Five
Losing the Political Initiative: The Impact of Financial Liberalization in Hungary

David L. Bartlett

Hungary undertook a series of financial reforms in the 1980s, including the establishment of a securities market, creation of commercial banks, liberalization of foreign exchange, loosening of wage controls, and decentralization of the budgetary system. While the technical design of these reforms bore some similarities to those initiated in China after 1978, their politico-economic circumstances differed decisively. China's financial reforms were part of a broader strategy of rapid economic growth, and the political dynamics attending their implementation resembled a positive-sum game to the extent they provided benefits to all relevant actors (Byrd 1983; De Wulf and Goldsbrough 1986; Naughton 1987; Shaoguang Wang, chapter 4 in this volume; Zhou Xiaochuan and Zhu Li 1987). By contrast, financial liberalization in Hungary was the central component of an externally imposed program of economic austerity. Here, the introduction of market mechanisms was intended to force a reallocation of capital and labor and curtail domestic demand in order to promote structural adjustment and macroeconomic stabilization. Thus, the politics of financial reform in Hungary more closely approximated a zero-sum game in which enterprises, banks, trade unions, and Hungarian Socialist Workers' Party (HSWP) authorities clashed over the distribution of economic resources.

In this chapter, I explore the political consequences of financial liberalization in Hungary during the late socialist period. I argue the following. The ruling party's employment of market-type financial mechanisms as instruments of austerity simultaneously produced economic distortions that forced the authorities to reimpose central controls and enlarged the capacity of local actors to resist such recentralization. The internal contradictions of Hungary's market socialist system induced banks, enterprises, and workers to behave in ways contrary to the goals of stabilization and

adjustment, thereby generating strong pressures on the party to recentralize financial policy. At the same time, financial reform transformed the resources and incentives of those very same actors to a degree that prevented the center from fully restoring the status quo ante. This peculiar push-pull dynamic severely weakened the party's collective authority and undermined its ability to manage the economy. The failure of market-type instruments to elicit the desired responses from local agents compelled the center to intervene in microeconomic decision making, thereby ensnaring party authorities in politically damaging disputes over bank credit, wage regulations, and foreign exchange. But the prior devolution of authority to the factory level sharply circumscribed these attempts to restore central administrative controls on market processes. In short, recentralization was both economically ineffectual and politically costly to the HSWP. Caught between the dual imperatives of decentralization and recentralization, by the late 1980s, the HSWP faced a deteriorating economy, diminishing political authority, and mounting distributional clashes. Its inability to cope with the contradictory effects of financial liberalization hastened the collapse of the one-party system at decade's end.

The Contradictions of Financial Reform

The final round of Hungary's New Economic Mechanism (NEM) differed from previous phases in that its departures from central planning were integrally linked to the problems of economic austerity. By the mid 1980s, it was apparent that the program of market-type reforms initiated in 1968 had not yielded any appreciable improvement in the performance of Hungarian state enterprises, the economy's main source of foreign exchange. In 1986, the balance of payments in convertible currency plunged into the largest deficit since the 1970s. Meanwhile, the gross hard currency debt approached $20 billion, the highest in per capita terms in Eastern Europe. These circumstances compelled the leadership of János Kádár to reorient reform policy away from economic growth and toward stabilization and adjustment.

The centerpiece of the program undertaken in the latter half of the 1980s was an ambitious reform of the system of financial regulation. This program had three primary components. First, the monobanking system would be transformed into a two-tiered system. The function of credit allocation, heretofore the monopoly of the National Bank, would be devolved to a set of commercial banks. The banks, organized as joint stock companies and enjoying operational autonomy from the central authorities, would base their lending decisions on considerations of profitability and hence generate a more efficient pattern of credit distribution. Freed of the obligation to supply state enterprises directly with credit, the National Bank could

then regulate the aggregate supply of liquidity through Western-type monetary instruments.

Second, the complex set of regulations prescribing wage rates for various categories of Hungarian workers would be dismantled, empowering trade union organizations and enterprise management to negotiate their own wage contracts. This, economists argued, was the essential step toward the creation of a real labor market, which would heighten allocative efficiency by enabling highly profitable enterprises to offer the most generous wage rates, and thereby attract the most highly skilled workers.

Finally, Hungary's elaborate array of foreign-exchange controls would be liberalized. This entailed deregulating the import licensing system to allow enterprises to exchange their surplus forints for convertible currency and gradually transferring authority over allocation of foreign exchange from the National Bank to the new commercial banks. Like the reforms of the banking and wage systems, these measures would in theory raise efficiency and productivity in the state sector. With profitability, not political or administrative criteria, determining access to hard currency, the most successful enterprises possessing the largest forint surpluses would be the ones best positioned to import high technology products from the West.

Recentralization versus Decentralization

The fact that these reforms were designed to reallocate capital and labor within the Hungarian state sector distinguished them from earlier phases of NEM, whose distributional effects were far less salient. This created new sorts of political challenges for the HSWP, which now had to deal with the competing claims of the winners and losers from financial liberalization in an economy undergoing externally mandated stabilization and adjustment. Equally important, the financial reforms of the 1980s sharpened the tension between the recentralizing pressures of market socialism and the decentralizing "ratchet effects" of departures from central planning. Specialists on the Yugoslav and Hungarian reforms have amply documented the self-reproductive logic of the "socialist halfway house" (e.g., Bauer 1978, 1981; Comisso 1979; Kornai 1980; Laky 1980; Milenkovitch 1971; Tardos 1986; Tyson 1983). The stop-go patterns, the periodic reinterventions characteristic of those reforms result not merely from shifting political currents within the ruling party, but from the systemic peculiarities of market socialism. Such reforms delegate decision-making authority to factory-level agents, while preserving the dominant position of socialist ownership of the means of production. Possessing greater control over economic resources, but still lacking strong incentives to use them efficiently, enterprise managers and workers replicate and even intensify the same behavioral patterns that characterized the prereform system. They bid up wages and prices,

procure excess credit, purchase unneeded imports, begin dubious investment projects, and build up inventories of unusable capital goods. These distortions eventually compel the authorities to restore elements of the old central planning system.

The internal contradictions of market socialism become even more vexing when the reforms are implemented under conditions of economic austerity, as in Hungary during the 1980s. Josef Brada, Ed Hewett, and Thomas Wolf (1988) show how stabilization, adjustment, and reform operate at cross-purposes. The market-type instruments of austerity commonly prescribed by the International Monetary Fund (price adjustment, currency devaluation, monetary contraction, etc.) often fail to work properly in socialist economies, forcing the center to reimpose quantitative restrictions on investment, consumption, and imports. While such measures may well restore short-term equilibrium, they are likely to impede the structural changes needed to raise industry to world standards of competitiveness. Financial reforms of the sort undertaken in Hungary further complicate matters in that they decentralize control on the microeconomic side without strengthening control on the macro side. Absent monetary instruments capable of restraining domestic purchasing power, the loosening of regulations on bank credit, wages, and foreign exchange merely generates an increase in aggregate demand and forces a return to administrative-type controls.

But the center's ability to restore such controls is constrained to the extent that the decision-making authority already relinquished to local agents cannot easily be recovered. To take the example of wage liberalization: the initial devolution of control empowered a large and strategically vital constituency of actors (workers), who now possessed both a compelling interest in retaining that authority and the resources (the power of collective bargaining and capacity to organize strikes) to resist the HSWP's efforts at recentralization. The burgeoning wage bill compromised the macroeconomic balance, but the authorities could no longer implement the measures needed to restore equilibrium. The center now faced both deteriorating economic performance and rising mobilization from below. For the HSWP, whose reputation and authority hinged on its capacity to manage the economy, the political implications of this dilemma were ominous.

Summary of the Cases

As the forthcoming case studies demonstrate, all three spheres of Hungary's financial reforms exhibited these tensions. The primary aim of the banking reform was to transform the role of credit and make it an active instrument of structural adjustment rather than the passive support of the central plan. However, the new commercial banks proved unwilling to use the credit

instrument to discipline their clients, and indeed took pains to sustain credit lines to the weakest enterprises in their portfolios. The earlier decision to relinquish the crediting function deprived the center of the means of intervening in a manner that would induce the banks significantly to shift their lending policies. The commercial credit instrument thus proving ineffectual, the authorities turned to political/administrative methods of economic adjustment. The result was to shift the locus of distributional conflict over industrial restructuring away from the new banks and toward the center, entangling the party leadership in a series of disputes over capacity reductions and labor dislocations in targeted sectors.

In the case of wage reform, attempts at liberalization repeatedly ran up against the exigencies of economic stabilization. Loosening of central controls emboldened Hungarian workers, already agitated over years of stagnating real income, to press their wage claims. Lacking compelling incentives to contain labor costs, enterprise managers offered little or no countervailing pressure, and indeed shared the interest of workers to promote the liberalization of wage controls. The resultant surge in domestic demand compromised the macroeconomic balance and created pressures on the authorities to recentralize wage policy. Workers, whose capacity for collective action had been considerably bolstered by the prior decentralization, resisted and forced the center to relax wage controls. The upshot of this tug-of-war was the emergence of a strong trade union movement that expedited the party's fall from power in 1988–89.

