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Economic Reform versus Rent Seeking

Anders Åslund and Mikhail Dmitriev

On August 17, 1998, Russia faced financial collapse. The government devalued the ruble, defaulted on its domestic treasury bills, and proclaimed a 90-day moratorium on its foreign debt payments. The ruble exchange rate quickly fell to one-third of its prior value. Within a week President Boris Yeltsin dismissed the reformist government headed by Sergei Kiriyenko, in effect for failing to secure Duma approval of measures that might have prevented the crisis. In the month of September, inflation rose to 38 percent per month, contributing to an annual inflation rate of 84 percent in 1998. The bank and payments system collapsed. As a result, the Russian gross domestic product (GDP) fell by 4.6 percent in 1998 (with a similar contraction expected in 1999). As of the end of 1998, Russia's GDP had fallen by almost half since 1990.

The severity of Russia's economic problems, and the seeming inability of a succession of governments to solve them, have raised numerous questions about the painful reforms Russia's people have endured since the collapse of communism. This chapter examines the main factors behind Russia's economic development since the end of the Soviet Union. It begins with a brief review of key events from the Soviet period that influenced the initial transition, then considers the successes and failures of the reformist government in 1992 and 1993. In 1994 and 1995, the government was no longer a reformist one, but it did complete the first macroeconomic stabilization and large-scale privatization. In 1996-1998, reform ideas were again much discussed, and some were even attempted, but their accomplishments fell short of their goals. In August 1998 financial disaster struck.

The August 1998 crisis caused great turmoil in Russia and hurt the welfare of its people badly. It is possible that the crisis will stimulate more realistic economic and political thinking, but in truth the main shortcomings of Russia's economic policy have long been known. A fundamental problem is that the Russian government has never achieved a fiscal balance. On the one hand, state revenues are declining because of an ineffective and widely ignored tax system. On the other hand, the government has failed to reduce and rationalize government expenditures. As a result of a lasting and large budget deficit, short-term government debts accumulated to a level that Russia's creditors no longer considered sustainable. The state debt service became excessive not primarily because of the size of the debt, but because of high interest rates caused by a badly functioning capital market.

Economically, the solution to Russia's problem was obvious. For years, the government and international financial institutions had made reasonable proposals to simplify the tax system, to broaden its base by abolishing exemptions, and to reduce the top tax rates. Other areas where there was general agreement on at least the broad contours of needed reforms included curbing abusive government interference; protecting property rights, including the private ownership of land; subjecting natural monopolies to market regulation; reinforcing the rule of law; and improving the social safety net.

The adoption of these and other widely discussed measures could have saved the Russian people a great deal of suffering. The key question is why hardly any of them were undertaken. Our answer is that the rent-seeking interests in Russian society were so strong that they overpowered concern for the common good.[1] Moreover, the competition among the rent seekers was so fierce that they could not halt their behavior but drove themselves to financial collapse.

By rent seeking we mean the attempt to make money from the government, either directly through state subsidies or indirectly through government regulations.[2] For much of the period since 1991, the history of economic reform in Russia can be best understood as a struggle between reformers trying to create a normal market economy and rent seekers trying to make money on market distortions. We focus in this chapter on what the most important forms of rent seeking were, and how and why they evolved. In our conclusion, we comment upon three aspects of the Russian transition: the design of the reforms, the efficacy of international assistance, and the politics of economic reform.

 

ECONOMIC ASPECTS OF THE SOVIET COLLAPSE

The demise of the Soviet Union had multiple causes, but serious economic imbalances and distortions were certainly among the most important of them. Soviet finances collapsed in 1991, as the union republics stopped sending tax revenues to Moscow. The Soviet government faced a huge budget deficit, but international financing dried up when the Soviet Union was no longer

able to service its foreign debt. In late 1991 the central government lived on little more than the emission of money. To make matters worse, the union republics started issuing their own ruble credits without any coordination with the Soviet State Bank: the more money any republic issued, the larger share of the common Soviet GDP it obtained.

This huge issue of credit would have caused hyperinflation had not most prices remained state controlled. Instead, inflationary pressures took the form of devastating shortages of nearly all goods. In the fall of 1991 food stores were typically empty, and whenever goods were delivered, long lines of customers appeared. For most workers it made little sense to earn money when one then had to spend hours queuing to use it. The idiosyncratic regulation of most prices led to incredible distortions: commodity prices were extremely low, often less than 1 percent of world prices, while industrial consumer goods were grossly overpriced.

The foreign trade regime aggravated these economic distortions. The Soviet Union essentially had a special exchange rate for every major good, and the differences between these rates were large. During the period of President Mikhail Gorbachev's partial economic reforms, the number of Soviet enterprises with the right to engage in foreign trade skyrocketed from 213 in 1988 to almost 20,000 in 1990.[3] With the right connections, these enterprises could acquire oil or metals at low Soviet state prices, obtain export licenses and quotas from foreign trade authorities, and sell the commodities abroad at the much higher world prices.

The Law on Cooperatives of May 1988 had made it legal to establish freely operating private enterprises, but the rest of the economy remained highly regulated. Many private trading cooperatives were set up by state enterprise managers together with politicians, state officials, and shrewd businessmen. One technique they favored was to buy commodities at low controlled prices from the state enterprises they managed and to sell them at market prices for private gain. Commercial banks became the most prominent new free-wheeling cooperatives.

The so-called red directors - state enterprise managers who flourished in the midst of the economic crisis because of inconsistent state regulations - belonged to the old communist elite, but their behavior was copied by new bankers, traders, and others. As Michael Dobbs put it:

There was a fin de regime atmosphere in Moscow in the spring of 1991, and bureaucrats were lining up to jump ship before it was too late. . . . Many members of the elite were now discovering that they could maintain their privileged positions in society even without ideology. . . . Why drive a Volga when you could be driving a Mercedes?[4]

In effect, the economic nomenklatura opted out of the socialist system for a partial market economy, leaving the Soviet elite split and politically vulnerable. This extraction of resources from the socialist economy virtually guaranteed the breakdown of the Soviet economic system. Ordinary Russians noticed who in the old elite had stood up against the Soviet system: since the red directors ensured the collapse of the Soviet Union, they were widely perceived as sensible heroes who understood that a market economy was necessary.[5]

But while these early proponents of a partial market economy had become quite rich, they still wanted more. They were prepared to fight for their privileges using their connections and fortunes - but not for a liberal market economy with real competition. Grave-diggers of the old Soviet system, these rent seekers were also the harshest enemies of radical reforms aimed at establishing a level playing field.

Russia at the end of communism has often been described as an institutional vacuum, but that is not quite true. Many institutional anomalies incompatible with a market economy lingered. Relative prices were enormously distorted; multiple and highly varied exchange rates persisted; monetary emission was virtually unconstrained; interest rates were set at low nominal levels in spite of rising inflation; entrepreneurship was subject to rigorous licensing; myriad regulations persisted on the books. Ironically, little in the economy was free except for banking. The government no longer owned or controlled everything, but real private property rights had yet to emerge. State enterprise managers tended to pilfer whatever public property they could. And most political institutions were too weak to stop them.

AN ATTEMPT AT RADICAL ECONOMIC REFORM, 1991-1993

In a speech to the Russian Congress of People's Deputies on October 28, 1991, President Boris Yeltsin announced his intention to move the country from the Soviet economic system toward a market economy. Yeltsin's main proposals were adopted as a guideline for the government's economic policies by an overwhelming majority of the deputies a few days later. One week after that, Yeltsin abolished the old Soviet branch ministries and appointed a new type of government with an economic reform team headed by liberal economist Yegor Gaidar. Yeltsin, Gaidar, and the young liberals who now led many ministries made no secret of their intention to build a Western-style market economy in Russia as fast as possible.[6]

Although the communists were discredited after the abortive hard-line coup in August 1991, the young reformers encountered vicious criticism from the outset. Even before the reforms had been launched, Vice President Aleksandr Rutskoi ridiculed the leading reform ministers as ``small boys in pink shorts and yellow boots.''

The reformers focused on getting state finances under control and drew up a balanced budget for the first quarter of 1992. Another priority was to liberalize prices, domestic and foreign trade, and entrepreneurship, but resistance to these changes was particularly fierce. Some of the arguments made against the reforms were patently absurd. Rutskoi claimed, for example, that, ``The liberalization of prices without the existence of a civilized market requires strict price control. . . . In all civilized countries such strict controls exist.''[7] Behind such bizarre statements, however, lay the interests of the so-called industrialists - managers of large state firms. And few among the public had enough understanding of a real market economy to judge the accuracy of such statements.

