Governance of Economic Transitions: A Case Study of
Andriy Sergeyev and Alfredo Moscardini
CAST (Cybernetics and Applied Systems Thinking) Centre
University of Sunderland, UK
Key
words: VSM, Governance, Transition
Economies, Institutional Transformations.
Abstract
Ukraine has had to change in ten
years from a strong centrally controlled communist economy to a market
economy. It has not been successful.
This paper uses Cybernetic principles to examine the attempts at Governance
over this period. Using the VSM methodology,
we identified serious structural flaws in the organisation of governance at the
national level and showed how this induced the formation of mutant strategies
at the level of economic agents. This
also allowed us to present credible explanations of phenomena such as barter,
corruption, growth of overdue debts and the existence of incentives (other than
profit maximizing ones) which drive the behaviour of firms. There are many
explanations of the same phenomena in contemporary economic literature but our explanations are based purely on an
analysis of the complexity management tasks performed at each level of
recursion:- from a government to a firm.
Moreover, we show that the structural specificity of a system shapes the
behavioural patterns of each systemic element, whether it be a government body
or a firm’s management. Therefore, the notion of structural determinism allows
us to state that structure defines the dynamics of any structural change.
Introduction
Over
the last decade, there have been multiple interpretations and hypotheses about
the nature of the processes that take place in transition economies. Ukraine began its transition in 1990 as one of the biggest
and most economically successful Soviet republics but there are several
features of the Ukrainian performance which distinguish it from transitions in
other Central European countries (such as the Czech Republic, Poland, and
Hungary). Some of these features are:
1.
Ukraine experienced a more severe level of hyperinflation during the first
years of independence than the others.
2.
There was a considerable decline of output, which lasted longer than in any
other transition economy and lasted about 10 years. GDP in 1997 was estimated
to stand at 30% of the 1990 level.
3.
Since 1993, a leap of barter transactions in sales was recorded. Within 3 years
this type of non-monetary transaction reached almost 50% of total industrial
sales.
4.
An immense growth of inter-firm arrears started in 1994. By 1998, overall debts
between enterprises exceeded GDP. In August 2000, debts came to 272 bln. Hrv.,
which was twice the GDP of 1999. Overdue debts were 90% of GDP. (Shygayeva,
2001).
5.
At the same time, a considerable growth of unprofitable enterprises was
recorded.
These
figures are strikingly different from other transition economies and indicate
the existence of structural systemic transformations which differentiate
Ukraine from the rest of the European countries.
In
this paper, we follow a critical realist approach which posits the idea of a
stratified reality and differentiates between the generative mechanisms (that
lay behind any observed phenomena) and the actual observations. (Bhaskar 1978a,
1978b, 1986) We thus reject the
positivist belief of causality as a constant conjunction of events. Social
evolutionary adaptations (that are needed to compensate for the misbalances
between external and internal complexity) are brought about by the system’s
inclination to conserve its identity. This conservation of identity is a
primary feature of autopoietic systems and thus we consider social systems to
posses the characteristics of autopoietic systems. However, conservation of
identity does not guarantee a permanent state. Under certain circumstances,
systems can undergo a change of class identity or sometimes even disintegrate.
We show that during the Ukrainian transition, many processes took place such as
conservation, pathological conservation, change of identity and disintegration.
The idea of the inevitability of such adaptive transformations enabled us to
show that abnormal, from a traditional economics point of view, phenomena such
as barter, arrears, corruption are effective solutions (from the system’s point
of view) which increase systemic internal stability and provide mechanisms for
effective complexity management. For example, arrears appear as a survival
strategy which allows ‘Production Chains’ to conserve their autopoietic
functions. Using Beer’s terminology, this is called ‘the pathological
conservation of autopoiesis’. Corruption is shown to be an effective substitute
for an underdeveloped institutional infrastructure which not only supplements
many behavioural norms but dislodges them from the agenda of economic
processes. Barter effectively replaced an inefficient banking system in order
to counteract the erosion of material resources under the pressure of hyperinflation,
fixing and consolidating its prevalence after hyperinflation was depressed.
These examples confirm our hypothesis regarding the autopoietic nature of
social systems. Thus, the observed phenomena can be explained by demonstrating
a path dependent progression for the whole system. If
the theory of autopoiesis serves as a scientific substantiation of the
inevitability of the “bio-logic” of social structural transformations, then the
Viable System Model (VSM) is the appropriate tool to operationalise our
explanation of such transformations. To do this, we show how Ukraine as a
system “Nation” can be presented as a set of recursively nested viable systems.
