THE SOVIET ECONOMY UNDER A NEW LEADER

Created: 3/19/1986

OCR scan of the original document, errors are possible

Theew Leader

A paper prepared jointly by the Central Intelligence Agency and the Defense Intelligence Agency for

submission to the Subcommittee on Econoniic Resources, Competitiveness, and Securityhe Joint Economic Committee, Congress of the United States

CIA HISTORICAL REVIEW PROGRAM RELEASE IN

The Soviet Economyew Leader

Table of Contents

Page

1

Gorbachev's 1

Gorbachev's 9

Addressing the Human10

Industrial

ear ofH

Actoitious

Dependence on UnrealisticProductivity16

6 Plan: Emphasis on18

Implications for

Factory Capacity

Materials. Intermediate Goods, and

Capitalizing On Sunk

The Politics of24

Future Decision26

Short-Term Economic

Long-Terra

Appendix A: Revised Estimate of Soviet31

Appendix B: 5 Economic Performance: Mixed

The Soviet Economyew Leader

Summary

During the year he has been General Secretary, Mikhail Gorbachev has shown himself to be the most assertive leader since Khrushchev. He has accumulated power by virtue of his strong personality and by inserting his own cadre Into key positions. Moving forcefully to place Ms personal stamp on economic policy, he has announced an ambitious strategy for modernizing the economy.

Gorbachev's plans call for boosting economic growth through massive replacement of outdated plant and equipment and an emphasis on high-technology industries. Both the general program goals he has laid out in public speeches and the investment targets set forth in6 Economic Plan would require record growth in the machinery allocated for modernizing Soviet plant and equipment. The machinery needed for Industrial modernizationroduced in the USSR in the machinery andlso the primary source of production of military hardware and consumer durables.

In the near term, the Soviet defense establishment is well positioned to acconmodate the possible shifts in machinery demand implied by the industrial modernization program. Since the, major investments in defense Industrial facilities have resultedubstantial expansion and upgrading of defense industry. onsequence, most Soviet weapons expected to be delivered to the Soviet forces0 will be manufacturedlants already built and operating.

Competition for resources could be intense, however, for some basic materials and some intermediate goods, such as high-quality steel and microprocessors, and for skilled labor--resources traditionally supplied on a

priority basis to military production. This competition could result in some trade-offs at the margin between military and civilian production. Nevertheless, in view of the immense sunk costs for plant and installed equipment in the defense production facilities, and the fact that these cannot be readily converted to civilian use, the industrial modernization goals are unlikely to significantly impede the completion of the major deployments of strategic weapons that the Soviets have programed through.

At this stage, Gorbachev's economic policies appear to command widespread politicalbecause of the consensus for the need to revitalize the industrial base and because defense procurement programs are largely unaffected in the near term.umber of senior military officers, moreover, have declared that industrial modernization is necessary if the USSR Is to meet the technical challenge of. The real test of Gorbachev's support will come in two or three years when renewed demands for expanding and renovating defense industries begin, as defense industries have to start preparing to produce new generations of weapons. How the Soviets are able to deal with their resource allocation problems then will depend on their success during the next few years in raising productivity, increasing the supply of advanced machinery, and building more modern Industrial facilities.

Introduction

This joint CIA-DIA report reviews the current state of the Soviet economy and Its probable direction after the first year of Gorbachev's stewardship. It begins by briefly discussing the economic situation when he took over with special reference to the defense sector. It then describes what Gorbachev appears to want to achieve with respect to the economy and the military, and how he plans to go about achieving his goals. Finally, the report analyzes the implications of the new General Secretary's gameplan for resource allocation and evaluates its prospects for success.

Before turning to theseethodological note isrder. Past assessments of the Soviet economy and defense expenditures submitted to the Joint tconoortc Committee by CIA were conducted0 ruble price base. The analysis in this report was carried out2 prices. The moveore recent price basehree-year research effort and allows us, we believe, toore accurate assessment of the resources associated with Soviet production. Although the basic trends have not changed, the use2 prices has resulted in somewhat different estimates of historical growth rates for the Soviet economy, as well as the share of GNP devoted to consumption. Investment, and defense. These findings are discussed tn more detail in Appendix A. Gorbachev's Inheritance

When Gorbachev came to power ine inherited the world's second largest economy. Itumber of major strengths,ighly skilled workforce and an enormous resource base. Nonetheless, over the past decade, despite continued growth, the gap between economic performance and plans and expectations had been widening, forcing Soviet leaders to turn

1

more and more of their attention to the country's economic problems. For example, despite generally increased use of fertilizers and other key resources in recent years, growth In agricultural output had failed to keep pace with the increaseopulationecade. Industry had also failed to live up to expectations. Problems in the energy, steel, and construction materials sectors, coupled with occasional transportation bottlenecks, had restricted industrial growtho only about half the planned rate. The net result was that Soviet GNP growth duringh Five Yearppeared headed for its worst showing In any FYP since World War II (see

Moscow's basic problem was that by thehe simple growth formula that produced major economic gains In the post-war period--ever Increasing Inputs of labor and capital resources--was no longer feasible. Over the past decade, the USSR had experienced:

Near stagnation in steel output.

A precipitous rise in energy and other raw material costs.sharp fall In investment and labor force growth.

ecline in productivity.

Gorbachev's predecessors recognized those problems and indicated, at least rhetorically, that In the future the economic system would have to operate differently Ifere to meet the USSR's needs. Efforts to increase the quality and quantity of output and make better use of available resources in thewitchattern of "intensive growth" based on productivityfrustrated, however,elatively backward technological base, inflexible production processes, and, perhaps mostumbersome and inefficient system of planning ana managementistorted structure of incentives.

Figure 1

USSR: Key Economic Indicators When Gorbachev Took Over

(Average Annual Percentage Growih)

Productivity

5 -

Output

10

5 -

Agricultural Output

10

Factor productivity measures the difference between the growth of gross national product and the growtheighted sum of inputs of land, labor, and capital.

rowth was calculated using not agricultural output, which excludes intra-agrlcultural use of farm products but does not make an adjustment for purchases by agriculture from other sectors.

