The Inverted Empire

The Soviet Union's Bizarre Trading System and its Strangulation of the Soviet Economy

The fall of the Soviet Union is a topic that has received significant scholarly and public attention. Copious books—including an excellent work of historical fiction—have been written about the topic, and several recent Substack posts have covered various elements of it in depth. For the most part, though, these pieces focus on internal problems within the Soviet Union that contributed to the communist superpower’s demise. You are likely familiar with the usual culprits: unsustainable military spending, excessive focus on heavy industry, misguided political reforms, and poor economic incentives, to list but a few. Yet the more fascinating driver of Soviet weakness, at least to me, derived from an external factor: Moscow’s commercial relationships with its Eastern European satellites. The bizarre trading regime that emerged between these communist states represented an enormous economic noose, slowly suffocating the Soviet economy. To be sure, Soviet economic issues were far broader and far deeper than those related to intra-bloc trade. Yet, in many ways the economic impediments created by trade inefficiencies represented a more irksome issue than many of the domestic economic challenges confronting Moscow. After all, they involved other sovereign actors, making their resolution more challenging. Soviet trade policy is also interesting insofar as it suggests that Moscow was not quite the omnipotent evil empire alleged by Reagan. The USSR was systematically outmaneuvered by its allies, who exploited its economic largess to engage in economically inefficient policies and risky borrowing. When the house of cards came crashing down, Moscow was on the hook for it all.

It is perhaps best to begin with a brief explanation of trade policy within the communist sphere. Unlike in free market countries, trade was not driven by the cross-border movement of goods in response to changing price signals. Instead, it was centrally coordinated through the Council for Mutual Economic Assistance (CMEA). This provided an intergovernmental forum in which representatives from various communist countries could haggle over resource flows. Rather than trade flowing to arbitrage price disparities, in this case it was centrally coordinated to alleviate (relieve) shortages (surpluses) in various national economic plans. So far, so good. But there was an important challenge to this model of trade: there were no price signals. Nor, in fact, were there any meaningful exchange rates. To circumvent the lack of a price signal, CMEA members developed what was known as the Bucharest Formula, which set prices based on a rolling average of the global market price. In other words, the communist states relied on capitalist markets to set their prices, but they did so in a way that introduced distortions by utilizing lagged prices. This was a problem for all traded goods, but it represented an especially ineffective approach for pricing goods not traded on the global market. Poor quality manufactures that could never find a buyer in the Western world were regularly traded among communist states, but the real price of these goods was impossible to derive simply by copying global prices, as these notional prices did not exist.

The lack of a clear price signal was compounded by the inherently political nature of Soviet trade policy. By virtue of allocating exports and imports through bureaucratic haggling within the Soviet state and among the various members of the CMEA, many non-economic considerations were introduced into Soviet trade policy. The biggest was the need to subsidize Soviet client states to prevent mass discontent from undermining communist regimes throughout Eastern Europe. This was particularly true following Khrushchev’s secret speech, which decried the violent excesses of Stalinism. Overnight, all Eastern European leaders were delegitimized by virtue of their association with Stalin’s murderous regime. Every brutal crack down, every show trial was now evidence of their illegitimacy. To sustain popular support for these regimes, therefore, Moscow had to ensure that economic growth and stability prevailed across its network of allies.

This imperative shaped the nature of Soviet trade policy. In particular, it led to the emergence of two implicit subsidies. First, Moscow sold oil and gas at heavily discounted rates to its Eastern European clients, who were reliant upon this cheap energy to sustain their industrial expansion. Not only was the energy provided by Moscow priced far below that available on the international market but, on account of the Bucharest Formula, its cost did not change in lock-step with global energy markets. This is because the Bucharest Formula introduced a lag in price adjustments by determining prices as a rolling average, which meant that Moscow was limited in its ability to benefit from price shocks, such as those of the 1970s. For one, Moscow was forced to sell energy at a heavily subsidized rate to its clients, and thus the difference between the global market rate and the subsidized CMEA rate represented lost profit. But Moscow was also unable to shift sales to the more profitable Western markets, because Eastern European demand so was vast, and central planning so cumbersome, that rapid adjustments were simply infeasible.

Moscow not only sold energy to its clients at subsidized rates but also imported low-quality imports from them at highly inflated prices. Recall that the “soft” nature of these goods meant that they were difficult to price. Many low quality CMEA manufactures were not traded on the international market, and thus their value was in essence whatever CMEA negotiators decided it was. This setup functioned as an additional subsidy to Moscow’s satellites, as it enabled them to earn far more for their manufactures than was justified by the these goods’ real value. More generally, the setup constrained the Soviet’s access to Western capital. Higher quality Western goods were crowded out, and the self-imposed limits on oil exports to the West limited Soviet access to Western currency with which to finance imports from non-CMEA countries. Thus, even by 1970, only 21.3% of Soviet trade was with the developed Western economies.

It was this combination of subsidies that explains why the USSR, one of the world’s largest energy exporters, faced economic disaster only a decade after the oil crises of the 1970s drove the price of its primary export to extraordinary heights. Moscow, by virtue of its trade setup, could not capture the full value of its primary export. But neither could it easily terminate the subsidies and risk destabilizing allied regimes. As Gorbachev lamented, “[t]he stability of the socialist countries is our vital interest from the perspective of both security and our economic interests… We should hang on even though the situation is strangling us.”

