The Specter of Inflation: Soviet case study and a modern solution

Permit me to start this post with a disclaimer.

One faces several problems when using historical analogies to analyze current phenomenons. Not least of all, there is the difficulty of extricating oneself from variables and trends derived from historical models that do not exist in the particular circumstance under review. However, when left with so little information to work with, as is often the case with conditions in the DPRK, observers must make certain presumptions to make sense of current realities and future possibilities. A key presumption that this blog has frequently applied in looking at North Korea was that command economies across time and space, whatever their reason for increasing state control over industries, are similar in their own ways. To pinch Tolstoy’s famous opener in Anna Karenina: Revolutionary economies are all alike; every non-radical economy is free in its own way.

Do take this article with a grain of salt.

Based on sources within the country, the Daily NK noted that rice prices in North Korea’s capital and border cities of Sinuiju and Hyesan have stabilized or fallen in the first three months of 2014. Cost of this most basic grain in Pyongyang remain at around KPW 3900 (KPW 4000 in mid December) while the rice price in Sinuiju has fallen KPW 800 since December to KPW 4100. Meanwhile Hyesan saw a dramatic KPW 1200 fall in prices from November to December of 2013 and have remained more or less steady since, hovering at KPW 4550.

All in all, this is good news. Stable prices allow people to anticipate future costs and this trust in the market facilitates trade, leading to further stabilization: a harmonious cycle. However, it is also critical to explore why this is occurring.

In January we examined some plausible causes (increased harvest, reforms, etc.) and raised the possibility that North Korea is exporting gold to defend the KPW exchange rate vis-a-vis the RMB. While the increased commerce resulting from KPW stability is stimulating the country’s market, if the state is subsidizing the stability through massive deficit spending (through gold exports), then price volatility and inflation have merely been repressed, carrying the risk of blindsiding the nascent North Korean market sometime in the near future.

Consider the case of the Soviet Union:

Some economists in the 1930s and 1940s strongly believed that command economies were well equipped to avoid inflation. After all, when the government determines both wages and the price of consumer goods, how could prices rise?

Nonetheless, economists at the U.S. Federal Reserve in October 1962 noticed that Soviet Premier Nikita Khrushchev was increasingly highlighting the need to control inflation in his policy outlines. It was a sure sign that not all was well in the worker’s paradise. But how did inflation come about in a command economy?

According to the historian Kuromiya Hiroaki, Joseph Stalin’s grip on power began to wane at the end of the Second World War. The social devastation resulting from the apocalyptic war against Germany had undermined the state’s ability to effectively coerce the people into following sanctioned economic behavior.

New critical thinking emerged among the military and in society in general. The Soviet people were hungry… [when famine struck Ukraine in 1946-7], people wondered why their mighty country, which had beaten Germany, could not even feed its own population… people became more vocal and critical… What is certain is that Stalin did not renounce terror, but used it selectively after the war so as not to de-stabilize the system of his creation (Kuromiya, Stalin: Profiles in Power, 2005, 176-180)

At the same time, labor growth had slowed down and the state was faced with the need to enhance labor efficiency.

When Stalin died in 1953, the new leadership had to bolster the legitimacy of the communist party and foster active public participation in state-led economic plans through different means. Stalin’s economic policies relied on maintaining the people money income and reducing the retail price in line with productivity improvements. As a result, consumer goods were simply distributed along existing lines of income distribution, exacerbating the wealth inequality and depressing traditionally poorer members of society like the rural peasantry.

In order to rectify this problem, the Soviet Union had briefly attempted to increase output during the Malenkov period (1953-55), but failed to meet targets.

Khrushchev outlined an alternative path in 1954. Inverting the Stalinist policy, the leadership shifted the economic focus to maintaining retail prices and improving the incomes of people. This was to be achieved through increasing the minimum wage and eliminating consumer charges (tuition, compulsory bond purchases, etc.). The principle idea driving this plan was the central planners’ expectation that expanding opportunities for higher income would incentivize workers and boost labor productivity. Advancing the planners’ faith in the profit-motive, Khrushchev also provided regional economic councils with more authority over production.

All these ideas were fine in theory but Khrushchev did not foresee how the basic tenets of the command economy would undermine his push to revitalize the Soviet economy. The ultimate goal of increasing productivity was to expand heavy industries, not consumer goods. As a result, the increase in the public’s disposable income was bound to outstrip the availability of consumer goods and services – leading to scarcity and erosion of the public’s purchasing power. The result was predictable. Almost immediately after major increases in minimum wage and pension payments, reduction of taxes, and elimination of specific consumer charges went into effect in 1957, inflation became a serious concern. The oversupply of money in the economy was acutely exacerbated when the state implemented the Seven Year Plan (1959-1965), forcing the Kremlin to postpone planned tax cuts and increase retail prices in 1962. A major retreat from Khrushchev’s economic plan.