A different politico-economic dynamic obtained in the case of foreign-exchange reforms. The center's efforts to widen access to foreign exchange for Hungarian households and enterprises resulted in deterioration of the balance of payments and depletion of the country's hard-currency reserves. For technical and political reasons, the center could more easily recentralize control of foreign exchange than commercial bank credit and wages. But while the center could reimpose controls on domestic actors with comparative ease, its efforts in the foreign-exchange area created a new constituency, Western investors, whose interests and resources strongly militated against recentralization. The HSWP was thus placed in the politically awkward position of retaining foreign-exchange controls on domestic actors while virtually eliminating them for foreign investors. This bifurcated pattern of foreign-exchange liberalization became a major source of political contention during the negotiated transition to democracy at the end of the 1980s.

Political Consequences for the Communist Party

The tensions illustrated in these cases had important consequences for the HSWP during its final years in power. As part of its post-1956 strategy of

consolidation, the Kádár regime staked its legitimacy on improvements in the population's standard of living. In this respect, the program of reforms launched in 1968 was aimed at strengthening the party's political position by raising economic growth. The onset of austerity in 1979 forced a shift in the regime's strategy: market-type reform was now geared toward the goals of stabilization and adjustment. But while the measures undertaken in the 1980s went well beyond earlier phases of NEM, they remained bound by the systemic constraints of market socialism, generating a variety of distortions that could only be corrected through reimposition of central controls. Yet those very same measures endowed key economic agents with the resources to thwart recentralization. For the Kádár leadership, the result was the worst possible combination of diminishing political authority and deteriorating economic performance. These were the principal factors leading to Kádár's ouster in 1988. The successor regime of Károly Grósz proved little more successful in stemming either the economy's decline or the unraveling of the party's power. Facing a well-organized labor movement that repeatedly foiled his efforts to implement an austerity program, Grósz entered the 1989 roundtable negotiations with a very weak political hand. The result of those talks was an agreement to hold parliamentary elections the following year, and the disintegration of the party itself into separate parties. The largest of those splinter parties was headed by the reformist faction of the old HSWP. However, it fared badly in the elections owing to its association with the failed economic policies of the communist regime, as well as the controversy surrounding foreign capital's highly visible role in the privatization program initiated by the outgoing socialist government.

Banking Reform and Structural Adjustment

The creation of a two-tiered banking system in 1987 was closely tied to the problems of both macroeconomic stabilization and structural adjustment. Separating the functions of currency issue and credit allocation would allow the National Bank to focus on curtailing growth of the aggregate money supply, a central objective of the IMF-supervised stabilization program. Meanwhile, the commercial banks, now operating under joint stock ownership and hence driven by the incentive to maximize returns to the shareholders, would redirect the flow of capital within the Hungarian state sector from weak to strong enterprises. In this way, commercial credit would become an instrument of structural adjustment: the banks would supply credit on favorable terms to their best-performing clients, while compelling loss makers to implement restructuring programs as the condition for restoration of credit lines. With heavily indebted enterprises unable to take the steps necessary to restore themselves to profitability, the banks could resort to Hungary's bankruptcy law and seek liquidation of the clients' assets.

In addition to raising allocative efficiency, the banking reform would be politically beneficial to the ruling party. Industrial restructuring entailed significant socioeconomic costs: downsizing of state enterprises long accustomed to soft budget constraints; sizable reductions of a blue-collar labor force long habituated to the full-employment guarantee; and dislocation of local communities whose livelihood depended on the targeted enterprises. To the extent that the new commercial banks used the market-type instruments at their disposal, it was thought, the center would be relieved of the political burden of economic adjustment.

However, the ultimate result of the reform was to heighten the party's political liabilities. The banks, unwilling to use commercial credit as a restructuring tool, turned the problem back to the center. The central authorities, having already devolved the credit function to the banks, could not effectively intervene to redirect capital flows. The center then resorted to political/administrative instruments of industrial restructuring, sharpening distributional conflicts between state, government, and local party organizations and deepening the HSWP leadership's own engagement in the adjustment process.

Credit Allocation in the Two-Tiered Banking System

Ronald McKinnon (1991, 1992) and other scholars have noted the risks of premature liberalization of banking in socialist market systems, whose perverse incentive structures create a moral hazard of overlending to loss-making enterprises. Yugoslavia's 1965 reform permitted workers' councils and local political organizations to become the principal capital subscribers of commercial banks, thereby providing labor-managed firms with highly elastic credit lines and depriving the National Bank of Yugoslavia of effective control of the money supply (Dimitrijevic and Macesich 1973; Furubotn 1980; Furubotn and Pejovich 1973; Gedeon 1986, 1987; Hauvonen 1970; Pejovich 1973; Tyson 1977). The main problem confounding Hungary's experiment with commercial banking in the late 1980s was the large number of bad loans the new banks inherited from the National Bank. The designers of the two-tiered system had expected that the profit orientation of the banks would induce them to redirect credit flows to the strongest enterprises in the state sector. However, their loan portfolios created incentives for them to sustain credit lines to their weakest clients. A major portion of those portfolios consisted of loans to the mining, metallurgy, and other loss-making sectors over several decades during the prereform period. Both the central authorities and the commercial bank managers understood that many of those loans would never be repaid. The key issue at hand was who would absorb the financial impact of disposing of these nonperforming assets.

The authorities argued that the banks should bear final responsibility. From the center's perspective, the fact that the banks were saddled with a large amount of dubious assets was a regrettable but unavoidable consequence of the transition to the two-tiered system. The high profits of the banks would allow them gradually to build up their loss reserves and write off the loans. The bank managers countered that the party was shirking responsibility for its own financial imprudence over past decades. Furthermore, the political authorities were pressuring the banks to write down their loan portfolios at the same time that the Hungarian state was sustaining the flow of subsidies to the very same enterprises that had fallen in arrears on those debts. To begin writing down the portfolios before the state terminated budgetary support of the loss-making sectors and initiated a restructuring program would simply prolong the process and confront the banks with the need to make repeated loan write-offs (Bartlett 1993). The willingness of the commercial banks to use market instruments to discipline loss-making enterprises would thus depend chiefly on the degree of resolve the party leadership demonstrated in structural adjustment policy.

The first test of this resolve came in January 1987. The managing director of the Hungarian Credit Bank, the largest of the new banks, announced his intention to initiate bankruptcy procedures against the Veszprém Construction Company. Veszprém turned out to be the first liquidation of a major state enterprise under Hungary's 1985 bankruptcy law.

While there were a number of other clients in the Credit Bank's portfolio equally deserving of liquidation, this particular company was an especially suitable test case. It did not have a large number of outstanding international contracts, minimizing external claims on the company's assets and simplifying liquidation procedures. Moreover, it was not a major employer in the local community, which would help contain the socioeconomic fallout of bankruptcy. But despite these factors that rendered Veszprém a convenient target, the political authorities in Budapest proved leery of supporting the Credit Bank's efforts to shut down the company, underscoring their sensitivity to the political problems of industrial restructuring. The case dragged on for months, with the center repeatedly erecting obstacles to the bank's pursuit of a liquidation (interviews 5, 7, 9, 10, and 14).^[1]

The Veszprém episode transformed the Credit Bank's business strategy. By the time the legal proceedings against the company were concluded, the bank managers had decided not only to forgo any further bankruptcies but to disengage the bank from restructuring policy altogether. If the party leaders refused to back up the commercial banks on a single construction company such as Veszprém, they could hardly be expected to show greater resolve in far more difficult sectors like mining and metallurgy. With regard

[1] Interviews conducted by the author are listed in the Appendix.

to the loan portfolio problem, the bank managers determined they would make no agreements until a structural adjustment program was under way with the full backing of the party leadership. In the meantime, they would keep the bad loans on their books as performing assets, rescheduling and refinancing them as necessary to allow the debtor enterprises to make payments (interview 8).

The banks' refusal to use commercial credit as a restructuring instrument left the center with the option of intervening in lending policy so as to redirect capital flows in a manner consistent with the goals of adjustment policy. But having already relinquished the power of credit allocation to the banks, the Hungarian political authorities faced major obstacles to financial recentralization.

Limits on Central Intervention in Commercial Credit Policy

Under the two-tiered system, the center retained a formidable array of regulations governing the commercial banking sector: refinancing quotas, legal reserve requirements, rates of taxation, loan classification rules, and so on. But while these devices could powerfully influence the overall financial position of the new banks, they did not allow the center to intervene in specific lending decisions. The only exception was long-term refinancing credit for fixed capital investment, applications for which underwent individual scrutiny by the National Bank of Hungary. But even this regulatory instrument proved of limited usefulness, as the National Bank allowed the commercial banks to fill up their long-term refinancing quotas within a few months of the start-up of the two-tiered system (interview 14).

