Russian Economic Reform

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1992 Article: “Russian Reformers and the IMF Get It Wrong.”

I first visited Russia in October 1991, after also visiting Hungary, Poland and Czechoslovakia. I again visited Poland and Russia in April/May 1992, and wrote the text below. In 1992 I met with Richard Layard, the British economist, who was then an adviser to the Russian Government. He told me how he and a fellow economist (who was Polish) boarded a Moscow-based plane in London with the idea that reform needed to be carried out gradually and with care. However, by the time they arrived in Moscow they had decided that it would be best to implement reform as quickly as possible, including the use of “shock therapy”. Layard told me that they thought there was a “less than 50% chance of this working, but it was worth a try”. Such—“worth a try”—was the low standard of economic advice being offered to Russia at that time.

Text of my May 1992 article:

“The economy of the Russian Federation will almost certainly deteriorate over 1992 and 1993. In particular, industrial production is likely to decline significantly in the state enterprise sector and both unemployment and underemployment will rise. Given the breakdown of much of the system of relationships that made the centrally planned economy, there is probably little that can be done to prevent this fall.

What economic policy makers can do, however, is influence the extent of the fall. Unfortunately, the Government’s pronounced economic policies (as outlined in the ‘Memorandum on the Economic Policy of the Russian Federation’ which was agreed with the IMF in March) are likely to exacerbate the difficulties. If implemented, they may even carry some risk of pushing the economy into an abyss.

The essential flaw in the stated economic policy is that it is one that is designed to appeal to the West in the pursuit of international financial help. Moreover, this appeal to the West is really to that side of Western opinion that believes that markets can solve all problems if only governments would get out of the way. Thankfully, for the West at least, not all Western opinion makers and governments have such an extreme view, let alone act on it.

The Russian Government’s program would be tough and ambitious even by Western standards. In particular, a program of the Government’s type might impede structural reform in a Western country by putting too much emphasis on fighting inflation and not enough on keeping the level of demand and production high enough to ensure that both existing and new enterprises have an incentive and an ability to invest to produce market goods and services.

This is precisely what happened in New Zealand in the late 1980s and the early 1990s. In the early 1980s New Zealand had a reputation as one of the most government controlled economies in the OECD. A comprehensive and effective program of privatization and micro-economic reform (eg by reduction of subsidies) was undertaken and there has been little criticism of this. Unfortunately the heavy emphasis on fighting inflation (which included the use of a very tight monetary policy) led production to stagnate and the level of employment in 1992 to be lower than in 1986.

Yet, for all of its government controls in the early 1980s, New Zealand was a long way from being a Russia. It already had a very large and experienced market sector. But even here, the lessons were clear. Structural reform takes a lot of time and effort and the macro-economic policies must be appropriate.

Closer to home, for Russia, is Poland. After much bravado about the success of its economic policies in 1990, the Polish economy has deteriorated significantly.

A number of experts on the Polish economy now point to three main lessons that should be learnt from the Polish experience. Firstly, too much emphasis should not be placed on reducing inflation and achieving currency convertibility. (The inflation issue lesson is the same as for New Zealand.) Secondly, a very great degree of focus needs to be given to basic issues such as the taxation system, banking system, legal system etc. which allow market economies to function effectively. Thirdly, there needs to be greater recognition that privatization is necessarily a slow and complex process.

If the Government’s ‘Memorandum on the Economic Policy of the Russian Federation’ is to be taken literally, Russia is to repeat many of the Polish (and New Zealand) mistakes.

Firstly, the ‘Memorandum’ says that it is intended to reduce the average monthly level of inflation to between 1% and 3 % in the last quarter of 1992. This is a fairly low and precise target and might be possible given the reversal of excessive price rises in the first part of 1992.

Evaluating the stance of monetary policy is difficult in any country. Monetary policy was not tight enough in 1991 and this is one of the factors contributing to very high inflation. However, there has been a significant risk that the tighter monetary policies in early 1992 in the pursuit of very low inflation would combine with attempts to tighten fiscal policy to crush the economy. This would impede the process of reform and recovery. Not only do existing enterprises need bank credits to restructure, and new enterprises need credits to begin, but budget deficit reduction inspired large decreases in government expenditure may launch a vicious circle of lower expenditure, weaker economic activity, lower tax revenue, increased budget deficit, lower expenditure etc.