The key to understanding this highly antagonistic period is the events of 1992 - the year the rich and powerful made their big money. In the spring of 1992 the state price of oil was 1 percent of the world market price; the domestic prices of other commodities were about 10 percent of world prices. Managers of state companies bought oil, metals, and other commodities from the state enterprises they controlled on their private accounts, acquired export licenses and quotas from corrupt officials, arranged political protection for themselves, and then sold the commodities abroad at world prices. Their gains can be calculated easily by multiplying the average price differential by the volume of commodities exported and deducting export taxes. The total export rents were no less than $24 billion in the peak year of 1992, or 30 percent of GDP, since the exchange rate was very low that year. The resulting private revenues were accumulated abroad, which led to massive capital flight.

A second way to get rich was to borrow money from the Central Bank of Russia. In 1992 the bank gave enormous credits at subsidized rates of 10 percent or 25 percent a year (at a time when inflation was 2,500 percent a year). Viktor Gerashchenko, also the last chairman of the Soviet State Bank, gave bank credits as a favor to well-connected businessmen. In 1992 alone, the net credit issue of the Central Bank of Russia was 32 percent of GDP. Directed credits to enterprises amounted to 23 percent of GDP. While these benefits were less concentrated than export rents, they made Russia's bankers rich.

The bankers, for their part, argued that the credit issue was ``Keynesian,'' that is, that it would expand demand and support industrial production. In fact, the bankers cared little when Russia's industrial production plummeted in the wake of hyperinflation caused by excessive credit issue. The reformers never managed to get control over the Central Bank of Russia. Georgy Matiukhin, Gerashchenko's predecessor as chairman, reported in his memoirs how he was ousted from the bank in June 1992 because he insisted on raising the absurdly low interest rates contrary to demands from Ruslan Khasbulatov, the speaker of the Supreme Soviet (the old semi-democratic Russian parliament).[8]

A third way of making a fortune in the transition period was through import subsidies. In the winter of 1991-1992, there was great fear both inside and outside Russia that the country would suffer famine. Under such a threat, the reformers could not abolish the existing import subsidies for food. The subsidies meant that an importer only had to pay 1 percent of the going exchange rate when he purchased essential foods. After importing them, he could sell the foods relatively freely on the domestic market and pocket the subsidy for himself. These imports were paid for with Western ``humanitarian'' export credits, which were added to Russia's state debt. The total value of the import subsidies was assessed at 17.5 percent of Russia's GDP in 1992 by the International Monetary Fund (IMF). These rents were highly concentrated among a limited number of traders in Moscow, operating through the old state agricultural monopoly companies.

 

The total gains from these three activities amounted to no less than 71 percent of GDP in 1992. (This is a gross number, so the net gains to several thousand people involved are significantly smaller, but the concentration of income was extreme, and the revenues were huge in 1991 and 1993 as well.) In a few short years, Russia went from having an income differentiation close to the European average to having one of much higher Latin American proportions.

Other rents, while significant and harmful, were much smaller. Direct state subsidies, mainly to agriculture, the coal industry, and large enterprises, for example, were 10.8 percent of GDP in 1992 (see Figure 1). Much has also been written about the economic impact of the Russian Mafia. If by Mafia one means ``an industry which produces, promotes, and sells private protection,''[9] we can estimate revenues from racketeering by focusing on the retail trade, whose total sales amounted steadily to one-third of GDP. In 1992 a standard protection fee was said to be 20 percent, but not all businesses paid for protection. If we assume that the average protection revenues were 10 percent of total retail sales, the total annual revenues from protection would amount to 3 percent of GDP.[10] Moreover, protection is a comparatively labor intensive occupation, which means that net revenues per person must have been much less in racketeering than in the other rent-seeking activities mentioned above.

The rent seekers - state enterprise managers, bankers, corrupt officials, and commodity traders - were well organized and politically influential. Even so, after initial defeats the reform government made amazing headway. Gradually, price and export controls were eliminated, bringing Russian commodity prices closer to world prices. The dysfunctional ruble zone was broken up, and each of the former Soviet republics established its own national currency by late 1993.[11] Subsidized credits were abolished in late September 1993 by government decree, and by November 1993 Russia had positive real interest rates. At the end of 1993 the exchange rate was fully unified, eliminating the last import subsidies. In parallel, the privatization of small enterprises was successfully undertaken, and large-scale privatization was under way. The economic and social costs of these changes were great, but in late 1993 the reformers had accomplished so much that the reforms appeared irreversible.

There are several explanations of why fundamental reforms that seemed impossible in the spring of 1992 were successfully undertaken in late 1993.[12] Several rents declined for reasons beyond the control of politics. First, as people and enterprises learned not to hold money in any form, the velocity of money rose, which reduced the inflation tax. Therefore, the budget deficit could no longer be financed with the emission of credits. Second, as the media exposed various forms of rent seeking and people learned more about how a market economy operates, the public grew much less tolerant of unjustified subsidies. Third, a majority of the Russian voters expressed support for radical economic reforms in a referendum in April 1993. This gave the reformers a strong boost. And finally, the dissolution of the Congress of People's Deputies in September 1993 created a temporary political vacuum that offered reformers (but also the rent seekers) uncommon opportunities to advance their agenda.

At the same time, a number of developments went against the tide of reform. At the end of January 1992 President Yeltsin issued a decree declaring the complete freedom of domestic trade. Instantly, tens of thousands of Russians took to the streets in the big cities and started trading all sorts of goods at whatever prices they could command. They also threatened the interests of established traders with their effective competition. Alas, after only three months, Moscow's Mayor Yuri Luzhkov prohibited free street trading. Mayors of other big cities followed suit, and this brief interlude of free enterprise in Russia came to an end. In May 1993 reform foes acted on regional demands for comprehensive licensing of all firms, which further blocked the free development of enterprise.[13]

The political support for the reforms expressed in the April 1993 referendum did not endure. Russians had anticipated a large decline in economic output and consumption, but when a new round of inflation began, many attributed the primary blame to the reformers who had liberalized prices - not to those who had issued more money. The reformers suffered a severe setback in the parliamentary elections in December 1993, forcing the departure of reformist deputy prime ministers Yegor Gaidar and Boris Fedorov. Anatoly Chubais, a lone reformist, stayed on as deputy prime minister in charge of privatization.

Yet the red directors received an even worse blow in the elections. Their leading organization, the Russian Union of Industrialists and Entrepreneurs, had sponsored the political party Civic Union. Although the Civic Union was perceived as a leading political force in the second half of 1992, it received only 2 percent of the popular vote. The declining political power of the red directors was reflected in shrinking benefits given to them by the government.

LINGERING REFORMS BUT NO REFORM GOVERNMENT, 1994-1995

The exit of all the reformers except Chubais from the government led to a widespread expectation of significant reversals in the reform policies, but in fact there was little change in economic policy in 1994. Prime Minister Viktor Chernomyrdin wanted neither reform nor reversal. Inflation declined and privatization proceeded, but few institutional reforms were undertaken: leading ministers were primarily lobbying for privileges for their favorite enterprises.

The budget balance was gradually being undermined. On ``Black Tuesday,'' October 11, 1994, the exchange rate of the ruble fell precipitously by 27 percent. By this time, the exchange rate had assumed a real economic meaning to many Russians. In response to a popular outcry against economic mismanagement, Yeltsin sacked his leading economic policy makers, apart from Chernomyrdin. At long last, central banker Gerashchenko was dismissed. Chubais was given the reins of macroeconomic policy as first deputy prime minister.

In 1995, for the first time, the Russian government and the Central Bank pursued a coordinated economic policy aimed at macroeconomic stabilization. The government halved the fiscal deficit to 5.4 percent of GDP, mainly by reducing all kinds of enterprise budgets in the consolidated state budget from 10.5 percent of GDP in 1994 to 3.4 percent of GDP in 1995 (see Figure 1). This was an extraordinary blow to a number of interest groups, reducing rent seeking to only 8 percent of GDP.

In the spring of 1995 Russia concluded a full-fledged standby agreement with the International Monetary Fund with substantial financing.[14] By the summer of 1996, financial stabilization had been attained. Inflation dropped to 22 percent in 1996 and to 11 percent in 1997.

Russian bankers were divided over the issue of stabilization. Until the summer of 1995, the Association of Russian Banks pressured the government and the Central Bank for subsidized credits. This, unfortunately, only led to continued high inflation. Opposing financial stabilization, the Association engineered the ouster of Tatyana Paramonova, acting chair of the Central Bank, in the summer of 1995. When the interbank market dried up in the fall of 1995, however, financially strong banks limited their trade to each other and excluded weak banks that they did not want to receive any state support. The strong banks benefited from the sale of cheap bank assets as one bank bankruptcy followed another. From 1991 until 1997, the Central Bank rescinded the licenses of more than 700 banks. The unity of the Association of Russian Banks had been broken.