According to the 1962 Federal Reserve report:

inflation in the Soviet Union manifest[ed] in increased absenteeism and continued high labor turnover. Suppressed inflationary conditions may also account for black market activities that became apparent in the 1960s. Although the increase in the activities could be a mirage brought on by more active surveillance of the Soviet economy, it is possible that they [were] bourne from monetary disorder within the economy. In fact, the willingness of the Khrushchev regime to return to extreme punishments for economic crimes reveal the proliferation of these activities in the Soviet economy

Amidst failures in both economic and foreign policies, Khrushchev was removed from power in 1964 and Leonid Brezhnev began his 18-year premiership. Much like how the economic reforms in the mid-1950s accompanied the Khrushchev thaw, the power shift in 1964 also went hand in hand with significant changes in central planning.

Under the 1965 economic reforms, recommendations were put forth to abolish the powers granted to the regional economic councils under Khrushchev, but the central planners remained faithful to the belief that profit-motive could be incorporated into a command economy without creating caustic externalities. Enterprises became the central economic unit and were given the freedom to make contracts with suppliers, determine production rates, and invest resources where they saw fit. To further induce productivity, the state mandated that wholesale prices of goods had to be profitable.

At the same time, however, central planners were unwilling to raise retail prices. With incomes continuing to expand and the state unwilling to diminish the consumers’ purchasing power, the state began massively subsidizing consumer goods in the market and use the banking sector to forcibly absorb the excess cash in the economy. According to a 2000 report by the Bank of Finland Institute for Economies in Transition:

  • Share of forced savings in total monetary savings increased from 9% in 1965 to 42% in 1989
  • Retail price subsidies rose from 4% of the state expenditure in 1965 to 20% in the late 1980s
  • Between 1965 and 1989, the budget expanded 3.8 times, but the total explicit subsidies (consumer subsidies) increased 20.7 times
  • In the 1970s, consumers paid 50-80% of the implicit prices of products. By the 1980s, consumers paid only 25-40% of the implicit prices

Adding to the Soviet state’s inability to keep the inflationary pressures under control, there was a “siphoning effect” caused by the spillover of purchasing power (money incomes) from state enterprises to the consumer sector. Unanticipated by central planners, it was a natural consequence of allowing the enterprises to make their own financial decisions, but it rendered the state unable to control the money supply.

The Soviet state was briefly reprieved in the mid 1970s and early 1980s due to increased oil sales following the oil embargo on Western industrial economies led by Middle Eastern states; however, the budget deficit proved to be a catastrophically burdensome drag on the economy. And when the state could no longer afford to finance the deficit spending, the long-repressed inflation spilled out into the market and became the precursor to the rapid collapse of the Soviet Union.

The problem with the post-1965 Soviet economy was the same as that during the Khrushchev years – the belief that a command economy could subsume the profit-motive to pursue an objective that did not benefit the consumer market. The end result was that the Soviet consumers themselves pushed back and created a “second economy” that operated beyond state control.

This process was eloquently explained by Professor Richard E. Ericson:

As the central authorities struggle with their loss of control, searching for a solution through reform, decentralization and re-centralization, monetization and administrative restriction, agents in the economy take advantage of gaps in control, of the autonomy and discretion offered by growing liquidity of the quasi-money in the system, to deal with problems of coordination and balance, inconsistency of plans and commands, and ubiquitous shortages/scarcities. Of course they operate in light of their own partial information, and in their own (private as well as official) interests, but in so doing save the system from collapsing under its own weight and rigidity. (Powell, 1977) Thus the second/shadow economy provides a spontaneous surrogate economic reform that imparts a necessary modicum of flexibility, adaptability and responsiveness to a formal setup that is too often paralyzing in its rigidity, slowness, and inefficiency… At the same time, it makes conditions livable and relieves inflationary pressures (monetary overhang) resulting from the necessary combination of monetary looseness and pricing rigidity.

Despite this positive functional role, the second economy also has a less positive systemic impact. It mocks the pretense of social direction and control, subverts its egalitarian impulse, accentuating differences in access and income, and gives lie to the pretense of a ‘new’ ideologically correct (‘Soviet’) man. Its very existence and usefulness thus subverts the ideology of the regime, and it works against and undercuts regime priorities by exposing the incompetence and incapacity of the authorities. Its provision of alternatives weakens the ‘plan, production, and labor discipline’ so essential to the proper operation of the command mechanism. Indeed, it attacks the core of the command mechanism as it ‘… elevates the power of money in society to rival that of the dictatorship itself, rendering the regimes implements of rule less effective and less certain’. (Grossman, 1977, 36)

As highlighted by a 1977 NBER study on financial flows in the Soviet Union, part of the problem was the Soviet Union’s failure to achieve controls via limiting credit extension to enterprises:

While control by the forint in Hungary or by the zloty in Poland has turned more and more into control through the terms of credit extension, in the Soviet Union it is still the flow of accounting data produced by the monobank that gives the measure of its contribution to keeping the economy on the beam, rather than the quality of decisions made by bank officials on the firing line. In fact, there is no firing line; for the issuance of credit, rather than having become a matter of negotiation between bank and borrower, retains its strictly implementary and semiautomatic character

