Price Increases in Eastern Europe with Special Regard to Hungary

RAD Background Report/78
16 May 1984

Summary: Unlike in the West, prices in Eastern Europe are not determined by the interaction of supply and demand. Instead, prices serve political objectives. For this reason they are determined by the state, which sets them at artificial levels. Maintaining prices at these levels requires a complicated system of state subsidies to enterprises and turnover taxes on most consumer items.

In the last few years there have been signs in the East, especially in Hungary, that the state would like to move away from artificial levels and allow market mechanisms to determine some prices. What measure of progress is being made on this sort of reform can be seen in recent developments in Hungary's economy.

The so-called "price problem" tormenting communist societies offers a seemingly contradictory picture. Prices are being raised in rapid succession, cutting deeply into the public's living standards and aggravating the impoverishment of the poorest members of society. Yet these price increases are presented as justified either because they are a precondition of economic reform (as in Hungary) or because they are a necessary adjustment to solve a supply crisis (as in Poland). Even some-Western observers admit that the price increases are a necessary evil, although they abhor the social consequences. They feel that condemnation of the antisocial effects would be somewhat hypocritical, since they are also the ones who have wholeheartedly advocated such economic reforms, which inevitably involve the establishment of a market-oriented price system and initial price increases.

Discussion about prices in Eastern Europe is often clouded by mistaken assumptions. Most Western observers, although they know that prices play a political role in centrally planned economies, tend to see them not as they are but as they should be--in their natural role of regulating markets--and any measure that restores this natural role seems reasonable to them. Communist leaderships, however, suffer from an opposite delusion. To them the price of something is more than anything else a political category and an instrument of power. Even if they think that prices could or even should assume a market-regulating role—as some Hungarian leaders do—they still treat prices as instruments of manipulation, because that is their perception of the "natural" role of prices.

The Genesis of the Power-Oriented Price System

Transforming prices from market-regulators into instruments of state power is just one of the important steps in setting up a command economy. As soon as this transformation has occurred, the market, created essentially by thousands of individual decisions, ceases to exist because the new "prices" do not reflect anything but the decisions of one central power. It is easier to understand this if one perceives the state sector as one gigantic enterprise that monopolizes the whole national economy. It has a board of directors (the party Politburo); a board of management (the government); a planning department (the state planning authority); and a central accounting office (the state budget). There are also thousands of subsidiary units ("workshops") carrying out the orders of the center: the so-called enterprises operating under the formal requirement of "economic accounting."

The central plan issues the directives to be carried out while the price system squares these orders with artificial principles of accounting. In other words, the price of something becomes nothing but a bookkeeper's category set and modified at will by a Central Control. If, for example, the central authorities decide that investment goods should be artificially "cheap," very low prices will be set by decree for the benefit of all the bookkeepers concerned. No matter how low these prices are, the books will remain balanced. Subsidiary units producing the investment goods will receive the required subsidy from the state budget, and this expenditure is promptly balanced out by drawing more "profit tax" from all units "buying" investment goods.

This closed system, however, is imperfect from the very beginning, because of the existence of millions of "economic units," i.e., members of society, that can never be fully nationalized. Apart from the special agricultural sector, where individuals still engage in some independent production, millions of wage earners in other sectors are "independent economic units" to the extent that they earn their own income and decide themselves how to spend it. From the beginning this has been a problem for a leadership seeking absolute control of society and its material and human resources. The problem was approached by setting up a two-tier price system: one for "producer prices," affecting all income in the state sector, and one for "consumer prices," thereby manipulating the public's income. The main purpose of this separation was to limit the public's income through artificially high consumer prices--by raising them by arbitrary turnover taxes--and to siphon back this expropriated income into the state sector in the form of enterprise subsidies, thus keeping producer prices at an artificially low level….

Such an initial expropriation of the public's income was characteristic of communist takeovers and began with an initial wave of drastic and artificial inflation in consumer prices, without a corresponding rise in nominal wages. The result was a one-time drastic reduction in real wages. By keeping real wages very low, the state achieved several objectives with one stroke: the scope of individual decisions--i.e., how to spend wages was kept within narrow limits; more resources could be concentrated in the state sector and because of low wages millions of dependents were forced to contribute to the household's income, thereby creating a huge army of additional manpower in the state sector.

The state must solve another problem, however, before this drastic expropriation can work. If consumer prices are inflated, real wages sink to abysmal levels. It is true that the communist state would like to restrict wages to such levels in order to reap the full benefits of a cheap workforce; on the other hand, the state must ensure that the members of society maintain a certain standard of living. Even in a dictatorship this is a basic condition for political stability. Thus, a second form of manipulation becomes necessary: an artificial consumer price structure set up within the two-tier system of prices. In this structure the necessities of life--especially housing and some food-stuffs--must be kept very cheap, so that everyone can at least make a living, despite such artificially low wages. This is ensured by carefully selected consumer price subsidies paid from the state budget...