The other big economic event of this period was the completion of the privatization of almost 18,000 large and medium-sized enterprises through vouchers. Officially, more than 70 percent of the economy - measured as a share of GDP - now belongs to the non-state sector. Many complaints have been raised about privatization; a common one is that the old management has acquired too much ownership. Studies show, however, that only 18 percent of the shares of privatized large and medium-sized enterprises belonged to the old managers in 1996.[15] When one considers that the state managers practically owned public enterprises before privatization, the current situation should be seen as a considerable reduction in the extent of their ownership.

Another complaint is that enterprise restructuring was too limited. In fact, 33 percent of large and medium-size enterprises changed management between 1992 and 1996, and about 25 percent of Russia's large and medium-sized enterprises have gone through substantial enterprise restructuring.[16] In our view, the insecure status of private property rights (including land ownership) and excessive state regulation of the economy are much more responsible for current economic problems in Russia than imperfections in the privatization process. Local authorities continue to harass entrepreneurs with arbitrary taxation and numerous inspections, and businessmen still have limited legal recourse.

A third complaint is that privatization has led to a concentration of wealth. Almost all of Russia's biggest companies have been traded freely on an open stock market, and the total market capitalization has vacillated between 5 and 20 percent of GDP from 1996 to 1998. This means that the market value that state enterprise managers got from the voucher privatization of their enterprises was only between 1 and 4 percent of GDP in total, compared with 71 percent of GDP through export rents, import subsidies, and subsidized credits in 1992. Thus, the concentration of wealth was not caused by privatization but by other forms of rent seeking. The fact that the privatization process was comparatively transparent and visible undoubtedly contributed to public resentment of it: the average Russian generally overestimated the value of industrial plants, for example, while not realizing the huge volumes of money passing through financial markets. Nonetheless, the political consequences of this popular illusion are real - and harmful.

A fourth criticism concerns a special ``loans-for-shares scheme'' that was introduced in 1995 for the privatization of a limited number of very large enterprises. The movers behind this scheme were not red directors, but some new bankers, notably Vladimir Potanin of Oneximbank and Mikhail Khodorkovsky of Menatep. The government's dilemma was that too many large enterprises remained state-owned, even after the voucher privatization was completed in the summer of 1994, and it had proven difficult to sell enterprises for money in cash-strapped Russia. Stock prices were tiny in relation to asset values, and large sales of additional stocks would have further depressed stock prices. The idea arose to sell large blocks of state shares through open auctions; it was thought that this would not depress stock prices, although the offering prices would be current market prices. Unfortunately, the auctions became closed, and the offering prices almost equaled the closing prices. As a result, Oneximbank seized control of Norilsk Nickel, the huge metallurgical company, and Sidanko, an oil company. Menatep took over Yukos, the oil company; Boris Berezovsky of the Logovaz car dealership got the Sibneft oil company at a very low price.

The loans-for-shares scheme attracted great public criticism, even though only fifteen enterprises were sold and not all the loans-for-shares privatizations were profitable for the auction winners. Only the four deals mentioned above were really economically significant. And these privatizations hardly changed the system; they only transferred the benefits of management theft from some red directors to some new capitalists (and tarnished Chubais's reputation). When Oneximbank took over Sidanko, it announced that the prior management had siphoned off $350 million a year from the company. Presumably Oneximbank's top managers started doing the same. Still, the total cash flows that could be expropriated from these companies were well below half a percent of GDP.

The importance of the reforms between 1994 and 1995 should not be exaggerated. A government of industrial lobbies ruled. Prime Minister Chernomyrdin secured extraordinary benefits for his creation, the Gazprom natural gas monopoly, granting it extensive tax exemptions at the end of 1993 amounting to some 1-2 percent of GDP. First Deputy Prime Minister Oleg Soskovets secured tax exemptions for the metal industry amounting to about 2 percent of GDP. Soskovets also supported the National Sports Fund, which got the right to import alcohol and tobacco tax-free. The Fund soon became the leading importer of these goods to Russia. These benefits amounted to another 2 percent of GDP. The agrarian lobby successfully resisted the privatization of land and the deregulation of agriculture. The rent seekers had regrouped to seek new forms of rents, notably tax exemptions. Nonetheless, the size of these rents was far less than they had been in 1992-1993, and they were increasingly tax exemptions rather than government financing. As massive tax evasion prevailed and the tax system was arbitrary, however, it is not obvious what a normal tax payment should have been.

Although Anatoly Chubais was the only significant reformer left in the government, the reformers were publicly blamed for the ongoing economic decline, while those in the government who unabashedly lobbied for their private interests escaped unscathed. The parliamentary elections in December 1995 dealt another blow to the reformers. The communists reemerged as a serious political threat, mainly because the reformers were split into too many parties.[17] In January 1996 President Yeltsin sacked his last reformist minister with the oft-quoted words: ``Chubais is guilty for everything.''

THE STAGNATION OF REFORM, 1996-1998

As Russia entered 1996, a new fear of communist revenge dominated Russian politics. Most anticommunist forces joined hands to counter that threat. This offered a new position of privilege to the so-called oligarchs, essentially new businessmen who had benefited from the loans-for-shares deals. The elections highlighted the political importance of money and owner control over media. Media magnates Vladimir Gusinsky and Boris Berezovsky (who controlled the TV channels NTV and ORT, respectively) emerged as major political forces. And the election results confirmed that the new Russian businessmen had gained real political clout. One reflection of their new power was that the top bankers nominated Vladimir Potanin to be first deputy prime minister, and Berezovsky became deputy secretary of the Security Council. Both aroused such controversy that they were soon ousted: Potanin lasted about six months, Berezovsky, twelve months.

Nineteen hundred and ninety-six was a year of no reform. The government contained no significant reformer, and the political will to reform was missing. The government let the budget deficit rise to 8 percent of GDP in 1996, and the real yields of its treasury bills exceeded 100 percent a year before the presidential elections in June 1996, as the government tried to sell more than the market was prepared to buy. The treasury bill market became a source of rent seeking for bankers, since only some privileged people were allowed to buy treasury bills for much of 1996.

The restless Moscow elite soon became frustrated with a government that did nothing to resolve the country's mounting economic problems. In response to calls from a broad political spectrum for a new reform government, Yeltsin reappointed Chubais as first deputy prime minister in March 1997. Joining Chubais in the cabinet was Boris Nemtsov, the successful reformist governor of Nizhny Novgorod. Their reform offensive, however, ended abruptly in July 1997. The new businessmen were no more prepared to accept free markets than were the old red directors. In July 1997 Berezovsky and Gusinsky turned against the reformers in the government with a vengeance because they had initiated an open auction of Svyazinvest, the telecommunications holding company. The new capitalists were as committed to rent seeking as the old red directors had been; they demanded their due from the government as payback for supporting Yeltsin in the 1996 presidential elections. In October 1997 Berezovsky worked with the communists and Prime Minister Chernomyrdin to increase the budget deficit in an apparent attempt to undermine the reformers in government.

The Asian financial crisis started to hurt Russia in late October 1997. Since Russia had just decided to increase the budget deficit, the government failed to tighten its fiscal policy until February. By then, interest rates had again risen to more than 100 percent a year. Only in late March 1998 did Yeltsin sack his passive Prime Minister Chernomyrdin; one month later, he appointed a reformist government under Sergei Kiriyenko. By then, however, the crisis was so severe that even a government with sufficient parliamentary support - which Kiriyenko did not have - would have had difficulty carrying out the necessary reforms.

Russia's financial problems had been a long time in the making. For years, the country had maintained an excessively large budget deficit. Its fast-growing, short-term government debt could not be sustained. As creditors withdrew, interest rates rose repeatedly above 100 percent a year. And at the same time that Russia badly needed capital inflows, red tape and arbitrary taxation rendered its enterprise environment cumbersome, deterring both domestic and foreign direct investment.

In July 1998 the Russian government concluded an agreement with the IMF on significant and swift budget deficit reductions. Yet four major interest groups continued pushing their country toward the abyss. First, the big oil barons, including Boris Berezovsky, who wanted lower production costs, campaigned for a ruble devaluation, although they knew that this would lead to the bankruptcy of most banks and create other serious problems.[18]

Second, in July 1998 the Russian State Duma refused to accept a government proposal to move from a valued-added tax (VAT) based on actual payments to one based on an accrual basis. Had it been adopted, the change would have led to the taxation of barter, which is now exempt from Russian VAT taxation. Nor would the Duma agree to transfer some government revenues from the regions to the federal treasury. These two votes by the Duma were the real trigger of the ensuing financial collapse.