Moreover, the leadership's inability to stimulate higher economic growth had contributedrowing malaiseubstantial and growing share of the population by the end of the Brezhnev era, not only because gainsiving standards had slowed but also because of an apparent belief that the system was Incapable of bringing about any meaningful Improvement. he rise in alcoholism and health-related problems-exacerbated the corruption and Inefficiency that had permeated the Soviet economicfarmhand to factory worker to the ministerial bureaucracy. Workers and managers alike spent increasing amounts of time and effort trying to insulatethrough illegalthe effects of shortages in both the home and factory. This reduced productivity on the job and aggravated shortages of goods and services throughout the economy, especially for Individuals and enterprises with little or no "special access."

Meanwhile, Gorbachev took chargeowerfulthat had been built upassive commitment of the nation's best resources over the past two decades and one that had been used increasingly to achieve political goals. , for example, Soviet military expenditures grewonstant rubles by nearlyercent (see Box Inset). Growth slowed in the, but the Soviets sustained spending at very high levels, enabling them to procure massive quantities of military hardware. esult, the share of GNP devoted to the military increased in current ruble prices from aboutoercent in theo aroundoercent in thes the growth of military spending during this period continued to exceed that of the overall economy.

->.

Box Inset Dollars ana Rubles

The CIA estimates the annual value of Soviet defense activities In both constant ruble prices and constant dollar prices:

-- The dollar valuation is used to measure how annual Soviet defense

activities compare in size with similar US activities. The ruble valuationsed to measure the impact of Soviet defense

spending on the country's econoqy.

In comparing the Soviet defense effort with that of the Unitedommon set of priceseeded. Military goods and services procured by the USSR are valued in dollar prices. Either dollars or rubles could be used, but dollar prices are used because they are most familiar to US defense planners and policymakers and because of the difficulty of estimating ruble prices for US defensehe cost of producing US weapons in Soviet manufacturing plants. These estimates can then be compared with US defense budget outlaysomparable set of activities over the same period of time.

The impact of Soviet defense spending on the economy must be measured in rubles. Our ruble calculation provides an estimate of the level of, and the trend 1n, the annual Soviet resource commitment to military forces. This estimate is used to assess the Impact of defense programs on the Soviet economy and, conversely, the Impact of economic factors on Soviet defense activities. The estimate permits insights into the resource constraints confronting Soviet planners and the priorities they assign to the elements of their defense effort.

End of Box Inset

Soviet gains In the strategic area were especially large. Over the last decade, Soviet strategic forces receivedCBMs and SLBMs, three tines as men as the United States procured. Similar sweeping improvements occurred in Soviet conventional forces where the USSR added large numbers of more sophisticated fighters, bombers, and tanks. In addition, throughout this period, Soviet defense industries, whose capacity expanded rapidly, produced an increasing amount of military hardware for delivery to other countries, particularly in the Third World, in an effort to both gain political influence and also to increase hard currency earnings. ompares procurement of selected military hardware by US and Soviet military forces, andresents estimates of the value of Soviet military exports

Oespite the priority given to the military In resource allocation, the defense sector was not totally Immune to the effects of economic problems. Resources devoted to military-related research and development continued tc growercent per year, but growth of military procurement dropped markedly and held overall defense growth (measuredollars) toercent per year duringhalf the rate of the previous decade. Both CIA and OIA agreelowdown in defense procurement occurred during this period, although the Agencies differ somewhat on procurement trends in recent years (see Box Inset).

In short, Gorbachev's predecessors left him with powerful military forcesarge but troubled economy. One of his primary challenges as General Secretary was, therefore, to find the resources to accelerate economic growth while sustaining the military gains of the pastears. Indeed, Gorbachev probably was selected as General Secretary in part because of the belief among certain of the elite that he was the best man to bringesurgence of

5

Table 1

US and USSR: Procurement of selected Weapons

and SLBMs

miss1lesb

and intermediate range bombers

surface combatants

a These numbers represent gross additions to weapons inventories and do not reflect retirements because of obsolescence or SALT restraints.

b Does not include naval or portable SAMs.

Table 2

USSR: Estimated Value of Militarybillion US dollars)

Six Warsawr

Iraq Libya

Vietnam India Algeria Cuba

5.4

Angola

ther countries

Total 5

Sox Inset

CIA-DIA Dollar Cost Estimates of Soviet Defense Procurement

CIA and DIA dollar cost estimates of Soviet defense procurement are derived from estimates of weapon systems production. esult of an5 review of such estimates, past differences between CIA and DIA have been narrowed greatly. Both Agencies agree on estimates for morefeapons systems examined. Both Agencies also agree that51 the dollar cost of weapons procurement increasedate ofercent per year.

Some differences still exist, however, on the growth of procurement In recent years. After several years of stability, 0IA estimates that,eriod, major weapons procurement increased atercent per year. In contrast, CIA believes that defense procurement was essentially flat during this period.

It should be pointed out that the DIA's methodology differs somewhat from CIA's, and therefore the results are not directly comparable. 0IA concentrates on estimating the year-to-year changes in the costs of major weapons procurement, which includeseapon systems. CIA estimates total procurement, which encompasses such additional categories and components as organizational equipment ana some weapons systems not costed by 0IAissile launchers and air-to-air missiles). esult, the 0IAalueboutercent of CIA's total procurement.

In addition to this differenceoverage, DIA and CIA do have different estimates for the production of some weapons systems, and some raethooologlcal differences In arriving at unit costs still remain.

End of Box Inset

B

broad-based economic growth and to push through an effective program of Industrial modernization. Gorbachev's Strategy

Gorbachev has,act, made it clear almost since the day he became General Secretary that revltalization of the economyop priority. Gorbachev has acknowledged that without improved economic performance the USSR would have trouble simultaneously meeting requirements for defense, boosting consumer welfare sufficiently to improve labor productivity, and modernizing the economy. In particular,ajor renovation of the country's industrial base, the new General Secretary probably realized that the USSR would continue to trail technologically in some areas vital to the military. In recent years, Soviet military authorities (including Marshal Ogarkov) have gone on record saying that, without major improvements throughout the economy, the USSR's military capabilities would continue to lag the West's technically in many areas, and Soviet forces would face increased difficulties in meeting the military requirements of.

In laying out his economic program. Gorbachev has focused his efforts squarely on increasing efficiency. To this end, he has essentiallywo-step approach. Initially, Gorbachevelyingombination of measures to strengtnen party discipline, improve worker attitudes, and weed Outhe refers to as the "human factor." Over the longer term, Gorbachev is counting on achieving major productivity gainsesulteries of organizational changes, reform initiatives, and, most Importantly, an extremely ambitious campaign to modernize the country's stock of plant and equipment.