The center could also use its voting power as majority shareholder in the banks to redirect credit flows. But this likewise proved of limited utility. The boards of shareholders of the banks met only infrequently, and on those occasions their formal sphere of authority extended only to appointment of the management, determination of the annual dividend, and approval of the bank's general business plan. Obviously, bank managers could not be wholly indifferent to the preferences of the senior party and state officials who figured so prominently on the boards of the new banks. But the high degree of separation of ownership and control characteristic of joint stock ownership did not readily permit central intervention in the individual lending decisions of the banks.

Beyond these impediments to intervention, the political resources of the banks limited the center's capacity to reshape credit policy. The banks vividly demonstrated their political clout in early 1988, when the National Bank enacted deep cuts in refinancing quotas in an attempt to force a redistribution of commercial credit. The banks responded by appealing directly to the HSWP's central committee to intercede on their behalf. They

also took steps aimed at provoking other actors to enter the fray. In direct contradiction to the objectives of the monetary authorities, the banks enlarged credit lines to their weakest clients, while cutting those to their strongest ones. As a result, well-performing enterprises, which might otherwise have supported the National Bank's position if the banks had reacted to the liquidity squeeze by diverting credit to more efficient sectors, were moved to join in opposition to the bank. Under pressure from the commercial banks, large state enterprises, farm cooperatives, and senior party leaders, the National Bank yielded and restored the refinancing lines to their previous level (interviews 1, 2, 4, 7, 8, 10, 15, 22, and 23).

The Party's Resort to Nonmarket Mechanisms

The Hungarian banking reform thus induced economic agents to reproduce the same inefficient credit flows that had prevailed under the old monobanking system. At the same time, it endowed those actors with the technical, legal, and political resources to resist the center's efforts to correct those distortions via recentralization. Facing a recalcitrant commercial banking sector, continued deterioration of the balance of payments, and mounting pressure from the international lending agencies to initiate a restructuring program, the party leadership was forced to resort to nonmarket mechanisms of structural adjustment.

Foremost among these political/administrative instruments was the Planned Economy Committee, a new intragovernmental body charged with overseeing restructuring of key industries in the Hungarian state sector. The main intent of this institutional innovation was to accelerate the restructuring process by detaching primary decision-making authority from the Ministry of Industry, whose organizational interests were too closely tied to the targeted enterprises, and investing it in a national-level body capable of transcending narrow sectoral interests.

But these expectations were dashed. The consequence of the commercial banks' disengagement was to draw state enterprises, trade unions, local party committees, state and governmental organizations, and the HSWP leadership into highly public clashes over the course of adjustment policy. The political ramifications of the center's use of nonmarket mechanisms of structural adjustment were particularly evident in coal mining and steel, two of the biggest loss-making sectors in Hungarian industry.

Structural Adjustment in the Mining Industry

In June 1988, the Planned Economy Committee announced its plan to restructure the coal industry, proposing to phase out all state subsidies to the sector over a two-year period. The committee's program appeared to gain momentum after a special conference of the HSWP in May 1988. The replacement

of Kádár by Károly Grósz as the party's general secretary reflected the latter's success in cultivating the image of a tough, decisive leader willing to take the painful measures needed to pull Hungary out of its economic morass.

But Grósz quickly yielded when the first test of his resolve occurred three months after his ascension to the party leadership. A group of miners at the Mecsek pits in southern Hungary staged a walkout to protest the management's decision to reduce the so-called fidelity bonuses allocated to employees annually on the basis of years of service. Although the direct cause of the strike was the dispute over the bonuses, it was widely understood that the underlying issue was the miners' anxiety over the proposed restructuring of the Mecsek operations. The walkout was intended less as a challenge to the local management than as a message to the Grósz regime that the miners had no intention of bearing the entire burden of economic adjustment by themselves. Grósz was sufficiently exercised about the affair to hasten down to the Mecsek mine and personally negotiate a settlement (FBIS/EEU: d, e, f, g).^[2]

Grósz's decision to intervene and accommodate the miners' demands was not motivated by any particular concern about the economic impact of the strike. One of the chief aims of the restructuring program was precisely to reduce capacity at Mecsek and other loss-making mines. The risk of diminished production resulting from a prolonged strike was thus hardly a credible threat, since this was what the authorities intended anyway. Rather, the walkout by the Mecsek miners was politically effective because it presented the danger of sparking similar actions by workers at other, larger Hungarian enterprises targeted for restructuring. With news of massive strikes by Polish workers in the Baltic ports filling the newspapers in the summer of 1988, and with the debate over industrial restructuring dominating the political agenda at home, Grósz feared that a strike at a single enterprise would stimulate labor mobilization in the loss-making sectors as a whole (interviews 6, 11, and 19).

The result was to send exactly the wrong signal to the opponents of restructuring in the branch ministries, trade unions, and local party committees: that the party leadership would relent if subjected to a very modest degree of pressure. If Grósz yielded so quickly to a handful of miners at a single small mine, there was little reason to expect that he would demonstrate any greater resolve if confronted by labor unrest in other, more strategically vital enterprises, such as the giant steel plants in northeastern Hungary.

[2] Citations of documents from FBIS/EEU (Foreign Broadcast Information/Eastern Europe) are indexed in the References at the end of the chapter.

Structural Adjustment in the Steel Industry

Steel did indeed present an array of problems. Much of the industry operated with open-hearth blast furnaces and other turn-of-the-century technologies. This meant not only the production of low-quality products, but also rising labor costs and extravagant levels of energy consumption that required massive subsidies to keep the enterprises afloat.

Against this background, in April 1988 the Planned Economy Committee issued a resolution setting down the following general goals: reduction and ultimate suspension of state subsidies to the steel sector; elimination of redundant capacity; regearing of the product mix to follow prevailing trends in world markets. The committee's plan displayed a prudent sensitivity to the socioeconomic consequences of restructuring. The total projected displacement in the steel sector amounted to ten thousand workers. This seemed a fairly modest number relative to total employment in the industry. And in view of the fact that implementation would be spread over a four-year period, with a concurrent expansion of unemployment benefits and retraining programs, the plan appeared to have a reasonable chance of gaining broad political acceptance.

But despite the committee's efforts to scale down the program to politically manageable proportions, the plan immediately provoked strong resistance by workers and managers at the affected plants, as well as by their allies in local party committees and the Ministry of Industry. Exemplary of the steel lobby's political strategy was the decision by the Ózd Metallurgical Company, the industry's biggest loss maker, to negotiate a joint venture with the West German firm Korf KG that would enable it to maintain current production capacity. Auditors dispatched to the plant to evaluate the progress of the restructuring program got wind of the scheme and reported it to the Planned Economy Committee, which prevailed upon the Minister of Industry to initiate disciplinary action against the Ózd management for violating the terms of the restructuring plan. The industry minister acceded, but not before privately assuring the Ózd managers of his continued support of the venture with Korf. Keenly aware of the potential political fallout from industrial downsizing, the party leadership declined to back up the committee, and so the joint venture proceeded (Bányai 1989; interview 13).

The Political Consequences of Adjustment via Nonmarket Means

This episode was striking for the conspicuous disengagement of the Hungarian Credit Bank, the main commercial creditor of the steel companies. The adjustment program included provisions for the disposition of the old steel loans as well as the resumption of credit lines to the targeted enterprises,

conditional on their attainment of specific restructuring goals. The Credit Bank's stake in the matter was considerable, as it supplied more than 90 percent of total commercial credit to the metallurgical sector, representing over 10 percent of its assets. The future of the bank itself was thus inextricably linked to the fate of the restructuring program. But despite the bank's vital interest in the case, the management was determined to minimize its involvement and shift the political onus of structural adjustment back to the center.

The banking-reform case well illustrates the political repercussions of attempts to use Western-type financial mechanisms as instruments of structural adjustment in market socialist systems. The loan-portfolio problem induced the new commercial banks to sustain credit lines to the weakest enterprises in the state sector, precisely contrary to the aims of the banking reform and adjustment policy. The prior devolution of the credit function to the banks limited the possibilities for financial recentralization, as the nature of the regulatory system and the structure of joint stock ownership militated against central intervention in individual lending decisions. The unwillingness of the banks to use commercial credit as a restructuring tool effectively placed the ball back in the center's court. The ironic result of the introduction of market-type mechanisms into the financial sector was thus to reinforce the ruling party's reliance on nonmarket methods of adjustment and deepen its involvement in distributional conflicts.

The politicization of structural adjustment seriously undercut the bargaining position of party chief Grósz when he entered into formal negotiations with the Hungarian opposition in summer 1989. The very political hegemony on which the HSWP based its rule proved to be its greatest liability: while the leadership could delegate policymaking authority to the Planned Economy Committee and other subordinate organizations, the nature of the one-party system prevented it from evading ultimate responsibility for the restructuring program and the general state of the Hungarian economy. With the party's authority declining, but its responsibility for the stagnating economy undiminished, Grósz could scarcely claim to his interlocutors that he possessed a credible plan of economic rejuvenation.

