Let's Talk Serious Economics

Yesterday, we were a bit crass in addressing the Castro regime's new "reform" dealing with hair salons and barber shops.

Therefore, we felt it would be much more prudent to analyze what this strange choice of "reform" tells us about the Castro regime's intentions and, given these, whether this "reform" will be successful. But in order to do so, it's first important to layout a "toy model" of the players in the Cuban economy, namely the owners, managers, consumer and workers.

The Toy Model

The Castro regime is the owner of all businesses in Cuba. Let's call this conglomerate, Cuba, Inc. As shareholders of Cuba, Inc., the nomenklatura receives and disposes of all the profits of Cuba, Inc.

Like most business owners, the nomenklatura delegates management to a business elite, the managers. As most Cubans know, these managers are siphoning off huge amounts of resources for their own use. This is what economists refer to as a principal-agent problem, a situation where owners (the principals) delegate on the managers (the agents) to maximize their profits, but the latter exploit their information advantage with regards to the day-to-day operation of the firm to maximize their own benefit at the expense of the owner's profits. This happens not only at the level of business (e.g. Cubana de Aviación), but also of public services (e.g. the scandal of Mazorra).

Meanwhile, the Cuban people receive compensation in the form of salaries and social services, albeit of varying quality and availability. However, because Cuba, Inc. is the sole employer in the island, it has market power similar to a monopolist (the technical term, when applied to an employer is a monopsonist). In practice, this means it can push compensation below what would have been the case under a system of free competition between numerous independent Cuban businesses. The situation is analogous to remote mining areas where there is a single mine owner, a surplus of workers due to a gold rush, and a sole supplier of goods -- the mine owner. The outcome is well known: the owner offers a pittance for pay and then charges exorbitant prices for basic goods and services. In Cuba, this is instrumented via the dual currency system, where workers are paid some US$0.5 a day in local currency and charged for most goods in a prohibitively expensive convertible currency ("CUC").

What is the Point of this "Reform"?

In very general terms, long-term growth, per capita, in a small economy like Cuba can happen in two ways: (1) Increased technical efficiency allowing for more output to be produced for given labor and capital inputs, and/or (2) climbing up the value chain by producing higher valued output for given capital and labor. Both require technical innovation and entrepreneurship, but the latter is often also associated with free entry and exit into an industry. That is, to go from producing generic footwear as a contractor for international companies, to becoming the next Puma brand, one must allow local entrepreneurs to experiment and set up shop with new products.

That is not what the Castro regime's "reform" is about. Long term innovation is impossible so long as Cuba, Inc. remains the only legal business entity in the country. In this scenario, any climbing up the value chain must come from within Cuba, Inc. which, like most monopolists, faces little incentives to do so. Instead of seeking the next great product, Cuba, Inc. seeks ways to squeeze the most monopoly and monopsony profits from its captive market. This is done by driving down compensation, jacking up prices and diverting as much as possible to the export market, where prices are highest. Clearly, this is antithetical to a free and prosperous Cuba for all Cubans.

A monopolist, however, would also like to jack up technical efficiency so that it costs less and less to produce a given output, thereby increasing profits. But here the principal-agent problem bites hard. In a huge privately held conglomerate like Cuba, Inc., with no external controls, audited accounts and limited competition, the opportunities for agents to exploit their informational advantage and steal from the owners (much like Bernie Madoff did) is huge. Moreover, agents often have no incentive to implement better management practices if they are not to be compensated for it. That is why barbers in Cuba are known to provide bad service: Why invest effort to improve service and build a good reputation if you will get the same salary no matter how many clients you service?

Hence, we may characterize this recent "reform" as a combination therapy to attack principal-agent problems. That being said, this reform is not designed to address problems related to product innovation. Its sole focus is maximizing the profits of the Cuba, Inc., monopoly and monopsony; not about growth, innovation and equal opportunity for all Cubans.

Will this "Reform" Work?

To the extent that the objective is to reduce principal-agent problems, it might have some limited effect. Why limited? In a state like Cuba, where there are no checks and balances, no clear separation of the various branches of government and of Cuba, Inc., accountability is likely to be limited. More often than not, the owner, the agent and the judge will all be one and the same.

Second, with regards to the incentives for barbers, much depends on the future appropriation of their returns to investment. A barber must work hard for months or years to establish a reputation for good services. And yet, before he sinks all this capital he will ask himself: Will the state not be tempted to increase his rent in lockstep with his profits? The government may issue some guarantees to prevent this but, once again, the absence of checks and balances and the rule of law in Cuba means that there will be very little investment security. Barbers will probably innovate, but remain fearful of being seen as too successful and, most certainly, they will not want to compete with businesses sponsored by the nomenklatura. In other words, the incentives to improve are weak.

To conclude, it is safe to say that this reform is first and foremost ill conceived -- it is not designed to unleash growth and innovation in Cuba for the benefit of all Cubans. Moreover, even the more limited aim of abetting principal-agent problems is unlikely to be met.

What Cuba needs right now is a game changing strategy for growth and prosperity, one where all Cubans face similar opportunities to participate and benefit in the market and where the fruit of their labor is, but for predictable taxes, for them to keep. At a minimum this requires private ownership, freedom of entry and exit into any line of business and legal certainty. At best, this is accomplished within the context of democratic institutions. This "reform" does not meet any of these goals. Faced with the urgency of a serious economic crisis, Cuba needs a revolution -- a democratic and entrepreneurial one. In light of this, Raul's "reform" is just a way of waiting for Godot.

Analysis courtesy of former World Bank economist Fernando Martel.