9

Addressing the Hunan Factor

Gorbachev's first and most accessible target in his campaign to boost productivity has been his campaigns for discipline and against corruption and alcoholism. Theseke those pushed less vigorously by Andropov--have received widespread public support and yielded positive results. According to Soviet figures, purchases of alcohol at state stores declinedercent during the second half5 compared with those of the last six months Soviet press statements indicate that,esult, there hasarked decreasebsenteeism, fewer Industrial accidents, and increased productivity overall.

At the same tiiae. Gorbachev has removed an unprecedented number of senior economic managers (see Since taking over, he has replaced the Chairman of the Council of Ministers and five deputy premiers with officials more beholden to him. He has also removed the Central Committee department chiefs who oversee the machine-building, construction, and trade and service sectors, while replacingf the country's economic ministers and state committee chairmen. Some of the replacements have backgrounds In defense Industries, reflecting Gorbachev's willingness to draw upon talented officials in that sector to improve management of the civilian economy.

In contrast to his personnel moves, Gorbachev has moved much more cautiously on the organizational front,udden sweeping overhaul in favorore selective approach in an apparent effort to reduce economic dislocation and political infighting. Since mid-October, he has established new bureaus to oversee the machine building ana energy industries and has embarkedajor reorganization of the agro-industrial bureaucracy. Similarly, while avoiding any major reform initiatives andreference for working within the system, Gorbachev has voiced support for

Figure 2

MAJOR PERSONNEL CHANGES UNDER GORBACHEV

Three Politburo opponents removed; five allies appointed.

Chairman of the Council of Ministers retired; someconomic ministers and state committee chairman replaced.

Eight Central Committee Department Chiefs removedincluding five responsible for economic affairs.

giving greater operational independence to enterprise managers and workers through expansion of such programs as the "Five-Ministry Experiment." Begun Inhis experiment is supposed to give enterprises greater control over investment and wage funds and to make fulfillment of contractual sales obligations the prime indicator for evaluating enterprise performance. Industrial Modernization

Without downplaying the importance of his personnel and organizational changes, Gorbachev has made it clear, however, that his call for accelerated productivity growth depends ultimately on fundamental improvements in the country's production base, or,is words, on nothing less than "the structural transformation of the economy." According to one unofficial Soviet estimate, the stock of machinery and equipment isears old on average. In laying out his program last summer and fall, Gorbachev proposed:

Doubling retirement rates of capital stock to accelerate the replacement of obsolete capital by more efficient, largely state-of-the-art machinery.

Modernizing the nation's capital stock so thathird of it, including up to half the machinery portion, is new.

ncreasing capital investment in civilian machine buildingyercent over that. The qualitative side of Gorbachev's modernization strategy has emphasized the development of those industries that provide the advanced equipment for industrialear of Transition

As Gorbachev was putting forward his blueprint for reviving the economy during the latter part of, the Soviet economy was turning in another lackluster performance. Shrinking farm output held GNP growth6 to

ercent for the second straight year. Meanwhile, non-farm output rose bypercent last year. Industrial output increased byigure about equal toace as the tabulation below shows. (Seeescription of Soviet performance bySSR: Growth in GNP by Sector of Origin8

Pprrpnf

Sectors (including industry)

Calculated2 rubles at factor cost. D Preliminary.

c This measure for agricultural output excludes intra-agricultural use of farm products but does not make an adjustment for purchases by agriculture from other sectors. Value added In agriculture grew by an average5 percentercentercent7 percent1 percentnd at an annual average rateercent for thehole.

Despite the relatively slow growth in the economy overall, Gorbachev could take some satisfaction from5 results. ombination ofear that started out very badly turned into one that was at least respectable. Certainly, improved weather after the first quarter eased pressures throughout the economy. imilar situation duringharsh weather also disruptednot result in nearly the same turnaround. (See Box Inset on Gorbachev's impact on the economy's performance)

Although Gorbachev probably deserves some credit for the economy's showing in the last halfhe programs and decisions involving

11

Box Inset

Did Gorbachevifference

At the recentlyh Party Congress, party leaaers hailed Gorbachev for the economy's Improved performance since he took over last March. On the surface, their praise seems Justified. iserable first quarter last year, non-farm output rebounded stongty. Industry, in particular, has done well and by the last quarter5 was growing at closeercent per year.

Much of the rebound is attributable to improved weather during the last three quarters of the year. Last year's winter was the coldest inears. Rail freight traffic fell sharply, apparently causing shortages of raw materials throughout Industry. As the weather improved, these problems disappeared. Another factor in the rebound was the "postponement" of two holidays during the second half esult, there were two more work days during the last six months5 than in the same period

Nevertheless, Gorbachev's vigorous campaigns to increase worker discipline and cut alcohol abuse probably paid some dividends. At an April plenum just after taking office, Gorbachev issued an urgent call for better economic performance. While acknowledging the severe winter weather, he blamed the lack of discipline and passive management for the poor first quarter results and told workers and managers, in effect, to shape up or "move aside." His firing of one-third of the industrial ministers during themostly in sectors that had been doing poorly showed thatBrezhnev-was willing to follow through on his criticisms of industrial leaders.

End of Box Inset

resource allocation resulted from policies that predate his selection as General Secretary. or example, growth in Investmentercent, up fromercent rateut far below the rate necessary to carry out Gorbachev's modernization program. Probably because of harsh winter weather that delayed many construction projects, Investment grew faster in the second half of the year. Even when the weather improved, however, problems in bringing new production facilities on line continued. Hew capacity commissioned5 was valued atercent more than the capacity brought on streamespite repeated calls by Gorbachev and other top officials to cut back on unfinished construction during the year.

Similarly, whatever Gorbachev's intentions regarding Increasing the availability of consumer goodspur to labor productivity,olicy was not evident In particular, shortages of sought-after goods and services continued, limiting growth of per capita consumption to lessercent, half the rate achieved Supplies of some qualitylittle increase4 levels. esult, queues continued to be widespread, and rationing continued in some areas

While weairly good sense of consumption and investment trendsur information on Soviet defense spending is much less solid and we have not settled on an estimate for last year. What is certain is that the Soviets continued the broad based modernization of their military forces They augmented their strategic nuclear strike capability by beginning to deploy new bases for the new mobileCBH. At the sane time, they added new units of both the Typhoon and Delta IV Classes of Ballistic missile submarines.