The Dilemmas of Wage Liberalization

In no other financial sphere was the tension between recentralization and decentralization more acute than in wage reform. As with the banking reform, economists saw wage liberalization as essential to improving the performance of the Hungarian state sector. Under Hungary's rigid incomeregulation system, wage rates were poorly differentiated. By the mid 1980s, the wage differential between Hungarian white-collar and blue-collar workers varied from 5 to 10 percent, compared with 30 to 70 percent in Western

market economies (RFE/RL: a).^[3] Wage leveling was one of the main factors underlying the rising absenteeism and declining productivity that plagued the Hungarian state sector. Labor productivity in Hungary was estimated to be 40–50 percent below that of the industrialized West (RFE/RL: b). By conferring wage control on trade unions and enterprise management, the authorities hoped to create a more highly differentiated wage scale that would promote labor mobility and boost worker productivity.

But in the context of market socialism, wage liberalization was highly risky. With neither workers nor managers facing effective inducements to control labor costs, the likeliest outcome of the reforms was growth of the total wage bill, and hence expansion of domestic purchasing power. Reimposition of wage controls would then become necessary in order to restore macroeconomic equilibrium (interview 12). Yet once they took the initial step of loosening wage controls, the authorities faced a number of obstacles to recentralization. The prior devolution of authority to the factory level catalysed a large group of actors, workers, who would resist any attempt to reimpose central controls on their incomes.

The economic circumstances in which Hungary undertook wage liberalization magnified the consequences of labor mobilization. By the time wage reform began in the late 1980s, Hungarian workers had endured nearly a decade of stagnating real income. For this reason, they not only seized upon the opportunity of the initial decentralization to secure compensatory wage increases, but staunchly protected those gains whenever the center tried to recentralize. Moreover, the decline of household income after 1979 solidified the collective interest of workers from different industrial sectors in obtaining across-the-board increases in wage rates. Workers' mobilization on a cross-sectoral basis worked to the detriment of wage differentiation (and hence structural adjustment) and stimulated growth in the aggregate wage bill (thereby impeding macroeconomic stabilization).

The collective bargaining power of organized labor was further strengthened to the extent that enterprise management failed to supply countervailing pressure against workers' efforts to bid up wages. The weak impulse of state enterprise managers to contain their wage bills was yet another manifestation of the perverse incentives of market socialist economies. With plant directors in Hungary's "plan bargaining" system still evaluated according to their fulfillment of the center's production objectives, enterprises continued the practice, long characteristic of centrally planned economies, of sustaining a labor slack, keeping superfluous workers on the payroll for deployment during rush periods (Antal 1983, 1985; Sipos and Tardos 1986). Consequently, labor demand remained very high under

[3] Citations from RFE/RL (Radio Free Europe/Radio Liberty, Hungarian Situation Reports) are indexed in the References at the end of the chapter.

NEM, even as the center was seeking to reduce capacity in loss-making sectors through its restructuring campaign. At the same time, the soft budget constraints of state enterprises relieved managers of the liquidity constraints that might otherwise have induced them to economize on labor costs. Hikes in their wage bills gave plant directors little cause for concern, as they were confident of eventually obtaining whatever credits or subsidies were needed to cover the increase in labor costs (interviews 18 and 24).

Finally, labor mobilization created serious problems for the HSWP leadership and the National Council of Trade Unions, the party's official union organization. The Trade Union Council was uncomfortably wedged between two opposing forces: (1) a ruling party obliged by economic circumstances to implement a harsh austerity program, the centerpiece of which was contraction of real household income, and (2) an increasingly agitated working class, whose interests the official union supposedly represented. The party could never gain the cooperation, much less the approval, of Hungarian workers for economic adjustment as long as they were deprived of effective means of interest representation. The upshot of these pressures was the emergence of independent trade unions, as well as the transformation of the Council of Trade Unions itself into an organization willing and able to defy the party to which it had long been allied.

Wage Reform versus Macroeconomic Stabilization

At several junctures during the early 1980s, the HSWP leadership proclaimed its intention to reform the wage regulation system, only to retreat in the face of a deteriorating balance of payments. The political authorities conceded that long-term economic development required a thoroughgoing overhaul of the maze of rules and restrictions, which created a variety of distortions in the labor market. But the exigencies of macroeconomic stabilization required the center to maintain strict controls on wage payments in the state sector (FBIS/EEU: a).

In mid 1988, the authorities announced their intention to launch a comprehensive wage reform the following year. They proposed to abolish all central regulations on wage setting, leaving wage determination entirely in the hands of the unions and enterprise management. At the same time, the center would introduce an "entrepreneurial tax," whereby all increments to the enterprise wage bill would be added to profits and taxed at 50 percent. The aim of this tax scheme was to induce enterprise managers to hold down increases in aggregate labor costs.

Even as the political authorities were announcing this plan, there was deep skepticism within official circles as to whether economic circumstances would permit its implementation. The skeptics argued that the new entrepreneurial tax would not induce enterprise directors to economize on

wages. With labor costs and profits subject to the same unified tax, managers would have every incentive to permit their wage bills to rise without limit. Any increases in wage disbursements would reduce net profits; if wages went up, taxable profits would go down, and the net effect on the enterprise's total tax liability would thus be zero (interview 20).

But the continued insensitivity of state-enterprise managers to labor costs was not the most important factor jeopardizing the party's plans for wage reform. The deterioration of Hungary's terms of trade and expansion of its hard-currency debt after 1983 had brought the country to the brink of insolvency. The economic crisis was the key factor leading to the ouster of János Kádár and his allies in the spring of 1988. In an attempt to halt the economy's slide, the new Grósz regime negotiated a three-year standby agreement with the IMF. The central element of this stabilization program was a reduction in household income and domestic consumption.

Economic data from the first year of the standby indicated that the program was biting: real per capita income declined by 2 percent in 1988, while retail trade turnover contracted in absolute terms for the first time since 1952 (PlanEcon Report 5, 18 [May 5, 1989]: 1–3). While the IMF standby included caps on domestic credit and deficit spending aimed at squeezing liquidity in the enterprise sector, Hungarian households were now bearing the brunt of macroeconomic stabilization.

The party's decision to shift the main burden of stabilization onto the household sector had a major impact on the political environment in Hungary during the final years of communist rule. Its most important effect was to catalyze a previously compliant labor force to push aggressively for compensatory wage increases. Rising labor mobilization magnified the contradictions between wage reform and stabilization policy: to the extent that workers succeeded in bidding up the total wage bill, the center could not proceed with wage liberalization without compromising the macroeconomic balance. But the ability of the authorities to restore wage controls was now limited by the growing power of organized labor.

It is noteworthy that the transformation of Hungarian labor, long pacified under Kádár's post-1956 compromise, into an active movement for political change began within the party-controlled National Council of Trade Unions. Whereas worker mobilization in Poland involved the emergence of a fully independent trade union movement that challenged the Communist party's political hegemony, in Hungary it was manifested by the disintegration of the party's internal mechanisms of labor control.

Transformation of the Party-Controlled Trade Union

The leaders of the Trade Union Council had on previous occasions defended Hungarian wage laborers against the effects of market-type reforms.

In 1969, they allied themselves with local party secretaries and ideological conservatives on the central committee to push for restoration of price controls, the first of a series of reversals leading to the suspension of NEM in 1972 (Soós 1987). In late 1983, they pressed for wage indexing and pension increases to compensate for the IMF-sponsored austerity program launched the previous year (Noti 1987). In December 1985, they secured the party's assent to a 23 percent increase in industrial wages (RFE/RL: a).

But in no sense had the Trade Union Council functioned as an independent political actor. The presence of the president of the council on the politburo of the ruling party gave the organization considerable influence over reform policy, but also signified the fact that its political clout was largely derivative of the party itself. The council's role under NEM was less to represent workers' interests than to advance the party's goal of perpetuating a politically quiescent labor force. To that end, the chain of command within the council remained highly centralized after the launching of the reforms in 1968. Until the mid 1980s, factory-level union organizations enjoyed little say over incomes policy, as branch-level representatives of the Trade Union Council continued their traditional practice of negotiating wage contracts with the Ministry of Industry and the State Office of Wages and Labor (Noti 1987). The Kádár regime's determination to maintain tight reins on labor reflected its sensitivity to contemporary developments in Poland, as well as its memories of 1956, when independent workers' councils played an integral part in the popular uprising that nearly destroyed communist rule in Hungary. The episodes cited above did not demonstrate the Trade Union Council's capacity to stake out policy positions independently of the party. Rather, its efforts to reverse reform policy in 1969 and the early 1980s converged with prevailing political currents within the party leadership.

The political and economic developments of 1988 prompted a transformation of the role of the council. Among the victims of the spring purge of the party old guard was Sándor Gáspár, the longtime president of the council. The fall of Kádár and the shake-up of the council leadership emboldened rank-and-file members to press for democratization of the union's internal structures and procedures. Gáspár's successor, Sándor Nagy, would prove far more sensitive to the demands of the membership and more willing to challenge the HSWP leadership over economic reform and stabilization policy. At the same time, the IMF standby agreement negotiated by the Grósz regime significantly raised the stakes for Hungarian workers by requiring deep, sustained reductions of real household income.

