Russia’s Rough Road to Capitalism

Shafiqul Islam. Foreign Affairs. Volume 72, Issue 2. Spring 1993.

The controversy over how to bring capitalism to Russia mirrors an argument of 100 years ago between revolutionary Marxists and agrarian socialists. In 1899, a revolutionary approach to destroying feudalism was staked out in Lenin’s thundering prose. At the time, the issue was how to move from feudalism to capitalism, in order to then create a socialist economy. Now the contenders are self-professed capitalists, and the issue is how best to transform a communist economy into a capitalist one. The debate among these ardent latter-day Bolsheviks over how to proceed has increasingly assumed a reductionist form, cleaving the complexities of a capitalist transformation into the competing slogans of gradualism versus economic shock therapy, also called the big bang approach.

Non-economist advocates of these differing theories are often long on criticism of the opposing approach while short on specifics of their own. Shock therapists favor proceeding rapidly on all fronts to wrench a centralized economy into a capitalist mode, fearing that anything less will leave the old guard in command. Gradualists argue that a dismantling of the old system before enough of a new one is in place will lead to chaos and uncontrollable disruptions.

The current controversy began in the late 1980s with President Mikhail Gorbachev’s perestroika and gathered steam with his rejection of the “500-day Plan” for instant capitalism in the Soviet Union and the initiation of rapid economic transformation in Poland. Since then debate has intensified. with stronger calls for gradualism in the wake of Russian President Boris Yeltsin’s year-old program of bold capitalist reform and an accompanying plunge into an economy with sinking output, runaway inflation and a shrinking ruble.

In 1992 Russia’s gross national product and industrial production fell about 20 percent. Retail prices rose twentyfold, with inflation reaching 30 percent in January 1993 alone. The ruble collapsed from the pre-reform market rate of 60 rubles to the dollar to nearly 600 at last reckoning. Furthermore the budget deficit continues to widen. The supply of money and credit is out of control and massive capital flight exacerbates the shortage of foreign exchange.

Some American Sovietologists are convinced that President Yeltsin’s radical reform program has failed. But it is worth remembering that the Russian government inherited an economy that was already in deep crisis. By the end of 1991, Russia’s gross domestic product had dropped 13 percent, industrial production had fallen 15 percent, retail prices had risen 90 percent, inflation had reached a monthly rate of 13 percent in December, and the budget deficit exceeded 30 percent of the gross domestic product. With these initial macroeconomic imbalances, any transition strategy would have failed to produce quick results. The collapse of trade with the Eastern bloc countries, the pressure to service the bulging foreign debt, and the production plunge in oil and gas only compounded Russia’s economic troubles.

The transition to democracy and capitalism was further complicated by a collapse of inter-republic trade and monetary arrangements, Russia’s assumption of the Soviet Union’s international obligations, and the growing assertion of independence by autonomous republics within the Russian Federation.

Some apparent failures were actually successes. Much of the decline in industrial production was a necessary downsizing of Russia’s inflated industrial sector. For example, in 1988 the Soviet Union produced fifteen times more steel per dollar of gross domestic output than the United States. The deindustrialization of Russia attempts to cut back the military-industrial complex, which was producing intermediate and capital goods no one wanted and weapons for which demand was shrinking.

Real failures resulted less from faulty policy than from political obstacles. Former acting Prime Minister Yegor Gaidar was unable to sustain the decline in inflation after August 1992 because the communist-dominated parliament reversed the policy of the Russian central bank. Initially, the Gaidar government convinced the central bank to hold down money and credit growth. Thus the monthly inflation rate declined from 245 percent in January 1992, when most prices were freed and others were raised, to 9 percent in August. As credit dried up, and the check-clearing and financial payments systems broke down, leading to an explosion of inter-enterprise arrears, the industrial lobby and the parliament pressured Yeltsin into replacing the head of the central bank with Viktor Gerashchenko. He immediately flooded the economy with credit, bringing Russia to the brink of hyperinflation and sending the ruble on a free fall.