Of course, the situation was also, in some ways, strangling the entire CMEA by introducing perverse incentives throughout the system. As Stone observes in his excellent book Satellites and Commissars:

Using artificial prices meant, unfortunately, that each trade transaction involved opportunity costs to one side or the other, because a better buying or selling price could always be obtained on the world market. Naturally, the East European satellites tailored their negotiating positions to the opportunities offered by the distorted prices. As a result, opportunities were missed for expanded trade, specialization, and investment that might have revitalized the socialist economies.

The existing trade system produced stagnation, as Eastern European countries pursued extensive growth rather than seeking innovation and intensive growth. Most Eastern European exports were in manufactures, and here the Soviet planning model cared more about quantity than quality. Eastern European producers were also disincentivized from improving quality, as this would involve expensive capital expenditures for factory retooling that they would rather avoid. And with ever growing flows of subsidized energy, they had no incentive to economize. They simply threw more resources into their immensely inefficient production systems.

Of course, these pathologies stymied economic growth throughout the CMEA. This was a problem, as the regimes in these states lacked political legitimacy and were thus forced to win popular acquiescence to their rule by ensuring that their citizens’ quality of life continued to improve. Without domestic economic growth, however, this was difficult. Eastern European regimes thus turned to borrowing. Countries such as Hungary and Poland became increasingly indebted to Western lenders, which put ever greater pressure on their finances. The situation became significantly worse following the huge rise in interest rates that accompanied the Volcker shock, which raised the cost of borrowing and made debt refinancing all but impossible.

This reckless borrowing did not characterize Soviet policy, as Moscow was careful to avoid excessive debt to Western institutions. But Moscow was nevertheless implicated by virtue of its central position within the CMEA. The Soviets, in effect, served as the financial backstop of the bloc, which is exactly why Western lenders had the confidence to extend credit to moribund economies such as Poland. Creditors knew that, were Warsaw to default, Moscow would bail out its ally to ensure economic stability. As you might imagine, this created an immense moral hazard, as Soviet satellites enjoyed all the benefits of endless credit without bearing much risk of default, as the Soviet financial backstop protected them.

This also, paradoxically, strengthened these states’ bargaining positions in trade discussions with the Soviets. Eastern European countries demanded increasingly favorable trade terms, as they needed desperately to sell to the West to acquire hard currency with which to pay down their loans. Thus, they asked that Moscow reduce its demand for Eastern European manufactures while increasing the flow of subsidized oil. Moscow was able to resist these demands in part, but its need for economic stability among its satellites meant that it was negotiating from a position of weakness. Even worse, many Eastern European states, such as East Germany, borrowed heavily to finance improvements to their manufacturing base, which they viewed as the key to improving export competitiveness and earning more hard currency. But when this gambit failed, they were left with even more debt and no way to repay it. This put even more pressure on the Soviets to sustain subsidies. As the Soviet Minister of Foreign Trade Patolichev wondered, rhetorically, why must “the standard of living in the USSR… be lower than, say, Hungary?” As he went on to note, “[i]t is not enough to say that the USSR bears the military burden or that it helps the developing countries.” He was correct. Soviet problems were not driven exclusively by military commitments or by direct support to a few economic laggards; they were the result of the completely insane trade system the Soviets had constructed.

The Soviet Union was, in many ways, at the center of an inverted empire. It was similar to countries of the economic periphery insofar as its primary exports were commodities. Simultaneously, it was the political, military, and economic core of the CMEA. But it was unable to truly benefit from either position. Unlike commodity exporters on the periphery, its heavy energy subsidies to allies meant that it could not fully capture the rents from commodity price spikes. Yet, simultaneously, its need to keep its economically stagnant allies afloat meant that it could not effectively wield the power that accompanied its central position within the CMEA to exert its will. De Groot argues convincingly in his recent book Disruption that the reason the U.S. triumphed over the Soviet Union was that it was better able to shift the economic burdens of the 1970s and 1980s onto its allies. Partly this was due to more adroit diplomatic maneuvering and targeted risks, such as the unilateral end to the dollar’s convertibility to gold. But it was also because the U.S. economic model helped to develop American allies into strong, resilient economies that could absorb more of the burden. The same was not true of the Soviet economic model.

There are many lessons to be learned from this element of Soviet foreign policy. Perhaps most obviously, the Soviet Union was not omnipotent. For all its military interventions in Warsaw Pact countries, it could not successfully weaponize its network centrality to compel change in its clients. This is important. As I noted in a previous post, weak states are just as self-interested as stronger powers, and what may on the surface appear to be supplication is often a deliberate and self-serving strategy. Another important takeaway is how crucial capable allies are. American allies during the Cold War were an economic asset. Soviet allies were an economic liability. Ensuring that alliance structures are set up in a way that does not introduce extreme perverse incentives is important to long-term success. But to me, the most interesting feature of this story is just how absolutely insane the Soviet trading system was. It is difficult to conceive of a trade regime that produces no positive economic returns for one of the parties involved, and yet somehow the Soviets managed to create one. Because of their refusal to use real prices, their trade policy became a foreign aid policy. That alone is fascinating.