These circumstances triggered a series of highly public confrontations between the party and the new leadership of the Trade Union Council. In September 1988, the council and the Hungarian government began negotiations for a new wage agreement. Breaking sharply from its subservient

position in the one-party system, the union leadership publicized its demands in advance of the meetings, claiming that higher-than-anticipated inflation necessitated retroactive wage increases in certain sectors. The union further insisted that the party move quickly on the long-delayed reforms of the wage system. Reacting angrily to the council's publicity campaign, the Grósz regime insisted that the Hungarian state was in no position to give the unions a blank check. By placing workers' needs ahead of the interests of the national economy, the council was putting Hungary at risk of international insolvency.

In addition to demonstrating the Trade Union Council's newfound assertiveness, the September negotiations were politically significant, in that they revealed the growing cleavages within the HSWP leadership. The head of the center's negotiating team was Imre Pozsgay, a politburo member and head of the reformist wing of the party. In his opening statement, Pozsgay noted that the council had historically served as an integral player within the one-party system and therefore shared some of the blame for Hungary's economic predicament. This underscored the need for a genuinely independent trade union organization answerable to the workers and not to the party. To that end, Pozsgay encouraged the council to implement internal reforms and asked the union leaders how they intended to deal with the growing pluralism within the Hungarian trade union movement (RFE/RL: d).

Tensions within the Trade Union Movement

Pozsgay's remarks underscored the uneasy duality of the Trade Union Council's position, the contradiction between its traditional role as vassal of a party leadership that was now implementing a strict austerity program and its putative responsibilities as representative of workers' interests. His mention of "pluralism" was an unmistakable reference to the recent emergence of new trade union organizations outside of the council, the most visible of which was the Democratic Union of Scientific and Academic Workers, established in May 1988 by research scholars from the Hungarian Academy of Sciences to protest the Trade Union Council's failure to represent their professional interests. The Democratic Union condemned the council for its role in the economic crisis and claimed that the official union's position on wage reform had helped thwart attempts to widen income differentials between blue-and white-collar workers (RFE/RL: d, h).

The leaders of the council at first refused to recognize this independent organization, but then retreated to a strategy of containing its growth by establishing a parallel union of professional and scientific workers. They meanwhile set about instituting the internal reforms deemed necessary to restore the confidence of the rank and file: elections by secret ballot, limitations

of tenure in office of union leaders, right of factory-level units to determine the composition of higher bodies within the organization. At the same time, the council leadership formally proclaimed its independence from the center, claiming that the HSWP's subjugation of the union had distorted the goals of the organization and prevented it from effectively representing the interests of Hungarian workers (RFE/RL: f).

Armed with its revamped policy platform, in December 1988, the council negotiated a new agreement with the center. The political authorities committed themselves to holding the inflation rate for 1989 to 12 percent. As compensation for the rise in consumer retail prices, they conceded to the council's demand for a 23 percent increase in the minimum wage. The authorities meanwhile announced their intention to proceed with the proposed reform of the wage-regulation system. On January 1, 1989, the center formally released large-scale enterprises, representing some 60 percent of the Hungarian state sector, from all wage regulations (RFE/RL: g).

The main intent of this measure was to heighten labor productivity within the state sector by encouraging enterprise managers and unions to formulate more highly differentiated wage scales. But because it was undertaken in the face of eroding household income, rising labor mobilization, and cost-insensitive state enterprises, wage reform produced wholly different effects. Far from promoting greater income differentiation, wage liberalization stimulated Hungarian workers, long deprived of effective means of collective bargaining, to agitate for ad hoc wage increases aimed at neutralizing the distributional effects of macroeconomic stabilization.

Conflict Between the Party and the Unions, 1989

In early January 1989, the center initiated the first of its planned price increases. A few weeks later, council chief Nagy declared that the January price hikes already surpassed the yearly inflation target agreed upon in December. Nagy emphasized that the union agreed in principle with the center's policy of freeing up prices, so long as nominal wages increased accordingly. In view of the higher-than-expected price increases, the union leadership now regarded the December agreement as null and void, proclaiming that either the minimum wage would have to be raised by more than the amount previously negotiated, the wage hike would have to be introduced ahead of schedule, or both. Nagy noted that the council presidium had recently disassociated itself from the HSWP, and that the union leadership regarded strikes as a justifiable method of achieving its demands. "It would be useless if the trade union movement had finally assembled a gun but did not have the ammunition for it" (FBIS/EEU: j). Within a few days of Nagy's statement, the party acceded to both of the union's demands (RFE/RL: i).

Its hand clearly weakened, the Grósz regime soon yielded to the unions' calls for legalizing labor strikes. In the aftermath of strikes in the coal mining sector and other industries the previous fall, the authorities prepared a draft of a law legalizing certain types of strikes. The draft narrowly circumscribed the range of legal strikes to those related to grievances within a specific enterprise. Sympathy strikes and work stoppages undertaken to protest broader economic policies (e.g., consumer price increases) would remain illegal. Under the draft, only official trade union organizations under the umbrella of the Council of Trade Unions would be permitted to organize strikes. Both the council and the independent unions promptly rejected the draft law. The party quickly conceded, offering a revised version that legalized sympathy strikes and granted both official and independent unions the right to initiate work stoppages. (FBIS/EEU: m; RFE/RL:j).

It was not long before the unions availed themselves of the opportunities presented by the new strike law. In April, the political authorities announced another set of utility rate hikes. The council leadership responded by demanding the suspension of the price increases. The union leaders protested that they had sought for months to engage the party in serious discussions, to no avail. At the same time, the Grósz regime was contemplating measures that threatened certain strata of the population with "mass impoverishment." Now, the council would refuse all negotiations until Grósz provided the public with detailed information about Hungary's hardcurrency debt and the state budget. Only when it was generally understood what commitments the party had undertaken could a new social consensus over stabilization policy emerge. In the meantime, the unions would have to make use of "other tools of interest coordination." To this end, the council leaders declared the upcoming May Day ceremony as a "mass demonstration of employee interests." The trade union threats again compelled the center to back down: a few days after the May Day demonstration, the authorities rescinded the utility price hikes and granted the council's request for an across-the-board increase in pensions and wage hikes for selected categories of workers (FBIS/EEU: o).

By summer 1989, Grósz was engaged in the roundtable negotiations with the Hungarian opposition that would culminate in the party's assent to multiparty elections. The unions chose this occasion to escalate their ongoing dispute with the center, calling a general strike to protest proposed hikes in meat prices. This event, the first general strike in Hungary since the 1956 revolution, attracted a large number of followers but failed to compel the center to back off the meat price increases. The union leadership then announced a shift in strategy: rather than seeking to rescind price increases, the unions would dedicate their efforts to securing compensatory wage increases. The unions charged that Grósz's austerity program was assigning higher priority to price reform than to wage liberalization; the long-promised

reform of the wage-regulation system should proceed immediately. In a jab at the newly legalized opposition parties, the unions noted they were still waiting for a party that offered an alternative to the HSWP's stabilization program and showed due concern for the interests of Hungarian wage earners (FBIS / EEU: p, q, r).

In addition to damaging the bargaining position of party chief Grósz, the decision of the trade unions to face down the party on the eve of the roundtable negotiations enhanced the leverage of the political opposition. Labor's demands for pluralization of the union movement paralleled and fortified the opposition's push for broader political democratization.

It is noteworthy that the Hungarian Chamber of Commerce, the chief lobbying organization of the enterprise sector, remained generally mute throughout the conflict between the party and the trade unions. Its role was limited to the issuance of broad statements asserting the desirability of holding inflation to the planned levels (FBIS / EEU: b). The refusal of Hungarian managers to exert offsetting pressure to contain wage costs simultaneously strengthened the collective power of labor and complicated the center's task of restoring macroeconomic balance. The end result was to reinforce the already strongly held perception, shared by both the IMF and the Hungarian political opposition, that the HSWP was incapable of formulating a credible stabilization program.

Political Repercussions of Wage Liberalization

The original objective of the wage reform was to raise labor productivity within the Hungarian state sector by widening income differentiation. Instead, the reform provided workers with the resources to bid up total labor costs, boosting aggregate purchasing power in the economy and compromising the macroeconomic balance. Fulfilling the conditions of the IMF supervised stabilization program now necessitated the restoration of central controls on wages. But as in the banking case, the party's opportunities for recentralization were limited once the process of wage liberalization was under way.

The main impediment to recentralization of incomes policy was the growing power of organized labor. The trajectory of the Hungarian labor movement in the late socialist period was distinct from that in other East European countries. Labor mobilization did not begin in Hungary until the end of the 1980s and never reached the levels attained by Poland's Solidarity, whose capacity to shut down major portions of industry ultimately forced the Polish United Workers' party to the bargaining table. The power of Hungarian labor derived less from its capacity to limit production than from its ability publicly to defy the ruling party, whose presumed raison d'être was representation of workers' interests. What made the comparatively

limited mobilization of Hungarian workers in 1988–89 politically consequential was the fact that it was spearheaded by the party's own official trade union. The public confrontations between the National Council of Trade Unions and the Grósz regime revealed the decomposition of one of the pivotal internal structures of authority of the HSWP, whose consolidation of power after 1956 hinged on its co-optation of labor, the Catholic Church, the intelligentsia, and other social groups.