There are some signs, however, that the ‘Memorandum’ will not be taken literally in this area. After a very tight monetary stance in the first two months of 1992, there has been as easing of monetary policy and an increase in central bank credits to commercial banks (and thus industry and agriculture). While this has probably increased the risks of higher inflation, it was probably necessary to avoid an almost complete industrial collapse in late 1992.

Secondly, while the ‘Memorandum’ discusses structural changes there is too little emphasis on the need for rapid and vital reforms in the accounting, banking and legal spheres, including anti-monopoly legislation. It is almost as if this very important component of an effective market economic system will rise by itself.

This criticism also applies to an aspect of macroeconomic policy. It would be acceptable to all but the most ideological anti-government Westerners that a larger than suggested Budget deficit (in the memorandum it is suggested that the deficit should be 1% of GDP in the first quarter of 1992, down from over 20% in 1991) would be acceptable if it could be financed by selling ruble denominated government securities into the domestic market. Even recognizing the difficulties, an insufficient amount of attention is being given to developing a market for such securities.

Thirdly, the mooted rapid pace of privatization in the ‘Memorandum’ is unachievable and dangerous. According to the memorandum, the ‘programme for 1992 envisages the privatization of 50 % of enterprises (organizations) in the building materials industry, wholesale trade and public catering, of 60 % of enterprises in the food industry, agriculture and retail trade, as well as 70% of enterprises in the light industry, construction, automobile transport and repair.

The pace of privatization is unachievable because of the lack of an existing market and institutional framework to support it. This pace is dangerous because of the massively disruptive effect that ownership changes and reorganization will have on the already mangled process of production in medium and large enterprises. Small enterprises and some service sectors, of course, may be privatized rapidly with less disruption. The other danger with rapid privatization of larger enterprises is that its lack of control may deliver many state assets into the hands of only a few groups who will then exercise monopoly powers and control over the economy. This appears to be a particular danger in Russia.

Having made these points, it should be emphasized that the Russian Government should not change its basics policy direction.

Rather than changing the direction of reform, the Government should slow the overall pace of policy change and re-orientate towards the building of mechanisms and institutions that will allow a market economy to function. This would reflect a recognition that one economic system (irrespective of how badly it is functioning) cannot be replaced by another “overnight”. In practical terms, this means that the Government would need to continue to play a significant role in determining both production and prices in parts of the economy. Some State plans would still be needed not only to ensure the continued production of many useful goods and services, but to ensure that as massive defense production is wound down the freed resources (both man and material) are put to some productive use. The market itself, will not be able to handle this huge task.

Finally, it is worth putting the view that Russia needs to find its own way of reforming. It may be that countries such as Hungary or those of East Asia provide more appropriate examples of what to do than the very “free-market” approach. It is more likely, however, that they will only provide bits and pieces. A very thoughtful and pragmatic approach is needed, for the risk remains that economic reform policies orientated excessively toward acquiring international financial help may end up doing more harm than good.

Past Articles on the work of each of the 21 Expert Groups can be accessed here:

Russia’s new privatization scam?
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As noted in the previous blog on this site, the final “Strategy2020” Report has six parts with the first being entitled a “new model of economic growth”. Also as noted, this part is divided into three sections with the second entitled “strategy for improving the business climate and increasing investment attractiveness with the aim of moving to more stable growth”.

Although this section makes some important points, it is not wildly exciting reading and I was tempted to pass-over it and try to go onto something else. However, I then noticed an article on the “Russia Profile” internet site about SMEs soon being able to more easily purchase the premises which they presently rent from various levels of government. See: http://russiaprofile.org/business/56557.html

These are extracts from the article:

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Published on March 31 2012

Strategy 2020 Final Report
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The final “Strategy2020” Report (of 864 pages), which was completed in December, has finally been released and I will attempt to cover some of the most interesting “economic” issues over the next few weeks as part of my commentary on unfolding economic developments. Many of the Report’s main recommendations have already been aired in the media, either as direct reporting or as part of coverage of the discussions of policy makers as they try to decide what course to set over coming years.  

Apart from the introduction the Report is divided into six main parts, but there is also a so-called “budget maneuver” section at the end which makes “suggestions for restructuring the expenditure side of the budget”. The six  main parts are: 1) “new model of economic growth”; 2) “basic macro-economic conditions for growth”; 3) “new social policy and development of human capital”; 4) “infrastructure, including balancing development and good living environment”; 5) “efficient government”; and 6) “external economic issues”.