By intervening in the different levels of recursion, we investigate how viable
systems conserve their initial identity by performing complexity management
tasks.
Initial
Conditions
We start our investigation from 1991, when Ukraine was
governed from Moscow by the Soviet central command system. P. Wiles
gives the following description of the state:
“The corporation is
identified with the state. Its Board of Directors is the Politbureau. Its
treasurer is the Minister of Finance. The profits of its branches, rather
misleadingly called enterprises), go automatically to this Minister being
decentrally retained by grace and favour only. There is not even any
distinction between managers and civil servants. There is only one career
structure with total transferability of pension rights, seniority, etc. The
command system can be viewed as a large corporation where a central planner
(the management of that system) allocates resources between its “subsidiaries”.
The corporation owns a large stock of natural resources, has no outside
shareholders (so that all “profits” can be kept for investments) and hires labour.
Transactions between enterprises are merely transfer prices between “divisions”
– the exceptions are purchase of labour and engagement in foreign trade”. (Wiles,
1977)
The aim of
such a corporation was to satisfy government
consumption (primarily defence), subject to the constraint that labour is
supplied in proper quantities. In order to obtain sufficient labour the
corporation must produce consumer goods, educate personnel, and keep it in good
health. Accordingly,
a model of the state governance is shown in figure 1 as a recursive structure.
Figure 1. The Recursive
Structure of the system “Nation”
The system “Nation” is represented as a set of
interrelated systems, which produce different aspects of Ukraine as a nation. In
the presented analysis we deal with explanations of economic phenomena,
therefore the system – in – focus is “Material Production”. The system
“Material Production” [1] is a viable system which is concerned with any
activity, whereby goods and services are produced. Its purpose is to organise
and use human and natural resources to satisfy the specific needs of the
Nation.
At the time of Ukrainian
independence, “Material Production” depended on a fundamental trait of a
command system – the asset specificity [2] of the production pattern. This
tendency of the “central planner” to optimise resource allocation led to
massive attempts to introduce economies of scale, which led to a situation
known as “small-numbers exchange”[3]. The absence of competition stimulated the
establishment of relatively stable technological chains without deep horizontal
diversification. These vertically integrated groupings [4] we call “Production
Chains” and are taken to be the System Ones of the system “Material
production”. Consequently, “Production Units” are taken as the System Ones of
the system “Production chains”. The purpose of “Production units” in the
command economy is defined as: “to be sufficiently efficient to fulfil the
imposed plans of resource utilisation and maintain the processes demanded by
the Production Chains”.
Based on this recursive
structure, the transition is analysed
in three stages which we call Disorganisation, Bad Governance and the Virtual
Economy.
The First Stage - Disorganisation
Under
central planning, the efficiency of variety management was greatly affected by
the factors shown in figure 2:
· Over-regulation
and restrictions within the whole society considerably reduced the complexity
of environmental variety.
· The softening of
financial discipline was a compensation for the restrictions of the autonomy of
the managerial activity of System Ones.
· Five-year plans
were high-variety amplifiers used by the System Ones to carry out their
operations.
Figure 2.
Complexity Management under Central Planning
We
regard any economic reform as a variety management problem. Reforms are
successful if they strengthen the homeostatic balance within any pair of
varieties introducing new effective institutional amplifiers and attenuators.
Such social reconstructions should not disobey the Fourth Principle of
Organisation: “The operation of the first
three principles must be cyclically maintained through time without hiatus and
lags” (Beer, 1979).
In Ukraine the
economic reforms had several major constituents:
1.
To abolish central planning and to liberalize trade
and prices.
2.
To tighten the fiscal policy (in order to eliminate the
practice of soft budgets) and in this way to reformulate the Resource
Bargaining at all levels of the recursive system in order to meet standards of
market economies.
Liberalization,
offering wider opportunities for entrepreneurial activity, aimed to compensate
for the resultant increased budget rigidity. Such a combination of increased
autonomy and restrictions were supposed to make the economy more financially
efficient, wiping out the non- viable units. Unfortunately, the reforms were
not as successful as expected. We explain this failure in terms of variety
engineering.
1. Liberalisation
loosened all the restrictions imposed on the environment by the ‘coercive
power’ of central planning and led to a boost of environmental complexity.
The effect of
efficient legislation is twofold. On the one hand, it damps possible
oscillations between the System Ones, serving as System Two (e.g. legal
frameworks: standards, efficient court systems and protocols of implementation
of its decisions), on the other hand, it serves as an attenuator of the
environmental variety by means of pre-concerted restrictions (laws). But the
main function of the law (to order the behaviour of economic agents and in this
way to attenuate environmental variety) was not being executed. Indeed, as a
result of the law's complexity (and therefore different interpretations), an
amplifier of environmental variety was created.