The loss of control of its own labor organization deprived the party of its primary means of recentralizing incomes policy. The wage hikes resulting from the initial liberalization now represented currency in circulation. The center was thus left with the problem of mopping up the excess liquidity the wage reform had already released into the economy. Having surrendered its capacity to manage wage bargaining through a centralized trade union apparatus, the only way the party could absorb this excess purchasing power in the hands of the population was to employ currency conversions, compulsory bond sales, freezing of personal savings accounts, and other ex post measures. But while such tools were readily available to party leaders in traditional centrally planned economies, their efficacy in socialist market economies like Hungary was highly dubious. Not only would their implementation antagonize a household sector already pressed to the limit by economic austerity, the expansion of the second economy, the decentralization of the financial system, and other departures from central planning that the party had previously undertaken restricted its ability to use ex post income-withdrawal devices to contract domestic purchasing power.

In short, wage liberalization simultaneously weakened one of the party's key instruments of political control and undermined its capacity to execute stabilization policy and thereby meet the conditions of the IMF standby agreement.

Liberalization of Foreign Exchange

The economic risks of liberalizing foreign exchange were at least as great as in banking and wage regulation: drainage of convertible currency reserves a enterprises, households, and foreign investors were granted rights of convertibility; expansion of the country's external debt as banks were given foreign-exchange licenses; deterioration of the balance of payments as import licensing was loosened; higher inflation as the central bank devalued the currency in preparation for convertibility.

But while the liberalization of foreign-exchange regulations generated similar sorts of contradictions between microeconomic incentives and macroeconomic control as other financial reforms, several factors distinguished it from the banking and wage cases. To begin with, foreign-exchange liberalization was unique in the nature of the political mobilization it triggered.

When the National Bank of Hungary engineered a succession of devaluations in the late 1980s, the Hungarian trade unions registered their sharp disapproval of the resultant rise in consumer prices. But whereas the unions could compel the center to roll back proposed price increases by threatening strikes or neutralizing such increases by extracting wage concessions, their political influence over exchange-rate policy was limited. A currency devaluation, once enacted, was a fait accompli; the trade unions could not compel the center to rescind it by threatening to organize strikes. Moreover, trade union opposition to currency devaluation was partially offset by support for this measure among Hungarian enterprises, particularly those engaged in convertible currency export. In contrast to wage reform, where the preferences of labor and management generally converged, in the foreign exchange sphere there was little basis for unity.

The inability of domestic actors to bring elective influence to bear on foreign-exchange policy meant that the ratchet effects of financial liberalization were weaker than those arising from the banking and wage reforms. In the latter cases, the initial decentralization caused an inadvertent loss of control that restricted the party's capacity to correct subsequent economic distortions via financial recentralization. By contrast, the party retained the technical and political resources to reimpose controls on local agents if liberalization of foreign exchange generated deleterious effects on the macroeconomic balance.

But foreign-exchange reform was also distinguished from the other cases in that it activated a new set of players—Western investors — who were not encumbered by the same political and economic constraints as Hungarian state enterprises and households. In contrast to domestic actors, foreign capital enjoyed high mobility and multiple alternative investment sites. These resources gave Western investors considerable leverage over the HSWP leadership, which depended on the continued inflow of foreign capital to service hard-currency debt and spur economic modernization. Whereas the authorities could Decentralize foreign-exchange policy in the household and enterprise sectors at relatively low cost, reimposition of controls on Western investors created a high risk of capital flight that would severely impair the party's ability to extricate Hungary from its economic crisis.

Because of the asymmetrical positions of domestic and foreign capital, the foreign-exchange sphere exhibited divergent rates of liberalization. In the domestic arena, the party made only tentative movements toward loosening controls on Hungarian enterprises and households, whose behavior continued to be shaped by the weak proprietary interests, supply shortages, and other distortions of market socialism. In the foreign arena, the party quickly dismantled barriers to private Western investors. The consequent rapid penetration of foreign capital became a highly contentious political

issue during the transition to democracy in 1989—90 and remained a major source of dispute under the successor government headed by the Hungarian Democratic Forum.

Foreign-Exchange Liberalization: The Enterprise Sector

Foreign-exchange reform in the enterprise sector had two principal aims. The first was to dismantle the cumbersome import-licensing system and allow Hungarian enterprises to exchange their surplus forints for the hard currency needed to modernize their plants and equipment. The second was to expand the foreign-exchange activities of the new commercial banks. Eventually, Hungarian enterprises would be allowed both to buy foreign exchange from the banks and to deposit their retained convertible currency earnings with them (FBIS/EEU: h).

Successful implementation of these reforms presupposed two things. First, the National Bank had to contract the money supply. If enterprises were to enjoy the right automatically to convert their surplus forints into hard currency, the bank had to manufacture a shortage of local currency in the enterprise sector. Failing this, conversions of forints into hard currency by the enterprise sector, and hence purchases of Western imports, would skyrocket. Second, the National Bank had to undertake a substantial devaluation of the forint. Unless import prices were sharply increased through devaluation, broadening enterprises' access to Western import markets would merely drive up domestic demand and worsen the balance-of payments deficit (interviews 16 and 17).

The danger was that in the socialist context, even a sizable devaluation might not have the desired impact on enterprise behavior. With state enterprises operating under soft budget constraints, demand for convertible currency imports would remain undiminished despite substantial increases in prices. Import liberalization coupled with devaluation would then produce the worst possible scenario: both the volume of Western imports and their prices would increase, generating a rapid drain on hard-currency reserves, a dramatic deterioration of the balance of payments, and a sharp rise in the domestic inflation rate (Tarafás 1985; Wolf 1985, 1988).

Against these constraints, in the summer of 1988, the National Bank began a series of cautious, incremental currency devaluations. By the time of the commencement of the roundtable talks the following year, the forint had been devalued by some 17 percent, enough to prompt a rise in the inflation rate, but still well below what experts had deemed necessary to proceed with full import liberalization. The combination of mounting inflationary pressures, a deteriorating external balance, and undiminished import demand by cost-insensitive state enterprises circumscribed the center's range of movement in the foreign-exchange area. Even as the center

granted partial foreign-exchange licenses to the commercial banks, it announced that 80 percent of Hungary's hard currency transactions would remain with the National Bank (FBIS/ EEU: c, 1, n; interviews 2, 3, and 18).

The absence of strong ratchet effects in the foreign-exchange area gave the political leadership greater latitude for ex post adjustments than it enjoyed in other financial spheres. In contrast to the banking reform, where the delegation of authority over credit allocation gave the commercial banks resources to resist reintervention by the center, the National Bank retained an assortment of regulations over the banks' foreign-exchange operations. This allowed the party to proceed with limited liberalization without risking a progressive and unintentional unraveling of central control.

Foreign-Exchange Liberalization: The Household Sector

The chief aim of foreign-exchange reform in the household sector was less economic than political. Broadening the population's access to foreign exchange would enable citizens to travel abroad and purchase Western products unavailable in Hungary. In this way, the party leadership hoped to alleviate some of the pain of economic austerity at home.

Unlike state-owned enterprises, Hungarian households operated under "hard" budget constraints: their liquid resources placed elective limits on their ability to purchase commodities. Thus, deregulation of foreign exchange in the household sector did not face the problem of perverse incentives that so complicated liberalization in the enterprise sector. However, it did run up against persistent shortages and pent-up consumer demand within the Hungarian economy. Those factors generated powerful pressures for recentralization in the late 1980s as the center began to widen the opportunities for Hungarian households to undertake foreign-exchange transactions.

On January 1, 1988, the Hungarian government eased restrictions on foreign travel. For the first time since the communist takeover in 1948, Hungarian citizens possessing a valid passport and the required amount of foreign exchange were allowed to travel to the West without restriction. At that point, Hungarians were allowed to exchange $400 worth of forints into hard currency per person over a three-year period (RFE / RL: c).

The world passport proved phenomenally popular with Hungarian citizens, as it gave them access to videocassette recorders, stereos, television sets, automobiles, and other products that were either in short supply or of poor quality in Hungary itself. Between January and August i 988, Hungarians made more than 1.4 million trips to Austria alone, nearly a 400 percent increase over the same period the previous year. The exodus of tourists reached unprecedented levels in November and December, as Hungarians

surged across the border to indulge in spending sprees in Vienna and other Austrian cities (RFE / RL: c).

But the drainage of hard currency had serious repercussions for the country's balance of payments. By summer 1989, it was apparent that Hungary's current-account deficit for the year would be more than double the center's target. The deterioration of the external balance provoked the IMF to suspend its standby agreement with Hungary jeopardizing the country's access to commercial credits and raising the specter of debt rescheduling (RFE / RL: k).