In December 1992, Yeltsin also replaced Gaidar with energy czar Viktor Chernomyrdin as prime minister. This was viewed as a victory of the hardline communists and the Civic Union—a coalition of the industrial lobby of enterprise managers led by Arkadii Volsky, conservative forces in the military-industrial complex led by Vice President Aleksandr Rutskoi, and supporters of a closer post-Soviet confederation led by Nikolai Travkin. However the Gaidar cabinet remained largely intact, and Yeltsin appointed Boris Federov—another radical reformer even less compromising than Gaidar—as his new chief economic adviser.

Getting to Capitalism

The debate between advocates of shock therapy and gradualism, within Russia and also in the West, is obscuring the fact that most Western economists agree on the four interlocking wheels of an overall transition strategy.

Stabilization: Tight budget and monetary policies are needed to curb inflation and reduce the external trade and payments deficits to sustainable levels. Incomes policies, such as a tax on enterprises granting high wages, should bolster stabilization measures.

Liberalization: Prices must be freed up, interest rates decontrolled and currency realistically devalued, made convertible, and then protected by peg or float mechanisms from overly large swings in the exchange rate. Concurrently, labor markets should be liberalized and barriers lowered on cross-border movements of goods, services, capital and technology.

Privatization: A private sector of new businesses must be created while existing state enterprises are converted into joint-stock companies with independent boards of directors, ultimately to be privatized in restructured form or liquidated if uncompetitive. Critical to the privatization program is the existence of laws protecting property rights of land, housing and business.

Institutionalization: A market-based economy requires a wide-ranging set of measures including reform of the constitution, the legal system, political bodies, the fiscal administration and the banking system. Also needed are appropriate accounting and regulatory procedures, capital and equity markets, social insurance and other safety nets.

Economists largely agree that ample foreign assistance is initially needed to maintain momentum of the transition to capitalism. High priorities are balance-of-payments loans for importing critical raw materials and industrial inputs, a currency stabilization fund, debt relief and technical assistance. Other key areas for initial foreign assistance include building physical and institutional infrastructure and providing on occasion food, clothing and medicine. Economists also agree that the birth pangs of capitalism must be alleviated with a social safety net for pensioners, as well as compensation, retraining and relocation for the unemployed.

Social, political and historical factors are unavoidable constraints to the transition strategy mix. So are the initial economic conditions such as the extent of macroeconomic imbalance, allocative controls and price distortions. Another difficulty is the massive redistribution of wealth, with the majority losing their savings to inflation and pensioners seeing their living standards fall below subsistence levels. Meanwhile, a growing minority, largely the younger generation, is working harder and doing better, while some entrenched apparatchiks are getting rich quickly and corruptly. A further source of social distress is the growing fear of unemployment, fueled by the Civic Union industrialists. Workers know that today’s subsidized employment rate of 98 percent cannot last.

The reductionist debate, implying a simplistic choice between shock and gradualism, hides the necessary sequencing and speed of the components of an overall policy package. A key problem is that some policies inherently take longer to implement than others. The resulting mismatches of speed cause perverse policy responses, raise the costs of reforms and undermine the credibility of reformers. The central problem confronting Russia’s reformers is that they are trying to bring democracy and capitalism to a country with an outdated constitution, governed by an enduring cast of autocrats and communists. In Poland, Hungary and Czechoslovakia, popular movements led by former dissidents overthrew the communists from the center of power. But no such revolution took place in Russia, where the Supreme Soviet (the standing parliament) and the Congress of People’s Deputies are still infested with old communist party bosses who continue to fight to preserve their vested interests in the old order. The superpower Cold War has ended, but a new political Cold War has begun within Russia between a presidency dominated by capitalist reformers and a parliament dominated by communist reactionaries. Meaningful reform may not be possible without a new constitution and the replacement of this rump parliament with a democratically elected one. Meanwhile, mounting public disillusionment underscores the importance of the reformers taking their message directly to the people. To date, the Yeltsin government has done too little on this score; instead it has relied on the age-old tradition of waging a battle within the ranks of the ruling elite.

Fighting Hyperinflation Now

With Russia on the brink of hyperinflation, the overarching policy challenge facing Federov and his economic team is to redesign the transition strategy first to contain inflation, and then to jump-start a recovery. The challenge is compounded by the need to keep the reform process going and the pace of marketization from slowing. Although difficult, the four components of a transition strategy can be tailored to meet the specific economic, social and political conditions prevailing in Russia.