The consumer price subsidy appears as a kind of income readjustment for the benefit of society, yet it is in fact simply the price the state must pay in order to make the artificially low wage level possible. At the same time the communist party turns this subsidy to its further political advantage by presenting it to society as proof that "the socialist state works for the welfare and social needs of the whole community."

Hungarian Developments: The Stage Is Set for Changes.

It follows from the genesis of this particular price system that it is intended to remain more or less constant. Once established, the price system continues to serve the interests of state power and pins society flat on its back. Hungary's situation exemplifies this. Consumer prices more than tripled from 1948 to 1952 (during which time the initial wave of artificial inflation reduced real income) and then remained constant for a very long period. The 1968 consumer price index, the year when economic reforms were introduced, was, in fact, two percentage points lower than in 1952. Prices started climbing after 1968, but at a very slow rate. The 1972 price index was only eight percentage points higher than twenty years before. Following the first energy crisis, prices increased at a faster rate, and the process accelerated from 1978 onwards.

As of 1978 Hungary's communist leaders were forced to face the consequences of their previous policies. In the early 1970s economic reforms had been put on ice and the command economy had been partly reinstated. At the same time huge loans, serving as a kind of "substitute" for economic reforms, had been raised abroad in the expectation that they would finance a fundamental modernization and restructuring of industry--the very basis for their repayment. This modernization, however, failed to materialize. Billions of dollars were raised and spent, yet no fundamental restructuring occurred. To a great extent the money was put to no effective use, but the huge burden of repayment remained. This failure was amply demonstrated by the growing gap in Hungary's balance of trade. A new policy initiated in 1978 gave top priority to the repayment of Western loans through the gradual building up of a competitive export industry. Since the loan strategy had failed (as it also failed under the Gierek regime in Poland), economic reforms were again suggested, this time to help repay the debts. During 1978 and 1979 market-oriented mechanisms were reintroduced, and a more consistent reformist policy has been followed since.

Price Increases in Hungary: Are the Justifications Solid?

Developments in Hungary document more or less why consumer prices increase in a country where the communist party is in power (apart from the initial wave of inflation mentioned earlier):
There is a pressing need to increase exports, especially for convertible currencies. If certain commodities slated for export are also in high demand at home, for example, basic foodstuffs, domestic prices are raised to discourage domestic consumption and free stocks for exports.
Production costs, or transport costs, for consumer goods are increasing. The state must decide whether producers should absorb the growing costs, whether their subsidies should be raised, or whether the burden should be shifted to the consumers. In the last case, the consumer price would be raised; when the cost of fuels or raw materials increases on the world market (gasoline is a good example) this almost always happens.
The state wants to get rid of some consumer price subsidies. The higher consumer prices are raised, then fewer subsidies are necessary.

The points listed above require more detailed explanation. In a situation where a country must service a huge external debt and is struggling for international credibility, there is some cruel logic in the argument that consumption at home must be reduced so that import needs be reduced and more commodities, mostly food, be exported. Whenever this argument is raised, however, it is also a clear admission that the whole economy, and industry in particular, is in such a poor state that it cannot pay its way in the world market. It amounts to the admission that producers can sell more abroad only if consumers buy less at home. The responsibility for this sorry state of affairs rests wholly with the communist regime. In Hungary large loans were raised to pump resources into industry, with the hope of restructuring it and making it profitable on the world market. This, however, failed to happen. Industry remains weak, most of its products are still not competitive, and the critical moment has arrived when the debts must be paid. Again, consumer prices are raised for the sake of exports for the reasons mentioned above. Deciding who should shoulder the burden of higher production costs cannot be separated from a full restructuring of an unrealistic wage system. Not only prices, but also wages should be raised to realistic "world levels" and should reflect the level of productivity in various industrial branches in relation to the level of productivity in industrially developed economies. In communist economies, however, wage levels do not reflect the level of productivity. Productivity is, in fact, lower in Eastern Europe than in other developed countries, but wages do not reflect even this lower level, they are still much too low. In Hungary, for example, the average level of industrial productivity amounts to at least 40% of the highly developed West European average, while in agriculture there is not much difference at all. From this, a one-to-two ratio in wage-levels would seem justified. Yet comparing Hungarian wages with West European earnings, one finds that the ratio is roughly one-to-six or one-to-five. It is clear then that wages are disproportionally low. Such low wages do not make economic sense, because they dampen worker incentive and therefore lower productivity, hinder intensive, labor-saving investments, and protect managers from reality. If all costs except wages are adjusted to world levels, then the price of manpower becomes an insignificant proportion of the cost structure.

There are two possible reasons for the state's wanting to get rid of consumer price subsidies. First, the state simply needs the additional resources that can be gained by saving on price subsidies to provide more investment funds, more export credits for enterprises, more subsidies for inefficient branches, or, for that matter, more armaments. As a result the state would have more resources at its disposal and the population fewer. In this case, the power-oriented price system remains operative, but the state contributes less to its operation.