2. Liberalisation
failed to amplify the operational variety of ‘Production Units’.
Amplifying the
operational variety of ‘Production Units’ introduces more flexibility into the
decision-making. The new liberal climate was intended to stimulate a
diversification of industrial potential, flexibility in price setting and other
innovative activities. However, none of
these opportunities were taken. The absence of market practice and the lack of
managerial variety to absorb operational variety made enterprises reluctant to
make use of their innovative potential and other efficacious factors such as
entrepreneurship. Therefore, the conditions to make use of autonomy were not
created (the time to restructure was too short and available resources were
insufficient).
3. The disruption of
the ‘central planner’ (the five-year plans, production programmes and
procedures) abolished powerful amplifiers of managerial variety for ‘Production
Units’ with nothing to put in its place.
The tightening of fiscal policy was executed
through increases in taxation which resulted in more rigidity in Resource
Bargaining. Five year plans were amplifiers in terms of variety engineering.
Some investments could be made in order to compensate this but this is
difficult to accomplish when faced with a tightening of fiscal policy.
Figure 3 shows
these changes.
Figure 3.
Complexity Management after Liberalisation
As
a consequence, ‘Production Units’ increased their operational variety at the
expense of a reduced managerial capability to make use of new opportunities but
still had to face the problem of coping with the proliferation of environmental
variety. These arguments reveal serious
flaws in the complexity control paradigm. Beer’s first Cybernetic Principle of
Organization was not resolved. In fact, the system took a path which was
totally contrary to the expectations of the reform designers.
1.
The reform
measures did not bring about much structural change within ‘Production Chains’. It did not
lead to the dissipation of the old ‘Production Chains’ and the creation of new
more viable ones. Therefore an increase of competition and massive resource
reallocation from low to high productivity areas did not take place.
In the Soviet
Union, natural resources, such as gas, oil, and energy were underpriced to
subsidize heavy industry. This led to the utilization of power-consuming technologies
in metallurgy, machinery, etc. However, the overall production inefficiency was
hidden due to the distorted system of price calculation and asset specificity.
The abolition of central planning exposed these flaws. The considerable
cost-overruns and relative inefficiencies in the open market and “the relative
incapacity to make good use of the resources essential for economic growth
based on technical progress” became evident (Daianu, 1997). But since the
removal of the “central planner”, enterprises started to act under asymmetric
or scarce information [5]. They lacked the flexibility to obtain
information in time and to restructure production chains. ‘Economic agents’
preferred to stay within the existing structures rather than seeking other potentially
more beneficial alternatives. Beer (Beer, 1979) connects such forms of survival
to the notion of pathology: Pathologically autopoietic survival became a
central theme for many production chains. Any alterations were not evident and
immediate at the beginning of transformation period. The production structure
was preserved. The specificity effect and the presence of “monopolist” (due to
scarce information) suppliers became a core element of the pathology having its
roots in the central-planning system.
2.
These reforms
resulted in a disruption of the system’s ‘Ethos’ which led to a change of
identity of ‘Production Units’.
The disruption of
‘Ethos’ meant that the existing well-known ‘Rules of the Game’ – central
planning - were replaced by the rules of a free market marking the beginning of
a change in the purpose of the system. To stress this identity change, starting
from the next section, we use the term ‘Economic agent’ rather than ‘Production
unit’.
The Second Stage – Bad Governance and Institutional
Transformations
The
disorganisation observed in the course of the first stage became a source of
oscillations between ‘Economic Agents’ who lost their homeostatic balances with
their environments and were forced to preserve the existing ‘Production
Chains’. This in turn constrained the potential of ‘Economic Agents’ to adapt
and restructure so that the oscillations became a serious threat to
meta-systemic cohesion. A counteractive strategy was then generated by the
meta-system at the levels of ‘Nation’ and ‘Material Production’ which
misleadingly favoured the utilisation of the command channel, by enlarging the
number of government officials. This overload and the dominance of the auditing
activity (System Three Star) characterised the mode of governance during the
second stage. This strategy also induced a spontaneous parallel process of
institutional transformations at lower levels of recursion which re-established
the homeostatic balance but introduced new behavioural norms like corruption,
barter and arrears.