Stopping hyperinflation is the top priority because a market economy cannot be built on major swings in relative prices, obscuring their signaling role. Price swings result in massive redistribution of income and wealth, causing great social tension. High inflation also leads to a downward spiral of currency depreciation, creating a vicious cycle. Furthermore, an environment of uncertainty erodes business confidence, discouraging new investment and encouraging capital flight. Like cancer, hyperinflation becomes more difficult to cure if allowed to grow.

An early halt to hyperinflation requires curbing the combined budget deficit of central and local governments and establishing firm control over money and credit growth. The pursuit of fiscal soundness must take into account the continued withering away of the tax base. Profit-starved state-owned enterprises cannot pay, new profitable private enterprises escape paying, and the collection of taxes and duties declines with shrinking international trade. Local governments are also not transferring to Moscow much of their tax collections. But the key problem is on the expenditure side. Central government subsidies to enterprises, regions, and the Central Bank, and credit to other republics have ballooned to massive proportions. The government should hold down the growth of subsidies to enterprises in the short run, improve tax collection and rely on foreign aid to finance most of the remaining deficit. The long-term task is to replace the previous fiscal structure with an internal revenue system built on the principles of fiscal federalism. Direct budget subsidies to failing state-owned enterprises should replace central bank credit. State-owned banks should be recapitalized by replacing their bad loans to enterprises with government securities. The government can eliminate these bad debts gradually as the debtor enterprises are privatized, restructured or liquidated. A modern settlement and payments system, capable of handling economic, financial and commercial transactions of a large market economy, should also replace Russia’s antiquated and strained structure.

If the parliament and the industrial lobby continue to use the central bank as a floodgate for inflationary credit, an effective countervailing pressure might be encouraged by the central banks of the United States, Germany and Japan. The heads of these central banks could come to Moscow and underscore the critical importance of Russia’s central bank stabilizing prices—not production. They can cite with authority the disastrous inflation that plagued Germany and Japan when they were building capitalist economies. These Western central bankers could establish an advisory committee to spend the next six months in the Russian central bank assisting decision-making on monetary, credit and exchange-rate policy and stiffening resistance to any political clamor for subsidized credit.

Putting priority on developing a new private sector over privatization of existing large state enterprises is the second task. A new private sector in services, construction and manufacturing of consumer goods is already developing. The process is being driven by new start-ups, as well as privatization of small enterprises. For example, by September 1992, about 130,000 family farms had been established. By year’s end, 18,800 shop and stores, 4,500 cafes and restaurants, and 11,000 other consumer services enterprises had been privatized. In fact, a quarter of Russia’s gross domestic product may already be produced by the private sector. The government should promote rapid expansion of this sector by offering concessionary loans. cutting red tape, clarifying property rights and offering needed technical assistance. As this process of greenfield privatization—developing entirely new private business—gather momentum, it can create new sources of economic growth and new jobs, offsetting falling income and unemployment resulting from privatization and restructuring of large state enterprises. A growing new private sector can also accelerate piece-by-piece privatization of large state enterprises by attracting talented managers and workers and by buying up assets with profit potential. The Polish economic recovery is being driven by the spectacular growth of a new private sector as privatization of large state-owned enterprises proceeds at snail’s pace. While Poland had a substantial private economy even before radical reforms were launched in January 1990. Russia’s “kiosk boom” and evidence of growing entrepreneurial activities demonstrate that with appropriate incentives and institutions Russians can catch up fast.

Under the leadership of Deputy Prime Minister Anatol Chubais, privatization of smaller state enterprises has proceeded faster than expected. The government has now launched a program of mass privatization of medium-to large-size state enterprises, which will be mostly financed by vouchers that Russia’s 14-7 million people have already received. The goal is to privatize 6,500 large enterprises by the end of this year. This is essentially a political agenda for making the capitalist transition irreversible, as it would demolish the state sector to prevent a great leap backward to a semi-command economy.

However, privatization of medium-to-large enterprises is being carried out while control and ownership remains largely in the hands of the managers and workers. In effect, the industrial lobby is getting what it wanted. Many of the enterprises are unprofitable or insolvent at market prices. The risk is that either the managers will force the government to keep them alive by obtaining subsidies and bank credit, or they will close down precipitously, creating a rapid rise in unemployment. Thus, either the state enterprises will be private only in name, or privatization will cause enough social upheaval to threaten the political sustainability of reforms. Here, a gradual approach may have more merit, especially if preceded by massive efforts to create a new private sector and industrial restructuring.

