August 14, 2002

David Veksler

A Policy Proposal for Economic Reform in Russia

 

Despite making a recovery after the 1998 market crash, Russia remains weighted with numerous holdovers from the Communist era that keep its economy from taking advantage of free-market reforms.  In short, Russia has not prospered under capitalism because it has not yet discovered it.  In order to do so, the Russian government must engage in extensive reform in several key areas: improving the rule of law, creating stable monetary policy, and ending a policy of favoritism to particular businesses.  Engaging in these reforms would lower the extremely high transaction costs of doing business legally, stimulating a wave of new investment and wealth creation within Russia, as well as encouraging investment from abroad. 

 

While the causes of Russia’s economic problems are numerous, the absence of a rule of law causes enormous unpredictability and uncertainty that is the primary barrier to economic growth.  The regulatory mess caused by presidential decrees, legislative changes and numerous bureaucracies putting out contradictory rulings is just one aspect of this problem.  The court system, which is supposed to be a neutral arbitrator of private disputes, is highly politicized, and even worse, it is used by the governments to silence critics and unfavorable companies.

 

One of the major challenges to reform is the uncooperative nature of the bureaucratic apparatus in carrying out laws and policies enacted by the executive.  While Yeltsin and Putin have generally been in favor of free-market reforms, the bureaucrats meant to carry out their policies are often rich oligarchs who stand to lose financially or politically from reform.  To combat this, Putin has replaced most of the Yeltsin-era ruling cabinet with his own men, but it is unclear whether they will be any better than their predecessors.

 

The lack of clearly defined and enforced property rights is another major problem.  The communist-era criminal code has only been partially replaced, and each contract must be carefully examined to check whether it contradicts an ever shifting mess of regulations.  In addition, it is unclear what success the communists will have in the next election, so long term planning is very difficult because the future is so unpredictable.

Despite an ambitions privatization program, many of the large factories remain state owned, partly because of the fact that their outdated and inefficient production would immediately and properly put them out of business under a free market.  However, because the government has so much influence over the banks, it keeps funding these inefficient enterprises to earn the support of the many workers they hire.   Many of the factories that were privatized, simply signed ownership to their communist bosses, and because of their pull with the government, stay alive by government aid.

 

Despite all the issues mentioned above, the biggest challenge to Russian economic growth is probably its monetary policy.  The Russian central bank is a direct holdover from Soviet times and needs to change its policy drastically to adapt to a free-market economy.  In a capitalist economy, private banks serve to store money and provide investment to business.  Because banks lose their investment when a debtor defaults, they are careful to insure that entrepreneurs large and small have sound business plans and refuse to loan to companies whose profits are dubious.  The central bank functions independently of private banks (ideally) serving only to manage the size of the monetary supply indirectly by open market operations, varying the discount rate, and setting reserve requirements. 

 

In a socialist economy, the function of the banking system is entirely different.  All banks are part of a single system to distribute funds from the central government to individual business and factories.  Branch banks don’t care whether any business is profitable or not because the credit risk of any investment is zero, since the government simply sends more money to an unprofitable factory instead of letting it go under.  Private savings accounts are small or nonexistent because there is nothing to invest in, and no interest to earn from the investment, and event if there was money to be saved, there is usually nothing to spend it on in the stores.  Instead of being independent, the central bank is simply an accounting organ of the state to determine which industry receives what funds.  Inflation however is kept low because all large purchases require permission from the state, exchanging rubles into other currencies is illegal, and outside the black market, there is nothing to spend money on anyway.

 

When the USSR collapsed, the banking system was officially privatized on some levels, but remained much the same in function. Most banks remained either partially state owned or state controlled, even if officially privatized.  These banks fund inefficient public and private enterprises with funding from the central bank, which simply prints new money to cover the expense.  State workers receive new rubles for doing little or nothing.  Of course, basic economic theory dictates that printing money without a corresponding increase in wealth is going to create huge inflation, which it did on a grand scale, with the ruble falling more than 20% in value on some days.1 One of the insidious effects of inflation is to transfer money from the money making companies to the recipients of new government money, diminishing the incentive of workers to get jobs in the private sector.  In an attempt to protect the value of the currency, the government made it illegal to exchange rubles for dollars, making them even more worthless because there was so little to spend the rubles on.  In effect, the government was printing enormous amounts of money to keep inefficient state enterprises alive, but not allowing workers to spend any of the money so as not to devalue the currency. 