The situation worsened in fall 1989. In November, lame-duck Prime Minister Miklós Németh announced that both the domestic budget deficit and the hard-currency debt were much larger than the HSWP had previously acknowledged. He explained that the Kádár leadership had taken the decision to conceal this information in the early 1980s for fear that disclosure of the true status of Hungary's finances would endanger its application to join the IMF and hence its access to badly needed Western capital. Németh added that he himself had known about the party's decision to cook the financial figures, and that he was utilizing the occasion of the impending political transition to effect a general clearing of Hungary's economic and political accounts. Insofar as Hungary's international financial position was concerned, Németh's announcement meant that the country was technically on the verge of insolvency (FBIS/EEU: s, t).

Against this backdrop, the central authorities and the IMF began negotiations for another stabilization program. The suspension of the earlier standby agreement and the disclosure of the debt had stiffened the IMF's resolve. In addition to deep subsidy cuts, a stringent monetary squeeze, and other stabilization measures, the Hungarian authorities agreed to reimpose foreign-exchange controls on the household sector. The amount of foreign exchange Hungarians could purchase was sharply reduced to $50 allotments for the next two years (Okolicsanyi 1989; interview 21).

And so while the worldwide passport removed essentially all legal constraints on the ability of Hungarians to travel abroad, the exigencies of economic austerity compelled the center to deprive households of access to the foreign exchange needed to enjoy that opportunity. In contrast to the banking and wage cases, the prior devolution of authority was of little use to the affected actors. The commercial banks, once established, could divert credit flows in ways contrary to the center's restructuring program. Workers, once granted the power of collective bargaining, could organize strikes to thwart the center's income policies. Hungarian households lacked any such leverage. Not only did the size and diversity of the household sector militate against collective action, it did not possess the economic and political resources needed to defeat recentralization. Thus, while the party's decision

to reimpose foreign-exchange controls on the population was politically unpopular, it did not stimulate elective resistance.

Foreign-Exchange Liberalization: Western Investors

The structural position of foreign capital was fundamentally different. The distortions of market socialism did not impede the center's attempts to loosen controls on Western investors, whose behavior was driven by the profit motive and not a skewed incentive structure or domestic shortages.

But while liberalization in the foreign sector did not encounter the same systemic constraints as in the enterprise and household spheres, it was politically risky. Like their counterparts in China, Hungarian party leaders had to weigh the developmental benefits of direct foreign investment against its political costs. Not only did the rapid penetration of foreign capital affect national and cultural sensibilities, it also implied a diminution of the party's capacity to control the economy. The degree to which the political leadership mitigated such adverse consequences depended on its ability to negotiate effectively with Western investors. Here, the HSWP was at a distinct disadvantage. Unlike China, Hungary lacked the bargaining chip of a large domestic market. At the same time, foreign capital possessed several important advantages—namely, high mobility and a multiplicity of alternative investment sites in Eastern Europe and elsewhere. This asymmetrical bargaining relationship ultimately induced the party to dismantle virtually all barriers to foreign capital.

For many years preceding the collapse of the one-party system, Hungary had had the most lenient foreign-capital regulations of any socialist country except Yugoslavia. Foreign direct investment dated back to 1972, when the Kédér leadership approved a law permitting minority foreign ownership of Hungarian-based joint ventures. But despite the looseness of the regulations and the evident eagerness of the central authorities to attract foreign capital, few Western investors availed themselves of these opportunities.

In an effort to attract more foreign capital, in 1986 the party introduced some important modifications in the joint-venture code. Foreign participants could now exercise majority ownership of Hungarian-based joint ventures. The revised law also gave foreign investors tax holidays and simplified the rules concerning repatriation of profits. Foreign partners could now convert significant portions of their forint-denominated earnings back into convertible currency.

These measures did have a salutary effect on foreign direct investment in Hungary, as scores ofjoint-venture projects emerged in light industry, agriculture, and food processing. But foreign investment in large-scale industry still fell short of expectations, reflecting complications stemming from Hungary's

obligations to the COMECON, as well as from excessively cumbersome bureaucratic procedures for approving investment applications. Moreover, Hungarian law still restricted foreign direct investment to participation in newly created joint ventures: it was not yet legally possible for Western investors to undertake equity investments in existing Hungarian state enterprises.

That barrier was removed in January 1989 with the party's approval of the landmark "Law on Economic Association." In addition to legalizing private capital ownership by Hungarian citizens, the new law entitled foreign investors to acquire up to 100 percent equity ownership of Hungarian state enterprises. The law also granted foreign investors highly favorable tax holidays, as well as legal guarantees concerning nationalization. Moreover, conversion of forint-denominated earnings, previously determined through ad hoc agreements between the foreign partner and the National Bank of Hungary, was now completely up to the discretion of the investor: foreign investors could freely convert and repatriate all of their after-tax profits (FBIS/EEU: i).

This opened the floodgates to Western investors, who would end up spearheading the privatization campaign initiated by the outgoing Németh administration and continued by the successor government headed by the Hungarian Democratic Forum (Marrese 1992). But while foreign capital assumed a dominant position in Hungary's privatization process, domestic actors remained hamstrung by an array of constraints, despite the fact that the 1989 legislation had removed most legal barriers to equity ownership by Hungarian investors: the general shortage of domestic capital, the population's unfamiliarity with equity investment, the lack of a well-developed system of financial intermediation, and the absence of an extensive secondary market that would permit households and enterprises easily to liquidate their shareholdings.

The Political Consequences of Asymmetric Liberalization of Foreign-Exchange Policy

The dilemma confronting the HSWP in the banking and wage-reform cases stemmed from the fact that financial liberalization created distortions that necessitated reimposition of central controls while simultaneously providing economic agents with the resources to resist recentralization. The party faced a different problem in the foreign-exchange arena. Here, the asymmetric positions of foreign and domestic actors compelled the central authorities to pursue a trajectory of liberalization that favored the former over the latter. This had important political repercussions both for the HSWP during its final years in power and for its democratically elected successor.

The fact that the measures taken by the HSWP placed domestic and

international actors on an uneven playing field was one of the many liabilities hampering its renamed successor organization, the Hungarian Socialist party, during the run-up to the spring 1990 elections. The ultimate victor, the Democratic Forum, and other opposition parties charged that the liberal foreign investment laws promulgated by the communists in the late 1980s were allowing Western investors to buy up national assets on the cheap (Bartlett 1992).

The political controversy over foreign capital's prominence in Hungarian privatization did not cease with the parliamentary elections. The leadership of the Democratic Forum soon faced charges from populist elements of its own ruling coalition that the government was allowing Western investors favored access to the Hungarian market. In spring 1993, the Forum expelled one of its senior members for publicly accusing the government of selling "whole industrial sectors complete with their markets, with huge discounts" to foreign buyers (Budapest Week, May 6–12, 1993).

But notwithstanding the adverse political fallout from foreign capital's domination of the privatization process, restoration of controls on Western investors was a very costly option for the HSWP, as well as for the successor government. In contrast to the enterprise and household sectors, where recentralization entailed minimal political or economic risk, the central authorities enjoyed little flexibility in the external sector. Owing to foreign capital's high mobility and the availability of many other investment opportunities, ex post amendments of the rules governing foreign direct investment were highly risky. Not only would such measures spur capital flight, but the transformation of the regulations would cast a chill over the general investment climate and discourage future investors from entering the Hungarian market. For these reasons, the center's influence over foreign capital was concentrated at the bargaining stage.

Here, Hungary operated at a disadvantage relative to other capital-importing countries. As Margaret Pearson (1991) shows, the Deng Xiaoping regime skillfully exploited the pull of China's vast market to cut favorable deals with foreign capital in the 1980s. By offering preferential access to the local market and certain regulatory incentives, Chinese negotiators were able to extract concessions from foreign investors on export production, technology transfer, domestic content requirements, and other issues vital to the party's economic development strategy. By contrast, the Hungarian authorities faced major handicaps. While Hungary's long history of market-type reforms gave it important advantages over other Eastern European countries, its small domestic market seriously weakened its negotiating position in a highly competitive international investment environment. The center was thus compelled to admit foreign capital on terms extremely favorable to Western investors.

Conclusions

This chapter has addressed the following question: What happens when departures from central planning simultaneously devolve political power to local agents and create distortions that compel the center to reimpose controls? That question has special resonance in the politico-economic context of Hungary in the 1980s, when deterioration of the economy compelled the Hungarian Socialist Workers' party to shift from a growth-oriented reform policy to one based on austerity. The use of market-type financial mechanisms as instruments of stabilization and adjustment produced a variety of effects that compromised the party's ability to execute the austerity program and undermined its collective political authority. The contradictions of financial liberalization in Hungary manifested themselves in interesting ways in the three cases discussed above.