The Command Channel Overload
In the VSM model,
the Command and Accountability channels between the Senior Management
(meta-system) and the System Ones are of low capacity and should not be
exploited for routine management. This should be done by the System Two which
is a high capacity channel and routinely fulfils most of the coordination
between System Ones. The absence of efficient coordination incorporated into
System Two leads to an overload of the command channel – the state when the
desired capacity of the channel far exceeds its actual properties. The ‘command
channel over-load’ can be represented as the interaction of Systems 1-3-5. If
System Three is busy trying to run the System Ones’ operations directly, then
its major role of looking for synergy and making decisions on the basis of the
whole ‘inside and now’ perspective will not get done. A channel’s incapacity to
transmit and transduce a given amount of information will always create delays
in control responses and thus, eventually, the quality of the co-ordination and
management of the primary activities deteriorates. To improve the quality of
control, Senior Management has to reallocate most of the available resources to
support the functioning of System Three. But, very often, in this situation,
System’s Four participation in the meta-systemic management is negligibly
small. When System Four doesn’t provide System’s Three with a high variety
model, then, System Three damps oscillations in an ad hoc manner sometimes just
responding to algedonic signals. This is then the trap: - a weak System Two
causes an overload on System Three which in turn denies appropriate resources
to remedy the System Two (see figure 4).
A typical example
of this trap was observed at the level ‘Nation’. Senior Management is required
to pass an annual Budget Law, which represents a compliant set of Resource
Bargains for all System Ones (e.g. Health, Army, Material Production, etc).
This law defines the annual budgets of the state authorities, tax levels and
the conditions for their execution. The protocols and forms of budget execution
and the principles of fiscal equalisation between tax revenues and expenditures
should be part of the System Two. Particular properties of the budget plan will
obviously influence the monetary policy of the National bank of Ukraine, which
is a part of the System Four at the level of ‘Nation’. This is the one of the
reasons why the Federal Budget should be passed before the start of the coming
financial year and thus be a high variety attenuator for Senior Management.
Observations of the functioning of Senior Management at the level of ‘Nation’,
over the whole history of Ukrainian independence, reveals considerable
drawbacks in its performance which can be explained by a persistent late Budget
Law - even as late as the middle of the financial year in which it was meant to
operate! [6]
Figure 4. System ‘Nation’: The Trap of Command
Channel Overload
Bad governance – Dominance of the System Three
‘Star’
In
order to satisfy public expenditures and transformation needs, the Senior
management of ‘Nation’ imposed rigid resource bargaining on ‘Material
production’ forcing its System Three to increase the tax burden for the System
Ones. This limited the freedom of economic agents and their opportunities for
autonomy. It also caused large oscillations on the operational axis which could
not be attenuated by System Three. The situation deteriorated further when this
rigidity became so excessive that it forced ‘Economic Agents’ (who are always
trying to reduce this rigidity) to violate the legal processes of
accountability. The consequence was tax avoidance, neglect of property rights,
devaluation of business reputation and the diminishing power of civil law.
According
to Beer’s first axiom of management the meta-system absorbs horizontal variety
through six vertical channels (Beer, 1979). Four of them can be directly
influenced by System Three. If the high variety channel of System Two is
underused then this usually results in an internal incapability of governmental
bodies to generate enough requisite variety to absorb the variety generated by
the System Ones. To improve control, the only option for the meta-system is to
allocate even more resources to enlarge the size of the governmental managerial
structures incorporated in System Three. In this way, the capacity of the
command channels is increased and System Three can handle more variety. This
explains the excessive number of state officials and governmental bodies in
Ukraine, compared to countries with developed economies. Thus, when it is
impossible for the meta-systemic response of ‘Material Production’ to create an
efficient System Two at the level of ‘Nation’, there is an over-load of the
accountability channel at the level ‘Material Production’ and a lowered
propensity of ‘Economic Agents’ to execute their own accountability. The
auditing activity of System Three Star then provides a solution. We call this practice “The Dominance of the
System Three Star”, because attempts to enforce accountability further decrease
the autonomy of System Ones at the level ‘Material Production’ and produced a
basis for continuing oscillations. The dynamics of such a lock-in is the
following:
System Three ‘Star’
has a dual auditing activity. On the one hand, it amplifies System Three’s
ability to control the System Ones’ fiscal accountability, on the other hand,
frequent penetration into their affairs restricts their freedom. This leads to
a fall of management efficiency among enterprises and a desire to improve their
performance. System Three interprets such behaviour as an indication of
insufficient control and invests more resources to strengthen System Three
Star. The critical point is reached when System Three cannot manage without
this rigid auditing activity. This, coupled with the absence of an
appropriately constructed System Two, leads to an even worse performance of the
System Ones. Therefore, the appearance of a new institutional norm is observed.
