Internalizing an "Externality":
the True Cost of Labor and Applied Knowledge

The most rigid structural characteristics of the socialist system at times afforded workers the opportunity for resistance, and the rapid growth of the second economy in the 1960s both enabled and this resistance (Gábor 1988). From then until the 1982 reform, the second economy—originally a coping mechanism for an experimenting state and a forcibly reorganized society— served as socialism's silent counterpart to capitalism's adversarial bargaining. The second economy is, in fact, one indication of the limits of rationality under a centrally planned economy, much as unemployment indicates these limits under capitalism.

In the foregoing section we saw that state-firm managers tried to protect themselves from the exigencies of the plan by hoarding workers, and workers hoarded labor power largely because the shortage economy demanded the goods and services they could produce outside working hours and/or on the side at state jobs. In this context, the control that managers and union officials could exert over workers was further compromised by the expansion of second-economy earning possibilities after 1968. On the one hand, firm managers' ability to increase wages remained limited even after the 1968 reform, and the nonmonetary incentives they could offer workers (e.g., housing, preferred vacation slots, and desirable work assignments) were often in short supply. On the other hand, the guarantee of full employment and the party state's reluctance to use force, especially after 1956, blunted managers' credible threats against workers who shirked or withheld effort. Managers' ability to reward and punish was curtailed in other ways. For example, even an openly uncooperative worker could reasonably expect that he or she would eventually receive many of the benefits allocated through state firms. For one thing, housing and vacations accrued as rights to state-firm employees. For another, state-firm managers who maintained good relations with all available workers could expect an easier time meeting plan targets. Finally, managers' discretionary application of incentives was restricted by the fact that workers' "pay" came in several administratively determined forms (guaranteed subsidized housing, free education and medical care, subsidized food, etc.), of which wages were, in effect, a residual category: in a sense, pocket money granted by the "paternal" state (Kornai 1993).

In short, even as the socialist system of work unwittingly provided workers with subversive capability, the system also attempted to externalize the true

cost of labor power.^[19] Although this attempt was never fully successful, workers suffered the consequences of the lack of property rights of disposal over their time and energy — or of rights poorly defined — and of firm behavior minimally constrained by markets. In a capitalist system, workers are a long way from being free to set the price of their labor power. But whatever the costs and risks, their relative freedom to relocate, to choose selfemployment, to work with friends, to obtain further training without need of official permission, or to switch professions, is far greater than in the socialist system, where most labor power could officially only be sold to the monopoly buyer: the state, represented by its firms.^[20] Even in relatively liberal Hungary, where especially after 1968, workers were free to change jobs and relocate, and firms had more autonomy in investment and wage decisions, serious hindrances to the institutionalization of smoothly functioning labor markets remained (Galasi and Sziráczki 1986, 14). In the context of full employment and labor shortage, firms persisted in their efforts to hoard workers in a variety of innovative ways, even as these failed to satisfy their "labor hunger."

Paradoxically, despite the lack of organized collective bargaining through independent trade unions, this situation afforded workers increased informal bargaining power as firms developed internal labor markets in the effort to keep them (Galasi and Sziráczki 1986, 15–16; Stark 1986): in effect, a

[19] Externalities are generally understood as the beneficial or negative effects that the production activities of firms bring to bear on one another. However, I want to generalize the concept here to include the beneficial or harmful effects that a group of state monopolies — socialist firms — may have on a factor of production, in this case, labor. Here, there are several externality-generating activities that lower the production or utility of the externally affected parties, including maintenance of administrative labor markets prior to 1968, and thereafter, of firm-level and economywide wage controls by indirect means. But fundamentally, the externality-generating activity is the curtailment of workers' choice between self-employment and employment by the state—that is, the effective abolition of private entrepreneurship. For an interesting discussion of externalities, including an elucidation of the long-standing debates over the income effects of transaction costs (e.g., Coase's theorem, whether the identity of owners matters, etc.), see Demsetz 1988, vol. 1, esp. chs. 2 and 7.