 

If the monetary policy of the Russian government is not bad enough, the International Monetary Fund directly supported it by funding the government with billions of dollars in loans.  Because more and more money was necessary to support the old state enterprises, the foreign aid went directly into dilapidated old factories, which often were not producing anything at all, with most workers employed elsewhere, but registered as working at the factory for the state salary.  As Russian reformer Grigory Yavlinsky said in 1993, "It has become clear that new Western credits are no longer a remedy for Russia, but a drug helping to maintain an unfit system."10

Inevitably, the ability of the Russian government to pay back loans steadily declined until it was forced to default in its debt in 1998.  The IMF failed to learn its lesson however, as it continues to fund inefficient and government favored enterprises all over the world, notably in South America, creating a false sense of economic stability that politicians use to stay in power and the IMF uses to prove its relevance until the country is no longer able to pretend to be able to pay back loans and engages in the familiar scenario of funding payments with inflation while trying to limit citizens ability to spend the new money.  At no time is any investment in new, economically efficient infrastructure actually made, something Russians would do well to mind when asking for international loans.

 

Historically, the inflationary policy of the new Russian government is typical of both Soviet and tsarist era central banking. 3 The nature of printing money to cover losses from inefficient state enterprises means that high inflation will be inevitable unless the government either confiscates private savings accounts or limits the ability to withdraw money from the savings accounts to drastically decrease the real money supply. The former has happened several times during the Soviet era, most recently in 1991, when Gorbachev allowed only a small amount of rubles to be converted into smaller bills, wiping out private savings of millions, and not surprisingly leading to the familiar sight of pensioners begging on the street, which the western media blamed on the effects of privatization rather than irresponsible monetary policy. The 1991 savings confiscation destroyed any remaining confidence in the ruble or the banking system, leading to a mass conversion of rubles into dollars, or dollarization.   Today, Russians illegally hold over 40 billion in dollars, five times more than they hold in rubles, 1 and this despite ruble to dollar conversion being against the law.  The difficulty in converting dollars to rubles combined with the inflationary instability of the ruble and the socialist era banking system is perhaps the primary factor in the huge underground economy. 

 

The solution to Russia monetary crisis is simple:  the ruble must be made sound by making it convertible and establishing an independent central bank which is not a puppet of the government and aims to maintain a stable monetary supply (as opposed to supporting state industry) as its primary goal.  This action would free up many billions of dollars by giving Russians confidence in the ruble.  It would also force the government to pay for state industries through taxation, not inflation.  In the immediate short run, the government would be force to cut loose thousands of state enterprises – which is why this policy is so difficult to implement, but in the long run Russia would benefit enormously from the increased investment.  Lenin correctly pointed out that the best way to destroy the capitalist system was to debauch the currency -- and wise versa, the best way to inspire confidence in capitalism is to establish a sound and secure currency.

One way of making the ruble convertible is to make the dollarization of the currency official by creating a currency board to establish a fixed rate of conversion between rubles and dollars. 5 This board must be limited to maintaining the exchange rate it set, so it would be unable to support state firms by inflationary policy, since that would drain its reserve of dollars.  Such a board would greatly reduce the size of the black market and enjoy popular support by following earlier dual currency policies employed both by the left and right, only it would be much more orthodox in its ability to control the monetary supply. 3

 

Whatever policy Russia employs to stabilize its currency, if it wishes to partake of the advantages of capitalism, it has to somehow let go of inefficient state enterprises which keeps millions of workers idle and sink a large chunk of the economy every years. As many as 40% of industries in Russia are still unprofitable, a situation that could never be tolerated for long in any capitalist economy. 7  The classic argument that a maintaining a losing enterprise is “for the good of the workers” ignores the fact that the rest of the nation must pay for the idle workers, something nations all over the world would do well to mind.  While critics argue that cutting lose millions of workers will lead to economic depression and a popular revolt, this argument ignores the fact that these industries are not producing anything worthwhile anyway, and that many of the workers already have other jobs to supplement the small and often tardy incomes they receive from the state.

 

In addition to cutting lose failing industries, the government must stop playing favorites with business.  Both the central and regional government regularly favor certain companies for lower taxation, less regulation and outright subsidies.  Oftentimes, the businesses show their appreciation by practically enrolling various bureaucrats on their payrolls. At other times, bureaucrats are owners or stockholders of the industries they regulate, as conflict-of-interest laws are practically non-existent.  Additionally, much of the foreign aid that Russia receives is funneled directly to these favored businesses, which then “thank” the officials who provided the aid.  Obviously, this is not an especially good situation for encouraging the most efficient companies to grow, but the ones with the most pull with the government.  This is also a leading cause of corruption in Russia as well as in many other developing countries that receive foreign aid. 

 

A similar problem exists with both the central and regional government using economic pressure to bend business to their will.  Recently, the last independent television station in Russia was shut down when a minority shareholder (controlled almost entirely by the government) sued it and had the court declare bankruptcy and shut down the network despite the fact that in was one of the few profitable companies among a government controlled industry. 9    Not surprisingly, the station had been critical of the Putin government.  Such political favoritism is common and does little to inspire investors’ confidence in impartial courts, further depressing both domestic and foreign investment.