Soviet general purpose forces modernization also continued apace, with many of thethose in the groundintended to make Soviet forces more capable of extended operations. As part

14

of this effort, for example, Moscow continued to field new tanks, an improved tracked infantry vehicle,ew wheeled armored personnel carrier. Meanwhile, Soviet air force units received their initial complement oflanker fighters, as well as other aircraft already in serial production. Finally, the Soviets continued their commitmentlue water navy with the additionew Oscar Class cruise missile submarine and the fitting out of both the fourth Kiev Class aircraft carrierew large aircraft carrier.lan:

Amoitious Targets

Whatever the economy's shortcomingsS, Gorbachev has made it dear that he expects much better results during the next FYP. The draft economic guidelineshat were Issued in early November set ambitious targets. GNP Is slated to grow atercent per yearnd byercent per year, rates not achieved in moreecade." Among the major sectors, agricultural outputlanned to increase byercent perubstantial improvement overesults. Meanwhile, In line with Gorbachev's strategy, industrial output Is scheduled to growercent per year, ledercent annual increaseroduction of the machine-building sector. Within machine building, special emphasis is to be given to the machine tool, computer, Instrument making, electrical equipment, and electronicssame sectors that have paced modernization efforts in the West. Production in these industries, identified by military leaders as being

The Soviets do notarget for GNP, whichestern concept. Rather theyarxist concept of national income which excludes depreciation, as well as most wages in services. To convert their national income targetIIP goal, we add an estimate for growth of most service sectors.

the key to modernization of the defense industrial sector, is to growtimes as fast as machine building outputhole.

Despite these impressive goals, the guidelines allow for only moderate increases in factor inputs. In line with demographic trends, little growth is anticipated in the labor force. What appears incongruous, however, is that total investment is slated to rise by onlyercent per year. Although somewhat above the rate of recent years, the Investment target is insufficient to meet Gorbachev's stated goals for increasing investment in the machinery sector, while satisfying the needs of other critical sectors such as energy, transportation, and ferrous metallurgy.

The reason for the low investment target is unclear. The fact that Gorbachev remanded the draft guidelines repeatedly before they were issued and that no Investment data other than an overall growth target appeared suggests that the issue of resource allocationifficult one. Moderate Investment growth appears inconsistentadical modernization of the economy.

Dependence on Unrealistic Conservation and Productivity Goals To make the planthe low investment figure--the guidelinesall for sharp increases in productivity and substantial energy and raw material savings. The guidelines exhort managers and workers to save industrial materials and fuels--an old theme. The leadership's problem is thathe short term there are few opportunities for quick savings that have not already been exhausted. While substantial savings could be realized by the use of more efficient equipment, itsigh priority of the Gorbachevdifficult and time consuming.

At the same time, to help bridge the gap between planned output and factor Inputs, substantial real growthroductivitylanned. Success in meeting this goal would stand In sharp contrast with the past two FYPs, when productivity actually declined (see To this end, the leadership is apparently banking on greater worker effort prompted by increased availability of consumer goods and services. For example,h FYP largely repeats the targets of the Food Program--first advanced by Bre2hnev ina goal for boosting per capita meat production byercent over the next five years.

urther incentive to the workers, the Politburo alsoonsumer Goods and Services Program last fall that lays down impressive goals for Improving the quality and quantity of nonfood consumer goods and services. Both are to grow at annual rates roughly double the average annual rates achieved duringeriod. While less ambitious than those proposed by Khrushchev in1 Party Program, they seem unrealisticight of recent trends and the apparent lack of any substantial Increase in planned Investment growth in these areas. Mo investment figures for these areas were given in the guidelines, but Gorbachev's emphasis on focusing investment resources on sectors related to Industrial modernization would seem toarge shift of resources In favor of the consumer.

even If the Soviets were to achieve all the targets set forth in the Food and Consumer Goods and Services Programs, It Is stMl unlikely that they woulo be translated into sizable productivitymatter how much greater effort the workforce putthey were also able to meet their plans for producing new machinery and equipment. Indeed, this point was made by

USSR: Growth in Factor'

Nlkolay Ryzhkov, the new Chairman of the Council of Ministers, in his speech toh Party Congress. He said that assimilation of new machinery would account for more than two-thirds of the planned Increase in labor productivity In the country.

6 Plan: Emphasis on Modernization

Whatever the reason for the low investment target inuidelines, and the need to set unrealistic conservation and productivity goalsesult, support for the investment program was back on center stage by the time6 annual plan was Issued. 6 growth target for new fixed investmentleast twice the average annual growth target foreriodhole, within the total, investmentivilian machinerylated tohoppingercent. Moreover, in apparent contrast with Gorbachev's previous statements that the share of investment in energy would be held constant during the FYP, Investment in oil extraction is slated to rise byercent, in the coal sector byercent, and in the electric power sector byercent. Similarly, agriculture's Investment share apparently will be held nearly constantather than decreasing as had been suggested earlier.

Although6 plan calls for rapid growthnvestment, the machinery sector will be hard put to meet the demands placed on it for investment goods, while at the same time meeting the requirements for consumer durables output and militaryother two major claimants on the sector's output. The Soviets probably could increase the supply of new capital somewhat without Increasing domestic production of investment resources by reducing the stock of uninstalled equipment and the backlog of unfinished construction. Success in accelerating capital assimilation wouldne-shot boost toward meeting equipment modernization goals. For

example, pronounced success in reducing the stock of uninstalled equipment mightillion rubles of new machinery. Once the additional stocks have been mobilized, however, inventory drawdowns are noource of additional machinery.

Some increase in machinery imports Is also certain The plan guidelinesake it clear that the leadership expects substantial help from Eastern Europe. They emphasize increasing economic integration within CEMA, and Gorbachev's appointments of Boris Aristov and Mlkolay Talyzin--both with extensive experience In East European affa1rs--as Foreign Trade Minister and Chairman of the State Planning Committee, respectively, could help in this regard. Moreover, the USSR may also be looking to the West for increased machinery imports, especially in key areas such as energy, advanced machine tools, and ferrous metallurgy. But while potentially helpfulhe absolute gains over the longer term probably will not be large because of (a) the lead times involved In contract negotiations with Western suppliers, (b) the deterioration In the USSR's hard currency position, and (c) the reluctance of Eastern Europe to provide more and better machinery.