[20] Two distinguished Hungarian economists have summarized the pre-1968 system in this way: "Central economic management attempted to restrict the enterprises' and employees' freedom of action in the allocation of labour as well as in the determination of wages. It tried to diminish unplanned labour turnover through legal punishments against 'migratory birds', and those who quit their jobs without employers' authorization ('unjustified turnover')" (Galasi and Sziráczki 1986, 12). The point, of course, is not that capitalist labor markets function purely through the price mechanism, or that socialist ones function solely on the basis of allocation; either characterization would be overdrawn. The authors show that in socialist practice, labor allocation "from the outset included some elements foreign to the nature of a system of obligatory plan targets" (ibid.). The foregoing is simply meant to illuminate differences in the degree to which administrative versus price mechanisms controlled classical socialist labor markets, which, in practice for most socialist workers, did amount to a difference in kind .

kind of micro-level internalizing of the "externality"— in this case a more realistic approximation of the cost of workers' labor power. Specialized and skilled workers were best situated to bargain up their wages, but virtually all workers could conserve a portion of their energies for second-economy projects. Thus state employees, the overwhelming majority of the population, maintained informal veto power over the only resource they effectively commanded at work: their own labor power.

By the early 1960s, with the rapid growth of the informal second economy, rigid wage-fixing and restrictions on labor mobility had become untenable. Even the changes wrought by the 1968 New Economic Mechanism could not, however, significantly moderate firms' demand for labor, worsening labor discipline, and the reduction in the ratio of wages to living standards, despite increasing wages. In the early 1970s, "drastic" direct intervention in the labor market proved unsuccessful and temporary (Hare, Radice, and Swain 1981, 49–53).

The 1982 reform of property rights represented a partial macroeconomic internalization of the externality. Workers had previously borne the financial and opportunity costs of administratively determined wages and forced state employment. At a deeper level, society as a whole bore the costs in loss of international competitiveness and comparatively low living standards. Now the party state would officially assume the "cost" of the highly motivated labor of the significant segment of the population willing to work intensively on their own account or for private-sector employers. It would, for instance, bear the practical costs of regulatory adjustment, as well as the ideological and political costs of an expanded private sector.

It appeared that the party and second-economy participants had made a mutually beneficial trade. On the one hand, the leadership would lighten the burden of the system's accumulating incapacities by allowing private production to meet consumer demand that state firms were unable to satisfy. The state could also collect tax revenue from private firms. On the other hand, citizens achieved the absolute right to dispose of their own labor power, as well as rights of control over, residual income from, and alienability of private enterprise.

Given this apparently mutually beneficial trade, then, it may be tempting after all to view the reform as a straightforward functional response to systemic economic exigencies. But if this is the case, why did other socialist countries not pursue a similar course? A combination of conjunctural and historical factors are frequently marshaled to account for the difference in the Hungarian response. The conjunctural factors have received widespread attention, especially Hungary's onerous foreign debt;^[21] among the

[21] Fearful of the social consequences of the price hikes implemented in 1979 and thereafter, the leadership hoped that the increases would be tolerated if they were not accompanied by serious shortages. The econonmic crisis made capital- or import intensive solutions to recurring shortages more costly, however, and writing on the wall was clear: they would soon be beyond reach even as temporary expedients. The assumption of a large foreign debt in the 1970s and early 1980s, for example carried tremendous new costs of its own in the form of debt services, pressure from international financial institutions and, by 1982, near-default. In addition, despite the fact that neither actually occurred on any significant scale, anticipation of wholesale reduction of subsidies to state firms and the possibilities of bankruptcies led reformers to think of private firms in terms of potential job creation in the event of state-firm layoffs.

historical factors, the social pact struck by leaders and society in the aftermath of the 1956 revolution figures prominently.^[22]

However, conjunctural and historical factors amounted to necessary, but not sufficient, conditions for the implementation of institutional reform. Many of the economic pressures experienced by the Soviet Union, Czechoslovakia, Bulgaria, Cuba, and even the much-vaunted former German Democratic Republic were as severe or worse than in Hungary, yet these countries undertook no comprehensive reform of property rights. And while the 1956 revolution helps explain the initial consumerist pact, it cannot account for its repeated renegotiation—for the dynamic process of reform and retrenchment, with its many points of political struggle.

Understanding what made Hungary different requires that we turn now to an analysis of a high-level reformer's perceptions of and justifications for the trade-off between decreased central control on the one hand and citizens' rights to engage in private enterprise on the other.