 

Despite failing to adopt an active program of reform, Russia has shown several promising signs since Putin took power.  Putin has taken actions to consolidate control and establish oversight over the regional provinces, helping him carry out policies that were previously resisted in distant provinces, some of which have remained de facto communist and ignored many of the central government’s rulings.  Another significant new measure to improve the economy has been a 13 percent flat tax that has helped the economy grow at 5% last year and boosted tax revenues 28%.  (The new tax rate doesn’t guarantee a responsible fiscal or monetary policy however, as Russia has used seignorage rather then taxes as the primary source of income, imposing much greater costs on the citizens in the process.)  A new generation of entrepreneurs is becoming proficient at managing private enterprises and learning the principles of individualism and self sufficiency, as well as pushing for a radical deregulation of the economy.  These entrepreneurs have cooperated, with help from the government and western advisors, to establish a stock market and worked together to push for reforms.  Nevertheless, Russia’s economy remains mired in regulation, bad monetary policy, unsound and corrupt banks, and an other vestiges of communism that drag it down.

 

In conclusion, despite several positive reforms under the Putin administration, Russians needs to take major steps to embrace capitalism if they want to partake in its benefits.  The most important reforms are: 

*      A radical reduction in federal and local government regulation.  Simple, clear, well publicized, standardized, and long term regulations and laws to establish a clear and predictable rule of law.  Increased transparency on both the central and local levels, centrally published regulations, standard forms, and well published government statistics would also help in this area. 

*      A complete privatization of the banking industry.   This would stop the hidden flow of money to failing industries and increase access to credit for private entrepreneurs.

*      Establishment of an independent central bank and a dollar convertible currency to stop inflation, allow people to invest their dollar savings,  and secure confidence in the stability ruble.

*      The IMF and other foreign lenders should exercise much more caution in the policies they promote, by focusing on funding promising private ventures, not corrupt government officials who funnel foreign aid into their own private accounts.

Some of these changes will not be easy, especially in the short run, but unless and until Russia bites the bullet and jumps head first into capitalism, it will continue to experience economic instability, corruption, and mass poverty like all other socialist and pseudo-socialist regimes.



References

  1. Kurt Schuler and George A. Selgin, Cato Policy Analysis No. 348: “Replacing Potemkin Capitalism: Russia’s Need for a Free-Market Financial System”. June 7, 1999.
  2. The Heritage Foundation: 2002 Index of Economic Freedom – Russia. http://cf.heritage.org/index/country.cfm?ID=122
  3. Steve H. Hanke, “Create a Currency-Board Law for Russia.” September 14, 1998.  http://www.cato.org/dailys/9-14-98.html 
  4. Central Bank of Russia: http://www.cbr.ru
  5. Steve H. Hanke, “The Case for a Russian Currency Board System”. October 14, 1998 http://www.cato.org/pubs/fpbriefs/fpb-049.pdf
  6. Kurt Schuler and Robert Stein, “The Mack Dollarization Plan: An Analysis” Paper for the Federal Reserve Bank of Dallas conference “Dollarization: A Common Currency for the Americas?”   March 6, 2000 http://www.dallasfed.org/htm/dallas/pdfs/schuler.pdf
  7. Clifford G. Gaddy and Barry W. Ickes, Russia's Virtual Economy, Brookings Institute, 2002.  Excerpt at http://www.brookings.org/dybdocroot/press/books/chapter_1/russiasvirtualeconomy.pdf
  8. Gary T. Dempsey, “Mafia Capitalism or Red Legacy?” January 7, 1998 http://www.cato.org/dailys/1-07-98.html
  9. Dmitry Pinsker, “TV6 saga nears final episode.” The Russia Journal  http://www.trj.ru/index.htm?obj=5321
  10. James A. Dorn and Ian Vasquez. Ending Russia's Chaos, September 9, 1998 http://www.cato.org/dailys/9-9-98.html
  11. Daniel J. Mitchell, “Tax Reform: Russia, 1; United States, 0,” March 21, 2002 http://www.heritage.org/views/2002/ed032102.html
  12. Rose  Brady, Kapitalizm : Russia's Struggle to Free Its Economy, New Haven, Conn. Yale University Press, 1999.
  13. Martha De Melo, and Gur Ofer, “Private Service Firms in a Transitional Economy: Findings of a Survey in St. Petersburg”
    Studies of Economies in Transformation, 1014-997X ; Paper No. 11: 1994.
  14. William C.Gruben, "Dollarization: The Greenback Goes Global," Federal Reserve Bank of Dallas Expand Your Insight, March 1, 2000 http://www.dallasfed.org/eyi/money/0003.html