson 1987). The combination of top down information flows and subjective feedback gave rise to unreliable information, hindering the planning activities (O Hearn 1980). Furthermore, the political priorities played a major role in the conception of plans: heavy over light industry, production over consumption and industry over services (Sampson 1987). This led to allocation problems and bottlenecks within the plans (O’ Hearn 1980) that caused a) underproduction conducting to high demand and shortages of consumer goods and b) overproduction that resulted in products being accumulated and stocked. A second economy developed to redistribute overproduced goods and to offer scarce commodities demanded by society. This parallel system of redistribution functioned like a market mechanism and responded to supply and demand forces (Katsenlinboigen 1977).

Inappropriate resource allocations also led to unrealistic performance targets. However, as plan fulfilment was the only way for managers to advance in their careers and not be punished for inefficient administration, they resorted to the shadow economy to cut through bureaucratic bottlenecks and procure the necessary supplies in order to meet these targets (Ericson 1982). It also involved bribing, misreporting to the authorities, and resorting to other managers in order to exchange supplies. Grossman (1982) [4] called it “the Four B’s: barter, black market, bribe and blat [5] “.

Another factor that contributed to the establishment of the second economy was the existence of a dual monetary system in the first economy. In the USSR, there were two types of flows: official funds [enterprise transactions] and cash [transactions with the population] (Ericson 1982). Any transaction between enterprises had to be officially justified to central institutions. Cash, however, was available for the population to utilise in whatever ways they wanted and provided anonymity and protection from the state and from the party authorities. It consequently became “the lubricant of second economy transactions” (Ericson 1982).

The Soviet Union’s ideology played a major role in government decision-making and moulded societal behaviours and values. The government officially forbade some commodities as they did not “correspond to the yardstick of socialist realism” (Katsenlinboigen 1977). Nevertheless, limiting the variety of goods only triggered a higher desire for diverse products, ultimately inducing activities in the black market. Moreover, the government tried to create the illusion of equality within citizens; the feeling that everyone had the same rights and accessibility to commodities. This is why prices were set below equilibrium and the state would not raise the price out of fear of the public’s possible discontent, which resulted in demand outweighing supply and ultimately consumer goods becoming artificially scarce (Katsenlinboigen 1977).

There were various human motives that demonstrate why a second economy emerged in the USSR. Low wages pushed people to want to earn money illegally; the demand for scarce goods provided them with the perfect opportunity to produce these with their own resources and generate an extra income (Katsenlinboigen 1977). In addition, by the 1970s, with the decreasing economic performance in the Soviet Union [6] and institutions not being able to provide for basic needs, the population’s disrespect for the state only increased. The comparatively low costs of production [home production, theft, utilisation of state resources, etc], the flexibility of price setting [goods could be priced as high as the market would tolerate] (O’ Hearn 1980) and the general attitude of “everyone is doing it” (Sampson 1987) made the second economy a very attractive niche. Besides, the decline in control mechanisms made operating in the second economy relatively risk-free: The aforementioned use of cash granted anonymity, complicated kin relationships and networks protected those involved in underground activities and bribing official institutions was easy. Inasmuch as the second economy did not oppose the interests of the state, it preferred not to hinder this process of demand satisfaction (Katsenlinboigen 1977).

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The existence of a second economy in the USSR had major implications for the functioning of the planning system. Managers destroyed feedback and modified data to appear to be fulfilling performance goals, which diminished the efficiency of resource utilisation in the economy (Montias and Rose-Ackerman 1981 [7] ). It created a vicious cycle as information was distorted to pretend that plans were fulfilled, planners then worked with wrong feedback, setting unrealistic targets and managers could not keep up with the new production goals. Shortages spiralled and the need for a supply of scarce goods in the shadow economy increased. In addition, the state’s political priorities for military industry production aggravated the shortcomings as it stimulated the will to achieve ‘wrong goals’ in both the first and the second economies at the expense of consumer goods (Alexeev and Treml 1993).