In sum,6 annual plan appears designed toowerful boost to modernization. The question still open is whether this commitment will be sustained throughout the five-year period or whether the Soviets will stick to the investment target in the draft guidelines. Indeed, if investment growsercent6 as planned, investment would have to grow atercent per annumo meet the FYP target. utback to these levels tn thes unlikely, however. Investment rising at this rate would not support industrial modernization on the scale Gorbachev has been talking about. Moreover, Gorbachev probably would not slow the investment momentumf he comes close to meeting6 target.

Imp]{cations for Defense

Gorbachev's plan for refurbishing the country's industrial base through the massive replacement of machinery and equipment will certainly Involve increased demands for many of the resources used in the production of weapons. We do not know how far Gorbachev will go in emphasizing modernization of dvil industry as opposed to defense industry. We do have evidence, however, that the Soviets are aware of the heavy resource constraints the military burden places on the modernization program.

Many Soviet military leaders appear to realize, however, that the military will be the ultimate beneficiary of successful industrial modernization and have voiced their support for it. Soviet military authors are aware that economic improvements will ease resource constraints and accelerate the Introduction of new technology, thus setting the stage for more rapid military modernization in. In particular, weapons to be Introduced in theill use more sophisticated guidance, sensor, computer, and communication subsystems, which in tum will require advanced microelectronics, design, fabrication, and testing capabilities. An example of the military perspective was contained In an articlehe5 issue of Kommunist vooruzhennykh sil by Major General Vasykov who Identified "fundamentally new instruments, computer-controlled machine-tools, rosot equipment, and the latest generations "the leading directions of scientific-technical progress and simultaneously the basic catalysts of military-technical progress."

To the extent the Soviets have difficulty finding the resources to meet Gorbachev's Industrial modernization goals and satisfy military requirements in the near term, the problem will be centered in the machinerytraditionally hasarge portion of its output to the military.

The increased demands for resources needed for these programs will be centered

around several areas:

actory Capacity. Implicit tn Gorbachev's call for increased output of advanced machineryhethe absence of rapid plant expansion--for modern workspace at production facilities. In this connection, robots, computer-numerically-controlled machine tools, computer-aided design systems, flexible manufacturing systems, and other highly automated manufacturing systems are important for the production of both advanced manufacturing equipment needed for boosting industrial productivity and for producing sophisticated weapon systems.

Basic Materials. Chemicals and metals are used in producing both weapons and advanced machinery. The ferrous metals ministry, for example, has failed to meet Its targets for many types of steel in recent years.

Intermediate Products. Engineering plastics, advanced composite materials, electronic components, and microprocessors are currently in high demand In the defense industry and, as modernization proceeds, will be needed increasingly by civil industry as well. These products, however, are In short supply.

abor. Both the defense Industry and modern civil industry require highly skilled workers, particularly computer technicians and software engineers.

The near-term competition for factory floorspace and investment goods has been mitigated by the substantial expansion and upgrading of defense-Industrial plants over the past decade. Comprehensive programs to modernize many weapons production facilities began In the. Efforts to modernize defense industry accelerated in the, and wearge portion of the best domestically produced machinery was delivered to defense Industry during this period. In addition, the defense sector was helpedurge in clandestine and open acquisition of Western manufacturing equipment.

esult of this investment in defense industry, almost all of the production capacity required to support Soviet force modernization over the

next six years or so is already in place. Our calculations suggest that

virtually no additional investment in the plant and equipment is needed to manufacture the military hardware that we believe will be in productionnd that most of the capacity required to turn out the military equipment projected to be in production in thes already available. Moreover, weapons development and industrial construction indicate that investment in defense industies will continueigh level, adding new capacity with greater capabilities. Thus, military production would not be constrained In the near termeallocation of new fixed investment in favor of civilian machinery and other priority sectors. Materials, Intermediate Goods, and Laoor

Although tne Soviets have the production capacity to maintain or even increase the current level of weapons production, competition for labor and material inputs used In the production process could force some trade-offs at the margin between military and civilian production. The nature of this competition is shown In Figurehich summarizes our judgments on (a) the degree of need for the particular resource in civilian machinery, (b) Its availability in non-machinery sectors of the economy, and (c) how easy It would be to shift the resource from military defense industry to civilian machinery.

High-quality steel and energy, for example, will be in great demand to manufacture oachines needed for both industrial modernization and weapons prooaction. The high targets the Soviets have set for machinery production will place tremendous demands on the ferrous metals branch. This Industry, however, has been doing poorly in recent years and apparently will receive little, if any, increasenvestment duringYP. Although there is likely to be some growth in the energy sector, the energy situation may be tight.

22

Figure 4

USSR: unitary-Civil Competition for Resources

Resource

Materials

Basic/Raw: Energy

Intermediate: Chemical feed stock Engineering fibers Micro-electronics

Heed In Civilian MbMUAval Sector for Modernization

Medium

High High High

Outside Sector

High

Medium Low-Med Low

Transferability from MilitaryW

High

Hed-Hlgh High High

Cotment

In very short suppl) In both sectors.

steel Muml num Titanium

Construction materials

Hed-Hlgh Mediurn Medium

High High Medium High

h High Medium High

Products

Conventional: Electric motors Diesel engines

Advanced:

Engineering plastics Micro-processors Composites Micro-electronic components

Med-High Med-Htgh

High High Medium High

Low Low

Low-Med Low-Med Low-Med Low

h Med-High

High

High Mediurn Medium

Skilled: Computer programers

Electronics technicians Software engineers Researchers Machinists

Industrial engineers Unskilled: Laborers

High

High

High Med-High Medium Medium

Low-Med

Low-Hed

Low-Med

Low-Med

Med-High

Low-Med

Low-Med

High

High

High High Medium High High

High

Shortage exists throughout economy

Ihe competition for human resources could be even more intense. Extensive underemployment exists in the Soviet economy, and Gorbachev may hope that he can support his modernization program by mobilizing currently underemployed engineers and labor. But shortages persist in the USSR in several skill areas critical to both defense andexample, systems analysts and,esser degree, computer programmers and selected types of engineers and skilled machinists. The most likely immediate source of additional specialists for dvil machine buildingeallocation of the employees already working In the machinery sector.