Third, the regional governors strongly resisted the transfer of any of their funding to the federal government. Regional revenues have held steady at about one and a half times as large as the federal revenues, and the regions spend slightly more than 2 percent of GDP on enterprise subsidies. Because these subsidies are disbursed by the governor in a discretionary fashion, they all but invite criminals to run for election as regional governors.

The fourth group that contributed indirectly to the financial collapse was the state bureaucracy, which doubled in size in the midst of economic crisis: an incredible 1.2 million bureaucrats (almost 2 percent of the labor force) were added from 1992 to 1998. The result is an extraordinary degree of bureaucratic interference in enterprises that deters investments and entrepreneurship.

It is easy to condemn the behavior of these groups as socially irresponsible, but in fact their actions were consistent with what their recent experiences had taught them: that the most ruthless and cunning rent seeker is the most successful; that the government was only bluffing when it warned of economic ruin; and that in an economic environment that changes all the time, one must seize all opportunities as soon as they appear.

The Russian economic crisis also had an important international dimension. The years 1996 and 1997 saw substantial foreign capital inflows into Russia, but these were almost entirely portfolio investments in stocks and bonds. Foreign portfolio investments skyrocketed from $8.9 billion in 1996 to $45.6 billion - or 10 percent of GDP - in 1997.[19] Foreign direct investment in 1997 was only $6.2 billion, and it fell to $2 billion in 1998. At the peak of the stock market in 1997, foreigners might have owned as much as 30 percent of the market capitalization of some $100 billion. The total stock of treasury bills in the summer of 1998 amounted to some $70 billion, of which foreigners held at least $25 billion.

All these inflows, however, actually encouraged capital flight of about $20 billion in each of the years 1996 to 1998, while capital outflows had subsided in 1994 and 1995. Rising capital outflows are a strong indication of increasing rents. Hence, the foreign portfolio investments contributed both to rent seeking and to the magnitude of the Russian financial crash. The loans to the Russian government diminished the need for the Russian state to collect taxes or to cut subsidies. The loans from the IMF and the World Bank were contingent on sound economic policies, but the contingency appears to have been ineffective, possibly because the much larger private portfolio investments were unconditional. Many Russian businessmen made big money by cheating foreigners or by seizing the assets of minority shareholders by any means possible (from transfer pricing to the straightforward seizure of assets to not servicing bond debts). Therefore, these inflows were counterproductive both to corporate governance and to reform. Opportunities for rent seeking appear to have dwindled after these inflows stopped in July 1998, but it is too early to tell whether this change represents a real adjustment on the part of government officials and Russian businessmen - or simply a lull while the rent seekers identify new opportunities.

STRATEGIC ECONOMIC PROBLEMS

The ultimate purpose of an economy is to produce economic growth, but Russia's economy has experienced significant contraction since 1990. While disputes over statistics make precise assertions difficult, the trendlines are quite clear: with the exception of 1997, the Russian GDP has fallen steadily for a decade. This steady decline can no longer be blamed on temporary factors (see Figure 2), but on fundamental, long-term problems that ultimately brought about the financial crash of 1998.

First, while every viable state must obtain revenues to finance essential government activities, the Russian government for years has spent more than it has collected in taxes. The Russian tax system is inconsistent and arbitrary: tax collection absorbs much of the government's attention and hampers many productive activities, but in the end taxation provides little state financing. Second, the government has failed to control and rationalize its expenditures; it often does not pay (or is late in paying) its commitments, while large unjustified expenditures are disbursed. Third, markets of all kinds still function badly due to excessive regulation and the absence of the effective rule of law. This leads to high transaction costs, limited competition, and various financial and monetary problems.

These economic problems have one dominant cause: the fact that those who made substantial fortunes on inflation, regulations, subsidies, and other rents continue to oppose the effective development of a competitive market economy.[20] The state as the representative of a common public interest is weak; the state as a bureaucratic impediment to productive economic activity is ubiquitous - a phenomenon Andrei Shleifer and Robert Vishny have termed ``the grabbing hand.''[21] The key question for the future is whether the Russian state can make the transition from stimulating rent seeking to encouraging profit seeking.

An Ineffective Tax System

The Russian tax system is an unfortunate combination of the old Soviet tax system, hasty and partial reforms from 1992, and subsequent changes of dubious legality often motivated by rent seeking - all enforced with large measures of inconsistency and sheer incompetence. While politically well-connected businessmen often escape taxation, many small entrepreneurs are forced out of business by confiscatory tax rates. Yet despite the high rates, the system collects little actual revenue.

Although declining tax revenues and growing budget deficits are the topics of frequent and alarmist news reports in Russia, total revenues have fallen only moderately - from 36.8 percent of GDP in 1993 to 32.8 percent in 1998 - if one includes as government revenues the federal budget, all the regional budgets, and extrabudgetary funds like the pension fund (see Table 1). In 1997 Russia's total state revenues as a share of GDP were slightly larger than in the United

States, but they were low by European standards, where the average is close to 50 percent of GDP. The average for other Commonwealth of Independent States countries, however, is slightly lower than in Russia, and it is the least reformist countries that maintain large state revenues.[22]

While Russia's formal tax rates do not appear to be excessively high, the country's tax laws do not define profits in the Western sense or permit deductions for many legitimate business expenses. Indexing taxes for inflation has also not been adopted. Taking inflation into account, the effective profit tax rate in Russia may have been as high as 77 percent in 1992 and 50 percent in 1994-1995.[23] The system is also quite complex: Russia has about 200 different taxes, most of which generate little revenue. Six main taxes account for about 75 percent of all revenues of the consolidated state budget.

Because the tax base is so narrow, a limited number of taxpayers pay huge taxes. Almost two-thirds of taxes are paid by industry, while only a tiny percentage of total revenues is collected directly from individuals.[24] The system suffers from a dangerous bias toward corporate taxation, especially taxation of manufacturing, and it discriminates against investment and production in favor of consumption. Even so, according to estimates by U.S. Treasury officials, an estimated 50 percent of the total VAT was not even collected in 1996, due to numerous exemptions, reduced rates, and lax enforcement. Tax exemptions are granted more on the basis of political and personal connections than for reasons of public policy. Individual income taxes and property taxes are still collected primarily through enterprises, as they were in the communist era. The system offers taxpayers little or no incentive to pay taxes; the risk of penalties hardly changes whether one pays taxes or not.

In the post-Soviet states, lower state revenues seem to be clearly correlated with faster recovery in GDP. The post-Soviet state is such a monster of arbitrary intervention that it can only be controlled if its resources are severely reduced. To stimulate growth, a government must accept a moderate level of tax revenues - 25 percent of GDP at most.[25] Subsidies need to be minimized to reduce harmful state intervention. Unfortunately, a statist approach has persisted in Russia, and the IMF has continuously supported this policy of high taxes and ruthless tax collection. In our view, Russia needs to cut taxes to boost production, in the expectation that economic growth will eventually reverse the temporary shortfall in tax revenues.

Excessive and Unjust Public Expenditures

Russia's public expenditures are large in comparison with other countries of the former Soviet Union, and Russia's budget deficit remains considerable (see Table 2). The huge state debt service is paid for by the federal government. Even so, regional and local budgets as well as extrabudgetary funds have expanded at the expense of federal expenditures in recent years.

During the period of high inflation (1992-1994), the Russian government (and the

governments of many other transition economies) boosted social expenditures as a share of the GDP, but did not render them more efficient. During those three years, contrary to public perceptions, social spending increased by more than 5 percent of GDP. In parallel, expenditures of regional budgets, measured as a share of the GDP, also grew rapidly, mainly because of increased subsidies and social spending. As a result, in 1994 social expenditures, including subsidies for housing and public transport, exceeded 50 percent of general governmental expenditures (probably for the first time in Russia's history).[26]

Unfortunately, these increases did not mean that the funds were spent efficiently or fairly. By 1994 only 12 percent of all social transfers (excluding pensions) went to the poorest 20 percent of the Russian people.[27] By 1996 the wealthiest 30 percent of all households received no less than 70 percent of social transfers. Housing subsidies have held steady at 4 percent of GDP - almost one-quarter of all social spending - although they primarily benefit wealthy households with large apartments in cities.

Another concern is the prevalence of producer subsidies and nontargeted forms of social protection. A significant share of Employment Fund expenditures, for example, was used not for unemployment benefits but for enterprise subsidies. In 1995, according to officials with the Ministry of Labor and Social Affairs, approximately one-third of the resources of the Social Insurance Fund (contributions to the Social Insurance Fund amounted to 5.4 percent of the total wage bill) was allocated to so-called compulsory tourism - that is, hidden subsidies to a noncompetitive network of boarding houses, holiday resorts, and recreation centers inherited by Russia from the Soviet era.