These main parts encompass the work of all of the 21 Expert Groups listed on the right-hand side of this page. The whole report (in Russian) can be accessed by clicking on “2020strategy.ru” in the top right hand corner of this page.

The first main part of the Report, “new model of economic growth”, is divided into three sections: “securing macro-economic and social stability”; “strategy for improving the business climate and increasing investment attractiveness with the aim of moving to more stable growth”; and “stimulating innovation”.

In this “post/blog/article” I will concentrate on the “securing macro-economic and social stability” section. Anyone familiar with the Russian economic policy debate will aware of most of the issues. So, I will only mention what I think are the most important or interesting issues and, occasionally, add some commentary.

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Published on March 18 2012

President Putin and his Prime Minister
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In terms of political and economic reform, the next six years of Vladimir Putin presidency will not be particularly eventful for Russia. The trend will not be “stagnation”, but a slow crawl progress in both political and economic terms. Thus, much of Russia’s huge potential to become a wealthier, smarter and more powerful country will be wasted.

Putin will serve his full 6 years. He will not quit early as it is not in his character, and he will feel that the “majority” who voted for him have vindicated his own belief that Russia needs him. And, there is no-one to tap him on the shoulder and say it is time to go. Moreover, the historical examples of someone in his position — much power over a prolonged period of time — tell us that he will stay while he can.

In some ways Putin reminds me of a CEO of a “business association” that I worked for some years ago. This man – I will call him Peter – had been a prominent sportsman and worked hard to maintain his fitness in his late fifties. He was, in many ways, a well organized and efficient administrator. He had been employed to bring order to an organization that was seen to have under-performed because the previous CEO was a somewhat whimsical man who was more interested in pursuing often unrealistic ideas than in tight administration.

However, it quickly became clear that Peter would be able to do little more than bring a sense of order to the organization. What he lacked was not intelligence, but the necessary personal characteristics that were needed in a leader to take the organization forward once some order was established.

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Published on March 11 2012

BRIC Jim O’Neill’s simplistic “thick-brick” thinking on Russia!
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Jim O’Neill of Goldman Sachs who originated the BRICs slogan has published a book, “The Growth Map”, which suggests his knowledge of Russia is quite shallow and unsophisticated (sometimes “thick as a brick” economiсs, with too little feeling for psychology or sociology).

Good analysis of a country’s economic prospects requires more than anecdotes and an ability to handle data. Demographics, the presence of technology, education levels etc – mentioned by Jim in his prognosis for Russia – are not particularly difficult issues to deal with, or even measure.

The really difficult issue to assess is how effectively a society will bring these, and other, things together to maximize productivity increases. The optimal way to do this will vary between countries, and over time for any one country. There are few general hard-fast rules, and a lot of judgment must be applied.

According to Stefan Wagstyl, in articles in the Financial Times, Jim argues that “that political ‘antipathy’ blinds western critics to Russia’s advantages, such as its strong position in technology and education. He concedes Russia does badly on corruption and the rule of law, but claims that Italy’s economy has ‘rolled along for years’, despite having weak rule of law for a long time.”

There is some truth in each of the points, but Wagstyl also wrote that Jim “has little time for western criticism of Russian authoritarianism or one-party rule in China. He quotes an American businessman recounting a line from a Chinese person, who had said: ‘What’s the big deal about voting? In the US everyone can do it and only half the people do. If voting were that great a thing, like sex for example, everyone would do it.’” According to Wagstyl, Jim argues that “a lack of democratic development does not seem to concern most Russians”.

This is childish simplicity – at least in regards to Russia!

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Published on December 03 2011

“Decentralization” of power and finances
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The issue of “decentralization” of power and finances (away from Moscow to the regions) is currently a fairly hot agenda item. However, in my view, its strongest proponents are going to be disappointed by the result. This is not so much because of a lack of will by most people involved in examining and making decisions on this issue — but, by very practical impediments which would be there irrespective of who is president!