Capitalizing on Sunk Costs

In view of the massive Investment already madeefense plant capacity and the powerful precedents of military priority, we believe that the Soviets will move ahead with most of the military modernization that the Intelligence Community has projected through the end of the decade. As noted, nearly all of the major systems expected to be delivered to the forces In the next several years already are being built on fully equipped final assembly lines. The Blackjack bomber, theighter, theCBM, and0 tank, for example, have all entered production, and although thes not yetroduction, the necessary capacity is ready and the production machinery fs probably installed.

The demands for basic materials, intermediate goods, and skilled labor to meet Gorbachev's industrial modernization goals, however, might cause the pace of production of some of these new systems to be somewhat slower and the date of introduction somewhat later than would otherwise be the case. Even allowing for such delays, however, the USSR can proceed with its strategic and general purpose programs over the next severalthe annual rate

23

of procurement spendingittle or even declines. For example,roduction of major weapon systems with representative levels of production of the same systems that are feasible over the next five years If procurement spending grows at an average annual rate of less than one percent. The specific mix of weapons may be somewhat different--some higher, some lower. Nonetheless, taking Into account the sunk costs and the momentum of ongoing programs, we believe these figures reflect the general level of procurement that will occur duringeriod.

At these general levels of production, improvements to Soviet strategic forces will be substantial. New generations of land and sea-based ballistic and cruise missiles recently have entered or will soon enter production. omprehensive modernization of the USSR's strategic offensive forces should be completed by the. Strategic defense force improvements, although less substantial, also will permit sustained improvementsapabilities.

Conventional forces willimilar upgrade. Two late generation fighters, thendre entering the inventory, while new submarines and warships--includ1ng the USSR's first full-sized aircraftimproving naval capabilities. ariety of improved land arms (most notably new artillery weapons and0 tank) are being deployed to the ground forces. The Politics of Modernization

Thus, Gorbachev can "coast"ew years on the strength of the USSR's past investment in its military industrial complex, which will permit the continued modernization of the USSR's strategic and conventional forces. As already noted, the military appears to suppot Gorbachev's basic

24

Table 3

USSR: Procurement of Selected Weapon Classes

Class

Aircraft

Bombers

a See text for explanation ofrojections.

0 Although our projections suggest lower overall numbers In these categories, the missiles, fighters, and helicopters the Soviets will procurere more complex, capable, and costly than those purchased.

?-.

because it will allow for the modernization of strategic forces and because of Its long-term promise of more advanced weapons. The extensive top level leadership changes and the formal endorsement of the Party Congress put Gorbachevood position to move ahead with Implementation of his programs for change. His preoccupation now will be with lower level elements of the entrenchedis, how to get them to implement his policies.

Nevertheless, over the longer term, the political risks for Gorbachev are likely to mount as the demand for new investment for defense plant and production equipment riseshend, when the Soviets will have to begin tooling up for the next generation of weapons. Unless Gorbachev's efforts to modernize Industry pay off in greater numbers of more advanced, high quality equipment andubstantially Increased productivity, Gorbachev will need to reconsider his overall economic strategy. Over the next few years, the defense industries will be expected to do more with the resources they have as they satisfy continuing defense requirements. In the, however, decisions will have to be made regarding the building of new capacity to produce the major new weapons of. At that juncture, shortfalls in industrial modernization and technological advance could Increase pressures to postpone certain major defensedevelopment that would be unpalatable to the military and some political leaders.

Future Decision Points

Short-Term Economic^Prospects

Gorbachev's political fortunes ultimately will depend on maintaining his political support within the Party. If Gorbachevot able to reverse the downward trend In economic growth, nis support will be greatly weakened. In the short run, at least, prospects for at least some success in reviving the

26

economy are promising- S, industry reboundedery poor start to register respectable growth. As noted earlier, much credit Is due to better weather, but Gorbachev's Initiatives may also haveositive impact which should carry forward6 and beyond.

Some modest improvements In economic performance also could show up when the "Five-MinistryHalted expansion of the operational decisionmaking authority of plant directors under way sinceextended industrywide next year. Positive results depend, however, on preventing the economic ministries from encroaching on the authority of industrial firmsthe samethat enterprise managers do not use their increased powers in ways that are Inconsistent with national economic goals. Historically, these have been elusive objectives, and, even as emended by Gorbachev, the Five-Ministry Experiment has not introduced changes in economic incentives that are likely to result in significant progress toward them.

Gorbachev's program should also benefit somewhat from the upturn in machinery production that began After averaging annual gains ofpercent, machinery output has picked up to an annual rate of more than percent rise in investment in the machinery sector planned for this year will help future growth.

Long-Tern Uncertainty

How much economic improvement can be expected, and how long it can be sustained, however, is very much an open question. Although personnel changes, reorganization of the planning and management apparatus, and increased discipline may boost labor productivityew years, we believe they cannot by themselves sustain growth Indefinitely. The key to success will be Gorbachev's ability to cope with some fundamental problems:

management efficiency and worker morale will require an effective incentive systemetter supply of consumer goodsime when the investment sector will be oriented toward producer goods. Investment in some consumer sectors has apparently received short shrift, risking consumer discontent that will counter efforts to raise productivity.

he greater managerial independence necessary for effective

technological development and resource use is inconsistententrally planned pricing and allocation system.

modernizationrocess best served by slackhe economy that give plants the time to retool and learn how to use new equipment. Gorbachev's emphasis on immediate acceleration of GNP growthontinued priority on currentmajor source of the traditional reluctance of enterprise managers to Introduce new technology.

Thus, Gorbachev could beonsiderable risk in Implementing his modernization program. If he tries to carry It out without raising the overall investment rate, the impetus to growth based on6 plan is likely to trail offew years, leaving the shortages and disproportions characteristic of an unbalanced plan. Shortchanging the energy sector after this year, particularly oil, could resulturther sharp decline In oil production. Already last year, falling oil pricesecline in sales to the West ledbillion drop in hard currency earnings. An erosion of the same magnitude is possible this year. To offset sone of this loss, Moscow will probably try to push arms sales, but lower oil prices have resultedeak demand from major Middle Eastern customers.

Hard currency arms exports fell aboutercent5 and could fall again this year. Moreover, unless the USSR is willing to underwrite Western Imports through massive borrowing--which seems unl1kely--Koscow may be forced to reduce Imports of state-of-the-art technology.