While regressive transfers go to the wealthy and the large administrative bureaucracy works for its own advantage, a substantial share of the Russian population - 38 percent in January 1999 - lives below the poverty line. But even if they were not so inefficient or socially unjust, Russia's huge expenditures remain too large to be sustained.

Poorly Functioning Markets

The battle to liberalize the Russian economy has been a protracted one. Although prices and trade have been liberalized, state intervention remains both pervasive and arbitrary. The market does not yet function well. Russia ranks very low on several liberalization indices,[28] and corruption is pervasive. In the Heritage Foundation index, which comprises the largest number of countries, Russia ranks 106 among 160 countries in terms of economic freedom, while the Fraser Institute index puts Russia at 102 among 114 countries.[29] In the index of corruption perceptions compiled by Transparency International, Russia was reckoned to be the 10th most corrupt out of 85 countries in 1998.[30] Prices and markups are still high, the choice of goods is limited and their quality is not impressive, and regional price differentials are sizable. Particularly strong resistance to liberalization has come from the energy, agriculture, and foreign trade sectors. Yet even if competition is limited, there are no longer significant shortages of goods and services as there were in the Soviet past.

Most Westerners are struck by the degree of regulation persisting in Russia. Virtually all economic activities are subject to licensing, and multiple licenses are usually required. More than sixty state agencies inspect businesses, but instead of enforcing the strict regulations, state inspectors attempt to extort bribes. Much new legislation, particularly on environmental protection, seems more likely to offer new opportunities for bribe taking than for improving public policy. And the only recourse most businessmen have is to file an administrative complaint with the local authorities.

One consequence of the limited deregulation is that Russia has few enterprises and very few small enterprises.[31] The number of registered small private enterprises actually fell from 900,000 in 1994 to 810,000 in 1996. By 1997 the total number of legally registered enterprises had reached only 2.7 million, about one enterprise per fifty-five Russians. By contrast, the successful reform countries Poland and Hungary have already attained the normal Western ratio of one enterprise per ten people.[32] The paucity of enterprises is a result of a hostile enterprise environment that limits competition; it explains why Russia has attracted little foreign direct investment.

Russia also suffers from poorly functioning financial markets. Ordinary Russians do not trust banks (and for good reason), but keep most of their savings - an estimated $40 billion - in hard-currency cash. In August 1998 most Russian banks closed down at least temporarily, and many Russians who did have their savings in banks lost most of them. The Central Bank wants to eliminate more than 700 banks, almost half of the total. The banking crisis imposes additional fiscal pressures on the government, as some banks will have to be recapitalized to restore the payments system. Meanwhile the real sector (that is, the nonfinancial sector) of the economy suffers from a poor payments system, excessive financial risks, and a limited supply of credits, undermining the prospects for investment-driven economic recovery.

Recent historical experience in Central Europe indicates that a gap of 10 percent a year between banks' lending and borrowing rates is the norm immediately after stabilization.[33] In Russia, however, this gap has remained greater than 20 percent a year, even before the outbreak of the financial crisis in October 1997. It is likely to stay at about that level. The legal system is much weaker in Russia than elsewhere in Central Europe, making the collection of debts more cumbersome and expensive. Collateral is scarce, since little private property is held in the form of land. Information about borrowers is more scarce and less reliable in Russia than in Central Europe. Banking skills and the ability to assess creditworthiness are rare. And the crime rate is much higher in Russia than in Central Europe (the murder rate is as much as five to ten times higher). For all of these reasons, Russian banks demand larger margins - and they can do so because of the limited competition. Even so, the Russian banking industry has entered a period of depressed profits, consolidation, and bankruptcies.[34]

While the banks have big financial problems, the situation with business enterprises is hardly better. Financial discipline at the enterprise level is lax, and it is exacerbated by byzantine bankruptcy procedures, poor legal means to enforce creditor claims, and a weak court system. The results are mounting arrears of many kinds and the proliferation of payments in kind.

Monetization is low and it is not advancing. At the time of high inflation, it was natural that the monetization (measured as M2 in relation to GDP[35]) fell sharply from the high Soviet level of forced savings to barely 13 percent in 1993. It dropped further to about 10 percent in 1995, when the eventually successful stabilization attempt was launched (see Figure 3). The surprise is that the monetization has hardly risen after 1995, although inflation was brought under control. By comparison, in 1995 successful Central European reform countries such as Poland, Slovenia, and Hungary had a monetization with M2 amounting to 30-40 percent of GDP. Monetization in most post-Soviet countries, though, persists at about as low a level as in Russia.[36]

An explanation of the low level of monetization is that barter and various forms of nonmonetary forms of payments are expanding. The share of payments in Russian industry undertaken through barter rose from 6 percent of all sales in 1992 to 54 percent in August 1998, according to the Russian Economic Barometer, a regular poll of managers of Russian industrial enterprises (see Figure 4).[37]

At the same time, plenty of money surrogates have emerged, so that only one-quarter of interenterprise transactions are conducted with money. The most common form of money surrogates are so-called offsets, which function like this: If an enterprise has not paid its taxes, it offers the government some products or services instead. If the government accepts, the tax delinquent has in effect extracted a government contract by not paying taxes. Moreover, through an offset an enterprise can avoid competition and boost its prices.

The standard communist explanation of why barter is so prevalent is that the economy suffers from a shortage of money. The typical suggested remedy is additional emissions of currency - but this confuses supply with demand. There is little demand for money because many enterprises prefer barter and money surrogates to payments in cash, while other businesses are too weak to demand payment in money. If the supply of money increased while the demand remained low, the result would only be inflation.

The standard Western explanation of barter is that it and other forms of noncash payments are motivated by tax avoidance, which seems supported by polls among businessmen.[38] Russia's value-added tax (VAT), in particular, is based on payments, not on invoices or deliveries on an accrual basis (as is typical in the West). Hence, companies that receive little or no payments in money are exempt from most of their potential VAT burden. For the Russian government and the IMF, one of the most important reforms that could be adopted would be to assess VAT on an accrual basis to reduce the incentives to barter in the current tax code.

Yet tax avoidance is not the whole explanation of the prevalence of barter. The same polls showed that 40 percent of the barter trade was perceived as involuntary. Typically, larger industrial enterprises compel smaller firms to accept payment in products they do not want.[39] Barter is most common among large enterprises producing intermediary industrial goods that can be sold easily - construction materials and metals, for example. It is clear that these manufacturers have chosen barter partly because it distorts prices and changes relative prices.

Clifford Gaddy and Barry Ickes have pointed out that the noncash economy is growing, not shrinking. The system is well-entrenched, with strong incentives for many to maintain it. The noncash economy is beneficial both to value-detracting and to raw-material producing companies, while the household sector loses in consumption and the government loses real tax revenues.[40] The essence of the post-Soviet noncash economy is the reluctance of large enterprises to adjust to market conditions at the expense of consumers (who get shoddy goods), the government (which cannot collect taxes), and politically weaker enterprises (which do not get paid in money). A transparent and competitive monetized economy offers no particular advantages for large enterprises. By contrast, relations with high government officials are crucial for an enterprise's success in a noncash economy, and large enterprises typically have greater access to senior state officials.

A good example of this phenomenon is Gazprom, the natural gas monopoly that is Russia's biggest and richest company. Gazprom receives payment in money for only one-tenth of its domestic deliveries, although the firm clearly has the clout to demand more. Because Gazprom produces more natural gas than it can sell on an ordinary market and has minimal marginal costs, the firm uses barter to facilitate price discrimination and discounts. Gazprom's close links to the government also allow it to leverage larger and more secure benefits than it probably could earn in a competitive market.

Offsets are by their nature discretionary negotiations between big businessmen and government officials about large amounts of money, a process naturally imbued with corruption. Regional governments appear to be most corrupt, accepting 60 percent of taxes in money surrogates. Local governments might not have much clout against big companies, but even so they only accepted 43 percent of their revenues in money surrogates in 1996, suggesting they tried hard to get real money.[41] The federal government received about 25 percent of its revenues in offsets, which is an indication that the federal government is less corrupt than regional governments.[42] Money surrogates also comprise a substantial part of the regional and local expenditures - no less than 39 percent in 1996.[43] Thus, money surrogates not only distort prices and tax revenues but also divert public expenditures away from social spending toward public-works projects and enterprise subsidies.

Barter is also an important mechanism of management theft. In the spring of 1998, coal miners staged large strikes to demand that the government pay them months of back wages. But many of the mines in which these miners worked had already been privatized, and the government had already paid subsidies to the mines. Investigations showed that the mines received only two-thirds of the price their customers paid for the coal. The remaining one-third disappeared into the pockets of middlemen connected with some mine managers, who cheated both their own workers and other mine owners. As a result of the subsidization of the coal industry, it has become not only inefficient but thoroughly criminalized.[44]

Thus, in almost every respect, the ongoing barterization of the Russian economy represents a serious regression. It implies demonetization, tax evasion, and the rule of big, old enterprises over small, new enterprises. Both workers and shareowners suffer from its consequences: the only winners are a small group of big enterprise managers. By avoiding money payments, they reassure themselves that their personal relations with government officials and each other remain decisive. Thus, barter and money surrogates conserve the power structure in industry as well as the production structure. Little modernization and restructuring are likely in this environment.

