Excerpt from the Ernst Sturc Memorial Lecture

Let us now see how the boom/bust model can be applied to the rise and fall of the Soviet system. The initial bias was a fixed one—the Marxist dogma—and there was a mutually self-reinforcing relationship between the rigidity of the dogma and the rigidity of prevailing conditions. The system reached its peak in the last few years of Stalin’s rule. The system was all-embracing: it was a system of government, an economic system, a territorial empire and an ideology. Even genetics obeyed the Marxist doctrine. Not every science could be subjugated with equal ease, but at least the scientists could be tamed and their contact with youth restricted by confining them to the institutes of the Academy and preventing them from teaching at universities. Terror played a large part in making the system work, but the cover of ideology successfully concealed the underlying coercion and fear. The system was comprehensive, isolated from the outside world and rigid. But the gap between the actual state of affairs and its official interpretation was wide enough to qualify it as a case of static disequilibrium.

It is a testimony to Stalin’s genius that the system survived him by some 35 years. There was a brief moment when Khrushchev revealed some of the truth about Stalin, but eventually the hierarchy reasserted itself; and the twilight period began, when dogma was preserved by administrative methods, but it was no longer reinforced by a belief in its validity. Interestingly, the rigidity of the system increased even further because as long as there had been a live totalitarian at the helm the Party line could be changed at his whim. But now that flexibility was lost. At the same time the terror also abated, and a subtle process of decay set in. Every institution started to jockey for position. Since none of them enjoyed any autonomy, they had to engage in a form of barter with the other institutions. Gradually, an elaborate system of institutional bargaining replaced what was supposed to be central planning. At the same time, an informal economy developed which supplemented and filled in the gaps left by the formal system. This twilight period is what is now called the period of stagnation. The inadequacy of the system became increasingly evident and the pressure for reform mounted.

Now comes a point that needs to be emphasized: reform accelerated the process of disintegration because it introduced or legitimized alternatives while the system depended on the lack of alternatives for its survival. Economic reform enjoyed an initial period of success  in every communist country with the notable exception of the Soviet Union itself. The Chinese reformers called this the Golden Period, when the existing capital stock is redirected to meet consumer needs. But eventually, when the existing capacity has been reoriented, the reform process is bound to run into difficulties because the system does not permit the economic allocation of capital.

It is understandable why this should be so. Communism was meant to be an antidote to capitalism, which had alienated the worker from the means of production. All property was taken over by the state, and the state was an embodiment of the collective interest as defined by the Party. Thus, the Party was put in charge of the allocation of capital. This meant that capital was allocated, not on economic grounds, but on the grounds of a quasi-religious dogma. The best analogy is with the pyramid building of the Pharaohs. That is why the portion of resources devoted to investment was maximized, while the economic benefit derived from it remained at a minimum. It would also explain why investments took the form of monumental projects.

We may view the gigantic hydroelectric dams, the steel plants, the marble halls of the Moscow subway, the skyscrapers of Stalinist architecture as so many pyramids built by a modern Pharaoh. Hydroelectric plants do produce energy and steel plants do turn out steel, but if the steel and energy are used to produce more dams and steel plants, the effect on the economy is not very different from that of the construction of pyramids.

Our theory tells us that in the far-from-equilibrium conditions of a closed society there must be distortions that would be inconceivable in an open society. What better demonstration could one ask for? The Communist system attributes no value to capital or more exactly, it does not recognize the concept of property. As a result, economic activity under the Soviet system is simply not economic. To make it so, the Party must be removed from its role as the guardian and allocator of capital. It is on this point that every reform is bound to come to grief.

Interestingly, the failure of economic reforms also served to accelerate the process of disintegration because it demonstrated the need for political reforms. With the advent of perestroika in the Soviet Union, the process of disintegration entered into its terminal phase because the reform was primarily political and, as I mentioned before, the Golden Period was missing. As the trend in living standards started to decline, public opinion turned against the regime, leading to a catastrophic acceleration which is culminating in the total collapse of the system.

The pattern is almost identical with the one we can observe in financial markets with one major difference: in financial markets we have observed only a process of acceleration while in the case of the Soviet system, the complete cycle consists of two phases, one which culminates in the standstill of the Stalin regime and the other which leads to a catastrophic decline.

The difference is not as great as it seems because, if we look hard enough, we can identify cases of standstill in the financial markets as well. Take the international lending boom. If we look at the history of the U.S. banking system and go back far enough, the conditions of changelessness resembling a standstill are easily located. We have to go back to the Great Depression when the banking system failed. Subsequently the banks were frozen into inactivity by regulation and it took them about 35 years to come to life.