It is costly to society and inefficient fiscally as its enormous size can not
be justified in terms of its benefits. However, a redesign of the system by
improving System Two would be very expensive which normally would not be
bearable for a financially weary society and consequently is usually not
undertaken (see figure 5).
There is ample
evidence of this phenomenon in Ukraine. It can be observed by the
deteriorating control of the economic environment. According to the 1997 IMF
report (IMF, 1997), Ukrainian enterprises rated harassment by local
administrations, excessive taxation, and import regulations as being more
severe than in 1994 and 1995. Other reports have shown that in Ukraine there
was rigid administrative control, an excessive taxation burden and frequently
changing legislation. (Kaufmann, 1996)
Figure 5. System ‘Material Production’: Poor
Governance Leads to Three ‘Star’ Practice
Institutional Traps
We argue that
meta-system ‘Nation’ showed features of bad governance during the initial
period which gradually improved to poor governance. The slight improvement was
due to institutional norm formation at lower levels of recursion which were
self organising. The creation of these norms mitigated the task of
meta-systemic complexity management.
Polterovich
points out that the appearance of inefficient institutions or detrimental
behavioural norms are often the unforeseen results of the extemporaneous nature
of transitional reforms. In some instances a newly evolved stable element of a
system’s structure may be disadvantageous relative to those elements which the
meta-system may have introduced [7]. Henceforth, we use the term ‘traps’ to
describe peculiar norms of coordinated behaviour that can result from a
system’s self-adaptations signifying detrimental consequences. (Polterovich,
1999)
The evolution of
traps results from the path-dependent behaviour of systems. If a system’s
structure is stable and the strength of external shocks is relatively small,
the structural changes most likely will not take place. If a shock moves the
system far from a stable state, the system’s structure may evolve into a new
stable form. Moreover, once institutional norms have locked-in within a
framework of social systems, they can obey the hysteresis effect, i.e. the cost
of exterminating economically disadvantageous norms, (even if the initial
conditions that triggered their appearance, have ceased) is more resource
consuming than the costs of their existence. Two examples of self-organisation,
which played important role for system’s development are now considered.
Institutional Traps of Corruption
Some
conditions that are conducive for the emergence of corruption are:
i.
System Four is inadequate, so that the 3-4
interaction cannot produce positive results.
ii.
Most of the systemic resources are directed to
develop System’s Three “inside and now” policy.
iii.
The ‘Economic Agents’ are suppressed by the auditing
system Three ‘Star’.
iv.
System Two cannot damp oscillations.
As taxes were not
a feature of the former Soviet Union, paying taxes was not part of the ‘Ethos’
of that society. Thus, tax evasion very quickly became a
part of the new ‘Ethos’ of the ‘Nation’ which affected the logic and nature
of the other elements. The inclination
to avoid tax leads to a corresponding adjustment of the whole system. New
‘rules of the game’, which include corruption, are
established. Systems Three and Four include these
rules in their pattern-recognition ability to amplify control. So, the
informal relations employed in System Two became organically incorporated into
the whole system. An ad-hoc System Two is created via the informal relations
between Economic Actors and the government at the level of the ‘Material
Production’. As a consequence, the oscillations on the operational axis of the
‘Material Production’ are relieved.
However, such a
damping mechanism is only effective for a while. It eventually generates
variety (in the form of a black economy) in the environment of the system
‘Nation’ which cannot be regulated. This is because neither the System Four nor
the System Ones at the level of ‘Nation’ can recognise the image of the
informal economy generated at lower levels. Using Beer’s terminology, this
image is encoded in language incomprehensible to the System Ones and System
Four. This creates a new wave of uncontrollability and instability at the level
of ‘Nation’. That in turn forces the meta-system to introduce more rigidity
into its resource bargaining at lower levels of recursion. So we observe a
vicious circle of the growth of an unofficial economy and deterioration of
complexity management.
The command
channel overload was a reason of a poor strategy coined as “if algedonic signal,
then generous damping payoff”. In 1992-1994 it resulted in unlimited money
supply and caused bouts of hyperinflation. Inflationary financing of budget
shortfalls damped oscillations at the level of ‘Nation’ but led to considerable
asset losses and therefore perturbations at the lower level of the system
‘Material Production’. Such a clash between different interests in different
levels of recursion encouraged self-organisation. The Connant-Ashby theorem
states that the model used by a regulator must have the requisite variety to
absorb the variety of the system that is regulated (Beer, 1979). If the model
does not have requisite variety to match the modelled situation, then the
system will not be able to counteract disturbances that are incomprehensible to
the regulator. This provides an explanation of what happened. Inflation was a
novel phenomenon for a post-Soviet economy. ‘Economic Agents’ tried to diminish
their losses by seeking ways to accelerate the rate of circulation of money.