To maintain or restore the momentum to his modernization program, Gorbachev could decide to step up Investment toward the end ofh FYP by trying to curb the military's demand for machine-building outputesources. The military obviously might become restless undercenario while waiting for the deferred improvements in the technological base of military industry. Alternatively, Gorbachev could find machinery for the modernization program by curtailing the resources committed to consumer durables production or the Food Program or by leaning more heavily on Eastern Europe. Scaling down resources for the consumer might be especially attractive if better than average weather over the next few years resulted In unexpected gainsgricultural output. In the absence of such an upturn, however, Gorbachev's plans to increase work effort would probably founder as general disillusion set 1n, with the population seeing Gorbachev as no mora effective than Brezhnev or Chernenko.

Rather than direct more resources to investment, Gorbachev might seek to promote productivity through organizational reforms. He could, for example, permit some legalization of private-sector activity, particularly in consumer services. This would indicate willingness to overturn past economic orthodoxy in order to improve consumer welfare and, thereby, economic performance. Although Gorbachev hasonservative approach to reform measures so far--preferring to work within the system--he may be willing to introduce bolder measures once his political support has solidified.

In sum,r adjustments probably will have to be made in Soviet economic policiesorbachev hopes to achieve his economic objectives, although at this stages too early to tell just what he will do. The one thing that appears certain is that the new General Secretary remains committed to his industrial modernization program. Indeed, at the recentlyh Party Congress, Council of Ministers Chairman Ryzhkov, in his keynote speech on the economy, reiterated the ambitious targets laid out in the draft guidelines ofh FYP. He repeated the Importance of investing more In machine-building, while maintaining the large share, about one-third, taken by the agro-1ndustr1al complex. He also announced, however, that investment in the energy sector would rise byercent duringh FYP. How the leadership intends to achieve these rates of growth without squeezing other sectors of industry--while staying within the overall investment goaly>ercent per year--was not addressed, which suggests that the leadership is still developing its resource allocation strategy.

Whatever adjustments have to be made, Gorbachev istronger political positionesult of the personnel changes conducted at the Congress. With the election of Lev Zaykov to the Politburo, Gorbachev gained an additional ally with voting membership. In addition, major changes were made in the Party Secretariat, strengthening Gorbachev's hand there. Five new Secretaries were added andonomarev, head of the International Departmentuarterentury and Ivanrezhnevlte with the light industrydropped, with these changes, only two Brezhnev era officials remain onmember Secretariat.

30

Appendix A

Revised CIA Estimates of Soviet GNP

Nature of the Revision

The economic growth rates presentedhis paper are basedajor revision of the estimates that have been published annually in CIA's Handbook of Economic Statistics and described in detail in USSR: Measures of Econociic Growth andissued In2 under the aegis of the Joint Economic Committee). The purpose of the revision is to base the estimates on pricesore recentinstead The results should be regarded as preliminary and subject to further revision as more information becomes available.

The shiftew price base affects estimates of GNP and its growth rates in three major ways when compared with previous estimates:

alues of output are higher, because prices in general increased

0- Rates of realpricelower for GNP and most key components. This result is to be expected when pricesore recent year are used to calculate growth rates (the "Index number"Box Inset). In converting estimates of US GNP2 prices2 prices, the Department of Commerce obtained similar results.

hares of key components of GNP are different because the components

experienced diverse rates of change in both real growth and prices. The estimates of Soviet GNP are calculated first by using2 prices and then adjusted so as to measure better the actual allocation of

Box Inset

To see why measured economic growthikely to be lower, the store recent the price base usedhe calculation, consider an example. Suppose we want to estimate the real growth In output of precisionroup of products ranging from clocks to automation equipment to computers. Depending on the base year chosen, the changeelative prices of individual products In this group will differ because of differences in technology, scale of production, and input costs. The prices of the new and fastest growingto fall relative to other prices because of more rapid gains from advances in technology and economies of scale. Therefore, the fastest growing products will have smallerless impact on average growth of thea later base year than they would in an early base year.

End of Box Inset

1 7

resources In the economy and changes over time in Its potential to produce goods and services. Official Soviet prices giveistorted picture of the true costs of economic resources, largely because the prices include huge sales taxes, levied mostly on consumer goods, and subsidies, which affect mainly food and services. Moreover, the profits Included in the prices do not reflect accurately the differences In efficiency among producers. To correct for such distortions in officialo-called "factor cost adjustment" is made in which profits and indirect taxes are subtracted and subsidies and charges on fixed and working capital are imputed. The resulting valuesuch better picture of patterns of resource allocation by producing sector and by final end use than the distributions shown by official prices. Also, estimates of changes in GNP using factor cost valuations provide more accurate measures of growth in production potential over time. Results of the Revision

With both prices and real output rising, Soviet GNP increased by nearlyercent0evelillion rubles. Prices accounted forhird of this increase,ate of Inflationittle moreercent per year. In contrast, official Soviet statistics for measures similar to GNP imply an inflation rate of less thanercent per year during that period. Most Western specialists believe that these official statistics seriously understate the extent of price Increases and therefore overstate Soviet economic growth.

Annual growth rates of Soviet GNP in real terms as measured2 prices are with few exceptions lower than previously estimated rates measured0 prices Shifting the price base reduced annual rates of increaseew tenthsercentage point. The differences

between ratesittle largerarliera percentage point or more.

The shiftew price baseignificant effect on the relative shares in total output coming from Uie two largest producingand agriculture The share of industrymaller when measured2 prices because average wages in industry Increased much lesshan average incomes in agriculture, and the capital-output ratio Increased more rapidly in agriculture than in industry. The shares of the trade and services sectors dropped somewhat, while the shares of the remaining sectors are little affected by the change in the price base. Impact on Estimates of Defense Spending

Moving Soviet defense spending estimates02 price base has affected assessments of defense spending and its components in four major ways:

The overall level of spending rose.

The share of GNP allocated to defense spending increased fromoercent in theooercent in the.

stimates of the rate of real growth decreased slightly.he shares of major resource categories in total defense spending changed.

The estimates of defense spending2 pricesigher overall level of spending than did0 series. The new series averages almostercent higher for the period0 than the series0 prices, indicating that military costs increased about three percent per year. When both price change and growth in real output are taken into account, the growth In defense spending averagedercent annually. Price changes accounted for moro than half of this increase.