The incentives for citizens to engage in extra plan activities were large as it directly impacted upon their personal incomes and increased their standard of living. This resulted in participants in the second economy diverting from planned tasks to fulfil their own economic needs, negatively impacting on state plans. Furthermore, as the second economy permeated the state sector, the corruption within the system increased. State officials allocated many of the scarce goods valued by soviet consumers, opening up the opportunities for bribery and fraud (Gregory and Stuart 1998). Amid soviet academics, the second economy had an adverse impact on the official state economy as it induced illegal incomes that contradicted the socialist ideology of income equality (Montias and Rose-Ackerman 1981) and it created a setting favourable for organised crime that led to a “socio-economic and political destabilization of society” (Korigiana 1990 [8] ). The state used these arguments in their propaganda to transfer the blame of goods shortages from bureaucrats to entrepreneurs. Instead of accepting the link between central planning inefficiencies and economic shortcomings that resulted in second economy activities, it accused speculators of purposely creating these shortcomings, isolating the markets, manipulating production and using monopolistic tactics (Montias and Rose-Ackerman 1981).

Nevertheless, the second economy only grew to such an extent because the first economy was in need of a supportive structure. It alleviated consumer shortages and bureaucratic blockages and acted as a social “mollifier”, as it funnelled societies distrust of the Party’s competences into consumption and minor crimes (Sampson 1987). In addition, the second economy helped to preserve incentives for managers as they fulfilled their production targets through extra plan activities or managed to appear to accomplish them. As a consequence, their wages and bonuses were increased and more money could be employed in the shadow economy (Gregory and Stuart 1990).

Ultimately, the citizens in the Soviet Union became the victims of the system. Since the mid 1960s, the standard of living deteriorated [“the year 1964 marked the beginning of a period of decline in life expectancy” (Brainerd 2002)]. As the variety and availability of products decreased, the frustration towards state institutions grew and, resorting to the second economy became the only way to endure the scarcities. Activities such as moonlighting [9] , bartering, bribing and offering favours, premiums and illegal gratuities became accepted in Soviet life. According to the Berkeley-Duke émigré interviews [10] “a large share of the interviewed people accepted these activities without misgiving”. These underground activities that were socially accepted became embedded in the Russian culture. The shadow economy left a legacy for the future as petty crimes and ‘law-bending’, such as tax evasion or moonlighting, are a daily reality in today’s Russia (Kim 2003).

The second economy complemented the official economy as it supplemented households’ incomes. It created alternatives and variety of products and responded to society’s needs. This diversity eventually led to differences in the distribution of incomes which was a concept completely opposed to the socialist ideology of income equality. It created wealth and opportunities. At the same time it made those without access to extra-incomes even worse off aggravating the income gap. As long as planners neglected to take the shadow economy into consideration, they only failed to see the underlying causes of its existence, which emphasized the malfunctioning of the central administration.

In conclusion, the second economy in the Soviet Union added efficiency to the central planning system. Equilibrium was achieved with underground markets complementing the administrative command economy (Ericson 1984). The intrinsic weaknesses of the soviet economy would have led the URSS to an earlier collapse had it not been for the shadow economy coming to its aid (Alexeev and Treml 1993). Kornai (1992) argued that the “average person, inspired by a great cause and a mass movement and confident of approaching victory, is capable of self-sacrifice for the community” although only for a short time. Soviet citizens were ready to give up product variety and freedom of choice to work towards a fair equal society. When this incentive disappeared, it became essential for society to stimulate performance through the provision of material incentives. The failure of the state to dispense the appropriate rewards and effectively control unlawful activities nurtured by the plan inconsistencies and the corruption in the institutions led to a slow disintegration of the system. History has shown that it is in the human nature to profit from any opportunity to improve its own individual position. As people looked to satisfy their individual needs, a shadow economy emerged to provide for these.

The state’s approach to control second economy activity was unsuccessful as they only addressed it as an attack to the socialist ideology (due to the market mechanisms that steered it) and tried to increase their punishment methods ineffectively. They failed to see that the shadow economy was a reflection of deeper political, economical and socio-cultural structural issues within the Soviet system. It was a manifestation of the need for entrepreneurship, private sector activities and better incentive structures. Of course, tackling these issues would have threatened the entire socialist structure and ideology which resulted in the rejection of these measures. Socialism, once a reaction to the exploitations and inequalities inherent to capitalism [11] , found in it a solution to its own troubles (Sampson 1987).