Even as the battle against inflation goes on, restructuring and recapitalization of a few key sectors can help the task of macroeconomic stabilization. They can slow down the free fall of demand and output, help create foundations for future growth, and put in place some building blocks modernizing the economy. The sectors with the biggest payoff are energy, telecommunications, agro-industry and those factories within the military-industrial complex that can be easily and profitably converted to producing nonmilitary goods. Taking a lesson from the postwar Japanese strategy, a Russian development bank should carry out this task, as well as promoting the new private sector. An advisory committee consisting of Western business people and experts from the World Bank, the European Bank for Reconstruction and Development (EBRD), and the International Finance Corporation could assist the bank’s management, guide the selection of projects, and evaluate the terms and conditions of loans.

With the $24 billion Western aid package announced in April 1992 effectively dead, Russia’s reformers need a renewed commitment from the West. The Tokyo conference on assistance to the former Soviet Union, held in October 1992, suggested World Bank-led consultive groups as the primary mechanism for international action. But that is not enough. The Western response must be spearheaded by President Clinton’s personal commitment. The president should coordinate assistance to Russia through a committee of key finance officials from the seven major industrialized democracies (the G-7). The committee, headed by a chairman with high international stature and assisted by on-the-ground technical teams, should concentrate on four areas-stabilization, privatization, industrial restructuring, and a social safety net. The International Monetary Fund (IMF), the World Bank and the EBRD should regularly communicate with this coordinating committee. Within this institutional framework, the G-7 could announce a three-year package of conditional and targeted assistance. The money could be provided by the multilateral agencies, the G-7 and others such as the European Community, South Korea and Saudi Arabia.

Grants of at least 3 billion to 464. billion per year could finance the operation of a social fund. The U.S. share could be about half a billion dollars. With this money, the West might partly offset the Russian disappointment with its earlier role, send a direct message to the Russian people that it is possible to have capitalism with a human face, strengthen the hands of the reformers and defang their opponents in the Supreme Soviet and the Civic Union. The bolder the stabilization measures and the faster the privatization program, the greater will be the need for resources to finance a carefully targeted and politically visible social fund.

Loans from the G-7 governments, the EBRD, and the International Finance Corporation of about 1 billion to 462 billion per year could be used to establish an enterprise fund for making small loans and financing technical assistance to new private businesses.

A Russian development bank could be established with equity provided by the Russian government and the EBRD. Long-term loans of 7 billion to 8 billion per year for industrial restructuring should be jointly provided by the World Bank, the EBRD and export credit agencies.

As a resource-rich country suffering from a temporary shortage of foreign exchange, Russia needs temporary liquidity relief, not permanent debt forgiveness. A three-year moratorium on its 65 billion of foreign debt accumulated by the end of 1991 can ease Russia’s foreign exchange shortage, but more critically it may help its macroeconomic stabilization program by substantially reducing the budget deficit. The moratorium can also give the stabilization program a political push by linking each year’s rescheduling of interest and principal payments to the previous year’s compliance with IMF performance targets.

The IMF should provide a balance-of-payments loan of about $2 billion to $3 billion in 1993 to finance critical imports and further ease the fiscal crisis. Once political obstacles to monetary responsibility are removed, or at least neutralized, and the government can put together a credible stabilization program, the IMF can provide the already pledged 86 billion for a ruble stabilization fund to inject additional confidence in the program’s viability. The total package would cost about $20 billion per year. Since the social fund is the only component with direct budgetary outlay for donor governments, the tab to the U.S. taxpayer would be $1.5 billion over a three-year period. Lastly, the West must further open its markets to Russia.

No amount of money and leadership from the West can promote democracy and capitalism in Russia if the apparatchiks win the political battle and derail the reform process. But the West can help the reformers in this battle by offering moral and financial assistance in a politically intelligent and visible way. Most Russians feel they are going from the zoo to the jungle. Yet they—especially the younger generation—still look to America with warmth and awe. History may not be so kind if, after selling democracy and capitalism for decades, the West pulls away just when Russia struggles to embrace them.