The second possibility is that the state has a broader purpose in mind, namely, to change the price system itself, gradually transforming its power-oriented structure into a market-oriented one. This would be plausible only if comprehensive economic reforms were already under way, because such a fundamental change would make sense only as part of putting the entire economy on a market oriented course. Of all the countries of Eastern Europe only Hungary could fall into this category. Upon closer inspection, however, one cannot attribute this deeper purpose even to the Hungarian party leadership. They have cut price subsidies, but so far they have taken no other steps that would lead to a real transformation of the manipulated price and wage system.

Conditions for a Real Transformation

The gradual transformation of the manipulated price structure into a market-oriented system would require several simultaneous processes. The logic of these processes follows from the make-up of the artificial price system. These are:
A gradual reduction and eventual elimination of enterprise subsidies, including, of course, budget support for artificially low producer prices. Instead, these prices should come to reflect actual costs. Only profit and trade margins should separate them from the prices paid by consumers.
A substantial reduction of turnover taxes, with the retention of only those taxes that are essential for balancing the budget, such as taxes on gasoline, alcohol, and tobacco. By eliminating turnover taxes a broad range of consumer prices could be reduced to realistic, market-oriented levels.
A step-by-step elimination of consumer price subsidies, with a few, socially justified exceptions. Apart from these, consumers should pay the full market price for both domestically produced and imported products.
Implementation of a comprehensive wage reform. A minimum wage should be established at a higher level so that all workers can pay the new, higher market prices of basic necessities and services. At the same time central wage regulation should be lifted, allowing a differentiated increase in earnings. Provided enterprises receive no subsidies of any kind, they would have to absorb the cost of wage increases themselves. In such circumstances the size of the wage increase would essentially depend on two factors: the profitability of the enterprise and the outcome of collective bargaining, that is, the relative strengths of management and the unions groups in any one enterprise.
Independent enterprises should be given the right to get rid of their surplus manpower. An unemployment insurance system should be set up and financed from workers' contributions and from the state budget. The compensation paid to laid-off workers and employees should not be less than the established minimum wage.
Pensions should be reformed so that pensioners are able to pay the market prices of essential consumer goods and services.

Such far-reaching reforms would justify the inevitable inflation in consumer prices. Turning to Hungary, one asks if these processes are evolving and, if so, are the present price increases justified?

...

Wage Differentiation: Downward Trend

So far no comprehensive wage reform has been carried out in Hungary although wage differentiation has often been discussed as one of the objectives of economic policy. Such differentiation, however, works only if it develops on a rising scale of wages, that is, rises in real wages are directly proportional to rises in productivity. Experiments last year allowed a few enterprises to free themselves of several (but not all) central wage controls if they fulfilled certain conditions, and wage scales were extended to reward outstanding performances. These limited steps, however, have not changed the general picture characterized by very strict central wage controls. As a result, the very modest increase in nominal wages does not compensate for the rapid rise of consumer prices and real wages are sinking. In 1984 the index of real wages is comparable to the levels of 1974 and 1975. In other words, all the gains of the 1970s have been wiped out because of changes begun in 1979.

As for wage differentiation, the net result has been a fall in real wages, with low-income workers and pensioners suffering most. This is hardly surprising since the elimination of price subsidies, and hence the increase in consumer prices, affects mostly those items that were formerly heavily subsidized—the prices of basic necessities and services. The lower income is, the larger the proportion of income spent on these items becomes. Naturally when these items become more expensive, the proportion is even larger. Thus the price increases assume an ugly antisocial aspect without raising well-founded hopes that they are only part of a comprehensive economic reform and will ultimately benefit society at large. Indeed, one might surmise that the purpose of all this is to maintain more or less the same system while gradually reducing the regime's own obligation in the form of subsidies. At the same time, however, the regime is removing one of the main supports that has kept the system in balance for more than three decades.

In other words, this kind of process carries political risks. If it continues, it can lead to popular discontent and serious social tensions, and, as a result, the conflict within the HSWP on the future of economic reforms would probably come to a head. The outcome could be a victory for reformist elements, leading to a more consistent market-oriented course, including a gradual transformation of the present price and wage system. On the other hand, one can also visualize a much less cheery outcome, namely, party hard-liners' making the best use of popular discontent, demanding a drastic brake on reforms "in the interests of the working class," and wooing a frightened party center to their side. There is no reason to believe that a full transformation of the power-oriented price system involves less political risk than the attempt to keep it in place while removing a main prop supporting it. Prices have been made political instruments in communist societies and any change affecting their function is bound to have political repercussions.

Original file at: http://files.osa.ceu.hu/holdings/300/8/3/text/37-1-56.shtml.