However the existing banking system couldn’t cope with the subsequent rocketing
number of transactions. In 1992-1994 the period of bank transfers could last up
to a month. Under such circumstances, the transaction costs of monetary
exchanges grew very rapidly. People living under permanent inflationary
expectations and inflationary attributes gain experience which allows them to
forecast its probable appearance. Gradually, the economic agents perceived that
the transaction costs could be lowered if barter was substituted for monetary
transactions and inflation could be tackled by getting rid of money in favour
of goods. Moreover, as more participants choose barter, the lower the barter
transaction costs would become since it was easier to find partners and put
together barter chains. Eventually, bartering as a behavioural norm was
consolidated in the System Two of the level of Material Production. As learning
how to improve this process took place, the variety of this anti-oscillatory
device was further amplified. Counteractive measures taken by the ‘Economic
Agents’ to damp the oscillations triggered by the poor control policy of the
Meta-system, led to a survival strategy named “the barter phenomenon”.
Bartering efficiently substituted the underdeveloped monetary and banking
systems. Therefore oscillations, initiated by hyperinflation and an uncertain
environment were damped by the boost of non-monetary transactions. The
appearance of this behavioural pattern allowed the system to cope with the
oscillations. Those ‘Economic Agents’ who started using barter transactions,
considerably reduced the scope of their operations and hence reduced their
business environment (and certainly environmental complexity). This helped to
regain homeostatic balance. Figure 6
summarises the effect of these two traps.
Figure 6.
Creation of System Two at the Level Material Production.
The Third
Evolutionary Stage – The Virtual Economy.
We argue that in
the course of the third stage, the recursive structure of the system turned
into a new convolution of the evolutionary process. The survival strategies of
‘Economic Agents’ and ‘Production Chains’ changed in accord with the newly
formed institutional traits of the system and principles of meta-systemic
control. The particular response of ‘Economic agents’ to reforms which
propelled rigid resource bargaining mixed with opportunities for soft budgeting
and weak state governance is now examined. It will be shown that enterprises
develop and coordinate informal activities as a means of survival during
systemic instability.
Liberalisation
and fiscal and monetary rigidity were applied by the government to master high
inflation and to wipe out the most inefficient entities. Hence, the complexity
at lower levels of recursion was supposed to be reduced which would eventually
increase the controllability of the whole system. Gaddy and Ickes explain intentions
of reformers as follows:
“They [reformers] viewed
Soviet-type enterprises as typical enterprises encumbered by political
controls. The notion was that without government control, and with hard budget
constrains, enterprises… would behave like “normal” enterprises. That is, once
political controls were lifted they would maximise shareholders value like any
firm in the west “. (Gaddy and Ickes, 1998)
However, the
tightening of budget constraints for all enterprises essentially diminished the
potential financial viability of
‘Economic Agents’. Those that were closest to the break-even point continued
functioning with losses. It turned out that attempts to increase taxes and
strengthen accountability were directed against those, who couldn’t lobby to soften
these measures.
Counteractive Survival Strategy of ‘Economic Agents’
It was shown in
the second stage, that the strong regulatory devices which allowed ‘Economic
Agents’ to resist Resource Bargain rigidity formed a System Two at the level of
the system “Material production”. These elements were:
·
Protocols of corruption (i.e. common “language” of
bribe takers and bribers, accepted customs in a society, other conventions).
·
Unified rules and norms of barter transactions.
Thus, ‘Economic
Agents’ invested a considerable part of their resources to erect a regulatory
system which they hoped would decrease the pressure of the rigid resource
bargaining structure. This took a form of finding efficient survival mechanisms
which would secure survival, when profit-maximising behaviour is unattainable.