WHERE IS RUSSIA GOING?

The Russian economy has gone through a decade of economic contraction. Economic policy is characterized by a duality: on the one hand, Russia wants to catch up with the developed world by embracing a liberal reform agenda. On the other hand, strong rent-seeking interests oppose reforms that would eliminate their particular advantages based on connections to power. Ironically, even as the role of the state is declining, the efforts of rent seekers to make money on the state effectively give the government less to redistribute, reducing rents more than output.

The current degree of government intervention in Russia is extraordinary by any international standard, and it is not likely to be sustained. Therefore, the government administration will have to be cut, as has happened in most other post-Soviet states. The degree of effective regulation will fall accordingly.

Similarly, the Russian government cannot continue to spend considerably more than it collects in taxes. Sooner or later the government must undertake a fundamental tax reform. A broad public consensus favors a fundamental tax reform leading to a system with a limited number of broad-based taxes with low tax rates of 20 percent or less. Similar tax reforms have been adopted in other former Soviet republics, such as Estonia, Georgia, Kazakhstan, and Kyrgyzstan.[45] In July 1998, after years of discussion, the State Duma incorporated many of these ideas in a new tax code. Even the Primakov government proceeded with the reduction of tax rates.[46]

Whatever happens with tax reform, state revenues are likely to decline in the short term. After the 1998 financial collapse, however, Russia has hardly any access to financing. It may get some additional loans from international financial institutions, additional privatization, or the refinancing of debt service, but selling Russian government bonds will be difficult for years to come. Even the inflation tax cannot reap much revenue because of the limited monetization. The key problem will be reducing the budget deficit at a time of declining state revenues. The Russian government will be forced to reduce sharply its expenditures, including those for state administration, enterprise and housing subsidies, and various nomenklatura benefits. In most of the post-Soviet states that have already done all this, the shrinking of government expenditures makes rent seeking less attractive. As the economy becomes more transparent, the incentives for entrepreneurship and profit seeking grow.

But is this politically feasible - or will the beneficiaries of the partial early reforms continue to block the necessary next steps? The key determinant for Russia's future is how rent seeking will evolve.[47]

The peak of rent seeking occurred in 1992, when the main rents were subsidized credits to enterprises (23 percent of GDP), export rents (30 percent), import subsidies (17.5 percent), and direct budget subsidies (10.8 percent), for a total of 81 percent of GDP.

By 1995 rents had plummeted. Subsidized credits and import subsidies were gone in 1994, when export rents contracted to about 3.7 percent of GDP.[48] Enterprise subsidies fell sharply in 1995 to 3.4 percent of GDP (see Figure 1). We may include 0.5 percent of GDP in rents from the loans-for-shares privatizations. Still, the narrow rents we focus on amounted to only about 8 percent of GDP.

Export rents continued falling, but they might still have been 2 percent of GDP in 1997. Enterprise subsidies recovered slightly to 4.2 percent of GDP in 1997. Here, however, we need to include foreign portfolio investments in our definition of rent seeking, since they were in effect free money, appropriated by ruthless businessmen as a consequence of a poor legal order or government inaction. We include enterprise bonds (about 2 percent of GDP in 1997), stock investments (about 4 percent), and excessive returns on treasury bills (about 3 percent). Thus, these amounted to 15 percent of GDP in rents in 1997 - almost a doubling of the rents from 1995, although our calculations do not include tax exemptions, the benefits of authorized banks, and gains from barter and nonpayments.

The financial crisis of August 1998 eliminated the rents related to foreign financing, as well as the excessive returns on treasury bills. The only remaining rents are enterprise subsidies and some refinancing of banks - less than half a percent of GDP. Hence, the financial crisis seems to have cleaned out many rents and possibly prepared the ground for a low-rent economy. Figure 5 presents an approximation of the development of rents in Russia in the 1990s.

The sharp reduction of rents means much less money can be spent buying politicians and officials, reducing the incentives to distort economic policy to the benefit of rent seeking. The forces for rent seeking are also being dissipated: the red directors, for example, were a dominant political force as late as 1993, but they have now been partly replaced by or merged with Russia's new big capitalists. The capitalists are split themselves: a few top businessmen can reap private gains from discretionary state intervention, but most of them demand lower taxes and more freedom, plus the protection of a well-functioning legal system. Even the leading rent seekers have fought each other since July 1997. They suffered badly from the financial collapse of August 1998. No longer able to extract large rents, they have that much less available to corrupt government officials and politicians.

The regional governors appear to be the greatest remaining hurdle to a normal market economy. In recent years the regions have steadily gained authority at the expense of the federal government. As automatic members of the Federation Council (the upper house of the Russian parliament), regional governors have a final say in Russian legislation. Their power is reflected in the relative increase in the budgetary resources and decisions controlled by them. As regional budgets account for two-thirds of the revenues of the consolidated state budget, Russia has become the most decentralized federation in the world.[49] Regional governments are likely to be much less constrained by declining revenues than the federal government.

The powerful regional governors oppose a large and intrusive federal government, but they do value federal transfers - as well as their own power to intervene in the economy, and their regional regulations disrupt the unified Russian market. Federal government transfers to the regions have been quite small, peaking at 3.4 percent of GDP in 1994 and then declining.[50] Most regions are net recipients. Ironically, transfers tend to go to the regions that voted against the government in both the 1993 and 1995 elections - not to the regions with the greatest social need - thus showing that these transfers reflect the weakness of the federal government.[51] The regional transfers are not likely to increase as a share of GDP because of the falling federal tax revenues, but the regional governors nonetheless defend them forcefully.

To date the regional governors have been notorious for controlling certain prices, licensing and subsidizing enterprises, allocating administrative credits provided by regional banks, controlling exports from their regions, and generously subsidizing housing, utilities, and transportation. Fortunately, some of these practices have stopped. But regional governors are eager to control the licensing of all private enterprises and to mandate inspections of them by multiple local authorities - both to generate bribes and to intimidate entrepreneurs. The federal authorities could possibly impose a far-reaching deregulation from the center, but many argue that the federal government lacks the power to do this in the short run.

Another concern is that no less than 60 percent of all taxes at the regional level are being paid in nonmonetary forms, typically in offsets.[52] An enterprise that offers to provide goods or services instead of paying its taxes is in effect asking for a public contract without competing for it. These practices breed further corruption, making the regional governments appear more corrupt than the more constrained federal government.

In summary, the increased political weight of the regional governors is likely to limit state expenditures as a share of GDP. A reduction of the revenues of regional budgets as a share of GDP, however, is necessary to persuade regional authorities to reduce subsidies and to improve the targeting of social benefits. For the time being, regional governments are likely to remain far too intrusive in enterprises. After the so-called oligarchs have been cut down to size, the regional governors appear to be the main impediment to successful reforms.

CONCLUSION

In Russia today, all the standard features of the communist command economy are gone. The government no longer determines who manages enterprises; what they produce, sell, or buy; or what prices they set. A pluralist structure of ownership has been established. From early 1996 until the summer of 1998, Russia had a reasonably stable currency. Since the summer of 1998, however, Russia has been in a serious financial crisis. Despite many improvements over what existed before, the emerging Russian market economy still displays serious imperfections. State ownership is more extensive than in almost any Western state, and even fully privately owned enterprises are heavily dependent on the state. State power is exercised with more arbitrariness than would be accepted in the West, and businessmen have little legal recourse in their relations with the state.

The main themes of the Russian reform agenda have been deregulation, stabilization, and privatization. Unfortunately, nothing conclusive can be said about the design of the reforms, since so little was actually implemented. Deregulation of all kinds is essential to end rent seeking. The reformers fought for the liberalization of commodity prices, but they lost. As the domestic commodity prices were kept artificially low, exports could not be liberalized. The fear of starvation in the winter of 1991-1992 made it politically impossible to unify the exchange rate, which would have eliminated import subsidies. The reformers tried to liberalize domestic trade but with limited success. Gaidar pushed for considerable freedom for enterprises, but his efforts were rebuked. The preceding bizarre freedom of private banks persisted.

On fiscal policy, the reformers started out well, opting for a balanced budget in early 1992. Various quasi-fiscal expenditures, however, such as subsidized credits and import subsidies, became the dominant fiscal problems, with the Central Bank as the main culprit. Only after two years did the Ministry of Finance acquire elementary control over state expenditures. The Central Bank was independent of the government, but it was not interested in monetary stability, and it bred macroeconomic disaster.