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Published on November 27 2011

“Free Trade Zones” and Medvedev stuff!
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The Strategy2020 team of Expert Groups is completing its final report for delivery in December. Initially commissioned by Prime Minister Vladimir Putin, it now appears that Dimitri Medvedev – as future prime minister – will be taking the running on this issue even before he steps down from the presidency. The Expert Groups have been quite critical of a number of the policies pursued by Putin, both as president and prime minister, and many of their ideas seem closer to those of Medvedev. But Medvedev is now in a much weaker political and psychological position than before announcing his decision. Putin now has the uncontested upper hand, even before legally assuming the presidency, so I am not sure that it makes much difference which one of them is the “curator” of the Strategy2020 project. 

Moreover, policy making is not on hold while this document is being finalized. The two most notable related issues reported last week were about “Free Economic Zones” and the possibility of the return of sales tax. 

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Published on November 20 2011

Putin’s dangerous reading!
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Anatoly Sobchak, the reformist mayor of Saint Petersburg with whom Vladimir Putin worked after he left the KGB in 1990, once suggested that Putin might be Russia’s Napoleon Bonaparte. And, in a sense Sobchak was right, and much of what I wrote in March 2000 in this article has occurred:

http://www.jeffschubert.com/index.php?id=20

Now, in order to justify his impending return to the presidency, Putin has invoked the cases of Franklin D. Roosevelt, Charles De Gaulle and Helmut Kohl as men who held power for a long time and who have been treated quite well by history – in contrast to Russia’s own Leonid Brezhnev.

Dmitry Peskov, his press secretary has said: “Putin reads all the time, mostly about the history of Russia. He reads memoirs, the memoirs of Russian historical state figures.”

This is dangerous reading!

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Published on November 06 2011

Regional “decentralization” – realistic or not?
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A working group on “decentralization of power” led by vice-premier Dmitry Kosak is due to present a report to President Medvedev by 1 December. Medvedev has in the past pushed the idea of greater decentralization of power, and his economic adviser Arkady Dvorkovich has suggested the introduction of regional sales taxes to increase regional fiscal autonomy.

According to an article in “Vedomosti”, the Kosak working group has considered the possibility of abolishing the post of presidential plenipotentiary to Federal Districts – which, on the face of it, would be a move toward “decentralization”. Each of the 8 plenipotentiary Federal Districts encompasses a number of the 83 Russian regions (oblasts, krais, republics, federal cities).

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Published on October 30 2011
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Pepsi’s love of Putin is good or bad for economic reform?
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Indra Nooyi, the chairman and CEO of “PepsiCo”, was clearly impressed with the performance of Vladimir Putin at a meeting of the Foreign Investment Advisory Council (FIAC) last week, saying that he “was on top of every issue” and “knew the facts”. George Buckly, CEO of 3M, said: “Mr. Putin was very impressive, strong and intelligent. He is extraordinarily well informed.”  And they were not the only ones who were impressed: consider the words of James Turley, chairman of “Ernst & Young”: http://www.jeffschubert.com/index.php?id=105

But, are the very positive assessments of such people positive indicators for the Russian economy and positive indicators for economic reform?

I am very doubtful.

Over the years I have participated in many groups and meetings considering Australian economic reform – particularly in taxation and anti-monopoly policy – which contained academics and very senior businesspeople (some of were who heads or former heads of Australia’s biggest companies).

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Published on October 23 2011

Taxation !!!
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It seems that Russia is making some progress in administration of the tax laws, and in the legislation itself.

Refunds of VAT payments have been an area of great fraud, particularly by way of refund claims for non-existent goods, fiddling the amounts on invoices, and ephemeral businesses. Last week an official of the Federal Tax Service told radio station “Echo Moscow” that such fraudulent claims are being reduced by better administration by the Service. Most of the improvement has occured in Moscow where a change of leadership at the beginning of the year has delivered positive results.

The claims of better administration by the Tax Service were supported by the director of the legal department at “ТНК-ВР management”, the deputy chairman of the tax committee at the Russian Union of Industrialists and Entrepreneurs, and by officials at the Ministry of Finance.

Also last week, “Vedomosti” ran an article on possible future changes to the tax laws. It quoted a report prepared by the Ministry of Finance, the Ministry of Economic Development, and the Federal Tax Service. In 2010 total tax concessions amounted to 2.48 trillion rubles, or 5.53% of GDP, with “business getting 1.063 trillion in stimulatory tax concessions”.

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Published on October 16 2011

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