Such a strategy was based on the existing regulatory system of informal
relations between System One and government officials and was further extended
to encompass managers who ran enterprises in the same ‘Production Chain’. The
key point is that enterprises were able to increase output without a decrease
of prices or change of technology, i.e. to improve their performance through
bartering and obtaining lucrative contracts from government and enterprises
integrated in the same production chain. Gaddy and Ickes called this
phenomenon, “investments in relational capital”. Relational capital is a
goodwill that can be transformed into improvement of primary activities. They
state:
“The conventional view
ignores the fact that due to mutation of the enterprise it has survival
strategies unavailable to the “normal” enterprise. The enterprise can produce
goods that can be used for barter or for tax offsets but cannot be sold on the
market. It also procures inputs at a lower cost because relations allow it to
pay in non-monetary means”. (Gaddy and Ickes, 1998)
The
introduction of relational capital, as an additional factor of a production
function of an enterprise, indicates that the initial conditions describing an
enterprise’s position in the market has one more dimension. Such investments
can improve the performance of an enterprise and give comparative advantages
against “normal” enterprises forcing more and more to be involved in the same
strategy. This is termed ‘the network effect’. The developing dynamics of this
process can be described as a positive feedback loop. Enterprises will imitate
behaviour that they observe to be successful. If some enterprises are able to
survive without undertaking costly restructuring, then other enterprises may
choose to follow this behaviour. If several enterprises are better off, when
they invest in relational capital, then it is more likely that others will
adapt their behaviour. Hence, once the strategy of lobbying soft budgeting
appears to be working, the system may rapidly learn. Even if initially,
enterprises were able to survive through investments in new technologies, soon
they became uncompetitive against those competitors that adapt soft budgeting
strategy. So we observe a network effect which forces enterprises to tune their
behaviour according to a new behavioural norm of survival.
The Appearance of a New Recursive Structure
In
our view, the existence of “mutant enterprises, operating under different
rules” and the “fixing of abnormal institutional norms”, can be explained by
the segregation of ‘Production Chains’, which governed ‘Economic Agents’ with
different behavioural patterns. It is justified by the fact that enterprises
are more likely to interact with like-minded enterprises. So we postulate that
two self-organised domains of ‘Production chains’ have been formed in Ukraine.
We term them a domain of ‘Real Production’ and a domain of ‘Real Destruction’.
The domain of ‘Real Production’ encompasses those ‘Production chains’, which
try to increase efficiency and produce value.
The domain of ‘Real Destruction’ encompasses those ‘Production chains’
which produce goods but consume rather than create economic benefit to the
Nation (i.e. destroy value). Phenomena discussed previously such as corruption
and barter provide stabilisation mechanisms that preserve the organisational
coherence of the whole system. Thus, these illegal practices and the implicit
consent of the meta-system feed off each other and eventually form
self-organising processes which lead to internal stability. We argue that this
is the real cause of “economic stabilisation”, the mastering of inflation, and
even the end of the decline in production.
A description of
the systemic transformation is shown diagrammatically in Figure 7.
‘Production
Chains’, segregated into the ‘Real Production’ domain and ‘Real Destruction’
domain, have the same structure and elements, but different purposes of
existence. In this regard Geoffrey Vickers famously stated: “The trap is a
function of the nature of the trapped”.
Figure 7. New
Recursive Structure
Some of the
features of the ‘Economic agents’ which constitute domain of ‘Real Destruction’
are:
a. they do not
exhibit profit -maximising behaviour- all that matters is the level of output
(asset flow) and employment.
b. they employ more
workers than it is necessary for their level of output. Such a policy avoids
social discontent while the level of salary stays at the lowest admissible
range.
c. they hunt for a
pool of funding or resources which allow them to maintain themselves.
d. they literally
allocate resources between one another. Arrears are a means of such latent
reallocation of resources.
Such
characteristics are possible because they operate within a favourable
environment where profit and efficient management are inept. Previously,
markets were defined as the environment of operational elements embedded into
the system ‘Material production’. The new environment which nourished systems
in ‘Domain of Real Destruction’ we term as the ‘Virtual Market’. This coincides
with the term ‘Virtual Economy’ [8] used by Gaddy and Ickes (ibid) which
described the new type of economic system as having its own rules of behaviour
which “based on
illusion, or pretence, about almost every important parameter of the economy: -
prices, sales, wages, taxes, and budgets”.
The ‘Virtual Market’ is a complementary phenomenon to a fairly well-organized system and has the following characteristics:
1) Money is inept in
this environment, as long as prices are not defined by market mechanisms.
2) Prices do not
reflect real values of selling goods.
3) Prices which are
normally a high variety attenuator of environmental variety in the competitive
markets don’t carry out their informative role.
4) In the virtual
environment prices are set by those who have bargainning power, i.e suppliers
overvalue their output – consumers accept these prices.
5) The law of demand
and supply is no longer valid and is replaced by the “forced supply”.[9]
6) A real market can
never match such prices, so barter and non-monetary transactions are
introduced.
A virtual economy
creates the prerequisites for an unsuccessful monetary and fiscal policy. In
such a situation, the government doesn’t have any direct tools (monetary or
fiscal policy) for regulating ‘Production Chains’ in the domain ‘Real
Destruction’ and its environment. For example, the fiscal policy of hard budget
constraints is an efficient tool in the domain ‘Real Production’ but promotes,
resistance in the domain ‘Real destruction’. For successful interventions,
System Four must have a model, which encompasses systems from both domains and
their corresponding environments. Until this problem is acknowledged,
homeostatic balance in system Three-Four interactions cannot be reached.