One of the greatest misperceptions of the Russian transition is that privatization was the primary means by which personal enrichment occurred. Contrary to the common understanding, Russian enterprise ownership is reasonably well distributed, but it has not become effective ownership. Privatization is no alternative to deregulation, though it might facilitate deregulation in the future. Nor has privatization been an effective impediment to rent seeking. In the financial crisis of 1998, the Russian tycoons did not behave like capitalists who cared about the value of their property, but like rent seekers who thought only of the short-term cash flow.

After the government failed to establish the main pillars of a sound economic policy, little else succeeded. In the first years of transition social expenditure rose sharply as a share of GDP, and even now social transfers remain much too large. Russia's social expenditures still benefit the old nomenklatura more than they provide any social safety net for the needy. With populist demagogy, the old establishment has even boosted the regressiveness of Russia's social transfers.

In Russia, ``industrial policy'' has been a code word for demands for subsidies. Three industries have secured the most: the coal industry, agriculture, and the military-industrial complex. As a result, trade in their products has become criminalized, because subsidies are not only an indicator of rent seeking but also a strong inducement to organized crime.

There has been considerable international involvement in Russia's economic reforms. The IMF has been the dominant force for several reasons. Its main mission is to promote macroeconomic stabilization, which was new Russia's most pressing problem. The IMF also has a lot of money to offer for concrete programs; its narrow agenda provides for a clear focus; and it has been more active than other international actors. The IMF's finest achievement was the standby agreement in the spring of 1995 that led to stabilization, mainly due to a cut in enterprise subsidies of no less than 7 percent of GDP (see Figure 1). It was a highly daring action, as it occurred just before parliamentary and presidential elections, and the only real guarantor was Anatoly Chubais, first deputy prime minister. The IMF and the World Bank were important forces behind the deregulation of foreign trade, which eliminated most foreign trade rents.

The worst failure of the West was a sin of omission: not to support the stabilization program in early 1992. If the West had sponsored an IMF-like program then, it would have been possible to liberalize commodity prices and exports, to unify the exchange rate, and to introduce market interest rates from the beginning of 1992. The main blame for missing this window of opportunity belongs to the U.S. administration, the decisive Western policy maker at the time. The IMF, however, was guilty of advocating the maintenance of the ruble zone in spite of the fact that fifteen mutually independent central banks were all competitively emitting the same currency.

In the spring of 1996 the IMF concluded a three-year loan program called an Extended Fund Facility (EFF) with Russia. The formal conditions were reasonably firm, but the country was heading toward a budget deficit of more than 8 percent of GDP and sold treasury bills at interest rates of as much as 150 percent a year in real terms. This was a political rather than an economic decision, intended to save President Yeltsin in the presidential elections of June 1996. Saved he was, but at the expense of sound economic policy. The EFF agreement set the stage for Russia's ensuing boom and bust. The soft IMF approach convinced foreigners and Russians alike that Russia was too big - or too nuclear - to be allowed to fail. The EFF signaled that in Russia anything is allowed.

As of the spring of 1999, it is still early to judge whether the IMF program of July 1998 was too small, too late, or never feasible. Yet, in retrospect, it is difficult to believe that the IMF could ever have had a decisive impact in Russia after April 1, 1992 - and no other international organization came close to matching its efforts.

A broader issue is the politics of reform, which is primarily a drawn-out struggle between reformers and rent seekers. Most advice given to reform governments tends to disregard how constrained their feasible choices really are, given the influence of powerful, rent-seeking interests. A common fallacy is that technical assistance will teach bureaucrats do their jobs, when the real problem is that many bureaucrats are corrupt and have no interest in seeing their powers or revenues reduced. Nor is it realistic to believe that a parliament that opposes private ownership will enact appropriate protections thereof.

Reformers face many important choices, particularly at the outset of reform. Before democratic governance has taken form, reformers must act quickly and decisively from above, as President Yeltsin did after he effectively assumed power in the fall of 1991. In November 1991 Yeltsin formed a government that swiftly formulated a reform program. He pronounced this program in a presidential speech to parliament, which voted to accept it. The missing element was international financial support, since the West was preoccupied with securing the Soviet debt, and was seemingly disinterested in Russia's future. Soon rent seekers got the upper hand in domestic politics.

Compared with Poland, the Czech Republic, and the Baltic states, all of which also launched radical reforms but received timely Western financial support, Russia looks like a failure. Compared with Ukraine, which did not try early reforms, however, Russia looks more successful. The reformers' failure was their inability to mobilize the popular majority that supported radical economic reform during the first year and a half of economic transition through early parliamentary elections.

In the second period of reform (1994-1995), the reformers could do little. In hindsight, the large-scale privatization hardly looks so important that it warranted the presence of a key reformer such as Chubais in the government. The stabilization of 1995-1996 appears less significant today, since it was not sustained but led to a new bout of rent seeking. Presumably, the reformers would have been better off politically had they declined to serve in a deeply corrupt government.

In 1997-1998, several prominent reformers held high government offices, but their reform proposals were obstructed by entrenched rent seekers. That this would be the outcome was not obvious at the outset; after all, Chubais had successfully stabilized the economy in 1995 with less political support. But the reformers themselves are ambiguous in their views on government service and international financial support. Boris Fedorov, for example, tends to argue that IMF support is harmful when he is not in government - but favors it as a lever against opponents when he is.

Russian reformers are learning to understand the new rent seekers' mode of operation, which makes their approach more political and less economic, and their political understanding is developing. Repeated failures of reformers in coalition governments to implement reforms successfully made many doubt the efficacy of reform from above at the current stage of development. And a growing reformist opinion argues that a parliamentary majority in favor of reform is necessary for real market economic reform. Russia is facing a regional conundrum, and no clear understanding about how to deal with the regions has arisen, making it unlikely that a solution will soon be found.

 

NOTES

1 Joel S. Hellman, ``Winners Take All: The Politics of Partial Reform in Postcommunist Transitions,'' World Politics, vol. 50 (January 1998), pp. 203-34.

2 In principle, rent seeking could also include social transfers and public wages, but here we limit the discussion to rents extracted by businesses.

3 Anders Åslund, Gorbachev's Struggle for Economic Reform, 2nd ed. (Ithaca: Cornell University Press, 1991), p. 141.

4 Michael Dobbs, Down with Big Brother: The Fall of the Soviet Empire (New York: Alfred A. Knopf, 1997), p. 373.

5 Boris Yeltsin seems to have shared this view. In his book The Struggle for Russia (New York: Random House, 1994, p. 168), Yeltsin declared that he believed more in middle-aged state enterprise managers than in his reform ministers.

6 This section is largely based on Anders Åslund, How Russia Became a Market Economy (Washington, D.C.: Brookings Institution, 1995).

7 Aleksandr Rutskoi, ``Is There a Way out of the Crisis?'' Pravda, February 8, 1992.

8 G. G. Matiukhin, Ya byl glavnym bankirom Rossii (Moscow: Vysshaya shkola, 1993), p. 69.

An additional reason for the lack of monetary restraint was that the ruble zone persisted: each country had its own central bank that issued ruble credits independently until the summer of 1993.

9 Diego Gambetta, The Sicilian Mafia: The Business of Private Protection (Cambridge, Mass.: Harvard University Press, 1993), p. 1.

10 Reliable data on protection fees are difficult to obtain. These estimates are based on conversations with businessmen and economists in Moscow.

11 Brigitte Granville, ``Farewell, Ruble Zone,'' in Anders ?slund, ed., Russian Economic Reform at Risk (London: Pinter, 1995), pp. 65-84. Tajikistan, a marginal economy, continued using Russian rubles.

12 Anders Åslund, Peter Boone, and Simon Johnson, ``How to Stabilize: Lessons from Post-Communist Countries,'' Brookings Papers on Economic Activity, vol. 26, no. 1 (1996), pp. 217-313.

13 Anders Åslund, How Russia Became a Market Economy, p. 144.

14 A standby agreement is a standard IMF loan program for one year based on a number of conditions concerning primarily budget deficit and monetary expansion.

15 Joseph R. Blasi, Maya Kroumova, and Douglas Kruse, Kremlin Capitalism: Privatizing the Russian Economy (Ithaca: Cornell University Press, 1997), p. 193.

16 Ibid., p. 203.

17 See the chapter by Michael McFaul and Nikolai Petrov in this volume.

18 A good example of the arguments used by one leading oilman is the interview with Vagit Alekperov, chief executive officer of Lukoil, ``Nuzhno ispol'zovat' opyt Yaponii. . . .'', Kommersant-Daily, November 11, 1998. Alekperov's suggestions included devaluation, lower taxes for the oil industry (which had already benefited from substantial devaluation), price controls, Central Bank credits for the oil industry, the inflationary emission of money - and continued taxation of the general population.