The banking reform, intended to place credit flows under the discipline of market forces, instead created a group of actors unwilling to serve as agents of economic adjustment. The portfolios of the new commercial banks, burdened by a large number of bad assets accumulated during the prereform period, gave loan officers strong incentives to sustain credit lines to loss-making enterprises. Thus, far from precipitating a redistribution of capital within the Hungarian state sector, the banking reform ended up reproducing the same patterns of credit allocation that existed before 1987. But once the crediting function was delegated to the commercial banks, the center had few means left at its disposal to redirect credit flows in a manner consistent with the aims of adjustment. While regulatory tools and equity ownership gave the Hungarian state considerable influence over the banks, such means were not amenable to intervention in individual lending decisions. The ineffectiveness of commercial bank credit as a restructuring instrument forced the center to resort to political/administrative devices to carry out restructuring policy. Thus, the unintended consequence of the introduction of market instruments into the Hungarian financial sector was to deepen the center's reliance on nonmarket mechanisms of structural adjustment, whose use drew HSWP leaders into conflicts over the pace and extent of industrial restructuring.

In the wage-reform case, the center's movements toward liberalization generated immediate pressures for expansion of the total wage bill. These pressures emanated from two sources: (1) the incentive structure of Hungary's hybrid economy, which deprived both workers and managers of strong inducements to contain wage costs, and (2) the pent-up demand for compensatory wage increases accumulated during years of declining real income. But once it began the process of wage reform, the center's capacity to recentralize control was severely limited. Not only did the party face

technical restrictions on its capacity to neutralize excess househol liquidity through ex post income withdrawal measures, but the initial liberalization of wage controls opened up political space for Hungarian workers, who were determined to protect the gains they had already achieved. While the fully independent trade unions that appeared at the end of the 1980s spurred this development, the most important manifestation of worker mobilization in Hungary during the late socialist period was the transformation of the ruling party's own labor organization. The Trade Union Council's shift to an opposition role removed one of the party's foremost mechanisms of political control and thwarted the Grósz regime's efforts to implement an IMF-supervised stabilization program. By 1989, the trade union movement had acquired sufficient strength to force the party leadership to back down repeatedly in its attempts to contract domestic purchasing power via consumer price hikes. The clashes between the center and the unions visibly weakened the party's hand precisely when it was entering into negotiations with the opposition over Hungary's political future.

Foreign-exchange liberalization, while generating recentralizing pressures as great as those produced by the banking and wage reforms, had different effects on the political capacities of the relevant actors. Foreign-exchange reform produced relatively weak ratchet effects in the domestic sphere, as the initial decentralization of control did not significantly enlarge the resources of local agents. The insulated nature of the issue area and impediments to collective action prevented enterprises, trade unions, and households from mobilizing in resistance to the center's restoration of controls. This allowed the party to proceed cautiously toward loosening foreign-exchange regulations in the enterprise sector and to retreat abruptly in the household sector. Yet recentralization was extremely difficult in the foreign sector, where liberalization stimulated a new set of actors, Western investors, who enjoyed strong bargaining leverage over the center. The consequent surge of foreign investment proved a highly contentious political issue both before and after the demise of the one-party system.

Hungary's experience with financial reform in the 1980s illuminates the unique dilemmas that arise when socialist market economics undergo externally imposed austerity. In full-fledged capitalist economics that face stabilization problems, the market serves as the primary means of redistributing capital and labor. The degree to which political leaders intervene to mediate local distributional conflicts depends on (1) the level of aggregation of the affected agents, and (2) the extent to which the structure of the state permits those actors access to the policymaking process (Lowi 1964). In traditional centrally planned economies, market forces are essentially nonexistent. This means, on the one hand, that political authorities need only resort to their existing repertoire of policy instruments to carry out the austerity program. On the other hand, it means that no prior decentralization

of control to the factory level has occurred that might impede the authorities' efforts to correct economic imbalances via centrally administered cuts in bank credit, wages, and imports. As Romania's experience in the 1980s demonstrated, such methods of stabilization are crude, but effective, insofar as they enable the center sharply to contract domestic consumption.

The political economy of stabilization and adjustment in market socialist systems like Hungary is distinct from that of both capitalist economies and Soviet-type planned economies. Here, neither the market nor the central planning apparatus are effective mechanisms of resource allocation. Market instruments do not induce local actors to redeploy labor and capital resources for more efficient purposes, but they do augment the capacity of those agents to resist attempts by the center to reclaim decision-making authority. Restoration of financial order thus requires the center to restore its jurisdiction in areas where it has already relinquished a significant measure of control. This places political leaders in socialist market economics in a peculiar quandary: the failure of market mechanisms to elicit the desired responses at the factory level pulls the authorities directly into distributional conflicts. But the prior introduction of those very same mechanisms prevents the authorities from employing standard central-planning tools to mediate these disputes.

All three cases illustrate the broader political dynamics underlying the collapse of state socialism in Hungary in the late 1980s. The demise of the HSWP resulted from the complex interaction of "bottom-up" and "topdown" forces: devolution of control simultaneously strengthened local agents and weakened the capacity of central authorities to correct the economic distortions arising from the initial decentralization. But the contrasts between the cases are equally illuminating, underscoring the differences and similarities in the political challenges of economic transformation confronting the successor government.

What gave leverage to the Hungarian commercial banks during the period preceding the political transition was the fact that bank credit was the primary "market" mechanism of structural adjustment then available. The banks' refusal to use it left the center with few alternatives but administrative devices whose employment unavoidably enmeshed the authorities in costly distributional conflicts. Both the banks' political influence and the center's role in the restructuring process changed markedly in the aftermath of the dramatic events of 1989–91. On the one hand, the rapid influx of foreign capital, which included a sizable number of commercial banks under full or partial Western ownership, whose portfolios were not burdened by large stocks of bad assets, transformed the competitive structure of the financial sector and reduced the relative weight of the Hungarian-owned banks. On the other hand, the abrupt collapse of the Soviet Union and the CMEA

generated a massive erogenous shock to Hungary and the other Eastern European economies. The upshot was a de facto adjustment involving deep reductions in industrial output and forced reorientation of trade. While the successor government of the Hungarian Democratic Forum assumed responsibility for subsidy cuts and other distributional issues requiring official policy decisions, its political burden was lightened to the degree that much of the process of structural adjustment was now driven by the logic of the world market.

The political power of Hungarian labor during the late socialist period stemmed not from its capacity to limit production, but rather from its ability to challenge the ruling party, which had long co-opted workers through the National Council of Trade Unions. As noted in the Mecsek case, the political efficacy of production strikes is apt to be limited in an economy undergoing restructuring, particularly when the striking workers are situated in enterprises already targeted for capacity reductions. The main exception here is Poland, where Solidarity was so well mobilized that it succeeded in virtually shutting down the Polish economy in late 1988 and forcing the ruling party to negotiate a political transition. The fact that a fully independent trade union organization was already well ensconced by the time of the transition to democracy has since given Polish workers a degree of economic and political power unmatched in the rest of Eastern Europe. The position of Hungarian workers in the postcommunist period is quite different. The political clout wielded by Hungarian labor in 1988–89 derived from the fact that the main thrust of mobilization occurred through the party's own trade union organization. The movement of the Trade Union Council into an opposition role hastened the progressive unhinging of the internal authority structure of the HSWP. But while that development played a key part in the demise of the one-party system, it did not leave Hungarian workers with a well-institutionalized, politically autonomous base for collective bargaining comparable to Solidarity's. With the transition to multiparty democracy, the political power of the Hungarian labor movement appreciably declined. The acceleration of industrial restructuring and the growing absorptive capacity of the private sector sapped the cohesion of blue-collar workers, while the splintering of the political left deprived organized labor of effective representation via the party system.

Foreign exchange shows a greater continuity of political and economic effects across the pre- and post-1989 periods. The extent to which the admission of foreign investors led to loss of economic control did have unique significance to a regime whose power resided in the system of central planning. Likewise, the rapid penetration of foreign capital had special ideological import for a ruling party anchored in Marxist-Leninist theory. But once the decision was made to liberalize foreign exchange in Hungary, the same structural factors that favored foreign over domestic capital during the

HSWP's final years in power prevailed in the posttransition phase. Thus, the trajectory of foreign-exchange liberalization after 1989 followed the general pattern of the late socialist period: full external currency convertibility for Western investors, combined with limited internal convertibility for local agents. The populist right's adverse reaction to foreign capital's privileged position, based on appeals to national and cultural values rather than socialist ideology, proved no less politically vexing to the successor government, which unlike its predecessor faced an electoral constraint.

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Appendix: Interviews Conducted by the Author
in Budapest, Hungary

Central Committee of the Hungarian Socialist Workers' Party

1 : 7 July 1988

2 : 30 August 1988

3 : 8 September 1988

Chamber of Commerce

4 : 15 July 1988

Council of Ministers

5 : 14 April 1988

6 : 5 September 1988

Hungarian Credit Bank

7 : 27 May 1988

8 : 8 July 1988

Karl Marx University

9 : 8 July 1988

Ministry of Finance

10 : 28 June 1988

11 : 6 September 1988

12 : 3 July 1988

Ministry of Industry

13 : 24 August 1988

National Bank of Hungary

14 : 12 April 1988

15 : 18 May 1988

16 : 15 July 1988

17 : 22 July 1988

18 : 12 August 1988

19 : 26 August 1988

20 : 8 September 1988

21 : 21 May 1991

National Commercial and Credit Bank

22 : 9 September 1988

National Planning Office

23 : 21 April 1988

24 : 10 May 1988