Conclusions
The problems of
economic transition from a strong centralised command to market conditions is
one of the most interesting current economic investigations. In our opinion,
current economic theory has not managed to capture all the intricacies as
evidenced by many of the disastrous policies advocated by the World Bank. A new
approach is needed and this paper suggests using a methodology based on the
Viable System Models created by Stafford Beer.
In our view, the
transition process is an historical process which takes place over a large
period of time. At many points in this
process, there are crises which could be described as bifurcation points and
actions are taken that destroy the ideas of causality. Thus it is impossible to
predict the future but it is possible to understand the structural adaptations
that are taking place and thus understand the potential for several possible
economic outcomes. We contend that the
basic mechanism is simple - the systems desire to preserve its identity.
Using this
premise, we have examined the case of the Ukraine. Three stages have been
identified; Disorganisation, Bad Governance and the Virtual Economy. Economic policy has been analysed as a
variety management problem and interesting
insights have been highlighted. A
subsequent paper will describe a working model which incorporates these
features
Notes
[1]
We use the term “material production” as it is widely accepted in a command
economy to stress that elements of the System of Material Production is merely
or primarily oriented to produce products and services without financial
considerations.
The process of production does not always coincide
with profitability or value adding.
Often
it is not even clear whether a producer is a value adder or not, due to
distorted calculation techniques.
[2]
An asset is specific to a given exchange relation (or transaction) to the
extent that it cannot be redeployed for use in another context without
appreciable loss in productive value.
[3]
A small-numbers exchange refers to when there are few parties available to fill
one side of an exchange, whether supplier or buyer. (Williamson, 1985)
[4]
In economic theory vertical integration means the merger of technologically
related operations under one controlling centre In the command economy vertical
integration is the most dominating phenomenon.
[5]
It is assumed that the centralised planner controlled all the information about
perspective partners in a production process.
[6]
According to IMF report, the 1997 budget was not approved until June 1997, but
the consolidated budget deficit, on a cash basis, remained under control. The
budget preparations in the previous years were even more lax. (IMF, 1997)
[7] Technologies which are inferior to others that might
have been chosen or abnormal behavioural patterns like corruption and barter.
(Sterman, 2000)
[8]
We differentiate markets as the environment of operational elements from the
widely used term “Economy”, which is in our notation stands for a description
of operational domain.
[9]
When entries to other markets are closed and only few suppliers exist in the
market, consumers are forced to except any conditions of the proposed deal.
References
1. Beer, S. (1979),
The Heart of Enterprise, John Wiley & Sons Ltd., Chichester.
2. Bhaskar, R.
(1978a), 2nd ed., A Realist Theory of Science, Harvester Press, Brighton.
3. Bhaskar, R.
(1978b), The Possibility of Naturalism, Harvester Press, Sussex.
4. Bhaskar, R. (1986),
Scientific Realism and Human Emancipation, Verso, London.
5. Daianu D. (1997),
“Resource Misallocation and Strain: Expanding Shocks in Post-Command
Economies”, William Davidson Institute Working Papers Series, No 96, University
of Michigan Business School.
6. Gaddy C., Ickes
B. (1998), “Beyond a Bailout: Time to Face Reality. About Russia’s Virtual
Economy”, Working paper, June 1998, Brookings Institution, Washington, D.C.
7. IMF,
(International Monetary Fund), (1997), “Ukraine- recent Economic Developments”,
Staff Country Report No 97/109, International Monetary Fund, Washington, D.C.
8. Kaufmann, D.,
Kaliberda, A. (1996), “Integrating the Unofficial Economy into the Dynamics
of Post-Socialist Economies: A Framework of Analysis and Evidence”, in
Kaminski, B, (Ed.), Economic Transition in Russia and the New States of
Eurasia, Armonk, NY.
9. Polterovich, V.
(1999), “Institutional traps and economic reforms”, working paper, CEMI,
Moscow.
10. Sterman, J.
(2000), Business Dynamics. Systems Thinking and Modelling for a Complex World,
Irwin McGraw-Hill, New York.
11. Shygayeva, T.
(2001), Industrial Production and Finance in Ukraine: Monetising a Transition
Economy, Alterpress, Kyiv.
12. Williamson, O.
(1985), The Economic Institutions of Capitalism, The Free Press. Macmillan.
13. Wiles, P. (1977),
Economic Institutions Compared, Blackwell, Oxford.