19 Russian European Center for Economic Policy, Russian Economic Trends: Monthly Update (Moscow: Russian European Center for Economic Policy, February 10, 1998), Table 10.

20 Joel S. Hellman, ``Winners Take All: The Politics of Partial Reform in Postcommunist Transitions.''

21 Andrei Shleifer and Robert Vishny, The Grabbing Hand: Government Pathologies and Their Cures (Cambridge, Mass.: Harvard University Press, 1998).

22 Vito Tanzi, ``Transition and the Changing Role of Government,'' paper presented at the IMF conference, ``A Decade of Transition: Achievements and Challenges,'' (Washington, D.C., February 1-3, 1999), Table 5.

23 European Bank for Reconstruction and Development (EBRD), Transition Report 1995 (London: EBRD, 1995), p. 88.

24 Russian Federation State Tax Service, monthly reports.

25 Vito Tanzi, ``Transition and the Changing Role of Government,'' p. 7.

26 Anders Åslund and Mikhail Dmitriev, eds., Sotsialnaya politika v period perekhoda k rynku: problemy i resheniya (Moscow: Carnegie Moscow Center, 1996).

27 Branko Milanovic, Income, Inequality, and Poverty during the Transition from Planned to Market Economy (Washington, D.C.: World Bank, 1998), p. 113.

28 See, for example, Martha de Melo, Cevdet Denizer, and Alan Gelb, ``From Plan to Market: Patterns of Transition,'' Policy Research Working Paper 1564 (Washington, D.C.: World Bank, 1996); European Bank for Reconstruction and Development, Transition Report; and Bryan T. Johnson and Thomas P. Sheehy, 1996 Index of Economic Freedom (Washington, D.C.: Heritage Foundation, 1996).

29 Bryan T. Johnson, Kim R. Holmes, and Melanie Kirkpatrick, 1999 Index of Economic Freedom (Washington, D.C.: Heritage Foundation and the Wall Street Journal, 1999), p. 331; James D. Gwartney and Robert A. Lawson, Economic Freedom of the World: 1997 Annual Report, as published on the Internet website of the Fraser Institute (www.fraserinstitute.ca), Exhibit 2-2.

30 Transparency International, ``The Corruption Perceptions Index,'' as published on the Internet website of Transparency International (www.transparency.de/documents/cpi/index.html), 1998.

31 A. Blinov, ``Maloe predprinimatelstvo i bolshaya politika,'' Voprosy ekonomiki, no. 7 (1996), p. 39.

32 Anders Åslund, ``Observations on the Development of Small Private Enterprises in Russia,'' Post-Soviet Geography and Economics, vol. 38, no. 4 (1997), pp. 191-205.

33 Biswajit Banarjee, Vincent Koen, Thomas Krueger, Mark S. Lutz, Michael Marrese, and Tapio O. Saavalainen, Road Maps of the Transition: The Baltics, the Czech Republic, Hungary, and Russia, IMF Occasional Paper no. 127 (Washington, D.C.: International Monetary Fund, 1995).

34 M. E. Dmitriev, M. Yu. Matovnikov, L. V. Mikhailov, L. I. Sycheva, E. V. Timofeev, and A. Warner, Rossiiskie banki nakanune finansovoi stabilizatsii (St. Petersburg: Norma, 1996). In 1997 the Central Bank closed more than 300 Russian banks.

35 M2 is defined as cash and bank deposits.

 

36 Yegor T. Gaidar, ``Taktika reform i uroven gosudarstvennoi nagruzki na ekonomiku,'' Voprosy ekonomiki, vol. 70, no. 4 (April 1998), pp. 4-13.

37 Russian Economic Barometer, vol. 7, no. 4, p. 86.

38 S. Aukutsionek, ``Barter v rossiiskoi promyshlennosti,'' Voprosy ekonomiki, vol. 70, no. 2 (February 1998), p. 53.

39 Ibid., p. 55.

40 Clifford G. Gaddy and Barry W. Ickes, ``Russia's Virtual Economy,'' Foreign Affairs, vol. 77, no. 5 (September/October 1998), pp. 53-67.

41 Organization for Economic Cooperation and Development, OECD Economic Surveys: Russian Federation 1997 (Paris: OECD, 1997), p. 181.

42 Andrei N. Illarionov, ``Effektivnost biudzhetnoi politiki v Rossii v 1994-1997 godakh,'' Voprosy ekonomiki, vol. 70, no. 2 (February 1998), p. 24.

43 Organization for Economic Cooperation and Development, OECD Economic Surveys: Russian Federation 1997, p. 181.

44 Sharon LaFraniere, ``A Hotbed of Crime in Cold Siberia: In Gang-Run Coal Land, Authorities Take Cover,'' Washington Post, January 7, 1999, p. A16.

45 Daniel A. Citrin and Ashkok Kilahiri, eds., ``Policy Experiences and Issues in the Baltics, Russia, and Other Countries of the Former Soviet Union,'' IMF Occasional Paper no. 133 (Washington, D.C.: International Monetary Fund, 1995).

46 Russia's current VAT rate of 20 percent is comparable to that in other CIS countries and is only slightly higher than the European Union average of 18 percent. A broad Russian consensus favors a sharp reduction. Ironically, the IMF insists on keeping the VAT so high. The profit tax rate of 35 percent was already low by international standards and was lowered to 30 percent in

1999. The Russian maximum income tax rate of 35 percent is also not high by international standards, although it too should be reduced, since hardly anyone pays at that rate. Reducing the income tax to a flat rate of 20 percent is a common proposal, although the communists advocate higher income taxes for the rich.

At 42 percent, the payroll tax is the highest tax rate and a considerable reduction has been widely demanded. In spite of all the talk of Russian protectionism, import tariffs remain low, averaging about 14 percent. The elimination of offsets and tax exemptions for privileged companies and agriculture are more controversial issues. In any case, tax evasion will inevitably continue to flourish.

47 We take a narrow view of rents as caused through government action, primarily direct or indirect government subsidies. We consider rents as annual flows, not as stocks. We are only concerned with rents going to enterprises, leaving social expenditures aside. Considering the arbitrary tax system and collection practices, a correct tax standard can hardly be established, which makes it impossible to assess the value of tax exemptions appropriately, compelling us to disregard tax exemptions. They have probably diminished slightly over time, because the total tax revenues have fallen and tax exemptions have been strenuously opposed by reformers and the IMF. For the same reason we leave the benefits from barter and offsets aside, which have clearly increased over time. Monopoly rents tend to be estimated at 0.5-1 percent of GDP in a Western economy, and they are likely to be several times larger in Russia, but they are difficult to estimate, which forces us to ignore them. They have probably fallen over time, as regional price differentials have contracted. We also leave aside racketeering fees, which appear to have declined. We are looking at rent seeking from the cost side, while net revenues are much smaller. An official may take a bribe of $10,000 as his private gain, for example, to let somebody seize public assets worth $1 million, which is the public cost. We try to avoid double counting, although we sometimes include the financing of rents and sometimes disbursements.

48 Oil and natural gas prices were on average about one-third of the world market price in 1995, but a free market price would probably have been about two-thirds of the world market price, because of the high transportation costs. Therefore, the export rent can be assessed at about one-third of exports of oil and natural gas. In 1995 total Russian exports of oil, petroleum products, and natural gas amounted to $39.3 billion, and GDP was $357 billion (Goskomstat Rossii, Rossiiskii Statisticheskii Yezhegodnik 1997 [Moscow: Goskomstat, 1997], pp. 577, 582, 586; Brunswick Warburg, Russian Monthly, Moscow, December 1998, p. 7).

49 World Bank, Fiscal Management in Russia: A World Bank Country Study (Washington D.C.: World Bank, 1996).

50 Aleksei Lavrov, ``Fiscal Federalism and Financial Stabilization,'' Problems of Economic Transition, vol. 5 (May 1996), p. 87.

51 Daniel Treisman, ``Deciphering Russia's Federal Finance: Fiscal Appeasement in 1995 and 1996,'' Europe-Asia Studies, vol. 50, no. 5 (1998), pp. 893-906; Daniel Treisman, ``The Politics of Intergovernmental Transfers in Post-Soviet Russia,'' British Journal of Political Science, vol. 26, no. 3 (July 1996), pp. 299-335; Aleksei Lavrov, Mify i rify Rossiiskogo byudzhetnogo

federalizma (Moscow: Magistr, 1997).

52 Organization for Economic Cooperation and Development, OECD Economic Surveys:

Russian Federation 1997, p. 181.