USSR: Shares of GNP by Sector of Origin at Factor2

(percent)

Value AddedAdded in

rices

Industry

personnel

branches

The change2 price baseomewhat higher share of GNP allocated to defense than did the earlier series. This result Implies that prices for defense goods and services increased faster than for civilian goods and services. , total defense spending increased on average by almost three percentless rapidly than the series0 prices.

The direction of this change in relative growth rates is what index number theory predicts (seeut it isarge effect. One reason for thishat in the conversion2 prices the share of defense spending devoted to procurement Increased, while the share of the more slowly-growing personnel category fell.

Appendix B

conomic Performance: Mixed Results

Soviet economic performance5 continued the uneven record compiled by the economy during the just completedh Five Year Plan. Disappointing farm output held GNP growth toercent, the same as oor first quarter, however, the pace of Soviet non-farmby strong recovery in industry andreturned to Its recent annual rate ofpercent. Industry grew by almost three percentut by more thanpercent in the last quarter. Agricultural output, in contrast, shrank for the second yearow, although an improved grain harvest allowed Moscow to cut grain imports substantially. This reduction was helpful in dealingpercent drop in hard currency earnings, largely the result of reduced oil and arras exports, although increased borrowing and gold sales also were needed. Industry

Afteroderate improvementrom the depressed levels of the previous two years, Soviet Industrial performance worsened abruptly during first The USSR was hit by the coldest winter of the lastears. Industrial growth slumped. Output of several industrial products was so low. in fact, that the customary data on their production were omitted from official monthly plan fulfillment reports during the early months of the year. Nonetheless, for the year, industrial production rose byercent, or roughly on par with the previous two years.

Machinery. Performance in all branches of industry improved during the course of the year. As usual, however, the Increaseachinerythe major source of consumer, investment, and defensemost other

branches, although growth for the year was belowercent Increase4 (see Production of computers, high-tech machine tools, and other types of automated equipment showed the best results. Growth In output of transport equipment, In contrast, was slight.

Industrial Materials. While machinery posted the best results overall, the most significant recovery was in the branches producing industrial materials--the raw materials and intermediate products used throughout Soviet industry. Afterercent decline during first5 (compared with first, output of industrial materials rebounded topercent for the year. Growth in the production of ferrous and non-ferrous metals wasar The chemicals branch did somewhat better as the addition of four new ammonia plants helped boost fertilizer outputercent. Only the construction-materials branch failed to rebound completely from the dismal first quarter in which output actually fellercent over thatear earlier.

Energy. Energy production continued to rise5 with strong performances in the coal, gas, and electric power sectors. Growth fell slightly, however, below that4 dueecline in oil production.

Soviet oil production declined for the second straight year,9 million barrels per day, orelow2osted- The Soviet gas Industry finishedbtllion-cubic-meter Increasepercent Jump over the previous year.

Meanwhile, Soviet coal production increased byillion tons, the largest annual Increment, while electricity production

USSR: Growth of Industrial Production by Branch3

Percent

2.3

Industry

Industrial

Ferrous

Nonferrous

Hood

Electric

Consumer

Soft

Processed

a Value added2 factor cost. Based on CIA's index of Soviet industrial production.

D Preliminary.

40

climbed by moreyj percentlmost reaching the plan target.

The Soviets were able to cope with declining oil production and less than expected output of other fuels by cutting exports, by shifting some oil users to naturalrocess expected to continue over the longer term--and possibly by drawing down oil stocks.

Other Branches. Other industrial branches did fairly well. Overall growth of consumer nondurables wasercentp from recent rates. Light Industry was not unduly affected by the bad winter, as textile production increased moderately. At the same time, the food-processing industryubstantial improvement overand fish products did particularly well. Agriculture

while industryelatively good showing, Soviet farm output shrank slightlymall Increase in overall crop production was more than offset by lower production in the livestock sector.* The same snow storms that hurt industry and spring sowing protected fall-sown grain and helped replenish the soil moisture neededood crop. For the year, grain production totaled anillion metric tons according to USOA (the USSR has notrain figurethe best harvest since theillion tons8 and someillion tons above4 estimated results. But this achievement, together with increased production of sunflower seed, fruits, and cotton, was largely offset By lower output of key crops such as potatoes, sugar beets, and vegetables.

* Value-added in agriculture (which excludes purchases from other sectors) declined byercent. (U)

The setback in the livestock sector resulted largely from declines In the number ofthe result of culling ofhe numbers of hogs, sheep, and goats. Meat production was up by lessercent. This result was unexpected In view of the much more robust monthly growth reported for meat produced on state and collective farms that accounts for roughly two-thirds of the total. The implied reductionhe share of meat produced by the private sector may reflect an accounting shift from the private sector to production under contract with state or collectiveractice the leadership Is encouraging. Officially, meat produced under such an arrangement Is counted against state and collective farm targets. Other Sectors

Performance in other major sectors of the economy was mixed.major problem in theproved to be another sector that reboundedegative first quarter and turnedairly strong showing. The recovery of the railroads was particularly impressive as rail freight traffic, which declinedercent during the January-March period,ercent gain for themuch better result than would have been expectediew of their poor performance after the weather-related strains of Highway traffic was also able to overcome some of Its recent problems and showed positive growth for the first time in three years. Only crude-oil pipeline shipments, which were affected by declining oil production, were lower than planned.

ln contrast to the better news In transportation, probably the most disappointing showing from the Soviet perspective washe foreign trade sector. Declining oil exports to the West precipitated anercent drop in overallfirst such reduction since the. Based on Soviet trade data fore estimate that exports to the

West dropped by almostercent from the previousthe result of declines ofercent In oil earnings andercentoviet arms exports. To offset the fallarnings from lower oil sales, the Soviets stepped up borrowing. Increased gold sales, and postponed some planned purchases. Imports from the West were down by as muchercent. Overall, Moscow5ess comfortable financial position than It enjoyed at the beginning of the year, althoughas still maintained its excellent credit rating.

Soviet trade with the Communist countries, in contrast, continued to increase As in the recent past, Soviet Imports from Communist countries have grown faster than Soviet exports, reducing Moscow's trade surplus with these countries, especially its East European partners. Overall, trade with the Communist countries grew by anercent (In rublend the share of this trade in total Soviet trade increased toercent, the highest level

Original document.

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