But this simply adds to the argument that command economies are fundamentally ill-equipped to foresee and control inflation

Shifting our focus to the DPRK today, current trends look similar to what we observed in the Soviet Union in the first decade following the death of Stalin:

  • Retail prices of rice in Pyongyang, Sinuiju, and Hyesan remain more or less stable
  • The state appears to be upholding the purchasing power of the North Korean people through deficit spending (via export of gold(?)/state assets to China)
  • The government is giving state enterprises increasing freedom to manage their own resources with the expectation that it will improve their productivity
  • Expansion of income for average workers via increased wages (ex. 100x wage increase for workers at Potongang Garment Factory in September 2013)
  • Tacit acceptance by the state of a second economy

It appears likely that Pyongyang is repressing the inflation that we witnessed in North Korea between 2009 and 2012. And if this is the case, then the state’s fiscal robustness is being sorely tested. As evident in the Soviet case study, the inherent tenets of the command economy will prevent North Korea from effectively utilizing the profit-motive to drive change and the resulting market distortions will manifest through inflation.

Of course China’s experience with market reforms (which involves the very necessary process of permitting private ownership) still presents a viable model for North Korea’s gradual economic transition, but there is a complementary, more long-term solution to fighting inflation that has shown to be a key harbinger of growth and prosperity in at least one instance where it was applied.

The case for an indexed unit of account was championed by Yale economist and nobel laureate Robert Schiller who saw an opportunity to utilize the electronic software behind Bitcoin to establish a more stable unit of account based on a basket of goods in the market. He cited the case of the Unidad de Fomento (UF) in Chile as an example of how a quasi-currency could help index and bring stability to an inflationary currency. In turn, monetary stability fostered growth and development in the country once the use of UF became habitual in the marketplace.

The principle behind UF was simple. A representative consumer basket would be used to establish the unit of account, which would then denominate mortgages, loans, long-term government securities, pensions, rent, and deposits (which would be converted back to legal tender upon maturity – which was 40 days in the Chilean case). Payments were still executed in legal tender while wages were excluded from indexing to avoid the vicious cycle caused by workers’ expectations for higher wages complementary to increases in prices of consumer goods. It is also crucial to not use the unit of account as actual currency as that would lead to speculation and undermine the stability of the index.

Because people in various behavioral experiments and empirical studies have repeatedly shown themselves to be unable to adequately take into account inflation in financial decision-making, the unit of account would greatly ease people’s ability to anticipate prices.

Introduced in 1967, it took 15 years for the use of UF to become habitual in Chile. This process can now be facilitated by technology as underscored by Dr. Schiller.

If applied to North Korea, a unit of account could help stave off inertial inflation, as seen after the 2009 currency reform, caused by the people’s lack of trust in the KPW. And we are currently witnessing how monetary stability could contribute to food security.

The final hurdle to implementing any change in North Korea is political. As Dr. Lankov often highlighted, the key issue behind most reforms in Pyongyang can be traced to political will and risk. Although this blog has often been at odds with his belief that the rural peasantry pose the chief political threat in a hypothetical land reform, we certainly recognize the importance of looking at North Korea’s political economy. In the case of utilizing an indexed unit of account, one must think in terms of how inflation affects the creditor-debtor relationship. Controlling inflation will at the end of the day help creditors who will benefit from their loans retaining value over the long-term. Given how political elites have greater command of assets via property, business holdings, and supply of hard currency, bolstering the creditor’s powers could foster savings and improve the lives of those who can afford to maintain bank deposits. And herein lies the great obstacle – can the implementation of new monetary policies without complementary policies like land reforms help average North Koreans? As of yet, we know too little about wages and other conditions inside North Korea to be able to assess the long-term ramifications.

In the end, the problem might simply rest with the central economic doctrine of radically centralized economies. As seen in the case of the Soviet Union, where the state’s attempt to bolster both its legitimacy and industrial plans through the expansion of incomes led to inflation and economic catastrophe when the budget could no longer continue subsidizing retail goods, North Korea may be falling down the same rabbit hole – distorting the market when attempting to co-opt the profit-motive within its rigid, centrally-planned economy.

This is over all a complex issue that deserves greater research and careful exploration. As stated in the disclaimer at the start, there are bound to be flaws and inconsistencies in comparing North Korea’s monetary policy to that of the Soviet Union, not to mention applying policies that were successful in Chile to North Korea. Nonetheless, it is clear that Pyongyang is in flux and the current economic structures are under great stress. This poses both risks and great opportunities. And under such conditions, it is imperative that analysts add wealth to the marketplace of ideas.


About Yong Kwon

I develop trade advocacy strategies for a DC-based consulting firm. Studied economic history at the London School of Economics, and can be found on twitter at @ykwon88
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4 Responses to The Specter of Inflation: Soviet case study and a modern solution

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