I wrote a brokerage report in 1972 entitled ‘The Case for Growth Banks,’ in which I showed how the market in bank shares had become ossified but I predicted that the situation was about to change. U.S. Banks at the time were considered the stodgiest of institutions. A dull business attracted dull people and there was little movement or innovation in the industry. Bank stocks were ignored by investors. But a new breed of bankers was emerging who had been educated in business schools and thought in terms of bottom-line profits. New kinds of financial instruments were being introduced, and some banks were beginning to utilize their capital more aggressively and putting together very creditable earnings performances. But bank shares were selling at little or no premiums over asset value. Analysts were aware of this relative undervaluation but they despaired of seeing it corrected. Yet many banks had reached the point where they were pushing against the limits of what was considered prudent leverage by the standards of the time. If they wanted to continue growing, they would need to raise additional equity capital. It was against this background that the First National City Bank hosted a dinner for security analysts—an unheard-of event in the banking industry. I was not invited but it prompted me to publish the report in which I recommended a bouquet of the more aggressively managed banks. Bank stocks did, in fact, have a good move in 1972 and we made about 50 percent on our bouquet.

Then came the first oil crisis of 1973 which prevented the banks from using their multiples to raise equity capital, and the big oil-recycling lending boom followed. Thus we can see the same full cycle consisting of two phases as in the rise and fall of the Soviet system, with the only difference that the rise of the Soviet system was the theoretical equivalent of the fall of the banking system.

The benefit of combining the experience of the Soviet system with the experience of the financial markets is that we can demonstrate that far-from-equilibrium conditions prevail at both extremes of change and changelessness. Closed society is the inverse of revolution and chaos; the difference is in the time scale but the reflexive process is the same.

The question poses itself: how can we avoid these far-from-equilibrium conditions? Or more exactly, how can we create a corrective mechanism which recognizes flaws before they become too powerful?

To give an abstract answer to an abstract question, we must ensure that a measure of separation between thinking and reality is maintained. What is taken for granted in economic theory is not in fact given. It is an illusion that needs to be deliberately preserved. Once it is recognized as an illusion or bias, the task can get awfully complicated.

Take the case of the financial markets. The illusion that fundamentals and values are independent has been very helpful in fostering stability. But it is an illusion that occasionally breaks down. Since the breakdowns tend to be associated with the use of credit, they can be quite devastating. To prevent them, some kind of regulation is necessary. But regulators also operate with a bias which tends to be more rigid than the bias of market participants. Therefore, regulation also breaks down, or, alternatively, the regulators need to be regulated by a political process. Perhaps the best way to keep the bias of the regulators within tolerable bounds is to force them to interact with the market. That is what central bankers have to do, and on balance, they provide the most efficient form of market regulation. Their presence leads to a sort of cat- and-mouse game which can get ever more sophisticated.

In politics the solution is to be found in a democratic form of government, but democracy is not enough. It needs to be supported by a belief in democracy and a willingness to place the survival of the system above the self-interest of the participant. The survival of the system cannot be taken for granted because it is inherently flawed. Stability requires a separation between fundamentals and values while the political system is characterized by a lack of separation.

Since we have little control over the fundamentals, we can ensure stability only by espousing a value system which draws a clear distinction between what is right and what is expedient.

Our founding fathers had such a value system but it is questionable whether it still prevails in Washington today. Institutions that have functioned for 200 years may be on the point of breaking down.

But I have strayed far afield from my main subject of interest: the revolution currently unfolding in the Soviet Union. Where do we stand in the process? The breakdown of the Communist system is now assured. The question is, what will take its place? Unfortunately, the destruction of a closed society does not automatically lead to the emergence of an open society because open society is a much more complex system than a closed one. In a closed society there is supposed to be only one conception which maintains its supremacy by suppressing dissenting views. But an open society not only allows but requires all participants to act on the basis of their own convictions. It also relies on sophisticated mechanisms for learning from mistakes and for keeping the participants’ bias within bounds. The Soviet Union does not meet these requirements and even the countries of Eastern Europe are very deficient after 40 years of Communist rule. So, a lot needs to be done.

In Eastern Europe the revolution is largely complete, so a constructive process can begin. But in the Soviet Union the revolution is only now approaching its climax and the process of destruction is not yet complete. The old center of power is still very much in evidence, although it is totally inept, paralyzed and lacking public support. The Shatalin Plan was a brilliant conception for creating a new center of power (the so-called Inter-Republican Council), which would gather public support by fighting the old center. But the old center was still strong enough to prevent it from being adopted. It used the time-honored bureaucratic device of co-opting the plan and thereby ensuring its failure. A historic opportunity was lost. But the situation is not hopeless; people in the Soviet Union still want to move towards a market system and only when the market has failed them will they be ready for a different solution. Thus the opportunity for a radical economic reform program may yet arise. The trouble is that it cannot succeed without large-scale Western assistance. The later it comes, the higher the cost. If and when it fails, the country is likely to turn to nationalism and fundamentalism of various kinds, with devastating consequences.

I must apologize for inflicting on you more ideas, particularly abstract ones, than can be readily digested in one sitting; but, then, I do not often get the opportunity to address an audience as illustrious as this one. I hope you will have many questions.